Q2 2021 U.S. Economic Insights
The seeds have been planted to produce the economy’s best calendar-year performance in more than a generation
- Ryan Severino
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- Short recession produced quick turnaround
- Economy still on track for best calendar year since 1984
- Productivity growth playing a key role – now and in the future
- Medium-run outlook favorable even as growth slows
- CRE sectors all benefitting from macro environment
Despite the many challenges posed by the pandemic, we retain a generally positive economic outlook more than halfway through 2021. This year remains on track to produce the economy’s best calendar-year performance in more than a generation. Our base case projects economic growth by roughly 6%. If that comes to fruition, it will represent that strongest calendar-year growth rate in the U.S. since 1984, no small feat given how much larger the U.S. economy became during that interval. Anyone familiar with how compound growth works understands how difficult maintaining even a constant growth rate becomes over time.
“This year remains on track to produce the economy’s best calendar-year performance in more than a generation.”
Therefore, such a strong projected growth rate raises the obvious question, “How can the economy achieve such a robust (and increasingly rare) growth rate this year?” The short answer: a number of factors combining at the right time. Some of the factors, such as government policy, typically play a role in economic recoveries. But others, such as the reopening of the economy and the release of pent-up demand are providing the economy with somewhat atypical fuel for growth. These factors are not contributing equally, all of them are playing their part in driving the U.S. economic growth to its fastest rate in 37 years.
The devil in the second quarter details
At first blush, the preliminary estimate of second quarter real GDP growth appears disappointing. Annualized growth of 6.5% came in meaningfully below expectations and slightly ahead of the 6.3% growth rate from the first quarter. But deeper analysis shows a strongly growing economy with fuel still in the tank. As expected, consumers led the way with consumption posting another robust quarter, contributing strongly toward growth. Consumption has now grown for four consecutive quarters following the sharp pullback during the onset of the pandemic in the first half of 2020. Private domestic investment from businesses declined for the second consecutive quarter. Although investment in equipment and intellectual property contributed positively toward growth, investment in physical structures (both commercial and residential) detracted from growth. Private inventories drove the underperformance for the quarter: most forecasters expected this category to grow at a brisk pace following the drawdown of inventories during the first quarter. But supply bottlenecks prevented the rebuilding of inventories. Government expenditures also detracted from growth for the second consecutive quarter. While the last major spending bill passed in March, that legislation predominantly provided funds to the private sector of the economy. Lastly, net exports contracted from growth for the fourth consecutive quarter, largely due to the U.S. economy reopening faster than other economies around the world, driving greater demand for imports than exports.
The second quarter also contained an important milestone. The economy reached a new record-high level, with real GDP surpassing the level from the fourth quarter of 2019. The phrase “gained back all of the GDP that was lost” misrepresents that situation, because undoubtedly some output lost during that period will never return. The recovery back to its previous peak nonetheless represents an important achievement on two fronts. First, speed. The peak-to-trough contraction in GDP during the first half of 2020 represented the largest contraction since the end of World War II. That presented the economy with a huge hole from which to dig out. While some of this process simply involved turning back on parts of the economy that got turned off during the pandemic, it only brought the economy so far back. The remainder required a much more serious effort which brings up the second important achievement: efficiency. With the labor market remaining net short roughly 6.8 million workers as of June, and average weekly hours worked largely unchanged during the pandemic, productivity growth further propelled GDP.
Real output per hour
The next six months
To recap, the U.S. experienced an incredibly deep recession that also became the shortest on record at just two months. Thereafter, the economy began to grow again at a brisk pace, reaching its previous peak level in just four quarters. What’s next? Economic growth during the latter half of the year should remain robust, even though the economy has likely moved past peak growth during the second quarter. Monetary policy remains incredibly dovish. Although the Fed’s own forecast for it to begin hiking rates moved up to 2023 (2022 fell one vote shy) as of the Fed’s June meeting, that of course means policy rates will remain low during the balance of 2021. Rates at the long end of the curve, which of course the Fed does not set and holds limited power to control, moved higher earlier in the year as the economy and inflation accelerated. But long rates have climbed back down since peaking in March as vaccination slowed and fears of overheating abated. Cheap debt should continue to support debt-fueled spending.
“Economic growth during the latter half of the year should remain robust, even though the economy has likely moved past peak growth during the second quarter.”
Meanwhile, fiscal policy probably has not yet fully run its course. Although no new deficit-financed packages appear likely in the latter half of the year, not all the benefit from earlier rounds of stimulus have fully exhausted. Those should continue to support consumers and businesses through the balance of the year. Moreover, the expiration of existing policies could hold implications for the economy. Recently, the moratorium on rent payments expired and extended unemployment benefits will expire over the next quarter. The exact impact of those expirations remains unclear but could provide a boost to the economy if those expirations encourage some people to reenter the workforce.
On the supply side of the economy, the reopening of the economy should continue through the latter half of the year. Although resurging cases have resulted in the reimposition of mask mandates in certain parts of the country, no appetite exists to return to the draconian measures implemented during the earliest stages of the pandemic. And vaccination continues, albeit much more slowly than earlier this year. That should enable more people to feel confident more fully re-engaging with the economy. Moreover, as supply bottlenecks ease, production should continue to ramp up. That should enable businesses to rebuild inventories, effectively reallocating some economic growth that did not occur during the second quarter (and causing growth to come in below forecasts) to subsequent periods.
Lastly, although consumers spent at a brisk pace during the first half of the year, they should still propel the economy in the third and fourth quarters. Pent-up demand has not yet fully been unleashed. Consumers continue to sit on excess savings and are transitioning their purchases away from goods consumption and towards services consumption. Moreover, more typical back-to-school (and back-to-work) shopping seasons, coupled with more typical shopping behavior for various holidays, should continue to drive consumption back toward pre-pandemic patterns.
The medium term
Beyond six months, the question of durability comes front and center. Many have wondered if this caliber of growth can continue. On one hand, we know that it cannot. The mere fact that the economy should grow at a rate unseen for 37 years demonstrates this. But delving into the details behind this year’s robust growth further reaffirms that view. All of the forces pushing the U.S. economy this year are temporary to an extent: interest rates across the yield curve will increase, fiscal stimulus will continue to fade, pent-up demand will not remain pent up forever, and the supply side of the economy will fully come back online. That would seem to indicate that once those factors abate, growth should revert to its pre-pandemic trend.
“… the economy will almost certainly need this kind of technology (AI, machine learning, automation, robotics) to boost the output of the workforce whose growth rate is at best slowing if not outright contracting.”
Yet, we should not discount the prospect of higher productivity growth. While the productivity growth that has propelled the U.S. economy to new heights also cannot continue, the U.S. economy seems poised for productivity growth at least marginally higher than its pre-pandemic trajectory. Over the last business cycle, organizations have been investing in technology – such as artificial intelligence, machine learnings, automation, and robotics – that can help boost productivity growth. Certainly, a lot of hype surrounding this kind of technology has proliferated, especially over the last five to six years. Could those investments finally produce a boost to productivity growth? The data from the last year conflates those investments with the reopening of the economy. But over the next few years, it seems likely that at least at the margin, productivity should increase. While many often view this kind of technology in adversarial terms, thinking of it as a destroyer of jobs, this technology will almost certainly prove necessary. Why? Because the U.S. is already experiencing a pronounced labor shortage that will almost certainly intensify over time as the Baby Boomers continue to retire and exit the workforce. Growth in the working-age population (people ages 16 to 64) has consistently turned negative for the first time in U.S. history. Therefore, without an easy or politically palatable political solution, the economy will almost certainly need this kind of technology to boost the output of the workforce whose growth rate is at best slowing if not outright contracting. The case of Japan proves instructive here. With a demographic profile even more challenging than the one in the U.S., Japan increasingly relies on this kind of technology to boost productivity and drive economic growth. Moreover, if an infrastructure bill gets passed (which at the time of this writing seems likely) that would also boost productivity growth: the less time wasted moving people, goods and information around, the better it will be for the economy and productivity growth.
When will the cycle turn for CRE?
The fortunes of commercial real estate (CRE) are looking up, underpinned by the rapid turnaround in the economy. But like any business cycle, fortunes differ by property type. Industrial stands out relative to history. Recovery in that sector began much sooner than during a typical business cycle. Vacancy rates should continue to fall during the balance of the year while asking rents continue to increase. Despite dire predictions to the contrary, the retail sector held up relatively well during the pandemic. That sector is nearing stabilization as vacancy rate increases and asking rent decreases slow. The strength of the U.S. consumer is proving resilient, underpinning the fortunes of the sector. The multi-housing sector is also nearing stabilization, buoyed not only by the overall economy but its status as a provider of a non-discretionary need. Over the next few quarters vacancy rates should stop rising and rents should stop falling, paving the way for recovery in 2022. Lastly, the office sector, garnering an outsize amount of attention this cycle, is not yet approaching stabilization, but precursors have emerged. Tours and showings are increasing, sublease space is being pulled from the market in certain locations, and interest in leasing space is clearly increasing. The sector likely has a few quarters until stabilization, but the path forward is becoming more certain. Overall, the situation in the market continues to change more rapidly than many are anticipating. Momentum in the CRE market should accelerate as we push further into 2021 and the data looks more favorable.
“(Office) tours and showings are increasing, sublease space is being pulled from the market in certain locations, and interest in leasing space is clearly increasing.”
Closing Thoughts and Risks
We remain relatively positive despite the ongoing challenges. But we see three key risks for this outlook. First, the ongoing pandemic (particularly the delta variant) continues to present challenges. We do not anticipate that it will produce the drag on economic growth that it did in previous quarters, but the heightened contagiousness coupled with stalling vaccination rates undoubtedly presents a headwind to economic growth. Second, inflation and associated supply-chain issues continue to create risk. We continue to foresee inflation settling at a level above the previous business cycle but not at dangerous levels akin to the 1970s. That said, if inflation does settle in at an elevated level, participants in the space markets and capital markets will have to accurately account for this development. Third, the ongoing labor shortage offers no easy solutions. It continues to marginally drag on economic growth and the CRE market. Though this drag should prove almost imperceptible in the short run, in the medium run the cumulative impact could become noteworthy.