Poised for a rebound
How far will the Fed push rates and can it thwart a potential recession?
- Ryan Severino
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- Underlying economic momentum slowing
- Labor market remains strong
- Inflation slowly moderating
- Fed continues raising rates
- CRE still faring well despite slowdown
During the first half of the year, the economy produced some incredibly confounding results. So much so, they resulted in a debate about whether the economy had entered a recession. GDP contracted for two consecutive quarters, setting off some alarm bells. Yet, as we have previously discussed, numerous issues surround the quality of that data and most other indicators continued to show positively. Net job gains remained strong through August’s data. Wage growth remained robust. The combination of the two continued to power consumer spending on a real basis, even with elevated inflation and rising interest rates.
Where does that leave us and more importantly, where are we going during the remainder of the year? We will examine some key components of the economy to answer this question.
Economic growth represents the most complex part of the analysis. While the question seems straightforward – did the economy expand or contract? – it is proving rather difficult to answer. Normally, we turn to real gross domestic product (GDP) for the answer. However, as we discussed in our mid-year analysis, many issues with the GDP data exist. Rather than rehash all of that, we want to focus on a key economic identity. In macroeconomics, gross domestic income (GDI) should equal GDP. Basically, producers must pay for the inputs they use to produce goods and services. While these two measures always come out unequal, recent observations show an unprecedented widening between the two. Since 1947, the difference between the two has remained within a narrow range of roughly 2%. But in recent quarters, GDI has broken through that 2% threshold and now nears a difference of 4%.
Unprecedented Difference Between GDI and GDP
Which measure is superior? While both have their issues, critics of GDP point out that we lack a system to capture all of the production in the economy. Instead, we rely on sampling and from there we estimate the total. But sources of income get audited for tax purposes. In that sense, they could prove superior. We are not taking a position on this issue. We simply reiterate our view that the GDP data from the first half of the year seems less reliable than usual. Nonetheless, the economy is generally slowing. After last year’s torrid pace, a slowdown seemed inevitable. Somewhat ironically, due to the anomalous data, real GDP growth should likely accelerate in the latter half of the year. Overall, we expect growth for 2022 to fall near 1.5% to 2%, but measurement challenges are clouding the outlook more than usual.
Although GDP faltered in the first half of the year, employment remained strong. Through August, net job gains averaged roughly 438,000 jobs per month. That created the fastest labor market recovery in roughly four decades. That occurred despite the ongoing, structural labor shortage that has made hiring relatively difficult, making the recovery even more impressive. Meanwhile, the unemployment rate remains low, hovering near the half-century low of 3.5% attained in July. Despite this strength, demand for labor continues to outstrip supply. Open jobs totaled 11.2 million in July, well above pre-pandemic levels. Unsurprisingly, wages continued to grow at a brisk rate, although the year-over-year change in average hourly earnings has declined since its cyclical year-over-year peak of 5.6% in March. We expect a slowdown in net job gains over the balance of the year as underlying economic momentum slows, but the labor market should remain healthy. The unemployment rate could tick up, but not likely by much and wage gains should remain robust, even as they decelerate toward 5%.
Strongest Labor Market Recovery in 40 Years
Inflation has also moderated in recent months yet remains near four-decade highs. The headline consumer price index (CPI) recently slowed from 9.1% year-over-year in June to 8.5% year-over-year in July. The core CPI, slowing since March’s cyclical high of 6.5% year-over-year, fell below 6% in both June and July. Yet, Inflation continues to stem from a complicated mix of demand-side and supply-side factors. That has not only propelled inflation to such high rates, but it also makes inflation a more intractable, difficult problem to solve. What’s behind the recent moderation? Most directly, declining energy prices have helped to push headline inflation downward. But the underlying dynamics have changed as well, impacting core inflation. While the supply side of the economy remains disrupted, it appears less so than earlier in the year. Demand is also cooling as the Fed continues to raise rates to tamp down demand. We expect inflation to inconsistently slow over the balance of the year. But because of the volatility of headline components such as energy, the path downward remains inconsistent and relatively slow. We foresee greater deceleration in 2023.
Inflation Starting To Slow
Speaking of interest rates, the Fed continues to hike rates to tamp down demand, especially for the interest-rate-sensitive parts of the economy. Thus far, their efforts appear successful, namely through housing. Most housing indicators, including sales, pending sales, mortgage demand, starts and permits -- have slowed as interest rates increased. Pricing is slowing, and potentially declining by some measures. Yet, the Fed has recently raised rates near most estimates of neutral, including our own. It appears that the Fed intends to push past neutral to pull even more demand out of the economy to slow demand-driven inflation, even if they can do almost nothing about supply-driven inflation. By doing so, the Fed runs the risk that they cause a recession. In fact, some voting members of the Open Market Committee might feel okay with that if it means avoiding the greater risk of an inflation-induced downturn, which they feel would likely be longer and more painful. Consequently, the Fed will continue to have a great influence on the trajectory of the economy over the next 12-24 months.
Implications for CRE
The first half of the year has brought an unusual dynamic to the economy and its relationship with commercial real estate (CRE). Despite technical slowing in GDP, overall CRE continues to perform well because the underlying components of the economy that drive CRE performance continue to perform well. Consumers continue to spend, even as consumption has shifted somewhat from goods to services. Ongoing consumption, driven by both wage gains and new jobs, has provided fuel for both the retail and industrial sectors. Continued job gains enabled many to go out and lease apartments. The resumption of travel has boosted occupancy, ADRs, and RevPARs in the hotel sector. Even office, which has lagged the other major property types, has benefitted from underlying economic strength. While gains in office-using employment have not translated into demand for office the way it has in past cycles (at least so far), pockets of strength continue to exist by both geography and by subtype, with markets in the south generally outperforming and high-quality office space continuing to perform well.
Risks and Outlook
The economy looks poised to rebound from the mathematical slowdown in the first half of the year. But underlying momentum is slowing. The key risk in the short term seems to be higher interest rates because Fed officials feel inflation poses a greater threat in the medium to long run. We continue to see the economy avoiding a recession in the base case. But downside risks will continue to build. The supply side of the economy remains disrupted, particularly with China adhering to its zero-COVID policy. Geopolitics remains a wild card, particularly with its impact on inflation. How far will the Fed push rates? Short-term pain for long-term gain? Possible. CRE will go as far the overall economy takes it, but the path there could be bumpy and unpredictable.