The General Economy
The first quarter of 2023 held two surprises. First, unexpectedly healthy personal consumption forced forecasters to push out the start of the recession. Gross Domestic Product (GDP) is estimated to settle around 1 percent. There were signs that pent-up demand had not completely played out; people were willing to rely on credit card debt1 to take a trip and go to restaurants. Retail sales for the three months ending in February rose 6.4 percent year-over-year. The job situation also remained very supportive. Unemployment ended the quarter virtually the same as it began at 3.5 percent, despite softening in the technology and warehousing sectors. It was also helpful that inflation was below 6 percent for the quarter. There was some concern that the source of inflation had shifted to more “core” items. Due to the way the Consumer Price Index (CPI) is calculated, shelter costs still reflected high home prices and rents from about a year ago. Housing costs accounted for 70 percent of inflation in February.
The second surprise was the failure of Silicon Valley Bank (SVB) and two other banks in mid-March. SVB’s insolvency was almost a perfect storm of unhedged interest rate risk and a heavy concentration in tech sector uninsured deposits. The Federal Reserve (The Fed), Federal Deposit Insurance Corporation (FDIC) and U.S. Department of the Treasury acted to preclude further bank runs, guaranteeing all depositor funds and offering a new lending program to shore up bank balance sheets. It appeared that confidence and some normalcy were restored to the banking sector by the end of the quarter.
The Real Estate Sector
Residential
Much weighed on the residential market in Q1 2023. Fears of recession, elevated mortgage rates, daunting affordability and persistently low inventory contributed to the slump. Sales of existing homes were down 2.6 percent from last quarter. Originations were less than half the volume they were a year ago. But the drop in single family starts abated, remaining virtually the same in Q4 2022 and Q1 2023, as builders worked through their backlogs. Both the Mortgage Bankers Association (MBA) and the National Association of REALTORS® (NAR) show that this quarter should be the bottom in the drop-off in existing home sales and housing starts that began a year ago.
Although the 30-year fixed mortgage rate ended the quarter close to where it began, at 6.3 percent, it was volatile and the market proved very sensitive to rate drops. Mortgage applications jumped almost 28 percent at the beginning of January and again at the end of the month, when rates temporarily ticked down. February’s total existing home sales swelled in response as well, per NAR. The magnitude of the positive reaction belied the unsatisfied market for homes. It could also signal a shift in what buyers now consider an “acceptable” interest rate, especially those who sat on the sidelines in 2022. According to the MBA, “Purchase activity that was put on hold last year due to the quick runup in rates is gradually coming back as rates ease and housing demand remains strong, driven by supportive demographics and the ongoing strength in the job market.” Moreover, the National Association of Home Builders reported that homebuying was supported by median price declines and a majority of builders offering purchase incentives.
Commercial
The conditions that plagued commercial deal activity in the second half of 2022 – rising interest rates, tightening credit and concerns about the fundamentals of the office sector – persisted and held back transactions in Q1 2023. Overall, deal volume was down 51 percent from a year ago. The apartment sector in particular was less attractive, as the national median monthly rent has tottered down since last August. One silver lining was the adjustment of prices, which fell almost 7 percent year-to-year, according to MSCI.
The industrial sector is not immune to the general financial environment, so 2023 looks like a “normal” year. Companies are reducing their "safety stock" thanks to supply chain bottle necks dissipating. Some e-commerce giants, which added millions of square feet in the last two years, are reassessing their warehousing footprint, but the fundamentals for this asset class are solid. Many of the changes in buying habits from the pandemic that propelled e-commerce growth have stuck. Demand for space has broadened beyond logistics and warehousing into electric vehicle production and its components. On top of that, the first $39 billion disbursement of the CHIPs and Science Act money came at the end of February (with more to come in the spring), which will pump up U.S.-based production of semiconductors.
A Glance Forward
When The Fed raised its rate by .25 percent in March, it was torn between its fight against inflation, which it anticipates will remain above its 2 percent target, and supporting financial system liquidity. “Credit tightening” has become its watchword. Banks, especially regional and local banks that are mid-sized like SVB, are expected to narrow their lending criteria to improve their balance sheets. This constriction will hit small business and home building lending particularly hard. Also, it does not bode well for commercial deal activity. These banks increasingly have been the source of funding for commercial investments, according to MSCI. At the end of March, the government’s National Financial Conditions Index2, which covers equity, bond and banking funding sources, showed the tightest conditions for the year so far. Whether a credit crunch does The Fed’s work by dampening economic activity will determine the organization’s next course of action when it meets again in early May.
The banking turmoil happened too late in the quarter to be reflected in projections published in March. But many forecasters, including Fannie Mae, stated that their general outlook for a shallow recession is not markedly changed. Concerns over the need to raise the debt ceiling and avoid a bond market meltdown have yet to re-emerge. Personal3 and business balance sheets4 look very similar to pre-pandemic levels, and federal money from the CHIPs and Inflation Reduction acts are flowing. According to the MBA’s Chief Economist Mike Fratantoni, the expectation for the housing market remains positive, with reductions in mortgage rates expected. If there are no surprises in the intensity of credit tightening, we are in for a melancholy but manageable spring.
1 Federal Reserve Bank of Philadelphia, Large Bank Consumer Credit Card Balances: Total Balances [RCCCBBALTOT], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/RCCCBBALTOT, April 5, 2023.
2 Federal Reserve Bank of Chicago, Chicago Fed National Financial Conditions Index [NFCI], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/NFCI, April 6, 2023.
3 Board of Governors of the Federal Reserve System (US), Financial Soundness Indicator, Households; Debt Service and Principal Payments as a Percent of Income, Level [BOGZ1FL010000346Q], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/BOGZ1FL010000346Q, April 6, 2023.
4 Board of Governors of the Federal Reserve System (US), Nonfinancial Corporate Business; Debt as a Percentage of Net Worth (Market Value), Level [NCBCMDPNWMV], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/NCBCMDPNWMV, April 6, 2023.