Economic Insights: Politics clouding economic outlook
Trade wars on multiple fronts from China to Mexico are roiling the markets and having an impact throughout the global economy
Politics clouding economic outlook
Political occurrences in recent weeks are increasingly clouding the economic outlook. With the threat of increased tariffs on Chinese goods still looming over the economy, last week the president threatened to place tariffs on Mexican exports to the U.S. This threat differs from the situation with China because it came as a response to a more political issue, undocumented immigration, and not an issue more directly rooted in economics. These trade developments arrive at a time when geopolitical uncertainty already sat at an elevated level, potentially the highest in decades. Rhetoric escalated in recent weeks fueling tensions. Moreover, the administration’s use of the threat of tariffs against Mexico holds two key implications beyond the obvious negative impact tariffs would have on prices and economic growth in the U.S. First, the threat alone makes negotiating with China more problematic since China could likely view the U.S. as an unreliable negotiating partner. Second, the ratification of the successor treaty to NAFTA has not yet been approved by the legislatures of any of the three signatory countries. Any breakdown in implementing the treaty would also likely present economic headwinds for the countries involved.
Publicly-traded markets continued to respond to these changes in negative ways, perceiving them as impediments to economic growth. The equity markets in the U.S. continued to retrench, though they remain up for both the year to date and up since equity markets bottomed out on Christmas Eve last year. And the yield curve, now inverted for most of the last few weeks, is gradually becoming more inverted as measured by the difference between the 3-month and the 10-year Treasury yield. When the yield curve initially inverted in the first quarter, the magnitude seemed minimal, just single digit basis points (bps). In recent weeks, the inversion rose to double-digit bps and now sits above 20 while yields across the curve continue to fall. We hesitate to put too much faith in any one metric, even one as generally reliable as the yield curve. But political developments spooked markets and raise legitimate concerns about the economic outlook.
We are not altering our generally positive view on the economy this year, but we acknowledge that risk to the forecast is increasing to the downside.
Forecasting in a time of uncertainty
These political considerations make forecasting even more complicated because they are idiosyncratic and impossible to forecast. No credible economist or political scientist was predicting the threat of tariffs on Mexican exports before the announcement last week. We had already seen signs that fiscal stimulus was fading and economic growth slowing — we expect growth in the second quarter to fall well below the growth rate from the first quarter. But the downside is that the risk continues to increase with each additional political hurdle thrown in the economy’s path. We are not altering our generally positive view on the economy this year, but we acknowledge that the forecast is moving towards a downside. We are not alone in this dilemma. The Fed must also contend with political uncertainty as it attempts to set appropriate monetary policy. We tend to agree with the Fed that no movement on interest rates should occur in 2019 barring a substantial change to the outlook for either inflation or the economy. But the outlook for both seems increasingly murky.
The risk of recession would clearly increase if either threat of increased tariffs aimed at China and Mexico (or worse both) becomes reality.
The futures market already believes that rate cuts are coming later in the year. Due to the increase in downside risks to the economy, we now see a greater chance of the Fed cutting rates than increasing them. But they will likely need to see impacts in the data and not just the potential for problems before moving on rates. And the risk of recession would clearly increase if either threat of increased tariffs aimed at China and Mexico (or worse both) becomes reality. Individual data points will likely get more scrutinized with the market on alert for signs of trouble in the economy.
For Mexico, the threat of tariffs from the U.S. looks potentially catastrophic.
Global collateral damage
The potential fallout from trade issues would spread beyond the U.S. Most directly, to the immediate countries facing the tariff threats. China is feeling the pressure of the trade war and its equity markets have fallen far more than U.S. equity markets have fallen. China seemingly has more to lose because of the significant trade surpluses that the country runs with the U.S., though it does not rely on exports for economic growth to the extent that it once did. For Mexico, the threat of tariffs from the U.S. looks potentially catastrophic. The tariffs on Mexican imports would start at 5 percent on June 10 and rise by 5 percent every subsequent month until reaching 25 percent in October unless the immigration situation at the border “is remedied.” At 5 percent, tariffs would begin to reduce GDP growth in Mexico. At 25 percent, the risk of a recession in Mexico escalates significantly. As a secondary effect, trade tensions are rippling throughout the global economy and being felt in places far from China and North America, such as Europe.
What it means for CRE
For commercial real estate (CRE) all these developments also cloud its outlook. Implementation of further tariffs would restrain U.S. economic growth, clearly a negative for CRE. All other things being equal, tariffs would raise prices for goods while slowing economic growth, serving as a bit of an aggregate supply shock. Prices for goods under tariffs would rise faster than wage growth — we have already seen this with goods currently under tariffs, reducing demand for those goods. The tariffs could potentially slow rent growth and stall vacancy rate compression, even potentially putting upward pressure on vacancy rates in some markets. Our proprietary forecast modeling suggests that Industrial and retail look the most vulnerable, with the greatest chance that a trade war causes fundamentals to deteriorate. But no property type would likely emerge unscathed from a wider trade war that reduced job creation and economic growth. CRE capital markets would likely cheer stable or lower interest rates, but if they are accompanied by meaningful deterioration in the economy and CRE fundamentals then capital markets might win a Pyrrhic victory.
What we are watching this week
We expect the ISM manufacturing index to show a decline in May, falling below the consensus view, with external factors weighing on the sector slightly. Meanwhile the nonmanufacturing index should show a slight increase. We expect construction spending for April to come in below consensus. The trade balance for April should widen again, following the trend of the last few years. The employment situation for May should show a net increase in employment near 200,000. We expect the unemployment rate to remain relatively unchanged near 3.6 percent. Wage growth should continue, but we expect the year-over-year growth rate to hold steady near 3.2 percent.
Thought of the week
According to a new study form the New York Fed, roughly half the population possesses the resources and ability to move but remain rooted for non-economic reasons such as family and community.