“What goes around may come around, but it never ends up exactly the same place, you ever notice? Like a record on a turntable, all it takes is one groove’s difference and the universe can be on into a whole ‘nother song.”
-Thomas Pynchon,"Inherent Vice"
It’s the first week in November, and of course we’re writing about what everyone is talking about. The third quarter gross domestic product print. We had hoped this would finally be the quarter that would break the media’s awful habit of reporting GDP as a quarter-over-quarter annualized number. That hope was in vain. So we will report it here as you’ve seen it in the headlines elsewhere. But we aren’t happy to do it.
GDP growth rose by an annualized 33% after an annualized 31% drop in the second quarter. See how silly this is? Annualized figures are always somewhat unnecessary and exaggerate already volatile components. It’s a messy reporting method for a fairly straightforward concept.
In that case, let’s simplify it. Below shows the level, not the growth, of annualized production by component of GDP. We’ve indexed each to 100 at the first quarter of 2020 to show how much each has recovered versus pre-pandemic levels. The chart shows that the level of economic output in the economy has yet to recover to early 2020 levels, still lower by 2.3%. And while each major component of GDP — consumption, investment and government spending — remains somewhat lower than pre-pandemic, there are a lot of moving parts in this recovery.
The improvement from the second quarter was vast, to be sure. Investment, led by equipment and residential investment, is nearly back to normal. Consumption is only down 1.5% from its previous peak, which sounds good on the surface. But we should note that, even with the big rebound in the third quarter, this has been the third-worst two-quarter change on record since 1952. The improvement on the headline consumption number misses some problematic trends we’re watching closely:
Household service consumption — which includes eating out, flying, movie tickets and the like — is still down 5%, 10 times the second-worst two-quarter change ever recorded. This is where the pandemic shows up most prominently, and the recent ongoing increase in new cases won’t help.
Investment in nonresidential structures — i.e., offices and stores — is still declining, now down 13% since the pandemic hit.
State and local finances continue to worsen. This is not unusual during a recession, but the lost tax revenues from the quarantine will continue to weigh on this part of the economy.
The fact that spending on services is lagging isn’t a surprise. It’s much easier to spend money on goods when you are in lockdown: Just order things from Amazon. It’s harder to spend money on services, which more likely require in-person interaction, during a quarantine. Part of the reason is that many firms in the service sector remain closed, and conditions in the most-impacted household service industries have improved very little.
As you see in the chart below, the number of leisure and hospitality firms open for business remains down 37% from pre-COVID levels, and has actually gotten worse since the summer. A similar, but less severe, trend can be seen in the other household service sectors.
How long these businesses can stay closed while remaining solvent is a difficult question. One bit of positive news for the sector came on Friday: The Federal Reserve is once again easing its lending conditions for its Main Street Lending program, and this time fairly substantially. The minimum loan size has dropped to $100,000 from $250,000 previously, opening up this program to smaller and smaller businesses.
A point we keep harping on in this note is how essential the Coronavirus Aid, Relief, and Economic Security, or CARES, Act, has been to the recovery. Consumption is the primary engine of the U.S. economy, and federal government support for incomes kicked in almost immediately once job losses began. The chart below shows how personal income was not only supported, but significantly boosted, by the CARES Act programs. Without this shot in the arm for consumers, we would not be talking about a big rebound in GDP in the third quarter.
The September data on personal income showed that the program successfully helped bridge the gap in lost income, and seems to be sunsetting just as incomes are starting to grow again on their own. But even through September, when the extra $600 per week unemployment insurance boost had completely worn off, total CARES Act contributions remained a substantial 5% of disposable income. The Lost Wages Assistance, or LWA, program — technically not a part of the CARES Act — dutifully supplemented some of the lost unemployment boost at 2% of disposable income, but that was all but used up by the end of the month.
Our hope is that the income recovery is durable, as the loss of government support is coming head to head with another spike in COVID cases. Income support is going to be much less than what we saw during the April or June COVID spikes.
One of those lagging areas of growth we mentioned above was investment in commercial real estate, which is still down significantly. When the Bureau of Economic Analysis talks about such investment, it means spending on construction. CoStar users who track our construction data will know that new development activity is indeed falling — outside of the industrial property type, which continues to boom.
But what about commercial real estate investment as we typically think of it, meaning deal volume? The chart below uses the same drawdown methodology used to parse the GDP data above, this time looking at investment activity across property types and subtypes. The rebound in deal volume hasn’t been as dramatic as the rebound in GDP, but does contain similar crosscurrents the more finely we slice the data.
While industrial investment has recovered in some segments, notably distribution centers and food processing, investment remains down 20-60% across most property subtypes. The effect of the pandemic shows up in the relative performance of almost every property type. The aforementioned strength in e-commerce and food being purchased at home has helped parts of the industrial space. Low rise apartments, often suburban with no need for elevators, have vastly outperformed student housing, which is suffering from a lack of students on campuses. The open floor plans and shared spaces of creative offices have also lagged.
It’s clear that investors continue to take a cautious stance. Investments that have changed hands show little pricing drop, but volume has been mostly limited to the safer select property types. It will likely take longer for commercial real estate investment activity to return to normal than for GDP. Maybe we should start reporting deal volume as a quarter-over-quarter annualized number?
The Week Ahead …
Election week is finally here, but that won’t stop economic data rolling in. We’ll get a lot to digest, most notably Friday’s jobs report for October. Will hiring have slowed down further as virus cases spiked? The current estimate is for a gain of 600,000 jobs, which would be down slightly from the 661,000 gained in September. The outlook beyond October, regardless of the election victor, looks trickier. With viral cases rising in most of the Midwest, manufacturing sentiment will be under the microscope. We get a key look into that with Monday’s Institute of Supply Management report, followed by the same for the service sector on Wednesday. As if the election and heavy slate of data weren't enough, the Fed meets on Tuesday and Wednesday. After Friday’s Main Street Lending announcement, expect the focus to be on how to further rev up business and municipal lending, as those programs have been little utilized. With the Fed’s rate guidance set at zero for the next few years, its balance sheet will have to drive continued monetary policy support for the economy.