Strong headwinds, including heightened geopolitical tensions, a major energy market disruption, surging inflation in OECD countries and aggressive interest rate hikes, are bearing down on the global economy and appear likely to end the current economic expansion cycle.
While robust consumer balance sheets, steady service and manufacturing sector Purchasing Manager Indices (PMI) and solid business investment suggest the post-pandemic bounce back still has legs, these tailwinds are increasingly unsteady. CBRE therefore maintains its house view that a recession will likely occur in early 2023.
This CBRE Viewpoint explains why the broad array of challenges confronting the global economy have yet to cause a material deterioration in economic activity.
The recent surge in inflation took many economists by surprise. Despite aggressive interest rate hikes by the U.S., U.K. and EU central banks and the recent easing of U.S price growth, inflation will continue to squeeze consumers in the months ahead. With China cutting rates and rolling out other economic stimulus, the outlook for Asia-Pacific over the next 12 to 18 months is considerably brighter than that of the other global regions.
Figure 1: Inflation rate by region
Note: EMEA is the average of France, Germany, UK and Italy.
Source: CBRE Houseview, CBRE Research, Q4 2022.
The U.S. Federal Reserve implemented its fourth consecutive 75-basis-point interest rate hike of the year this month, with an additional 50-basis-point hike expected in December and more expected in the first half of next year. With further rate hikes expected in the U.K., EU and Asia-Pacific (excluding China and Japan), economic activity will increasingly slow and heighten the risk of financial market volatility.
Figure 2: Short-term policy rates
Source: CBRE Houseview, Oxford Economics, CBRE Research, Q4 2022.
Continued economic and political tension between the U.S. and China remains a threat to global economic growth. The process of decoupling the economic relationship between the two nations, which has driven the global economy for the past two decades, accelerated this year as U.S. public opinion hardened.
Figure 3: Opinion of China by Americans
Source: Pew Research Center, updated in Spring 2022, CBRE Research Q4 2022.
Unfavorable views of China have accelerated since the pandemic, when U.S. reliance on China for a wide range of essential goods became readily apparent. In response, the U.S. accelerated efforts to relocate production to other nations and institute trade sanctions and curbs on tech, such as microchips, to lessen the country’s reliance on China.
U.S. midterm elections
With U.S. election results still being tabulated as of this writing, a slim Republican majority in the House of Representatives is likely, while Democrats have retained control of the Senate.
Should Republicans win the House, they likely would block Biden’s ability to raise taxes and institute further fiscal stimulus that could refuel inflation. As they have in the past, equity markets likely would react favorably to divided government.
Russia-Ukraine war and energy prices
Russia’s war with Ukraine appears to reflect a desire to reestablish its influence on former satellite countries of the Soviet Union and weaken the West’s influence in the region.
Russia remains extremely small in GDP terms at around half the size of the U.K. and slightly bigger than Spain. Its GDP per capita is relatively low and growth is slow. The country nevertheless remains geopolitically significant due to its huge land mass straddling Europe and Asia, abundant natural resources and large nuclear arsenal.
Figure 4: Economic fundamentals comparison
Source: World Bank, OECD, CBRE Research Q4 2022.
The Ukraine war remains a major headwind for the global economy, particularly its impact on energy prices. High gas prices remain a key challenge in the U.S., while Europe continues to suffer from a generational energy crisis. Although the pressure feeding out of geopolitics and into the global economy may not be the decisive factor in tipping the global economy into recession, it remains a major headwind.
Figure 5: Rise in energy prices
Source: Macrobond, CBRE Research Q4 2022.
The end of the cycle is imminent
CBRE’s analysis of the U.S. unemployment rate reveals four clear economic cycles over the past four decades. The recession of the early 1980s was followed by a strong recovery under the Reagan administration, while the Clinton administration presided over a steady rebound from the recession of the early 1990s. A relatively short growth cycle commenced after the dotcom bubble burst in the early 2000s under the Bush administration and ended with the onset of the Global Financial Crisis (GFC) in 2008. The current economic cycle began in 2010 under the Obama administration and has lasted until now.
Figure 6: U.S. unemployment rate/economic cycles
Source: BLS, CBRE Research, Q4 2022.
Many economists viewed the onset of the COVID pandemic as the end of the current 12-year-long cycle, with the subsequent drop in unemployment heralding the beginning of a new eight- or nine-year phase of economic expansion. However, this view has shifted in recent months despite certain aspects of the pandemic having caused a cyclical reset. In hindsight, the massive stimulus unleashed during the pandemic precipitated the end of the economic cycle. As the global economy was already at capacity, with excess demand and insufficient supply, this resulted in unprecedented inflation.
CBRE believes the current economic cycle is ending because the labor market fell below equilibrium, which triggered rising wages and an accelerated rate of inflation. Unemployment falling below equilibrium has marked the end of each of the four economic cycles since 1980.
Figure 7: U.S. unemployment rate/economic cycles
Source: BLS, CBRE Research, Q4 2022.
When unemployment falls to very low levels in the U.S. and Europe, it tends not to remain low for long as it reflects too much demand and not enough supply. This inevitably leads to inflation, higher interest rates and recession.
While CBRE maintains its forecast of a soft landing and a mild recession, history suggests this is not the most likely outcome. Analysis of the previous 11 U.S. interest rate hike cycles shows that seven led to hard landings, three led to soft landings and one was interrupted by a pandemic.
Figure 8: U.S. interest vs. unemployment rates
Source: Fed, BLS, CBRE Research Q3 2022.
Despite mounting recessionary fears, basic underlying data in advanced economies paints a somewhat different picture, with little evidence that a downturn is already underway. Air travel and restaurant visits, both of which emerged as important indicators of real-time economic activity during the pandemic, are holding up well in the U.S., U.K. and even Germany, which is most exposed to high energy prices.
Figure 9: U.S. airport passengers & restaurant reservations
Source: TSA, OpenTable, CBRE Research Q4 2022.
Figure 10: U.K. airport passengers & restaurant reservations
Source: Heathrow Airport, OpenTable, CBRE Research Q4 2022.
Figure 11: German airport passengers & restaurant reservations
Source: Frankfurt Transport, OpenTable, CBRE Research Q4 2022.
Although service PMIs are weakening, with those in the U.S., EMEA and Asia Pacific showing little to no growth, the decline thus far has been gentle.
Figure 12: Service Purchasing Manager Indices
Source: Markit, CBRE Research Q4 2022.
Despite some weakness in EMEA, which could be due to a slowdown in exports from Germany to Asia, particularly China, manufacturing PMIs remain in expansionary territory, with the U.S. reporting a slight increase in September.
Figure 13: Manufacturing Purchasing Manager Indices
Source: Markit, CBRE Research Q4 2022.
Business investment, which proved resilient during the pandemic as difficulties in securing labor stimulated the adoption of automation in different industrial sectors, also is not signaling a recession, with the U.S., EU and U.K. reporting continued high levels.
Figure 14: Business investment as % of GDP 25%
Source: OECD, CBRE Research Q4 2022.
A moderate recession is most likely
Strong economic headwinds, combined with a lack of material deterioration in economic activity, can primarily be explained by the delayed response to monetary policy, the effects of which may not emerge for six to 12 months. The lag effect is also why CBRE is forecasting a moderate recession for the world’s advanced economies.
While interest rate hikes are designed to slow consumer and business demand, they often have the unintended effect of exposing economic issues that were previously hidden from view. Recent turmoil in the U.K. bond markets stemmed from Liz Truss’s government announcing plans for unfunded tax cuts during a period of high inflation and rising interest rates.
This exposed the highly leveraged derivative positions held by U.K. pension funds in the expectation that interest rates would continue to fall, causing turbulence that subsequently spread to other markets, including the U.S.
While volatility has eased in recent weeks following the appointment of Rishi Sunak as U.K. prime minister, such a situation could arise again as pension funds in advanced economies are still loaded with leveraged government bonds, yields on which remain elevated. This could yet turn a moderate recession into a severe one.
Figure 15: Recent 30-year government bond yield, U.S. & U.K.
Source: OECD, CBRE Research, Q4 2022.
CBRE expects interest rate hikes to result in little economic growth in the U.S. next year. While unemployment will rise, it is unlikely to breach 6% provided there is not a major financial crisis. EMEA will be harder hit by its greater exposure to high energy prices.
Figure 16: Real GDP growth, U.S. & Europe
Source: CBRE Research, Q4 2022.
Thanks to slower inflation in key economies and the injection of large stimulus, the outlook for Asia-Pacific is more positive than elsewhere. However, China has yet to resolve key issues, particularly the downturn in its property sector.
Figure 17: Real GDP growth, APAC
Source: CBRE Research, Q4 2022.
The severity of a recession often depends on the state of the economy leading up to it. CBRE expects the upcoming recession to be mild because the economy currently is in healthy shape, with households, especially in the U.S., and businesses not significantly leveraged.
This makes it unlikely that there will be a major retrenchment, such as consumers significantly cutting back on spending and companies laying off large numbers of workers. While some tech firms have cut jobs in recent months, Q3 2022 corporate earnings were better than expected. The difficulties companies encountered in hiring over the past 18 months likely will result in a degree of labor hoarding that will protect against major layoffs, with cautious cost containment set to be the norm.
Other factors that will ward off a major recession include continued strong growth of the digital economy, with tech investment remaining especially robust. Despite the impending recession, sectors such as life sciences and biotechnology are pushing ahead with new investments.
Figure 18: U.S. household & corporate credit, gaps from trend (% of GDP)
Source: BIS, CBRE Research Q4 2022.
While some observers believe U.S. inflation will drop quite fast, it likely will take at least a year to fall to 4% from 8%. Lowering it any further will be challenging, with the Fed likely to loosen monetary policy once inflation falls to 3.5%.
Figure 19: Inflation rates, U.S. & Europe
Source: OECD, CBRE Research, Q4 2022
What does it mean for real estate?
Real estate, including the global housing market, has benefited enormously from a decade of ultra-low interest rates. With pandemic-era economic stimulus also creating a strong late-cycle boom, this suggests some retrenchment is due. Real estate investment activity is already falling as the cost of capital rises, with cap rates in the U.S. up by an average of around 100 basis points (bps) so far this year, equating to an approximate 15% loss of value. Properties that sold in recent months tended to be higher quality assets.
Figure 20: U.S. cap rates by sector
Source: CBRE EA, CBRE Research, Q4 2022.
While cap rates are also rising in EMEA, those in Asia-Pacific have been more stable as the local cost of capital hasn’t risen so aggressively. With global interest rates set to fall in H2 2023, the lower cost of capital should reduce cap rates in 2024.
Figure 21: EMEA cap rates by sector
Source: ERIX, CBRE Research, Q4 2022.
Figure 22: APAC cap rates by sector
Source: CBRE Research, Q4 2022.
Although both global M&A deal value and corporate real estate capital flows have fallen in recent months, a mild recovery is expected to begin in Q2 2023. U.S. commercial real estate investment volume is forecast to fall by 15% year-over-year in 2022 and drop another 10% in 2023.
Figure 23: M&A deal value & global CRE capital flows
Source: S&P Global, RCA, CBRE Research Q4 2022.
Lending for real estate has tightened significantly since the beginning of the year, especially relative to other sectors. Amid concerns about a price correction for high-value commercial real estate, the Fed may be instructing banks behind the scenes to exercise extreme caution when lending for real estate.
Figure 24: Net % of U.S. banks reporting tighter vs. looser lending conditions by loan type
Source: The Federal Reserve, CBRE Research.
Leasing activity also is softening, with office demand in the U.S. increasingly focused on top-tier space. This has pushed up prime office rents, while driving down those for lesser-quality space. With companies preferring high-amenity space to hasten employees’ return to the office, investors are narrowing their focus to the highest quality properties.
The retail market has been performing well in the U.S., with solid net absorption this year on the back of strong consumer spending. However, multifamily is beginning to suffer from mounting economic pressure that is reducing household formation—a trend that also likely will emerge in the U.K. and Europe.
Industrial & logistics occupier demand will weaken in 2023 but will still outperform other asset classes during the recessionary period. Other bright spots will include the life sciences sector, which continues to generate strong job growth in the U.S., U.K. and Europe and demand for related real estate.