Love is in the Air for the U.S. Economic Outlook in 1Q2024

Hello to our readers and new subscribers, my name is Ryan Severino, CFA and love is in the air this week, for people and for the economy!

Consumers are projected to spend roughly $26 billion on Valentine’s Day this year, a nominal record.

With so much being spent on love, it presents a good opportunity to discuss five things to love about the quarterly US economic outlook!

The US economy capped off a solid year of outperformance in 2023, defying widespread expectations of a recession (though not from BGO) and growing faster than it did in 2022. The economy proved incredibly resilient even in the face of relatively high inflation and interest rates, typically a potent combination of forces that can shorten economic expansions. The labor market remained remarkably tight, returning some power back to workers after a decade in which labor struggled to recover. Consumers continued to spend despite fears they might not. Corporations invested in equipment and IP to position themselves well for the future. The federal government continued to spend in ways that supported economic growth. And even the housing market received a fillip from declining mortgage rates during the latter stages of the year. The economy carried significant momentum into 2024. Can that last, and what does it mean for commercial real estate (CRE)?

Why Were We Right?

Our prediction that the US economy would avoid a recession in 2023 proved prescient. But why? What did we foresee that ultimately came to fruition? Three key items. First, our proprietary modeling suggested that the majority of inflation stemmed from supply disruptions and not excess demand. That mattered because the former simply requires patience, waiting for the supply side of the economy to recover and resume functioning. The latter would require a pullback in demand and likely a recession. But inflation slowed as the supply side healed, even as demand remained resilient, proving our thesis. Second, the ongoing structural labor shortage made it difficult for the economy to overheat. Labor remains the main input to production in our modern economy and without enough of it, the economy grows at less than its full potential, not above its full potential. The labor market remained tight, generating real wage growth, but not excessively so. Third, the US economy has become far more resistant to interest rate increases than in the past.

Some of this stems from shrewd financial decisions on the part of households, businesses, and even governments, which locked in financing at low fixed rates. But also, the economy has evolved from a more capital-intensive manufacturing economy to a less capital-intensive services economy. Services-focused businesses rely relatively more on skilled labor and relatively less on sheer brute capital and machinery. Every economy has its breaking point. But even with the target fed funds rate range of 525 to 550 basis points (bps) and with the 10-Year Treasury yield pushing 5% as recently as October, we did not reach that threshold. And the economy grew stronger as the year progressed, even with interest rates at their highest levels in decades. The US economy continued to set itself apart from the rest of the developed world, which experienced tepid growth last year.

Where To Next?

The economy brings considerable momentum into 2024. In some respects, more so than it did heading into 2023. Growth accelerated in the latter half of 2023 due to robust job gains and a significant rebound in productivity. But the pace from the latter half of the year appears unsustainable. And while we expect real GDP growth to decelerate, likely into the 1.5% to 2.0% range, we do not expect it to collapse. The labor market should remain tight but ease a bit as momentum slows. The pace of job growth looks untenable and will likely downshift in 2024. We also forecast that labor productivity will abate. But investments in equipment and intellectual property (such as artificial intelligence) are likely bearing fruit and supporting productivity growth. The recent pace seems unsustainable, but we see upside risk to productivity growth due to substantial investments. Slowing job growth and productivity growth should cause consumption growth to slow, but gradually. Private investment should remain relatively healthy, particularly as declining rates spur increases in residential development. And although we are starting fiscal 2024 with a larger deficit than last year, we expect the deficit to begin declining as spending pulls back in accordance with the Fiscal Responsibility Act. Economic growth should decelerate in 2024 and 2025, but we still do not foresee a near-term recession in our base case.

Inflation should continue to slow, with the Fed’s preferred measure, the core personal consumption expenditures (PCE) index nearing the target rate of 2% by the end of the year. The consumer price index (CPI) should remain above PCE inflation, largely due to the higher weighting for shelter which continues to significantly lag overall inflation. But even the CPI should head closer to 2% before the year ends. That should provide the Fed with enough cover to begin cutting rates, likely around mid-year. The Fed has stated that it doesn’t explicitly need economic deterioration to cut rates, just more confidence about slowing inflation. Declining interest rates should help support economic growth, even as growth slows. And as inflation decelerates and monetary policy shifts, pressure on the long end of the curve should alleviate as well. But we foresee less contraction there, with the 10-year yield likely staying in the mid-3% range. That should cause the yield curve to flatten and ultimately steepen over the medium term as the Fed moves its policy rate closer to its nominal neutral rate, which we estimate near 3%. In short, financial conditions should gradually loosen, easing pressure across financial markets.

Will Everyone Still Feel More Upbeat?

During the last couple of years, sentiment from businesses and consumers seemed incongruous with economic reality. Both consumer confidence and consumer sentiment remained weak even though the economy made great strides in bouncing back from the pandemic-induced downturn. Similarly, businesses have also exhibited a relative lack of confidence, particularly the services sector of the economy which continues to thrive despite numerous headwinds. But in recent periods, the winds have shifted, with consumers and businesses generally feeling more upbeat.

Why? Of course, a tight labor market, slowing inflation, and a more benign outlook for interest rates brightened the mood. But additionally, the shift in markets is also boosting sentiment. First, energy prices have pulled back notably since 2022. In no small part, this is due to the record-setting oil and natural gas production in the US. The country now ranks as the largest producer of both oil and natural gas in the world, the largest exporter of natural gas, and the fourth-largest exporter of oil thanks to the innovative shale revolution. Second, the public equity market continues to reach record-high levels, bolstering household wealth. Third, similarly, the housing market continues to generate increasing wealth for homeowners. Although it is pricing many potential buyers out of the market, roughly two-thirds of households own their own home, a sizable portion of the population. We expect these general trends to continue, with some volatility. Energy production should remain elevated, equity markets should remain generally buoyant, and the housing market should receive a boost from declining interest and mortgage rates. That combination should shore up balance sheets and keep consumers feeling upbeat and eager to spend, limiting the downside risk to consumption and growth.

What Will It Mean For CRE?

Although we do not expect the recent resurgence in the economy to last, its broad scope suggests that it is not random or fragile. Deceleration seems more likely than collapse, which typically does not occur in the US economy outside of very extenuating circumstances. While space market fundamentals have held up relatively well, producing consistent income returns, both could receive a shot in the arm from a more supportive economic backdrop. Meanwhile, the main force holding back appreciation, and consequently, total returns, remains the CRE capital markets. But even there, green shoots are emerging. Already interest in CRE investment appears to be increasing. As the Fed shifts from tightening to loosening that will provide both transaction volume and pricing with the grease for the engine. The market will likely remain tentative at first – because of the abrupt regime change in monetary policy in such a short period of time, the CRE capital markets are still adjusting in some ways. But the farther we push into 2024 the more confidence will build, especially as the Fed begins cutting rates. Therefore, a reversion to positive total returns seems more a question of when, not if. Sooner rather than later remains our base case, and we see upside risk to the timing of such a change.

Risks and Closing Thoughts

The Fed and monetary policy remain the key risk for the US economy. Real rates remain positive and the longer they stay somewhat elevated, the more collateral damage they can do. Every economy has a breaking point if policy remains too restrictive for too long. The budget and the debt ceiling remain political footballs to get tossed around by both parties. Neither usually causes enough trouble to trigger meaningful economic fallout, but it remains possible. This will get exacerbated by the election this year, which usually produces minor restraint on economic activity when the outcome and related policy decisions remain unclear, as they do this year. Geopolitical risk continues to increase. Ultimately, the economy likely has too much momentum to stall. But if enough of these risks break bad, especially if that happens simultaneously, it could spell more serious trouble. That remains a relatively low-probability downside scenario. And we see potential upside from resurgent productivity growth. Even with some bumps along the way, the economy should keep moving forward in 2024.

Thanks for sharing your time with me this week, and stay tuned for much more from this newsletter in the weeks ahead. Happy Valentines Day!

Ryan S.

BentallGreenOak (“BGO” or “BentallGreenOak”) includes BentallGreenOak (Canada) Limited Partnership, BentallGreenOak (U.S.) Limited Partnership (“BGO U.S.”), their worldwide subsidiaries, and the real estate and commercial mortgage investment groups of certain of their affiliates, all of which comprise a team of real estate professionals spanning multiple legal entities.

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