How Much Longer Can The Record Economic Expansion Last?

The U.S. economy is in its longest economic expansion on record. The unemployment rate fell to a 50-year low of 3.5% in September (Figure 1).

Unemployment is a good way of observing the economic cycle. It is not exactly correlated with economic growth, but it gives a good picture of demand conditions and it reflects most people’s perception of the state of the economy [i]. To understand why this cycle has been so long in the U.S., we need a theory of why recessions happen.

Typically, after a period of sustained above-trend economic growth, aggregate demand catches up with aggregate supply and inflation begins to rise. Interest rates move up to control prices, but often not quickly enough because poor economic data create policy lags. “Explosive” late-cycle growth sets in mainly due to over-aggressive lending by banks [ii] and often in response to buoyant real estate conditions or high rates of new business creation. Inflation rises sharply and interest rates must play a quick game of catch up. Economic activity slows and a realization occurs in the banking business or household sectors that debts cannot be repaid as planned. A recession ensues.

Why Not This Time?

The answer lies in low inflation and a sustained period of below-trend growth. In the U.S., three negative demand shocks and two positive supply shocks have created a slow but sustainable economic expansion, in which inflation has not shown up.

Three Negative Demand Shocks:

The Eurozone Crisis of 2011 to 2012

Following a brief recovery from the Great Recession, the eurozone economy entered a multi-year economic downturn as several members looked likely to default on sovereign debt obligations. Inflation dipped below 1%. Consumer and business confidence dropped in the U.S. and the softness affected U.S. exports in 2012 and 2013. It also weighed on the U.S. stock market and bank lending (Figure 3).

The 2015-16 Oil Price Slump & U.S. Dollar Surge

The growth of U.S. oil and gas production is a very big deal for the global economy. In the early stages (2010-2014), it created a surge in capital expenditures that helped drive the U.S. economic recovery. However, when oil prices slumped in 2014 due to a global build-up of supply, some very negative consequences set in for the U.S. economy (Figure 4). The dollar surged [iii], causing exports and capital expenditures to decline. A very weak period of GDP growth ensued, and the U.S. came close to recession (Figure 5). 

The Trade War & Manufacturing Recession of 2018

A decline in corporate confidence due to the U.S.-China trade war and the possibility of a hard Brexit has clearly lessened capital expenditures and manufacturing output. The rise of populism has had negative consequences for the economy and potentially the fortunes of the average citizen. However, it is not the only factor at play. An as-yet poorly explained downturn in the global auto industry is also at work, as are the ongoing difficulties at Boeing in the wake of the 737 Max debacle.

The Rise of the Sharing Economy Since 2009

Led by millennials and Gen Z, and facilitated by technology, consumers have developed a penchant for sharing cars, bikes, clothes, hotel rooms, workspace and even homes for the sake of cost-savings and sustainability. As well as opening a broader range of consumer choices, the “sharing” economy allowed a more intense use of society’s supply of capital, whether it be for clothing, vehicles or real estate (Figure 8). Greater output for the same level of input is deflationary.

How Long Can It Go On?

The answer is probably quite a while. Mediocre aggregate demand alongside aggressively expanding supply has totally suppressed inflation. The Fed has latitude not just to cut rates to support economic growth, but to engage in further open-market activities if necessary. It might be that further monetary stimulus will, and possibly already has, created asset-price booms in stocks and the technology and commercial real estate sectors. But this does not accord with generally solid fundamentals in each of these markets. One of the benefits of slow and volatile growth is that, despite low interest rates, it has prevented the kind of heedless risk-taking behavior that typically emerges late in the economic cycle. For once, there is no overhang of speculative real estate!

What Could Bring It To An End?

A very major Middle Eastern war that impacts oil supply might do it. A major military confrontation between the U.S. and China, perhaps over Taiwan, would also be very problematic. Alternatively, a further wave of radical populism leading to anti-trade policies might further undermine corporate sentiment and the stock market. Even after 10 years of growth, the U.S. economy has yet to substantively lift the living standard of working-class people. A hard Brexit, and/or a further fracturing of the Euro Area also would be highly disruptive. But it is very hard at this stage to see an interest-rate-generated recession due to rising inflation. This is a quite different situation to any of the last four cycles in the last forty years.

By Richard Barkham, Global Chief Economist and Wei Luo, Associate Director, CBRE.


[i] See the close relationship between unemployment and the rate of real estate vacancy, and for that matter the VIX index (Appendix).

[ii] Over aggressive lending is specifically linked to implicit deposit insurance. Put simply, the banks know that they are too big to fail, so they pursue market share growth. This lending is often linked to an asset bubble in real estate or another sector of the economy, but the bubbles are the result, not the cause of perverse incentives in the banking system.

[iii] There is an inverse relationship between the price of oil and the value of the dollar.

50 Years Later, Same Bumpy Roads

2020 could be a pivotal year for the U.S. commercial real estate industry, with geopolitical, economic and local regulatory issues in keen focus.

As I turn 50 years old next year, I well remember that we’ve driven the same bumpy roads before. I think back to my formative years in the 1970s when big events like the end of the Vietnam War, the Iranian hostage crisis, the Cold War and an oil embargo that led to maddening gasoline shortages for American motorists had huge impacts on our economy. The bumps may be different today, but the roads are the same 50 years later. The problem is that our approach to underwriting commercial real estate risks is also the same and needs to adjust to the times.

Our industry in the 1970s was characterized by a slow-and-steady mentality, with long-term leases offering a good hedge against the volatility of the broader market. High inflation led to a nasty recession, making commercial real estate a good inflationary hedge. But the 2010s are the exact opposite, with low inflation and steady job growth leading to a historic economic expansion. The rise of coworking and material increases in license and short-term lease agreements have made the office and retail sector less predictable. The tech disruption of retail is increasingly encroaching on other asset types, including Airbnb’s effect on the multifamily and hotel sectors. As inflation and interest rates ticked down, so did cap rates, yet we still underwrite with a 1970s “fear-of-inflation” rule of 50 to 100 basis points added to exit cap rates.

Despite these transformational changes to our business, CBRE’s 2020 U.S. Outlook predicts a very good year for commercial real estate. And it can be even better if we help dispel some 1970s thinking, particularly around the fear of inflation. Transaction volume and cap rates are expected to remain largely stable, though we likely will see more fundamental/secular-driven cap rate compression in multifamily and industrial and, due to declining inflation and massive liquidity, some downward pressure on cap rates for other CRE sectors.

2020 will not be without its challenges. We expect some risk of oversupply in industrial and Class A multifamily, but secular shifts that have heightened demand far in excess of historic norms should mitigate material impact on fundamentals, which are expected to stay strong. While retail’s overall troubles are well reported, the sector is expected to show good rent growth as it becomes more experiential with limited new construction.

Though business confidence has weakened and business spending has slowed, the office market is more dynamic today than ever before. Reasons for this include strong but slowing office-using job growth, the renaissance of the “new city” (new live-work-play neighborhoods in old-school cities), massive capital expenditure in older office inventory in major CBDs and agile office design. While a lot of the growth is expected in up-and-coming “tech cities,” old-school cities and many suburban markets that have what I call the “five pillars of awesome” (talent, infrastructure, foreign capital, live-work-play and low regulatory burden) should shine as well.

As the CRE industry becomes more dynamic and operational risk increases, alternative investments are gaining popularity. As a result, we expect 2020 to be another big year for data centers, alternative forms of industrial like self-storage and alternative forms of multifamily like senior living.

Commercial real estate has changed a lot since the 1970s, but many of the mega geopolitical and economic risks still ring true today. We hope you enjoy CBRE’s 2020 U.S. Outlook and that you underwrite commercial real estate with a 2020 “a-lot-has-changed” mentality, particularly since we’ve been traveling this same bumpy road for at least 50 years.

By Spencer Levy, Chairman of Americas Research & Senior Economic Advisor, CBRE.

The Sad Story of Global Inflation

Whatever the popular story of the time, the reason that cycles come to an end is that central banks raise interest rates to suppress inflation.

Initially, business and consumer confidence prevents interest rates from having an immediate effect. Later, leverage and over-expansion on two or three sectors of the economy usually cause a bigger decline in economic activity than is expected. At least it has been this way since the late 1970s.

The chart below shows the rate of inflation (core CPI) for the G7 and BRICs economies in the year ending Q1 2018, and for comparison, in the year ending Q3 2007, the peak of the last cycle.

  • Core inflation (excl. energy and food) is below target in five of the G7 economies and on target in the U.K. and the U.S. It is also considerably lower than at the peak of the last cycle in the most important developing economies (the BRICs) [1];
  • The U.K. has the highest core inflation among the G7 that partly reflects a tight labor market but is mainly due to the specific effects of Brexit;
  • Abenomics appears to be succeeding in Japan, where the economy seems at last to be breaking out of its long period of deflation. This is one country in which a significant increase in inflation is a good thing!

Why, after almost ten years of economic expansion, is inflation so low?

  • The world economy still has spare capacity. Although the U.S., Germany and Japan are operating at full capacity, the rest of the advanced economies still have some slack to use up. The level of unemployment in the EU as whole, for instance, is higher than the previous cyclical low. Emerging markets also have quite a lot of spare capacity, partially due to the severe commodity slowdown that took place between 2015 and 2017. Meanwhile, global capacity may have been increased by the rise of the “sharing economy.” CBRE Research has discussed its real estate and retail implications but the overall economic impacts have yet to be fully understood.
  • A sense of insecurity has taken hold of workers in the advanced economies that reduces the incentive to forcefully pursue wage increases. According to The Pew Research Centre: “A majority of Americans (63%) believe jobs are less secure now than they were 20 to 30 years ago, and about half (51%) anticipate jobs will become less secure in the future.”
  • Despite its many benefits, automation, this cycle’s major storyline, undermines economic optimism. “Disruptions” by technological advancements generate many more negative than positive headlines. USA Today’s take on a recent McKinsey report says: “Automation could kill 73 million American jobs by 2030.

Are we missing anything?

By focusing on the conventional measure of inflation, such as core-CPI, it is possible that we are missing potentially destabilizing price growth in other areas. The chart below compares annual price changes of key assets and commodities in Q1 2018 and the end of the last cycle. In general, prices pressure looks less intense than before, but there are three possible areas of concern: equities, steel and oil, with the last being the biggest worry. In the tight labor markets of Japan, the U.K., Canada and, in particular, the U.S., rising gas prices could trigger stronger pressure for higher wages, but it is not happening yet. Fear of change and gently rising interest rates continue to suppress inflation.

Globally, inflation growth remains muted and spare capacity means that it will probably trend up only very softly in the year ahead. The U.S. may be an exception, with a slightly faster increase in core prices due to labor shortages and rising gas prices. Three further rate hikes in 2018 should be sufficient to get on top of inflation, to be followed by further tightening in 2019.

For the time being, inflation is unlikely to derail the global economy, in part because so many people remain fearful of the future. Oddly enough, that has helped to stabilize growth.

By Professor Richard Barkham, Global Chief Economist, CBRE.

[1] Brazil, Russia, India, China



Whatever Happened to Inflation?

Inflation has not picked up in the way that many of us expected, but what does it all mean for the macro economy and real estate?

Over the last three months, inflation has surprised on the downside:

• In the U.S., core CPI, which excludes food and energy, has dropped from 2% in April to 1.7% in May.

• In the Euro area, core CPI is slowly trending up, but at 1.1% is still way below the 2% target rate of the ECB.

• The G7 has an average core inflation rate of only 1.4%, and this is trending down.

• The U.K. is the only country in the G7 with an inflation rate over 2.5%—and that is largely to do with the sharp, post-Brexit drop in the value of sterling.

The U.S. inflation numbers are most surprising, given how far it is into an economic expansion and how low the unemployment rate remains.

Economists are mulling a range of possible explanations:

A weaker-than-expected oil price at $45 per barrel is down from $54 in February, due to excess production capacity. This does not affect the core measures of inflation quoted above, but it does impact the cost of living and the degree to which workers push for pay rises. It also reduces the costs of a wide range of manufactured products, including plastics. It also weakens aggregate demand via lower levels of investment in plant and machinery. I give this possible explanation a 3 out of 5 for plausibility.

A surge in productivity is finally taking place, after a decade or more of weakness. Although there is tendency for productivity to improve in the latter stages of an economic expansion, as labor becomes scarce, I have seen no hard evidence that this is occurring. So I give this a 1 out of 5 for plausibility.

Government statisticians are getting better at measuring the quality of goods and services in the technology sector. For example, when the price of a new model smartphone rises by 30%, but its memory, processing power and camera is 30% better, there is no inflation. The methodological improvements in inflation measurement, which are most advanced in the U.S., are not sufficient to account for the recent downside surprises, but there is something in this argument. I give it a 2 out of 5.

Unemployment is higher than the headline statistics suggest in the U.S. because of hidden unemployment, and is still quite large in the Euro area. U6—the U.S. government measure of broad unemployment1—was 9.4% in January but has dropped sharply to 8.4% in May. That is 1.6 million workers back in employment, with the potential for another 1.5 million to follow. The headline unemployment rate in the Euro area is 9.3%, with a cyclical low of about 7.5%. Potentially another 3.5 million workers are available. All things considered, I give this one a 4 out of 5.

Globalization, though much reviled, is alive and well and doing its work through Business Process Outsourcing (BPO). BPO is the process by which large corporations shift service sector jobs to lower-cost locations of equivalent skill. There are BPO hubs all over the world, but three English-speaking nations are worth mentioning here: India, the world capital of BPO; the Philippines; and, South Africa. The below figure shows how job growth in India’s service sector started to increase rapidly after about 2003, when BPO started to take off. I estimate that there are now at least 5 million in BPO industries, and the number is growing very fast. The Philippines is estimated to have 1.2 million workers in BPO, and South Africa 40,000 to 50,000. This factor gets a full 5 out of 5 from me as a plausible explanation for inflation not picking up.

Given the above, and a few other anti-inflation processes that are too complicated to mention, it is not that surprising that inflation is so subdued. But what does it all mean for economics and real estate?

• Central banks should probably reset their inflation targets to 1% or 1.5% (but they won’t, because such a move would come under intense scrutiny from politicians);

• Interest rates will continue to rise, because central banks will react to the level of unemployment (but the rise will be slow);

• Lower-than-expected rises in interest rates will encourage risk behavior and preference for risk assets, suggesting that the end of the next cycle will be driven by an asset market event or a rise in bad debts;

• Real estate yields and cap rates may fluctuate according to fundamentals, but have a solid anchor in low bond rates; and last, but certainly not least,

• Investors who like office should head for India.

By Richard Barkham, Global Chief Economist, CBRE.

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1U6 is official unemployment (U3) plus part-time workers who would like to work full-time plus others that would like to work but are not looking for work or claiming benefit because they believe that there is no work available.