by James Lane | Apr 07, 2016

Originally published on February 5th 2016


  • The recovery has room to run, thanks to U.S. consumers.
  • Financial market turbulence is affecting sentiment on Wall Street, not Main Street.
  • Talks of recession are premature but a sharp stock correction is a risk.
  • U.S. real estate is a popular investment amid low interest rates and global economic jitters.

The Glass Is Half-Full

There is plenty of evidence to justify both pessimistic and optimistic forecasts of the U.S. economy. Those feeling nervous about the outlook need to look no further than Wall Street: the S&P 500 tumbled through mid-January, oil is stuck at around $30 per barrel, and growth outside the U.S. appears weaker by the day. Even some downplaying these warning signs as temporary have expressed concern about stubbornly tepid productivity and wage growth.

Forecasters who see the glass as half-full have an equally convincing argument. The economy added 2.65 million jobs in 2015, with hiring accelerating through the end of the year. The unemployment rate of 5% is the lowest since 2008 and is close to what most economists consider the equilibrium rate in a normally functioning economy. Consumer spending—which makes up more than two-thirds of the economy—has been growing at an annual average of 3% for the last 18 months, thanks to brimming consumer confidence and the tailwind of cheap oil.

Figure 1: Consumers Have No Problem Spending

Sources: BEA, University of Michigan, CBRE Econometric Advisors, Q4 2015.

The EA outlook leans toward the optimistic end of the spectrum, while acknowledging that the recovery is likely entering its cool-down phase. Fundamentals suggest that expansion has a few years to mature before cyclical forces idle the economy. Although a number of risks are squarely on the radar, none is potent enough to derail the economy on its own. A series of mishaps would have to occur in order for the U.S. to flirt with recession in the next couple years.

Our near-term forecast has been slightly downgraded, as trade and manufacturing are fighting global headwinds. Still, we anticipate GDP growing at 2.1% in 2016 and at 1.5% in 2017, and about 4.3 million new jobs are expected to be added during those two years. Job gains will decelerate as the pool of qualified labor diminishes, and wage growth should encourage the Federal Reserve to gradually raise interest rates. This cyclical denouement—combined with tighter policy—will eventually put the clamps on growth. It would not be surprising to experience a mild recession toward the end of this decade.

Dont Wake The Sleeping Bear (Market)

Stocks have fallen precipitously, raising concern that the bear market may come out of hibernation early this winter. The S&P 500 has bounced around in negative territory, but stocks aren't all that is hurting. Oil has sunk to its lowest price since 2002 and risk measures in the bond market are deteriorating. With these warning signs flashing yellow, it makes sense that investor sentiment has turned sour.

But this turbulence is not an accurate litmus test for the U.S. economy; it is symptomatic mostly of external factors. Many of the ingredients can be traced to China's slowdown and its ripple effects through the global economy. Tumbling commodity prices are one key result, with their huge impact on emerging markets and U.S. energy-producers.

Markets are expected to be choppy, given that the Fed just raised rates for the first time in a decade. Monetary policy is not the primary catalyst for the turbulence but it does add fuel to the fire. A rise in credit spreads indicates heightened risk, but it is also a common occurrence after the Fed raises interest rates. Meanwhile, stocks were overvalued by most measures, so their selloff is no big surprise either.

Figure 2: Garden Variety Financial Stress is Manageable

Source: St. Louis Federal Reserve Bank, Q4 2015.

Disentangling "normal" fluctuations from legitimately bearish movements is difficult, but the St. Louis Financial Stress Index provides some guidance. The index is currently at its highest level since late 2011, and is climbing—yet is still below its average over the past 20 years. Its gradual increase since mid-2014 contrasts with the sharp rises that characterized the financial crisis period, and with the subsequent jitters about the European debt crisis during 2010-2012. This indicates that investors are slowly coming to terms with the idea that monetary policy will not provide financial markets with the support it has over the past few years. A sharp spike would be more consistent with a knee-jerk turn in sentiment. While the recent volatility is a change from the smooth sailing of the past few years, it is not the beacon of doom that some have portrayed it as.

That said, a deep stock market decline would likely short-circuit the recovery via its wealth effect on consumers. An equity price decline of 10% is manageable, but 20% would be difficult to swallow. A stock market correction is a necessary condition for a return to recession, but on its own is not sufficient. There is a saying—that stock corrections predicted 9 of the last 5 recessions. So far, this seems like one of those false alarms.

Real Estate As A Safe Haven

Despite some angst in the global economy—or perhaps because of that angst—U.S. commercial real estate looks to be one of the best performing assets for yet another year. Investors remain in "risk-off" mode due to myriad red flags around the world, and the returns bonds offer aren't much better given that interest rates are low everywhere. U.S. real estate returns, on the other hand, are besting traditional investments by a nice margin, due to the expectation for solid fundamentals over the next few years. This has encouraged investors of all types to ramp up real estate holdings, causing property prices to skyrocket virtually across the board. The Moody's/RCA Commercial Property Price index gained 12% in 2015, thanks to double-digit increases in all property types except industrial.

According to Real Capital Analytics, commercial property sales totaled $533 billion in 2015—just shy of the $573 billion transacted in the record year of 2007. Foreign money made up a sizeable 17% of the total volume last year—$91 billion that set an easy record for foreign capital in U.S. commercial real estate. Foreign portfolios began targeting warehouses for the first time, while also augmenting their holdings of other property types. With prices in gateway markets having advanced drastically over the past few years, secondary and even tertiary markets are getting more attention. Atlanta and Dallas, for example, saw more properties transacted in 2015 than Manhattan, San Francisco, Los Angeles, and Boston combined.

Figure 3: Foreign Capital Floods U.S. Markets

Source: Real Capital Analytics, Q4 2015.

Foreign capital should continue to flow freely to the U.S. in 2016. The accommodative zero-interest-rate monetary policy that fueled a run-up in asset prices—especially commercial real estate—will not be reversed in one fell swoop. The Federal Reserve's policy stance has turned more dovish in recent months, signaling that interest rates could remain lower for longer than previously expected. With mounting concerns about growth elsewhere in the world and unimpressive returns on bonds, U.S. real estate will remain a popular investment. Additionally, the easing of FIRPTA taxes on international pensions' real estate assets removes a barrier that may have been preventing even more foreign investment.

Keep Calm And Carry On

Jitters within real estate markets are greater than they've been in recent years, and justifiably so. The risk profile has become more menacing in light of heightened concerns about the global economy, which are spilling over into financial markets. Pair that with the fact that prices are well above their pre-recession peak, and it has many peering around the corner for the next downturn.

But we are not there yet. Just like the general U.S. economy, real estate is underpinned by robust employment and consumer spending growth. Calls for an imminent recession are unwarranted until these fundamentals start to wobble; so far they have not. Capital markets appear to be well aligned with fundamentals. Economic indicators bear close watching over the next several months. Any deterioration should be reflected in prices, and if not, eyebrows will rise. Looking ahead to the next cycle is always prudent, but premature alarm can leave opportunities on the table.

Figure 4: Economy Will Cool But Not Freeze

Sources: BEA, BLS, Federal Reserve, Econometric Advisors, Q4 2015.