Recession Tug-of-War: Downside versus Bright Side

Grim trends are massing on the US economic horizon: commercial real estate (CRE) vacancies are piling up, interest rates remain high, home insurers are backing away from more locations, and climate change is heating up the planet. 

Yet, the US economy remains resilient. Inflation is falling, employment remains strong, people are still spending money at a good clip, and GDP (which measures economic health, though it’s not a full measure of wellbeing) is up from Q1 2023 and has been positive for several quarters after a brief decline in the first half of 2022. What gives?

As a metaphor for this very weird time, picture a tug-of-war between kids on a playground. Team Downside lines up holding one end of the rope, and Team Brightside lines up holding the other end. Then each team tries to pull the other group across a line drawn in the center of the field. Something like this: 

In the near term, the heavy hitters in this tug-of-war match are probably CRE and AI, but other team members also play a role. 

On the Downside

Major players for Team Downside are CRE, interest rates, inflation, the brewing insurance crisis, and climate change.

• CRE: Commercial real estate is heading for disaster—and this disaster seems locked in by the permanent societal shift to hybrid, flexible, and remote work.¹ Commercial tenant leases can range from 6 months to 10 years or more, though three- and five-year terms are common. Post-pandemic, as these leases expire and some tenants choose not to renew, vacancies are rising and revenue is falling (unless new tenants can be found). 

  At the same time, commercial building owners may have outstanding loans on the building, and if those loans need to be refinanced periodically, much depends on how high interest rates still are when that happens. The interest rate hikes of the past year are an immediate problem for buildings that refinanced recently, but if interest rates stay high (not a given, just a possibility!), more and more buildings may face steeper loan payments. If costs increase as revenue declines, the math may not work. Then what? 
  A recent, candid Curbed interview with Scott Rechler of RXR digs into the dilemmas facing CRE owners and is the best article I’ve read on this topic to date, even getting into some details on residential conversions and why they aren’t always feasible.

• Interest rates: The recent hikes haven’t fully cascaded through the economy. Their impact will be felt for not just months, but years (barring a fast reduction in rates, which I don’t expect). The longer interest rates stay high—especially if they keep going up—the more regional banks will likely come under stress. Also, high interest rates pressure commercial real estate projects that are already suffering, as mentioned earlier. (High interest rates also affect residential real estate, but there’s an outright housing shortage in the US, so demand will probably stay strong despite higher rates.)

• Inflation: It’s falling and the trajectory is good, though not good enough yet. I used to think we’d get stuck around 3% annual inflation for an extended period of time, but I now think we’ll approach 2% (and maybe approaching it will be good enough if the overall economy stays healthy). COVID-related supply shocks are finally easing, which helps. Basically, inflation is thinking about switching teams from Downside to Brightside, but hasn’t made a final decision yet. 

• Brewing insurance crisis: I wrote about the coming insurance crisis for coastal property last September (timing entirely coincidental). I think the essay is worth a read, but the TL;DR is that coastal property will become uninsurable, and it’s happening on a mostly staggered schedule because insurance renews and reprices annually. Very smartly, the insurance companies are acting early and incrementally. This will give savvy homeowners a chance to escape before their property loses most of its value.² Whether they will take that opportunity is another question. This essay also covers the possible knock-on effects related to reinsurance and retrocession. (What is a retrocessionaire? Find out!) Since I wrote the essay, insurers also have started backing away in volume from properties in wildfire-vulnerable areas, so it’s moving faster than I expected in that regard.

• Climate change: This catastrophic megatrend will make the insurance and CRE crises worse over time, heating up the planet and ramping up the magnitude and impact of natural disasters. We are starting to hit tipping points. Many more tipping-point thresholds haven’t been crossed yet but probably will be. We are in for a rough transition to a post-carbon society, which will (in my opinion) cause at least one depression in the next fifteen years. But that won’t happen yet; people are not great at thinking about and addressing longer-term risks. 

This seems pretty grim. Is there a bright side?

Yes: I don’t think we’re going into recession soon, largely because of the players on the other team in our tug-of-war metaphor, which are AI, the Inflation Reduction Act, consumer demand, residential real estate, and labor strength.

• AI: The star quarterback who saved the team from ignominious defeat. I believe AI staved off a recession this year (time will tell, of course; I’m fully aware “this time is different” rarely works out well). Specifically, the ChatGPT release in November 2022 was a turning point at which the market began to look forward and appreciate AI’s vast potential for future productivity gains and societal changes. 
  AI is not just hype, in my view. It is real, it is a long-term trend, and it will change many things about the ways we work and live, how our economies and societies function, and how we solve difficult problems. I believe it is an advance and upheaval on the order of electricity or perhaps the Industrial Revolution. (Its inherent risk is also potentially catastrophic, which is why AI requires strong operational risk controls, effective alignment techniques that probably don’t exist yet, and well-crafted regulation that targets leverage points. Those topics are covered in other Risk Musings essays.) 

• Inflation Reduction Act: Just like it’s taking a while for interest rate hikes to percolate through the economy, it’s taking a while for the Inflation Reduction Act to spur the economy. An important point is that the sooner permitting reform is enacted to make approvals easier for green energy projects, and the more effective that reform is, the more the Inflation Reduction Act will act as a counterbalance against recession. The good news is that permitting reform appears to have bipartisan support, so it might be feasible and a matter of compromise on the details. 

• Consumer demand: The pandemic stole years of life from us. Like evil Count Rugen in The Princess Bride, but with more Netflix. Now, with COVID in an ebb phase, lots of people are understandably looking to make up for lost time. They are spending money, to the degree they can afford it, and this is helping the economy keep ticking forward despite the formidable forces arrayed on the downside. 

• Residential real estate: There is an outright shortage of residential real estate, as I wrote in this essay. That shortage has blunted the price declines some predicted, and in many areas prices are still rising. We do not have enough homes in the US (especially starter homes!), given current demographics, full stop. For that reason, rising interest rates can’t keep residential real estate down (much!).

• Labor strength: Why is the labor market so strong? Contributing factors likely include demographics, COVID aftereffects, and policy. The strength of labor keeps consumer demand humming and makes a soft landing possible. (Note that if AI eliminates many jobs in the medium term, this could change.)  

Who will win this tug-of-war match?

I’m not all-knowing, so I’m not certain which side will ultimately win the tug-of-war. I suspect the answers will differ by timeframe.

In the short term, I anticipate the Bright Side will come out on top, primarily because of AI’s momentum, rapid implementation and integration into society, and long-term potential. In the medium term, the CRE storm will get gnarly, but I expect AI to simultaneously keep booming, so the net performance of the economy might look flat, with large variance and high volatility by sector. In the long term, it seems clear that climate change will cause major problems and massive rethinks. AI and other broad societal initiatives might help with this, but it’s too soon to tell. 

We are all in this together: which side of the line do you favor? 

1. Yes, some top companies will always have enough applicants and can find superstars among their applicant pool, but at the vast majority of more mundane companies, if top performers vote with their feet, that will be enough incentive to keep remote work on the menu.

2. But of course they will be selling to someone who may not be so lucky in the future.