Despite strengthening headwinds, global economy may still avoid recession

Executive Summary

• After a strong recovery in 2021 and early 2022, the global economy is facing several headwinds that raise the possibility of a downturn.
• Russia’s war in Ukraine is inhibiting economic growth in Europe, negatively impacting industry energy supply, consumer confidence and corporate spending.
• Growth is slowing in China, reflecting strict COVID lockdowns and continuing government restraint of the tech and real estate sectors.
• Real estate debt remains broadly available but terms have tightened, as the U.S. Federal Reserve and other central banks seek to curb inflation by aggressively raising interest rates.

Interest rates matter most

Worries of a global economic downturn are being stoked by the nascent cycle of interest rate hikes in the U.S. Expectations are for 10 to 12 rate hikes between this year and next, which would bring the federal funds rate to between 2.5% and 3.5% by the end of 2023.

Every recession has been preceded by a spike in interest rates, but it is where rates stand relative to where they have been over the previous four to five years that matters most.

Historical data shows a rise in interest rates of more than 2.5 percentage points above the previous cycle-average level typically triggers a recession. Based on that, the near zero rates of the past five years mean that once short-term rates rise above 2.5% to 2.75%, a mild recession is likely to occur.

Figure 1: Expected trajectory of U.S federal funds rate

Source: Federal Reserve, Goldman Sachs, JP Morgan, CBRE, CBRE Research, Q1 2022.

So if interest rates were to rise above a 2.5%-to-2.75% range in 2023, particularly if inflation expectations begin to fall, then there would be a pronounced impact on the economy. Neither CBRE nor the Fed believe that interest rates need to rise above that 2.5% to 2.75% level but some economists do.

Higher interest rates are not yet hurting the U.S. corporate sector, with service and manufacturing sector sentiment remaining upbeat. Consumer sentiment is weakening, mainly as a result of increased gas prices, but this has not had much impact on spending so far. From a demand perspective, the U.S. economy is in good health.

Although U.S. 10-year Treasury yields briefly fell below two-year Treasury yields on March 31, this yield-curve inversion—typically a harbinger of a recession—was reversed by the end of the trading day. As of May 10, the 10-year note was at 3.0% and the two-year was at 2.6%.

Other areas of concern include higher mortgage rates, which at times have led to a sharp decline in new home sales—a substantial driver of economic activity.

Figure 2: PMI Manufacturing Index and recessions

Source: Markit Business Survey, NBER, CBRE Research Q1 2022.

War in Ukraine

Extended economic sanctions on Russia for its war in Ukraine will disrupt the supply of certain commodities, likely lowering global economic growth and increasing inflation.. Ukraine and Russia account for nearly one-third of global wheat exports, any declines of which could keep food prices elevated for an extended period. Exports of important raw materials used in the manufacturing of semiconductors could also be limited.

Europe will experience the most pronounced economic slowdown from the Russia-Ukraine war, with a quarter or two of negative growth seen as a possibility. Much depends on whether Russia introduces an embargo on the export of oil or gas to Europe, particularly the latter, or the EU moves to an outright ban.

Russia is the world’s largest exporter of natural gas, accounting for roughly 45% of the EU’s imports in 2021. Many countries in Europe depend on Russian gas, particularly Italy, which in 2020 purchased around 24% of Russia’s total natural gas exports. Ongoing increases in gas prices will negatively impact industry energy supply, lower consumer confidence and curtail corporate spending.

Figure 3: Natural gas use in Europe

Source: Eurostat, CBRE Research, March 2022.

Early data suggests that while European business confidence is holding up, consumer confidence is falling due to increases in heating costs resulting from higher natural gas prices. However, with the release of pent-up demand and savings accumulated during the pandemic’s lockdown phase, weaker consumer confidence has not yet begun to severely impact retail sales.

Figure 4: European manufacturing and services PMI

Source: IHS Markit, CBRE Research, April 2022.

Figure 5: European Consumer Confidence

Source: European Commission (DG ECFIN), GfK UK, CBRE Research, April 2022.

Germany is most exposed to the war owing to its heavy reliance on Russian gas, with the country also seeing lower exports of automobiles and capital goods to China. However, the German economy has been resilient thus far, with workplace and retail mobility still trending upward.

Slowdown in China

While China reported Q1 2022 GDP growth of 4.8%, actual growth is likely far lower and the economy may be in a recession.

Figure 6: China Economic Activity Indicator

Source: People’s Bank of China, China National Bureau of Statistics, CBRE Research, April 2022.

The slowdown is partly a result of COVID containment measures, with 45 cities that collectively account for 40% of China's economic output under full or partial lockdowns as of the end of April.

Other contributing factors to weaker growth include earlier government policies to tighten liquidity in the real estate sector, particularly overleveraged residential developers. These measures have led to a marked slowdown in the Chinese property market, particularly the residential sector, and had a strong knock-on effect on construction and retail activity.

Slower growth in China will drag on the rest of Asia-Pacific, with the region also set to be impacted by waning growth in Taiwan, Hong Kong and Korea. Moreover, COVID lockdowns in China could have some bearing on the path of inflation in the U.S. and Europe by creating further supply chain bottlenecks.

CBRE nevertheless believes that in due course some positives could emerge from slower growth in China. China has begun to devalue its currency and will hope to use exports to generate economic growth. As so often in the past 20 years, China will be exporting deflation to the rest of the world. For once, the world will be thankful.

New waves of COVID-19

While the emergence of new COVID-19 variants remains an ever-present threat, omicron has proved to be less fatal than earlier strains, ensuring most countries have been able to manage a rise in cases without reintroducing mobility restrictions.

Although widespread vaccinations and effective therapeutics appear to have brought the pandemic under control, China’s retention of a “zero-COVID” containment policy involving strict lockdowns and restrictions on social and business activity continues to weigh on domestic consumption, disrupt global supply chains and constrain economic growth.

In addition to China, other Asian markets like Hong Kong and Taiwan reported a spike in infections in Q1 2022. In Europe, the BA.2 omicron variant drove a surge in new cases in March and April, although this latest wave now appears to be subsiding.

COVID-19 infections began to rise again in the U.S. from mid-April, prompting some cities to raise alert levels and leading to a slight increase in hospitalization rates in some states.

Tightening real estate debt markets

Debt markets are an emerging area of concern as rates continue to rise. Lending in the U.S. paused following the Russian invasion of Ukraine but restarted shortly thereafter. While transactions that were near the finish line in March were still concluded, an uptick in yields led to some repricing.

Although sellers are eager to bring assets to market, buyers are proceeding more cautiously. Despite rising rates and decreasing loan-to-value ratios, there is still substantial debt capital available for deals, but uncertainty remains about what the debt market will look like in the second half of the year as rates continue to rise.

Outlook remains positive

Despite strengthening headwinds, economic growth remains steady. The U.S. and Europe will continue to enjoy strong momentum from the reopening of their economies, which are not yet complete and should precipitate further above-trend growth.

Figure 7: CBRE House View, April 2022 vs January 2022

Note: German bond yields used for European 10 year.
Source: CBRE Research Q1 2022.

In Asia-Pacific, China is now stimulating its economy quite hard. This should be good for global demand, while China’s depreciation of its currency should export deflation to the West over the next year. In the U.S., positive impacts of the government’s infrastructure spending program should boost economic growth in 2023.

Consumer and corporate balance sheets remain strong, underpinned by previous asset price gains and accumulated cash from pandemic stimulus. So even as financial conditions tighten, the private sector likely will not institute widespread layoffs. With an extremely tight labor market, companies will focus on retaining their workers.

CBRE nevertheless expects slower economic growth to weigh on real estate demand in the coming months. However, with real estate still in a catch-up phase and pent-up demand from the pandemic continuing to be released into the market, particularly in the office sector, performance could surprise on the upside even as the economy slows.

Capital markets activity likely will decline from the highs of the past two years. Higher cap rates are emerging in segments of the market where fundamentals are weakest, such as U.S. Class B and C office, and for bond-like assets with long-weighted average lease terms. High-grade office remains popular, as do multifamily and industrial properties, and value-add assets with the ability to capture rent growth.