The wrong kind of record and the economy
Setting the wrong kind of record
During this past weekend the current federal government shutdown set a record as the longest ever. While government shutdowns usually impact the economy very little, the risk of a more severe impact increases as the shutdown drags on. We estimate each month of a shutdown reduces annual economic growth by roughly 25 basis points. But the longer the shutdown lasts, the greater the impact will become as more departments and divisions run out of funding, government contractors do not get paid, and public sentiment sours. The government will also release important economic data on a lag and it will take months for the releases to get back on schedule.
The risk of government workers leaving their jobs permanently will increase with time because of the tightness in the labor market and the shortage of labor.
And within the next few months, the government will need to reach an agreement on raising the debt ceiling. Failure to do so would be catastrophic for the economy. Even worse, the shutdown comes at a time when geopolitical risk has likely reached its highest point in decades. Political gridlock and infighting seems the order of the day in Washington, D.C., U.S.-China trade tensions remain elevated amidst ongoing negotiations, Brexit is entering home stretch, and financial markets remain volatile, even though they have rebounded from their December lows. Even without raising the debt ceiling, the right combination of political risks coming to fruition could trigger a recession this year.
What are the odds?
Observers have thrown the word “recession” far more frequently over the last few weeks. The downturn in the equity market seemed to indicate that investors believed the economy is headed for a recession in 2019. But we do not believe that is the case. Although economic growth is slowing around the world and in the U.S., and financial conditions in the U.S. have tightened, we believe the markets have taken too dim a view of the economic outlook. The underlying economic data likely remains too strong for a recession in such a short timeframe. And recent releases only support that thesis. Although the ISM Nonmanufacturing index for December fell from recent high levels, it remains elevated and the underlying details show strength in the service sector. Open but unfilled jobs remain near 7 million, an incredibly high level indicating ongoing demand for labor. Initial jobless claims have ticked up in recent weeks, but still hover near cyclical lows. The shutdown will distort this data for a while so getting good cues from the unemployment data should become more difficult until after the government reopens. And the consumer price index (CPI) data demonstrated that underlying pricing pressures remain firm, even with the significant pullback in energy prices.
We foresee economic growth in the U.S. slowing toward the mid-2-percent range, but a recession seems like a distant possibility.
Fed swings from foe to friend
With economic growth slowing, market volatility increasing, and credit conditions tightening, the Fed has been forced to revise down their projections for the Fed funds rate. Moreover, the Fed has also softened its tone in recent weeks. The official Fed statement from December’s meeting and recent speeches by Fed officials appear designed to assuage concerns that the Fed is tightening too much. The Fed has taken pains to emphasize that they will increasingly focus on the data in 2019, amidst a period of uncertainty. Markets have largely cheered the Fed’s actions since they raised rates in December.
But with the economy remaining firm, we do not believe that the Fed will completely walk away from rate hikes in 2019 as the market currently anticipates.
If the economy only slows, as per our projections, then the labor market will remain sufficiently strong to keep pushing up wage growth, risking stronger inflation that continues to rise above the Fed’s target rate of 2 percent. Inflation has remained relatively tame in recent years, even as economic growth has accelerated. But many overlook the role that rising rates have played in keeping inflation in check, especially over the last two years. If the Fed eases up too much on rate hikes while underlying scarcity continues to put upward pressure on prices, inflation could surprise on the upside. Ultimately, the data will dictate where rates are going and the data thus far looks firm.
What we are watching this week
The shutdown will prevent the government from releasing some data this week, but key data will still circulate. Inflation for December, measured by the producer price index (PPI), should show similar trends to the CPI released last week. Headline PPI should moderate due to declining energy prices, but core PPI should remain near 2.8 percent due to consistent underlying pricing pressures. Similar to the PPI, import prices for December should also show a decline due to energy prices. We expect housing starts and building permits for December both to have declined – the market weakened a bit in the face of rising mortgage rates in the fourth quarter. Consumer sentiment for January likely declined due to the equity market pullback. Nonetheless, the tight labor market and accelerating wage growth should keep consumer sentiment at elevated levels.
What it means for CRE
The year ahead could become an important transitional one for commercial real estate (CRE). During most of the current expansion, risk has resided internally, mainly via supply growth. But with economic growth set to slow in 2019, coupled with rising geopolitical risk, CRE could find itself more influenced by external than internal factors for the first time since the early stages of the recovery. That’s when supply growth was muted but the external environment seemed uncertain and shaky. We still believe that CRE will perform well in 2019, but the rise of external factors could present an environment that many have not faced in years.
Thought of the week
According to a 2017 National Bureau of Economic Research study of 135 unicorn start-ups, researchers concluded the companies were overvalued by an average of 50 percent.