Economy
CUSHMAN & WAKEFIELD RESEARCH
The U.S. economy, led by the resilient consumer, seemed to defy gravity in 2023. Only a year ago, the consensus was that risks were overwhelmingly tilted to the downside and that real GDP growth was expected to grow at a paltry rate of 0.5% in 2023 with many—20 of the 51 professional forecasters surveyed—foreseeing a recession.1 Predictions of economic weakness for 2023 were certainly understandable given the numerous headwinds facing the U.S. economy throughout the year, including higher interest rates, elevated inflation, banking turmoil, labor strikes, tight lending conditions, and an abundance of geopolitical tension. But the most advertised recession in history never materialized—or at least it hasn’t yet. With a few weeks remaining in 2023 (as of this writing), the U.S. economy is on track to grow in the 2.5% range and will likely create over 3 million net new jobs for the year.
📣 Rebecca Rockey, Deputy Chief Economist, Global Head of Forecasting
As we look to 2024, however, top of mind for us is that it takes time for monetary policy actions to fully impact economic activity. In Fed speak, monetary policy works in “long and variable lags.” Some of the lagged effects are just now beginning to show up in the economic data. For instance, we are now observing rising delinquency rates on auto loans, credit cards, and mortgage loans—yellow flags signaling that the consumer is starting to feel the pressure of higher rates. In addition, the leading economic indicators—the tried-and-true predictors—continue to point to weakness. Most notably, both the 10-year versus 3-month and the 10-year versus 2-year Treasury yield curves have been inverted for more than a year now. On average historically, yield curves have inverted 11 months before a recession starts, but there is a high degree of variance in the lead time. There have been four recessions wherein the yield curves inverted more than 12 to 16 months in advance. Not only does this signal weaker views of economic growth by bond market participants, but inversion also makes it harder to extend credit as net interest margins get compressed. Credit availability—not just the cost of credit—is key to economic growth and the contraction in credit has been tied to the depth of recessions historically. Lending and underwriting standards have tightened meaningfully in the banking sector over the last year, and such swift movement to debt conservativism has tended to lead declines in jobs by six to nine months, on average. Temp jobs, which are easy to purge when cost consciousness necessitates it, typically also lead recessions. These jobs have been on a downward trajectory since November 2022 and have retreated by 193,000 jobs since peaking then.
It is also our view that, although certain aggregate economic measures—such as real GDP growth— appeared healthy in 2023, a “rolling recession” in which some industries contract while others evade damage has already begun.
Interest-rate sensitive sectors are feeling the pinch of tighter monetary policy and higher rates while government, healthcare and educational services tend to lag and remain the chief drivers of employment growth in 2023. Although some catch up in leisure and hospitality has been occurring in 2023, these sectors are highly coincidental, meaning that they will respond in real time as consumers hunker down—not in advance. Sectors that are currently experiencing some version of a recession include manufacturing, transportation and warehousing, finance, and real estate. Whether it is leasing or investment volumes, construction starts or home sales, real estate has slowed across the board—which we will examine in greater detail throughout this report.
One sector that epitomizes “defying economic gravity” is construction, where employment continues to grow as workers are needed to finish up existing projects, but the pipeline of new projects continues to fall off a cliff. As the current pipeline of commercial and residential projects deliver, job cuts will start to mount. The pullback in this high multiplier sector will also have a ripple effect throughout the economy, negatively impacting demand for materials, equipment, and other housing-adjacent retailer/wholesaler sectors—which again, increases the odds of recession. On the upside, weakness in the construction sector is likely to benefit the highest quality segments of the property markets and, in general, help existing buildings repopulate a bit quicker.
As we near the end of 2023, the U.S. economy is looking increasing fragile. Payroll growth is clearly slowing, and consumers are becoming more restrained this holiday season amid lower savings, higher debt burdens and less confidence in the economic outlook. The potential for a government shutdown in early 2024 is still looming; even if we avoid one, the budget deficit’s widening has gotten more attention and is likely to be a key element of the upcoming election cycle. Any discipline shown through reducing government spending or raising taxes—while positive for the deficit—will slow growth. Widening geopolitical issues carry risk for supply chains with another rapid increase in oil prices being a key risk for U.S. consumers. Although oil prices have trended lower in recent weeks, given the war in Ukraine and the recent turmoil in the Middle East, it’s not difficult to draw up a scenario where oil prices spike back up again. Moreover, the burden of interest payments on the economy is rising: when measured as a share of revenue across major sectors of the economy, debt costs are now above the pre-pandemic average and rising rapidly.
And we mean rapidly—anywhere from around 30% year-over-year (YOY) in the information sector to over 70% in the professional and business services sector.
And this is at a time when revenues and earnings are slowing, meaning this burden is going to increase. For households, this is also true despite many being locked into lower mortgage rates. Given the profile of debt maturities across the economy—after all, CRE is not the only sector with a maturity wall—the slow burn of credit cost on hiring and investment will grow, not lessen. Reference visual on page 3
It could be viewed that on the plus side, the Federal Open Market Committee (FOMC) appears to be done with its rate hikes—though it continues to posture on the hawkish side, likely in an attempt to keep financial conditions outside of their purview sufficiently restrictive. Our forecast assumes the Fed is done raising rates. However, this tells only part of the story: as inflation continues to moderate, however choppy that may be, the real federal funds rate will continue to rise and not peak until the first half of 2024, even as the benchmark rate stays where it is.2 We expect the real fed funds rate to peak in Q1 2024 when using headline Consumer Price Index (CPI) and in Q2 2024 when using core CPI. Despite the end of rate hikes by the FOMC, the process of quantitative tightening (QT)—i.e., the Fed allowing security holdings to roll off its balance sheet—will continue well into the foreseeable future. Reference visual on page 5
The path back to 2% inflation has been fairly quick so far. In June 2022, headline CPI inflation peaked at 8.9% YOY, and a few months later, in September 2022, core CPI inflation peaked at 6.6% YOY. Since then, headline CPI has been cut by essentially two-thirds and now is flirting with 3% while core CPI has only come in by less than half and continues to sit near 4%, nearly double the Fed’s preferred rate. There are both positive and not-so-positive trends emerging in the inflation data. On the plus side, goods inflation has been sharply reduced, energy prices are down and, when shelter is removed, it seems as though inflation is essentially at the 2% target (YOY). On the not-so-positive side, services inflation—even after
excluding shelter costs—remains sticky and elevated. As services sectors have a higher share of operating expenses dedicated to labor, the Fed remains focused on tight labor market conditions and sustained wage growth. According to the Federal Reserve Bank of Atlanta, overall wage growth is still at 5.8% YOY (as of the latest data for October 2023), while the U.S. Bureau of Labor Statistics’ Employment Cost Index (ECI) is at 4.6% YOY in Q3 2023 (and accelerated quarter-over-quarter in Q3 2023). This is uncomfortable for the Fed: high nominal GDP growth and high wage inflation are not friends of the 2% target.3 The Fed’s hawkishness thus, in our view, also reflects its ongoing concern that the current labor market is too tight to ensure durable 2% inflation over time. This implies an extended period of restrictive monetary policy and below-trend economic growth.
As we head into 2024, we believe the economy will start to bend under the magnificent weight of the Fed’s cumulative actions and ongoing QT, ultimately resulting in a modest recession. As mentioned before, this will roll through the economy at different speeds and with different magnitudes by sector. However, as inflation is already on a downward path and peak tightness is not even upon us, we believe that the demand destruction in H1 2024 will add further disinflationary pressures while also causing the unemployment rate to start trending towards 5.5%.
As mid-year approaches, this will put the Fed in a position to start cutting rates by Q3 2024, which in turn will allow the long end of the yield curve to begin compressing again, although it should settle in around 4% over time (over long periods, it tends to revert towards nominal GDP growth).
There are many scenarios that could play out, and we acknowledge that a soft landing is possible—although so is a harder landing. In our view, the upside from a soft landing is limited in that ultimately it is still an environment of below-trend growth, tight labor markets, and, if there is not immaculate disinflation in wages, a higher-for-longer-than-already-expected fed funds rate. The ultimate soft landing is one where wage disinflation is immaculate. Even in this more benign economic scenario, the CRE sector will remain under pressure in 2024 before turning a corner in 2025.
The backdrop for CRE in our baseline forecast is one with many shades of grey. Those sectors that are decelerating will probably surprise onlookers with their resilience—such as what we envision for industrial and multifamily demand. As for retail, limited supply puts a cap on just how high retail vacancy will go. Although office is complicated, we believe we are well into the hybrid transition, and thus demand destruction will start to taper off. Nuance here matters and laziness in studying the sector may result in lost opportunities for both occupiers and investors. The capital markets, still finding its way as the whiplash from Treasury market volatility wears off, will start to unfreeze. Without the tailwind of structural declines in the Treasury market, the focus on income and operational alpha will only increase. At the same time, investors will need to elevate strategy and risk assessment going forward.
