This week we’ve got Joe Keating back on the show to discuss what might be next for the economy.

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: Well, hey everybody, and welcome back to the Community Bank podcast. I’m Caleb Stevens. Thanks for joining the conversation today, we are talking all about the economy on this episode, Tom Fitzgerald, our director of strategy and research here at the correspondent division, sat down with Joe Keating, who is the co-Chief Investment Officer of NBC Securities in Birmingham, Alabama. Joe is a regular on the show. If you’ve listened to this podcast for any length of time, you’ve probably heard Joe’s voice. He is a wealth of knowledge, he follows the economy very closely, and we like to have him on the show pretty regularly just to get his take on where things are headed in terms of the fed rate hikes, what it means for community banks, what it means for the economy in general. And so, we hope you’ll enjoy this discussion with Tom Fitzgerald and Joe Keating. Thanks for joining us.

Tom Fitzgerald: Well, Joe, it’s great to have you back again. I think it was back in August that you were here, and as usual, a lifetime goes by in these quarterly meetings that we have. But I think our audience certainly wants to hear the latest that you have to say on what’s been happening and what may happen in the near future. But again, welcome back to the program.

Joe Keating: Thanks, Tom. Glad to be here.

Tom Fitzgerald: Well, let’s just get right into it because like I say, we could talk forever on this stuff with the way things are rolling right now. But it certainly has been a turbulent time since we last got together. Like I said, back in August, if we can remember back in June when we hit lows in the stock market and in bonds as well, we had a nice little rally right from the end of June into July. And then that has been completely reversed, in both the stocks and the bonds, and the Federal Reserve has turned incrementally hawkish, and I would say they’ve continued that hawkish stand even more. So, in the last September meeting, the inflation data has been decidedly mixed. The topic of Azure right now remains if the economy goes into recession. And if so, how severe will that recession be? So, let’s kind of start off with that question, Joe. What is your assessment of the Federal Reserve and there more hawkish stance of monetary policy that we’ve seen over the last couple of months?

Joe Keating: Well, from a historical perspective, Tom, the Federal Reserve is acting very aggressively, giving us back at the September 2021 FMC meeting, the third 75 basis point hike getting the range for the fund’s rate up to three to three and a quarter. You’d have to say that the message from the FMC meeting could be summarized as higher for longer for interest rates. The fund’s rate is expected to end the year according to the dot plot at 4.4%, compared to the dot plot saying 3.4% in June, and that’s materially above the central bank’s expected longer run average for the fund’s rate of two and a half percent by moving aggressively since the June 1415 meeting, the Federal Reserve has likely taken interest rates above the so-called neutral rate, that rate which neither stimulates nor restrains the economies forward momentum.

Mr. Powell said the Federal Reserve was making policy, quote-unquote, purposely restrictive. I think that the key is that the policy makers at the Fed are likely viewing the increase in the core consumer price index in August as evidence that the tight labor market and housing shortages, rather than pandemic-related problems are currently driving inflation pressures in the economy. So, the Federal Reserve will want to see clear evidence that the jobs market has weakened home housing prices are falling and rents are stabilizing before letting up. So, what the Fed is telling us they’re likely to do is another 75 basis points at the November 12FOMC meeting, followed by a 50-basis point hike at the December 13,14 meeting, which would bring the target for the federal funds rate to four and a quarter to four and a half.

The Central Bank expects a single 25 basis point hike in 2023, likely at the Jan 31 February 1FOMC meeting. It clearly appears the Federal Reserve is tightening policy at a historically rapid clip to get ahead of the inflation curve and appears to have lost its patients waiting for inflation to subside and the labor market to slow. After the meeting concluding on February one, the initial effects of the cumulative policy adjustments should be quite evident, and it appears officials that the Fed are pointing at to that meeting as a time to finally pause and assess the impact of the tightening put in place to that point. In our view, a flat-out stall in the economy in the months ahead is almost a lock at this point. As policies on track to become quite restrictive, while the risk of a shortened mild recession has increased consistent with the higher for longer theme, the Central Bank does not expect to start using policy until 2024.

Tom Fitzgerald: And it’s interesting like you said, you go back to July and we had that nice rally in the stock market, and bonds rallied, and the Fed really didn’t want that to happen. They want financial conditions to tighten. And so, they came, like you said they came out with some ish rhetoric at the time, basically saying, you’re not understanding our message. We’re going to be continuing to hike, we’re not going to be pivoting to any kind of a dovish posture anytime soon, and the market took that message and then ran stocks down and bond yields up into the end of the quarter. It’s funny, as we record this, we’re into the second day of a huge rally in stocks and in bonds as well as there’s getting, we had the credit sweet kind of something going on there.

And then you had the Royal Bank of Australia raising rates only 25 when 50 was expected. And so, that you’re starting to get the traders again thinking, oh, there’s going to be a dovish pivot soon, and I don’t think so, and I think you feel the same that, and the Fed’s probably not looking on this huge stock rally with a kind eye and it, we may see the rhetoric kind of ramp up again given what the market is doing right now. Do you see that as a possibility?

Joe Keating: Well, I tend to agree with you, Tom, I don’t see a pivot to an easier policy anytime soon. I think a pause is, is likely, somewhere when the fund’s rate is north of 4%. So, could it be after the December meeting possibly maybe out into the first quarter of 2023, and that is all going to be data-dependent in terms of both in terms of growth and inflation? And as you mentioned whether or not something breaks that’s always the concern when the Fed is when any central bank, but in this case, the Fed is raising rates that there’s some kind of dislocation in the financial markets and something breaks, and that’ll bring the tightening cycle to a halt sooner than anything.

Tom Fitzgerald: And certainly, credit suis could just be a one-off, and that would be one thing if it became more of a systemic issue, which we don’t see at this time. But the Fed, like you said, the Fed would get a lot more concerned about that kind of issue. But Europe is a lot weaker than the US economically. Australia is, depends a lot on exports. And so, it’s a lot weaker. And so, I can understand some of the moves that they are making and you even had the UN come in and kind of weigh in on the Fed to kind of back off, but what the Fed is seeing is like you said, a still very strong labor market. We’ve got inflation that remains stubborn to come down, and I think they’re going to continue to… they told us they’re going to get to 450, 475, and I think that’s going to be a minimum level that they get to with the numbers that we’re seeing today.

And let’s talk about that. Obviously, inflation is job number one for the Fed, and they want those numbers to come back down closer to 2%. What is your outlook, Joe, for inflation? And are we going to be seeing some relief here in the near future?

Joe Keating: Well, I think we’re going to see some relief, but clearly, its inflationary pressures are stubborn, let’s use that term at the moment, particularly on the rent side, and rent’s going to lag in the stated indices for a while in terms of remaining high. So, that’s going to take a further decline in the housing market and in rents in order to pull that piece of inflation down. There are four drivers of inflation currently, and the Federal Reserve can only impact two of them. First commodities are largely out of the control, the Federal Reserve is energy, lumber, agricultural, industrial commodity prices soared earlier in the year following Russia’s invasion of Ukraine and the housing market coming to a peak. But they have fallen sharply over the past six months. And that’s good news.

The disruption to supply chains also boosted prices over the past year. But a silver lining of the global slowdown is that supply chains are unclogging quickly. Another article today in the Wall Street Journal about the auto industry, shipping costs and delivery times are declining lightly, likely helped by the rapidly falling orders, which helps clear backlogs and close the gap between supply and demand. The two drivers of inflation that the Federal Reserve can impact are the strong jobs market and keeping inflation expectations under control. The central bank is raising rates to cool demand in the economy, which we’ll eventually soften the jobs market. And maybe we saw the first inkling of that this morning with a 1.1 million drop in job openings, in August compared to July, which was reported. Their tightening will eventually soften the jobs market.

What’s unknown is how high-interest rates must rise to lower wage demands. The Federal Reserve has been very successful, however, in controlling inflation expectations as seen in both survey and market-based measures. You’ve probably been following this time, but it’s pretty remarkable. The two-year inflation expectation embedded in treasury securities has fallen from just under 5% in March to under 2% today. So, despite the gloomy, the gloom is currently in the financial markets. So, I wrote that on Friday, little brighter Monday and Tuesday this week, but as of last Friday, it was pretty gloomy. Not all hope for low inflation is lost as September inflation data might well show that some elements have pushed inflation higher in August, such as prices for household furnishings and personal care products were quirks. It really didn’t make any sense that those two categories were up in August.

Moreover, recent downward pressure on some prices could become more pronounced. Gasoline prices continue to drop, and given the decline in gasoline futures, prices seen poised to go lower wholesale used car prices continue to ease pointing to price declines on dealer lots coming. Meanwhile, excess inventories are leading several major retailers to cut prices, and retailers in general are putting more items on sale as demand weakens. The issues are how soon and to what extent will pricing pressures fall, aside from the impact of rents on core inflation that I already mentioned. We look for a broad-based easing and if inflationary pressures to develop over the next three to six months. Finally, significant declines in medium and long-term inflation expectations from both survey and market-based measures have fallen over the past six months, along with what’s happened at the two-year expectation. Consider that five-year inflation expectations in the treasury market have fallen at 2.16% from 3.59 in March, while 10-year inflation expectations have declined to 2.15% from a little bit over 3%. So, those declines in market expectations for inflation are pretty remarkable, and they’ve happened in such a relatively short period of time. And they do, I think poor tend of a real pullback in the inflationary pressures, in the next three to six months.

Tom Fitzgerald: And it’s interesting, as we were talking kind of off record, I did a presentation last week and I was showing a number of slides, like you talked about, of wholesale, different wholesale pricing of lumber, of used cars, of wheat, the list just kind of went on and on. And like you said, this has just been a huge decrease in the pricing of those since kind of mid-march to June. But it’s funny, I looked at one I looked at this it’s Manheim used car index, and basically, I think they track auctions of used cars and it had declined, significantly. But when you look at the CPI component of used cars, it had barely budged lower. So, and you kind of see that over and over again to where wholesale prices have dropped tremendously in a number of categories, but it’s not really flowing through yet into the CPI numbers that the, I don’t know if the retailers that finally had pricing power, and they don’t want to give it up.

And so, they’re hanging on to those higher prices as long as they can. But I think like you were saying, inevitably that demand will drop off to the point where they will have to kind of cut prices. It just, I think we’re still in for a few months of kind of sticky core CPI numbers, but probably at the end of the year, turn of the year, first part of next year. We could see some decent, decent size drops in that, and I just wanted to ask you too, you talked about owner’s equivalent rent, which is about 40%, I think, of the core index, which obviously, right, I mean, it’s a huge player in that index, and like you said, it notably lags what’s going on in the housing market. Obviously, the Fed knows this too, so I would think, or I would hope when they see that that maybe is the only thing really propping up the core CPI numbers, um, that they don’t keep dialing in rate hikes and rate hikes beyond what is necessary given that lagging feature of the ore. Do you think they would operate that way or just as long as that number is what the number is, they’re going to keep layering in rate hikes?

Joe Keating: Well, I think you raised a really good point, Tom, and you might recall back about six, seven years ago when oil prices collapsed, everyone started talking about corporate earnings X, the energy sector. So, I wouldn’t, not at all be surprised if we start seeing fed officials and other folks be, begin to talk about core CPI, X rents be because the deal there is that you’ve got contracts in place, with rent escalators that are just going to be moving upward for some period of time, even though the new rent market, new rentals could be soft. So, one thing that we know about the Fed is that it is somewhat a political animal.

We hope it’s not a major league political animal, but it is to some extent, and the heat that they’re going to take from continuing to raise rates, particularly as they are no longer self-funding. They’re paying out more in interest on reserves, and then their bond portfolio is earning them, and folks like Elizabeth Warren will be all over this. So, at some point, they’re going to have to acknowledge reality when the real-time pricing pressures are easing. But the indices, given the way that they are… the inflation indices given the way that they are constructed are lagging behind, and I think this will be something that you appropriately bring up Tom, and will be talked about in coming months.

Tom Fitzgerald: And let’s talk about that next subject because as obviously, they raise rates, the higher end they go, the question of can the economy stand it without falling into a recession? So, how do you see the next couple of quarters playing out that is? Do you see a recession on the horizon? And if so, is it the short and mild variety or more of a deep and prolonged version?

Joe Keating: Not deep and prolonged by any stretch of the imagination? Tom? So, the way that I described the for the economy recently is a flat-out stall in the economy in the months ahead is almost a lock at this point, as a policy is on track to become quite restrictive as the Federal Reserve continues to ratchet up the tightening of policy, and let’s define that restrictiveness, I mean, if the Fed does get the funds rate, the range target range of funds rate up over 4%, and those inflation expectations are running around 2%, despite what whatever inflation number gets reported, there is your restrictive policy stance that the Fed is, is going towards. So, if I had to write down for the next starting in the fourth quarter and through 2023, a forecast for real GDP growth, I would put down numbers that are between 1% and minus 1%, uh, for the next five quarters.

And accordingly, therefore, the risk of a shortened mild recession has increased. The higher prices, negative real wage growth, and higher interest rates are taking the wind out of the sales of the economy, within consumer spending. The shift in household outlays from goods to services continues, and we talked about that back in August, following good outlays, following in both the first and second quarters of the year, and services growing. We saw spending on goods fall again in August following a drop in July, whereas outlays for services were up a very healthy pace in August and up slightly in July. So, consumer spending on services plus business capital spending on equipment, and outlays for intellectual property like software research and development, entertainment literacy, and artistic originals will be the strongest sectors of the economy through 2023.

The dramatic drop in housing affordability has brought about a market deterioration in the housing market, and we talked about this back in August, that the bond market is making sure that the housing market endures an extended contraction with housing prices giving back a good portion of the more than 40% rise in home prices since January 2020, as new home sales are almost 34% below their 2020 peak. Existing home sales are about 20% lower year on year, and single-family housing starts are 23% lower over the past six months with mortgage rates approaching 7% look for housing starts to drop from about one and a half million currently, and this number was 1.7 million in the first quarter to less than one and a quarter million through 2023. This weakness will spread to all housing-related expenditures, which are extensive, and the rise in borrowing costs will lower outlays for consumer durable goods and business capital spending on structures.

So, there’s going to be a real dichotomy in the economy with certain sectors faring, okay, a slight positive growth, but other sectors really having a tough time like housing. And that’s why I say when you put it all together, I think starting in the fourth quarter through most of 2023, just look for numbers between 1% and minus 1% growth. And therefore, depending on how they actually fall out we could see a mild and short recession, but like I said, I think the best characterization or character characterization of the economy is just a flat-out stall.

Tom Fitzgerald: And it’s always people like to harken back to the great financial crisis and to me that was a balance sheet recession where people just lost huge amount of wealth from the decline in their home prices, the decline in their 401ks, and that takes years to rebuild, like which slowed the recovery at that point. This is a rate driven, if it does become a recession, a rate driven one where the fed just raised rates until it killed off demand. And the way to bring that back, I guess, is the lower rates and then the demand should kind of spring back a lot quicker than what we saw, coming out of the financial crisis. Do you kind of share those thoughts?

Joe Keating: I do. Absolutely Tom, but it’s going to be off more than a year before we get the housing market to recover.

Tom Fitzgerald: And it’s funny, as you were talking about the housing market and the higher mortgage rates, and you think about those first-time buyers that are struggling to try to get the qualified for a mortgage, and then they’re basically being priced out of the market and staying in the rental market, which keeps that rent component again elevated. So, it’s almost like the Fed is working almost across purposes. That’s kind of the nature of what they’re dealing with here. But again, it’s another reason why, like you said, I would like that idea of kind of looking at that core rate X the rent component because it could be sending off false signals or just incorrect signals when the Fed is kind of getting near that terminal rate.

Joe Keating: Yes, I agree. Yeah.

Tom Fitzgerald: Let’s move to just the market itself. I mean, there’s just the massive backup that we had in treasury yields during September, and everybody’s looking at those unrealized as losses on their portfolios. The inversion of the treasury curve, the two 10 inversions got pretty significant in the last couple weeks. Just give us some of your thoughts about the, I guess the treasury market in general, and kind of where you see it going.

Joe Keating: Yeah, well let’s start with what you already mentioned, Tom the yields backed up quite markedly from the low on August, or excuse me, on to the end of July. Because we saw the yield on the tenure fall from 348 on June 14 to 265 and the yield on the two-year fall from 343 to 288, and of course, during that time, we had the more than 17% gain in the s and p 500 from June 16 to August 16. And boy, those things changed quickly when Jerome Powell rebuked the market for its summer Dalliance of looming policy pivot in his Jackson Hole address and emphasize that the Federal Reserve must continue raising interest rates and hold them at a higher level until it is confident inflation is under control, even if unemployment rises.

And then you lay on top of that the August CPI report in the most recent FOMC meeting in September, and the backup in treasury yield has been significant with the two-year ending September. So, last Friday at 4.28%, I think this morning we’re at just over four, maybe 4.05. So, we’re actually down 23 basis points this week after having risen 140 basis points. Similarly, with the 10 years, we went from the 265, at the end of July up to 383 at the end of September. Now, we’re down 25 basis points this week. So, as you mentioned, the curve remains inverted at about 47, basis points. So, we think the message from the continued inversion of the treasury yield curve and the sharp rise in treasury yields is that the economy, and I’ll say it again, is likely to stall over the next couple of quarters and the risk of a mild recession has increased.

We do not see the 45 basis-pointed version as forecasting a deep and prolonged recession as the yield curve has not inverted to a significant degree, nor has it been inverted for an extended period of time. 10-year treasury yields, I think, will trade between three and a half and 4% for the next couple quarters as the Federal Reserve is now shrinking its bond portfolio by 95 billion each month, and we look for longer data, treasury yields to decline towards 3% next year as inflation moderates in the economy’s growth rate, as I’ll say it again, essentially stalls. The yield on 2-year treasuries will fall later in 2023 in anticipation of the Federal Reserve moving to lower rates, possibly by late 2023.

Tom Fitzgerald: Let’s finish up then with the… we talked about the bonds and yields and let’s look at that other big market that’s out there, the stock market and it had its troubles, it broke below the June 16th lows last month, which I think we all thought at the time would be the low for the cycle, but there was that it did break below that. Do you see more downside ahead or have we probably touched the lows for this cycle?

Joe Keating: Well, it’s a dangerous thing to try to forecast on, but I think we probably saw the lows at the end of September. If we have not, it will be due to earnings. And particularly as we get the third quarter earnings reports. If they dramatically disappoint, and if there’s some real downward pressure on guidance that could bring about a lowering of stock prices. But I think some weakness in earnings is already discounted in the market. September certainly lived up to its reputation as the worst month of the year for returns in the stock market. I mean, it was brutal. The major market measures were down 8.8% to 10.5%, and for on the year, the major market measures are lower by 20.9% to 32.4%.

So, as the Federal Reserve has transitioned here from a very easy monetary posture to an incrementally tougher inflation fighting restrictive monetary policy stance, the markets had to reset, and the reset has four distinct stages. First is the rise in the treasury yields, which takes all fixed yields higher, including a doubling of the mortgage rate since late 2021. Following the rise in treasury yields, a market compression of multiples on com stocks has occurred with the price-to-forward earnings ratio on the S&P 500, falling at least of last Friday, the 15.2 times, which is below where it was back in mid-June at 15.9 and materially below the 21.4 times at the beginning of the year. Third is a downward adjustment to expect earnings growth to reflect the slower pace of growth this year and the 2023, and basically, analysts at standard pos are looking for no growth in earnings over the four quarters of 2022. Now, as opposed to a 9% growth rate at the beginning of the year.

The fourth stage is the outlook for the economy and has already stated the odds of falling into a mile recession have increased, as the Fed continues to ratchet up a tightening of policy. But I think the better way to think about it is that we’re just going to see the economy flat-out stall with some sectors being hurt and other sectors growing, at a modest pace. It appears a lot of bad news is currently discounted in the market similar to the at the previous low on June 16, stocks appear to be oversold and I guess given what’s happened Monday and Tuesday of this week. They were oversold last week and at some point, investors will begin to anticipate the end of the current rate hiking cycle. Make no mistake, and you’ve already said this, Tom, this is a central bank-driven market.

We look for stock prices, however, to be higher a year from now as inflationary pressures ebb and the economy starts a full-on recession, the repricing of risk has given investors in a point. So, everyone with their 401k will live through. But I got some money to work at a much better pace or rate for there to be any rebound in stock prices before year-end. Investors will need to turn their attention to the longer-term benefits of what the Fed is doing by attacking the nation’s inflation problem rather than the short-term pain of tightening monetary policy. We all know that there’s nothing more detrimental to the efficient function of the economy and the financial markets than runaway inflation. The market should eventually cheer the longer-term benefits, but in the near term that cheering cannot commence until definitive signs that the inflation is on a downward trajectory and the labor market is slowing become patently obvious.

Tom Fitzgerald: Well, Joe, I want to thank you for all that insight and I hope we can get back together before the year-end so we can kind of take one more look at what has transpired in 22 and more importantly, probably look ahead, hopefully to a better 23. I know you’ve mentioned it’s more of a flattish kind of market looking ahead, but hopefully, like you said, as we get to the closer to that point where we see the Fed is done hiking and getting closer to an easing cycle, I think that would. Obviously, cheer the markets, both the fixed income and stocks for sure. So, Joe, I’m going to thank you again for coming, and let’s get together in December and talk about all this one more time.

Joe Keating: Thanks, Tom. I look forward to it. You take care.


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