Q3 2021 U.S. Economic Insights

Quick takes:

• Aggregate demand growing strongly
• Aggregate supply struggling to keep up
• Economy expanding but producing inflation
• Outlook remains positive
• CRE cycle unfolding as forecasted

Staying on target

Through three quarters, the U.S. economy remains poised for a banner year. It generated torrid growth during the first two quarters of 2021, posting 6.3% annualized growth in the first quarter followed by 6.7% annualized growth in the second quarter. The last time the economy generated growth that strong for two consecutive quarters occurred during the first half of 1984. Although growth of 2% during the third quarter came in below our expectations, the economy has now grown for five consecutive quarters and gained back all the GDP lost during the recession. It has shifted from recovery to expansion as we head deeper into the next business cycle.

The economy remains on track for its strongest calendar-year growth rate since 1984. Due to the tepid third quarter results, we have revised our growth projection for 2021 down slightly, to roughly 5.5% in our base case. Yet, we continue to view the third quarter as a speedbump and not a roadblock. The factors that held the economy back are already abating and growth during the fourth quarter should much more closely resemble growth from the first two quarters of this year. What will drive growth during the latter stages of the year? Many of the same factors that drove growth during the first two quarters as well as a robust holiday shopping season should make the third quarter look like an anomaly and provide the economy with momentum heading into 2022.  

On demand

The economy’s rapid and robust turnaround owes much to strong aggregate demand. After contracting during the initial stages of the pandemic, demand in the economy has expanded briskly. Consumption expenditure from consumers remains the main driver of demand. Initially, consumers pulled back on their spending when uncertainty and fears about the pandemic prevailed, but that gradually changed. As consumers came to better understand the risks associated with the pandemic, they recalibrated their tolerances and their actions. Nominal advance retail sales growth set a calendar-year record in just the first three months of this year. But pent-up demand nonetheless increased, even as consumers spent money, because they did not fully resume their pre-pandemic consumption habits. Government transfers to consumers provided additional discretionary funds. And low interest rates incentivized borrowing. Yet the proverbial dry powder kept building faster than consumers were willing to spend it. That began to change with the advent of vaccination early this year. That unleashed a deluge of demand that continues to wash over the economy. 

Record retail sales propelling demand

Consumption should remain robust during the fourth quarter, propelling economic growth. Consumers continue to use their unspent dry powder, especially heading into what should feel like a more normal holiday season. Meanwhile a tightening labor market not only puts more people to work but also provides all workers with strongly growing wages. Moreover, as the stock market and housing market continue to reach record-high levels, the wealth affect should boost the spending of the investor class and homeowners. Therefore, we anticipate a strong holiday shopping season and robust consumption during the fourth quarter.

Private investment from businesses has grown more inconsistently since the economy began to recover. During the latter half of last year, it expanded at an incredibly fast pace. Businesses looked to put capital to work as many workers sat idle. Yet by the first half of this year private investment pulled back again, only to see growth surge in the third quarter. Businesses seem intent on putting capital to work in a world where labor often proves scarce, vulnerable, and in some ways inferior to technology. But history has proven that growth in investment can be volatile and inconsistent, even when businesses are motivated to utilize capital. We anticipate that private investment should continue to grow during an era of increased utilization of technology and automation as companies look to boost productivity growth during a prolonged labor shortage. 

Government expenditure has also followed a volatile path recently, dictated by legislation. Government spending grew briskly during periods when Congress passed emergency funding, namely the first half of last year and the first quarter of this year. But during periods when spending legislation did not occur, growth in government spending slowed notably or turned negative. Although Congress finally passed the long-awaited infrastructure bill last week and looks set to pass a reconciliation spending package of roughly $1.5 trillion, we foresee government spending providing a smaller boost to aggregate demand in future periods. Spending plans are smaller, relative to previously passed stimulus packages and some spending (such as on infrastructure) will occur over a prolonged period. 

Finally, though net exports have structurally dragged on economic growth for decades, the trade deficit widened during the pandemic, especially during 2021 when U.S. consumers’ spending patterns quickly reverted toward normal while those of consumers in other countries remained muted. Early vaccination in the U.S. drove this rift. Although vaccinations around the world have caught up to and often surpassed levels in the U.S., U.S. consumers’ appetite for goods and services should keep net exports generally on the negative side of the ledger, including during the fourth quarter. In sum, aggregate demand should continue to grow at a rate closer to the first half of the year than the third quarter. But it should gradually decline in the coming years as pent-up demand and excess savings get unleashed while government spending continues to have a less-pronounced impact over time. 

Supply lift

On the other side of the economy, aggregate supply is also expanding, but not as quickly. During the nascent, uncertain stages of the pandemic the supply side of the economy contracted notably as government edicts forced certain businesses to remain closed or operate a limited capacity (e.g., tables spaced farther apart, stores limiting the number of patrons permitted inside, travel restrictions). Some businesses failed due to complete or near-complete lack of demand, taking supply offline. The supply side began to recover relatively quickly as some of those constraints were removed but supply typically takes longer to recover than demand. And this cycle offers some new challenges. The pandemic continues to disrupt production as outbreaks among unvaccinated populations take factories and ports temporarily offline. The creative destruction of churn in the economy has resulted in the loss of some jobs permanently, even as it has created new ones. Some workers remain out of the workforce due to a complex combination of factors – concerns about their health and safety during an ongoing pandemic, lack of adequate and affordable care services for children and elderly relatives, enough excess savings to delay reentry to the workforce, and even the desire to retrain for better careers. These factors have constrained the ability of aggregate supply to grow, and it has struggled to keep pace with the rapid rebound in aggregate demand. 

Order backlog builds as demand exceeds supply

Looking ahead, growth in aggregate supply should accelerate. Ongoing vaccination around the world should lessen the ability of the pandemic to take production and distribution offline. As the labor market tightens, empirical research shows that tightness in the labor market (often measured via the unemployment rate) induces workers back into the labor force, even more so than growing wages. Workers who are currently retraining should eventually reenter the workforce with a different and likely better skill set than the one they possessed when they exited the workforce. These changes will not occur overnight, but gradually. Therefore, we see aggregate supply growth catching up to aggregate demand growth, but over time. 

As theory dictates

With aggregate demand growing faster the aggregate supply, the results from the economy seem almost exactly in line with what macroeconomic theory suggests. The economy continues to expand, but because demand growth exceeds supply growth the price level in the economy is rising, producing inflation. In that sense, inflation can be viewed as a by-product of a positive development – a strong snapback in demand that supply is struggling to keep pace with. While unpleasant at times, this inflation is not a rehash of the 1970s, even though many have been quick to make that comparison. Hyperinflation during the 1970s occurred because of an insidious combination of factors that we do not see today. First, the government took the U.S. off the gold standard which caused the dollar to depreciate significantly, making imported goods more expensive. Second, the oil embargoes of the 1970s, largely a consequence of geopolitical events, made energy expensive at a time when domestic production was declining and few if any substitutes for fossil fuels existed - that produced a true aggregate supply shock which pushed up the price level in the economy, even as economic growth turned negative. Third, productivity growth began declining notably in the 1970s, reducing the output per worker per hour, causing supply growth to decelerate.  

Clearly, the current environment is not repeating what occurred then. Excess demand is largely driving inflation today, not a true supply shock or other idiosyncratic factors. Inflation should decelerate in future periods for a few key reasons. First, base effects – as prices rise inflation will slow because growth will get measured versus a higher price level. This is already occurring in the month-to-month data and it appears that monthly inflation already peaked during the spring when aggregate demand growth accelerated. Year-to-year inflation remains elevated but should slow notably by the second quarter of next year for the same reasons. Second, it seems highly unlikely that the torrid pace of aggregate demand growth can continue. We see it slowing over time as spending patterns normalize. Third, supply disruptions should lessen, not increase, over time, enabling the supply side to continue to heal and return toward normal production levels. Fourth, frequent readers of our weeklies know that we believe that investment in technology and automation should boost productivity growth during the next business cycle. We already see nascent signs of this. Although this investment will unfold over several years, it should help to boost productivity and offset inflationary pressures. Lastly, central banks around the world (including the Federal Reserve) are moving to tighten loose monetary policy. The Fed has begun the tapering of asset purchases and looks set to raise interest rates starting next year. That tightening should prevent demand from running too hot and help to keep a lid on inflation, even if it restrains economic growth. Therefore, we retain a positive outlook on the economy, characterized by slowing yet robust economic growth and a congruous slowing in the price level in the economy. 

Sticker shock

Yet, we continue to believe that inflation will remain elevated relative to pre-pandemic levels from the previous business cycle for a few key reasons. First, some supply disruptions seem more durable than others. For example, notable shortages in semiconductors (due to no excess capacity and limited investment during the pandemic), energy (due to traditional sources of energy being taken offline faster than new, renewable sources get brought online), and labor (due to structural demographic changes as society ages) should prove more intractable. Second, the Fed recently revised its inflation target and seems willing to let inflation run a bit hot relative to the previous targeting regime, even as it moves to tighten monetary policy in the coming years. Finally, inflation expectations could change, particularly if the Fed continues to adjust its target rate of inflation upward. Though the Fed has not yet suggested that they will do so, other independent economists have suggested that they might. Either way, we do not foresee somewhat higher inflation as a massive constraint on economic growth. In some respects, it could be viewed as a positive, potentially (and we stress potentially) enabling the Fed to more easily and aggressively raise rates than they could during the last business cycle. But ultimately, we do not foresee marginally higher inflation creating a severe constraint on economic growth in our base case. 

Update on the CRE cycle

The outlook for commercial real estate (CRE) continues to brighten with the overall economy. While performance always differs by property type and geography, the CRE cycle is evolving almost exactly as we have forecasted. We predicted that the national industrial vacancy rate would stabilize in 2020, outperforming historical business cycles by roughly two years. Through the third quarter, that clearly appears to be the case with the national vacancy rate continuing to reach record-low levels while asking rents continue to reach record highs. We predicted that both multi-housing and retail vacancy rates would stabilize during 2021, exactly in line with historical business cycles. While still a bit too early to call those predictions correct, the national vacancy rates for both sectors started to decline during the third quarter. While vacancy rates can potentially fluctuate near turning points, typically that does not occur. We forecast further declines in in the national vacancy rates of both types. Lastly, even office, often maligned during the pandemic, looks like it should perform in line with historical cycles. We predicated that the national office vacancy rate would stabilize in 2022. Although the market continued to weaken during the third quarter, notable improvement occurred. Net absorption posted its best quarter since the onset of the pandemic and stands on the precipice of turning positive. With some new supply coming online, we believe it will take at least a couple more quarters before vacancy stabilizes, but we continue to foresee that occurring in 2022. Continued tightening should put further pressure on asking rents and cause concessions to burn off faster, supporting effective rent stabilization and ultimately growth. 

On the capital markets side, prices remained elevated and cap rates held at low levels during the recession. Investors saw through the crisis to the underlying value proposition of CRE. With most of the pandemic-induced disruption behind us and the CRE cycle turning, demand for assets is increasing with volumes likely to test record-high levels this year. That should sustain robust pricing in the market and keep downward pressure on cap rates.

Closing thoughts and risks

We maintain our cautiously positive stance but continue to acknowledge ongoing risks that could cause the economy to veer toward our downside case. First, the pandemic has not yet ended, and winter is coming. Another wave and potentially new variants lie ahead, even as vaccination spreads to more of the population. Second, while we see the constraints from the supply chain lessening over time, they could abate more slowly than we anticipate. Though not catastrophic, that could certainly slow economic growth. Third, structural shortages, such as the pronounced labor shortage, should prove much harder to resolve. Though such shortages typically induce investment that ultimately produces greater supply and efficiency, such a positive outcome remains uncertain. We see none of these as problematic enough to throw the economy into reverse given its underlying momentum, but they could prove troublesome in 2022.