by James Lane | Aug 30, 2016

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August 3, 2016

Volume 15, Number 11


Jeffrey Havsy, Chief Economist, Americas Research, CBRE; and James Bohnaker, Economist; CBRE Econometric Advisors

A CBRE Clients-only Publication

  • The tight labor market has slowed job growth. Wage growth is picking up, however.
  • "Brexit" has jolted financial markets but will not materially impact the U.S. economy.
  • U.S. real estate is a safe haven investment in the prevailing low-yield environment.
  • Bond yield forecast downgraded because of dovish Fed and sustained capital flows into the U.S.
  • Our baseline forecast calls for a mild recession beginning in late 2018.


Ups and downs in the economic data maintained some drama through the second quarter, after an already jumpy start to the year. In May, the usually upbeat job data broke character and turned in its worst monthly total of the recovery (11,000 new jobs)—only to be followed in June by its largest gain since October 2015 (287,000). Trying to predict the monthly figure has proven fruitless, but one clear takeaway—and no real surprise, given that the unemployment rate is below 5%—is that trend job growth has slowed. Employers are having a difficult time finding skilled workers in some industries, so the hiring rate is expected to decelerate further as the expansion ages.

The upside is that workers are finally being rewarded with higher pay, thanks to the tight labor market. The Atlanta Fed's wage growth measure—which tracks earnings for individuals, rather than an aggregate—shows a marked improvement over the past six months. Wage growth for job-switchers is back to its prerecession rate of more than 4%, and the elevated quit rate should cause wage growth to accelerate for all labor market participants sooner rather than later.

Figure 1: Job Market Churn Yields Wage Growth


Sources: Atlanta Federal Reserve, BLS, CBRE Econometric Advisors; Q2 2016.

Higher earnings are giving households the confidence to spend freely. With consumers apparently unfazed by recent geopolitical events, the two most closely watched measures of consumer confidence—the University of Michigan and Conference Board indices—show confidence to be high. Consumer spending may have grown by as much as 4% (annualized) in Q2, and is far and away the biggest economic driver. And as solid as they have been, consumer fundamentals may have room to strengthen if pent-up demand for housing can be alleviated. For that to happen, lending standards and new-home construction must continue to recover.


Britain's referendum vote in favor of leaving the European Union caught many by surprise, raising urgent questions about the global economic outlook. Stock markets initially reacted with a sharp selloff before bouncing back to fresh highs within days. The hope is that negotiations between the U.K. and the EU over the coming months will yield an agreement that facilitates trade between Britain and the rest of Europe. Heightened uncertainty means it will take some time to declare winners and losers in Europe, but the U.S. economy is likely to be no better or worse off. Trade with the U.K. is a very small part of the U.S. economy, and the sting to financial services should be limited to banks across the pond.

U.S. commercial real estate will likely come out a relative winner for investment in the post-Brexit era. Safe haven status—particularly among gateway cities—may tilt the scales in favor of the U.S. at the expense of European destinations saddled with greater geopolitical risk. Investment volume in the U.S. is already stabilizing after a slump in large deals earlier in the year. The negative economic implications of a worst-case scenario—in which Britain's exit is the catalyst for the disbanding of the entire EU—would be tremendous, even to the relatively strong U.S. economy.


During this recovery, the Federal Reserve has established a track record of downgrading its economic outlook—which it lived up to again in June. Low inflation and softer job numbers have caused the Fed to delay raising interest rates, and the Brexit vote ensured that another rate hike would be postponed until at least September. Late last year, the FOMC expected to raise interest rates four times in 2016; now, even a single 25-basis point hike is a toss-up.

Globally, a prevailing low-yield environment—underscored by negative government bond yields in much of Asia and Europe—will be a near-term tailwind for investment into U.S. commercial real estate. Market fundamentals are broadly upbeat, and with few better alternatives, real estate is a popular investment for both domestic and foreign buyers. Although entity and portfolio deal volume is down from year-ago levels, trading activity for individual assets should get back into positive territory in the third quarter.

Buying opportunities are still very much alive—the difference is that investors have to be more careful with bundled portfolios. Investing strategies based solely on picking markets and property types will not be as valuable as the cycle matures and performance becomes more nuanced. When we eventually enter the next recession, certain tranches of properties will turn sooner and with greater magnitude. Generally, cap rates have a little room to compress or stabilize, at least. It does not appear that interest rates will rise significantly any time soon, and there is a big enough spread relative to U.S. Treasurys to provide cushion when rates do move.

Figure 2: Entity Deals Are the Culprit Behind Lower Volume


Sources: CBRE Research, Real Capital Analytics; Q2 2016.


The job market slowdown that EA has been anticipating is finally happening. As a result, we have downgraded our job growth forecast to reflect the maturation of the business cycle. Despite several near-term headwinds, the economy will manage to add roughly 2 million jobs this year and 1.5 million in 2017—enough to pull the unemployment rate close to 4.5%. Wage growth should accelerate more vigorously with this level of job market tightness, providing a nice lift to consumer spending.

We see the Fed taking a very dovish stance in order to prevent stagnation. Monetary policy is already tight compared with elsewhere in the world, and the Fed would rather sacrifice a little inflation to prevent being stuck in a deflationary trap. FOMC members have recently become more vocal about their preference, moving more into line with what financial markets had been expecting all along. Consequently, we have revised down our forecast for the 10-year yield. The heightened inflow of global capital only strengthens the case for the shallower path. All else equal, the U.S. economy—and commercial real estate prices—should benefit from the low-yield environment.

The downside is that low interest rates and a tight labor market can quickly translate into inflation, which would likely cause the Fed to rein in consumer and business investment with higher interest rates. By that point, bond investors would be nervous about economic growth and would pour capital into safe-haven bonds, which historically leads to an inverted yield curve and subsequently a recession. Thus, our baseline scenario includes a short technical recession beginning in late 2018, which yields a net loss of 400,000 jobs by the end of 2019.

The timing of these dynamics is difficult to predict, but the Fed's efforts to stoke inflation are bound to yield results as the labor market tightens. Some industries are already reporting difficulty in hiring skilled workers, and there are not enough people to fill those positions. This will become the economy's biggest concern over the next 18 months. Uncertainty about the presidential election and global geopolitics may also figure into the timing and magnitude of the slowdown.

Commercial real estate is similarly positioned, in terms of its place in the cycle. It still has room to run, but we are likely to see a moderation in fundamentals and pricing over the medium term. We do not anticipate any distinct cause for the economic slowdown, so markets and property types should behave similarly to their performance in past business-cycle recessions, per conventional wisdom. Markets with the largest supply/demand imbalance will falter first. Office markets in the Bay Area and Houston stand out as examples, as do a handful of multifamily markets burdened with a flush supply pipeline.

Figure 3: We Expect Economic Growth to Moderate


Sources: BEA, BLS, Federal Reserve, CBRE Econometric Advisors; Q2 2016.

Figure 4: Fed Hesitance, Capital Flows Will Keep Bond Yields Low


Source: CBRE Econometric Advisors, Q2 2016.


The EA upside scenario presents a more optimistic take on the U.S. economy. Under this scenario, the apparent slowdown of recent months proves to be temporary, as the manufacturing, trade, and housing sectors kick into a higher gear. Underlying this narrative is a marked improvement in the global economy—China gets back on track, commodity prices rebound, and central banks' negative interest rate policies stimulate demand. The absence of any negative external shocks—such as a major terrorist attack or unfavorable geopolitical developments—is also intrinsic to this scenario.

Under such a best-case scenario, job growth would accelerate during the next 18 months, generating 2.5 million and 2.7 million jobs in 2016 and 2017, respectively. Employers would have trouble finding these workers in the existing labor pool, so some portion of the jobs would go to arriving immigrants, new graduates, and previously disenfranchised workers. Inflation and interest rates would both rise at quicker rates as well. The Fed would likely tolerate above-trend inflation initially, but would soon begin to raise interest rates on a steeper curve than in the baseline.

Figure 5: Upside Scenario: Economic Growth to Increase Slightly


Sources: BEA, BLS, Federal Reserve, CBRE Econometric Advisors; Q2 2016.


The EA downside scenario paints a picture of what could realistically go wrong for the U.S. economy in the next few quarters. There are plenty of risks for investors to be concerned about, and this scenario assumes that some combination of shocks sinks the economy into a recession in the next year. The single necessary precondition for our downside scenario to take shape is some degree of financial market turbulence. Recessions are always accompanied by a stock market correction, even though the reverse is not always true.

In this hypothetical, such a selloff could be prompted by any number of factors—notable possibilities are unfavorable UK/EU negotiations or separatist contagion elsewhere in Europe. The U.S. presidential results could also tank markets, depending on how the rhetoric develops between now and November. Natural disasters, terrorism and geopolitical events—the usual suspects—could exacerbate other stress fractures in sentiment. Consumer and business confidence support the crucial linkage between financial markets and the real economy; once confidence begins to head south, it's difficult to turn it around. Firms put their investment plans on hold, households tighten their wallets, and the entire economy loses the wind from its sails.

A realistic downside scenario would look more like the dot-com bust than the Great Recession, in terms of overall damage to the economy. Our model predicts 3 million net job losses through 2018, before a cyclical recovery takes hold. The Fed's aggressive response—along with foreign capital flows into the U.S.—would likely keep the 10-year yield below 2% until 2020.

Figure 6: Downside Scenario: Growth Goes Negative in 2017


Sources: BEA, BLS, Federal Reserve, CBRE Econometric Advisors; Q2 2016.


The EA severe downside scenario is meant as a proxy for the Federal Reserve's "Severely Adverse" supervisory scenario under its Comprehensive Capital Analysis and Review (CCAR) program. CCAR is meant to evaluate the capital planning processes and capital adequacy of U.S. banks under stressful macroeconomic scenarios. This scenario is certainly stressful, as the Fed assumes that the unemployment rate hits 10%, which is equal to its peak in 2009. Its peak-to-trough decline in GDP is also on par with what was recorded during the Great Recession.

Since the Fed does not provide guidance on payroll employment growth, EA uses the change in the unemployment rate path to approximate the impact. The scenario's supposed recession occurs immediately and wipes out 6.5 million jobs by the end of 2017. Although the Fed is quiet on what might cause such a severe recession, we can safely assume that financial markets would suffer some sort of systemic failure, likely leading to government intervention. The Federal Reserve does not discuss a hypothetical reaction in terms of monetary policy, either, but history tells us they would use everything in their toolbox to stop the bleeding. This could mean negative interest rates, quantitative easing, and even helicopter money. The severe downside scenario has an extremely low probability, but it offers a useful guide to capital planning under the direst macroeconomic situations.

Figure 7: Severe Downside Scenario: Stress Test


Sources: BEA, BLS, Federal Reserve, CBRE Econometric Advisors; Q2 2016.

Figure 8: Macroeconomic Scenarios Run the Gamut


Source: CBRE Econometric Advisors, Q2 2016.