Making Sense of the Recent Economic Data with Joe Keating & Tom Fitzgerald

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Tom Fitzgerald: Joe, I want to welcome you back. I forget how many times we’ve had you on, but it seems like every time it’s sort of a pivotal point in the market and this certainly is different, but anyway I want to pass on my welcome back and thank you for taking the time to sit with us this morning.

Joe Keating: Thank you, Tom. I’m pleased to be here; the sun will come up tomorrow if we all need to remember that. So it’s all, it’s all good.

Tom Fitzgerald: That’s right. First, I want to say we’re kind of recording this apart from our usual equipment, so if it sounds a little bit off that’s the excuse that we’re going to give so don’t adjust your set it’s it is what it is. But anyway, so much is going on Joe, let’s just kind of launch right into it because I know people are listening and wanting to hear what your thoughts are. We just had the first quarter GDP come in at a negative 1.4% annual rate, so kind of jokingly does that mean we’re halfway to the recession already. But I say that tongue in cheek, of course, but kind of give us your views on that first quarter performance that we just witnessed.

Joe Keating: Well, I like your tongue-in-cheek comment there, Tom. I don’t believe we’re halfway through a recession currently, we’ll talk later I think about whether or not we could fall into a recession but actually, the reported decline in the economy during the first quarter was a very misleading representation of the state of the economy to start the year. A much more accurate representation was the very solid 3.8% annualized gain in real domestic private final sales, which is the sum of consumer spending, business capital spending, and residential construction outlays. In essence, in the domestic private economy, consumer spending, which as we all know is roughly 70% of the economy grew at a 2.7% rate and consumers are spending more on services, which were up at a 4.3% annualized rate. Business capital spending rose at a strong 9.2% rate led by outlays for equipment, and finally, residential construction outlays were largely unchanged coming in at 2.1% which tends to be a very volatile sector of the economy, as soaring housing prices and rising mortgage rates over the course of the quarter, took a large bite out of affordability.

The 1.4% reported a decline in real GDP came from three factors first and most importantly, imports rose at a very strong 17.7% rate while exports fell at a 5.9% rate. The result was a 192 billion erosion in real net exports and that alone net exports reduced real GDP by 3.2 percentage points in the first quarter. The second factor was that business inventories rose at a slower pace in the fourth quarter, which brought real GDP down another 0.8 percentage points. And then lastly government purchases declined both at the federal as well as at state and local levels, which accounted for a further drag of one-half of one percentage point. So in total, these three sectors subtracted four and a half percentage points from the real GDP figures. So in our view, the 3.8% growth in private domestic final sales, the private domestic economy, more reflected the health of the economy in the first quarter than the reported 1.4% decline in real GDP.

Tom Fitzgerald: It’s almost like the intricacies of how they calculate the import export part of the equation. As you said, we were out there buying imports, hand over fist, whereas the global economy was really backing off on buying our exports. The way the math works it subtracts quite a bit from the earnings or from the GDP numbers. When in fact, you could say it was really a vibrant economy for the most part.

Joe Keating: It is truly one of the anomalies in terms of the way that the GDP numbers are put together. I’m not saying, and I don’t think you are either Tom that it’s right or wrong, it is what it is in terms of the way the calculations are done. It just means that we need to take a hard look at the data to make sure that what the headline number is saying is truly representative of what went on in the economy during the quarter.

Tom Fitzgerald: Because it is a gross domestic product and not gross overall products and so if we’re buying stuff something overseas, that means we’re not buying it here, which that does have its peculiarities in the calculations. But anyway, given that the first quarter probably was not as weak as what kind of that first blush would have you think, what’s your outlook for the 22 and if you want to risk doing it, what would you think about 23?

Joe Keating: Well, we definitely look for the economy to slow over the course of the year and into 2023. It’s interesting, that means the Federal Reserve will be tightening policy in a slowing economy. For the full year we expect growth to come in around 2% could be as high as two and a half, but right now I’m leaning more towards two and in comparison, the economy last year grew at a five and a half percent annualized rate. There, are four reasons the economy could slow rather abruptly. First, fiscal stimulus pushed demand up in both 2020, and 2021 through the stimulus checks, enhanced unemployment benefits, money for state and local governments, and forgivable business loans known as the PPP program. These programs have expired and nothing new is taking their place, second household purchasing power has been sapped by inflation, and real wages have fallen by 3.3% over the past 12 months. And there are a lot of difficult conversations going on around kitchen tables right now about, which things families can buy and which ones they can’t afford to buy.

Third, mortgage rates have risen more than two percentage points over the last six months, the fastest rise since 1994. When you combine that with the 15 to 19% increase in home prices over the past year, housing affordability hit a 13-year low in February and it’s pretty close to all time low, pushing some potential buyers into the rental market. And then lastly, as we all know, the federal reserve has just embarked on an increasingly aggressive tightening of monetary policy, but financial conditions have already tightened, with the federal funds rate higher by only 75 basis points so far. The recent hawkish rhetoric from Federal Reserve officials is a coordinated and deliberate effort to prepare the markets for an increasingly aggressive tightening policy, and to help ease back the level of demand by tightening financial conditions. What does it mean to tighten financial conditions? Well, just think about the rise that we’ve seen in treasury yields, the yield on the tenure years basically doubled since the beginning of the year, as well as we already mentioned the rise in mortgage rates, we’ve got the flat treasury yield curve, the modest widening of credit, yield spreads, which actually has picked up a little bit over the last week or so in terms of the widening and obviously the decline in stock crisis. Then you add in regulators and investors will reinforce this process by tightening lending and investing requirements and we’ve heard, and time you may have an insight on this also, bank examiners have already increased their scrutiny of bank loans when they’re doing their examining. So, all of these things are combined to slow the economy down.

Tom Fitzgerald: Yeah, and that’s the thing, the recession seems to be coming up more and more. I know back in March, you stated there was a risk of recession, but it wasn’t really your base case scenario, I guess, kind of what I hear your thoughts are, is that you still feel that way, but can you kind of spell out, do you think we could fall into a recession in the next year or so?

Joe Keating: Sure. Well, our position is still at the same time. We continue to say that the risk of recession in the coming months has increased, but it’s still not our base case. You know, to start the current situation is not 1979 redux, for one thing, the macroeconomic starting point is far better. The Federal Reserve is currently trying to steer a basically healthy economy. It knows it must raise interest rates substantially, use forward guidance to make clear that higher rates are coming, and change quantitative easing into quantitative tightening, which will happen in June. If the Federal Reserve tips the economy into recession, it will likely be a mild one. Why? Well, chair Powell’s starting point is not Paul Volker’s starting point, when Volker became chair in 1979, inflation had been raging for more than 10 years and was deeply ingrained in expectations. Mr. Powell’s inflation is young, barely over a year old and the expected inflation rate implied by Treasury bond yields is just over 3% for five years and just under 3% for 10 years, they’re not much above the Federal Reserve’s 2% target. In addition, the unemployment rate is at 3.6%. We found out that again last Friday and there are 11 and a half million open positions in the economy, which makes a slowdown in job creation, more digestible.

Further J Powell’s Federal Reserve is not Paul Volker’s Federal Reserve. The FOMC committee members have strongly expressed the intention to shoot for a soft landing. They may miss, but because landing softly is their goal, they’re unlikely to body slam the economy into the ground. The vulgar Federal Reserve harboured no such illusions, the landing was going to be hard and painful. Finally, households and businesses on average, aren’t in very good financial shape, raising the odds that they can weather of significant slowdown in the economy. Now, could the economy experience a technical mild recession? Sure. Remembering the definition of a recession is two consecutive quarters of negative growth, irrespective of the order of magnitude. Of the 11 previous tightening cycles we’ve lived through, seven were followed by a mild recession or none at all, basically several soft landings. They were not on average deep recessions, like the sudden stop recession that we just lived through in 2020, the great recession of 2008/09, or the hyperinflation double-digit recessions of the early 1980s. You know, a recession is one word, but it covers a large range of outcomes given its simple definition. It can be a couple of quarters of stagnant below zero growth, or it can be, and here’s a technical term for everybody, it can be a humdinger like the financial crisis or the crushing recessionary periods of the early 1980s.

Tom Fitzgerald: You mentioned that 11 and a half million job openings and we just had the jobs report Friday, which to me was kind of surprising that we didn’t see an increase in the labour force. You would think that many job openings when you see wage gains that are historically fairly high right now, right. Five and a half type percent year over year gain and get when wages and I would’ve thought we would see a labour force increase in and some of those job openings being filled. But to me, I guess my point is that instead of seeing layoffs start to tick up the Canary and the coal mine to me is going to be seeing those 11 and a half million job openings start to come down as companies say, well, our demand is easing off a bit, maybe we don’t need to hire 50 people, we can hire 25. To me, I’m going to really look at that Joel’s report every month to see if that number starts to kind of received, you sort of feel the same way?

Joe Keating: Tom, I agree wholeheartedly with that, I think that’s a really good insight on your part. It’s a lot less painful for the economy to remove job openings than to actually lower and that’s employment levels as the economy slows great point.

Tom Fitzgerald: And that’s why I kind of agree with your outlook that if we do fall into a recession, it would be fairly short and shallow. So, that 25 cents won’t even get you Starbucks coffee. Given your outlook that we’re probably going to slow, I mean that’s sort of a given where rates are and kind of like you said, the fiscal stimulus is fading by the day. The fed is intent on getting that fed funds rate up even higher from where we are. What’s your outlook for inflation? I know we’re going to have a new number in a couple of days from our recording here, but do you think we’ve seen the peak in inflation?

Joe Keating: You know Tom I do, so as you mentioned we’re going to get the April CPI report on Wednesday. Our view is we think the March CPI report that we got last month will likely prove to be inflation’s high watermark, what concerns me about that statement is a lot of people are saying that, but I do think it’s in the data. The year-on-year comparisons are about to start getting less severe. The big move up in inflation began last April, when core prices rose nine-tenths of 1% from a month earlier, a jump that remains the largest in September 1981. So, when we get the April report on Wednesday that gain will no longer be part of the year-on-year comparisons it’s going to be in the base. So even if core prices registered the same monthly gain in April as they did in March, the year-on-year gain will slip to 5.9% compared to 6.5%, admittedly still too high, but it’s lower and that goes back to my point of saying, I think March was the high water mark. Last Friday’s personal income and consumption reports showed the first year over year easing in the core consumer inflation data, 5.2% year over year in March versus 5.3 in February, a small decline, but nonetheless going in the right direction since February of 2021, 13 months ago.

It’s possible to imagine a situation where the combination of easing shortages and easing year round year comparisons will bring inflation down fairly rapidly in the months ahead, especially if some of the categories that saw big price increases through the course of the pandemic, such as used car prices give back more of their gains, more broadly many of the shortages and shipping snarls that left retailers chasing after inventory has shown signs of EAs easing. So, while we expect that peak inflation is behind us, primarily due to these base effects, the period of inflation running above the federal reserves the 2% target still has legs. The primary reason is the extremely tight labour market, which will keep wage pressures higher than we’ve experienced over the past couple of decades. For instance, in the report Friday, the April average hourly earnings number was up five and a half percent year over year, still high, but it was lower than in the previous month at 5.6%. So, we think the peak is in but as I said, we think the period of inflation above the Fed’s 2% target still has some legs.

Tom Fitzgerald: You’ve talked about the wages, before the jobs numbers when the wages that are in there, the ECI came out I guess a week or two before, and that was at an all-time high. So, I know that’s something that the fed is intently watching and certainly, Powell talked about that at the press conference at his meeting. Just wanted to ask you kind of your general observations of that meeting and what Powell said at the press conference, and then kind of give us your idea of how we see the policy from the fed playing out in 22 and if you want to venture our guests into 23.

Joe Keating: Well, I guess the simple statement is the Federal Reserve did not deliver any surprises at the May three, four FOMC meeting. You know, they rose raised the target range for the federal funds rate by 50 basis points to three-quarters of 1% to 1%, which we all expected, and indicated that it will begin trimming the size of its 9 trillion bond portfolio starting June one. Going forward we think inflation expectations will determine how aggressively the federal reserve tightens policy, as it must keep inflation expectations under control or using the Fed’s term well anchored and as I said, they’re running, slightly be, above 3% for five years and slightly below 3% for 10 years. The recent hawkish rhetoric from the Federal Reserve officials really turned very hawkish during April which I think is part of the reason why stock prices fell so sharply during April and have continued here into May.

It’s been a coordinated and deliberate effort to prepare the markets for an initially aggressive tightening of monetary policy, and to help the effort ease back the level of demand. It is actually very unusual for the Federal Reserve to be tightened monetary policy when consumer and small business sentiment is as low as it currently is. The poor sentiment readings should make the tightening moves by the Federal Reserve, very effective. So, it looks to us like the FOMC committee plans to raise rates at whatever pace necessary until the inflation data convincingly demonstrates that pricing pressures are headed lower. So, we look for at least two more 50 basis point hikes and recent in incoming months and I would not be surprised if a fourth, 50 basis point increase is thrown at the economy if the central bank does not view the progress on cooling inflation as sufficient. For now, the inflation data is the only thing that matters to the Federal Reserve.

Well, when you think about the slowing forward momentum in the economy that we think is going to happen, and some easing inflationary pressures, we think this could lead the federal reserve to announce a dovish policy pivot later this year or early next year. Yes, I did say a dovish policy pivot, maybe it only takes a less hawkish policy pivot, something along the lines of the fed saying there’s been progress made to support stock prices that will ease the volatility in the stock market and actually boost stock prices. And I would not be surprised if the Federal Reserve’s annual Jackson Hole symposium, which will take place this year on August 25 could be a timely venue for an update on the FOMC committee’s thinking.

Tom Fitzgerald: Yeah, and I think everything in this cycle has happened so fast from, of course, the falling into recession and then the rebound coming out of that, and then just the growth and jobs that we’ve seen over the last year and a half or so. As you said, you talked about maybe a dovish pivot early in next year, maybe even late this year, but I’m kind of on board with that too. Everything has gone so quickly here that I don’t see any reason why this couldn’t be sort of that same situation and that this cycle is so unique as it is. Let’s kind of venture into the world of treasury yields and as we record this the tenure hit three 20 this morning, and then it sort of backed off from that. I think right now we’re about the kind of three, ten-ish as far as a yield goes, that’s going back to 2018 levels. Kind of in your thoughts, what is really driving that bump and longer dated Treasury yields that we’ve seen, and are we getting close to a peak in those yields?

Joe Keating: Well, I do think we’re getting close to a peak time. You know, we think the upper pressure on longer data treasury yields will persist until there is a significant short-run capitulation in the housing market. It appears to us that fixed-income investors are determined to cool the red-hot housing market to a significant degree to assist the Federal Reserve in taming the current inflationary pressures. Housing has started to roll over on the back of the recent rise in mortgage rates to over 5%, actually, five and a half percent, and the surging in housing prices over the past 15-18 months, which as I already mentioned together has negatively impacted affordability, pushing many households into the rental market. The forward momentum in the housing market has been broken. If you take a look at single-family housing starts or existing home sales, which is the largest piece of the data, or new home sales, they’re all lower so far here in 2022. And it’s not unreasonable to think that the high yield on longer-dated Treasury securities is basically taking place right now. When the yield on the tenure as you mentioned Tom, has got up to around 3.2%, and it’s kind of persisted in trading above 3% here for the past couple of weeks. Further declines in housing activity would confirm for us the longer dated Treasury yields have peaked, which would therefore set the stage for declines in Treasury yields later this year.

Tom Fitzgerald: You had mentioned that they really want to cool the housing market and that’s one of the more esoteric pieces of the CPI report is its owner’s equivalent rent, and it tries to capture that housing expense and it’s so lagged, it took so long for it to start to show increases. And now it is it’s really showing some significant month-over-month increases in that component. And so, I think as the housing market cools, it’s still going to be showing some pretty strong numbers, at least for the next several months and that may fool some people that say, these higher rates aren’t dimming the housing market. When in fact it’s just sort of a way that calculation I think is made, you probably know more about it than I do, but that it seems to really lag what’s going on in the actual market. And so, it may give some false signals when the turn has already happened downward, it’s still showing some pretty strong monthly numbers. So, I just wanted to kind of throw that out there as sort of a caveat to be on the look at for that.

Joe Keating: No, I agree with that, Tom. I think that the high-frequency data to be watching on housing, relative to bond yields is really going to be those monthly reports on single families’ housing starts, the existing home sales, and new home sales, and all of them as I mentioned have cracked here in 2022. Existing home sales are down over 11% since January and new home sales are down also over 11% since the beginning of the year. So, I think that high-frequency data is what we need to keep an eye on.

Tom Fitzgerald: That’s a good point, and I’ve saved the ugliest for last and that is kind of get your thoughts on common stocks. Obviously, we’ve had a very ugly start to the year, April really kind of just was the icing on a cake, I guess. But what do you think in general, and is the worst of the selling behind us or do we still have more to go?

Joe Keating: Well, let me make two comments that hopefully will make folks feel a little bit better. You know, if you’re contributing to a 401k plan either every two weeks or twice a month, like Tom and I are, this is good news, right? You’re getting some money to work at better prices, so that’s good news. The second thing is if you take a look at the average decline in the S and P 500 during a calendar year, if you go back to 1980, the average peak of the trough decline during a year is 14%. If you go back to World War II as a starting point, it’s 13%. That’s right around where we were as of Friday night, we’re down a little bit more here this morning, but so far, we’ve had kind of a typical run-of-the-mill decline in common stock prices compared to the average. The repricing of the financial markets and that’s what’s taking place, it’s a repricing, it continued during April and into the first week of May. and again, here today, as inflation has remained persistently high the federal reserve signaled an even more aggressive tightening and monetary policy, bond yields, and mortgage rates, gross levels, not seen since 2018, as Tom mentioned earlier. Commodity prices searched the levels not seen since 2011 and the major stock market averages gave back all their gains from the second half of March and then so.

Investors are trying to determine the extent to which these concerns will cause the economy and earnings to slow this year, while most definitely keeping their eyes out for any signs of the economy, sliding into recession. We’ve consistently taken the position over the years that the outlook for common stocks always comes down to the outlook for earnings and the outlook for earnings comes down to the outlook for the economy. For common stocks to begin a rebound and they will at some point folks, from the fresh early may low over the coming quarters, earnings must grow during 2022 and the federal reserve needs to avoid making a policy mistake and success successfully bring the economy in on our soft landing. You know, it’s interesting if you go back and look at the data, 80% of the time, one year after the Federal Reserve starts to increase interest rates, and common stock prices are higher. So, as I look at April and so far here in May, it’s clear evidence that the choppy and volatile trading is not completely behind us. Investors continue to face a tremendous amount of uncertainty and that is likely to be evident in the market for the foreseeable future. The expected volatility will require discipline and a focus on longer-term objectives as the resolve of investors will continue to be tested.

We expect the volatility to remain high until the federal reserve makes a dovish policy pivot as I mentioned earlier, possibly as early as later this year, as the economy’s forward momentum slows to a much greater extent than most analysts are anticipating. It would not surprise us if a fairly long period of consolidation was ahead of us as the market has largely priced in the tightening of policy and awaits the dovish policy pivot or as I mentioned previously, possibly a less hawkish policy pivot before stock prices can begin to recover. Now, no one can tell when a bottom will be put in the repricing of risk just needs to run its course, given the decidedly slower rate of growth we expect this year and the federal reserve signaling in an incrementally aggressive tightening a policy here recently, we continue to recommend that investors stay very high quality with their investments. Namely invest in companies with durable revenue streams that can grow their earnings through a meaningful slowdown in the economy. Look for companies that are built to last with high-quality balance sheets, have reasonable valuations and are returning significant amounts of capital to investors in terms of dividends and share purchases. And we need to maintain a longer-term investment horizon and therefore ride out this federal reserve-induced period of volatility.

Tom Fitzgerald: Well, I think that’s advice is good for any type of market and that means it’s probably pretty solid advice. So, Joe, I really appreciate that. One thing, right now, the market’s focused on the inflationary aspect of the higher wages, but I think once that inflationary impulse starts to recede a bit those higher wages lead to higher consumption, which will flow into the earnings of those companies. So, I think as we kind of get through this turbulence right now that we’re probably setting the stage for a really good earnings top for these companies, maybe not this year, but certainly possibly in 23. So, I think the outlook like you say, I think is a long-term positive.

Joe Keating: I agree.

Tom Fitzgerald: Well, Joe, thanks again. I know we’ll be back here in a few months to kind of see how the world has changed in the intervening period. And again, I want to thank you for your thoughts and, and your knowledge, we really do appreciate it, and we hope to have you back real soon.

Joe Keating: Thank you, Tom. I really appreciate the opportunity and everyone out there hang in there, things will get better over time and as I said earlier, the sun will come up tomorrow morning and the mornings after that.