Economic Insights: Warning, bumps ahead

Stronger than expected economic growth is tempered by a fading fiscal stimulus, inverted yield curves and ever-changing trade policy

May 15, 2019

The outlook for the global economy does not appear as dire as it did earlier in the year, but a decelerating global environment also creates some minor speed bumps for the U.S. economy.

Economic growth surprised on the upside during the first quarter. Annualized growth of 3.2 percent represented the best start to a calendar year for the U.S. economy since 2015. The year-over-year growth rate in the first quarter, also 3.2 percent, came in just above our expectations. Inventories and net exports drove the upside surprise. And while not directly measured, looser financial conditions during the first quarter undoubtedly helped, with the stock market recovering all the lost ground from the four the quarter. We foresaw the economy growing at a roughly 3 percent pace to start the year, then slowing to roughly 2 percent year-over-year by the end of 2019. With fiscal stimulus fading and the fed funds rate 100 bps higher than a year ago, growth should slow accordingly. Additionally, global economic growth has clearly downshifted. The outlook for the global economy does not appear as dire as it did earlier in the year, but a decelerating global environment also creates some minor speed bumps for the U.S. economy. Yet once again a familiar pattern among developed economies is occurring — the U.S. economy is decoupling from the rest of the developed world. The divergence between a relatively robust U.S. economy and weakening in other major developed economies replaced the concerted acceleration in global growth observed in 2017. With trade tensions returning to the fore, the road to robust economic growth looks more uncertain. Therefore, we anticipate that economic growth in the U.S. for 2019 should register in the mid-2 percent range for 2019, slowing down as the year unfolds.

While we remain cautiously optimistic that tax legislation has slightly boosted investment in the economy, we see other signs the “sugar high” is wearing off.

Fiscal stimulus fading

While growth during the first quarter surprised to the upside, the underlying data shows that the fiscal stimulus implemented last year (primarily via tax cuts and secondarily via government spending increases) is fading. While we remain cautiously optimistic that tax legislation has slightly boosted investment in the economy, we see other signs the “sugar high” is wearing off. First, growth peaked during the second quarter of 2018 when the impact from tax cuts first hit. Since then growth has been pulling back, though inconsistently. Second, income growth continues to lag spending growth. This likely means that once the impact from the tax cuts are part of the economic base (starting with next quarter) the impact from consumption should slow. Additionally, major sentiment indexes, such as the ISM manufacturing and nonmanufacturing indexes, are already pointing to some rocky roads ahead for companies. And productivity growth, currently enjoying a bit of a surge, should fall back along with the economic growth rate.

Recent Improvement in Private Investment

However, we also do not foresee an abrupt slowdown in the major drivers of the U.S. economy. We still believe that recession fears for 2019 look overblown. The labor market, already the strongest in half a century, should tighten as the year unfolds. The unemployment rate could still fall slightly but should remain below 4 percent while wage growth remains above 3 percent. That should provide consumers with the ability to continue to spend, even if the pace eases. But a lack of qualified labor continues to constrain growth, with 7.5 million positions open but unfilled. Companies seem (and we stress seem) willing to invest a bit more, particularly in intellectual property, given the temporary tax incentives to do so. Government spending does not appear on the verge of a significant pullback with the federal budget balance widening over time. And net exports — a bit of a wildcard given trade policy — could help a bit as well.

Trade policy reemerges as the key wild card in setting monetary policy.

Interest rate guard rails

Over the last few months, the Fed has significantly walked back its stance on future rate hikes. As recently as October, the Fed was planning multiple rate hikes in 2019. Since then it has continued to downshift its own forecast for the fed funds rate. Deteriorating financial markets provided the initial impetus for this stalling, with the stock market undergoing a significant correction in the fourth quarter of last year. Since then, financial conditions have eased. But despite continued economic growth, inflation has not accelerated the way the Fed had anticipated. In recent periods, inflation has cooled slightly due to transitory factors. We expect modest acceleration in inflation in 2019. Yet because we do not anticipate significant weakening in the economy, the Fed finds itself between guard rails on rate policy. Inflation should not warrant additional rate hikes in 2019 yet underlying growth does not warrant any rate cuts. Reasonably, we think the Fed should not change interest rate policy for the balance of the year. It still looks set to end its quantitative tightening program and wind down the paring back of its balance sheet by the fourth quarter. The Fed thus is not out of the monetary policy game completely. But it will sit back and observe the data as it comes in, looking for clearer direction on either inflation or underlying economic momentum. Trade policy reemerges as the key wild card in setting monetary policy. A more benign trade policy allows the Fed to remain patient and data-driven. A more damaging trade policy could force the Fed’s hand.

Even with the Fed boxed in by economic reality, interest rates sent important signals in the first quarter. The yield curve inverted (with short-term Treasury rates above long-term Treasury rates) for the first time since before the Great Recession. An inverted yield curve continues to present one of the best, though not infallible, signs that indicate the economy is heading down the road to recession. The inversion in the first quarter did not reach either the magnitude nor duration that we have observed in prior business cycles, but it served as a warning. In recent days the yield curve inverted once again, indicating that the outlook for the economy remains cautious and markets will respond to any factor that they view as negative. We do not expect much movement this year at the short or long end of the curve, but the shape of the curve should prove very instructive.

Yield Curve Inversions Precede Recessions

Trade policy makes a move

After falling back for several months, trade policy made a move toward the front of concerns surrounding the economy. The U.S. administration decided to increase existing tariffs on imports from China to 25 percent from 10 percent, covering roughly $250 billion worth of imports. This increase occurred after the administration felt like China was renegotiating terms after months of progress. China retaliated with tariffs on $60 billion of imports from the U.S. Because China knows that it runs a significant surplus in goods trade with the U.S. — $122 billion of imports from the U.S. in 2018 versus $540 billion of exports to the U.S. — they could take additional measures such as discouraging or restricting the importation of certain goods. That could likely require further measures from the U.S. administration, but those are apparently being mooted. If the U.S. administration adds imports on the additional $300 billion of imports from China, they will almost certainly respond with more tariffs of their own. The precise impact on the U.S. economy seems opaque because too many issues remain unresolved. For now, with the tariffs in place as of the time of publishing this outlook we foresee trade policy mildly restricting economic growth by roughly 10-20 basis points this year and 30-40 basis points next year. Any changes will alter our assessment of impact but are virtually impossible to predict.

Implications for CRE

For commercial real estate (CRE) we hold to our view that we foresee little deterioration in space market fundamentals this year. Net absorption has slowed across some markets, falling behind new completions. That combination produced slightly rising vacancy rates in some property types and markets and flat vacancy rates in others. At this relatively late stage of the CRE cycle we are not surprised to see some upward pressure on vacancies and correspondingly downward pressure on rent growth (though no widespread declines in rent yet). New completions remain a relative non-factor as they have throughout most of the current expansion, save for certain pockets. Our proprietary forecast model continues to show vacancy flat to slightly up across markets in 2019 while rent growth continues to slow slightly. That reflects an environment of continued economic growth and demand for space. As net absorption slows supply could because more of a factor over time, even though we do not foresee a significant surge in construction like the ones that have occurred in previous business cycles. Trade policy clouds the picture here as well, most directly for industrial real estate which could see dampened demand for space if trade skirmishes turn into a full trade war. Markets driven by imports from China, including major hubs on the West Coast, possess the greatest risk of fallout. Retail also sits in the way of oncoming trade problems. Thus far, the tariffs implemented by the U.S. have been on intermediate goods used by companies. Consequently, the impact hits companies most directly. But the increase in the tariff rate on intermediate goods plus the potential for tariffs on consumer goods means a potential increase in prices of consumer goods which could lessen demand. This has already occurred on several goods that fall under tariffs, including washers and dryers, so it is reasonable to expect something similar for other consumer goods.

On the capital markets side, with the Fed on hold for the time being, transaction volume and pricing could get a bit of a boost, though likely not a turbo boost. Transaction volume could be propped up a bit by largely unchanged rates. Investor appetite which remains strong but somewhat wary of pricing, could surge if investors are emboldened by the lack of rate hikes. At a minimum, it gives buyers and sellers time to assess deals without the risk of additional rate hikes this year hanging over their heads and potentially forcing their hands. But the longer the Fed sits on hold with a relatively strong underlying economy, the greater the probability that an asset bubble (including CRE) emerges like in the two previous business cycles. The Fed does not have a good recent track record on extending the business cycle without engendering an asset bubble. Currently, we do not believe that a bubble in CRE exists. But across several markets, particularly the institutional gateway markets, cap rates are hovering at or near historically-low levels. We will closely watch the markets for signs of a bubble forming as the year unfolds.

Risks and closing thoughts

Underlying economic momentum is slowing as fiscal stimulus fades. Higher interest rates after four rate hikes last year should moderate economic activity versus 2018, even as rates sit on hold this year. Scarcity of qualified labor to fill open positions restricts the ability of the economy to grow, particularly with productivity growth set to slow. And the wild card of trade policy, which seemed benign until recently weeks, now presents a serious complication for forecasters because those decisions are often politically expedient but economically counterproductive. We sit less than two months away from the current economic expansion becoming the longest in U.S. history. We expect the economy to break this record. But even in the short term, things look more challenging than they did just a year ago.

In addition to the ongoing U.S.-China situation, other geopolitical risks remain relevant. Populism and key elections dot the landscape in 2019. Brexit, likely delayed until the fall, remains another political wild card. The domestic political situation remains rife with rancor, even in the wake of the Mueller report’s release. Policymaking will remain contentious in such an environment, even over issues that should present little debate. For example, raising the federal government’s debt ceiling must occur by September or the government will need to implement extraordinary measures to avoid defaulting on any debt. Lastly, oil prices remain so difficult to predict because of their geopolitical nature. Last year they declined significantly after many had forecasted continued increases. Oil prices have quietly creeped back up in recent months. While the U.S. has reemerged as an energy superpower due to the shale revolution, higher oil prices still tend to restrict global economic growth and present another pot hole on an already uneven road.

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