Perception is reality when it comes to our economic outlook. And right now—perception is definitely mixed.
Psychology plays an important yet sometimes overlooked role in economics.
Undoubtedly the economy is slowing, as we anticipated. Fiscal stimulus continues to fade the farther we go from 2018. In addition, we expected higher interest rates to drag on growth and become the key domestic economic concern. Our informal surveys conducted in 2018 confirmed this belief. We also knew that global political risk would reach its highest level in decades, with policy heavily impacting this risk. And political risk, stemming from trade policy uncertainty, has pulled psychology to center stage. Psychology plays an important yet sometimes overlooked role in economics. And that role should take on increasing importance over the next few quarters, possibly determining whether the economy backslides into a recession or just a slowdown.
While the consumer confidence index remains near levels seen during the dot-com bubble years, the consumer sentiment index has declined and fallen to its lowest level since October 2016
In addition to economic fundamentals like jobs, GDP and interest rates, psychology influences the behavior of economic actors. Optimism can generate economic activity while pessimism or uncertainty can curtail it. We currently see this happening in different components of aggregate demand. Private investment is faltering, and companies are cancelling or at least delaying investment because of trade policy uncertainty – investment declined during the second quarter and core durable goods data for July showed ongoing weakening. But consumers, still feeling rather upbeat, continue to consume, propelling aggregate demand. Can they remain so upbeat? Up to this juncture most of the implemented tariffs have avoided consumer goods. That changed this week with the implementation of a 15% tariff on $112 billion of Chinese imports, mostly consumer-oriented goods such as apparel, shoes, and sporting goods. Additional 15% tariffs are currently scheduled to hit another $160 billion of (mostly) consumer goods on December 15. And some signs of faltering have started to appear. While the consumer confidence index remains near levels seen during the dot-com bubble years, the consumer sentiment index has declined and fallen to its lowest level since October 2016. One-third of survey participants cited the recent tariffs as a concern. These feelings have not yet translated into economic activity, but that risk is becoming greater. Most importantly, consumers and businesses are connected. If weakening business confidence not only hurts investments but also hiring, that could begin to impact how consumers feel. If so, the economy’s main demand source could weaken, imperiling growth.
Thus far the implemented tariffs impacted the economy in only marginal ways. And even once all the new tariffs are implemented and most existing tariffs increase (set to occur on October 1) we estimate the drag on economic growth to total only 50 to 60 bps. Not insignificant, but not strong enough to bring about a recession. But in this case the bark is worse than the bite. A relatively minor drag on GDP growth from tariffs could pale in comparison to the consequences of continued deterioration in consumer and business confidence and spending.
Rate cuts coming
With trade barriers increasing and investment already faltering, more rate cuts are likely to come but the exact number seems unclear. We expect the Fed to cut rates by 25 basis points at its next meeting in two weeks. It will likely follow that with at least one more cut of 25 basis points this year, likely at the October meeting. Another cut of 25 basis points sits on the table for the December meeting, depending upon the data. We remain skeptical that rate cuts will help much because they do not directly address trade policy, but still believe that the Fed will use them to get ahead of any additional signs of trouble in the economy.
What we are watching this week
We expect the ISM Manufacturing index to decline and fall below 50, driven by ongoing trade issues and the slowing of manufacturing economies around the world. That would signal a contraction in the manufacturing sector of the economy for the first time in roughly three years. We also anticipate a small rebound in the ISM Nonmanufacturing index, avoiding a direct impact from trade policy tensions. The employment situation release should show that the economy created roughly 170,000 net new jobs in August with unemployment rate holding steady near 3.7% and wages continuing to drift higher amidst labor market tightness.
What it means for CRE capital markets
We expect commercial real estate (CRE) to continue to perform well unless the economy takes a serious turn for the worse. Slower economic growth did not imperil the performance of the asset class during the current expansion. As the economy downshifts from fiscal stimulus we see no reason to believe that slower growth will now cause great harm to the sector. The downside risks are intensifying and our outlook for the economy is slightly worsening. But even in a downturn, we believe that CRE would offer compelling relative value to other asset classes.
Thought of the week
Back-to-school (including college) spending should total roughly $80 billion this year.
Note: We will not publish economic insights for the next two weeks while we update our website. We anticipate returning on September 25.