Research

Economic Insights: Rise of the Boogeymen?

With a hike in interest rates now on the back burner, the markets are wary of a trio of boogeymen. Any of which could put a serious damper on the economy.

Both equity and credit markets responded favorably to the Fed’s newfound dovish stance. With the Fed largely on hold, the market will focus on new boogeymen as it looks for signs of trouble in the economy. No shortage of candidates exists, but the impact of successor worries appears far more muted than the Fed’s impact. These risks stem from the political realm and, as we mentioned in our note from January 25, political risk sits at elevated levels in 2019.

Global economic growth is slowing. Increasingly signs of this slowdown are emerging from more and more parts of the world making it look like a more durable than temporary phenomenon. Thus far, U.S. exports to the rest of the world have held up rather well. But keep in mind two important points. Exports constitute roughly just 14 percent of GDP, blunting the direct impact of any slowdown that would come from weakening foreign demand associated with any economic deceleration. But foreign revenues represent roughly 43 percent of S&P 500 revenues, which means the biggest companies in the U.S. economy could disproportionately feel any impact. That could filter through to market psychology and sentiment which could ultimately impact behavior and the real economy.

Also on the global front, as we predicted. the U.S.-China trade situation seems unlikely to reach any grand agreement by the March 2 deadline. Negotiations moved to Beijing from Washington this week. We see some sort of middle ground emerging from the discussions: we do not foresee an escalation in trade restrictions coming soon, but we also do not see a withdrawal of existing restrictions either. Modest restraint on U.S. GDP growth looks like the most likely outcome for 2019, but the risks still tend toward the downside.

While another shutdown seems unlikely, progress on negotiations stalled recently and the outcome remains highly uncertain.

Lastly, domestic political tensions return to the spotlight this week. The funding from the continuing resolution passed to end the government shutdown expires Friday. While another shutdown seems unlikely, progress on negotiations stalled recently and the outcome remains highly uncertain. If nothing else, situations like these can undermine business and consumer confidence at a time when the U.S. economy is already slowing.

Market conditions have rebounded

As we mentioned above, markets responded favorably to the Fed’s turn toward patience and seem less threatening than they did in December. The stock market has regained most of the ground that it lost late last year. The Fed’s Senior Loan Officer Survey indicates that while lending standards are tightening, spreads remain relatively narrow. With underlying growth for this year looking firm (which we will specifically address in our quarterly economic outlook next week) we still wonder if the Fed turned too dovish too quickly. Its about face helped markets stabilize, but it seems a bit too excessive relative to underlying strength in the economy.

The focus should be on inflation

While inflation remains tame, the environment should stay stable. But the trend over time remains upward.

Underlying economic growth and the labor market look firm and the Fed sits on pause. In that environment can inflation keep rising? That certainly appears true. Data from the consumer price index (CPI) and the producer price index (PPI) for January should show sustained underlying pressure, particularly in core inflation. We expect both core readings on a year-over-year basis to have changed little in January, partly because of base effect (i.e. strong inflationary readings in January 2018). While inflation remains tame, the environment should stay stable. But the trend over time remains upward. The bond market, and thus the prescient yield curve, will rightly focus on inflation this year. If inflation is ever going to surprise on the upside, this year looks promising with interest rate hikes gone for now and wage growth accelerating. We do not foresee significant jumps ahead and we believe that inflation expectations remain well anchored for now. But that could change if accelerating wages continue to erode profit margins, resulting in costs passing through to consumers. Stay tuned.

What else happened last week

The ISM nonmanufacturing index for January declined, falling below expectations again. Yet, the index signaled moderation and continued expansion, rather than contraction. The trade balance for November showed that the trade deficit shrunk for the first time in six months. This looks like a reversal after imports surged in anticipation of higher tariffs amidst the U.S.-China trade dispute. Initial unemployment claims pulled back for the week ending February 2. Claims ticked up slightly in recent weeks, but still look healthy. As we watch the labor market for wage acceleration we will also keep a close eye on claims, looking for any early signs of labor market slowing.

What we are watching this week

In addition to inflationary readings and unemployment claims, we look to retail sales for December and business inventories for November to provide better clarity on growth in the fourth quarter. We will not receive a first look at fourth quarter GDP growth until February 28 because of the government shutdown, but these data points will help inform our model and forecast which is missing some important data. And consumer sentiment for February should show a slight uptick after a meaningful drop in January due to the shutdown and pullback in the markets.

 

What it means for CRE

For commercial real estate (CRE), stabilizing external factors harken back to the goldilocks economy of past years. Growth does not appear too strong or too weak and interest rate increases seem a slightly distant prospect providing a sense of stability. We see little serious near-term risk to the market, barring the wrong combination of idiosyncratic factors materializing. Inflation will hold importance for CRE not just because of the role it will play in the overall economy’s fate, but because CRE can provide investors with a useful if imperfect hedge against inflation. In that sense, the CRE market itself seems hedged right now. Higher inflation could pose a risk to the economy but incentivize investors to own CRE. Lower inflation would remove that incentive but present a favorable economy that bolsters CRE fundaments. Either way, the environment looks favorable.

 

Thought of the week

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