"The Changing Landscape of Commercial Real Estate," UCLA Anderson Forecast, June 2014

On the surface it would appear that the commercial real estate asset market is booming. The prices of “institutional grade” real estate have surpassed the prior boom levels of 2006-2007, the commercial mortgage backed securities (CMBS) market has risen from its nadir in 2009 and is half way back to the level of 2007, interest rates remain extraordinarily low, and commercial construction generally remains constrained, at least for now. (See Figures 1, 2, 3, and 4) Capitalization rates (net operating income divided by purchase price) for high quality properties are in the 5% range or lower and investors in a yield-starved world are willing to accept ten year pro forma internal rates of return in the 6-7% range. We are in truly heady times.

However, beneath the surface commercial real estate, with the notable exception of apartments, faces the challenge of disruptive technology that is undermining tenant, as opposed to investor, demand for commercial real estate.[i] Put simply, disruptive technology is defined as a low cost solution that offers lower performance but, represents a true value at the price.  Think tablet computers compared to personal computers. In the following sections I will discuss the major issues facing each property type in turn.

  

Figure 1. Green Street Advisors Commercial Property Index, Dec 97 –April 14, 2007 Peak = 100.

Source: Green Street Advisors

Figure 2.  CMBS Issuance, 1999-2014F, In $ Billions

Source: Real Estate Alert and UCLA Anderson Forecast

Figure 3. Real Commercial Construction Spending, 2000Q1 – 2016Q4F

Sources: U.S. Department of Commerce and UCLA Anderson Forecast

Figure 4. Federal funds vs. 10 Year U.S. Treasury Yields, 2005Q1 – 2016Q4F

Sources: Federal Reserve Board and UCLA Anderson Forecast

Retail

Fifteen years ago fear of internet competition stalked the retail real estate world. Then the fears were premature; today it is reality. The share of retailing going to e-commerce has risen from 1% in 2000 to 6.2% today. (See Figure 5) Indeed if you strip out the non-e-commerce intensive automobile, gasoline, retail food and restaurant groups the share of retail spending devoted to e-commerce doubles to 12.5%.  In fact since the recession lows e-commerce sales have advanced 110% while retail sales ex- autos have risen just 23%; not a pretty picture. Slowly but surely e-commerce is eroding the very foundations of retail real estate.

Figure 5. E-Commerce Sales as a Percent of Total Retail Sales, 2000Q1 – 2014Q1

Source: U.S. Department of Commerce via FRED

This trend is manifested in still very high mall vacancy rates which are at recession levels, and in the bifurcation of the mall business. (See figure 6) For now the Class A malls are thriving with sales per square foot exceeding $700. However the bottom tier malls with sales/ square foot of less than $300 are suffering. They are certainly not being helped by the slow motion demise of JC Penney and Sears. Of the 1050 open and enclosed malls in the U.S. about 150 of them have vacancy rates in excess of 20%.[ii]  Instead of being retail draws they have become places where retailers go to die. At the end of the most of those malls will be “scraped” with alternative uses found for the land.

  

Figure 6. Mall Vacancy Rates, 1980-2014Q1

Sources: Calculatedriskblog.com and REIS.

Although the top tier malls appear to thriving underlying sales growth has been eroding over time. For example Simon Property Group, the nation’s largest mall owner, has reported consistently rising leasing spreads (new leases above existing leases), sales growth is stagnating. (See Figure 7) This trend is not sustainable. Simply put retailer profitability is eroding in the face of sluggish consumer spending and greater pricing transparency induced by smart phones and to the detriment of the mall; retailers are upping their own e-commerce games. Thus it is no surprise that mall operators are keen to add more restaurant tenants into their mix and they too will have to up their investment in technology. Thus the travail of the B-malls might just represent the canary in the coal mine.

Similarly power and community and even neighborhood centers are facing digital competition. Home Depot is no longer expanding its store count as it is now concentrating its efforts on e-commerce. Although there are e-commerce retail food distribution models, the entrance of Amazon into this arena certainly bears watching. Needless to say e-commerce is making huge inroads into kitchen, bath personal care and pharmacy items. Look out Bed, Bath and Beyond.

Figure 7. Simon Property Group, Sales/Square Foot, Percent Change, Year over Year vs. Releasing Spread, 2011Q4 – 2014Q1

Source: David Harris, Imperial Capital

What is working in retail appears to be street level retail in dense urban centers that have a significant tourist component to support underlying demand. For example retail rents in Manhattan have been known to exceed $2000 a square foot with rents in high hundreds common. Contrast this with top mall rents of around $100 a square foot. Critical for this model to work is a dense environment of high income consumers. Aside from Manhattan, think Boston, Chicago, San Francisco and parts of West Los Angeles/Beverly Hills/Santa Monica.

Office

Aside from a few exceptions such as Manhattan, San Francisco, San Jose, Seattle, and Houston, the office market remains in the doldrums. The national office vacancy rate stands at a high 16.8% and has only marginally come down from its recession peak of 17.5%. (See Figure 8) There are two very important factors at work. First as we discussed previously, the historic drivers of office demand, financial and legal services employment are but a shadow of their former selves.[iii] (See Figures 9 and 10)  For example, financial activities and legal services employment increased by historically modest 55,000 and 1,000 jobs over the past year and both are still below their pre-recession peaks. In contrast employment in computer systems design, management and technical consulting and support services for mining (largely oil and gas) increased by 63,000, 51,000 and 29,000 jobs, respectively. Indeed all three categories are at new highs.

This change in the pattern of office employment growth explains why the technology and energy related office markets are doing so much better than the more traditional markets. And it also explains why the previously out of favor mid-town south markets of Manhattan, where technology firms tend to concentrate are doing far better than the very traditional Park Avenue market. In the Los Angeles the same goes for Silicon Beach compared to Brentwood.

  

 Figure 8. National Office Vacancy Rate

Sources: Calculatedriskblog.com and REIS.

  Figure 9. Financial Activities Employment, 2000Q1 – 2016Q4F

Sources: Bureau of Labor Statistics and UCLA Anderson Forecast

Figure 10. Legal Service Employment, Jan 2000 – April 2014, In Thousands

Sources: Bureau of Labor Statistics via FRED.

A far more serious challenge to office demand is that under the impetus of changes in technology and technology-oriented tenants, the space demanded per office worker is dramatically contracting. Instead of 200 square feet of office space per worker, office space is now being designed around utilizing 150 square feet per worker. Moreover in many new buildings for tech-oriented tenants space planners are now allotting only 120 square feet per worker.

Why is this happening? First technology has reduced the demand for file space and reference rooms as records have become digitized. Second technology firms emphasize collaborative work environments utilizing open floor plans. The densification of work spaces has not been limited to technology firms as Goldman Sachs, Credit Suisse and Unilever have adopted floor plans allocating 150 square feet per worker.

What this means is that much of the existing office stock is technologically obsolete. It is no easy task to go from 200 square feet per employee to 150 square feet or less. At higher employment densities existing building have issues with elevator, restroom, ventilating and fire stairwell capacity. Further in suburban markets with limited mass transit, the traditional parking ratio of 4 spaces per 1000 square feet of office space will prove to be inadequate. Thus even in high vacancy markets we will see new construction to accommodate the new workplace of the 21^st century. Put bluntly, even at higher rents an office building in a dense configuration can cost less on a per employee basis than a lower density building.  As a result the national office vacancy rate will stay high for many years to come. And it should surprise no one that urban office buildings are being converted to residential use and suburban office buildings are being “scraped” to make way for high density residential development.

Industrial

The industrial market is gradually recovering from recession as the availability rate has gradually declined from 14.5% in 2010 to around 11% today according to CBRE. Industrial space has and will continue to benefit from e-commerce as warehouse space is substituted for retail space and the need to be closer to the consumer. However the main driver of demand on the coasts has weakened with softer import growth.

Of greater consequence will be the completion of the delayed widening of the Panama Canal in 2016 to accommodate the larger container ships. That mega-project has the potential to shift warehouse demand from the west coast to the gulf and east coast ports benefiting such port cities as Houston, Savannah and Charleston. (See Figure 11)

Figure 11. Panama Canal Logistics

Source: Google

Hotels

Technology has made the hotel business far more transparent. There are a host of on-line services that supply up-to-the-minute pricing data for hotel rooms throughout the world. There are also consumer reviews available for practically every hotel in America. More than ever hoteliers have to be on their toes. All of this has been true for about the past decade. What is new is the rise of the “sharing economy” where individuals offer up their own houses, apartments or rooms to be made available for temporary rental.

The prototype of this new form is Airbnb a website that offers up private accommodations in people’s homes. Earlier this year Airbnb received venture financing that established a $10 billion value for the firm, greater than the market capitalization of Hyatt Hotels. This is truly disruptive competition. It doesn't have to be as good as a hotel room. All it has to be is cheap and convenient. Of course it should not be surprising that the regulation-heavy cities, under the guise of protecting rent control, of New York and San Francisco are making moves to stifle this new form of competition to the hotel industry. There is also the issue of collecting hotel taxes where the owner is responsible for both collection and payment of the tax. Airbnb is in the process of seeking legislative change to allow it to collect and pay the required taxes. Meantime a recent perusal of the Airbnb found a host of accommodations in or near Westwood Village at prices ranging from $50-$350 a night.

Multi-Family Housing

Multi-family housing is in the sweet spot. The sector is benefiting from:

·                 A decline homeownership rate (See Figure 12)

·               An increased consumer preference for urban and suburban density.

·              A still sluggish economy that is delaying such life cycle events as marriage and           childbirth.

·             The need for 24/7 tech workers to be close to their employment.

·            Transit-related development being viewed as “green.”

Figure 12. Homeownership Rate, 1995Q1 -2014Q1.

Source: Bureau of the Census

All of these forces have led to a free fall in the apartment vacancy rate to 8% from the recession high of 4%, increasing rents, and a surge in construction. (See Figures 13, 14 and 15) We would also note that the 3% increase in year-over year rents reported by the Bureau of Labor Statistics is understated because of a few technical issues. Specifically we are forecasting multi-family housing starts to easily exceed 400,000 units a year in 2015 and 2016 which will represent their highest level since the mid-1980s. Of course by 2016 the increases in construction and a leveling off in the homeownership rate will cause vacancies to rise and rent increases to abate. Meanwhile the boom is on.

Figure 13. Apartment Vacancy Rate,

Sources: Calculatedriskblog.com and REIS.

Figure 14. Consumer Price Index, Rent of Primary Residence, Jan 2000 – Apr 2014, Percent Change Year Ago.

Sources: Bureau of Labor Statistics via FRED.

Figure 15. Multi-Family Housing Starts, 1980 – 2016F

Sources: Bureau of the Census and UCLA Anderson Forecast

Conclusion

In this report we have outlined several very important issues facing commercial real estate. We do not expect investors will focus on the technological disruption facing retail, office and hotel real estate until capital market conditions become less favorable. There is too much money pouring into real estate to worry right now. Simply put the worriers don’t get the deals. Nevertheless when the capital markets turns investors will wake up to the changing landscape for commercial real estate.

---

[i] For a discussion of disruptive technology see, Christensen, Clayton M., “The Innovator’s Dilemma: When New Technologies Cause Great Firms to Fail,” (Boston: Harvard Business School Press, 1997)

[ii] See Kapner, Suzanne and Robbie Whelan, “Struggling Malls Suffer as Penney, Sears Shrink,” The Wall Street Journal, May 10,11, 2014, p.1.

[iii] See Shulman, David, “An Uneasy look at office Space Demand,” UCLA Economic Letter, December 2012

My Amazon Review of David Reynolds "The Long Shadow: The Legacies of the Great War in the Twentieth Century"

Cambridge history Professor David Reynolds has written a kaleidoscopic history of the influence of the Great War on the politics and culture of the twentieth century and early twenty first century. Although he discusses all of the major combatants, his primary focus is on the United Kingdom and Ireland. He goes well beyond the inter-war years that are covered very well by Richard Overy and Zara Steiner, and that is a major contribution. In my view his book is more of an academic history than a popular history and as a result I give it four stars, not five.

Reynolds covers the role of the anti-war poets (e.g. Sassoon, Owen and Blunden) and their impact in fermenting the anti-war sentiment that percolated through British society in the 1920s and 30s. Their views would be revived in America during the anti-war movements of the 1960s.

In economics he discusses the pressure to return to the pre-war gold standard the deflation it wrought on the global economy. But make no mistake he really doesn’t emphasize economics and he leaves out completely the London Economic Conference of 1933. He does cover the British economy well by highlighting the fact that the 1930s were far better for Britain than the 1920s and the adoption of a very aggressive housing policy by the Tory government. The Tory property owning society of the 1930s became the Republican ownership society in the early 2000s.

Most striking to me was the influence of the propaganda exaggerations of the German atrocities in 1914 Belgium anesthetized British and U.S. policy makers and public opinion to the reality of the 1942-45 extermination of European Jewry.  Simply put all too many policy makers refused to believe that the holocaust was taking place.

He also discusses the role of Wilsonian idealism in American foreign policy. America’s role in the world is far different in 1945 that it was in 1918. A lesson was learned.  The long shadow of the war shows up in George Bush’s democratization program in the middle-east earlier this century. It also shows up as the Wilson-Lenin rivalry of 1918 for global opinion that many believe to be at the origin of the Cold War.  

All told Professor Reynolds has taught us that we are truly products of our past and I highly recommend this book to serious students of the history of the 20th century.

The Amazon URL is:  http://www.amazon.com/review/R2T6T5HF6K9U0V

My Amazon Review of David Downing's, "Jack of Spies"

Having read all six of David Downing’s “station series” about Germany in World War II, I was looking forward to his new series on World War I. Unfortunately I was disappointed. Simply put his lead characters, Jack McColl and Caitlin Hanley, lack the depth of John Russell and Effie Koenen. Perhaps it’s the times. The world of 1913-14 had yet to experience the horror of the trenches, the ideological struggles of the 1920s and 30s, the Great Depression and the rise of Hitler. It was a simpler time.

Downing’s protagonists are Jack McColl, an automobile salesman initially freelancing as an intelligence agent before moving on to that line of work full time and his romantic interest Caitlin Henry, a very attractive proto-feminist working as a journalist. Jack’s spying takes him to the German concession of Tsingtao, China, San Francisco, New York, Mexico during the U.S. occupation of Veracruz, Dublin and London. Quite a full itinerary, but he is far from operating on the high political level of Sidney Reilly, the “Ace of Spies”. It is more the day-to day stuff dealing with naval deployments, arms shipments and IRA terrorism. Through it all McColl and Henry find the time to frequently end up in bed.

There are appearances of the founding fathers of British Intelligence. We meet McColl’s boss, George Smith-Cumming the head of the Special Intelligence Service responsible for foreign activities, now MI-6, and Vernon Kell the domestic intelligence chief of the Secret Intelligence Bureau, now MI-5.

There is a lot of good stuff in this book and it is worth the read, but I only hope that in future volumes Downing will improve his character development under the strains of The Great War.

The Amazon URL is:  http://www.amazon.com/review/R60CA1I0970MX 

Reliving the 1930s

According to aphorism attributed to Mark Twain, “history does not repeat itself, but it rhymes.” I am afraid our generation is reliving some of the horrible experiences of the 1930s. The Great Recession of 2008-09 was our version of the Great Depression. The recent experience certainly was not as bad, but after many decades of plenty, it certainly felt that way.

As the 1930s progressed concerns shifted from the still depressed economy to the rise of fascism and a series of foreign policy crises in Europe and Asia. Instead of Hitler fascism we are now witnessing the rise of Vlad, “The Impaler,” Putin’s version of it. In the 1930s Germany was the revisionist power seeking to undo the strictures of the post- world War One settlements. Today Putin is attempting to revise the post-Cold War settlement established from 1991-1994. His seizure of the Crimea and his attempts to further dismember Ukraine are part and parcel with his strategy to restore the past greatness of Russia. Just like Hitler, he is succeeding.

Why? The West is doing its best to rhyme the failed policies of the 1930s of vacillation and appeasement. Both the United States and Europe want the world go away so they can hide in cocoon of isolation. This is true of factions of both the left and the right of the political spectrum. Unfortunately this policy is a luxury we cannot afford. To paraphrase the Russian revolutionary Trotsky, the U.S. and Europe might not be interested in the world, but the world is interested in them.

Instead of making speeches, our vacillating President should act by imposing real sanctions on Russia, providing direct military aid to the Ukrainian government, increasing rather than decreasing the military budget, moving NATO forces into the front line states on a more permanent basis and take the energy infrastructure steps necessary to wean Europe off of Russian gas. Will President Obama act? The stakes are high! 

My Amazon Review of Thomas Piketty's, "Capital in the Twenty-First Century"

Thomas Piketty has written a big data-driven book and an important book about the growing unequal distribution of wealth and income in advanced capitalist societies. However, never once does he mention in his 685 pages why rising inequality matters. For Piketty it is a given. Although Piketty is not a Marxist he wears his social democratic identity on his sleeve with such a statement as “the evil genie of capitalism will be put back in its bottle.” (P.350)  To him the 1914-1970 period where income inequality was on the wane was a brief hiatus between the Gilded Age and Belle Époque of 1890-1910 to what he perceives as the new gilded age of today. After all from 1970 to 2010 the share of income going to the top 1% of the income distribution increased from 9% to 19.8% in the United States.

What interests Picketty is what a Marxist would describe as the laws of motion of capitalist society. For Picketty it is the concept that the pure return of capital (r) is greater the overall economic growth rate (g).  He demonstrates that the pre-tax real return on capital is roughly constant approximating 5% and in most cases economic growth is well below that. For him there is no falling rate of profit.

In order for capital to grow faster than income both the tax rate on capital income (dividends, capital gains, interest and rents) and the propensity to save has to be low. Otherwise the retained return on capital would fall to or below the growth rate in the economy. Thus as long as the retained return is above the growth rate of the economy the capital/income ratio increases faster than the economy and the share of income derived from capital rises. And here is the punchline because capital is more concentrated than wage income; income inequality has to rise over time. This notion explains English and French inequality, but unfortunately it is not a good explanation for what has happened in the U.S. where the labor income of the top 1% has exploded.

Returning to the history, income inequality significantly declined from 1914-1950 and then stabilized for another 20 years. Why did this happen?  Answer: two very destructive wars and a depression. Simply put capital (and millions of lives) was destroyed and the income from it disappeared. Along the way tax rates sky rocketed and growth collapsed. Similarly during the Great Recession of 2008-09 inequality was reduced as stock prices and real estate values crashed. Unfortunately the collateral damage on the average worker was far greater than it was for the owners of capital. Witness the more than complete recovery in stock prices and wages for the top 1% post-2009 while average wages have stagnated. The cure was far worse than the disease.

Although Picketty denies it, the laws of motion in the United States differ from Europe. Here as Picketty notes we have witnessed the rise of the super-manager who has captured an increasing portion of labor income. The share of wages going to the top 1% increased from 5.1% in 1970 to 10.9% in 2010 accounting for half the gain in their total income share over that time period. I would argue the wage share gain is far greater than that because in the late 20^th Century and in recent year’s human capital is monetized into financial capital. The return to Bill Gates’, Mark Zuckerberg’s, Sergey Brin’s  human capital  comes not only from their salaries and the ordinary income that comes from the exercise of stock options, but also from their initial ownership positions in the companies they founded. For example according to the Forbes 400 list the wealth of such corporate founders amounts to $72 billion for Microsoft’s Bill Gates, $41 billion for Oracle’s Larry Ellison, $27 billion for Amazon’s Jeff Bezos, $25 billion for Google’s Larry Page, $19 billion for Facebook’s Mark Zuckerberg and $7 billion for Tesla’s Elon Musk. Is this the 19^th Century wealth of an Andrew Carnegie or a John D. Rockefeller whose assets were tied up physical plant? I think not. In the new world of capitalism intellectual property is valued more highly than physical capital.

Moreover Picketty’s 19^th century view of capital is the role of real estate in national wealth. Real estate holdings accounted for more than 60% of French capital, more than 50% of British capital and more than 40% of U.S. capital. True it not the landed wealth of the 18^th century, but it is the 21^st century urban version of it.  This is important because if Picketty is really serious about equalizing the distribution of wealth he would advocate a radical reduction in the planning constraints that artificially increase real estate values in the great urban centers of New York, London, Paris, Los Angeles, San Francisco and Washington, D.C. It would be far more beneficial to do that than to impose income tax rates of from 60% -80% on the top 10% and the progressive wealth tax he advocates. While higher tax rates on capital would arguably reduce economic growth, an easing of planning constraints would increase it. I know Picketty would argue that the post war economy grew rapidly in during the postwar era in regime of high tax rates. That is true, but much of the growth came from a recovery from the depression and World War II. Recall that, although high, the tax burden dropped from its war time peaks.

All told Thomas Picketty has written a book that is and will continue to be much discussed. It should be the subject of serious debate and readers should note that the book is not an all-encompassing treatment of inequality. He ignores the role of assortative mating at the top where, for example an investment banker marries a corporate lawyer, and the role of single-parent households at the bottom of the income distribution. But any economist who quotes Jane Austen and Honore de Balzac has to have a lot going for him.

For the amazon URL see:

http://www.amazon.com/review/R365VSU9UE3P37

"There Will be Growth in the Spring....and Beyond," UCLA Anderson Forecast, March 2014

The weather played havoc with the economy in the
first quarter. In a mirror image of the balmy winter of 2012
where unusually warm temperatures temporarily enhanced
economic activity, near record cold weather suppressed it.2
As a result of this year’s polar vortex the states of Illinois, Indiana,
Iowa, Michigan, Minnesota, Missouri, Oklahoma and
Wisconsin experienced among their twelve coldest winters
in the past 119 years. (See Figure 1) The cold weather was
exacerbated by unusually heavy snow falls across the Great
Lakes and into the Northeast. Interestingly, while the middle
of the country was freezing, California was experiencing a
drought along with its warmest winter in recorded history.
Indeed the entire southwest from Texas to California was
experiencing severe drought condition.

Simply put, the seasonal factors the Bureau of Labor
Statistics uses are incapable of fully accounting for extreme
weather conditions. In order to highlight the impact
of weather in January and February of 2012, we note that
payroll employment growth averaged, as initially reported a
robust gain of 256,000 jobs. 2 In contrast, this year job gains
were a far more modest 152,000 for the first two months. As
a result, we expect that first quarter real GDP growth will
come in a sub-par 1.4% annualized rate.

Nevertheless as our title suggests, there will be growth
in the spring as such weather affected activities as factory
production, automobile sales and the construction rebound
from their winter lows leading to real GDP growth of about
3%. Furthermore, as we have argued previously, we continue
to believe that the economy is poised to remain on a 3% or so
growth path through 2016 buoyed by increased housing and
business investments along with gains in consumer spending.
(See Figure 2) In this environment we can visualize the
economy creating between 200,000-250,000 jobs a month
with the unemployment rate dropping to 5.4% by late 2016.
(See Figures 3 and 4) To be sure, total payroll employment
will surpass the prior 2007 peak, but the economy will
remain well below its pre-Great Recession growth path.

Modest Inflation Ahead

While inflation has been quiescent for most of the post-
2009 recovery period, it is about to experience an uptick.
Specifically, we forecast that the core consumer price index
will increase from 1.8% in 2013 to 2.5% in 2016. (See Figure
5) Because of increases in domestic energy production, the
increase in headline inflation will be somewhat more muted.
Admittedly, food prices might pose an upside risk should
drought conditions in the Southwest and political uncertainty
in the Ukrainian breadbasket persist.

As we have written elsewhere, the increase in inflation
will come from the shelter and healthcare components
of price indices. 3 Both measures are now running at a 2.5%
rate along with a general increase in wages. To be sure,
for most Americans, the increase in wages will be most
welcome, but for those wary of inflation it will be signaling
a cautionary yellow light. Specifically, we are forecasting
total compensation per hour to increase by 2.4%, 3.5% and
4% in 2014, 2015 and 2016, respectively, compared to a very
low increase of 1.6% in 2013.

Fed Policy: From Taper to Modest Tightening

The Federal Reserve’s long experiments with zero
interest rates and quantitative easing are slowly coming
to an end. We anticipate that the monthly $85 billion bond
buying program, now down to $55 billion, known as quantitative
easing will be all but wound down by September.

Although most market participants do not expect the Fed
to actually begin to raise rates by mid-2015 at the earliest
and a few anticipate that it will wait until 2016, we believe
that the first overt tightening will begin in the first quarter
of 2015. (See Figure 7) Our view was strengthened at Fed
Chair Yellen’s recent news conference where she defined
“considerable period” as approximating six months as the
time between the end of tapering and the beginning of overt
tightening. Thereafter, we forecast that the Federal Funds
rate will rise, to use “Fedspeak”, at measured pace reaching
3% by the end of 2016. In essence, the “Yellen Fed” will be
very much like the “Bernanke Fed.”

Why? Under the Fed’s dual mandate to maintain
maximum employment and price stability there would be
little intellectual justification for continuing a zero interest
rate policy with a 6% and falling unemployment rate and a
2.5% core inflation run rate in the first quarter of 2015. We
are aware that the Fed’s official inflation target variable are
the core and overall price deflators for personal consumption
expenditures in the GDP accounts will be running somewhat
below the consumer price indices. But at that time, there will
be little doubt as to where they will be heading.

In this environment, long-term interest rates will begin
to normalize. We would not be surprised to see 10-Year U.S.
Treasury rates exceeding 3.7% by yearend and be above
4% thereafter. We would also point out that relative to the
2%-2.5% inflation rate, both the real Fed Funds rate and the
10-year treasury yield would still be well below pre-2007
levels. Our short-term interest rate forecast is broadly consistent
with the higher end of published consensus beliefs of
the open market committee after the March meeting.

Sources of Growth: Housing, Business Investment
and Consumption

As we have noted for the past several years, we believe
that housing construction is in a period of sustained, albeit
moderate recovery. After bottoming at below 600,000 units
a year in 2010, housing starts recovered to 931,000 units
in 2013 and are expected to exceed 1.2 million units this
year and approach 1.5 million units in 2015. (See Figure
8) Thereafter, housing activity is expected to plateau in the
1.4-1.5 million unit range as mortgage rates in excess of
6% exact their toll. As we have noted on many occasions,
multi-family construction will account for about 30% of
overall starts as it has in recent years, up from the 20% that
has characterized the prior decades.

Meantime, investment in business equipment and
software along with nonresidential construction will begin
to experience a sustained pickup. (See Figures 9 and 10)
Real equipment and software spending, which increased at
a very tepid 3.1% in 2013, will likely increase by 6% this
year and 10% next year. The improvement in nonresidential
construction will be even more dramatic where that sector
will rebound from a meager 1.4% growth rate in 2013 to
5.2% this year and 11% by 2016.

The rebound in corporate spending will be caused by
the need to replace aging capital equipment, accelerating
global growth, reduced domestic political uncertainty, the
on-going energy renaissance in the U.S. and “most importantly”
in the words BofA Merrill Lynch, the stock market is
no longer rewarding share buybacks.4 Put bluntly, instead of
spending big bucks on financial engineering, American companies
will step up their spending on physical engineering.

Along with increases in business spending, the long
suffering U.S. consumer will begin to spend more robustly.
The increase in spending will be driven by the improved
employment and wage picture, a very big deal, along with
the $10 trillion increase in wealth that took place in 2013.
Yes, a bull market on Wall Street is largely concentrated
in the upper income brackets, but that is where half the
purchasing power is. Furthermore, last year’s rise in stock
prices will take some of the pressure off the fiscal stress
facing most defined benefit pension plans and individual
retirement accounts. As a result, real consumer spending
gains are expected to approach 3% in 2015 and 2016 well
above the 2% recorded in 2013. (See Figure 11) Even with
the increases in consumer spending we envision the saving
rate after modestly declining in 2014 to 4.3% will be well
above 5% by 2016.

Conclusion

There will be growth in the spring. The economy will
shake-off the weather induced weakness and begin to grow
at a 3% growth track bringing with it rising employment
and wage gains. Growth will be led by housing, business
investment and the consumer. Along the way inflation will
modestly increase causing the Fed to begin increasing rates
in early 2015 and longer-term interest rates will begin to
normalize. Not great, but what’s not to like.


Endnotes
1. With apologies to Chance the Gardener in “Being There” (United Artists, 1979).
2. See Shulman, David, “Curb Your Enthusiasm,” UCLA Anderson Forecast, March 2012.
3. See Shulman, David, “The Inflation to Come in Housing, Healthcare and Wages,” Ziman Economic Letter, January 2014.
4. See “The cap-X factor,” BofA Merrill Lynch Global Research, 11 March 2014.