August 7, 2018
It’s not a 4.0+ percent economy. 
The Big Picture: What an incredible second-half of July in terms of economic and real estate news. As we ready for “Back-to-School” in August, every sector from small business and housing to manufacturing and capital markets have posted refreshed metrics. While the economic data and Q2 earnings are broadly supportive of economic growth honing in on the average annualized GDP rate of 3.2 percent post World War II, the U.S. economy is not expanding at a 4.0 percent plus level as suggested in the “Advance Estimate” of Q2 GDP Friday, July 27 – nor a 5.0 percent level as suggested by the Atlanta Federal Reserve’s GDPNow forecast model for Q3. The first half of 2018 is behind us; and it is the second-half of the year that will determine the final metrics for CY 2018.  2H 2018 has headwinds. I would caution regearing your business plans for a 4.0 percent economy. With that said, let’s start this column with the Bulls & Bears scoreboard and then dive into the metrics, reports and respective sectors of the economy impacting real estate.
The Bulls & Bears Scoreboard: With approximately two-dozen economic reports released in 2H July, the Bulls did not lose any momentum - and maintain a 2:1 YTD advantage. 2H 2018 and the second half of July commenced with a slew of corporate earnings and housing related reports, including Existing Home Sales, New Home Sales, and the broader and more reliable FHFA Home Price Appreciation Index. Last week was then dominated by GDP and employment reports. This coming week fills in the economic puzzle pieces with inflation (CPI), jobs (JOLTS) and fiscal reports (Fed Balance Sheet and Treasury Budget). So what were the key takeaways from the 2H July reports?

  • Q2 corporate earnings grew by 24 percent with >80 percent of companies having reported. Q2 is likely to go in the books as the second-highest YOY growth since Q3 2010.
  •  Jobs: ADP +219k / BLS +157k / Unempl. <4 percent / Jobless Claims lowest in 50 years / JOLTS – more openings than unemployed.
  • Existing Home Sales are stuck below 5.4 million annualized units (5.38 million for June).
  •  The median price for Existing Home Sales in June was up 4.5 percent (less than that for New Home Sales) to $276,900
Existing Home Sales activity in June represented a decline of 0.6 percent over May - and down 2.4 from percent June 2017. June also represented the third consecutive month-to-month decline. Recognizing that housing accounts for 15-18 percent of GDP, this economy can’t grow at a 4.0 percent level without more get-up-and-go from housing.

  •  Alabama home sales activity compares more favorably than the national average with sales up more than 10 percent to 18,157 units.
  • New Homes Sales also decreased in June. They declined 5.3 percent in June to 631,000 annualized units despite price concessions. Unlike Existing Home Sales, the median price of new homes declined 2.5 percent MOM to $302,100. Year-on-year, the median price is down 4.2 percent.
  • Pending Home Sales were the bright spot in housing during June. They increased 0.9 percent to 106,900 contracts. The good news/bad news in Pending Home Sales is: i) Good - All regions showed gains in June; and ii) Bad - Total YOY pending sales are still in the negative column at minus 2.5 percent.
  • Home Price Appreciation is running approximately +6.5 percent YOY for both Case-Shiller and the broader FHFA HPI indices. FHFA is running +6.4 percent and Case-Shiller +6.5 percent. Year-on-year rates from Case-Shiller are led by Seattle at 13.6 percent, Las Vegas at 12.6 percent, and San Francisco at 10.9 percent. These home price appreciation rates raise questions whether Western markets are in a new housing-bubble zone. lagging at the bottom end for home price appreciation are Washington DC at 3.1 percent, Chicago (3.3 percent), and New York at 4.2 percent. Alabama beats the nation here too.
  • Auto Sales: The implementation of tariffs and consumer anxiety over rising prices due to the tariffs is beginning to register. Auto sales in July fell 3.4 percent and below 17 million annualized units at a time of the year they should be surging with year-end model clearance sales. New models manufactured outside the U.S., such as the popular Toyoata RAV4 undergoing a major model change for Fall 2018 and built exclusively in Canada (400,000 units), are going to be impacted. The charts below show this slowing trend in both car and truck sales. 
  • GDP – One quarter at 4.1 percent fueled by advanced trade activity in anticipation of a trade war does not make a 4.0 percent economyKeep the following trailing 3-year GDP chart in focus as you adapt your business plans for 2H 2018. The trailing 4 quarter average is still not even a 3.0 percent economy. With housing not contributing to GDP like it historically has at this stage of the cycle, and distortions like accelerated trade activity in advance of tariffs, I am not in the camp this economy is functioning at a 4.0 percent growth rate – certainly not anywhere near the Atlanta Fed’s GDPNow forecast of 5.1 percent
  • Manufacturing:  Factory Orders, the PMI (Purchase Managers for Manufacturing Index) and ISM (Institute for Supply Mananagement) are sending mixed signals. The good is being told by Factory Orders. Factory orders for June rose a sharp 0.7 percent. Orders for commercial aircraft as well as orders for vehicles rose 0.4 percent in June. However, were these influenced by the Tax Act or orders in advance of the anticipated tariffs?  Looking beneath the +0.7 percent rise in Factory Orders headline metric for June, there is reason to be concerned for 2H 2018. June was held down by tariff-related disruptions. One can see this in the 3-month trend for new orders. Although the year-on-year growth in orders was a positive 6.1 percent, that rate is down from 9.2 and 7.9 percent in the two prior months. Inventories were also drawn down and it is not likely those will be rebuilt until the uncertainty of tariffs and a trade war clears. This observation is clear from the following chart depicting orders and shipments.
The ISM and PMI appear to tell a good story regarding manufacturing, but both actually highlight a number of manufacturing concerns for 2H 2018. Although the PMI reading for July posted a healthy reading in the mid 50s at 55.3, the report highlighted signs of stress. Thise signs include: i) rising input costs that are now at a 7-year high; and ii) increasing delivery times due to skilled labor shortages that now register the longest in the PMI’s survey history. The in-depth narrative in the July PMI report is warning that manufacturing is beginning to struggle with supply shortages, rising prices and weak exports. Those challenges won’t abate in 2H 2018 and are not accretive to GDP growth.
A similar set of concerns are present in the July ISM report despite it registering a healthy 58 reading – a reading down from June’s 60. The July ISM indicated intentional stockpiling to avoid shortages from anticipated tariffs. The latest ISM report reveals like the PMI report that the key risks are: i) capacity stress from skilled labor and key materials shortages; ii) high steel and other imported materials costs; and iii) supply-chain risks from tariffs. With respect to manufacturing, look beneath the surface and not the metrics resulting from 1H 2018 and a pre-tariffs environment.
 
  • Rail Traffic:  AAR.org produces my favorite monthly economic report related to rail traffic known as Rail Time Indicators.  Although the YTD and latest July rail carload numbers are stellar, they hold some warning signs for 2H 2018 that connect the dots with the outlook for 2H 2018 GDP and manufacturing. The July Rail Time Indicators report revealed rail carload traffic was up 3.5 percent YOY totaling more than 35,000 carloads – and resulting in the fifth straight year-over-year monthly gain. And not only was total carload activity up, but 15 of the 20 commodity categories tracked by AAR saw higher carloads. Grain led the way, with carloads up 14.7 percent due largely to a pre-tariff surge in exports. Other carload categories that had higher carloads in July 2018 than July 2017 included petroleum and petroleum products (up 27.0 percent, the biggest monthly percentage gain since September 2014); motor vehicles and parts (up 10.4 percent); and primary metal products (up 12.6 percent, the sixth consecutive increase. And finally, Intermodal volume (movement of shipping containers and truck trailers) was up 6.9 percent. July intermodal rail traffic activity represents the largest percentage increase in 19 months and should result in 2018 will be another record year for intermodal carload activity.  A breakdown of this rail traffic activity is below. It highlights: i) why industrial real estate is performing better than all other core property types; and ii) how 1H 2018 benefitted from growth in energy, the Tax Act accelerating CapEx spending, consumer spending on autos in advance of tariffs, and AG shipments also in advance of the tariffs. Those 1H 2018 tailwinds turn into headwinds for 2H 2018.
  • REITS and Industrial Real Estate:  In a previous 2018 column, I relayed that Industrial REITS were top performing among REIT types behind Infrastructure and Healthcare segments. Q2 2018 will represent the 33rd consecutive quarter for net positive industrial warehouse absorption in the U.S. despite adding more than 200msf new space per year, On July 31, Forbes published a piece titled “Its Boom Time for Logisitics Landlords.” In this piece, the ripple effect of e-commerce on industrial real estate was highlighted noting that the growth in e-commerce will generate another 339msf of demand just by the end of 2021. This Forbes feature article concluded with a “How to Play it” section that highlighted its top four industrial REIT picks: i) Prologis Realty (PLD); ii) Duke Realty; iii) Monmouth Real Estate (MNR;, and iv) STAG Industrial (STAG). The author (Brad Thoms - Editor of Forbes Real Estate Investor and co-author of The Intelligent REIT Investor) concluded with the statement that: “These four REITs have enhanced exposure to logistics firms and they generate impressive growth.” I do not disagree - and remain long on the industrial real estate property sector. You too may concur with me after having just read the July Rail Time Indicators data. One final point on these industrial and logistics focused REITS is examine their performance metrics. Take a Monmouth REIC as an example with a 99% weighted average occupancy rate and achieving 15 percent YOY revenue growth based on their August 2,, 2018, earnings release. These REITS know what they are doing and understand logisitics. They are positioned to weather tariffs with buildings leased on long-term leases to credit tenants like FedEx, Amazon, etc.
  • Real Estate Design – It is a Changin’!  As I move to close out this column’s economic and real estate news, I ran across an interesting story pertaining to how building design is adapting to meet with the challenges of rising construction costs while simultaneously evolving to meet e-Commerce’s need for more efficiency. The story appeared in the Memphis Daily News regarding Amazon’s development of a warehouse made of a taut fabric supported by steel-tube trusses and cables with no columns. The design, engineering and construction is not too dissimilar to that used to construct the Denver International airport main terminal. This first-of-its-kind warehouse for Memphis, TN (home to FedEx) and the building’s tenant (Amazon - the world’s largest retailer and likely next trillion dollar company) is going to be a disruptor for industrial warehouse space. Pictured here, Amazon is building a 16,575 square-foot, “tent warehouse” on an empty truck parking lot in south Memphis at 109 W. McLemore east of I-55. The building design and components are being provided by ClearSpan Fabric Structures HQ in Dyersville, Iowa for a cost of $595,000 - or just under $36 per SF.
From a functionality standpoint, the building will have a 35-foot clear ceiling height, six dock doors, no columns inhibiting layout or stacking plans, and will be ready for use in approximatetly half the time as a conventionally built masonry warehouse.  The facility is expected to employ 575 people in an operation for receiving and repackaging goods for shipment to Amazon fulfillment centers. This type innovation is ideal for ports, inland ports and high-cost of construction markets such as those in CA and NY.  This tent-warehouse design will be as disruptive to industrial real estate as co-working has been to office space, or Airbnb and VRBO have been to hotel real estate.  So what are the primary impediments to widespread adoption in key industrial markets such as Los Angeles, Dallas, Denver, Atlanta, Chicago, New York, or Miami?  They are: i) building code modifications to allow for a full range of distribution and maybe even manufacturing uses; and ii) capital markets acceptance to bring construction and permanent debt funding to this new type of industrial building.  I believe these impediments will be quickly scaled in much the same way as the adoption of metal buildings were a half-century ago or manufactured construction is being adopted today to bring efficiencies and affordability to multi-family housing. I am visiting Iowa this week and Memphis this month and will report back after touring the ClearSpan Fabrics Structures HQ and the site for this new Amazon warehouse in Memphis.  Innovation is coming to commercial real estate at a pace we have not experienced since retail went suburban in the 1960s and 1970s.
Conclusion: The economy in 1H 2018 was the best first-half since the onset of the Financial and Housing crises. It won’t be repeated in 2H 2018 – and this is not a 4.0 percent economy. Do not gear your business plans for the second-half 2018 assuming 4.0 perecent growth in GDP, employment, housing activity, trade, auto sales, etc.  Do expect another Fed rate hike in September, tarifffs to remain as a political issue thorugh to the November mid-term elections, and a 10-Year Treasury to migrate toward 3.5 percent by year-end. We have energy, wage, housing and materials inflation above a 3.0 percent level and the Fed can’t ignore it this Fall.  We won’t invert the yield curve or enter a recession in 2018, but  I remain in the camp 2019 brings about a better than 50 percent chance of a normal cycle recession.  The wild cards are the mid-term elections and an expanding trad e war
 
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Disclaimer: This report reflects the analysis and opinions of the author(s), but not necessarily those of the faculty and staff of the Culverhouse College of Business or the administrative officials of The University of Alabama.
Advancing Relationships
Sincerely,
KC Conway
ACRE Director of Research & Corporate Engagement
CCIM Chief Economist
kcconway@culverhouse.ua.edu / 678.458.3477