Stormy on many fronts

18 septembre 2018

Uneven economic data last week reflected both the weather roiling parts of the country and reminders of Lehman Brothers' collapse 10 years ago. This does not mean that the results were poor, but certainly a bit more uneven than expected. Retail sales for August fell below expectations, rising by just 0.1 percent. Core retail sales also came in below expectations. But July's data was revised to the upside, meaning the trend in consumer activity for the third quarter remains strongly supportive of economic growth, likely around 3 percent.

Similarly, inflation data disappointed a bit, but the overall trend shows underlying strength and upward pressure on prices.  The headline producer price index (PPI) for August declined slightly, pulling the year-over-year growth rate down to 2.8 percent, from 3.3 percent year-over-year in July. Core PPI increased slightly and dragged down slightly the year-over-year change to 2.8 percent after rising 2.9 percent year-over-year in July. The deceleration in inflation follows robust inflation over the last two months and PPI has clearly accelerated over the last year. A similar trend occurred with the consumer price index (CPI) for August, with the data falling marginally below expectations. The headline CPI pushed higher but base effects (essentially the price level last year) lowered the year-over-year growth rate to 2.7 percent, down from 2.9 percent in July. Core CPI also decelerated, pulling back to 2.2 percent year-over-year, after July's 2.4 percent pace which was the strongest since September 2008. Import inflation also decelerated during August, mainly due to declines in volatile fuel prices. We frequently caution not to read too much into any one data point in a series and we reiterate that here: 

Tariffs and continued strength in the economy (fueled by fiscal stimulus) should continue to put upward pressure on pricing.


Fed should remain on track

The trends in inflation should keep the Fed on track for two more rate hikes this year, with the next one arriving next week and one more in December, in line with our expectations. Importantly, the futures market, which has consistently trailed Fed expectations, now also believes that two rate hikes will arrive this year. 

That would push the target Fed funds rate into the 225-250 basis points range and continue to flatten the yield curve. 

As long as nothing deters the Fed's current path, the yield curve should invert by 2019. We do not think the prospect of an inverted yield curve will prevent the Fed from continued hikes. Many people, including some members of the Federal Open Market Committee that actually vote on interest-rate policy, believe that an inverted yield curve will not explicitly signal a recession for a variety of reasons, notably the massive intervention by the Fed since the financial crisis began. We do not share that opinion and remain wary of an inverted yield curve (irrespective of underlying cause) because it produces a negative net interest margin which makes lending by banks unprofitable. In turn, that causes banks to pull back on lending, leading to slowed economic growth. While no one can guarantee that an inverted yield curve will lead to a recession, its ability to foretell recessions remains intact thus far.

Florence's likely impact on the economy

Though damage estimates vary, and some time will pass before we know the full impact, 

Hurricane Florence could cause to up to $30 billion in damage. 

That would rank it among the top 10 hurricanes by financial damage in U.S. history. Based on empirical evidence, Florence could detract up to 50 basis points from third quarter growth, depending upon how long activity remains subdued while flooding subsides. The timing of the hurricane (the majority of the impact occurring on the weekend) and the large amount spent in preparations (purchases made in advance that wouldn't have otherwise occurred) should blunt some of the impact from output loss. We should also expect some distortion in the data releases for September.

Ten years later, how are we doing?

This week marks 10 years since the fall of Lehman Brothers. While the economy has recovered and expanded since then, potential output has declined below levels from 10 years ago and the recovery has certainly been uneven. From a commercial real estate (CRE) perspective, the downturn exacerbated the evolution of the economy, continuing to concentrate in metropolitan areas while rural and outlying exurban areas fall further behind. Even within metropolitan areas, the expansion has progressed at different speeds: knowledge economies increasingly dominate at the expense of economies that cannot attract and retain high value-add talent. By property type, the picture varies as well. 

Apartment and industrial have fully recovered, with fundamentals surpassing vacancy rates and nominal rent levels from before the downturn. But the office and retail markets have not fared as well. 

The vacancy rates for both of those property types remain above levels from before the downturn while nominal rents have only recently surpassed previous peak levels.

What it means for CRE

Because of its location, we expect Florence to have minimal impact on CRE. Some markets in the Southeast U.S. could be temporarily disrupted, but we do not anticipate lasting effects. Underlying trends in the economy still present a favorable environment for CRE, keeping the situation relatively stable for the balance of the year. We do not anticipate significant changes to vacancy rates and rent growth across the major property types. Any upward pressure on vacancy rates and slowing in rent growth should come more from escalating new completions than a decline in external demand drivers.

What we are watching this week

Housing starts should make solid gains in August while building permits should remain relatively unchanged. Existing home sales should also show little change in August. After reaching lows unseen in 50 years, we expect initial jobless claims for last week to rise slightly. 

Thought of the week

It appears that the administration will move forward with additional tariffs of around 10 percent on another $200 billion of Chinese imports. As we highlighted in our special report last month, this will further weigh on GDP growth and industrial rent growth over the next 12-18 months. 

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