Q1 2022 U.S. Economic Insights

Quick takes:

• Positive outlook despite surprise 1Q contraction
• Demand growth slowing as government policy shifts
• Supply side faces some new challenges
• Fed moving aggressively to tackle inflation
• Economy still provides fuel for CRE

The U.S. economy got off to an unexpectedly slow start in 2022. A surprising contraction, -1.4% on an annualized basis, represented the first pullback in growth since the pandemic-induced recession during the second quarter of 2020. Yet, even in a surprise contraction, the underlying details remained positive. Consumers, still the engine of the economy, powered ahead with consumption growing at a 2.7% annualized rate. This occurred despite the numerous challenges that abound: a resurgent pandemic fueled by the Omicron variant and subvariants, continued high inflation, higher interest rates, and even a major war in Europe for the first time since World War II. where the economy has been but where it could likely head in the coming months. A few key items are playing breakout roles as we dig into data from the second quarter.

The contraction stemmed predominantly from a surge in imports, which drove down net exports as the trade deficit widened. Yet even here the story stems from something broadly positive – the health of the U.S. consumer is incentivizing producers to bring their goods to the U.S. The notorious backlog of ships waiting to arrive at ports in Southern California eased and offloaded goods made their way to consumers. The other noteworthy detraction from growth, government spending, looks like a harbinger of things still to come in 2022. 

Beginning the year with a surprise contraction holds clear implications for the 2022 forecast. We have revised our forecast down, below 3%, mostly to reflect the reality of the mathematics – a negative quarter severely challenges calendar-year growth. But we remain cautiously optimistic about the outlook, with continued healthy aggregate demand (AD  We still anticipate that economic growth will accelerate during subsequent quarters. Yet challenges remain, skewing risk to the downside. Inflation is slowing as we anticipated but will not decelerate quickly. The pandemic continues to evolve, finding new ways around our defenses, and continuing to threaten global aggregate supply (AS). And the outbreak of war not only exacerbates existing constraints on the economy but adds a highly unpredictable variable to the equation. 2022 still looks like another year of above-potential growth, but slower growth than anticipated earlier in the year.

AD shifting gears

We maintain a healthy outlook for AD this year and our broad narrative has not changed. Despite noteworthy surprises, demand is changing just as we anticipated. First, economic growth is clearly slowing. While consumers have done a tremendous job of driving growth, some of their fuel is dwindling. Fiscal stimulus, which placed money into the pockets of many consumers, is shifting from forward to reverse and should become more of a drag on AD as the year progresses. We expect smaller spending packages from the federal government after record-setting spending during recent fiscal years. That should restrain both consumption and government expenditures. Aggregate earnings growth, driven largely by spectacular net employment gains, also looks set to slow over the balance of the year. While we continue to forecast healthy employment growth, an incredibly tight labor market should cause net job gains to decelerate. Coupled with easing wage gains, that should slow growth in consumption. Additionally, interest rates have already moved higher across the yield curve. We already see some tentative signs of this having an impact on the interest-rate sensitive part of the economy and expect that higher rates should continue to provide some restraint on AD in future quarters. Meanwhile, businesses look set to continue to invest in equipment and technology that should help them expand their businesses, important as they confront the ongoing structural labor shortage. 

Second, the composition of AD continues to change as we anticipated. During the pandemic consumers shifted relatively more consumption towards goods, which they could safely consume at home. They simultaneously shifted consumption away from services which largely require consumption somewhere else, a potentially precarious situation during a pandemic. Although consumption remains roughly 15% above its pre-pandemic peak and services has only recently reached its pre-pandemic peak, a notable shift is occurring. For the last  three quarters consumers have spent relatively more on services as they revert to some semblance of pre-pandemic norms. In fact, spending on goods declined very slightly during the first quarter, meaning that all the growth in consumption came from services. While we expect spending on both to increase during the year, we foresee society continuing to adapt to the pandemic and partaking in services activities such as returning to offices, dining out, going on vacation and frequenting cafes and bars. 

AS facing new roadblocks

On the supply side, through February, the global supply chain appeared as if it had stabilized and was heading down the road to recovery. But since then, new roadblocks have emerged, muddying the supply outlook. While the pandemic itself is not new, its impact on the global economy has changed. With the Omicron variant and subvariants spreading in China over the last few months, production and distribution facilities have once again shut down as China maintains some version of its restrictive COVID policies. This produced the greatest restraint on China’s economy since the earliest stages of the pandemic in 2020. We expect that these measures should produce additional disruption to the global supply chain. 

Additionally, the war in Ukraine is causing disruption to production and distribution of several key commodities, namely oil and food (among others). While that most directly impacts the U.S. via inflation, we should not underestimate the ripple effects on the global economy. Higher food and energy prices could disrupt production and distribution in various places around the world. With the U.S. still so reliant on non-domestic goods production, disruption from the war could manifest in the U.S. economy in multiple ways. 

Lastly, AS growth will remain challenged by durable shortages that will take time to alleviate. The labor shortage presents a structural challenge because of its demographic origins and companies will continue to face this for the foreseeable future. Energy supply remains below its pre-pandemic peak. And while the chip shortage looks like it will ease later this year, it remains in place for now. 

Inflation and interest rates

We maintain our view that inflation should slow over the balance of the year but remain elevated in the near term. We have already seen base effects start to kick in during the second quarter which should persist for the next two months. With AD growth slowing, AS growth assumes the wild card role this year. The geopolitical context remains fraught with uncertainty. While we believe that AS will improve over time, the short run lacks transparency and remains prone to idiosyncratic shock. 

With inflation elevated and the labor market tight, the Fed sees one half of their (main) dual mandate satisfied and one clearly unsatisfied. As it focuses its attention on bringing down inflation, it might have to sacrifice the labor market to accomplish that. The Fed believes that it can take excess labor demand out of the market without causing a spike in unemployment. But with inflation running so hot, that will remain a challenge, especially because the neutral interest rate has likely not changed materially relative to the previous tightening cycle. That means the Fed has limited runway to raise rates without triggering a downturn. The Fed has also signaled that it will begin unwinding its balance sheet, likely by hundreds of billions of dollars this year and potentially another trillion dollars next year. That should also put some pressure on the long end of the curve and other yield instruments and potentially enable the Fed to manage monetary policy without having to push too far on the fed funds rate. But the Fed’s path seems narrower this cycle because inflation is running so hot. That gives them a smaller margin of error versus previous tightening cycles to raise rates without causing a recession. What remains unclear from our point of view is how quickly the Fed wishes to see inflation back near its target. For example, what level of inflation would the Fed deem acceptable by year end if inflation were decelerating? Hopefully, they will provide more clarity on this as the year unfolds.

CRE and the economy

The economy continues to provide fuel for the commercial real estate (CRE) market. The industrial market remains strong, with vacancy rates at or near historically low levels while rent growth continues to exceed inflation. The apartment market recovered as anticipated and is once again showing strength exhibited during the previous business cycle. Even in urban centers that some had written off, net absorption has rebounded, concessions are burning off, and rents are growing quickly. The retail market is performing better than many had anticipated. Yet retail remains an amalgam of subtypes. The high end and low end of retail continue to perform well (the proverbial barbell) while the middle continues to face challenges the reflect the hollowing out of the middle class in the U.S. Lastly, office, the laggard this cycle, is also nearing stabilization. The national vacancy rate increased only 20 basis points in the first quarter. Asking rents are ticking up and greater clarity on the return to office in subsequent quarters should only help. Yet even in office we continue to see a strong divergence in performance by both asset quality and geography. The highest-quality assets continue to outperform while markets in the south generally boast the highest leasing volumes relative to pre-pandemic levels. In short, CRE should have a favorable economic road ahead over the balance of the year despite ongoing roadblocks and detours. 

Risks and closing thoughts

Despite our cautiously optimistic outlook, risks have increased in number and clearly shifted to the downside in recent months. Last quarter we warned that the pandemic could continue to disrupt in unanticipated ways. Within weeks it proved us sadly prescient. Until we put the pandemic’s disruption behind us, its potential impact should not get overlooked. The geopolitical situation took a turn for the worse not long after our last quarterly outlook with war in Eastern Europe. The ultimate outcome remains unclear and the timing uncertain, making the war’s impact on the economy highly unpredictable. Lastly, the battle between inflation and interest rates remains unsettled. During any tightening cycle the risk of the Fed going too far takes prominence. But this cycle that looks more pronounced. Empirical research shows that unless inflation reaches hyperinflationary levels, its impact on economic growth typically proves minimal. Even this cycle high inflation has not impeded spending and growth. But with inflation having a strong impact on psychology and consumer sentiment, the Fed seems intent on bringing inflation down, hopefully without sacrificing growth The risk of near-term recession remains relatively low and even when the next recession occurs it will likely produce a more limited impact on the economy than the prior two downturns. We maintain our positive view, but note the increasing challenges that have emerged.