Economic Insights:
A risk of contagion

While many major U.S. office markets are currently experiencing robust demand the data shows there may be trouble ahead. Which ones are poised to outperform?

October 09, 2019

The index now signals two consecutive months of contraction and is nearing a level typically seen during economy-wide recessions.

A risk of contagion

While the economy is undoubtedly slowing, the damage thus far seemed confined to the manufacturing sector. But is that slowdown finally spilling over into the services sector of the economy? Data released last week might just indicate this.  The ISM manufacturing index for September declined more than anticipated to its lowest level since June 2009 (when the Great Recession was just ending). The index now signals two consecutive months of contraction and is nearing a level typically seen during economy-wide recessions. The index is declining under the weight of tariffs, ongoing trade policy uncertainty, and slowing economic growth, all of which are connected. Railroad data closely supports the ISM manufacturing data, with U.S. rail carloads declining for the last three quarters and experiencing their largest drop in three years during the third quarter.

Signs of concern recently emerged beyond the manufacturing sector. The ISM nonmanufacturing index for September also surprised on the downside, sliding to its lowest level since August 2016. At that level, the index still signals growth, but at a slower pace than in recent years. It appears that the factors holding back the manufacturing sector are at a minimum turning the sentiment of business leaders in the services sector more negative. The index cited concerns over tariffs, labor resources, and the direction of the economy. The services sector constitutes most of the U.S. economy and any sign of faltering would strengthen the case for a recession.

Job creation of 136,000 net new jobs fell below expectations and reflects the continued trend in slowing job growth evident throughout 2019

What does the labor market say?

While definitive evidence of such faltering does not currently exist, the data from the employment situation release for September gives us some concern. Job creation of 136,000 net new jobs fell below expectations and reflects the continued trend in slowing job growth evident throughout 2019. Private sector payroll growth totaled just 114,000 jobs. Up to this juncture, the slowing in payroll growth stemmed primarily from a lack of qualified supply – we have often written in the past about the significant labor shortage in the U.S. and lengths that employers have gone to in order to hire workers. These include: hiring workers that cannot pass a drug test, offering to pay for workers drug treatment programs, and recruiting at prisons for inmates about to be released. But the decline in the ISM nonmanufacturing index’s employment sub-index makes us wonder if declining demand is also starting to impact job creation. The employment sub-index fell to a level just above neutral, a level indicating very slight growth but precariously near a level that could indicate job losses. In recent weeks some noteworthy services companies have either announced layoffs or have warned that layoffs might be forthcoming.

The other data points from the report do not show immediate distress. The unemployment rate fell to 3.5%, a new half-century low. Weekly unemployment claims show no apparent uptick yet either. And hourly earnings data showed slowing, but also had encouraging components. Production and non-supervisory workers’ wage growth remained elevated at 3.5% year-over-year (which means that supervisory wages declined to 1.4% year-over-year). And continuing a trend from recent periods, workers with the lowest wages continued to outpace their more highly-paid counterparts, buoyed not only by a tight labor market but also by state- and city-level minimum wage increases. This growth stemmed from minimum wage increases in populous or economically vibrant geographical areas such as California, New York, New Jersey, Florida, Ohio, Massachusetts, and Washington, DC. 

Trade talks follow more tariffs 

Trade talks between the U.S. and China resume this week, though expectations should remain modest. China looks unlikely to want a broad agreement, which dovetails with our view that limited agreements remain far more likely than a grand détente. These negotiations follow the World Trade Organization’s ruling on European Union subsidies for Airbus last week, in favor of the U.S., a case stretching back more than a decade. The ruling permits the U.S. to quickly implement tariffs on $7.5 billion of European exports to the U.S., including aircraft and food products. 

What it means for CRE

For commercial real estate (CRE) a services sector contraction could spell trouble, particularly for the office market. But we have not yet seen any indication of this in the demand data. Office demand remains robust, especially in key office markets such as New York, San Francisco, Silicon Valley, Los Angeles, Phoenix, and Seattle. How quickly demand slows along with the economy will dictate the near-term fortunes of the office market. For now, we anticipate only modest slowing. Other property types would not come through a services contraction unscathed, especially if job losses ensue. Retail, hotel, and industrial could become impacted if consumers get defensive (as they often do amidst contractions) but third-quarter data for those property types show no real sign of demand weakening. The multihousing sector would not avoid the fallout from services contraction either but should fare relatively well given the scarcity of housing supply relative to demand, particularly among the more affordable segments of the housing market.

What we are watching this week

Inflation data from the consumer price index (CPI) and producer price index (PPI) should both show modest pressures in September. Jobless claims for last week could inch higher, due in part to the strike at GM. And consumer sentiment looks set to decline, potentially back near the nearly 3-year low set in August.

Thought of the week

Workers in hot-desking offices take about 18 minutes to find a seat. That translates into roughly 66 hours per year of lost output versus workers with assigned seating.

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