Joe Keating’s Economic Outlook for 2021

Caleb Steven: Well, hey everybody and welcome to the Community Bank Podcast. Thanks for joining us today. I’m your host for this episode Caleb Stevens. I serve banks in Georgia, as well as Kentucky in our Business Development Group. I am joined by our Director of Strategy and Research, Tom Fitzgerald. Tom, how are you?

Tom Fitzgerald: Caleb, I’m doing good and I hope you are as well.

Caleb Steven: Doing great. I’m glad that we can keep the theme going this week of the economy and what that means for investments. What does that mean for community banks? And last week, we kind of did a deep dive into the bond portfolio, and I think Todd Patrick provided some really helpful insights there. Today, we kind of want to zoom out and take a more macroeconomic look at what the bigger picture is for the economy. How a Biden Administration is going to play into that? And who better than our friend Joe Keating over at NBC Securities, Chief Investment Officer with NBC Securities in Birmingham, Alabama has been a long time speaker at conferences for us and just a wealth of knowledge when it comes to macroeconomics.

Tom Fitzgerald: Yeah, he really is. I think this is the third show that we’re going to have Joe on and they’re always some of the most listened to. So we’re excited. I think the last time we had him, it was right around the election, I think just after the presidential election. So a lot of uncertainty was still on the air, you know, with the Georgia runoffs and a lot of that has now been settled. So really looking forward to getting Joe’s views on kind of where we go in 21 given the new lay of the land from a governmental aspect and also from, obviously the vaccine and how that’s going impact the economy as well.

Caleb Steven: Good deal. We’ll go to that interview right now.

Tom Fitzgerald: Well, Joe, I want to welcome you back to the show. How are you doing in this age of COVID? Are you surviving?

Joe Keating: Tom, good to hear from you. I am surviving very well. Thank you for asking.

Tom Fitzgerald: I think this is the third time you’ve been on our program, if I’m not mistaken and I know each of the shows has been probably the top 5 or 10 as far as most listened to. So we’re really excited to have you back and especially with everything that’s gone on in the last few months from elections to COVID to vaccines and all of that. And a lot of that’s been settled, at least from the election standpoint. So we’re really looking forward to kind of getting your views from how we transitioned in the fourth quarter and to this year. And then also obviously what you’re seeing in 2021. So again, the listeners, I’m sure are ready to hear from you. You always bring some really good insight and information, so let’s just get right into it. We’ve got a series of questions for you, Joe, and we’ll just kind of knock them off one by one.

It appears in the last quarter of the year, the economy really took a little bit of a slowdown and from what it was doing in the summer. The good news is I think the market was preoccupied with COVID and with the election, so it didn’t really give much attention to how the economy was slowing in the fourth quarter. How do you kind of take the economy now, are we in a rebound coming off of that slow quarter? You know, considering the balance that we had coming out of the second quarter recession?

Joe Keating: Well Tom, I think your observation is absolutely correct. You know, the economy did slow a bit as 2020 drew to a close. And it’s interesting while the fourth quarter is over, we do not have the real GDP data for the quarter yet. They will arrive next week. So let’s just take a look at some of the high frequency, monthly data to provide some insights into what the fourth-quarter real GDP data will look like. And that’s important because that’s obviously going to be the starting point as we move into the data in the calendar year 2021.

The economy’s growth rate slow to around 4% in the fourth quarter by our calculations versus that 33.1% rebound in the third quarter. And it did face some growing headwinds as the quarter went on. First, as the weather turned cold and stricter mobility restrictions and shutdowns were implemented as new cases of COVID-19 surged over the course of the quarter. Probably the most important data would be to take a look at the retail sales data. Particularly when you take a look at the in-store sales and restaurants and bars, retail sales fell in both November and December. And we all know the economy is reported to have lost 140,000 payroll jobs in December, with leisure and hospitality employment dropping by 498,000. So, three times what the overall economy lost in terms of jobs.

For the full quarter, consumer spending on services likely grew at a faster pace than outlays for goods. As many of the hard-hit service sectors saw some modest improvement late in the third quarter and into the early part of the fourth quarter. However, the rise in activity in the services sector came from very low levels as we all know and understand.
Housing outlays remained strong in the fourth quarter, likely posted the fastest growth rate of any sector. But they began to level out as the quarter due to a close as home price increases and a modest rise in mortgage rates dented affordability at a touch. We do expect that the new work from home flexibility and the flight from a higher-cost urban area, that those two phenomena will continue as a secular shift in housing preferences for some time to come, along with a greater interest in spending on home improvements. Business capital spending on equipment remains strong again in the quarter. We read that as technology spending and outlays on structures remained weak.

The manufacturing sector, if you take a look at industrial production, the purchasing managers’ surveys of the manufacturing sector, the various Federal Reserve Bank surveys of manufacturing activity remained strong in the fourth quarter with all the measures posting healthy and improving readings over the second half of the year. It appears that the surge in consumer spending on goods back in the third quarter and business capital spending on equipment in the third quarter, drew down inventories leading to the rebound in manufacturing and industrial activity. The political haggling in Washington over the second round of coronavirus relief aid for millions of households of small businesses, which finally came to a successful conclusion on December the 27th after weeks of stop and start efforts to finish a deal further weighed on the economy’s forward momentum over the course of the quarter.

This additional coronavirus relief is important because a two-track recovery has emerged from the country’s pandemic driven recession. As the livelihoods of well-educated and white-collar professionals, businesses tied to the digital economy or supplying domestic necessities and regions that are home to technology forward companies are by and large prospering. The bulk of the newly unemployed are lower-wage workers with few credentials and are concentrated in service sector jobs in hard-hit industries that we can all recite, right? Restaurants, lodging, entertainment, retail. You know, it’s interesting that it’s estimated that the unemployment rate among the bottom core tile of workers is 20% compared to the nation 6.7% unemployment rate for all workers. You know, I covered this last time and I think it’s kind of interesting the quarterly growth rates in real GDP during 2020 were so distorted by the enormity of the decline in the economy during the second quarter and then the massive rise in the third quarter, that we think looking at some non-annualized growth figures add some necessary perspectives.

By the second quarter, the economy was 10.1% smaller than in the fourth quarter of 2019. As a point of comparison to total drawdown in the economy during the great recession was 4%. So the drawdown that we experienced to the bottom of the second quarter was two and a half times what we saw during the great recession. The economy was about 7 1/2% larger in the third quarter than the second quarter, but still remained 3.4% smaller than in the fourth quarter of 19. In the fourth quarter, when we get the data, the economy was likely 8 1/2% larger than in the second quarter, but still remained about 2 1/2% smaller than in the fourth quarter. It will likely take until late in the second quarter of this year or early in the third quarter for the economy to exceed its size in the fourth quarter of 19 before the pandemic. So that’s our take in terms of how the economy ended in 2020.

Tom Fitzgerald: Yeah. It was really striking to look at some of, certainly in the summer and in the fall, the difference between the two economies. The service side of the economy was certainly starting to struggle when the virus trend started ticking up again. Whereas the manufacturing base sort of just kept on buzzing right through it all. So any business that had a customer-facing element to it, it really did seem to struggle in that last the third, fourth quarter when you were having increases in cases again and then lockdowns kind of being re-instituted in certain areas. So kind of like you said, a tale of two economies for sure for the second half of the year, and certainly the third and fourth quarter. Let’s move on now, like you said, we kind of covered what we saw at the end of 20. Let’s take a look, Joe, at your outlook for what you see for 2021 and some of the key drivers that you’re going to be focused on as we go through the year.

Joe Keating: Sure. Well, let me give you the conclusion of what we see for 2021. Vaccines and Easy Monetary Policy point to better growth this year. So the following year in which the longest business expansion on record came to a sudden and violent end, we do have an optimistic outlook for 2021. Since the economy started to recover in May, the economy has had one foot in the pandemic and one foot in an economic recovery. The development and distribution of the vaccines are a game-changer as they will eventually end the pandemic this year. The COVID-19 vaccines are the best stimulus measures anyone could ask for this year. As the distribution of vaccines will boost the pace of economic activity as 2021 wears on. As people get vaccinated, they are likely to normalize their spending on areas impacted by the virus shortly thereafter i.e. on services.

So the largest improvement in the economy will take place in consumer outlays for services, hospitality, lodging, entertainment, retail, which, you know, it’s kind of surprising that sector accounts for 44 1/2 % of the economy, or did account for 44 1/2 % of the economy in the fourth quarter of 2019, prior to the pandemic. Consumer outlays for services remained almost 8% below pre-COVID levels in the third quarter, as large segments of the service sector remained in partial or complete shutdown or phased to sharply reduced demand. Along with higher consumer spending on services, as we go through 2021, jobs in the service sector should rebound at a healthy pace during 2021.

So we talked a little bit about the fact that the economy stalled a bit as the fourth quarter came to an end as a worsening of the COVID-19 crisis sent a new wave of caution across the nation. You know, this prompted several states and local municipalities to impose fresh restrictions on social and business activity to combat the surge on top of 9 million fewer employed Americans compared to February. This raised the possibility which we mentioned in the November podcast and in my recent monthly writings of the strategy statement that the economy could post a small negative growth rate in the first quarter. We now believe, however, that the recent passage of the $900 billion coronavirus relief package in December has likely eliminated the risk of a modest contraction in the economy this quarter as household income will experience a large temporary boost from the $600 stimulus checks and unemployment insurance extensions and supplements totally nearly $290 billion.

These income boosts will arise quickly, and we expect them to be spent quickly providing a boost to consumer spending in the first quarter. This income support and the roughly $284 billion in new small business loan funding added to the paycheck protection program have hopefully built a bridge to the end of the pandemic. And if it hasn’t, we all have heard that the Biden administration is proposing another $1.9 trillion coronavirus relief package to be passed here in the first quarter. Now, I sincerely doubt that the package is going to wind up being 1.9 trillion, but there probably will be another package of relief coming the way of the American households.

While we still face the unknown of how severe this latest surge in COVID-19 cases might turn out to be, we encourage everyone to stay focused on an acceleration in the pace of quarterly growth over the course of the year. As the distribution of vaccines proceeds with reported new cases of the virus, hopefully, fall into something close to zero by the fourth quarter. The economy is primed for further recovery, growth, and continued adaptation to a new normal. By the end of the fourth quarter of this year, the economy should be fully recovered in about 2 to 3% larger than in the fourth quarter of 2019. The economy space of growth is expected to ramp as the year goes on as the distribution of vaccines ramps up, the Federal Reserve remains very economy native and the coronavirus relief package passed in late December, along with possibly another one combined to help the economy reach, and this is key, a self-sustaining and self-reinforcing, you can read that as job growth, economic glide path over the course of 2021. Meaning no additional federal assistance would be needed after the first quarter of this year.

You know, the commitment by the Federal Reserve to keep interest rates near zero until, and unless inflation reaches 2% and unemployment drops to its pre-pandemic levels, that being 4% or lower could actually turbocharge consumer and business capital spending once both imposed and self-imposed restrictions are lifted with the widespread distribution of vaccines. The economy should grow in the 4 to 6% range this year. And my hunch is that it’ll be more like six than four with a sharp pickup in economic activity possibly occurring as soon as the second quarter if the distribution of vaccines leads to a sharp decline in the number of new virus cases.

Tom Fitzgerald: Wow, that sounds pretty positive. And I tend to agree with that. When you think about it, the Fed, in a lot of their recent comments have been pretty, pretty forceful that they are going to keep the pedal to the metal as far as monetary accommodation goes for quite some time. There was some talk last week, some chatter about when are they going to kind of taper their QE program. And Powell was kind of quick to kind of squash that in the bud, so to speak that he just said, we’re not even thinking about, you know, getting to the topic of when to taper. So they’re giving all the signals to the market that they’re going to keep this thing wide open until like you said, they do get that inflation up over 2% and they get employment back down under 4%. And that’s, you know, we’re a long way from that right now.

So, you know, indications are we are going to have strong, strong accommodation for the monetary side. And when you’ve got Janet Yellen, as we record this, is testifying to the Senate Finance Committee I think this morning to go big, I think is the words in her pre-released statement on fiscal stimulus. So like you said, that $1.9 trillion tag maybe just sort of the wish list and so it’ll be whittled down to something less. But I still think we do see a stimulus 3.0 at some point, and it’s just going to provide a further boost to the economy when it does come online.

The last time we met Joe, we were, I think right after the November election, the presidential election, and we were still sort of up in the air about the Senate because of the runoffs in Georgia. Now, all of that has been settled and so basically we have a unified democratic government with both houses of Congress and the White House. So give us some of your policy ideas or implications from having democratic control of the Federal Government?

Joe Keating: Sure. Well, so as you stated, we all know the Democrats won both Senate runoff races in Georgia on January 5, giving the Democrats a very slim margin in the Senate. The new Senate is evenly split between the two parties at 50/50 with Vice-president Kamala Harris serving as the tiebreaker vote if it comes to that. Democrat control of the Senate means President Biden has a friendlier chamber in which to advance his cabinet picks, judicial nominations, and a legislative agenda. Notice I said, agenda. You know, elections have consequences, and we anticipate that there will be some tax increases as we go through the next two years. You know, when you think about the top tax rate on a regular income, I think it’ll head back to 39.6. We’ll likely see an increase in the corporate tax rate, which was 35% for a generation before president Trump cut it to 21%. He, President-elect Biden has proposed lifting it to 28%. Maybe in a compromised situation, it winds up at 24, 26, we’ll see. Neither of these moves will help the economy grow, but the US at a top personal tax rate of 39.6 and a corporate tax rate of 35% from 1993 to 2000 and 2013 to 2017 with no recession during any of those years. As an offset, we’re likely to see the limit on state and local tax deductions double from its current 10,000 to about 20,000 which would be a concession to the high tax blue States.

The Biden campaign has also proposed treating capital gains taxes on the dividends as regular income for those earning a million dollars or more. But this, you know, almost 40% tax rate on the income, which is basically a doubling of the tax rate would push rates to levels we haven’t seen since the Carter administration. Slender majorities in the Senate and the House should make this virtually impossible. The slender majority should make this tax rate more like 24% from the 20% presently. Why 24? Because combined with a 3.8% Medicare tax, the effect of the federal tax rate would be close to 28%, which is where it was when President Reagan left office in 1989. Optics matter and we could see Biden arguing that he’d be raising these rates no higher than they were under President Reagan. The one big proposal that will likely fail in applying the social security tax to earned income above 400,000. Changes to social security benefits, or taxes, can’t be done through budget reconciliation, and raising the tax won’t have the 60 Senate votes needed to break a filibuster.

One big issue is when would these tax changes start? And we think that given that the unemployment rate is going to remain, I feel fairly high here during 2021, we think that they will more likely to be delayed until 2022. When you think about Mr. Biden’s or President Biden’s legislative agenda, he’s still going to have to navigate between the Senate’s moderate centrist Democrats and the progressive members of the Senate. In fact, moderate Democrat senators, such as Senators Joe Manchin of West Virginia, Kyrsten Sinema of Arizona, and Jon Tester of Montana have become the most powerful members of the Senate as all Democrat legislation will necessarily lead to run through them. Any legislation that these senators find distasteful has little chance of passage. Others who might resist far-left progressive measures include the newly elected Mark Kelly of Arizona, Mark Warner of Virginia, and Angus King of Maine, an independent who caucuses with the Democrats.

You know, we continue to believe, and I mentioned this last time that the main takeaway from the November 3 election is that America remains a largely moderate centrist nation that’s driven by common sense over ideology and which has little general interest in far left-leaning progressive policies. Moderate Democrats in Congress should act as a firewall against far-left policies with the Democrats winning the two Georgia Senate seats, as it is difficult to envision moderate Democrats lining up to add justices to the Supreme court, changing filibuster rules in the Senate, passing universal healthcare, supporting sweeping tax hikes and granting statehood to Washington DC and Puerto Rico. So, as I said, elections have consequences, but I do think the consequences will be fairly centrist in nature and not far-left progressive.

Tom Fitzgerald: I agree with that. And I would say too, that, you know, Biden is definitely a creature of the Senate spanning 36 years there, maybe. That number has just kind of popped in my head for some reason, but he’s been there a generation or two. And so he kind of knows how to negotiate and how to kind of make things happen. But like you said, I think he’s got to control those centrist Democrats, I think, to kind of get his package through. And also probably at the same time, try to act as a, you know, kind of temper some of the ambitions of the more liberal part of the caucus. So it’s going to be you know, certainly will challenge his negotiating skills as we work through the early months of his administration. But yeah, all key points, Joe, thanks for that.

Let’s turn now, I can’t get you out of here until we take a look at what’s your outlook for inflation and for Treasury yields this year?

Joe Keating: Sure. Well, you know, we all know that the yield on the 10-year dropped all the way down to 54 basis points back in March right at the depth of the recession. But actually the low in yields occurred on August 4th of last year where, when the yield on the 10-year was actually 50 basis points. But the 10-year tip yield at that date was a negative 105 basis points resulting in a year expected inflation rate of 1.55%. Since then the yield on the 10-year Treasury note has risen 61 basis points to 110, actually 111. The 10-year TIPS yield is higher by a modest 4 basis points to minus 96 basis points. Consequently, the 10-year expected rate of inflation is higher by 57 basis points to 212 or 2.12% and that accounted for 93% of the increase in the 10-year treasury notes yield rise.

It appears the Federal Reserve’s commitment to maintain a very accommodative monetary policy until it sees evidence of a tight labor market and inflation rising at 2% and is on track to moderately exceed 2% for some time is being taken seriously by investors, as they’ve got the 10-year expected inflation right now, you know, a little bit over 2.1%. We also expect to see inflation rise fairly quickly in the coming months as the service sector reopens more fully. You know, think about what’s going to happen to airlines fares and hotel costs, but they should drop back precipitously by year-end. Expect core inflation measures to rise above 2% this spring, only to drop below 2% by year-end. We expect the move higher in inflation and the expected pickup in economic activity that will take the yield on the 10-year Treasury rather quickly to 1 1/2% and then towards 2% as more and more Americans get vaccinated and more and more the economy service sector reopens and employment in the service sector moves higher.

We are not expecting the yield on the 10-year treasury to rise materially above 2% this year as longer-dated Treasury securities are still the single best source of yield in the world and will attract buyers as yields rise. And remember the Federal Reserve is still in there buying bonds. Some investors fear that the huge ramp in the money supply over the past year and the explosion of federal debt combined with cyclical inflationary pressures as the economy reopens could have serious inflation consequences. We continue to expect the secular or structural forces such as using the internet for comparison shopping, sourcing goods from around the globe, technology, aging populations, and inflation targeting by Central Banks around the globe to swamp, any near term cyclical pressures. So we need to watch what happens with inflation. But as I think it will pop up here over the coming months, but we don’t see it moving out of this long-term secular trend of 2% or less.

Tom Fitzgerald: Yeah, I think back to, you know, prior to the pandemic, we were 3 1/2% unemployment. You know, average, hourly earnings were taken up a little bit. But we still couldn’t manage to get anything, you know, constantly over 2% or really even close to 2%. So I think with a 6.8% or 6.7% unemployment rate until when that comes back down to something closer to what we had at full employment, that, as you said, the inflation numbers we’ll get will kind of be these little spikes of maybe a shortage of supply or your excess demand that gets itself worked out over time. And then just as the economy continues to heal, we get unemployment back down and get the average hourly earnings up. Then I think that you’ll probably see a more durable push to inflation, but that could be still some time in the future. Joe, I can’t let you run away without first giving us your thoughts. You’ve kind of talked about inflation and bonds. What do you think about the stock market for 2021?

Joe Keating: Okay, well we think vaccines and Easy Monetary Policy should cause Stock Pirates to be higher a year from now. The economy in our view is the most important factor in yellow for stock prices, basically all the time, but particularly here in 2021 as stock prices depend upon yellow for earnings, which depends upon economic growth. The key will be the economy reaching, what I referred to earlier, as a self-sustaining and self-reinforcing glide path, once again think about that as jobs growth, as distribution of vaccines leads to a decline in the number of new virus cases, and hopefully fall into something close to zero by the end of the year, allowing the service sector to reopen and new service sector jobs and businesses to grow. So, you know I said earlier since the economic recovery began in early May, the economy has had one foot in a pandemic and one foot in an economic recovery.

Once the distribution of vaccines hits critical mass, the economy will have both feet firmly planted in an economic recovery. The COVID-19 vaccines are the best stimulus measures anyone could ask for this year. Looking forward, consider that operating earnings on the S&P 500 are estimated by analysts at the center quarter to grow by more than 36% over the four quarters this year, compared to the drop of roughly 23% during 2020. Earnings are expected to rebound as the pace of quarterly growth accelerates over the course of the year, as the distribution of vaccines ramps up. The bottom line is the economy is early in this business cycle. There’s plenty of slack in the economy, particularly in the service sector, which made up, as I said earlier, 44 1/2 % of the economy in the fourth quarter of 2019. And monetary policy and fiscal policy are very focused on bringing the pace of economic activity back to full potential. So our advice to everyone is to stay invested in great high-quality companies, which will benefit from the [inaudible 00:29:25] economic recovery continuing.

Tom Fitzgerald: Well, thanks, Joe. That’s just some great information once again. You know, really appreciate you taking the time to kind of sit down with us and kind of give us your thoughts and your experience and your ideas on all things markets, whether it’s fixed income, whether it’s equities, or just the economy as a whole. So we’d love to have you back in a few months when the Biden administration is up and running. Maybe that stimulus 3.0 packages are kind of out and about by then, and kind of take a fresh look at where we see the market and the economy at that point. So, can we get you back in a few months Joe?

Joe Keating: Oh, you bet. Thank you, Tom. I appreciate you inviting me today. And you just let me know when we can do this in the future and I’ll be ready.

Tom Fitzgerald: Okay. Well, thank you very much. Take care.