Economic Insights:
2Q 2019 Economic

The second quarter of 2019 was filled with dichotomies—inverted yield curves and strong consumer demand—leaving economists with quite the conundrum.

August 20, 2019

Time will tell

Is the clock ticking for the U.S. economic expansion? Many are posing that question now that the current expansion has surpassed the dot-com expansion to become the longest on record and recession indicators started to flash warnings. Data in the second quarter remained solid but showed some signs of potential trouble. Overall economic growth exceeded expectations, but growth is clearly slowing as we anticipated. Real GDP grew at an annualized rate of 2.1%, down from 3.1% in the first quarter. While the overall results showed solid growth, the details presented some concerns. The domestically oriented parts of the economy performed well, with consumer spending, and to a lesser extent government spending, driving growth. But the parts of the economy either directly exposed to, or indirectly influenced by international conditions struggled. Private investment, particularly in non-residential structures, declined while exports of goods and services both dropped off considerably. The divergence stems largely from trade policy implemented by the current administration. Companies are growing increasingly cautious about making investments and tying up large sums of capital with trade policy uncertainty looming. And exports to the rest of the world took a hit as countries got caught up (directly or indirectly) in trade restrictions and tensions, reducing their appetite for U.S. goods and services. We still believe that underlying momentum should keep the economy on track to grow in the mid-2% range in 2019, with little probability of a recession this year. But downside risks are building and to many it feels like the sands are running out of the hourglass.

Consumers still clocking in

Consumption remains strong. Consumers remain upbeat (though recently less so) thanks to an incredibly tight labor market, relatively healthy wage growth, and strong performance out of asset markets, including the stock market and the residential real estate market. Consumer spending continues to outperform and is accelerating in recent periods. Thus far consumers remain insulated from the impact of the trade war and that should persist through most of the year. Because consumption represents 70% of demand, the U.S. economy can weather slowdowns in private investment and exports. In 2015-2016, private investment fell into a “recession” due to the declining oil price. Yet the overall economy did not contract, largely because of the rude health of consumers. With private investment recently faltering and trade policy imperiling exports, the fate of the economy will likely rest in consumers’ hands over the next 12-18 months. 

Can consumers stave off a recession

Policy concerns abound, but not what many expected

During the second quarter, economic policy has played an important role in 2019, but not in exactly the way many were anticipating. Through most of 2018 and early 2019, concern centered on monetary policy – specifically, the chance that the Fed could raise interest rates too much too soon and jeopardize the expansion. By the fourth quarter of 2018 publicly-traded markets reacted as if that were true. And by March parts of the yield started inverting. The 10-year/3-month Treasury curve remains inverted since May while the 10-year/2-year Treasury curve just recently inverted. Though imperfect and imprecise, yield curves remain a solid recessionary indicator. That caused the Fed to soften its tone and signal that it would start cutting rates. The Fed cut rates by 25 basis points (bps) in July and expressed that it could cut rates further if warranted by the data.

While the Fed was attempting to allay fears concerning monetary policy, trade policy became a more pressing concern with the U.S. ramping up the threat of further trade restrictions, notably tariffs, amidst stalled negotiations with China. Trade policy thus supplanted monetary policy as the key policy to watch in 2019. And concern over trade policy is slowly manifesting in the hard data. Private investment in the U.S. declined during the second quarter, with many businesses citing uncertainty over trade policy while global trade is suffering. And China is experiencing its slowest economic growth in 27 years.

Yet in the modern interconnected global economy, many countries got caught in the fallout between the U.S. and China, particularly countries whose economies more heavily depend on international trade. Declining exports pushed Germany’s economy, the fourth largest in the world, into a contraction during the second quarter. But Germany has company including some key global economies – the U.K., Italy, Brazil, Mexico, Singapore, and South Korea all contracted at some point during the first half of the year. Growth around the globe was slowing before the trade war, but it is almost certainly exacerbating the situation.

The Fed to the rescue? 

With parts of the economy showing signs of distress and the yield curve inversions, many are hoping that central bankers will ride to the rescue. Many believe that if the Fed cuts rates, ends quantitative tightening (QT), and implements further measures as needed that it can help stave off or blunt the impact of a recession. And they argue for cutting rates now because of the lag between the time when rates are cut and they begin impacting the economy. We remain skeptical of cutting rates now. As we have previously stated, most of the disruptions (especially the contraction in private investment) stem from trade policy and monetary policy does not address trade policy concerns. Cutting rates simply makes the cost of debt capital cheaper. But companies are not complaining that capital costs too much or has become too hard to obtain. Consumers continue to spend at a healthy rate, using significant levels of debt. And balance sheets across the economy (including corporate balance sheets) hold record-high levels of debt.

What is the yield curve telling us?

The Fed could fall into the trap of Maslow’s hammer – essentially using the only tools they have, even if those tools do not fix the problem. We believe in the power of cutting interest rates and we believe that the yield curve (in concert with other indicators) remains a powerful signal of recession risk. But we think that markets could place too much faith in the Fed to address issues that I cannot. If we thought cutting rates could fix the underlying problems we would be more enthusiastic about them. But the Fed possesses limited firepower, especially with interest rates still so low. If it uses that ammunition now to little or no avail then the economy could find itself in a longer, potentially deeper recession. The obvious remedies? End the trade war, or have foreign countries stimulate their own economies. But of course, the Fed cannot take either of these actions

Cutting rates also holds risk, particularly if rate cuts do not (as we believe) noticeably stimulate the economy. Cutting rates has a first-order effect of causing asset values to increase because of the decline in discount rates. But historically, as a second-order effect, markets sometimes overshoot, and prices rise too much, potentially resulting in an asset bubble where prices exceed intrinsic value. This risk becomes heightened if rising rates do not positively impact the economy and asset fundamentals. And declining rates incentivize the use of debt and risk taking which could make the next downturn worse.

Implications for CRE

For commercial real estate (CRE) we see no reason to deviate from our view that space market fundamentals should remain healthy this year. Retail and multifamily vacancy rates have increased, but not substantially, while office and industrial vacancy rates have held steady. Asking rents across the major property types continue to grow, even if the pace of growth has slowed in recent years. Unlike the last cycle, new construction remains muted. Despite robust deliveries and pipeline of new projects, only pockets of overbuilding in select submarkets across the country exist. Net absorption has held up well and any problems with demand tend to stem from factors specific to individual properties or property types, not from a systematic pullback in demand for space. We expect little change to the trajectory of fundamentals over the next 12-18 months. Vacancy rates should hold flat or increase slightly while asking rents continue to increase at a decelerating rate. We do not anticipate that cutting interest rates will ultimately translate into a second wind for CRE demand. We caution against expecting a change in the trends in vacancy rates or rents explicitly due to monetary policy. On the capital markets side, any upward pressure on cap rates that was building due to rising rates and gradually slowing fundamentals should dissipate. Lower rates could provide a fillip to the CRE debt and markets by encouraging borrowers to take on greater amounts of debt and potentially fueling transaction volume. The decline in interest rates should produce a decline in discount rates and a corresponding increase in valuations. Those two effects could, of course, reinforce each other. Thus far, CRE does not appear overvalued, with spreads relative to other asset classes remaining healthy. If anything, CRE continues to offer attractive relative value versus other competitive asset classes. But prices remain rich and cap rates remain low. When coupled with little change in CRE fundamentals, we reiterate our concern over future prices at this relatively late stage of the cycle. If looser monetary policy stimulates capital markets without providing a boost to fundamentals, that could present a situation that could foment an asset bubble. Investors will need to remain vigilant and avoid complacency.

Risks and closing thoughts

Clearly concern about the outlook for the economy increased during the last quarter. The U.S. and global economies were already cooling without being doused by the cold water of a trade war. While trade looked almost certainly to take a hit, the decline in private investment raises a concern because recent tax legislation was designed to propel investment. If favorable tax treatment coupled with still-low interest rates cannot overcome trade policy concerns, it speaks volumes. Trade policy quickly changes from a minor concern to a serious concern on the part of U.S. businesses, usurping higher interest rates as the key risk for economic growth.

We share the concern about private investment. If companies pull back on investing it lowers demand in the economy and increases the risk that companies pull back on hiring or reduce payrolls for employees involved in this segment of the economy. That causes those consumers to retrench and their pullback in spending further reduces demand which could lead to further layoffs, loss of confidence, etc. That cycle continues until cutting stops and spending stabilizes, often helping by monetary and fiscal policy intervention. Higher interest rates have typically caused that vicious cycle, but in this case trade policy could produce a similar result. That dynamic produces a more typical post-war contraction, unlike the asset-bubble recessions of the last couple of decades such as the Savings and Loan Crisis, the Dot-Com Bubble, and the real estate-centered Great Recession.

Should we be counting down? We still forecast continued growth in the U.S. economy in 2019. Our proprietary model sees little risk of recession in 2019 and somewhat higher risk of one in the first half of 2020. But risks are building, concentrated in late 2020 into 2021. We are not predicting a recession, but we (and our model) clearly see the increased risks in recent periods. So, what to watch for? We will keep a close eye on private investment and hiring associated with capital investments. Trouble in the labor market will almost certainly accompany any serious deterioration in the economy. High-frequency metrics such as weekly unemployment claims and the monthly employment situation should provide clues as to where we are headed, particularly if parts of the yield curve remain inverted. As a social science, economics contains a large psychological component with both companies and consumers. For now, things seem optimistic, but as we have seen in the past, the time it takes to switch from optimism to pessimism can be very short. And the time it takes to switch from expansion to recession? Could be as short as two quarters.

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