overview & forecast

2023: RECESSION OUTLOOK

Over the last half of 2022, the big question hanging over the US economy was whether the economy would move into recession. More specifically, the question was whether the pace of interest rate hikes by the FRB to tame rampant inflation would, or even could, succeed in bringing about a “soft landing” that wouldn’t send it into a downturn. There was good reason for this; the pace of interest rate hikes in 2022 was the fastest in its history. A total of seven rate hikes over the course of the year effectively doubled the target federal funds rate to 4.25% to 4.50%, with the central bank indicating more hikes were to come in 2023, though likely at a slower pace.

Adding fuel to the fire, one reliable economic indicator sounded a huge alarm for economists in 2022 from the bond market. Starting in April 2022, yields on short-term U.S. government debt (threemonth) vs. long-term (ten-year) inverted. Typically, U.S. government debt with a later maturity earns a higher interest rate than bonds with a shorter term. When the curve between those two rates inverts and suddenly short-term rates rise above longer-term rates, lending is impacted. Banks and lenders can earn more on their loans for shorter-term lending than they can on the kind of longer-term loans that fuel economic growth. This phenomenon—the inversion of the yield curve—has proven to be a reliable indicator for recessions in the modern era. Since 1980, the yield curve has inverted twelve times and, in eleven of those, a recession occurred within six to 18 months of this occurrence.

The reliability of this economic indicator alone would usually mean we were likely doomed to a downturn in 2023, although there has been nothing historically “normal” about economic activity in the pandemic era. Polling of the National Association of Business Economists (NABE) revealed that 64% respondents polled in October 2022 believed that the economy was either already in a recession or that we were likely to be in one over the next 12 months. But then a couple of things happened. After peaking at 9.0% in June 2022, inflation started to turn a corner. By December it had fallen to 6.4%, still well above the FRB target rate (2.0% range) but indicating that sharp interest rate hikes were having the intended result of cooling the economy. This is despite the continued resilience of the

US Retail Sales Monthly Change Shows Slow Return to Earth

US consumer—which is hugely significant because consumer spending drives nearly 70% of American GDP.

Though retail sales have been slowing slightly over the course of 2022 as inflation took a bite out of consumer buying power, they remained resilient. For example, between November and December 2022, U.S. retail sales fell -1.1%, but on an annual basis, the $677.1 billion that American consumers spent that month was still 6.0% above 2021 totals. While the annual rate of increase the prior year was 17.6%, keep in mind that for the 20 years prior to the pandemic the average annual increase in retail sales was typically in the 2.0% to 3.0% range.

US Retail Sales Annual Change Shows Continued Strength

The continued resilience of the American consumer, despite significant headwinds, was a critical reason why overall economic growth (GDP) has remained on positive footing. The U.S. Bureau of Economic Analysis shocked most economists in January 2023 when it released data indicating that GDP increased by 2.9% in the final quarter of 2022.

While GDP totals pleasantly surprised many economists, there was a slew of data late in 2022 that provided optimism. Despite increasing levels of layoffs, the job market remains extremely resilient. While layoffs have been on the rise—for example, combined cuts from major tech companies have accounted for over 80,000 layoffs in the past year—nearly every employment sector needs workers. Total job openings in the US remained near record levels as 2022 ended. While many media talking heads have been quick to compare current conditions to the economic malaise of the late 1970s and early 1980s by throwing around terms like “stagflation,” the reality is far from that truth. Stagflation means an economy with high inflationary pressures but little economic growth. The late 70s and early 80s were marked by both double-digit inflation and double-digit unemployment. Our current period has the significantly elevated inflation part of the equation, but near-record low unemployment. It is not currently stagflation at all—instead, it is uncharted territory for which there are no modern historical periods for comparison.

Meanwhile, so far, layoffs have almost exclusively come from some of the sectors that benefited immensely from pandemic conditions, hired aggressively, and now are trimming down as the new postpandemic “normal” begins to emerge. While we may be moving in on the three-year anniversary of CoVid-19’s arrival in the United States, that “new normal” is still being formed after years of one economic anomaly after the next.

The shifts have been significant enough that as of January 2023, the NABE conducted another survey of the top economists in the US and found that the rate of those who believed we were already in or were facing an imminent recession had fallen from 64% in October 2022 to 53% in January 2023. In other words, the prevailing wisdom of most prognosticators has moved from a 2023 recession being a near certainty to that of being a coin flip. They haven’t been the only ones encouraged by the latest data. JPMorgan Chase CEO Jamie Dimon who had predicted a 2023 economic “hurricane” last year, changed his forecast to “storm clouds.” Moody’s Analytics, one of the pre-eminent U.S. economic forecasting organizations, also upgraded their prognosis for the year ahead, stating that “the more likely scenario is a ‘slowcession,’ where growth grinds to a near halt but a full economic downturn is narrowly avoided.

Accurately predicting the economy is highly difficult under the best circumstances. The best indicators are typically asset price bubbles, but it is impossible to predict shocks to the system that unforeseeable “black swan” events can trigger. For example, the 2000/2001 collapse in tech stock pricing (“the tech wreck”) did not infect other sectors of the economy and was an isolated headwind on economic growth (though it certainly took its toll on high growth tech markets at the time) it did not spill over into becoming a national downturn until the September 11th attacks happened—pushing the US into one of its briefest, and ultimately mildest, recessions in its history.

There are many parallels between then and the current situation, due largely to the major price reset of tech stocks that has occurred over the past 14 months (and prompted layoffs from major players like Alphabet, Meta, Microsoft, etc.). But there is one big difference, the early tech players of the tech wreck largely did not have proven track records of profitability and were highly speculative investments. Outside of recent, still more speculative assets like cryptocurrencies, NFTs or metaverse real estate, nearly all the companies that have experienced the most significant stock price corrections have strong records of being immensely hugely profitable endeavors. Their valuations simply became disconnected from underlying business fundamentals because of the tsunami of capital that was unleashed by central banks across the globe early in the pandemic to keep a public health crisis from turning into a global depression. If anything, we anticipate that the economic whiplash of the last three years will come to an end in 2023 as a new post-pandemic norm finally begins to emerge.

Ultimately, the two most likely scenarios ahead are either a modest, but likely brief downturn, or a 2023 “slowcession” or “nocession,” in which growth is flat but does not veer into negative territory. Black swan events could derail either of those scenarios; for example, a spread and worsening of the Ukraine war or a potential default of the US on its debt as new debt ceiling debate showdown looms. The latter is likely the biggest risk factor that could potentially derail the current favored scenarios of either no recession, or modest one.

Debt Ceiling Risk

Total U.S. debt stood at roughly $31.5 trillion as this report went to press—its highest level on record. This equates to a future per capita tax liability of over $85,000 per person in the United States and is simply unsustainable in the long run. The last time the Federal Government balanced its budgets or operated in the black was in the late 1990s. This is a long-term challenge that must be dealt with by policymakers—sooner, rather than later. However, while the debt ceiling debate has surfaced multiple times over the past 20 years, it has primarily been used as a political game of chicken to force spending cuts. Perhaps the best analogy would be a household with a spending problem that, rather than address the problem of spending more than it takes in, just decides not to pay the bills it already has accrued. On a personal consumer level, all this would do is damage your credit and result in even more debt through higher interest rates and penalties. It’s not that different at the governmental level.

In 2011, the US came within days of defaulting on its debt before a deal was cut—causing the nation’s AAA credit rating to be lowered briefly for the first time in history. That move alone is estimated by the Government Accountability Office (GAO) to have increased government borrowing costs by $1.3 billion that year alone. It also rattled the global financial markets and sent stock prices into a tailspin with the NASDAQ falling -6.9%, S&P 500 dropping -6.7%, the

NYSE losing -7.1% and the Dow Jones shedding -5.6% of its value. Investors and 401Ks lost billions and market values did not return to where they had been until early 2012.

It is impossible to know the full economic impact that a default would have if it were to occur, but it would be severe to catastrophic. It would not just keep the government from paying employees, the military and issuing social security and other entitlement checks. It would send global financial markets into turmoil, possibly lead to bank collapses, and paralyze capital flows. It would guarantee recession, but almost certainly a severe one that could potentially match the 2008 Global Financial Crisis.

We think it highly unlikely that this will occur and that legislators won’t reach an accord before an actual default. However, it is likely that this year’s anticipated showdown on raising the debt ceiling could, like in 2011, come within days of it. If so, just as we saw in 2011, it will create additional economic headwinds for an economy already facing its fair share.

2023: FROM PANDEMIC WHIPLASH TO THE EMERGENCE OF A NEW NORM

There have been a whole lot of economic buzzwords thrown since the arrival of the pandemic that, no doubt, you are likely as sick of hearing as analysts are as sick of using. Acceleration, agility, digital disruption, new normal, unprecedented, etc., the list goes on and on. Indeed, nearly three years after the US start of the pandemic, it is challenging for economists to conduct business as usual because that typically means comparing historical behavior to current conditions and extrapolating forecasts based upon that. But nothing economically over the last three years has a precedent. The last economic “normal” we had was in February 2020, before CoVid-19 exploded in this country. But the impact of that public health crisis, and then the steps we collectively took to avert financial disaster, haven’t just been unprecedented, but their impacts could best be described as the one buzzword that probably should have been used: whiplash.

In six weeks from March to April 2020, global stock markets lost an estimated $7 trillion in value, setting off unprecedented reactions from governments and central banks. The resulting wave of economic stimulus was both global and unprecedented. In the United States, it came out to a price tag of roughly $7 trillion ($3 trillion in bond purchases to stabilize the stock market and $4 trillion in forgivable small business loans or direct aid to individuals). Adjusted for inflation, the US spent $5.5 trillion on WWII. The resulting wall of money would have immense impact on the US economy.

The stock market, after nearly crashing in April, had regained its losses by August 2020 and by November 2021 it had gained another 50% in value--before it began to come back to earth. The housing market, which saw activity fall off a cliff in the initial months of the pandemic, was surging by the second half of 2020. By June 2021, the average home price in the US had surged 44.5% over where it had been pre-CoVid—before it began to come back to earth. US venture capital investment, which had averaged $81.5 billion annually from 2010 through the end of 2019, spiked to $169 billion in 2020 and then doubled to over $320 billion in 2021—before starting to slow in 2022.

Early winners from pandemic lockdown era conditions all saw immense spikes in value but are now normalizing. While these corrections are painful for anyone that has checked their 401k balances or likely home valuations today against peak values, they may prove to be a good thing in the long run. Corrections are what prevent much more painful busts. Early winners from pandemic lockdown era conditions all saw immense spikes in value but are now coming back to earth. As you will see in the data section of our report, the stock market was clearly in bubble territory by late 2021.

As for the housing market, though it will continue to feel pain in 2023 with the Fed likely to hike interest rates at least twice early in the year (if not more), it will likely play out as a correction. The absence of the kind of toxic loan product (adjustable rate, stated income loans, etc.) in the marketplace that drove the 2006 housing meltdown and subsequent financial crisis is one reason. The decade-plus of residential underbuilding in most markets is another. Prices are, and will continue, to reset downward as the price of money goes up. But the housing market is not likely to collapse under these stresses. While there are certainly asset classes that are going to face a challenging year ahead (for commercial real estate, the office market in particular), there are no glaring asset bubbles likely to burst in 2023 that would have the power to crash the US economy.

Looking forward, while we see multiple headwinds and plenty of potential crisis points that could negatively impact the economy, but we anticipate that 2023 will be a year in which the chaotic highs and lows of the past three years finally smooth out and the long theorized post-pandemic norm finally materializes. This should be the case whether the economy avoids recession completely or if it has a brief, but mild one. It likely won’t hold true, however, if any black swan events tip the economy into something much more severe. But assuming our forecast holds, the Sacramento region’s commercial real estate market is poised to perform better than most in 2023 for multiple reasons.