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Chief Economist's Perspective:
U.S. Macro Outlook

The next few months of economic data will be critical in determining the economic and CRE outlook for the remainder of the year.

The headline figures on the U.S. economy remain largely resilient. Real GDP grew by an advanced estimate of 1.6% in the first quarter and the economy continued to crank out jobs, adding an impressive 829,000 over the same period.  With an unemployment rate of 3.8% as of March, the labor markets are not only on par with pre-pandemic levels (having ended 2019 at 3.6%) but are likely at or beyond full employment. Accordingly, the stability in the economy drove recession odds down. We entered the year with a roughly 40% probability of recession according to the WSJ survey of economists. As of April, that probability has dropped to 22%, the lowest since the Fed started hiking rates in March 2022. 

 

Similarly, the optimism spread to the CRE sector. As the 10-year Treasury yield dropped from Q4 and stabilized throughout Q1, so too did CRE borrowing costs. CRE mortgage rates declined from the mid-7% range in October to the mid-6% range in Q1 2024 (and to under 6% for multifamily). Credit spreads tightened relative to Treasury yields and investment grade corporate bond yields, indicating that confidence in the CRE sector was growing relative to other asset classes. As recession risks faded and corporate profits came in strong, leasing activity also improved in the early months of 2024. Even the beleaguered office sector experienced a moderate pick up in sales volume in Q1 and now stands roughly 40% higher than the likely nadir in this cycle (Q3 2023).   

And yet, despite those green shoots, challenges remain. Uncertainty over the near-term macroeconomic outlook continues to translate into an inverted yield curve which is putting pressure on the financial system (particularly on banks). Meanwhile, inflation remains stubborn, and there are cracks forming beneath the surface, signaling that the U.S. economy is beginning to throttle back. On top of that, more recent inflation prints caused renewed volatility in the Treasury market, as investors dialed back their rate cut expectations to align more closely with the Fed’s higher-for-longer messaging. The next few months of economic data will be critical in determining the economic and CRE outlook for the remainder of the year and into 2025.  

Higher interest rates beginning to take their toll

Although the economy appears to be pulling off a soft-landing in the face of higher interest rates, it is worth remembering that monetary policy works in long and variable lags. Historically, it has taken an average of 24 months after the Fed’s first rate hike before the economy starts to show weakness. We’re right around that 24 month mark now—as the Fed began raising rates in March of 2022—so some cooling in the U.S. economy should be showing up soon, and it is. Most notably, the U.S. consumer is beginning to dial it back. The latest retail sales reports from the Bureau of Economic Analysis reveal that consumer spending on furniture, electronics, clothing and several other categories are now declining year-over-year (YOY). Sales of big-ticket items are also under pressure. Home sales are down roughly 40% from their peak and have shown little improvement in 2024. Vehicle sales have also cooled off sharply—from double digit YOY gains in 2023 to low single digit gains (2%) thus far in 2024. This in combination with rising delinquency rates on credit cards and auto loans, along with weaker confidence readings (particularly consumer expectations going forward), suggest the consumer is coming under increased pressure. In addition, energy prices have generally been trending higher since the year started. Unleaded gasoline prices started the year at $3.05 per gallon but are now hovering in the $3.75 range, beyond what normal seasonality patterns would cause given greater spring and summer demand. Higher prices at the pump leave less cash for consumers to spend on other things. This is another headwind that will likely weigh on consumer spending going forward, and there is a nontrivial risk that oil prices could push up even further given rising tensions in the Middle East.  

The labor markets are also weaker than some headlines suggest. Although the U.S. economy created over 800,000 net jobs in the first quarter, those job gains have largely been concentrated in just a few sectors: healthcare, education, leisure and government. Take those sectors out, and there is very little job growth occurring in the U.S. economy. Temporary employment—often a leading indicator for permanent workers because when demand cools, businesses cut temp workers before permanent workers—has been steadily declining since early 2023 and that trend has continued into 2024. Full-time employment has also been falling over the past year, all as layoff announcements are trending higher and hiring rates lower. A rising share of unemployment is being caused by permanent job loss. 

 

Not a recession, just a slowdown

Despite the growing headwinds, there are solid reasons to believe the U.S. economy will be able to avoid a recession and continue to expand, albeit at a slower pace. Most notably, household balance sheets remain in excellent shape. The household debt service ratio—a measure of debt payments to disposable income—remains historically low (though climbing) as of Q4 2023. This means that, on average, consumers have enough income to make their monthly payments and still have money left over to spend. It’s also worth noting that roughly two-thirds of households own their home, and of those, only 40% have a mortgage. Most of these homeowners have locked in low mortgage rates under 4%, and therefore are somewhat insulated from the higher rate environment. Another important dynamic that points to continued resiliency in the U.S. economy is that the top two-thirds of the income distribution are generally doing extremely well. This segment of the population, big owners of stocks and homes, have watched their net worth soar, creating a very robust wealth effect. In fact, household net worth now stands at an all-time high of $147 trillion, up from $100 trillion in 2019. Moreover, the top two-thirds of the income distribution account for an estimated 90% of all consumer spending and are positioned to keep the bulk of the economy expanding. The bottom third of the income distribution is the segment that is under the most pressure, feeling the brunt of high inflation (in particular, food and energy, since it is a greater share of their monthly budget), but this segment accounts for a much smaller share of all spending (about 10%).  

Additionally, corporate profits remain solid, which makes mass layoffs unlikely to occur anytime soon. Real wage growth also remains positive, which boosts consumer purchasing power. A macroeconomic recession doesn’t seem to be in the cards for 2024, but a slowdown is. 

Bad news is good news

From a Fed policy perspective, more weakness in the economy is likely needed to get inflation fully back to target. Prior to this year, inflation statistics had been trending in the right direction. The consumer price index (CPI) peaked at 9% in June 2022 and had fallen all the way to 3.1% by the end of 2023. But since then, progress has stalled above 3%. The latest reading on the CPI shows it was up 3.5% YOY in March, still a good way from the Fed’s stated objective of 2% and going in the wrong direction. Likewise, progress in getting core CPI—a better measure of underlying inflation—back to target has stalled. The core CPI was up 3.8% YOY in March and has generally remained at this same level since December. Indeed, the last mile of getting inflation back to target is proving difficult. On the bright side, the Fed’s preferred measure of inflation, the core personal consumption expenditures index (sometimes called the core PCE deflator), is closer to target. The core PCE deflator was up 2.8% YOY in March. But 2.8% is not 2%. With the core PCE deflator still above target, and with the latest CPI prints coming in hot in addition to resilient payroll reports, markets have pushed the timing back on the first Fed cut. According to most economists (including us) and the Fed futures, a rate cut in June is now off the table. Most are now assuming the first cut will occur in September, but even that is starting to feel iffy.

 

Despite this year’s disappointing inflation statistics thus far, there’s good reason to believe inflation will continue to come down, but it will likely need help from a slowing economy to get all the way back to target. In this way, bad news about the economy is, oddly, good news in a way. And although we are getting some “bad news” now, indicating growth is slowing and labor markets are cooling off, there are also some positive developments coming from the supply side of the economy that should help: 

  • Immigration into the U.S. has been surging in recent years. The Congressional Budget Office estimates that 3.3 million people migrated to the U.S. in 2023, up from 2.6 million in 2022. CBO’s estimates are above official Census Bureau estimates and the historical average, which is closer to 1 million. Although this is clearly a politically charged topic, from a pure economic perspective, strong immigration into the U.S. is boosting labor force growth, which is facilitating the strong job gains we’ve had while also taking pressure off wage inflation.   
  • Strong worker productivity has been another positive development. For various reasons, worker productivity began to surge in 2023, growing at an average rate of 3.5% the last few quarters versus its underlying growth rate, which is estimated to be closer to 1.5%. Strong productivity gains should help on the inflation front; if businesses are producing more per worker, they can sell more product at lower prices and still maintain healthy profit margins.  
  • Moreover, many of the pressures that caused inflation to ignite in the first place are now fading. After getting rocked by the pandemic, supply chain issues have now largely resolved, factories are up and running, product is moving, and inventories are rebuilding.  
  • The silver bullet to solving the inflation problem may ultimately come down to arithmetic. Inflation is currently propped up by the shelter component, which receives a large 36% weight in the CPI calculation, and a still significant 15% weight in the PCE index. The Fed has openly acknowledged that and is keenly aware of the lagged influence of last year’s slowing multifamily rental growth and single-family price growth, which are still collectively expected to percolate their way into measured inflation. It is not necessarily reasonable to assume that shelter will exert no pressure on inflation whatsoever moving forward, but if you remove the shelter component from the CPI equation, headline inflation is essentially already back to target. 

The moment of truth

The next few months will be critical in setting the economic trajectory for the remainder of the year and into 2025. Will we see the CPI and PCE prints resume the disinflation we observed last year, or not? The consensus base case is that the U.S. economy will continue to perform reasonably well and inflation will continue to come in, allowing the Fed to pivot and begin cutting rates in September. This is a bit too sanguine for us, but we are not too far off from consensus. Our base case is that the cracks we are seeing in the economy now will result in a more meaningful slowdown in growth, and that slowdown will be important for getting inflation back to target. Fortunately, if the economy were to turn meaningfully worse, the Fed now has much more room to cut rates, unlike in prior years when rates were abnormally low. In our view, the Fed will be patient and will not shift stance prematurely without ample, consistent evidence.  We’ve also penciled in the first cut for September, but we are aware that they may decide to wait a bit longer before starting the cutting cycle. Of course, the Fed’s decision will be data driven and a lot of change can happen between now and then.  

Fed pivot—it’s becoming a parlor game

The proverbial “Fed Pivot” has turned into something of a parlor game. Will the first cut be in September, in November, or will it get pushed into 2025? It’s important to recognize that certain aspects of the CRE sector are less interest-rate sensitive than others. From a leasing perspective, if the economy generally remains healthy (though slowing) and is still creating jobs, then we should see continued momentum in leasing. Growing payrolls create more demand for space, translating into leasing and net operating income (NOI). Of course, this varies by product type, and for the office sector specifically, which confronts its own unique headwinds (though those headwinds are expected to fade as remote work has peaked and pre-pandemic leases filter through). Whether the Fed cuts rates or not in 2024, the CRE fundamentals are generally expected to weaken this year, in part, because of the assumed economic slowdown, but also due to a supply wave (particularly in industrial and multifamily). Beyond this year, there is an inflection point coming, even for office. Occupancy—though drifting lower because of supply wave in certain sectors—generally remains healthy across most product types. The leasing fundamentals will firm in 2025 and NOI growth will generally outpace inflation over the next few years.   

For the capital markets, one or two rate cuts in 2024 (though important in getting the yield curve on a path to un-inverting), wasn’t really going to move the needle for this year. What is moving the needle is that buyers/sellers/lenders are finally getting conditioned to higher cost of capital environment. The 10-year Treasury has been above 4% for a solid year, and investors are slowly getting acclimated to the higher interest rate environment, which is leading to yield adjustments and subsequent price corrections, which so far have been between 15-20% according to RCA. There is still some ways to go, but the price reset is in the works which will lead to more activity. In fact, in some ways, higher-for-longer may help the market unfreeze. Sellers have been using the impending rate cut to justify “waiting.” The longer rates stay where they are, the more needs-based sell-side conditions will emerge, stimulating more market-wide alignment and transparency on valuations, which in turn, will lead to more transactions.  More acceptance also implies that the marketplace will be receiving fresh capital infusions not only from new and eager buyer sources, but also from public-private partnerships and federal programmatic support focused on opportunistic or value-add property-level repositioning and conversion plays, which will collectively propel ongoing innovation and evolution throughout our industry. The good news is the conversation is shifting away from interest rates and now there is more of a focus on operating fundamentals. 

It will be bumpy, the contours of the recovery in property markets are unlikely to be V-shaped, but a recovery remains in the works.   

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