Trade war trumps
While many were focused on the Fed this week, international trade policy took center stage leaving many to wonder how CRE will fare.
The rate cut marked a stark reversal in monetary policy from the Fed’s stance just last fall when it forecast multiple rate hikes in 2019.
Trade war trumps rate cut
The economic story unfolded largely as we expected last week, except for one major development. The Fed cut interest rates by 25 basis points (bps), the first cut since December 2008. It also decided to immediately end quantitative tightening (QT) instead of waiting until September as previously scheduled. We correctly anticipated both developments. The rate cut marked a stark reversal in monetary policy from the Fed’s stance just last fall when it forecast multiple rate hikes in 2019. Chairman Powell’s press conference riled markets a bit due to its somewhat ambiguous messaging. But he ultimately signaled that the door remained open for further “mid-cycle” cuts, with another cut of 25 bps likely coming at the Fed’s next meeting in September. He reiterated the case for rate cuts: below-target inflation, potential fallout from trade policy uncertainty which could limit private investment and hiring, and slowing global growth (which is connected to trade policy).
The tariffs themselves should not directly impact the economy much – our modeling suggests roughly 40-50 bps of drag on growth spread out over two years.
In addition to the rate cut, two other noteworthy releases occurred last week. First, the ISM manufacturing index for July declined, but showed that the sector continued to expand. Manufacturing is more directly bearing the brunt of the trade war, but not yet contracting. Second, the employment release for July demonstrated the economy’s ongoing ability to create jobs and wage gains, even with some slowing in the data. Although payrolls gains are decelerating, we see that simply reflecting the tightness in the labor market more than deterioration in demand for labor. Open positions remain near all-time highs. While some continue to doubt labor market tightness (we do not subscribe to this theory), the unemployment rate held steady near 50-year lows. And the broad U6 unemployment rate (which includes marginally attached workers and those working part-time involuntarily) fell to 7%, its lowest level since December 2000. This data affirms the weekly unemployment claims data, which hover near half-century lows. Nominal year-over-year wage growth ticked up to 3.2%, down slightly from the cycle-high of 3.4% in February, while real wage growth benefits from tepid inflation.
The major unexpected event was the president’s announcement that the U.S. intends to implement tariffs of 10% on an additional $300 billion of Chinese imports. While we do not find the idiosyncratic nature of trade policy developments surprising given recent experience, the specifics of the announcement caught many off-guard. The tariffs themselves should not directly impact the economy much – our modeling suggests roughly 40-50 bps of drag on growth spread out over two years. But we believe that the major concern for economic growth comes via its potential negative impact on business confidence. China, in turn, ordered a halt to the importation of agricultural products from the U.S. And it also halted support for the yuan which rose to its weakest rate against the dollar (7 per dollar) since 2008, in order to make its exports cheaper and blunt the impact of tariffs. That risks the trade war also becoming a currency war.
What does it all mean?
We remain skeptical that a rate cut will impact the economy much or address the Fed’s concerns:
- The last 10 years demonstrates the limited ability of monetary policy to directly influence inflation. Research indicates that inflation is slowing globally. Other economies are also struggling to boost inflation, in some cases despite lower interest rates than U.S. rates. Modern inflation derives from a complex set of interacting factors, not just monetary policy.
- The Fed does not control trade policy. As far back as November 2016 we cited trade policy as one area where the executive branch holds latitude to implement policy without Congressional approval. While the Fed is likely aiming to boost confidence, that seems a tall order, particularly considering the recent salvos in the ongoing trade war. How do rate cuts address trade policy uncertainty? They do not.
- Moreover, businesses do not cite the cost of capital as an impediment to investing. Balance sheets are already flush – the ratio of non-financial corporate debt to GDP continues to reach record-high levels. The economy is slowing as fiscal stimulus fades and employers exhaust the pool of qualified labor. Interest rates remain low and a cut of 25 bps in already-low interest-rate environment should hold minimal impact on an economy still performing well.
We reiterate our concerns that “mid-cycle” cuts serve to potentially delay recessions and ultimately bring about worse recessions when one finally arrives.
Therefore, we see little upside to the economy from this cut. Moreover, we reiterate our concerns that “mid-cycle” cuts serve to potentially delay recessions and ultimately bring about worse recessions when one finally arrives. We also worry about the Fed futilely using its precious and limited ammunition now when the economy continues to perform well. Historically the Fed has cut over 500 bps heading into a recession. The fed funds target range now stands at 200-225 pbs. With at least one more cut likely coming in September, that will take the range down to 175-200 bps, giving the Fed less than half the firepower it usually possesses to blunt the impact of a recession. We are not against the idea of rate cuts – we just don’t see how one will have much impact now versus when a downturn truly arrives.
But what about the yield curve?
The yield curve became more inverted toward the end of last week after flattening leading up to the Fed announcement. While we continue to believe that the yield curve remains a good recessionary indicator. We reiterate that its precise timing remains uncertain and that any one signal, even one as good as the yield curve, should not be used in isolation. Moreover, we doubt that simply ending the inversion would accomplish much. Banks are not reporting a lack of demand for loans and report little direct impact thus far from the inverted yield curve. Should the macroeconomy or the labor market begin to deteriorate in a more meaningful fashion, that would signal intensifying trouble and strengthen the case for further rate cuts.
What it means for CRE
For commercial real estate (CRE) fundamentals, we see little impact from the rate cut because we see little impact on the economy. While rental rates across property types should keep increasing and vacancy rates should remain low, any changes in those metrics should derive from other macro-level and metro-level factors, not the rate cut itself. For landlords, we caution against expecting a pop in rents or increase in demand for space directly from the rate cut. For tenants fearful that a rate cut might make an upcoming renewal more expensive, we see little risk of that direct impact. We continue to foresee general strength in the CRE market until greater deterioration in the economy emerges. The next couple of quarters will prove highly important for both the economy and CRE.
What we are watching this week
The ISM non-manufacturing index for July, the most important indicator this week, should decline slightly. That would indicate that the service sector of the economy cooled, but continued to perform better than manufacturing, and grew at a healthy pace.
Thought of the week
The last three times the Fed implemented “mid-cycle” rate cuts, they ultimately cut rates by a total of 75 bps.