Macro Markets Podcast Episode 51: What's Holding Up Inflation…And Other Macro Themes
Matt Bush, Guggenheim Investments’ U.S. Economist, and Maria Giraldo, Investment Strategist, join the Macro Markets podcast to discuss our newly published Quarterly Macro Themes for 1Q 2024 and provide an update to our baseline views on the economy.
This transcript is computer-generated and may contain inaccuracies.
Jay Diamond: Hi everybody and welcome to Macro Markets with Guggenheim Investments, where we invite leaders from our investment team to offer their analysis of the investment landscape and the economic outlook. I'm Jay Diamond, head of Thought Leadership for Guggenheim Investments, and I'll be hosting today. As we begin the second quarter, recent economic data and a new round of Fedspeak have both the bond market and the stock market reassessing expectations for the future course of monetary policy. The shifting view is causing the yield curve to bear steepen and stocks to hit a wall. Now, while these short-term considerations and market dynamics are important, it is equally important to maintain a focus on longer-term issues as well, which is what we do in our Quarterly Macro Themes, which we are discussing today. Now, our QMT, which can be found on our website at GuggenheimInvestments.com, features research topics that help develop our macro and market outlook. Here to discuss the latest issue of Quarterly Macro Themes are the leaders of our Macroeconomic and Investment Research Group, our US Economist Matt Bush, and Investment Strategist Maria Giraldo. Welcome back, Matt and Maria, and thanks for taking the time to chat with us today.
Matt Bush: Great to be back on.
Maria Giraldo: Always a pleasure, Jay.
Jay Diamond: All right. Well, let's start with the macro outlook. Matt, in this issue of the QMT, it's titled “Downside Risks Are Decreasing, Not Disappearing”. You discuss several factors that have contributed to resilience in the U.S. economy, but recession risks still exist. Please explain what you mean here.
Matt Bush: So, our macro outlook walks through an important shift in the economic and monetary policy cycle, namely that the Fed has now kept interest rates unchanged for the past eight months. The Fed's hiking cycle did lead to a lot of turmoil. We had interest rate sensitive sectors, most notably housing, getting hit pretty hard, we saw stresses in the banking sector, a pullback in credit availability. And in a more typical business cycle, these factors would usually be sufficient to cause a recession, but this cycle has been anything but typical and we highlight a number of forces that help cushion the economy from the impact of rising rates. One of the biggest of those cushions has been the fact that debt service costs have stayed pretty manageable both for households and businesses, because so much borrowing was essentially locked in during the ultra low rate period of 2020 and 2021 We also had an unexpected surge in immigration that helped boost growth and lower inflation last year. And then we had expansive fiscal policy that likely further offset the blow from monetary policy. So, none of these factors are going to last indefinitely, but with the Fed drawing nearer to rate cuts, we're seeing broader financial conditions ease and lending channels become less tight, all of which suggests that the most acute risks from Fed tightening are probably behind us at this point. So that does brighten the economic outlook. But in our view, does it mean risk of an economic downturn has completely gone away as the exuberant market seems to be pricing in currently?. The level of interest rates is still elevated and as time goes on, more debt will need to be rolled over into these higher rates, and we also know historically it's been difficult to sustain low unemployment rates for extended periods of time. There's just fewer available workers to pull into the economy. Now, continued high immigration or accelerating productivity growth could help sustain the cycle, but we still think the market is currently underpriced for a softening economy.
Jay Diamond: Now, your macro outlook is intertwined with the first theme, which is titled “What’s Holding Up Inflation, and Why It Will Fall Further (Even If the Economy Doesn’t)”. So let me just tee you up with those exact questions, Matt. What's holding up inflation?
Matt Bush: Well, first, let me cover what's not holding up inflation, because I think that's important to understand. Most investors and many economic models have the idea that strong economic growth and/or a low unemployment rate should lead to rising inflation, but we've seen over the past year that that hasn't been the case. Inflation has come down from 9 percent to 3 percent, with real GDP growth actually accelerating last year and unemployment staying below 4 percent, which is near historical lows. The reason that this strong economy has been able to coexist with falling inflation is that we've seen a sizable increase in the supply side of the economy. More workers have been added through rising participation rates and high immigration, and those workers are also becoming more productive through strong productivity growth as supply chains are healing and the big reshuffling of jobs during the pandemic has started to settle down. So, as we've seen this dynamic play out, it's led to an important shift from the Fed, where they've gone from explicitly targeting a weaker economy, talking about needing some economic pain to get inflation down as they were at the end of 2022 and beginning of ’23, to now being much less concerned about economic growth and really being solely focused on the inflation data itself. And so, to get back to your question, what's holding up inflation is not necessarily a strong economy, I think it's better to think about it in terms of sectoral contributions and specifically the services sector is where all of the inflation right now is coming from. So, over the last six months, core PCE inflation is up 2.9 percent, about one percentage point of that as housing inflation and all the rest is services outside of housing. Those prices at this point, which were actually a big contributor to inflation in the early stages of this inflation wave, are now actually falling and pulling inflation down, so it's all really a service sector story at this point.
Jay Diamond: So that's what's holding up inflation, why will it fall further?
Matt Bush: We highlight three reasons in the Macro Themes report, starting with the biggest contributor to inflation services outside of the housing market. We expect this category will continue to slow because of a slowdown in wage growth that we've seen. We're seeing cooling labor demand combined with this strong boost to labor supply I talked about helping to balance out the demand for workers and bring the wage growth down, which for most service sector businesses is their biggest input. And because of strong productivity growth, the slowdown in unit labor costs, or wages adjusted for productivity, should lead to a slowdown in prices of these businesses are charging. The second reason inflation should fall further is pretty well known at this point, but it's worth repeating because it's so critical, has to do with housing inflation falling further. The official measures of rental inflation lag what's going on in the market for newly signed leases and that market has cooled a lot and should stay pretty subdued with a lot of multifamily supply coming online this year. So, when we look at a variety of models that we maintain for housing inflation, they continue to show a lot more slowdown in rental growth coming, and that should have a big impact on the inflation numbers since it accounts for 40 percent of the core CPI basket and about 18 percent of core PCE. And then the final reason is that after a pickup during 2021 and 2022, inflation expectations both on the consumer and business side have fallen a lot to much more kind of normal pre-pandemic ranges. And that really helps prevent the risk of self-fulfilling or spiraling inflation if both businesses and consumers expect inflation to stay pretty subdued. So, we do think inflation will cool further from here. On a core PCE basis, which is what the Fed tracks most closely we think we can get down to around 2.4 percent year-over-year in the early second half of this year, close enough for the Fed to be comfortable that inflation is heading back to the 2 percent target and allow them to start cutting rates.
Jay Diamond: Thanks, Matt. That chart on page 5 for housing costs is very powerful. So Matt, how does all of this play into the house view on Fed policy going forward?
Matt Bush: The March Fed meeting increased our confidence that the first Fed rate cut is coming in June. Powell wasn't overly concerned about the January and February inflation prints that came in pretty hot. He was also very clear that strong job growth by itself is not a reason to delay cuts. In fact, he expressed a little bit of concern that there's growing downside risk for the labor market. So, we expect the first cut in June. We expect four total this year, which is more than the three cuts that are in the dot plot, and that's because our economic forecasts differ from the Fed's. We think core inflation, as I said, will come in lower than the 2.6 percent projection and their unemployment projection for the end of the year at 4.0 percent is a pretty low bar to clear. We're at 3.9 percent right now, so we only need a little bit of a softening in the labor market to have a slightly softer labor market than the Fed expects, and so that's how we get the four cut this year. Ultimately, we think the Fed cuts to just above 3 percent in 2025, which is where we think a neutral policy stance is. We saw the Fed mark up their estimate of the neutral rate for the first time since 2018 at the March meeting, up just a little bit to 2.6 percent. We think that probably will drift higher over the course of the next year and settle around 3 percent, which is where we think the Fed ends up.
Jay Diamond: Thank you, Matt. Now, Maria, let's turn to you. You wrote the theme called, “Corporate Default Outlook: A Peak in Sight But Increased Dispersion”. Now, does this mean you're bullish or bearish on credit?
Maria Giraldo: Yeah, so sometime around November of last year, I joined the podcast and outlined my views on credit and described it as cautiously optimistic. So, I would say that that view still holds now. In general, taking a step back, I'm bullish on fixed income because we're past a severe Fed hiking cycle, as Matt just outlined. We're approaching the start of an easing cycle and we think that rates are going to fall a bit more than the market currently anticipates. So, in any case, whether that a rate easing cycle starts in June, December, or sometime in 2025, we’re ultimately going to see rates lower for investors of various horizons. The challenge, though, with credit is that for investors that can choose between a corporate bond allocation and a Treasury bond allocation with the same duration profile like Guggenheim does in several of its accounts and strategies, by some measures, corporate bonds can look pretty rich. Matt also outlined how there's this sort of element of exuberance in pricing across risk assets, so that presents a bit of a downside skew to where credit spreads can go, and credit spreads is how we measure the relative value between corporate bonds and Treasurys. And now those credit spreads are nearing the tights that we saw just before the tech bubble in the late nineties. So, the market is telling us that compensation for credit risk is very low, which means that the market's anticipation of credit default is also either very low or is very concentrated to only a select few, and maybe that's already priced in. There's a variety of different signals we might be getting from very tight credit spreads. At a high level, I would say that the corporate fundamentals do justify the view that in aggregate the credit market is going to be okay. So, what we highlight in our piece is that our top-down default rate model is signaling that the credit default rate could peak later this year as credit conditions are easing, markets are reopening. And this is really more of a macro model because it takes inputs related to bank lending and corporate fundamentals, again, at a very high level. So, it's really more than anything signaling whether conditions are such that would support the view of high or low default rates, or default rates increasing or decreasing. But the nuance that I highlight in the piece is that that's not a conclusion you want to make across the board in credit without having some level of differentiation in credit risk, because small companies have been more impacted by rate hikes. And we can see that in the ratio between interest expense and earnings, which has gone up for small companies. So that means that more and more of their cash flow is going to just servicing ongoing interest expense on that debt. So, I guess going back to your question, to answer it, we are bullish on credit, but you still have to pick your spots so that as an investor you don't jeopardize the very narrow compensation you're getting for credit risk right now relative to say if you just bought a Treasury security.
Jay Diamond: Maria, in the third theme in the Quarterly Macro Themes, titled “Rising Commercial Real Estate-Related Stress in Banks’ Loan Books”, you address the elephant in the room--the long-term elephant in the room--for credit markets and the economy, commercial real estate. It sounds like you think that the situation is poised to get worse and not better. Why is that?
Maria Giraldo: There's definitely a lot still to unpack in commercial real estate. I've heard podcasts spend an entire hour just on the topic, and of course, you had Jenny Marler, too, who heads up our commercial real estate sector group here at Guggenheim spend time with you discussing our outlook. And for the benefit of new listeners, potentially, and to be more specific, I think it's generally acknowledged that the real issue is the office market. So, we think that's going to get worse because the problem is that commercial real estate owners, developers and their lenders, they're just trying to delay as long as possible the realization of where prices really are now. Last year, from what we can tell in the commercial mortgage-backed securities market, where there is a little bit better transparency and monitoring of these metrics, what we saw is that about 30 percent of what was scheduled to mature actually paid off, then the balance of that that remained either defaulted or the maturity was just pushed off. Right? It was just extended. So that's really not a really great payback rate of scheduled maturities for 2023. But traditionally, at least over the past 15 years, the credit market in general has gotten used to refinancing loans at maturity, and that's not just in the commercial real estate market, but it's true of like the high yield corporate bond market or the institutional bank loan market. Actually, especially in the bank loan market, we'll typically see an issuer in the in the syndicated space before the loan actually comes due, and they're issuing a new loan to repay one that they had outstanding that might be coming due six months from now. It's just a general practice of kicking the can down the road that has existed for at least, again, 15 years, basically, since rates have been so low. So now if a commercial real estate borrower wants to or needs to do that because they don't have the means to repay the loan, they'd have to revalue the property so that the lender can evaluate these credit ratios that they typically use to assess credit risk, and a big one that's often mentioned is the loan-to-value, right?. These metrics will drive what the appropriate rate should be, but then also as a lender, they have to categorize these loans by their credit risk. Even more so, if you're a bank, you have to model out lifetime credit loss estimates to hold capital in reserves for those estimated losses. And that's what I cover a bit more in-depth in the piece, because it looks like the banks, the smaller banks, they're kind of dragging their feet in reserving appropriate losses relative to what we expect are going to occur in this cycle. And so why are they delaying the realization of property values? Because this is going to be a very big revaluation down in where property prices actually are, and more recently, what we're seeing is properties getting sold for about 40, 50 percent of their 2019 sales price. I'm actually starting to see more and more indications that buildings are starting to sell just for land value. So that's going to be a bit painful for a borrower and the lender. And there's a bit of an incentive on both sides to just wait and see if maybe the Fed cutting interest rates could help ease some of the pressure that's plaguing the commercial real estate market, maybe take some of that pressure off. I think as we continue to hit a maturity wall in the office space, eventually the banks are just not going to be able to keep extending these loans further. The buck's got to stop somewhere, and that's what makes it so difficult to predict with any timing precision, because there's a very big human element to what's happening in the market. But we just don't see catalysts to reverse the secular trends in the office space. We're not really seeing any improvement in occupancy rates or other statistics that track the trend of working from home. It just seems the push to return to office has sort of stabilized now over the last several months around kind of the metrics where they are. It's interesting. I'm not totally sure there's a lot of disagreement about the trends in office getting worse. I think where there's probably more disagreement about is in the implications to the economy. Some people think it's going to be pretty dire spillovers, but I don't think that's necessarily how we're thinking about it. For us, the key area is really that the CRE pain could transmit to the economy to some extent through the banking system because small banks are a large lender to commercial real estate. And for some bank groups like the $300 million to $100 billion in assets, CRE can represent a third of their loan books. So, for some pockets in the economy, this is going to likely cut off lending. And that's where, you know, we're starting to see more and more dispersion throughout the economy.
Jay Diamond: Refusing to reserve now is kind of like refusing to face the music before it happens.
Maria Giraldo: Yeah. And that never ends well, does it?
Jay Diamond: Exactly. So, Matt, if there's another elephant in the room or shoe to fall, it is the government debt burden, which you address in our final theme, “Fiscal Policy: Near-Term Headwind, Long-Term Calamity”. So how do you expect this to play out?
Matt Bush: So as the title of the section says, we're really highlighting to cut two distinct themes here. One is very short term and cyclical, really just pointing out that 2023 saw a huge expansion of the fiscal deficit that helped provide some stimulus to the economy. Depending on how you measure it, either a large stimulus or a modest stimulus, but it definitely was a factor behind outperforming economic growth last year. The fiscal deficit will remain large in 2024, but what matters for economic growth is the change in the deficit. And so it's set to get smaller in 2024, which is one reason why we expect overall economic growth will slow this year. So that's kind of the short term, more cyclical growth picture. The bigger picture theme is the unsustainable nature of these deficits. Even with the deficit decreasing this year, it's still expected to be over 5 percent of GDP. Historically, these kinds of deficits were only seen in the aftermath of severe recessions when tax revenues were hit hard, and government stimulus programs were underway. So, to see this in an economy growing 3 percent with unemployment below 4 percent is just totally unprecedented. And we could get away with these deficits when interest rates were ultra-low, but with the likelihood that rates are not returning to what we saw in the last cycle, these deficits do put us on a concerning and unsustainable path. The Congressional Budget Office forecasts federal debt relative to GDP will rise from about 97 percent currently to 116 percent in 2034, the highest we've ever had as a country. And to put that into context, debt to GDP was just 35 percent in 2007, and furthermore, these numbers from the CBO are probably optimistic. They assume things like the 2017 tax cuts will expire at the end of 2025. In reality, both parties are in favor for at least partially extending those, which could add trillions more to deficits over the next 10 to 15 years. So, we're not predicting or even particularly worried about any kind of imminent fiscal crisis, but what we're saying is that, after years of warnings about fiscal policy being unsustainable, we are getting closer and closer to having it actually matter from a market perspective. And so to us, that means upward pressure on interest rates that could lead to Treasury yields falling less than typical when the Fed cuts rates. So, we're not saying fiscal policy means rates are immediately headed higher. It just means that there's this kind of structural pressure pushing up interest rates and leading them to decline less than they would when the Fed does start cutting. It also means that sometime probably in the next few years, there's going to need to be difficult fiscal consolidation choices that have to be made to get deficits on a more sustainable path, whether that's raising revenues through taxes, cutting spending programs--the result is going to have to be some fiscal belt tightening, and that's going to be a headwind for the economy.
Jay Diamond: Fiscal belt tightening doesn't sound like a calamity, though. What makes it a calamity?
Matt Bush: The calamity is if we don't make that belt tightening. And so, the reason it's not a massive concern for us is because there are realistic choices to address the problem. This is purely a policy driven problem. It's not completely out of our hands or politicians’ hands. So, we just need the political will to address it. So, it probably will take some forcing event from the market, something akin to the selloff in Treasurys we saw last October, for example. But ultimately, it's a problem that can be addressed, we just again, need that political will to do it. So, the calamity is really if we don't address it, but we don't think we'll ultimately get to that point, because after all our choices are exhausted, politicians will choose to do the right thing.
Jay Diamond: We need the vigilantes to come back.
Matt Bush: Exactly.
Jay Diamond: Well, guys, thank you so much for walking us through the Quarterly Macro Themes, which I encourage all of our listeners to check out on our website. Before I let you go, is there any final message or takeaway that you'd like to leave with our listeners?
Maria Giraldo: I would just say we hope that this podcast and our publication have helped answer some of the questions that we have been getting a lot from our clients and prospects and that are really top of mind for investors. So just a quick thank you to all the listeners, and we welcome additional thoughts and feedback and questions through you, Jay.
Jay Diamond: Of course. And again, thank you, Matt and Maria for your time. Please come back and visit with us soon.
Matt Bush: Thanks, Jay.
Jay Diamond: And thanks to all of you who have joined us for our podcast. If you like what you are hearing, please rate us five stars. If you have any questions for Matt, Maria, or any of our other podcast guests, please send them to macromarkets@GuggenheimInvestments.com and we will do our best to answer them on a future episode or offline. I'm Jay Diamond. We look forward to gathering again for the next episode of Macro Markets with Guggenheim Investments. In the meantime, for more of our thought leadership, including Quarterly Macro Themes visit GuggenheimInvestments.com/perspectives. So long.
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