Economic Insights: Expectations Met
The data doesn’t lie and our eyes didn’t deceive us—growth for 2018 was exactly as we expected. What will 2019 bring and how will CRE fare?
In Line with Expectations, Growth Moderates
As we anticipated, economic growth in the U.S. is slowing. During 2018 annualized growth decelerated for two consecutive quarters: from 4.2 percent in the second quarter, to 3.4 percent in the third quarter, to 2.6 percent in the fourth quarter. The impact of expansionary fiscal policy via tax cuts and spending increases, which predictably boosted the economy in the middle of 2018, is fading over time. As global economic growth slows, so does demand for exports. And financial conditions remain somewhat tighter and more restrictive than toward the middle of 2018. The combined force of these factors is pulling back on growth. Nonetheless, growth for 2018 clocked in 2.9 percent, in line with our expectations. And 2018 matched 2015 with the strongest growth during the current expansion.
Fourth quarter’s growth clocked in a bit below our expectations. Fixed business investment drove economic growth, the first sign that the tax legislation passed in late 2017 had some impact on business behavior. Through the third quarter, fixed investment grew at the same rate as 2017. But fourth’s quarter’s spurt pushed investment growth for 2018 ahead of 2017’s pace by roughly 90 basis points. While that still falls far short of the growth rates from earlier this decade, and we do not yet see a trend, fourth quarter investment growth could presage greater investment to come. For most of 2018 the corporate tax cut windfall fell into share buybacks and dividend increases which do not boost GDP directly. Inventories grew during the fourth quarter, though that could become a constraint on growth in future periods as they are unwound. In addition to business investment, consumer spending supported growth in the fourth quarter, though at a slower pace than previous quarters. Retail sales during the December portion of the holiday shopping season came in well below expectations. Government spending provided a small positive boost to growth. On the negative side of the ledger, net exports once again provided a drag on economic growth, but not as large as feared (though the ongoing trade disputes slightly restrain growth). Residential investment also disappointed, pulling down growth. For 2018, growth drivers mirrored fourth’s quarter’s performance: consumption and fixed investment drove growth with slight support from government spending while net exports and residential investment slightly restrained growth.
Turning toward our forecast, our views remain unchanged. We continue to foresee the impact from fiscal stimulus waning over time, likely running its course by the end of 2019. Consumption and business investment should remain the key drivers of growth, possibly switching places if consumption continues to slow and investment continues to accelerate. Economic growth is slowing around the world which, coupled with the uncertainty of trade restrictions, should modestly pull back on GDP growth. Government spending looks like a relative nonfactor in near term. For 2019, we continue to see GDP growth slowing toward the mid-2-percent range, with further slowing toward 2 percent in 2020. Although recession risks are increasing, the probability of a recession remains relatively low in 2019. Risks of a recession should escalate toward the latter half of 2020.
For 2019, we continue to see GDP growth slowing toward the mid-2-percent range, with further slowing toward 2 percent in 2020.
For commercial real estate (CRE) we do not foresee significant deterioration in space market fundamentals this year. Generally, net absorption is slowing while relatively modest construction volumes are keeping vacancy rates relatively stable. We foresee some upward pressure on vacancy rates in a greater number of markets than in 2018, but that trend does not seem universal yet. Construction volumes are declining slightly across a number of markets. Those supply/demand dynamics continue to produce positive asking rent growth, but the rate of growth is already decelerating across several markets. That does not surprise us at this relatively late stage of the business cycle, but market participants should take note that the environment could turn more challenging this year. CRE capital markets have provided a bit of an upside surprise. Transaction volumes for 2018 exceeded expectations. despite most markets maintaining rather lofty prices. We do not expect a repeat surprise performance on volume this year, though pricing should remain relatively stable with the Fed currently on hold for interest rate increases.
Our proprietary forecast model continues to reflect our outlook for the economy over the next few years. Vacancy rates should continue to drift slightly higher while rent growth slows down. Even if the economy skirts a technical recession over the next few years, growth is slowing and that will filter through to market fundamentals and pricing. On the capital markets side, we foresee relatively flat cap rates in the near term, trending up over the forecast horizon of the next few years.
Can anything drive inflation higher?
Inflation trended higher on a gradual basis, in line with our forecast. All the major price indexes are showing inflation near or above the Fed’s target rate of 2 percent. Despite the fiscal stimulus prices did not rise in a manner that signaled any sort of economic overheating. But inflation came under pressure from a near-continually tightening labor market. Net monthly job gains averaged roughly 223,000 in 2018, the best performance since 2015. Although only 4 percent of businesses surveyed said that they increased hiring because of the Tax Cuts and Jobs Act, rising demand for goods and services pushed firms to hire more workers. In the process both the U-3 headline unemployment rate and weekly initial unemployment claims reached half-decade low levels. As labor became increasingly scarce, open positions reached a record high of roughly 7.3 million in December, and wage growth began to accelerate. By the end of 2018, year-over-year wage growth reached 3.3 percent on a nominal basis, the cyclical high during the current recovery, up 60 basis points during year. An annual leap that large last occurred in 2008. On a real basis, year-over-year wage growth reached the peak levels from the previous business cycle.
We forecast that job growth will slow in 2019, falling below 200,000 jobs per month, but the labor market should tighten further. With open positions increasing faster than companies can hire workers, competition for employees across the skills spectrum is intensifying and employers are increasingly offering higher wages to attract and retain talent. We anticipate that nominal year-over-year wage growth will rise into the 3.5 percent to 4.0 percent range, unseen since late 2008 and early 2009. If so, real wages could near 2.0 percent, a threshold unbreeched since early 2009 when wage growth was surging.
We still believe that the data tends toward tightening and loosening monetary policy and are forecasting one rate hike in the second half of the year.
The tightening labor market helped provide the Fed with cover to keep raising rates throughout 2018, citing the fear that wage growth could translate into inflation if left unchecked. The Fed raised rates four times, 25 basis points each time, once per quarter. As recently as October, the Fed seemed set to continue raising rates, ready to push past the neutral rate in order to tamp things down. But over the following two months, the markets lost faith in global economic growth and worried that the Fed would push too far, causing a recession. The equity markets pulled back into correction territory, long-dated Treasury yields fell precipitously, and the yield curve inverted at the short end and flattened at the long end, with the prescient 10-2 yield spread falling to just 9 basis points before ticking back up. Worried about declining wealth negatively impacting consumer and investor behavior, the Fed received the message from the markets loud and clear and proceeded with an incredibly sharp about-face. It now sits on hold with rate hikes, likely until the latter half of the year. We continue to believe that the Fed may have overreacted somewhat to the markets (the Fed’s mandate does not include propping up markets) because the underlying strength in the economy remains, even if growth is slowing. Markets reacted as if a recession was lurking just around the corner, and unlikely outcome in 2019 even if the Fed had continued raising rates. We still believe that the data tends toward tightening and loosening monetary policy and are forecasting one rate hike in the second half of the year. Forecasting interest rates remains incredibly complicated, particularly now with the Fed willing to change course so abruptly.
Inflation in the spotlight
The labor market and interest rates struggled in a grand tug of war over the last year. On one side, a tightening labor market and faster wage growth tried to push inflation upward. On the other side, higher interest rates served to make borrowing relatively more expensive, tamping down on the ability of consumers to spend and business to invest by utilizing debt. We do not underestimate the role that higher interest rates have played in keeping inflation well behaved over the last year. But with the Fed effectively letting go of the rope for the foreseeable future, it has eliminated the key external force putting significant downward pressure on inflation. If inflation is going to break out and accelerate at a more meaningful rate, 2019 is providing a conducive environment: the economy sits relatively late in the business cycle with a still-strengthening labor market and the Fed sitting on the sidelines for now.
Risks and closing thoughts
Economic growth is slowing, and the Fed is attempting to engineer the near impossible, a soft landing, marked by a slowdown in economic growth but not an outright recession. For now, the rate of decline seems moderate and reasonable. But headwinds are strengthening. Business and consumer sentiment, which seemed unflaggingly optimistic in 2018, faltered a bit to open 2019. Animal spirits pepped up recently but worries still abound. And the outlook for earnings growth continues to get revised downward despite the rebound in markets in early 2019.
Headwinds are strengthening
Risks to the outlook are multiplying, particularly in the geopolitical realm. The broad U.S.-China relationship (beyond, but including trade) turned more adversarial in 2018, reversing an accommodative stance held for most of the last 40 years of China’s rise. Populism remains prominent and many regions of the world face key elections this year. Brexit could ripple through the global economy or impart no meaningful impact. At home, the political situation has turned more standoffish with the Democrats seizing control of the house. The economy seems strong enough to withstand the strengthening risks and headwinds in 2019 so the likelihood of a recession this year remains low. But with growth already slowing, the margin for error is narrowing.