Geopolitical risk
dominates in early 2020

Geopolitical risk dominated headlines and attention in early 2020. Last year we thought geopolitical risk would reach its highest point in decades. In that regard, 2019 acquitted itself quite well. Yet 2020 seems poised to top it. Internationally, the Wuhan coronavirus sparked fear around the world, including in the U.S. But it reflects something important beyond important health concerns.

China is quickly becoming the largest economy in the world, but it poses a higher risk profile as a still-developing, middle-income country vis-à-vis other major developed economies such as the U.S., Japan, and Germany.  The risk of the coronavirus turning into a pandemic from any of those places rests far lower because of better health policy, government transparency, etc. With the world now more interconnected with China than ever, issues like this ripple through the global economy in a way they would not just a decade or two ago. The responses to the crisis – quarantines, shutting down stores and factories, travel limitations or bans -- will likely produce an impact, primarily on China’s economy and secondarily on the global economy and the U.S. economy. Much of this should only temporarily hit economies because it concerns the movement of people, not goods. That will likely persist, even after the cause becomes resolved, a phenomenon in economics known as hysteresis. Ultimately, much of any slowdown will reverse, but some will not. Some business and leisure trips will never occur. This outbreak is occurring during the lunar new year when many people (particularly in China) travel. And some business meetings will convert into conference calls and web presentations in lieu of face-to-face meetings. For now, the situation seems more temporary than permanent disruption, but the situation remains highly idiosyncratic and should increase market volatility. Other risks, particularly the fraught U.S.-China relationship, could prove more problematic. 

Domestically, this week should end the impeachment proceedings while election season kicks off with the Iowa caucuses. Based on a review of historical data (albeit limited) we expect impeachment itself should produce little to no impact on the economy. The election itself should prove more complex. For now, it looks far too early to make any prognostications about winners and potential policies. But the uncertainty surrounding the outcome of this year’s election and the policy differences contingent upon that outcome could cause businesses and consumers to restrain spending until they have more transparency. That remains one of the key reasons why we are forecasting decelerating GDP growth in the U.S. this year.

As we anticipated, the Fed left rates unchanged last week. The Fed came away looking dovish with commitments to keep using its balance sheet as needed and continuing to aim for its inflation target rate of 2%. While the futures market now expects a 25 basis points (bps) rate cut in April, we remain unsure of this. The Fed is processing combinations of good news (e.g. the Phase One trade agreement) and bad news (e.g. coronavirus). And the Fed’s preferred measure of inflation, the core personal consumption expenditures (PCE) index shows inflation at 1.6% year over year, below target. Other measures of inflation remain at or above the Fed’s target rate but show no sign of inflation breaking out. We could see the Fed going either way but think more data should provide clearer guidance in the coming months.

Meanwhile the 3-month/10-year yield curve inverted again for the first time since October. The combination of fears concerning coronavirus caused investors to flee into safer assets while the Fed signaled dovishness. We do not take this inversion explicitly as a harbinger of recession but remind everyone that we remain within the time period for last year’s inversion’s signal of recession.  Do inverted yield curves still predict recessions? We will find out over the next 12-18 months. Stay tuned. 

U.S. real GDP grew by 2.1% annualized in the fourth quarter of 2019, consistently in line with growth rates from the second and third quarters. The data unfolded largely as we anticipated. Investors continued to pull back on spending amidst ongoing geopolitical and policy uncertainty. Spending on non-residential structures continued to decline at a brisk pace and investment in equipment continued to slide. Consumers continued to spend but at a declining rate. And net exports positively helped. But here a warning signal flashed. A temporary collapse in imports drove the improvement in net exports which in turn contributed roughly 70% of growth. That seems unlikely to repeat while the statuses of business and consumer spending seem more permanent. That underlying momentum drives our thesis that economic growth should slow in the U.S. in 2020. On a positive note, residential investment grew for the second consecutive quarter, the first time since early 2017. Residential investment continues to receive a shot in the arm from rate cuts. 

The employment situation for January should show continued but slowing job gains. The unemployment rate should hold steady while wage growth should see little movement. We anticipate a rebound in the ISM manufacturing index, boosted by the Phase One trade deal. The ISM nonmanufacturing index should remain healthier, showing a services sector that continued growing. Together, they reflect an economy that continues to grow, but at a slowing pace. 

For commercial real estate (CRE), geopolitical risk is becoming a feature of the economic landscape, not a bug. The sector thus far has sloughed it off well with fundamental and capital market performance driven by economic factors. Our view on that has not yet changed. Hotel demand and travel-oriented retail could take a small hit, though we don’t anticipate significant fallout in the U.S. and any impact should largely reverse over time. Other sectors should see little direct impact. Uncertainty surrounding the outcome of the election should produce a marginal impact on spending, contributing to the slowdown in GDP growth this year. That should produce somewhat greater consequence for CRE, but nothing significant. In sum, CRE should continue to largely ignore geopolitical concerns. The pullback in nonresidential construction could reduce the development pipeline in the coming quarters. Although development remains in check this cycle, reducing it further could put marginal upward pressure on the pricing of existing assets.  

Almost four years after voting in favor of leaving the European Union, the United Kingdom completed Brexit on Friday. The sides now have a transition period of 11 months to reach a trade agreement before the end of year.