The General Economy
The economy in the second quarter was unsettled but consumers showed some resiliency. This was the first full quarter to absorb all the jolts from earlier in the year. In addition, people dealt with a falling stock market, traumatic headlines and a brutal reminder of supply chain issues with the scarcity of baby formula. On top of these concerns was unrelenting inflation. The Consumer Price Index (CPI) rose at an 8.6 percent annualized rate in May, higher than many Americans can remember. Propelled by fuel costs, inflation also crept into every category of economic activity. It was difficult to avoid.
Consequently, consumer sentiment deteriorated along with economic expectations. Projections issued in early June showed Gross Domestic Product (GDP) expansion of 2.5 percent, but by the end of the quarter, some estimates saw indications of a downturn.
People did not completely give up their spending plans, however. Personal Consumption Expenditures growth was expected to be significant. Retail sales for the three months ending in May showed that the travel industry, restaurants and clothing retailers were some of the biggest beneficiaries of a supportive employment situation and the enduring pent-up demand from the pandemic. With wage improvements not keeping pace with prices, determined consumers had to look in other places to find spending money. Credit card (revolving debt) usage increased, saving rates1 were below pre-pandemic levels and the excess savings from pre-COVID levels were spent down.
The Real Estate Sector
Housing is one of the first markets to feel the pain in the war against inflation. The Federal Reserve (The Fed) battled mounting inflation with escalating rate rises of 0.50 percent in May and 0.75 percent in June. These pushed the monthly average 30-year fixed mortgage rates to 5.52 percent, after reaching a weekly high of 5.81 percent in late June. The housing market reacted as expected. Fannie Mae forecasted that single family home sales and starts would be down over 10 percent for the quarter. Building permits also dropped for the third month in a row in May.
The momentum of demand was still evident. Supports for the market included a strong job situation, the cohort of millennials house hunting, and historically healthy consumer and bank balance sheets. Furthermore, mortgage interest rates are still relatively low by historical standards.
(Source for chart: www.freddiemac.com)
Purchase originations were projected to grow by 25 percent in terms of value and volume according to the Mortgage Bankers Association. Thus, home prices (as measured by Fannie Mae’s Home Price Index) remained relatively high, advancing almost 16 percent year to year.
As with consumer goods, home buyers found ways to make purchases. More borrowers chose adjustable-rate mortgages to lower their initial interest rate. According to the National Association of REALTORS®, many dipped into their savings and leveraged home equity to make hefty down payments, reducing their loan size and payments. Some buyers bypassed the higher interest rates all together; earlier this year, all cash sales made up the highest percentage of transactions since 2014.
The commercial real estate (CRE) market was impacted modestly by the climbing interest rates. Deal volumes2 tottered but stayed above pre-pandemic levels and investor appetite for CRE remains strong. According to JLL, “Interest [in deals] remains high, but the rapidly changing environment requires extra homework.” Credit availability for CRE did not change. The retail and hotel sectors continued to normalize, thanks to the return of travel and shopping in person. Apartments enjoyed healthy rent increases. Concerns over the industrial sector softening due to moderating e-commerce demand did not materialize; industrial rents remained on an upward trend.
One area of apprehension over the last year was central business district (CBD) office space, but this sector performed better than expected in Q2 of 2022. The flight to quality continued and may have supported overall prices. JLL reported that while overall vacancy rates worsened in the first quarter, they improved for new buildings. The reappearance of technology and professional services employees in the cities helped, as did the broader return to the office. Companies, after months of trial and error, have ironed out many of the kinks in hybrid work.
A Glance Forward
While most economists foresee a slowdown, one question is when it will start. It is unclear when individuals will feel too economically insecure to spend down their savings or take on debt further. The third quarter may be the end of pandemic-deprivation demand. Or summer plans, back to school spending and further declines in unemployment may bolster GDP. Projections done by Fannie Mae in early June forecast it to be over a respectable 2 percent.
Elevated mortgage rates may temper housing market sales and starts further. Home price growth is also expected to soften, but there is not a consensus to the degree.
The biggest determinant of the economic mood is tenacious inflation. The current forces behind climbing costs may persist, possibly exacerbated by the first infrastructure bill monies hitting local coffers. Some forecasters anticipate that the CPI could rise almost 9 percent in the third quarter. To respond, the government expanded its tools to tame inflation. The Fed signaled more rate increases, potentially as high as another 0.75 percent. It also began Quantitative Tightening (QT), the process of reducing the size of the Federal Reserve’s balance sheet. In 2020, The Fed grew its holdings of government bonds and mortgage-backed securities to make money available for the faltering economy. In June, the reversal of this process started, removing liquidity from the economy, which will put upward pressure on mortgage rates. U.S. administration moves included the use of the Strategic Petroleum Reserve and Defense Production Act to address some short-term supply-side issues. It also announced initiatives to alleviate longer-term price pressures.
Many of the propellants of inflation are happening abroad and are thus minimally impacted by U.S. policy. However, Federal Reserve Chair Jerome Powell is confident these tools will bear fruit. “Our job is making sure that the public does have confidence that we have the tools and will use them and they do work, to bring inflation back down over time. It will take some time we think to get inflation back down, but we will do that.”
1. U.S. Bureau of Economic Analysis, Personal Saving Rate [PSAVERT], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/PSAVERT July 8, 2022.
2. Copyright ©2022 “Commercial Market Insights May 2022.” NATIONAL ASSOCIATION OF REALTORS®. All rights reserved. Reprinted with permission. May 2022, https://cdn.nar.realtor/sites/default/files/documents/2022-05-commercial-market-insights-06-03-2022.pdf