3Q 2019 Economic
Outlook: How will
While the global economic outlook is mixed, here in the U.S. many data points remain positive, especially surrounding commercial real estate.
For the first time in roughly two years, residential investment grew and positively contributed to economic growth.
How will it end?
With less than one quarter left in the year, people are wondering how it will end. With a bang? With a whimper? What about a random shock given all the lurking geopolitical risk? Through the third quarter, data indicate that things are certainly slowing down, but not abruptly. The economy is losing momentum gradually. Growth during the third quarter clocked in at 1.9% on an annualized basis, down very slightly from 2.0% during the second quarter. The underlying details looked broadly similar to how the economy performed during the second quarter, with one noteworthy exception. Personal consumption expenditures (consumption) and government consumption expenditures and gross investment (government) both positively contributed to growth during the quarter. Yet the rate of growth in both sectors declined during the quarter. Conversely gross private domestic investment (investment) and net exports of goods and services (net exports) negatively contributed to growth. But they did not impact growth as severely as they did during the second quarter. Essentially, the major sectors of the economy converged during the quarter: expanding sectors grew more slowly, contracting sectors did not contract so quickly, and the net result produced a little-changed growth rate. All of this broadly lined up with our expectations. The one noteworthy difference? Housing. For the first time in roughly two years, residential investment grew and positively contributed to economic growth. The economy will likely lose further momentum in the fourth quarter, though an outright contraction seems unlikely. We forecast economic growth for 2019 will fall into the low-2% range, down slightly from our mid-year projection, due to ongoing loss of economic momentum.
In the end, as often occurs in the economy, a battle of sentiments between businesses and consumers will determine the fate of the economy.
Hinging on the labor market
How quickly the economy slows and whether it can ultimately avoid a recession hinges on the labor market. Third quarter data showed that businesses remain concerned about ongoing trade policy uncertainty, slowing global economic growth, and increasing geopolitical risk. They reduced their investment for the second consecutive quarter, including noteworthy declines in both nonresidential structures (essentially investment in commercial properties) and equipment. The manufacturing sector of the economy is faring worse than the services because of more direct exposure to global issues. But even the services sector slowed in 2019 with business leaders feeling dour about the outlook for the economy. That contrasts with the consumer which remains upbeat amidst the tightest labor market in at least half a century (by some measures such as the unemployment rate) if not ever (by other measures such as the number of open, but unfilled jobs). With the economy creating jobs and driving wage growth, consumers feel confident in spending. If businesses continue to hire, the consumer should further boost the economy, even though we expect the impact to decline over the next year as consumption growth slows. But, if businesses’ negative feelings eventually manifest themselves in reduced hiring and not just reduced investment, then that risks a spillover into the consumer sector and a potential recession. Our base case scenario does not expect this to occur, but improbable does not equal impossible. And businesses often see and react to signs of trouble in the economy before consumers do. In the end, as often occurs in the economy, a battle of sentiments between businesses and consumers will determine the fate of the economy.
We do not expect a global recession in the near term, so the global economy should continue to support U.S. growth.
Global mixed picture
Looking outward, the global picture still looks mixed for the U.S. economy. On one hand, growth in other economies has slowed, in some cases noticeably faster than in the U.S. That is pulling down global GDP growth. China is experiencing its slowest growth rate in roughly three decades while several noteworthy economies, namely those of Germany and the U.K., have flirted with a recession this year. The ongoing trade tensions between the U.S. and China have caused some of this slowdown, but not all of it. Some of this global slowing stems from idiosyncratic issues in specific countries, be those issues Brexit, demographics, or regulatory issues. We do not expect a global recession in the near term, so the global economy should continue to support U.S. growth. But global economic growth is undoubtedly slowing and will consequently provide less support to the U.S. economy.
On the other hand, hope for a reduction in trade tensions saw some “green shoots” in recent periods. The U.S. and China have dialed back tensions and are tentatively moving toward a phased process of reaching trade agreements. We still anticipate little meaningful progress, even as negotiations progress, and expect any agreement to be piecemeal. At this juncture, there exists more hope of trade improvements than actual improvements. And if the two sides cannot conclude a phase 1 trade deal, or at least make more meaningful progress, the threat of increased tariffs on Chinese consumer imports on December 15th remains on the table. Implementation of those tariffs could undo most of, if not all, the resurgence in positive feelings around trade, and potentially worsen the outlook among business leaders. But, for now, hope springs eternal that some progress can occur before that deadline.
Where to now for the Fed?
The potential for contagion between the business sector and consumers, coupled with a deteriorating global picture and below-target inflation motivated the Fed to embark on a path of monetary loosening. The Fed cut rates three times thus far in 2019, 25 basis points (bps) each. The Fed argued that even though the current economic picture seemed fine – a strong labor market, economic growth near potential, etc. – that future risks justified rate cuts. We remain somewhat skeptical of this view. As we have stated many times, cutting rates does nothing to directly address the two main issues that the U.S. economy faces: trade policy uncertainty and slowing global growth. And cutting rates lessens the Fed’s ability to stave off a recession or a period of slower growth in the future now that the fed funds rate sits in the 150-175 bps range.
For a variety of complicated reasons, inflation remains subdued, falling below the Fed’s target rate of 2%. Surely the Fed is hoping that cutting rates helps to move inflation closer to that target level. But we remain skeptical that low interest rates alone will spur inflation given all the other forces that now weigh on pricing in the economy and the inability of historically-low interest rates to push up inflation during the current business cycle. One area where it appears that cutting rates is having an impact is the residential housing market. Residential investment grew during the third quarter for the first time in 7 quarters. Construction of both single- and multifamily units received a bit of a boost with rate cuts. The resurgence in residential investment did not offset ongoing issues in corporate investment and how long the boost will last remains uncertain.
Rate cuts, coupled with a somewhat improved economic outlook, caused the yield curve to steepen and normalize after being inverted through the summer. That does not mean the economy has avoided a recession – this kind of steepening typically occurs when central banks cut rates, even in periods leading up to recessions. But it certainly produces a result the Fed will like. For now, it seems like Fed will pause rate hikes through the end of the year and then reassess in 2020.
Implications for CRE
Commercial real estate (CRE) should close out the year in fine fashion. Asking rents continue to grow across all major property types while vacancy rates trend flat to slightly down. The rate of change in market fundamentals has clearly slowed, but we expected as much given the length of the expansion. Our proprietary forecast model continues to see market fundamentals holding up well, predominantly because of restraint in new supply growth. The current CRE cycle looks more like the previous cycle, with restrained supply growth limiting internal market imbalances. That differs from the prior cycles in the 1980s and 1990s which exhibited widespread overbuilding and localized overbuilding, respectively. With supply largely in check, any disruption will likely come from the demand side of the market. And if the labor market remains stout, demand should remain stable if not accelerating. That bodes well for stability over the near term.
On the capital markets side of CRE, things also look relatively stable. Cap rates have increased marginally, but recent rate cuts could ease some of that pressure since they are unlikely to spur much improvement in fundamentals and consequently net operating income (NOI) growth. Valuations remain rich, but that has not impeded transaction volume which has exceeded expectations this year. While some concern about elevated valuations remains, the asset class is not experiencing a bubble. Investors rightly wonder about the length of the business cycle and how much they should pay for CRE assets, which is reflected in the significant amounts of “dry powder” sitting on the sidelines. Nonetheless, CRE yields still compare quite favorably to other classes and CRE still offers attractive relative value. That should keep interest in the asset class high, particularly among institutional investors.
Risks and closing thoughts
Details on the economy seemed to brighten somewhat during the third quarter with a number of data points exceeding expectations. Yet the downtrend in growth has not reversed. We still foresee the U.S. economy continuing to slow into the fourth quarter and that loss off momentum will likely carry into the new year. We anticipate the current divergences persisting – consumption and government spending should continue to support growth while investment and net exports struggle. While we expect a relatively healthy holiday shopping season, we foresee that consumption will slow which will cause economic growth to fall toward the stall rate in the coming quarters. Will that influence companies’ behaviors and reduce demand for labor, creating a vicious cycle? That remains to be seen, but we expect that job growth will continue slowing as we exhaust the supply of qualified labor. That will also limit economic growth. Ultimately, slower growth seems more likely than an outright contraction. We remind everyone to keep a close eye on the labor market. If it remains strong, severe downside risks should not materialize. If it weakens, due to any of the dynamics that we mentioned in this report, then all bets are off.
Note: We will not publish Economic Insights next week. Happy Thanksgiving!