Research

Economic insights: Follow the signs?

There are signs everywhere, but what exactly are they pointing to? Is a recession on the horizon or was the inverted yield curve wrong?

April 03, 2019

If the equity market still sits below its peak by late summer, we will take that as a recessionary signal.

Signs, signs, everywhere a sign

Signs indicating the direction of the economy abound, but what are they saying? On March 22nd, the yield curve, measured as the spread between 10-year and 3-month Treasury yields, inverted with yields on the 10-year instrument falling below yields on the 3-month instrument. This inversion continued until March 29th. The duration did not reach the unofficial (give or take) 10-day threshold that usually precedes a recession. Does that mean the inverted yield curve signaled a false alarm? A bit of context can provide some helpful information:

  • Some have argued that yield curve analysis constitutes data mining, but sound economic research demonstrates that yield curve inversions precede recessions. As we mentioned last week, inversion is not a perfect signal. And the 10-day threshold serves as a proxy for a long enough period to sufficiently demonstrate the Treasury market’s loss of faith in the medium-term economic outlook. Could a period shorter than 10 days signal a recession? Certainly. Inversions do not explicitly cause recessions; they are a useful sign along the road. But they make bank lending less profitable or even unprofitable and therefore can contribute to recessions.
  • Others contend that the more meaningful inversion lies with the spread between 10-year and 2-year Treasury yields, which did not invert. We find both yield curve measures meaningful, but do not feel that both need to invert to signal a recession this cycle. With interest rates so low, the 10-2 spread could struggle to invert. Moreover, other, less prescient portions of the curve, particularly the shorter duration instruments, inverted months ago, providing extra evidence.
  • Other market indicators also signal a warning. The equity market, measured by the S&P 500 Index, peaked in September and has yet to return to those record highs. If the equity market still sits below its peak by late summer, we will take that as a recessionary signal. And the housing market, measured by construction activity, shows signs of slight retrenchment.
  • Other economic data, such as consumer spending and hiring, also signals slowing, but not implosion. Consumer sentiment and confidence remain at elevated levels. Taken together, these reflect our view that the economy is slowing in 2019, but not dramatically.
Follow the signs?

We expect the economy to reaccelerate toward the middle of the year, replicating a pattern that has become all too familiar during the current expansion.

Viewed in its entirety, the evidence signals a slowdown, but not enough leading indicators are flashing red to signal a recession. We will closely monitor leading economic indicators now that the yield curve alarm has tripped. Yet we also do not believe that the economy has weakened enough to justify rate cuts, despite the fed funds futures market indicating otherwise. Likely, the labor market would need to weaken considerably before the Fed seriously considered lowering rates. Recent chatter from the Fed seems to support this view.

A bump in the road

No doubt, the economy has hit a bump in the road. The third and final report on real GDP growth for the fourth quarter showed that the economy lost more momentum at the end of last year than previously believed. Growth was revised down to 2.2 percent on an annualized basis, roughly half the growth rate from the second quarter. Sales growth to start the year reinforces the view that growth is slowing. Growth in the first quarter should come in below the fourth quarter and likely less than two percent. But we see this as a temporary condition. We expect the economy to reaccelerate toward the middle of the year, replicating a pattern that has become all too familiar during the current expansion.

Death of inflation redux?

Not long ago we posed the question, “Is inflation dead?” We asserted that if inflation could not accelerate during 2019 with the tightest labor market in half a century, the Fed on hold and trade policy that increases costs for U.S. consumers, then it might never accelerate outside of a tepid range. The data thus far in 2019 seems like we should prepare a requiem. The headline personal consumption expenditure (PCE) index fell to 1.4 percent year over year in January, its slowest growth rate since late 2016 when energy prices were falling. Meanwhile core PCE inflation declined slightly to 1.8 percent year over year. We reiterate that the relationship between the labor market and inflation will merit watching this year.

What we are watching this week

This Friday’s employment situation report, now critical for both the overall economy and inflation, should show payrolls increasing near 200,000 net new jobs. We expect the year-over-year wage growth rate to hold steady near 3.3 percent while the unemployment rate should change little from its current 3.8 percent. Retail sales for February should show some slight weakness, but the overall trend should not seem as dire as many expected. We look for a rebound in the coming quarters. We look for an increase in the ISM Manufacturing index and a slight decline in the ISM Nonmanufacturing index, with both still reflecting expansion in the economy.

What it means for CRE

For commercial real estate (CRE), we stand by our view that the outlook for 2019 remains firm despite increasing fears of a coming slowdown. Although slowdown remains a valid concern, a near-term implosion seems unlikely. On both a macro basis of aggregate U.S. data and a micro basis at the individual market level, we see few signs of deterioration. But signs of slowing are abundant. Rent growth and vacancy compression are not occurring as quickly as they once did. Cap rate compression has largely stalled, though we see still little evidence of rising cap rates. Fears seem a bit too pronounced relative to underlying strength in the short term.

Thought of the week

By 2030, all baby boomers will be older than age 65. By 2035 people 65 years and older will outnumber people under the age of 18 for the first time in U.S. history.

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