Mild Global Recession Remains Likely

Although China GDP grew by 6.3% year-over-year in Q2 2023, the quarter-over-quarter annualized rate was much lower at 3%. A slump in China’s residential real estate market, which drives up to 25% of the country’s GDP, contributed to the slowdown, as did weakening exports. Many buyers will not make purchase commitments until they see signs that falling values are bottoming out. It is possible that this is the end of the property boom that has pushed growth for the past 30 years. The Chinese government is cutting interest rates and boosting spending, which should help invigorate activity in H2 2023, but it will be hard to fully offset effects of the stalled housing market.

China, has accounted for more than 30% of global demand growth over the past 20 years. Weakness in China will be felt across all the developed and emerging market economies and will contribute to subdued real estate market activity.

Stock market investors have been anticipating a soft economic landing in the U.S. As of late September 2023, the S&P 500 Index was up by approximately 11% for the year.

By contrast, the steeply inverted yield curve, with much higher short-term than long-term interest rates, historically signals a recession with a lag of up to 18 months.

CBRE expects a broad-based slowdown, characterized by several quarters of either very slow or negative growth, similar to the dot-com recession of 2001.

Figure 1: 10-Year vs. Three-Month Treasury Yields

Source: The Federal Reserve, National Bureau of Economic Research, CBRE Research Q3 2022.

U.S. headline inflation currently stands at less than 3%, not far from the Fed’s 2% target. Core inflation, which excludes food and energy prices, has fallen from recent highs but remains elevated at 4.8%.

While the U.S. economy has continued to grow amid rapidly rising interest rates, the last mile to the Fed’s 2% inflation target will be challenging. Although there has been a sharp drop in one-year inflation expectations, three- and five-year expectations are both at around 3%.

Figure 2: U.S. Consumer Price Index (y-o-y change %)

Source: U.S. Bureau of Labor Statistics, CBRE Research Q3 2023.

European Union core inflation is expected to fall in the short term. The U.K. has struggled to bring inflation under control, but better-than-expected data for July and August seems to herald a turning point.

Achieving 2% inflation will require slower wage growth through higher unemployment. However, with demand for labor still exceeding available supply, average U.S. wages are up by 4.4% year-over-year. Other challenges to lower inflation include rising oil prices caused by OPEC’s recent production cuts.

While the Fed’s interest rate-hiking cycle appears near an end, it may be some time before rates are lowered. This will weigh on the economy, which is why CBRE forecasts a mild recession.

Figure 3: Change in Federal Funds Rate during Past Tightening Cycles

Source: Oxford Economics, CBRE Research, Q3 2023.

Although overall U.S. bank stocks have recovered since several bank failures earlier this year, the rebound has been led by larger institutions. Regional banks’ share prices were down by 30% year-to-date as of Sept. 26 (Figure 4).

Figure 4: Financial Equity Indexes (March 2023 = 100)

Source: FDIC, CBRE Research, Q2 2023.

With Moody's downgrading the credit ratings of several small- to mid-sized banks in early August, citing financial risks and strains that could erode profitability, the U.S. banking sector remains a potential source of stress.

Banks are in far better shape than just before the onset of the Global Financial Crisis (GFC), with both community banks and regional/national banks currently holding higher percentages of Tier 1 capital (Figure 5) and less exposure to commercial real estate (Figure 6).

Figure 5: Tier 1 Capital Percentage of Banks’ Total Assets

Source: Federal Financial Institutions Examination Council, CBRE Research, Q1 2023.

Figure 6: Value of Commercial Real Estate Loans as Percentage of Banks’ Tier 1 Capital

Source: Federal Financial Institutions Examination Council, CBRE Research, Q1 2023.

However, larger banks are more exposed to long-term Treasury investments (Figure 7), which are expected to decline in value by 38%, well exceeding the 19% drop during the GFC. In weighted average terms, banks’ assets have taken a significant hit, raising the likelihood of further strain (Figure 8).

Figure 7: Value of Long-Term Treasurys as Percentage of Banks’ Tier 1 Capital

Source: Federal Financial Institutions Examination Council, CBRE Research, Q1 2023.

Figure 8: Peak-to-Trough Drop in Bank Asset Values (%)

Source: CBRE Econometric Advisors, Q3 2023.

Despite the Fed continuing to provide liquidity and acting as banks’ lender of last resort, some 250 banks are expected to fail within the next six months—fewer than the 469 banks that failed during the GFC. Total banking system losses of 1.5% are expected during the current cycle vs. the GFC’s 2.8% loss (Figure 9).

Figure 9: Comparison of Past Bank Failures with Current Forecast

Source: Federal Financial Institutions Examination Council, Q3 2023.

CBRE’s State of the Market Index (SMI), which measures the forces generating real estate investment activity, picked up strongly in May and June (Figure 20). However, the index fell once again in July and August after the yield on the 10-year Treasury note rose to above 4% amid heightened concerns about interest rates potentially staying higher for longer.

Figure 10: CBRE State of the Market Index

Source: Macrobond, CBRE Research ,Q3 2023.

While U.S. and Europe REIT markets remain down on both a year-to-date and post-COVID basis (Figure 11), some capital is moving into real estate via REIT borrowing, with a slight rise in bond issuance since 2022.

Figure 11: U.S. & Europe REIT Indexes (2019=100)

Source: Oxford Economics, CBRE Research, Q3 2023.

Global property yields are showing signs of stabilization, with cap rates across the office, retail and logistics sectors rising at a slower pace in recent quarters (Figure 12), increasing the likelihood of them peaking in Q4 2023.

Figure 12: Composite Yields by Property Type, %

Note: Top market average in each region, end of period quarterly.
Source: CBRE Research, Q2 2023.

There is some evidence cap rates are peaking in the U.S. but are still increasing in Europe due to rising interest rates and in Asia-Pacific due to slower economic growth in China (Figure 13).

Figure 13: All-Property Yield by Region, %

Note: Top market average in each region, end of period quarterly.
Source: CBRE Research, Q2 2023.

Despite signs of improving capital markets sentiment, the spread between average all-property yield and bond rates is still probably too narrow for real estate to be a compelling investment, although some sectors and markets are attractive (Figure 14). With commercial real estate investors typically requiring a spread of 200 to 400 basis points between property and bond yields, either cap rates will have to increase further or bond yields will have to decrease for investment activity to gain momentum.

Many factors are preventing the 10-year Treasury yield from falling, including quantitative tightening by central banks, increased government debt issuance, stubbornly high inflation, rising oil prices and geopolitical tensions. Nevertheless, lower inflation, rising unemployment and economic weakness likely will contribute to lower bond yields over the next six months.

Figure 14: Average All-Property Yield & Bond Rate (%)

Note: Top market average in each region, end of period quarterly.
Source: CBRE Research, Macrobond, Q2 2023.

Office market fundamentals remain the most challenged, with weak demand and rising vacancy as occupiers continue to reduce their overall footprint.

In the U.S., demand has been flat so far this year but office leasing activity has not yet stabilized, indicating that tenants are deferring leasing decisions until there is greater economic clarity. Economic challenges also are weighing on leasing activity in Europe, with volume down by about 20% year-over-year in H1 2023. The Asia-Pacific office market is also being affected by an economic slowdown and new construction that has pushed the region’s overall vacancy rate to a 20-year high.

Despite these concerns, prime office rent has remained resilient this year as occupiers seek top-quality space to attract their employees back to the office. This is driving flight-to-quality relocation and leading to a strong preference for newer, high-quality offices with good transportation and amenities.

Retail sector performance remains a mixed bag globally. Retail sales volume in Europe is slightly down so far this year, although still about 2% above pre-pandemic levels. Consumer confidence remains challenged, but foot traffic at CBRE-managed retail properties across Europe continues to improve.

In Asia-Pacific, core inflation has decelerated in China but accelerated in Japan. Spending levels, particularly among urban households, could be affected as consumers tap into savings.

In the U.S., the retail availability rate remains at just 4.8%. Despite relatively strong retail fundamentals, developers are hesitant to break ground on large projects because construction costs remain so high. Renewal activity among retail REITs has been strong, with many reporting near record-high occupancy levels.

Globally, retail rents are up by 4% in the Americas, 3.8% in Europe and down by just 0.5% in Asia-Pacific.

As for the industrial sector, space demand and rent growth in the U.S. have slowed this year as occupiers delay leasing decisions due to ongoing economic uncertainty. While absorption of 126 million sq. ft. in H1 2023 was down by 50% from the same period last year, it was on par with the H1 totals in 2018 and 2019 before the pandemic-induced surge in space demand. Despite an influx of new supply, average rent increased by 17% year-over-year in H1 2023.

Europe has similar industrial market conditions, with leasing activity down by 30% year-over-year in H1 and expected to remain relatively subdued for the rest of the year. However, CBRE’s recent European Logistics Survey found that the largest occupiers remain very bullish, with more than two-thirds of respondents planning to expand their logistics footprint over the next three years.