“We’ve been modeling for the U.S. to enter recession this quarter for the last year now,” began Dana M. Peterson, chief economist and center leader for economy, strategy and finance at The Conference Board, to a sold-out audience in a keynote at NAIOP’s I.CON East this week in Jersey City, New Jersey. She explained what a recession would look like, emerging economic trends, and their implications for industrial real estate.
Expect a “short and shallow” recession, with (mostly) strong labor.
“The Conference Board’s Leading Economic Indicator has been signaling a recession for the last year starting in the second quarter. If not this quarter, then next quarter,” said Peterson. The Board expects three quarters of negative GDP, or reduced U.S. spending, before returning to growth. Despite recession, Peterson anticipates a limited impact on the labor market. “Unlike the Great Recession or during the pandemic, the economy will likely only lose 1 million jobs,” explained Peterson, causing unemployment to rise from 3.5% to 4.5%. This level is still considered full employment, and thus why it would be regarded as shallow.
Sectors most affected by job losses will be those that benefited from the pandemic and need to rightsize as consumers have shifted their spending preferences from goods to services. Transportation and warehousing, manufacturing and real estate are relevant industries to this group that will suffer more than others.
The debt ceiling deal will reduce growth short term and lower borrowing over the long run.
The debt ceiling agreement calls for the federal government to spend $1.5 trillion less over the next 10 years. As measured by GDP, the impact on U.S. spending will be negative but minimal at -0.1 basis points in 2023 and -.3 to -.4 basis points in 2024. “Over the long term, credit agencies and other governments that lend us money will see that the U.S. is addressing its debt issue. It preserves our credit rating, allows us to borrow at a lower interest rate, and lowers costs,” said Peterson.
To an audience question, Peterson answered that the debt ceiling agreement was wise to avert default and catastrophic consequences; however, “what was missing was discussion of revenues and raising taxes to pay down debt and solve the problem inevitably.” Further, the agreement only addresses curbs on discretionary spending and doesn’t speak to mandatory spending, including entitlements like Social Security and Medicare. Those programs comprise the bulk of government spending.
Interest rates to control inflation will settle to a higher long-term rate than before.
Peterson said she believes interest rates will soon peak from the Federal Reserve rate hikes. Core Personal Consumption Expenditure, one of the Fed’s inflation indicators, is still hovering around 4.5%, so Federal Reserve rate cuts will not likely occur until 2024. When we reach a terminal rate, Peterson said she expects the optimal interest rates to hover around 3.5-4%, and well above the 1.5-2% we have experienced over much of the last 30-40 years.
Structural forces that will keep inflation sticky and necessitate a higher interest rate level include semiconductor chip demand, millennials needing housing, labor shortages, deglobalization and onshoring, and the transition to renewables. “Until we clear these transitions and their costs, don’t expect that terminal rate to decrease,” maintained Peterson.
Banks’ lending standards are tightening across the board.
“It does seem like the worst is over from the fallout of Silicon Bank and the related banking crisis,” said Peterson, but banks “are looking at CRE, which is the Achilles heel, mostly in the office space.” These institutions are the largest lenders of commercial mortgages, and smaller banks are the most exposed to CRE loans. The office space is in a tough spot, and a cascade of defaults here would be felt in the economy if it’s not carefully managed. Year over year, banks are tightening their lending in this space and commercial real estate in general.
Aging population is one of several factors driving labor shortages.
Demographically, we are finding it more challenging to replace workers. In 1980, there used to be 4.3 working-aged persons for every retired person. That number has significantly shrunk to 2.2 persons currently. Besides the aging population, other factors that make the labor shortages sticky include excess retirements, caregiving responsibilities, skills mismatches, low wages, tight job requirements and strict immigration policies. Peterson explained that businesses have primarily increased wages and offered flexible benefits to ease tight labor. Still, the solutions must expand to include policies like licensing reform to make headway on tight labor.
US Manufacturing is having an onshoring renaissance.
The U.S. relationship with China has grown chilly from battling over technology, trade, investments, and involvement in the South China Sea. “All of this has given rise to protectionism, and the establishment of Industrial policies to prevent economic disruption and protect national security,” explained Peterson. In response, U.S. companies are onshoring, nearshoring, and diversifying supply channels into the U.S. to benefit industrial real estate. “You are seeing a factory boom in the U.S, especially in the East North Central and East South Central regions,” explained Peterson. “And as a less expensive alternative friend-shoring has many opportunities in places like Mexico and Canada.”
The green transition is here for commercial real estate.
There will undoubtedly be turnover out of old buildings and into new green buildings. In the short term, it will be expensive to transition energy modes, replace and equipment and buildings, and pay carbon taxes. The goal is to “gain the benefits of improving your ESG print” of the long run and to participate in the smart cities and green infrastructure. “This is the future and this is where we are headed, with buildings that are automated, touchless and have fiberoptics, and with infrastructure that is not only energy efficient but energy generating and non-polluting. Commercial real estate is leading the charge here,” said Peterson.
E-commerce is down but not out.
“Online is here to stay,” Peterson said in answer to an audience question, as “the goods purchased will need to be produced, warehoused.” The percentage of e-commerce sales to total has plateaued to around 10%, and hovers around pre-pandemic levels. Currently, consumers are shifting spending dollars to services from goods, but this should balance out long term. Peterson sees a new equilibrium a little higher than we are now. She believes that Web 3 can improve the virtual buying experience to create this growth.
Location, location, location.
According to Peterson, it comes down to “location, location, location.” Industrial is a great sector because the country needs big spaces for reshoring and nearshoring of our manufacturing. When determining where to build, it’s important to consider if there is labor in that location. Builders must also keep inflation costs in mind as well. Peterson can see industrial real estate values rising depending upon location. People moved southward and inward over the last few years. “The Sunbelt probably will see a lot of demand because it’s a business-friendly climate and that’s where the people are.”
One trouble spot Peterson sees is office space. “Work from home is here to stay. Employees are used to it and businesses save on costs. I expect there will be big defaults in the future.”