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Tick, Tock: Timing of the Next Downturn and What It Means for Commercial Real Estate

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Tick, Tock: Timing of the Next Downturn and What It Means for Commercial Real Estate Bulletin October 2018 Contacts Tick, Tock: Timing of the Next Jeff Adler Vice President & General Downturn and What it Means Manager of Yardi Matrix [email protected] For Commercial Real Estate (800) 866-1124 x2403 Jack Kern Director of Research and Economic downturns in recent decades have generally started with a bang— Publications bubbles bursting in the housing or technology markets or oil price shocks [email protected] come to mind—but the next one is more likely to arrive as a whimper. (800) 866-1124 x2444 Paul Fiorilla As the U.S. economy approaches a decade without a recession—closing in Director of Research on the longest such period post-World War II—guessing what will cause the [email protected] next downturn and when it will commence has turned into a parlor game (800) 866-1124 x5764 for business. Chris Nebenzahl Institutional Research Manager Analysts looking for an overheated sector that could bring the entire econ- [email protected] omy down are searching in vain. Problems that caused previous recessions (800) 866-1124 x2200 seem relatively under control. For example, commercial mortgage lending has grown through the cycle, but leverage levels seem under control. Con- sumer debt is at an all-time high, but consumer debt-to-income ratios and household balance sheets are healthy. The stock market dropped 10 per- cent in October as investors worry about rising interest rates, the impact of trade policy and an economic slowdown, but it’s hard to predict a bear market when corporate profits are at record levels. Oil price shocks have been a major factor in virtually every recession of the last half-century, and while oil prices have risen lately, they remain nowhere near all-time highs, while oil’s impact on the economy is diminishing. It’s true that the next bubble is rarely obvious until after it pops. And there are many potential trouble spots—just none identified to date that have the capacity to create major waves by themselves. Consequently, the next downturn might be caused not so much by the pop of a major bubble but by the cumulative effect of a series of economic events. As to when economic growth might turn negative, it’s unlikely to happen soon. U.S. and global GDP is likely to hit a multi-year high at about 3% this year, and the consensus view is that growth will slow only slightly in 2019. The U.S. employment market continues to be robust. Absent an unforeseen event, 2020 is the earliest a recession could commence, and even that might be a stretch. © Yardi Systems, Inc., 2018. All rights reserved. All other trademarks are the property of their respective owners. Bulletin | October 2018 | 1 Potential Headwinds: A Series ing it difficult for first-time buyers to afford Of Unfortunate Events? homes, and construction will get more ex- pensive due to tariffs on housing construc- Factors that could serve to reduce economic tion materials. growth include: ■ Rising oil prices. Crude oil prices rose to the ■ Corporate debt bubble. Corporations have mid-$70 range before dropping. The add- taken advantage of low Treasury rates by ed cost to consumers of gasoline and other issuing huge volumes of debt. Total corpo- products has mitigated the positive impact of rate debt tops $9 trillion, nearly 50% above tax cuts. Prices could go up further for several the peak during the last bubble. However, reasons, including political tensions and sanc- debt-service levels and corporate debt as a tions on Iran that cut into global production. share of GDP are not as high as in past cycles. ■ Auto production. The U.S. auto industry has ■ Weaker global growth. Economies in most of rebounded well since 2009. Sales are topping the world have picked up in recent years, but 17 million per year, led by light trucks and trouble spots are on the horizon. Examples: SUVs, and auto debt is increasing accord- Japan’s population continues to shrink, GDP ingly. An increase in gasoline prices could eat growth in China is slowing as the government into sales of popular vehicles, while higher attempts to control rising debt levels, and interest rates could reduce credit available Europe is struggling to deal with the fallout for loans to purchase vehicles. of Brexit and anti-immigration movements. Emerging markets such as Argentina and Tur- ■ Immigration. Economists largely agree on the key are showing signs of stress, which could benefit of skilled immigrant workers to the grow worse. economy, and policies that make it harder to bring workers to the U.S. are a headwind ■ Slowing housing market. Housing prices have to growth. Example: Commercial real estate rebounded well, with home equity growing by development companies report critical short- $9.2 trillion since the Great Recession. But af- ages of skilled construction workers, in part fordability and rising interest rates are mak- due to restrictions on immigration. 220 Home Price and Wage Index 200 180 160 140 120 Index Jan 2000 = 100 Index 100 Jul-01 Jul-04 Jul-07 Jul-10 Jul-13 Jul-16 Apr-02 Apr-05 Apr-08 Apr-11 Apr-14 Apr-17 Jan-00 Jan-03 Jan-06 Jan-09 Jan-12 Jan-15 Jan-18 Oct-00 Oct-03 Oct-06 Oct-09 Oct-12 Oct-15 Average Hourly Earnings Case-Shiller Home Prices Sources: U.S. Bureau of Labor Statistics; S&P Dow Jones Indices LLC; CoreLogic, Inc.; Source:S&P U.S. CoreLogicBureau of LaborCase-Shiller Statistics; S&PHome Dow PriceJones Indices Indices; LLC; Moody’s CoreLogic, Inc.:Analytics S&P CoreLogic Case-Shiller Home Price Indices; Moody's Analytics Bulletin | October 2018 | 2 ■ Fiscal policy reversal. Corporate and personal ■ Yield curve. A related concern is that the short- income tax cuts have injected a fair amount term interest rate will increase above the 10- of stimulus into the economy, although the year Treasury rate, which is called an inverted impact diminishes in 2019 and turns into a yield curve, a phenomenon that frequently negative drag on growth in 2020. Greg Daco, has presaged recessions. The yield curve has chief U.S. economist at Oxford Economics, steadily declined since January 2014 and was said policies signed into law in 2017 and 2018 about 25 basis points before the latest jump will boost U.S. GDP by 65 basis points in 2018 in 10-year rates. If the Federal Reserve con- and 50 basis points in 2019 but will reduce tinues to raise short-term rates and growth GDP by 30 basis points in 2020. falters, the yield curve could invert. ■ Rising interest rates. The federal funds rate ■ Tariffs. Economists almost universally hate is up to 2.0% and the Federal Reserve is ex- a trade war, and the Trump Administration’s pected to raise policy rates by 0.25% per use of tariffs as a policy tool is a stress on quarter. The 10-year Treasury rate climbed the economy, increasing the cost of consum- to 3.2% in early October, the highest lev- er goods, housing, autos and more. So far, el since May 2011. The Fed is trying to pre- the impact has been minor, but that could vent inflation from rising above the 2% tar- worsen if other countries such as China and get level, but there is concern it could wind Canada retaliate, and the number of tariffs up choking off growth. Interest rates are a escalates. Nouriel Roubini, a professor at particular concern to commercial real estate NYU’s Stern School of Business and CEO of because growth in the 10-year Treasury will Roubini Macro Associates, lists tariffs and increase the cost of permanent debt financ- unpredictable policy responses among the ing and reduce the premium between debt likely causes of the next recession. costs and acquisition yields. Cap rates have remained near all-time lows even as the Although it’s late in the cycle, there are possibili- 10-year Treasury has risen over the past 18 ties with upside, as well. One would be that corpo- months, but something will have to give as rate tax and regulatory reform produces a wave the premium narrows even more. of investment and higher productivity. Another is 10-Year vs 2-Year Treasury Yield 8 7 6 5 4 Percent 3 2 1 0 Jul-07 Jul-02 Jul-12 Jul-17 Apr-06 Apr-01 Apr-11 Apr-16 Jun-05 Jun-00 Jun-10 Jun-15 Jan-10 Jan-05 Jan-15 Jan-00 Oct-08 Oct-03 Oct-13 Feb-07 Feb-02 Feb-12 Feb-17 Sep-06 Sep-11 Sep-16 Sep-01 Dec-07 Dec-02 Dec-12 Dec-17 Nov-05 Nov-00 Nov-10 Nov-15 Aug-09 Aug-04 Aug-14 Mar-09 Mar-04 Mar-14 May-08 May-03 May-13 May-18 Two-Year Treasury Yield Ten-Year Treasury Yield Sources: U.S. Board of Governors of the Federal Reserve System; Moody’s Analytics Bulletin | October 2018 | 3 that wage growth could accelerate and produce is 2.9% in 2018 and 2.7% in 2019. The biggest con- a wave of consumer spending. Still, the most cern expressed by economists is on the issue of likely positive economic scenario is for growth to trade, as tariffs could lead to an increase in infla- maintain its current level, producing steady job tion and decrease economic growth by one-quarter growth and low volatility in the capital markets. to one-half of a percentage point. The other risks cited most often by economists in the NABE survey With growth solidly near 3% , and the unemploy- were higher interest rates and a declining or volatile ment rate at 3.7%, the lowest since 1969, it must stock market.
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