by James Lane | Nov 17, 2016

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November 3, 2016

Volume 15, Number 13


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

A CBRE EA Clients-only Publication

  • Job gains will slow as the labor market tightens, but wages and labor force participation are finally improving.
  • Uncertainty surrounding the U.S. presidential election has had a negligible impact on the economy.
  • The Fed will nudge interest rates higher in 2017; longer-term monetary policy is more uncertain.
  • U.S. real estate remains an attractive investment in the prevailing low-yield environment.
  • Our baseline forecast is unchanged from Q2 2016; we call for a mild recession in late 2018/early 2019.


The U.S. economy stabilized in Q3, following some turbulence in the first half of the year. Growth has ebbed and flowed over the past few quarters, which is what we've come to expect from this expansionary cycle. The resulting trend has been subdued economic growth—not necessarily a bad thing. Many sectors of the economy are still trying to backfill pent-up demand for goods and services, so we should see this "slow and steady" expansion prevail for a few more years before the business cycle runs its course. This pattern applies broadly to commercial real estate markets, with the exception of multifamily housing, which is further along in its cycle and is approaching an inflection point.

The labor market data is the strongest evidence of the economy's health: job gains averaged 192,000 per month in Q3—slower than Q3 2015 but strong enough to keep the unemployment rate to 5% or less. Labor force participation and wage growth also improved; to buoy household optimism late in the business cycle, we must see both of these key trends sustained. Without a significant rebound in participation, it will be difficult for firms to find the right workers and job growth will have no choice but to slow.

Figure 1: Anticipating a Rebound for Wages and Participation


Sources: Federal Reserve Bank of Atlanta, BLS, CBRE Econometric Advisors; Q3 2016.


Economic data have taken a backseat to the dramatics unfolding in the U.S. presidential election—and rightly so. The candidates' starkly contrasting policy proposals and personalities suggest that the election's outcome holds important consequences for the outlook. As of yet, political angst has not had much discernable drag on the economy, as consumer confidence and spending remain solid. It's not clear whether politics has directly weakened recent business investment, since the latter was soft well before the election cycle got underway.

Financial markets have acclimated themselves to the unusual political climate. Although investors point to the election as a key risk event, volatility in stock prices and credit spreads has decreased as we have proceeded toward Election Day. This may be because the odds of a "surprise" Donald Trump victory have diminished, according to most odds-makers and polling outlets. Hillary Clinton's economic policies are essentially an extension of the current administration's agenda, so the improving odds that she will gain the White House represent "business as usual." Markets are pricing-in a legislative stalemate, so a Clinton victory accompanied with a Democratic takeover of the Senate majority would also classify as a surprise. This scenario could rattle financial markets if a one-sided legislative agenda were to materialize. A more substantial stock market shock would likely result from a Trump victory, since there is greater uncertainty about what his administration would prioritize. Over the longer term, it is difficult to say which candidate would be better for the economy and commercial real estate in particular—both candidates' agendas have pro-growth components, but again, it remains unclear whether and how they might be implemented.

Both candidates have spoken of infrastructure programs that could benefit the economy and the real estate community. Assuming that work on an infrastructure bill wouldn't start until 2017 (and would then follow the usual path through Congress), no money would be spent until 2018 at the earliest. This timing works well, since we expect economy to be slowing at that time. The country's infrastructure is in dire need of an upgrade and if the money were spent properly, a program of this type could provide significant boosts to both the economy and productivity. A poorly designed bill or one that spends money in early 2017 could have a negative impact on the economy, however—by pushing up wages and private-sector construction costs.

Figure 2: Financial Markets Remain Calm Amid Election Uncertainty


Sources: Federal Reserve Bank of St. Louis, S&P Dow Jones, CBRE Econometric Advisors; Q3 2016.


The Federal Reserve's expectation that 2016 would be an active year for interest rate normalization proved wildly optimistic. Instead of the three or four rate hikes planned for 2016, at best, we will see one 25 basis-point increase when the FOMC meets in December. An unexpected slowdown in the global economy—which rippled through to U.S. trade, manufacturing and financial markets in early 2016—persuaded the FOMC to take a more cautious stance in keeping interest rates lower for longer. The surprise "Brexit" vote and heightened risk related to the U.S. presidential election have likely spooked Fed officials as well.

The repeated delays in raising rates—though understandable, given the fragility of this expansion—may carry some negative consequences down the road. First, the Fed may find its credibility diminished the next time it needs to move interest rates quickly. Financial markets have greatly discounted the Fed's forward guidance, the most important tool the policymakers have in a low-rate world. The Fed would benefit from improving its communication.

Secondly, there is general agreement that extremely low interest rates tend to stoke asset price inflation by incentivizing risk-taking. It is currently difficult to point to any definite "bubbles," but that does not mean there are not areas of concern. Janet Yellen and colleagues have called out commercial real estate as being at risk of overvaluation. Indeed, U.S. property markets have attracted a substantial amount of capital from previously uninvolved foreign buyers, due to the persistence of low returns.

Figure 3: CRE Values at Record Highs


Sources: Moody's Investors Service, Real Capital Analytics, CBRE Econometric Advisors; Q3 2016.

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. 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.


Our baseline forecast is unchanged from Q2 2016. The job market slowdown that EA has been anticipating is underway. Despite global economic headwinds earlier this year, the economy will manage to add roughly 2 million jobs by the end of 2016 and 1.6 million in 2017—enough to keep the unemployment rate below 5%. Wage growth should accelerate more vigorously with this level of job market tightness, providing a nice lift to consumer spending.

Figure 4: We Expect Economic Growth to Moderate


Sources: BEA, BLS, Federal Reserve, CBRE Econometric Advisors; Q3 2016.

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. The heightened inflow of global capital has put long-term interest rates on a shallower path as well. All else equal, the U.S. economy—and commercial real estate prices—should benefit from the low-yield environment over the next couple of years.

The downside is that low interest rates and a tight labor market can quickly translate into inflation, which would likely bring 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; historically this has led 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.

Commercial real estate's cycle will closely mirror that of the U.S. economy. Over the next several years we are likely to see fundamentals and pricing moderate, with negative nominal rent growth by 2019. Multifamily should be the first to falter; several large markets have already reached an inflection point.

Since we do not anticipate any distinct external shocks to the economy, markets and property types should behave similarly to their performance in past business-cycle recessions. We do not anticipate idiosyncratic patterns like those associated with tech-bubble or housing-market crashes. Rather, markets with the largest supply/demand imbalances will falter first. Office markets in the Bay Area and Houston stand out as examples, as do a handful of multifamily markets burdened with flush supply pipelines.


Our upside scenario reflects a more optimistic view of the U.S. economic outlook. 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. In other words, all of the upside risks come to fruition and there are no negative shocks.

Figure 5: Upside Scenario: Economic Growth to Increase Slightly


Sources: BEA, BLS, Federal Reserve, CBRE Econometric Advisors; Q3 2016.

Under such a best-case scenario, job growth would accelerate over the next 18 months, generating 2.4 million and 3.0 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 under our baseline scenario, resulting in higher long-term bond yields as well.


Our downside scenario describes what could realistically go wrong for the U.S. economy during the next few quarters. Plenty of risks exist for investors to be concerned about; this scenario assumes that some combination of shocks sinks the economy into a recession in the next year. Some amount of financial market turbulence is our downside scenario's single prerequisite. Recessions are always accompanied by a stock market correction, even if the reverse is not always true.

Figure 6: Downside Scenario: Recession in 2017


Sources: BEA, BLS, Federal Reserve, CBRE Econometric Advisors; Q3 2016.

Such a selloff could be prompted by any number of factors—notable possibilities include unfavorable UK/EU negotiations or separatist contagion elsewhere in Europe. The U.S. presidential results could also tank markets if there is a surprise upset by Trump or a Senate sweep by Democrats. 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 more closely resemble the dot-com bust than the Great Recession, in terms of overall damage to the economy. Our model predicts about 3 million net job losses at its worst, 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.


Our 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; the Fed assumes the unemployment rate to hit 10%—equal to its 2009 peak. The peak-to-trough GDP decline in this scenario is also on par with that recorded during the Great Recession.

Figure 7: Severe Downside Scenario: Stress Test


Sources: BEA, BLS, Federal Reserve, CBRE Econometric Advisors; Q3 2016.

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 it would use everything in its 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.