Economic Insights: Economic plot twist
While the global economy may be slowing, growth in the U.S. continues to outperform the rest, surprising many by exceeding expectations
Recent months have brought many stories with surprise endings, and the economy is one of them. Growth in the first quarter surprised on the upside, registering 3.2 percent on an annualized basis and exceeding all expectations. This outcome seemed highly unlikely, especially with the weakness the economy exhibited to start the year. Concerns began to surface amid signs that the global economy was slowing. While those fears were justified, a deeper dive in the global data revealed that the global slowdown largely centered on the manufacturing sector, not the service sector, which drives the U.S. economy. The first quarter performance reflects this — while consumption of goods detracted from growth, consumption of services contributed to growth. But the outperformance itself stemmed from international trade and inventories, two unusual suspects that contributed roughly half of all growth. Other components of growth behaved largely as anticipated. Trade and inventories likely will not repeat this performance, particularly because inventories tend to decrease before they are built back up. That could indicate some slowing in future quarters, which would mark a reversal from recent calendar years.
Despite its outperformance, the economy is tracking in line with our general expectations. We believed that the economy would begin 2019 growing at a roughly 3 percent year-over-year pace and slow toward 2 percent near the end of the year as fiscal stimulus fades. At 3.2 percent year-over-year in the first quarter, with some slowing likely ahead for the reasons mentioned above, we are sticking to our forecast. Yet relative to the global economy, the period of convergence in growth that was spotted in 2017 appears to have ended. Once again, the U.S. economy is diverging from the global economy, certainly the developed nations. As major industrial economies around the world are slowing faster than the U.S., the U.S. economy once again emerges as the outlier among developed nations.
We were right — Fed clearly on hold
As we asserted last week, the combination of tepid inflation coupled with continued economic growth will keep the Fed on hold for a while. That prediction looks even more correct after seeing the first quarter data. Core inflation, measured by the personal consumption expenditures (PCE) index, declined to 1.7 percent year-over-year. With inflation slightly slipping in the face of growth, monetary policy should change little over the coming quarters, barring some sort of idiosyncratic shock. The Fed will need to see more pronounced strength or weakness before moving on rates. Growth looks too strong to cut interest rates while inflation looks too weak to raise interest rates. This presents a new form of the Goldilocks economy. But it does not mean that the market will not take it upon itself to adjust rates. In recent days the effective fed funds rate has moved up near the top of the Fed’s target range which potentially could force the Fed’s hand and lead it to reduce the interest on excess reserves (IOER). IOER helps the Fed set the target rate. If the Fed cuts this rate, the market could view it as easing even if it is just a technical adjustment. But for now, inflation still looks dead until something brings it back. Maybe a tight labor market can do the trick, but that prospect now seems more distant despite continued strength.
Consumers still feel confident against a backdrop of ongoing economic growth, a tight labor market, and rising wages.
What else happened last week
Initial unemployment claims for the week ending April 20 jumped by a relatively large amount after hovering near half-century lows. While that looks like an anomaly, unemployment (both claims and the rates) will take on increased importance over the next year. Consumer sentiment for April ticked up from its preliminary monthly reading but nudged down slightly versus March. Consumers still feel confident against a backdrop of ongoing economic growth, a tight labor market, and rising wages. Existing and new home sales for March diverged. Existing home sales declined while new home sales increased.
What it means for CRE
For commercial real estate (CRE) we believe that the environment still looks favorable in the short term. Continued economic growth should support demand across property types. Cap rates should hold steady with growth supporting investor appetite and interest rates on hold for now. Construction could get a shot in the arm, but we only see this occurring in select markets that can support new inventory. We do not see this as a widespread occurrence. The potential for an asset bubble, including CRE, becomes a greater possibility as these conditions — growth plus low interest rates — persist, as occurred during the previous two cycles. We will explore this topic in-depth in the coming weeks, but for now, we want to place that possibility on the radar screen. Until now, we did not view that risk as significant. But it appears to be rising once again.
What we are watching this week
We expect income growth for March to come in below expectations while consumption exceeds expectations. This reflects our view that fiscal stimulus is fading over time. Core PCE for March should fall below expectations as inflation keeps ebbing. The employment cost index (ECI) for first quarter should show continued wage gains, even if the year-over-year pace pulls back slightly versus fourth quarter 2018. The ISM Manufacturing and Nonmanufacturing indexes should change little with the manufacturing index likely to pull back slightly while the nonmanufacturing index ticking up a bit. The employment situation for April should show continued strong job gains near 190,000 with wage gains likely to keep the year-over-year rate little changed. We also anticipate little to no change in the unemployment rate.
Thought of the week
People who work 50 or more hours per week earn roughly 8 percent more per hour than people who work 35 to 49 hours per week.