Joe Keating on Inflation, the Delta Variant, & Outlook for the Economy

[Intro]: Helping community bankers grow themselves, their team and their profits. This is “The Community Bank Podcast”.

Erik Bagwell: Welcome to “The Community Bank Podcast”. I’m Eric Bagwell, Director of Sales and Marketing for the correspondent division of South State Bank. Joining me, Tom Fitzgerald, Director of Strategy for our correspondent division. Tom, you’re doing okay?

Tom Fitzgerald: Eric. I’m doing great. How are you doing?

Erik Bagwell: Good. We need to give a shout out real quick to the folks who made our, soundboard that we use for this podcast; I think we’ve done so many shows. We tore it up but, it’s a company called Road and they are actually helping us for free fix this thing, so we’re excited. So Tom recorded on the show today, did a recording with Joe Keating. Joe is Co-chief Investment Officer at NBC Securities. He’s probably our longest running, I guess he’s our oldest guests too as far as the number of.

Tom Fitzgerald: Our most frequent yes.

Erik Bagwell: He’s on here a lot. And if it sounds a little choppy, we are actually using an old microphone. Tom and I are way too close for COVID protocol right now, but we’ll still go with it. But Tom, tell us a little bit about the interview before we get to it.

Tom Fitzgerald: Well, Joe and I just talked about the thoughts on second quarter GDP and also what he expects for the rest of this year and into next year. Talking about economic growth, but also talking about where he thinks rates are going to go and finally, where he thinks a stock market’s going to go. So I think it covers sort of the waterfront on, on economic and investment ideas. So I think everybody’s going to get a little bit of something out of it. So it’ll be good listen.

Erik Bagwell: Good deal. Well, I didn’t think I had anything that didn’t have anything to add to this conversation, so I bowed out, but this’ll be a great conversation. You guys, thanks for listening as always, please, subscribe on iTunes, Spotify, just please subscribe so that you get notified right away when we have a new show. I think this might be close to, I think we’re over 50 shows now.

Tom Fitzgerald: Yes.

Erik Bagwell: A little over 20,000 listens I believe. So thanks for tuning in and we love doing this and we’re thankful for the feedback we’re getting from you guys that are listening. So let’s go to that interview right now.

Tom Fitzgerald: Well, Joe, it’s great to have you back again. I think you’re probably one of our most frequent guests on the show and it’s always a welcome addition, I know it’s always some of the most listened to episodes, we do. Our listeners really like to get your insights into the economy as well as what’s happening in the bond market, stock market. So, with the pandemic economy, there’s no shortage of things to talk about and so it’s a matter of what do you want to talk about? And so I know we’ve got, a short timeframe, so I think we’ll just jump on into it if that’s okay with you Joe.

Joe Keating: That sounds great, Tom.

Tom Fitzgerald: Okay. The second quarter GDP data is going to be coming out at end of July and by all accounts, it’s going to be a strong number, probably the strongest that we’re going to see in this recovery. When I looked at, Bloomberg this morning, they were showing the consensus at coming in at around 9% as on an annualized basis and that’s really reflecting reopening of the service side of the economy as those vaccines have kind of moved through the population. And so, what other trends in the various sectors of the economy, Joe are yare you looking for, and how do you see the economy fairing? Not only in 21, but also kind of looking in further out 22 and 23?

Joe Keating: Sure. Well, as you said Tom, we’re probably going to see a number reported, 8 to 9% of this for the second quarter and something maybe just a tad shy of that for the current quarter. It’s interesting if we get a growth rate in the second quarter, that is just 3.6%, that’s all we need for the economy to exceed its pre-pandemic peak in the fourth quarter of 2019. And obviously, I think we’re going to blow that away. As you said, we’ve had very accommodative monetary policy over the past 16 months, a massive influx of relief and stimulus payments since April of last year, and the very successful widespread distribution of COVID-19 vaccines, which began in January of this year. And that’s in our view is the key reason for the very rapid reopening of the economy. We’ve long said that the development and distribution of vaccines was the best stimulus measure anyone could ask for in 2021. A year ago, we stated that the economy had one foot in economic recovery and one foot in a pandemic; the successful development of distribution of the vaccines now has the economy with both feet firmly planted in an economic recovery. In terms of some of the sectors consumer spending is going to be very strong in the second quarter on the order of 10 to 11%, and we’ll probably advance at a 7 to 9% rate during the current quarter. But the key is that a handoff from spending on goods, both durable and non-durable to services, is taking place while spending on goods likely, still all paced, spending on services in the second quarter, by a couple percentage points spending on goods will at best be flat over the second half of 2021 while spending on services will likely proceed at a pace greater than 10% housing outlays, residential construction outlays flattened out in the second quarter at a high level and will largely move sideways over the second half of 21 due to materials, shortages, and sharp price increases for building materials and finished home prices.
There’s been a long running deficit in new housing construction, which needs roughly one and a half. Housing starts per year based on population growth and replacement demand and we haven’t hit one and a half million starts since 2006. In fact, it’s interesting from 2008 to 2015, we only averaged 727,000 starts a year, roughly half of what we needed and from 2014 to 2019, we were just shy of 1.2 million. So while we don’t expect housing starts and activity to rise from where it’s going to stay at a fairly strong level for, we think an extended period of time business capital spending on equipment, particularly for technology reflecting businesses continuing to adapt to a new way of doing business. Following the economy, being overtaken by the pandemic has the potential to be the strongest sector of the economy during the second half of the year and structural outlays should stop falling following six quarters of decline and begin to recover during the second half of the year. So bottom line is the economy is expected to grow at its fastest pace since 1984 this year, on the order of 7- 8% for the full year. The setting for 2021 and moving into 2022 is very clear; a powerful growth trajectory fueled by the distribution of the vaccines which is quickly moving economy towards fully reopening, a massive influx of relief and stimulus payments, and as I said before, very accommodative monetary policy. So for 2022, we think growth should stay above the long run average in the area of three to 4% before falling back to two and a half percent in 2023.

Tom Fitzgerald: And as you mentioned, this recession has been very unique given the fact that it was really brought on by the shutdowns in basically the economy that we experienced in March to May of last year, but then that was quickly followed by just unprecedented levels of fiscal and monetary policy support. So the recovery was pretty quick and pretty rapid, and then follow that up with the vaccines which have allowed the economy to almost completely reopened at this point. So in that regard, where would you put sort of where we are in the economic cycle today? Are we still early stages, more middle stages or in the late innings?

Joe Keating: Yeah. Well, and it’s an interesting question, Tom and in fact, it’s Al it’s also very important for investors to try to figure out. You probably saw that the National Bureau of Economic Research just came out, I guess it was Monday and actually defined the recession as a two-month long recession. The deepest and the shortest on record [inaudible 09:14] started in April. The policy response was extraordinary and really focused on those, service sector workers making less than $40,000 a year which were largely female and heavily minority, so where we’re at in the cycle, I think is a really good option. Our take is that the economy is entering the middle phase of the economic expansion and that it could well be a long middle, as we expect the expansion to rival the previous expansion, which lasted 10 and a half years, which coincidentally is now the longest on record. There are two keys for our expectation to ring true. One, is that the economy reverts to a low inflation environment near 2% following the current spurred higher in the inflation reports which will keep the federal reserve from significantly tightening monetary policy to address building inflationary pressures, so low inflation is one of the two keys. The other key is that the forward momentum in the economy needs to see a handoff from stimulus flowing from Washington to jobs growth, which is a necessary ingredient for a self-sustaining and self-reinforcing economic [inaudible 10:38]. We look [inaudible 10:42] centers we’re returning to operating a more normal levels and enhanced unemployment benefits expiring. And lastly, of course, the reopening of the economy continuing at a steady pace.

Tom Fitzgerald: Also as part of that, Joe is as far as obviously the, inflation to statistics of the last couple of months have been, we were expecting some pretty hot numbers when they actually came in hotter than expected. And of course the fed has been pretty adamant about the fact that they see a lot of this as transitory as we have kind of the reopening happen demand kind of surges supply is not really there to meet that demand and the supply chains are still damaged a bit from the pandemic. What do you attribute to some of those hotter than expected, inflation numbers that we’ve seen over the last couple of months?

Joe Keating: It’s an interesting time as we talk about this, that the word transitory is now like a bad word but it’s almost pejorative in nature in terms of people not wanting to think finally of what it is Mr. Powell is saying, although I think Mr. Paul is absolutely 100% correct. Consider that roughly two thirds of the price increases in the inflation reports were due to higher used car and truck prices and as you mentioned, a normalization in prices of things like airfares, hotel rooms, rental cars, and gasoline, these are all temporary or transitory items, which are in the process of playing out, and the inflation reports we think are likely to cool later this year. One reason is that the prices of many goods and services are getting crushed once the pandemic struck in spring of 2020 the year over year comparisons are temporarily right magnified, we understand [inaudible 12:48] team. Well the personal consumption headline price index, and the measure, the fed watches, which is the core, consumer price index have risen at just a 2.2% annual rate, despite the recent distorted comparisons. Additionally, as you mentioned, the inflation reports have been impacted by supply chain bottlenecks and shortages, pushing some prices higher in ways that are clearly unlikely to persist.
The consumer data reported at the end of June for May, show that use car and truck prices were higher by 38% and rental car prices by 115%. It’s more than a stretch to think those practices will keep in pace over the last year is the definition of , [inaudible 13:45] computer chips would limit the ability of automakers to supply new cars and trucks so severely , that the demand for used cars and trucks would skyrocket. The markets for new and used cars and trucks will normalize eventually along with many other products, [inaudible 14:02] then slowing to 1% next year, we think that due to some of the experience, the core inflation data will not touch hotter this year, due to the next year as demand rebalances way from goods consumption back towards services consumption, lowering the prices on many goods currently in short supply. So looking beyond 2022, we expect the secular or structural forces that we’ve talked a lot about such as using the internet for comparison shopping, sourcing goods from around the globe, technology based innovations, aging populations and inflation targeting by central banks to swamp any cyclical pressures out there and we’ll basically see the secular trend in of inflation around 2% return.

Tom Fitzgerald: That is good to know because I kind of agree with Turpal that a lot of these forces are transitory and, certainly I think they’re going to want to see those numbers plateau if in the near future and start to trend down to where we get back to those. I kind of look at it, you’ve got these longer run demographic forces that I think that were in play before the pandemic, and they’re going to reassert themselves after sort of the kind of the adrenaline shots that we’ve had into the economy from the pandemic.
And so I kind of agree. I think we’ll gradually drift back down to that 2% level that we’ve seen and not be a threat to any long run type of higher inflation. As a part of that, we did have, the last fed meeting in June came out kind of interpretation of it was a little bit slightly more hawkish than what was expected; they moved to the rate hikes from 24 into 23. So that was interpreted as a fed that’s maybe not so sanguine about just sitting around and watching inflation that they might have a kind of, an itchy trigger finger, if it does continue to run a little bit hotter than expected. From taking that meeting and their response to the market, how would you kind of characterize that the market’s response to it and also a kind of a secondary question, Joe is that, given what we’ve seen in the markets in the last few days with sort of a repricing of growth down because of the Delta variant the upcoming fed meeting, will there be a slight change in tone from the fed at that meeting, given sort of these thoughts that maybe second half growth at 23 growth won’t quite as strong as we thought, maybe just even a month ago?

Joe Keating: Well, Tom, I agree that the fed did appear to be a little bit more hawkish, at the June meeting and they had to, because they were raising their inflation forecast for 2021 from three point from 2.4% to 3.4%; so they needed to come across as a little bit more hawkish. And as you mentioned, the first rate hike in terms of the median forecast move from 2024 to the back end of 2023, there are only two rate hikes, there are only two projections or dots away from moving that median forecast for the first rate hike into 2022 as opposed to [inaudible 17:45] talking about down it’s $120 billion monthly bond purchase program. But the standard of substantial further progress in the economy’s recovery remains away, and I’ll come back to that point in a minute when we talk a little bit about the upcoming FLMC meeting. I think the most insightful response in the financial markets to the more hawkish tone of the fed occurred in the implied ten-year inflation forecast and bodied and treasury securities for context. The ten-year inflation forecast peaked recently on May 12th, that was the day the April CPI report was released at 2.58%, but it had declined it to 2.35% by June 10,the Friday before the week of the [inaudible 18:37], following the conclusion of the meeting on Wednesday, June 16, the ten-year inflation forecast fell to 2.282% and ended June at 2.35.
So in the eyes of the treasury market, the federal reserve gained some credibility for not being soft on inflation by modestly shifting its tone at the June FLMC meeting, we suspect that the 2.58% reading on May 12th for the implied ten-year forecast for inflation was at the upper end of the federal reserve’s comfort range of inflation expectations remaining well anchored while the 2% inflation target is being pursued. We feel the 2.35% implied inflation forecast at month end was the market’s way of saying job well done to the federal reserve and by the way, that tenure implied inflation outlook currently is at 2.29%. So, we think the market liked what they heard from the fed. Relative to the upcoming meeting, I don’t see much of a change in what they’re going to be saying however, the Delta variant may give them a little cover if you will, to not address the tapering of the bond buying program. I think if we hadn’t seen the current growth concerns over the Delta variant that they probably would have started laying the groundwork for announcing that they’re getting close to tapering sometime during the fall. They may just be able to postpone that discussion for the time being and push that discussion out into the fall.

Tom Fitzgerald: Yeah, I think you’re right, because you’ve listened to the fed communications over the last year and a half, they have really tied economic growth to the public health direction of the country and so, if we see these increases in the cases given the Delta variant like you said, I think that gives them cover to sort of just stand back and say, we’re just going to kind of table that thought and those discussions for another month or so, and move into August and get to the Jackson Hall Meetings and maybe go from there, so I certainly agree with that answer. Speaking of which, it’s been unique kind of in the last several days, maybe a week or so, the market really has kind of taken hold of those increasing case numbers coming from the Delta variants, not only globally, but also domestically, and has really repriced, treasuries yields lower, especially on the longer end. Can you give us kind of what your outlook of where you see the longer data treasury securities kind of going on a yield basis? And also, kind of what that taper tantrum over that tapering talk, do you see any chance that we will experience a tantrum like we did almost 10 years ago?

Joe Keating: Well, the whole taper tantrum talk, I think is really interesting. Let’s recall what took place back in 2013. Recall that the federal reserve was engaged in an $85 billion a month bond purchase program and federal reserve chairman Ben Bernanke reminded investors and congrats congressional testimony on May 22, that the bond buying program was temporary, not permanent and that the federal reserve could start reducing the bond purchase program at one of its next few meetings. So the tantrum, if you will, was that the yield on the ten-year treasury ended in April at 1.67%; it jumped to 2.16%, so 49 basis points higher following Mr. Bernanke, his comments and reached 3.03% by the end of December after the federal reserve announced at the December 17, 18 FMC meeting, that it would begin to reduce the pace of his monthly bond purchases in January. So the taper tantrum totaled 136 basis point rise in the yield on a 10-year treasury note over an eight-month timeframe. It’s also interesting to note that when the fed ended the bond buying program in October of 2014, the 10-year treasury was yielding 2.34%, 69 basis points lower than when the federal reserve began to wind down of the bond buying program. So, what lessons do the taper tantrum of 2013 in the wind down to the bond buying program in 2014 provide for us today? Well, first remember that the bond buying program, the federal reserve initiated back during the 2008- 09 financial crisis was the first time the federal reserve purchased bonds in the secondary market. Consequently, when the federal initiated the current bond buying program in March of last year to quote -unquote support the smooth functioning of markets, following the economy, entering that government mandated sudden stop recession, and in February, investors were more aware of the fact that the bond purchases would end than they were back in 2013.The markets had already been through that drill. Based on this knowledge and the myriad programs put in place by the federal reserve and congress last year, along with a massive push to develop vaccines, to combat the coronavirus, investors became hopeful that the pandemic could realistically come to an end sometime during 2021.
This also suggested that at some point in 2021 or 2022, the policy measures put in place to support the economy would start to be [inaudible 24:34] wound down the second lesson from 2013, 2014. So with the benefit of hindsight, we now know that the low in tenure treasury yields occurred on August the fourth at 50 basis points. So as we look at the path of ten-year treasury yields over the last 11 months, we believe the upward adjustment in longer data treasury yields that was expected from the reopening of the economy and from the federal reserve, eventually tapering its bond purchases has already occurred with the recent high tenured treasury yield of 1.75% on March 31. It’s interesting, the 125-basis point rise in yields from August 4th to March 31, over an eight-month period of time looks remarkably similar to the taper tantrum of 2013. So, what does this mean? Well, when the fed officially announced it as a plan to wind down its current bond buying program, sometime later this year, we do not expect a taper tantrum pushing the yield on a ten-year treasury securities higher on the order of a 100-150 basis points over the next several months, once the announcement has been made similar to 2013, the adjustment has already taken place. We continue to think it’s likely that the policymakers of the fed will by the November, December FMC meetings, that substantial progress has been made towards its macro-economic goals [inaudible 26:06] 1.75% yield on the 10 year treasury is the high yield for this cycle? Not necessarily, but we continue to expect that even if longer data treasury yields make another run at 2% with the economy reopening.
The rise and tenure treasury yields will be contained as the current upward pressure on inflation measures proves to be temporary, and as longer data treasury securities remain the single best source of yield in the world and will continue to [inaudible 26:39] as yields arise. So with the economy reopening at a rapid pace, we’re not looking for pronounced decline and ten-year treasury yields and with the federal reserve, turning a touch hawkish and investors expecting inflationary pressures to remain under control, given the recent easing inflation expectations, we are also not looking for a significant rise in longer data treasury yields. So I believe the ten-year treasury is trading about 1.28% today and we expect the yield on the ten-year treasury note to trade within a 1.25 to 1.75 range for the next couple months.

Tom Fitzgerald: Well, that’s good to know, and I tend to agree. I know we live through that taper tantrum of 2013 and I think, if I remember correctly, it all kind of started with almost an offhand comment by Bernanke that he didn’t even realize, I think at the time it would do it would start emotion, what it started in motion. And I think Powell was a good student of seeing that and has been very clear and transparent in kind of a long runway between discussions and then implementation, and then I think the market is very comfortable with the idea. So I tend to agree. I think it’ll kind of take place and almost be just, little ripples in the market if that, as we move through it, so of course, we’ll have to see when we get there. Some people call it, fourth quarter of this year, maybe early part of next year, but we’ll just have to see how it turns out, but I, like you, I tend to agree. It’s not going to be a big market moving event, like it was 10 or so years ago. Well, Joe, I can’t let you get away without giving us your thoughts, given where we are in the economy, where the inflation bond yields, federal reserve policy, also fiscal policy, what is your outlook for common stocks as we move through, the challenges of continuing to reopen the economy from the pandemic?

Joe Keating: Well, as always Tom, to us, it all comes down to earnings; operating earnings on the S and P 500 for the first quarter were 143% higher than in the first quarter of 2020 now, while the first quarter of 2020 was the low point for earnings during the recession and at 143% gain is still pretty darn impressive. For the quarter, just ended and it, with the earnings reports that are coming out right now, the analysts had centered in pores look for a gain greater than 60% versus a year ago when the economy and earnings began to recover from the recession. What’s happening this year is that on average priced, operating earnings ratios are falling, stocks are becoming less expensive, as earnings are growing at a faster pace than prices are rising, those same analysts standard reports are looking for operating earnings on the S and P 500 to grow by more than 50% over four quarters of 2021. So as already mentioned, our take is that the economy is entering the middle phase of the economic expansion, and we think it will be a long middle, which should lead to an extended earnings cycle. We repeat that the bottom line for us is that the economy earnings and the stock market have the wind at their backs as the economy reopens this year, and we’ll enter next year with a head of steam. Now let me just address this issue that’s top of mind right now with the Delta variant; our position on the current state of the pandemic is really what the new head of the CDC stated, I think last week, there’s a pandemic currently among the unvaccinated. There’s been a very small increase in the number of new cases, basically no increase in the number of deaths.
Our view is you need to look through the Delta variant, because you’re either going to choose to get vaccinated or you’re going to get COVID and the nation is moving toward herd immunity one way or another. The economy has a head of steam and earnings are powering ahead. So if you think about what you want to do with your money, do you want a 1.3% yield on a ten-year treasury note, or would you rather own half of the stocks and the S and P 500 which have a yield greater than 1.3%? And the ability for that yield to rise, the dividend payment to rise over time. So our position hasn’t changed. Stay invested in great companies, which will benefit from nation returning to an adapted normal that will turn out to be surprisingly close to the old normal, the economy’s growth rate remaining very strong over the next couple of quarters, and then leveling out as we get out to say, 2023 back to the economies. Well, long run growth rate is around 3%, the, growth rate over the last two decades has been closer to 2%, so we think we’ll probably go back towards that 2% growth rate when we get out to 2023 and 2024, but all of this should be good for an extended earning cycle.

Tom Fitzgerald: So keep those 401ks invested, right.

Joe Keating: Yes, sir. And take advantage of any little, wiggle in stock prices by contributing on a regular basis.

Tom Fitzgerald: Right. Well, Joe, I want to thank you again for your generosity and giving us your time and your insights. I know, like I said, these episodes are always some of the most listened to, and I’m sure the listeners have gotten another real, heaping plate of information to take back to not only to manage their bond portfolios, but also to manage their own personal investments. So again, thank you so much for your time and for your insights, Joe.

Joe Keating: My pleasure, Tom, you take care of yourself.

Tom Fitzgerald: Okay. You take care too, and I’m sure we’ll get back together in a few months to cover all this all over again. Take care.

Joe Keating: Thank you.

Tom Fitzgerald: Bye-bye.