Joe Keating’s Economic Outlook Update
This week we’re sitting down again with Joe Keating, Co-Chief Investment Officer of NBCSecurities to get his take on where the economy is headed for the rest of 2022.
The views, information, or opinions expressed during this show are solely those of the participants involved and do not necessarily represent those of SouthState Bank and its employees.
SouthState Bank, N.A. – Member FDIC
Intro: Helping community bankers grow themselves, their team, and their profits. This is the Community Bank Podcast.
Caleb Stevens: Hey everybody. And welcome back to The Community Bank Podcast. I’m Caleb Stevens and we are going to get right into today’s episode. We have a conversation between Tom Fitzgerald, our director of strategy and research here at the Correspondent Division, and Joe Keating, a co-chief investment officer of NBC Securities. They talk all things, economic, the fed, and what it means for community banks. So, hope you enjoy
Tom Fitzgerald: Well, Joe, it’s good to have you back again on our podcast. I know it’s getting to be something of a tradition with you, and it seems like we’re never at a shortfall of things to talk about. So, welcome back. And I know the listeners are eager to hear your thoughts as we move through some of what’s happened since you last met with us.
Joe Keating: Thanks, Tom. Since we started doing these… we had a pandemic and now we’ve got inflation. So, as you say. [inaudible 01:15]. And so, we’ve had plenty to talk about.
Tom Fitzgerald: Generationally high inflation too.
Joe Keating: Yes, absolutely.
Tom Fitzgerald: It’s never, like I said, never a dull moment. Well, let’s just top right into it. As we record this, we recently received the first estimate of second-quarter GDP last week, and it was the second consecutive quarter of a negative GDP row. So, I wanted to get your thoughts on the report itself. And with that back-to-back, negative GDP reading has the economy fallen into a recession in your view?
Joe Keating: Yeah. Well, let me answer your question. No, I don’t think it has. As you said, we did get a second negative print. The 9th, 10th of 1% in the second quarter, following the minus 1.6% drop in the first quarter, and it did reach some simplistic definition of recession to consecutive quarters of negative. However, the economy, as I said, did not fall into recession during the first half of 2022. Rather I would characterize it as the economy’s forward momentum, essentially stalling over the past two quarters. It’s kind of interesting over the first six months of the year, monthly payrolls grew by an average of 457,000. The unemployment rate fell from three nine to three, six, and industrial production grew at a 5.2% rate. So, as we all know, these data points are not consistent with a recession.
I think a much more accurate representation of the first quarter growth rate was a 3% gain in the sum of consumer spending, business capital spending, and residential instruction. If you use that measure for the second quarter, the economy flat out stalled, it was zero. This is exactly the outcome the federal reserve is attempting to achieve, and it really was an inventory drawdown that subtracted two full percentage points from the economy is reported 9, 10 to 1% negative growth rate during the second quarter. The more interesting insight in the second quarter data is the shifting demand in the economy. While real consumer spending grew at a modest 1% rate following a 1.8% pace in the first quarter. However, outlays for goods fell at a 4.4% rate following a decline of negative three, 10 to 1% in the first quarter.
And while that was occurring, spending on services grew at a 4.1% rate in the second quarter, following a gain of 3% in the first quarter. So, we talked in the past how there was going to be a shift in household outlays from goods to services. As the economy reopened, and we put the pandemic more in the rearview mirror and it’s happening, and it’s helping to balance the shortage gap between supply and demand in the economy that developed as the reopening occurred. The other interesting point in the data was that the formerly red-hot housing market has entered a downturn. As the combination of higher mortgage rates and sharpened higher home prices have taken a bite out of housing affordability. Residential construction outlays were clearly the weakest part of the economy falling at a 14% annualized rate in the second quarter. After being flat, basically during the first quarter.
And this data is consistent with other measures of housing activity that we’ve talked about in the past time. Single-family housing starts are down 19% over the past four months. New home sales are lower by almost 30% since December and existing home sales are down a little bit more than 21% since January. Again, this is the outcome the federal reserve has sought. So, in my view the debate about whether the economy is in a recession should be about real economic pain, significant losses of jobs in income, bankruptcies, significant earnings, declines, and businesses closing up a shop, not academic style semantics on whether the data fits some simplistic technical definition of recession. A recession is a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible and a decline in real GDP in real incomes rise in unemployment, and declines in industrial production.
That’s not what we’re seeing. If the federal reserve does tip the economy into recession during this tightening cycle. It will likely be relatively short and mild. I would actually characterize it more as a mid-cycle pause. Why? The FMC committee members have expressed their intention to shoot for a soft landing, and that intent was just reinforced at last week’s FMC meeting by chair Powell. They may miss, but because landing softly is their goal, they are unlikely to body slam the economy into a deeper prolonged recessionary period. The Volker Federal Reserve from 1979 to 1987 Harbor, no such illusions. The landing in the early eighties was going to be hard and painful. Finally, in the scenario of a mild recession caused by the federal reserve, potentially over-tightening policy. The central bank could make a course correction, which would kick the economy back into expansion rather quickly. So, the bottom line is we are not expecting a deep and prolonged recession in the economy.
Tom Fitzgerald: And I agree with that, and I think just anecdotally, we’ve been on a couple of trips this summer, and I could tell you the travel and leisure industry is going great guns. The airports were packed, everything I did, it was packed, and I think the consumer after being kind of pulled up for a couple of years has said, I’m going to go out and enjoy my summer for the first time since 2019 and I think the numbers that we come out in the third quarter are going to be fairly impressive. Now, what happens in the fourth quarter? You know, we’ll see. But I think the third quarter numbers should be fairly impressive as far as consumer consumption goes.
Joe Keating: And along that line time it’s… you might recall the 2000 recession. Which was a one-sector recession. It occurred in business capital spending on equipment because it was after Y2K, and in fact, consumer spending grew as during that entire recessionary period. We might experience something similar here. If we fall into a mild recession or the mid-cycle pause, as I refer to it where obviously we’re going to see housing down. It is already down. But in consumer spending and services should continue to grow nicely, and it’s any pullback of the sewer spending is going to be confined to the good sector. So, it’s having some similarities to the post Y2K era.
Tom Fitzgerald: Right. And I think we’ve seen that even in July now with the from that handoff from goods to services. The ism manufacturing and services came out this week and they show that same thing that manufacturing is still expanding but on a weakening trend. Where services are just going in the opposite direction. They’re continuing to see that, like I said, that handoff from the good services side. So, that trend is certainly intact into the third quarter.
Joe Keating: Yeah. Most definitely a great observation.
Tom Fitzgerald: Moving on to kind of rates and yields. We all notice that somewhat dramatic drop in treasury yields since the middle of June. Particularly with that 10-year note. What do you think the message is the treasury market is sending with that decline in yields that we’ve experienced?
Joe Keating: Well, I think the treasury market did a real good job of forecasting of the slowing in the economy. But yet not a significant downturn in the economy. We’re slowing from a 5/1.2% Growth rate last year. But I don’t think the treasury market is telling us that a deep and serious recession is necessarily in the carts. We saw the yield curve flattened further in early July, and then it inverted slightly mid-month. Following the very hot consumer and producer price reports, and I think the reason that occurred was that we saw 2-year treasury yields remain pretty firm in speculation that the fed may need to increase interest rates at an even faster pace in order to slow down inflation.
That was the concern in mid-July and then 10-year, treasury yields fellows. The decline in inflation expectations pulled nominal yields level. Plus, I do think the expectation of slower growth took place. So, this morning time, as we’ve got a 36-basis point inversion, 2-year treasury yields above 10-year treasury yields. That’s quite a change from the 121 basis point yields spread back on September 30, before inflation picked up ahead of steam and the fed made an aggressive shift in policy to fight the build and inflationary pressures. Interpreting this is sort of an art form. We don’t believe the 36-basis point inversion from twos to tens is forecasting a deep and prolonged recession as the yield curve is not inverted to a significant degree. And I would say a significant degree is well over a hundred basis points, nor has it been inverted for an extended period of time.
It’s basically been a month or so. Secondly, as you mentioned, we saw the yield on the 10-year treasury versus this morning. It’s lower by 68 basis points at 280 from the high of 348 back on June 14, and we talked about this last time, we thought upper pressure on longer data treasury yields would persist until there was a significant perpetuation in the housing market, and we already covered that data housing market has cooled off clearly to a large extent. The two years has fallen 27 basis points to three 16 or 343 back on June 14. So, while it’s hung in there at a fairly high level above the yield and the ten years. It is down and I think that basically is looking out, saying, okay, either the fed won’t have to take the funds rate up to three and a quarter and three and a half by late 22, or if it does take it up to three and a quarter to three and a half. It could subsequently be lower rates by mid to late 2023. Looking out a year into two timeframes. So, I think across the board, the treasury market is very consistent with the slowdown in the economy, but I don’t think it’s telling us that a painful, deep, and long recession is on the horizon.
Tom Fitzgerald: It kind of reminds me of that old joke about the inverted curve, predicting 10 of the last five recessions, because it may not miss the recession, but it has been like you said, it sometimes it sends out a false signal. If you try to fall it pretty religiously. I think too you look at the drop in all manner of commodity prices over the last several months. Especially, when you the oil and gas complex and the wheat, which is obviously going to feed into the food prices, copper, I mean, lumber. Which is a reflection of the softness in the housing market. I think a lot of that price decline is also kind of a factor in what’s driven yields lower over the last six weeks or so.
Joe Keating: Absolutely. Totally agree.
Tom Fitzgerald: Yeah. Going back to the fed now. Last week as we’ve recorded, they say they delivered their second consecutive 75 basis point rate hike. What are your thoughts on this more aggressive cycle that they’re into now and where do you see the rate of hiking ending and at what level?
Joe Keating: Well, I’m in full agreement with what they’re doing. Not that that matters, but I am in terms of the front loading, the increases. This is the biggest broadside yet against inflation that we’ve seen in many years with, as you said, that second consecutive 75 basis point height, and at the press conference chair Powell, said that the central bank was strongly committed to bringing the inflation back down and that ongoing increases in the target rate for the fund’s rate will be appropriate. he made it very clear that the tightening of monetary policy is not intended. However, to tip the economy into a recession by stating we’re not trying to have a recession, we’re not trying to make the mistake of causing too large, a downturn in the economy.
So, they are committed to trying to pull off this, this soft landing. I just popped in my mind in many ways, this is not all that dissimilar from 2018 when Paul went about the kind of being oblivious to what the market’s reactions to the hikes that he was putting in place that year, and then they had the abruptly shift course and actually cut rates during 2019. I think that that was a real lesson for him, and I think that’s one of the reasons why they’re talking tough because they want inflation expectations to come down and they want everyone to believe that they’re going to move us towards a 2% inflation rate over time, but I think they’re also very cognizant of the lagged impact of monetary policy on the economy.
And they wanted to slow down in the policy statement, the committee said that they were very committed, or excuse me, strongly committed to returning inflation to its 2% objective. However, I think the most important thing relative to the markets and Mr. Paul said was that future rate hikes will be determined on a meeting-by-meeting basis and that as monetary policy gets tighter. There’s the punchline. It likely will become appropriate to slow the pace of rate increases. So, it wasn’t a pivot, but it pointed to the fact that, hey, we’re going to pivot at some point. So, right now the following the second 75 base point hike last week. I think we’ll see 50 basis points in at the September FMC meeting, I think we’ll see 25 at the November meeting, and then whether or not we get another 25 in December, I think is a toss-up somewhere in there after November or after December, I think the federal pause and whichever of those rate hikes November or December, is the last one. I think that likely could be the final rate hike for this cycle. Of course, the key there is that the inflation data is going to have to play ball and truly moderate. We’re going to see a pretty good moderation in the July data. When we get the report here in August, as you were just talking about Tom what’s going on of the commodity places?
Tom Fitzgerald: So, if my math is right, that kind of for tens, like a 325 to 350 kind of terminal rate as they call it. In your view.
Joe Keating: Yeah. So, plus or minus 25. But that or minus 25 basis points, whether or not they stop after the November or the December meeting. If they go all the way through December, you’re spot on. It’s going to be interesting because they’re going to start taking a lot of heat as they continue to tighten. And I don’t think they want to throw the economy into a serious recession. So, I do think sometime after November, or December, they’ll pause.
Tom Fitzgerald: Yeah. And I think that June, CPI report was pretty ugly, and it’s interesting though. I understand that the data collection for these reports ends kind of mid-month. So, say June 15th for the June report, and that’s right about when all of these pricing, the commodity side, the gas, and stuff started declining. So, they totally missed a half a month of decline in that June report. So, I think the July report and probably even into August, you’ll see some fairly good month-over-month changes in those numbers. Which hopefully that will come to pass. But there are so many moving parts in those reports. It’s hard as you can’t just pick out one or two items and say, oh, that’ll generate a decline. But I think the timing of when these prices started moving lower kind of worked against them for that June report, but it should be fully in view for the July report as we get those numbers next week.
Joe Keating: Totally agree with that.
Tom Fitzgerald: And that kind of leads me to the next question. These report, like I said, the June report was pretty ugly from it certainly didn’t show any signs of a trend reversal, but the inflation or expectations in the market have dropped significantly. How do you reconcile kind of that the sticky nature of what we’re seeing in the actual reports to what the market is expecting?
Joe Keating: Well, you had a good part of that already, Tom by talking about the fact that the reporting in June, that the data collection in June really did what happened the second half of a month. As you mentioned the inflation expectations in the treasury market have dropped considerable. If you take the two-year implied inflation expectation, it peaked in late March at just under 5%. I mean, that’s a big and ugly number. It’s currently at 313, almost at two full percentage point drop in four months. So, that’s significant the Fed’s having an impact on inflation expectations. If you move out the curve, the five years gone from a little over three and a half to a little over two and a half. While the 10 years has gone from just a touch over three to around two and a half.
So, across the curve, these are noteworthy declines in inflation expectations over the past three, four months, and indicates that the shift to a more hawkish policy stance by the fed along with the four rate hikes that they’ve delivered has is definitely having an impact and as you mentioned. If you take a look at the consumer and the producer reports for June, nearly 50% of the rise in each of those reports was caused by a sharp rise and gasoline prices. Well, since then gasoline prices are down. Well, when I last updated this, they were down 16%. I think they’re down a little bit more than that now, and the gasoline futures prices are down around 18%. So, and then if you consider the commodity price indices, as you mentioned. All of this is pointing to some sort of a rollover in those inflationary pressures.
So, we expect the inflation measures to soften in a fairly noticeable way over the next few months, and that lower as these lower commodity prices feed into the reports. Lastly, on inflation, the silver lining of the global slowdown that’s occurring is that supply chain bottlenecks are unclogging quickly. That’s kind of a tough thing to say unclogging quickly. Shipping costs and delivery times are declining likely helped by rapidly following orders. Which helps clear the backlogs and close that gap between supply and demand. So, I think this is what the markets are looking at, both the treasury market, as well as the equity market since mid-June.
Tom Fitzgerald: Well, let’s kind of shift and finish up with the stocks. And I know everybody who’s got a 401k or any kind of stock investment the first half of this year was brutal, but it’s interesting from a kind of mid-June, the S and P through the end of July S S and P 500 rallied, almost 13%. what are your thoughts on why the stocks were rallied? So, starkly and I think we’ve touched on some of that already, but more importantly, well, that June 16th low in the stock market holds through the balance of the year.
Joe Keating: Well, you mentioned the markets underwent a pretty good reset as the fed transitioned from that very easy money posture to an inflation-fighting restrictive stance. The reset really has three distinct phases. First is the compression of multiples on common stocks, and when we hit that low in mid-June, we were all the way down to 15.9 times forward earnings, and at the beginning of the year, we were 21.4 times. So, a pretty good compression in price-earnings ratios. Second is a downward adjustment to earnings to reflect the slower growth in the economy. So, the analysts at standard employers, and I tend to follow their earnings forecast on operating earnings at the beginning of the year was 9% for all of 2022 it’s been roughly cut in half down to 4.8%.
It could actually potentially go a bit lower, but it’s down, but it hasn’t gone negative. And then the third stage is, as we talked about the landing for the economy. Which as we’ve said, we’re in the soft-landing camp. So, we think the three stages of the reset are well advanced, and that the reset is largely complete. So, we’re expecting a better second half of 2022. Which erases a good portion of the losses during the first half of the year as the inflationary pressures ebb and the economy skirts a full-on recession, and as you mentioned, Tom July, or if you want to go back to mid-June, it was a good start to that better. Second half now thinking about June 16, a lot of bad news was discounted in the market to the low on June 16.
And I would characterize the rebound from June 16 by, well, maybe things will not be as bad as the fear. So, the ultimate bottom in the selloff will occur once there is definite evidence of inflation peaking, and as we already talked about it’s clear a reversal in some pricing pressures is coming. The issues are how soon, and to what extent will the inflation trend, return to its pre-pandemic pace, or will it be a touch higher due to strong wage demands at high rents? So, it would not at all surprise us if the June 16 low holds, but regardless the repricing of risk is given investors a very attractive entry point, and we look for stock prices to be higher a year from now. And you mentioned 401ks, there, it’s such a blessing that we have access to these vehicles and that we make contributions to them every two weeks or twice a month on how you get paid because no one had to be a genius during the first half of the year of averaging money into the market as the market fell. The 401k system did that for us and a year from now, when we look back at that, where we’re all going to be very happy that we actually put money to work during the first half of 2022, even though it didn’t feel good as we looked at our balances.
But that flow was coming in. As long as we were going to stocks, that flow was coming in at much better prices. So, I believe that June 16, low is likely to hold, but markets are going to do what markets are going to do. So, we’ll see.
Tom Fitzgerald: There’s always that tail risk of some unknown event. We’re in the middle of China and Taiwan and the saber-rattling that’s going on there. And so, it’s like you said, it’s always subject to events that sometimes are not known to you as you make predictions. So, it’s what makes it a tough and interesting business. Well, Joe, I want to thank you again. I know it seems like, you know, we could go on for hours on this stuff, but I really appreciate your time and your insight. I’m sure our listeners do too as well. So, I’m sure we’ll get back together in the next quarter and have plenty to talk about then. So, again thanks for all your insights, Joe. We really appreciate it.
Joe Keating: You’re entirely welcome, Tom. You have a great day.
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