A strange quarter

Quick takes:

• Data confirms GDP contraction
• Inflation and spending intact for now
• Strong earnings should help
• Labor market in focus
• CRE performance could be unusual

As the third quarter comes to an end, we close an unusual chapter for the economy. Despite a clear loss of momentum, GDP growth looks set to technically rebound. Inflation remained stubbornly high, but that did not dissuade consumers from spending more money. Meanwhile, demand for labor continued to exceed supply, keeping the labor market in an incredibly tight position. And despite all of this, corporate earnings and balance sheets remained healthy overall.

Data “reaffirms” contraction in 1H2022

Last week, GDP data “reaffirmed” that the economy contracted in the first half of the year. We have already voiced our concerns surrounding the quality of this data so we will take it at face value for now. Therefore, the third quarter should present a strange period where the underlying economic momentum and supporting data are clearly slowing, yet GDP growth should rebound and turn positive. We also reiterate that two quarters of negative GDP growth alone do not equate to a recession in the first half of the year given the strength observed in the rest of the economy, namely the labor market. Nonetheless, as we discussed last week, the risk of a recession is clearly increasing following the Fed’s more aggressive forecast for the fed funds rate.

Not a Recession

Inflation and spending intact for now

August’s income and spending data showed that U.S. consumers continued to spend and power the economy, but in the process also likely contributed to inflation. The increase in nominal spending matched the consensus forecast while the increase in real spending exceeded expectations. Nonetheless, spending is slowing down as the economy loses momentum amidst high inflation and higher interest rates. We expect further slowing in the months ahead as those factors remain largely intact, and the wealth effect (from declining housing and stock markets) coupled with fiscal drag (as we discussed last week) further restrain spending. Meanwhile, inflation, measured by the personal consumption expenditures (PCE) index showed something like August’s consumer price index (CPI) data. Headline inflation slowed slightly on a year-over-year basis.  But core PCE (which excludes food and energy) increased on a year-over-year basis. Inflation should continue to slow (albeit inconsistently) as the economy slows, but we continue to expect greater deceleration in 2023 after both monetary and fiscal policy changes have longer to take effect. That means, relative to recent downturns in the economy, this slowdown presents a bit of a mixed picture. While a slowdown in the economy would be unwelcome, a deceleration in inflation would be welcome. Heading into recent downturns, inflation was relatively low, presenting little benefit as the economy slowed. But this cycle, the prospect of slowing inflation could help to offset any pain felt by any contraction. 

Strong corporate position

Thankfully, corporate earnings and balance sheets remain generally healthy as we head into a period of slower growth. Corporate profits in the U.S. remain at record high levels, which should provide some buffer heading into a slowdown. And balance sheets have benefitted from such strong earnings. That contrasts with the period heading into the global financial crisis (GFC) of 2008-2009, when balance sheets sat in a relatively weak position with excess debt and entanglements that nearly crashed the global financial system and economy along with it. While no panacea, this should help cushion the blow of any slowdown experienced over the next 12-18 months. 

All eyes on labor

Against this backdrop, the labor market takes on an even more important role. In many respects, the labor market ultimately determines the health of the economy. Thus far, it continues to show strength with demand continuing to exceed supply, keeping unemployment low and wage growth relatively high. This week we will receive important information and its recent health. On Tuesday we will receive the August job openings data which should remain elevated and on Friday we will receive the employment situation release. We expect another strong release with net job gains into the hundreds of thousands, the unemployment rate little changed, and another strong showing from wage growth. 

|   What else we are watching this week   |

The ISM Manufacturing Index should show a modest decline in September but remain above 50 indicating expansion. The ISM Services Index should also remain in expansion territory and ahead of the manufacturing index. We expect construction spending to slow in September as higher rates bite into activity, especially residential. We expect durable goods orders to decline slightly. 

|   What it means for CRE   |

Given the highly unusual nature of this business cycle, we might see unusual performance with commercial real estate (CRE). While CRE remains a very procyclical asset class, we could see significant divergence by property type and geography. While that always occurs to some extent during all phases of the business cycle, it could get amplified over the next 12-18 months depending on how this plays out. For example, strong demand for labor, especially blue-collar labor, could help the apartment market hold up relatively well. Pent-up demand for travel might endure a slowing economy. And a weakening of the labor market could provide a boost to employers trying to get employees to return to the office. Even consumption patterns might look different than previous downturns, impacting industrial and retail in unexpected ways. 

|   Thought of the week   |

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