Research

Economic Insights:
A complex system

The government’s spending and so are consumers. Businesses are not. And the construction pipeline is still robust, for now.

July 29, 2019

Slowing global economic growth, coupled with uncertainty over trade tensions, likely restrained businesses and their investment appetite despite already-low interest rates and favorable short-term tax treatment

A complex system

Real GDP growth performed in line with our expectations in the second quarter. The overall growth rate declined, but growth continues to exceed long-run potential. We anticipated that the economy would receive a boost from fiscal stimulus in 2018 of roughly 40-50 basis points (bps), which would then fade over time. The GDP data reaffirms this view. 

Things get trickier when looking at the details. First the good news: the U.S. consumer continues to spend, driving the demand side of the economy. Consumption grew at a 4.3% annualized rate, the strongest since the fourth quarter of 2017. Consumers appear to have confidence in the labor market and the economic outlook and continue to spend. Also on the positive side of the ledger, government spending increased by 5% on an annualized basis, its fastest growth rate since the second quarter of 2009 when the federal government began spending fiscal stimulus funds in an attempt to stabilize the economy. 

Now for the not-so-good news: private domestic investment contracted during the quarter. Fixed business (nonresidential) investment spending declined slightly after a growth spurt over the prior few quarters. Investment in physical structures led the way, declining by double digits. Slowing global economic growth, coupled with uncertainty over trade tensions, likely restrained businesses and their investment appetite despite already-low interest rates and favorable short-term tax treatment. Also, on the negative front, exports of both goods and services restrained growth.

Subdued Business Investment

The Fed appears to think that things could get significantly worse and will attempt to inoculate the economy by cutting rates (likely by 25 bps) and ending quantitative tightening (QT) this week instead of in September

Solving the equations

This gulf between consumer and business outlooks dominates the minds of economic number crunchers, including those at the Fed. Right now, the situation seems fine, even with business investment pulling back slightly. The concern (and rightly so) lies with the future. If business investment continues to contract further, it could ultimately lead to job losses and potentially a recession. How much is uncertainty surrounding trade impacting business sentiment and how much worse could it get? 

The Fed appears to think that things could get significantly worse and will attempt to inoculate the economy by cutting rates (likely by 25 bps) and ending quantitative tightening (QT) this week instead of in September. How much worse? The Fed feels compelled to cut rates despite the labor market remaining strong, the economy continuing to grow, the stock market hovering near all-time highs, tax cuts and deregulation supporting businesses, and interest rates still lurking at very low levels. Inflation remains relatively low, but that is not primarily driving the Fed’s decision. Its decision ultimately boils down to one key factor: the perceived risk to the economic outlook caused by weakened business sentiment stemming from trade policy uncertainty. We say that because even the global slowdown around the world is tied to U.S. trade policies. Do 25 bps of a rate cut and calling the game two months early on QT fix that?

We will address the implications of a rate cut next week. For now, we note for context that during the current expansion economic growth contracted during three quarters and the economy did not end up in a recession. In late 2015 into early 2016 business investment fell into a “recession” with two consecutive quarters of negative growth, but the economy did not fall into a recession. Yet at this juncture, with the economy on firmer footing than in any of those periods, the Fed’s concerns sit at elevated levels.

Fiscal policy boost

Another variable to add to the equation – Congress and the president agreed to a budget deal last week. The two-year deal will prevent a default on government debt while not only preventing a contractive fiscal policy (which would have come from a cut in discretionary spending) but also bringing about an expansive fiscal policy with discretionary spending increasing by $324 billion over the next two fiscal years. The deal also suspended the debt limit for two years. This agreement should provide a small boost to the economy. 

What else we are watching this week

The Fed will overshadow a torrent of data released this week. Nonetheless, we highlight a few things to watch. Income and spending data for June should show a slight year-over-year increase in core prices, demonstrating that inflation is not collapsing. Consumer confidence for July likely rebounded versus June. The employment cost index likely will show that year-over-year compensation growth held steady in the second quarter. And the employment situation release should show payroll growth declining, with the unemployment rate and the year-over-year change in hourly earnings both holding steady. 

What it means for CRE

For commercial real estate (CRE) the decline in nonresidential structures during the second quarter does not alter our view of the construction pipeline – still robust in 2019 but moderating over time. Most major property types are experiencing construction volumes at or at least near cyclical highs. Retail remains the notable exception, with construction activity still muted as the sector undergoes an important structural transformation. Retail is shifting toward experiential and mixed use and away from traditional business models (such as a large department-store anchor complemented by smaller in-line tenants). That will focus construction activity largely on modifying existing centers, rather than building new ones. Yet, the market is not building excessively for the other property sectors, a hallmark of previous downtowns, despite cheap and plentiful debt capital. That is helping to keep the supply demand dynamic relatively healthy, even at this relatively late stage of the business cycle. The outlook for CRE capital markets largely depends on the Fed’s next move, which we will also discuss next week.

Thought of the week

More dogs than children live in San Francisco.

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