Today, the Q2 2022 GDP report from the Bureau of Economic Analysis (BEA) was released. As was widely expected, it revealed that Q2 2022 real GDP declined by 0.9% at a seasonally adjusted annualized rate (SAAR). This follows a decline of 1.6% (SAAR) recorded in Q1 2022, marking two consecutive quarters of “negative growth”—an oft-cited standard for a “technical recession,” but far from the official criteria used to determine if the U.S. economy is in a contraction or expansion.
Indeed, the National Bureau of Economic Research (NBER)—the arbiter of recession calls—uses a broader definition: a significant decline in economic activity that is spread across the economy and lasts more than a few months. The NBER reviews a variety of data to broadly measure the depth, diffusion and duration of changes in economic demand including total employment, industrial production, real income and several measures of inflation-adjusted consumer activity.
So, do the latest two quarters of negative GDP numbers mean that a recession is upon us or not?
While we know we aren’t the NBER, we wanted to provide our take on why we believe the recent declines are not indicative of a current recession—while simultaneously acknowledging that current growth is choppy, uneven and decelerating.
Measures of the Economy and What They are Telling Us
Real GDP is but one measure of the size of the economy, defined as the total gross value of goods and services produced in the U.S. (without double counting intermediate goods and services used to produce them). Because inflation can impact the value of things produced, this measure is inflation-adjusted (thus in “real” terms).
But there is another way to measure the economy: via the income that is earned when the sale of (or expenditures on) produced goods and services occurs. This is called GDI or gross domestic income. Although both real GDI and GDP should be identical in theory, they are not in practice. The BEA reports GDI separately—this measure of the economy grew at a 1.8% SAAR in Q1 2022. Figures for Q2 2022 GDI do not get released until the next revision in August.
The difference between GDI and GDP is unusually large at present. This could suggest that GDP gets revised up and/or GDI down months or even years from now. This happened in the opposite direction in 2001. When NBER declared a recession in November 2001, the GDP data was actually positive (it was later revised to be negative) so there is precedence for looking past GDP.
What Caused Negative GDP in the First Place?
In Q1 2022, real GDP declined by a 1.6% SAAR. Three components of GDP were the main culprits: inventories, government spending/investment and net exports. Overall, real GDP growth would have been much closer to flat—but still slightly negative—were it not for inventories and government spending, which subtracted 0.4% and 0.5% from the headline number respectively. Inventories actually grew at a 6.8% SAAR in Q1 2022 from Q4 2021. So how did inventories subtract from growth? In the estimation of GDP, inventories add to GDP if they grow at a faster rate than in the prior quarter; it’s the change in the growth rate and not just the level that matters. In Q4 2021, inventory growth was 7.1% (SAAR). Investment in inventories detracted from growth according to the way that GDP is calculated because we are comparing 7.1% to 6.8%. Meanwhile, total government spending has been a drag for three consecutive quarters through Q2 2022, and federal spending has been a drag for five consecutive quarters now. Thus, these declines were largely expected and are generally less informative about how the private real economy is doing.
Recession or Not: Contributions to Real GDP Growth
The line item that really drove Q1 2022 real GDP into the red was net exports, which subtracted 3.23% from headline growth. In other words, real GDP growth excluding net exports was positive. Since 1947—when detailed GDP data began—net exports have rarely caused such a drag: in only four quarters has it exceeded -3% in magnitude. A few reasons why this happened in Q1 2022:
- U.S. consumers continue to spend an elevated share of their money on goods, which tend to be imported. Strong import demand reflected strong domestic demand for “things.” Imports grew by an average of 18.4% (SAAR) in Q4 2021 and Q1 2022. In the post-WWII, pre-COVID era (1950-2019), there were only 12 instances in which two sequential quarters of import growth exceeded 18%, most of which were before 1985, implying this is a fairly rare occurrence, especially today.
- U.S. exports contracted by a 4.8% SAAR after surging by 22.4% SAAR in Q4 2021. This could have been due to a variety of factors:
- Lockdowns in China caused a sharp slowdown in trade flows—the largest bilateral relationship for the U.S. In Q1 2022, IMF trade data show that exports to China were down by more than 20% from Q4 2021.
- While not substantial trade partners, exports to Russia declined by 37.5% from Q4 2021 to Q1 2022, and exports to Ukraine by 13.5%.
- The U.S. dollar surged in value, dampening the competitiveness of U.S. exports. In March 2022, the trade-weighted real dollar value was up 5.5% year-over-year. It has since strengthened further and was up 9.4% year-over-year as of June 2022.
In Q2, some of the same detractors from Q1 GDP were still at play. Namely, another deceleration in inventory growth subtracted 2.0% from GDP growth as inventories grew by 2.9% compared with 6.8% in Q1. In other words, businesses are still adding to inventory levels but at a much slower rate. Retail sectors such as general merchandise are paring back inventories intentionally after stockpiling last year, while other sectors such as auto dealers are unable to replenish stocks due to severe supply chain issues. While these phenomena subtract from GDP, they are not fundamentally reflective of a recession. Government spending and investment continued to be a drag on growth, reducing GDP growth by 0.3% in Q2. Meanwhile, net exports flipped from a negative to positive contributor to GDP growth, adding 1.4 percentage points (ppts), as some of the headwinds from Q1 began to fade.
An important shift in the composition of growth from Q1 to Q2 was consumer spending. While real personal consumption expenditures (PCE) continued to grow (up 1.0% SAAR in Q2), the contribution to growth was only 0.7 ppt compared with an average of 1.5 ppts in the prior two quarters. This means that the consumer sector provided less of a positive offset to weak areas such as inventories. A notable shift in the composition of spending is underway; real PCE for goods decreased by a 4.4% SAAR in Q2 while that for services increased by 4.1% (SAAR). Inflation and supply issues have been more impactful for purchases of goods while consumers are also reverting to pre-pandemic levels of spending on travel, recreation, and other services.
Weakness in the residential investment sector also stands out in this report. Rising mortgage rates have significantly raised the cost of homebuying, while materials and labor shortages have also led to less investment in construction and remodeling. Residential investment declined at a 14.0% SAAR in Q2, reducing GDP growth by 0.7 ppt.
Why We are Not in a Recession Right Now
NBER declares recessions months after the event is underway, but CRE and other business leaders do not have the luxury of hindsight when making forward-looking decisions. Based on our analysis of a wider swath of economic data, we believe that the U.S. economy is not currently in a recession despite declines in GDP over the first two quarters of 2022.
In addition to the recent idiosyncrasies discussed above, GDP fails to capture key labor trends which are crucial in understanding inflection points in the business cycle. A closer look at employment measures suggests robust labor demand characterized by strong hiring across sectors. In June, the unemployment rate held steady at 3.6% for the fourth straight month as payroll employment increased by 372,000 net jobs. Every recession dating back to 1947 has been characterized by an increase in the unemployment rate during the first six months of the downturn, with the smallest increase being 0.3 ppt in 1973. So far this year, we have seen the unemployment rate decline by 0.3 ppt, so recent jobless trends are highly inconsistent with recessionary periods. Another recessionary indicator called the “Sahm rule,” which is closely watched by the Federal Reserve and other policymakers, declares a recession anytime the three-month average of unemployment rate rises by 0.5 ppt over its prior twelve-month low. Currently the Sahm rule is 0.0—another vote against recession.
Those suggesting that we are currently in a recession may point to the rise in initial unemployment claims over the past several weeks, and while this could be a precursor for more widespread layoffs in the future, it is more likely a reflection of job-cut announcements by a few hard-hit sectors such as technology companies struggling with plummeting stock values. In a recession, we would typically see hiring weakness pervading a wide range of sectors and that is not the case right now. A diffusion index measuring the net percentage of private industries adding jobs in June was 68.6 and the six-month average is an even higher 70.8; these measures typically drop below 50 in the first few months of a recession. Moreover, the amount of labor demand as suggested by the near-record 11.25 million job openings suggests that most industries maintain strong hiring plans which will continue to overshadow isolated layoffs in hard-hit sectors. The job market is the best argument in favor of “no recession” at present.
U.S. Labor Market Strength
Income and Spending are Still Rising Despite Elevated Inflation
Even with jobs prevalent and wages rising, inflation is weighing down household finances and consumer sentiment. A significant pullback in household spending would be a good barometer for recession since consumers make up about 70% of overall economic activity. We can best evaluate the health of consumers by considering how much income households bring in and how much they are spending. On the income front, real personal income (excluding government transfer payments such as stimulus and social security payments) increased 0.25% in the first five months during 2022. The fact that real income is rising despite decades-high inflation paints a healthy picture of consumer finances. Add in the fact that households have ample income buffers in the form of low debt burdens and stimulus savings and the personal income picture looks even better. Solid balance sheets are great but do not add to economic growth if consumers cut back on spending. Real PCE declined in May but, on average, remain higher than three or six months earlier, suggesting that consumers are still purchasing more goods and services. This would not likely be the case if Americans were preparing for a sustained economic downturn. Spending would be even higher absent supply-side factors such as low inventories of automobiles and other goods. It is also plausible that shoppers are waiting for inflationary pressures to subside before expanding discretionary purchases. Even with these hindrances, income and spending are not yet in a recessionary state.
Although it is difficult for the economy to enter a recession without a nudge from consumers, it is possible (see the 2001 recession) if domestic production diminishes materially. This could come in the form of fewer purchases of equipment and software, building construction and output of goods produced. While it is difficult to boil down the entire manufacturing sector into one indicator, the NBER tends to favor the industrial production (IP) index as the most reliable gauge for overall business activity. The IP index in June was 2.6% higher than six months earlier and 4.2% higher than a year ago, although it did slip modestly from the cycle high achieved in May. Materials and labor shortages are ongoing challenges for manufacturers, but it has not prevented factories from achieving high capacity utilization, which are also near the highest levels seen during the recovery from the 2020 pandemic recession. The regional Federal Reserve banks also conduct survey-based measures of production around the country, many of which showed deteriorating conditions in recent months, but these can be noisy and sensitive to temporary factors. Some regional surveys also deviate from trends reported by the Institute for Supply Management (ISM) whose manufacturing index, at 53.0 in June 2022, remains in expansionary territory. Time will tell how production reacts to softening demand, and we should indeed expect it to shift as consumers purchase fewer goods and more services, but there is no clear indication of a broad-based contraction at this time. Inventory levels in the wholesale and retail sectors remain broadly low compared with sales volumes, so there is a pathway for increased production in sectors where output has been suppressed by supply chain disruptions.
What Does This All Mean for CRE?
Commercial real estate fundamentals continued to improve in the first half of 2022. Deeply linked to the health of the broader economy, this is yet another sign that economic momentum was significant heading into the year and that property markets are tied to the real economy (and don’t behave like the stock market). Though there has been a broad slowing and a pick-up in choppiness, many measures of domestic demand have weathered these headwinds and point to the economy still being in an expansion.
- Demand remained positive for most CRE. Industrial absorption hit 236.3 msf in the first half of 2022, on par with the 2021 level and historically high—and this is despite some occupiers suggesting they would slow their footprint expansion and/or give back space. Retail absorption rose by more than 270% from its H1 2021 level to 20.9 msf. This is on par with demand levels recorded during robust expansion years, like 2017-2018. Demand for apartments remained resilient against a cooling housing market: absorption remained positive at 134,800 units in H1 2022, below the frenetic pace of 453,300 recorded in H1 2021 but generally on par with the six-month rolling average from 2010-2019 (126,100 units).
- The U.S. office market continues to improve steadily. U.S. office using employment has increased by 1.9%, adding 635,000 jobs in the first half of the year. There are now about one million more office using workers in the U.S. as of June 2022 than before the pandemic began. Moreover, the pace of negative absorption has decidedly slowed, and gross leasing activity continues to improve.
- Details matter. Whether it is the details of the GDP report or any other economic data, the backdrop of what is going on is complicated and nuanced. This is also true within many types of real estate. Headline figures often mask the true and perhaps more interesting storyline of what is unfolding.