Cloudy with a
chance of rate cuts
Tame inflation combined with increasing geopolitical risks make for challenging forecasts
Cloudy with a chance of rate cuts
Inflation data released last week emboldened those that believe rate cuts should occur this year. The producer price index (PPI) for May showed that headline inflation fell below 2 percent on a year-over-year basis while core inflation accelerated slightly to 2.3 percent on a year-over-year basis. These developments follow a general trend in recent periods: slowing in headline inflation and a reacceleration in core inflation. Yet, taken together they represent a lack of sustained pricing power on the part of producers.
Data on the consumer side also supported interest rate doves. The consumer price index (CPI) for May saw headline inflation slow to 1.8 percent year-over-year while core inflation slowed to 2 percent year-over-year. This slowing occurred despite what remains the tightest labor market in half a century (by some measures) with the greatest labor shortage ever (by other measures). As we have previously mentioned, inflation results from a complex set of forces, so ascribing the slowing in inflation to any individual factor seems problematic. But the risk now appears that inflation expectations turn weaker – consumers’ inflation expectations in the consumer sentiment survey fell to a 40-year low - becoming a bit of a self-fulfilling prophecy.
We see greater risk in slowing investment than in consumer weakness.
Retail sales silver lining
Despite the tame outlook for inflation, underlying economic momentum is slowing, but still firm. Retail sales embodies this phenomenon. Headline retail sales for May grew briskly, in line with expectations, while revised retail sales for April leapt from a decline to an increase. Of note, the component that feeds into GDP calculations showed solid results for both months, causing the outlook for second quarter GDP growth to turn brighter even as growth slows versus the first quarter. We see greater risk in slowing investment than in consumer weakness. We still believe that economic momentum is slowing as fiscal stimulus fades, but not as quickly as some believe. And we are holding to our view that economic growth, which started the year closer to 3 percent will slow throughout the year toward 2 percent. But we see little risk of recession in 2019 even though we concede that the probability of a recession occurring at some point is increasing.
Geopolitical risk complicates the forecast
Amidst such a climate, we would normally feel that many are overreacting to the slowdown. But the complicating factor remains heightened geopolitical risk. It has taken over the role of key risk to the economy (from tighter monetary policy) in 2019. Geopolitical risk appears to sit at its highest level in decades. In the past, geopolitical risk often originated in the developing part of the world. In recent periods, much of this risk emanates from the developed world, a noteworthy break from prior periods. Most prominent for the U.S. economy lie many positions of the current U.S. administration. Tariffs garner many of the headlines, but the administration has also targeted other policies. Blacklisting companies (namely from China) prevents them from purchasing vital inputs to production or merging with or acquiring U.S. companies.
Extenuating factors make this current period a particularly difficult time for forecasting and understand why so many feel unsettled.
Sanctions on countries can stymie their economies and provoke reprisals. Withdrawals from treaties and the invocation of national security in economic dealings undermines confidence and risks the loss of economic allies. Elevated geopolitical risk complicates forecasting because of the idiosyncratic and capricious nature of many of these policy decisions. While we do not agree with the “sky is falling” faction, we recognize that extenuating factors make this current period a particularly difficult time for forecasting and understand why so many feel unsettled.
Fed prominently on the radar
The Fed sits prominently on the radar with its meeting this week. While we do not expect the Fed to cut rates this week, the markets will surely put its statement and Chairman Powell’s post-meeting press conference under the microscope. Will the Fed reiterate its desire to remain “patient” when setting monetary policy? Will it signal an increased willingness to ease policy if things break the wrong way geopolitically? Will the dot-plot forecast for the fed funds rate change? Given the Fed’s recent abrupt alterations to its outlook, we are taking a cautious view of the Fed.
The futures market now expects a rate cut as soon as next month with possibly two more to come before the end of the year.
While we feel some sympathy for the Fed given the cloudy geopolitical picture, we stand by our view that their changes hurt more than they helped. The futures market now expects a rate cut as soon as next month with possibly two more to come before the end of the year. We still believe that the economy likely does not need rate cuts in 2019 (barring enough of that geopolitical risk going wrong), but we increasingly see the likelihood of that occurring. And we still view “mid-cycle” cuts as more effective in delaying recessions than preventing them. We are becoming a bit concerned that markets are putting too much faith in the Fed to ride to the rescue. The last 10 years demonstrated that monetary policy has limited impact and we still worry about how effective monetary policy could be during the next recession if interest rates sit as low (or even lower) as they sit today.
What it means for CRE
The commercial real estate (CRE) market should pay close attention to the Fed this week. With the economy still firm and fundamentals across property types holding up relatively well, the capital markets side of the CRE market takes on increasing importance to the performance of the sector. Rate hikes for this cycle almost certainly ended. If the Fed signals it could or will cut rates, the CRE market will likely view that as a positive development. But we ask the same question of the CRE market that was asked of the overall economy: are rate cuts needed? Institutional cap rates still hover at or near record-low levels across both primary and secondary markets and across virtually all major property types. Unlevered total returns for CRE have slowed, but still offer attractive relative value versus other major asset classes. At this stage of the business cycle, we see more potential harm than help to cutting rates. Without significant deterioration in the economy, which we do not see in the short term, lowering rates will raise the risk of an asset bubble including CRE. That could ultimately mean greater pain for the sector when the economy inevitably slows.
Thought of the week
Economic roles of parents have changed over time. Between 1965 and 2011 fathers increased their time spent doing housework by 2.5 times and roughly tripled time spent on childcare. During that same period mothers nearly tripled their time spent doing paid work while time spent on housework declined by almost half.