Q4 2021 U.S. Economic Insights

Quick takes:

• Economy posed for another strong year
• Demand should slow amid policy changes
• Supply continues to heal
• Inflation and interest rates ticking up
• CRE is built for a year like 2022

Another banner year for growth in 2022

Despite concerns over Omicron, the U.S. economy closed out 2021 with its best quarter of the year, generating a 6.9% growth rate. It followed the somewhat disappointing 2.3% growth from the third quarter. The economy has grown for six consecutive quarters, with all but one of those quarters registering growth of at least 4.5%. The economy now stands roughly 3.1% above its pre-pandemic peak and has entered its next expansion phase. Although the size of the economy still falls roughly 1.5% below its pre-pandemic growth trend, it continues to close that gap, growing far faster than its underlying long-term capacity.

With a growth rate of 5.7%, the economy produced its strongest calendar-year growth rate since 1984 when it grew at 7.2%. Although just a first estimate, subsequent revisions should generate only minor changes which puts the result close to our original forecast for 2021 of 6%. Growth for the year played out largely as we anticipated, with growth in aggregate demand (AD) and aggregate supply (AS) propelling the economy. Inflation ran ahead of our expectations because the pandemic continued to disrupt AD and AS to a greater extent than anticipated. Yet higher prices did not stymie real economic growth, even during the fourth quarter when year-over-year inflation reached its highest level in four decades.  

We expect another solid year for 2022, with growth currently forecasted at roughly 4%. Although the economy could experience a slowdown in growth during the first quarter due to the Omicron variant, we anticipate that growth will accelerate in later periods. The pandemic should continue to impact the economy, but less so over time as society continues to adapt. Correspondingly, we also anticipate that inflation should slow during the year, particularly once higher base effects kick in during the second quarter. 

AD growing, but changing

The outlook for AD remains positive in 2022. But demand should change in two important ways. First, growth should slow in 2022. While consumers are still sitting on roughly $2.5 trillion in dry powder and wage growth is accelerating, policy changes appear set to restrain AD growth. After two consecutive years of large stimulus packages, we expect no such spending to occur this year. That should create a significant restraint on AD from fiscal policy. Moreover, the Fed has clearly signaled its intent to tighten monetary policy this year, with the first rate hike likely arriving in March. Although it takes some time for that to translate into real economic activity, higher interest rates across the yield curve will raise the cost of capital for borrowers and restrain the wealth effect of consumers.  

Second, the composition of AD continues to change. Since the onset of the pandemic, consumers reoriented their spending away from services toward goods. Relative to the peak pre-pandemic GDP during the fourth quarter of 2019, goods spending remains up more than 15% while services spending remains down roughly 1.5%. Yet during the last two quarters, goods spending has slowed slightly while services spending continued to recover. We expect this pattern to continue in 2022. As society continues to adapt and confront the pandemic, consumers should increasingly feel more confident about returning to pre-pandemic routines including returning to offices, dining out, taking vacations, all of which should boost services spending. That does not mean a collapse in demand for goods, but a return to more typical spending patterns.

AS still seeking stabilization

On the supply side of the economy, disruptions persist, especially with the Omicron variant forcing many people out of work due to illness. Yet as warmer weather arrives in the Northern Hemisphere, the Omicron wave abates, and vaccination continues around the world, the supply chain is showing signs of stabilization if not outright improvement. We generally expect that AS will expand in 2022 as the economy continues to adapt and find ways of producing and distributing goods to consumers. The most recent jobs data reflects this dynamic. Despite the largest pandemic wave since testing began, job growth exceeded expectations in January and the two previous months saw substantial upward revisions. Labor and capital are finding ways to safely expand production in the face of the continuing pandemic. 

Yet production should remain constrained by a structural shortage of a few key inputs and the corresponding relative high price for those inputs. The labor shortage should remain firmly in place, even if an abating pandemic enables the continued return of workers to the labor force. The massive demographic changes occurring in the U.S. mean that demand for labor will continue to grow faster than supply can expand. Inputs such as semiconductors need greater investment in production capacity because a larger number of devices increasingly use them, even seemingly mundane “old technology” products. And energy remains a vital input to production. The world is struggling provide enough energy to satisfy growing demand as the global economy continues to develop. Higher energy prices reflect this dynamic. Yet the situation becomes complicated by the push to move away from traditional sources of energy toward newer sources. None of these should restrain growth dramatically in 2022, but they provide limitations that must get addressed, even if the solutions take longer than just a calendar year.

Inflation and interest rates
 

The Fed will want to see how inflation unfolds to determine how aggressively it should move, but additional hikes are almost certainly coming later in the year. The long end of the curve has already responded to the Fed’s more hawkish stance, with the 10-year Treasury yield now approaching 2%. We anticipate higher yields across the curve this year to help tamp down inflation and to try to prevent inflation expectations from becoming unmoored. As of early February, they have not, and the Fed would like to make sure that remains true. Yet over the medium term the Fed will walk the tightrope between tightening financial conditions too little and risking overheating or tightening too much and risking a recession.

CRE and the economy

The economic environment remains of paramount importance to the performance of commercial real estate (CRE). Empirical research clearly shows that the biggest threat to the performance of CRE remains the macroeconomic environment. When the economy generates real economic growth, both space market fundamentals and capital markets perform well. Empirical data from the last four decades supports that view. Although inflation and higher interest rates often concern market participants, CRE has clearly and repeatedly demonstrated its ability to address both and still pass muster as an asset class. Therefore, we foresee 2022 as another year of attractive performance from CRE despite the headwinds and headlines. 

Risks and closing thoughts

The pandemic remains the main risk and beyond anyone’s ability to accurate forecast. Our base case assumes a persistent yet less intrusive pandemic. If the pandemic becomes more disruptive than forecast, risks skew toward the downside. That would also be the likely source for inflation and interest rates settling above where we anticipate. Both could produce a greater drag on growth than forecasted. During the last period of persistently high inflation and high interest rates, during the 1980s, CRE performed relatively poorly. Yet performance suffered not because of inflation per se, but because significant overbuilding led to poor performance of market fundamentals, widespread commercial mortgage defaults, the worst returns for CRE in recorded history, and ultimately the S&L Crisis Recession of the early 1990s. Currently, overbuilding seems remote in aggregate, and only somewhat present at submarket level. Market participants that are quick to point to the 1980s as evidence of the dangers of high inflation (and interest rates) to CRE would do well to remember the role overbuilding played then and disentangle its impacts on CRE.