Before we launch into the discussion, let’s just remind ourselves of how important economic conditions are for real estate markets. Figure 1 shows U.S. unemployment—probably the best single indicator of the global economic cycle—alongside office rental growth in the U.S., U.K. and world.
We consider two potential scenarios: one that forecasts an end to the current economic expansion in late 2018, the other that contemplates a longer-lived expansion.
End date 2018?
In the post-war period, the U.S. cycle has averaged 7 to 8 years in length. The last three cycles have lasted 9 years, on average, with the 1990s expansion being 10 years in length. It is not impossible for the current cycle to go beyond 2018, but statistically speaking, it is unlikely. Why?
- The Fed is increasing the short rate quite steadily now. It is likely to hit 3% by end 2018. There is much evidence to suggest that the equilibrium interest rate is now only 2.5%. Ergo, 3% is easily tight enough to kick off a chain of events that would lead to a stock market correction and a mild recession.
- The Fed is about to shrink its balance sheet. This is an unprecedented monetary manoeuvre and no one quite knows what the result will be, even if it is carefully managed. So this may push up Treasuries quicker than expected.
- The U.S. output gap is now positive, and the U.S. is running out of labour. There is no inflation yet, but there will surely be a build up from this point on.
- Stock market valuations look stretched by historic standards, even if they are not as stretched as they were prior to the tech crash in 2000.
- Real estate investment volumes often lead the wider U.S. economy, and these are slowing.
And it’s worth noting that any Trump stimulus in 2018 would be pro-cyclical and could overheat the U.S. economy, which is already running short of labor.
2019, 2020 or beyond?
There is no inflation, nor will there be. U.S. interest rates will rise much more slowly than even the pessimists expect.
For all the populist backlash, globalization is alive and well and preventing workers in the developed economies, including the U.S., from seeing anything other than a modest rise in wages. Corporate outsourcing is at full tilt, particularly in the services sector.
More broadly, there is still excess capacity in the global economy, and this is acting to constrain inflation, even in countries like the U.S. which have an ultra-low rate of unemployment. Unemployment in the Eurozone is at 9.5%, despite the recent surge in activity. Unemployment in China is low, but we know there is excess manufacturing capacity following a period of over investment.
The rise of U.S. oil production is a game changer. Not only does it help suppress inflation, but it also boosts the value of the U.S. dollar, so, even at a time of a yawning goods trade deficit (excluding oil), the pressure to raise interest rates to support the currency is much weaker than in previous cycles.
Slowly but surely, digital technology is beginning to expand the supply side of the U.S. economy, alongside continued high levels of immigration.
Betwixt and between
On balance, I still side with the arguments for late 2018/early 2019, but the case for a longer cycle is gaining strength.
For real estate investors, this means: “Stop worrying about the demand side and start to focus on rising supply.” This, of course, means careful analysis of local markets with time-honoured real estate techniques.