The economy:
As bad as we thought

The U.S. economy experienced the worst quarter in recorded history. Is the office sector the canary in the coal mine?

August 04, 2020
>> Quick takes:
  • 2Q GDP in line with our base case forecast
  • Worst quarter for economy in recorded history
  • Fed reiterated its accommodative stance
  • Nascent recovery faces headwinds
  • Downturn in CRE already apparent in the data


We received good news and bad news about the economy last week. The good news? The economy performed in line with our forecast during the second quarter. The bad news? The economy performed in line with our forecast during the second quarter. Real GDP declined by 32.9% in the second quarter on an annualized basis, the worst quarterly drop on record since the quarterly GDP time series began in 1947. It marked the second consecutive quarter of decline in the economy. Peak to trough, real GDP contracted by 10.6%, the worst performance since the demobilization effort at the end of World War II and the third-greatest contraction since the Great Depression. That effectively brought the size of the economy back to its level from late 2014/early 2015, swiftly eliminating five years of growth in just two quarters. Both the quarterly and peak-to-trough measures fell roughly in line with (though slightly worse than) the base case in our scenario modeling. Some of this stems from skill and some stems from luck. And economic data during downturns always gets revised, sometimes substantially. But the massive uncertainty surrounding the pandemic has made forecasting even more difficult than it already was during more benign economic periods, turning small forecast victories large ones.

Real GDP declines near 2015 levels


The details also agreed with our expectations. Personal consumption largely drove the downturn, notably in services. Many businesses closed (at least temporarily) and consumers avoided many out of fear, causing services spending to plummet. Private investment also contracted significantly across all major subtypes, from structures to equipment to intellectual property. Net exports declined, with exports falling more than imports. Government expenditures managed to eke out a gain, with an increase in federal government spending more than offsetting declines in state and local government spending.

Labor market data signaling trouble

Despite the massive contraction, data began to improve as the second quarter progressed. Both job growth and retail sales turned positive in May and improved further in June. Weekly unemployment claims, though still elevated, had been declining for months. But by July signs of trouble began emerging. Weekly unemployment claims stopped falling and increased slightly. Meanwhile, layoffs continued to transition from temporary to permanent. And other non-traditional, real-time indicators of economic activity, such as mobility indexes, also display signs of faltering.

Headwinds emerging

Two key, related headwinds emerged during July to alter the trajectory of any nascent recovery. Across several states COVID cases began increasing at a rapid pace in July. Ultimately, this caused state governments to slow or reverse the reopening of businesses. It also caused consumers to once again avoid certain businesses out of fear of falling ill. And the CARES act officially expired last week without a replacement. Congress continues to debate what should follow it, but the overall size of the spending package will almost certainly decline relative to the CARES act. The greater the reduction in spending and the longer the delay, the more harm will likely occur to the economy. Private spending from consumers and businesses will almost certainly remain below capacity until the pandemic abates, which will in turn limit state and local government spending due to lower tax receipts and balanced budget requirements. All of that will limit hiring and economic growth. Net exports will likely prove no panacea because of the global nature of the pandemic (which will limit foreign appetite for services such as vacations and education, which drive U.S. exports). While we typically avoid taking normative positions, federal government spending seems like one of the few options to limit the economic downside until the pandemic lessens. Even the Fed, which typically avoids discussing fiscal policy positions, has mentioned the vital importance of continued government support.

Fed leaves policy intact

Speaking of the Fed, last week it decided to leave all its support programs in place. The Fed seems confident that its policies are supporting the economy appropriately and felt no need to change tack. But Chair Powell reiterated his “whatever it takes” approach to monetary policy and emphasized that the Fed stands ready to become even more accommodative if necessary. At a minimum, we expect short-term interest rates to remain near zero for the foreseeable future and long-term rates to remain low while the Fed continues to purchase assets.

What it means for CRE

For commercial real estate (CRE) the economic environment clearly presents significant challenges and impediments, in excess of recent downturns. Looking at office – still the bellwether sector for CRE – proves instructive. In the second quarter, despite the massive contraction in GDP, asking rents across markets declined relatively modestly. Some took this as a heartening sign. But looking at historical cycles shows why this is concerning. During the early stages of recessions, asking rents typically continue to increase even though the economy is contracting. Landlords typically proffer up concessions before conceding and cutting asking rents, which typically occurs 2-3 quarters after the onset of the recession. This cycle asking rents already began declining just one quarter after the start of the recession, a potentially worrying sign. We will provide more detailed guidance in our second quarter economic outlook next week.


| What we are watching this week |

The ISM Manufacturing and Nonmanufacturing indexes readings for July should show noteworthy if not spectacular increases as economic activity continues to mount a recovery. In the labor market, initial unemployment claims should hold steady at elevated levels. And while we expect another month of positive job growth for July, we would not be surprised if job growth turned negative due to the building headwinds.


| Thought of the week |

Research estimates that without government spending, an additional 12 million people in the U.S. would have already fallen into poverty.