Vito Sperduto
Hello and welcome to Strategic Alternatives, the RBC podcast where we cover new ways to raise capital, drive growth, and create value in an ever-changing world. With insights and outlooks from the RBC Capital Markets team. I'm Vito Sperduto, Global Head of Mergers and Acquisitions. And as always, I'm joined by Larry Grafstein, Deputy Chair of Global Investment Banking. Hey, Larry.
Larry Grafstein
Great to be here. As always, Vito
Vito Sperduto
Vito Sperduto as we head into the end of the year and look forward to 2024. We'll be releasing four very special episodes of strategic Alternatives, which will focus on the macroeconomic outlook in key regions across the globe. Today we're joined by our U.S economist, Michael Reid and Blake Gwinn RBC's, Head of U.S Rates Strategy. Gentlemen, welcome to the podcast.
Michael Reid
Hi Vito. Thanks for having us.
Blake Gwinn
Yeah, thanks for having us.
Vito Sperduto
Well, we're excited to dive in to hear your perspectives, especially as we think about the impacts on the U.S economy in the year ahead. So let's dive in. I think first and foremost, everybody's talking about a soft landing, which Michael, as we've talked about, it hasn't been the case throughout the year. In fact, if you go back to the beginning of 2023, as you've always talked about, that wasn't the expectation, but certainly now that's what folks are dialing into based on where monetary policy has taken us and really as, what we're seeing the consumer behavior right now and across all the metrics that you track. So year to date, the U.S economy is holding up better than expected, as we'll talk about. And estimates of economic growth have been bumped up to better than 5% coming out of the third quarter. But the consumer headwinds are starting to become apparent and we'll see if they cause issue with regards to achieving a soft landing. So with all that in mind, how do you think about it? Are we actually going to hit a soft landing and what's that going to look like?
- 01:56 Is a soft landing achievable?
Michael Reid
Yeah, that's a great question. Vito and certainly a soft landing is achievable and the Fed can help deliver that. If you look at inflation data that's on the right track. But a good place to look, as you mentioned, is Q3 growth and what we saw there is recently an upward revision to headline growth to 5.2%, but on consumer spending that was a revised lower. That's really a result of some of the mounting headwinds that we expect to see leading to slower growth as well as weakening in the labor market. Certainly though we would stop short of calling for a recession in 2024. Overall, we see the risks around our 2024 GDP forecast skewed to the downside. While in contrast, some geopolitical conflicts and higher energy prices could tip the balance of risks around our inflation forecast to the upside. But really for the inflation front, one thing that is worth noting is there's a long runway for housing prices. In particular, the owner's equivalent of rent to push inflation lower over the course of 2024. And in fact, if you look at home prices, while those are continuing to tick up, OER lags existing home price sales by about twenty-two months. So we still have quite a runway ahead for prices to move lower in the eyes of CPI.
- 03:13 Consumer sentiment
Larry Grafstein
So Michael, just on that interesting point, how are you thinking about inflation psychology embedding itself? Because even though inflation is on the right track, it feels like the Fed is working to control it. The longer it's out there, the more there's a risk that expectations get embedded. What are you seeing now and when you look forward to 2024, what are going to be some of the key things you're watching in terms of how the consumer is reacting to the Fed?
Michael Reid
Sure, great question. And if you look at some of the inflation expectation data, a lot of it revolves around the changes to prices for gasoline and food. Certainly the pace of growth for real incomes is slowing. So that's going to weigh further on the consumer here. Add to this some of the growing burden elsewhere, whether you look at durable, large-ticket items that tend to use consumer debt at the rates in which we have now, a lot of those purchases are becoming untenable. And on top of that, the existing debt load, whether it be from consumer credit card debt, auto loans, personal loans, is certainly weighing on the consumer as in the form of non-mortgage personal interest payments. So right now, non-mortgage personal interest payments are at 2.8% of disposable personal income while the savings rate has fallen to 3.8%.
Larry Grafstein
Thank you. That's very interesting and obviously something that feeds into general economic confidence.
- 04:44 Consumer confidence and labor market overview
Vito Sperduto
Building upon that confidence point, Michael, how do we balance that with the consumer?
Michael Reid
So I think what we're seeing right now is kind of a divergence in confidence. On the one hand, as you mentioned, confidence is being hurt by higher prices, but on the other hand, the labor market is in a great place. We have the unemployment rate at an all time low, still quite a high level of job openings, and still through the end of 2023 here, we expect payrolls to continue to rise on the labor market front. While we do expect some weakening heading into 2024, we're not looking for job losses to materialize certainly here by the end of the year.
Larry Grafstein
What are the biggest risks you're worried about, Michael? Obviously things that are beyond maybe the Fed's control. What are the things that can at least foreseeably affect your outlook?
Michael Reid
Yeah, great question and one thing we've been watching quite closely is the consumer and household debt report from the New York Fed as well as non-business bankruptcies. Just recently we saw the household and consumer debt report come out that showed credit card delinquencies are on the rise. And mind you, this is reporting data through quarter three. So this is not yet capture the impact from federal student loans resuming. And in particular, I want to highlight a group there, the 30 to 39-year-old age cohort, which happens to have one of the highest shares of federal student loan debt burden. So already we're starting to see some consumer stress before even adding on that additional debt. On top of that, we're also starting to see those non-business bankruptcies tick up. So it's just a sign that while certainly households are in good financial shape coming out of Covid, the cracks are starting to show.
- 06:32 Impact of AI on job market
Vito Sperduto
But just as we think about the labor market, a topic that a lot of people obviously are injecting into every aspect of all the conversations we have is generative AI. Is it actually starting to impact job loss in terms of jobs that are now not necessary because of that? Or is it more just of a psychological impact in terms of the consumer?
Michael Reid
As what we're seeing in the data, I would say it's more of a psychological impact at this stage. If you look at payroll numbers, whether it be in the tech sector or occupational sector, for those folks who are employed, say as software engineers outside of the tech sector, we're not really seeing strong growth. Add to this, if you look at the investment side of GDP, we're not really seeing strength in the intellectual property component there. So that's really where you would expect to see notable strength if indeed the AI was having some sort of impact that would be measurable in terms of our national accounts.
Vito Sperduto
Yeah, no agree. I think this is all much more psychological at this point, even though it's been less than a year since chat GPT even came out at this point. It's amazing how much of the headlines it occupies.
- 7:52 Political trends and fiscal spending dynamics
Larry Grafstein
So let me ask about a perennial question. Politics and the impact of presidential and congressional elections in 224, as well as geopolitics. Talk to o us a little bit about how the domestic political dynamics that we're seeing could affect the overall economic outlook from your perspective next year.
Michael Reid
Sure, , I think you have a few things going on. First, it's just worth highlighting that there are some fiscal programs that have had a notable impact in 2023, and that's in the form of the CHIPS Act and Inflation Reduction Act (IRA). But those should largely fade through 2024. And what we have now is certainly a political situation where there is no clear winner in terms of either political party passing through any kind of programs, and in our view really, we're going to see kind of a status quo moving into 2024.
Blake Gwinn
So just to add on to that, Michael, I think if you look at the last two presidential elections, we had very large market moves. Markets took both the 2016 and the 2020 elections very positively. We saw risk assets rise, treasury yields sold off, but I think there's some really important differences about those two elections that I think kind of changed the way we're thinking about 2024.
I think the expectations of any kind of big infrastructure or fiscal spending are going to be much, much lower than they were in either 2016 or 2020. You can see over the last few months even how much inter-party fights that have kind of been going on, the margins are likely to remain very, very slim in both houses of Congress. And I just think it's going to be very difficult for either Biden or Trump to really push through any kind of large fiscal package through Congress. I would also say that unlike the Biden 2020 election, there really isn't this unifying issue to deal with in the way that we had with Covet and that was able to bring in both parties and that's why that was able to pass.
We don't really have that set up going into here, so I don't think you have the infrastructure piece. I think the expectation that Trump could maybe do a little bit of deregulation, but on the flip side, I think some of that is nullified by the fact that he's largely expected to kind of pick up the trade war where we left off. So you kind of have that market positivity on deregulation, but market negativity on trade war, you flip over to the Biden side, I think it's largely going to be status quo. So I just have a hard time thinking that we're really going to see as big of a market reaction around this election as we did in 2016 and 2020.
- 10:16 Monetary and rates policy outlook
Vito Sperduto
Why don't we talk a little bit about the outlook for monetary policy and the Fed. As we record this podcast in the first week of December, last week Federal Reserve, Bank of New York President John Williams reiterated that the Fed's benchmark lending rate is at or near its peak level. And look, I think he also said that the Fed expects to maintain a restrictive stance for some time to bring inflation back to its 2% goal, which we all look towards. And Williams was very specific when he said that inflation, he expects it to continue to move down to 2% in ‘24 and close in on that target in twenty-twenty-five, which I think a lot of folks have varying views on and they expect economic growth to be below trend but positive next year. So given all that, what are you seeing as the current view out there? What are your expectations and what do you think convinces the Fed that inflation is down and it's going to stay down?
Blake Gwinn
Yeah, well, I would say you kind of mentioned two different fed narratives there, or at least two things that I kind of separate. One is the terminal rate. How high does the Fed have to hike to really get on the right side of inflation? And then I think there's this kind almost separate question of how long they stay at the current rate and when did they start cutting. And I think as far as that terminal rate and the hiking story, I think we can pretty much leave that in 2023. I think it's become very clear that the last hike was in July. And I think even from the Fed, they're communicating that they have a very high bar to cuts to delivering any more hikes.
So I really don't see that starting outside of a very convincing re-acceleration of inflation. So I think that really means that the first half of 2024 that the story is really more about this, how along do they hold, where did they start to cut question, and I think that's what's been driving. We've seen the kind of market volatility switch from that first theme to the second theme. In 2023 a lot of the pricing volatility in rates markets was about that conversation around the terminal rate and how many hikes. Later in the year that started to shift to cuts and when that first cut occurs, and I think that just continues into the early part of 2024. Where I think that conversation goes is really one of these soft landing adjustment type of cuts rather than a forced very rapid attempt to get rates back into accommodative territory that's brought on by some kind of hard landing. If everything Mike was talking about before comes to pass, we see this slowing in the data, but again, not really recessionary, not hard landing. Inflation continuing to gradually come down. I think it's going to relatively quickly become appropriate for the Fed to start paring back on some of that hiking that they've already delivered. The way I think the Fed looks at it is really through balance of risks. So for the last year and a half, two years, the only thing that they have had to consider are upside risk to inflation. Unemployment rate has been extremely low. They've had no downside risks on the labor side of their mandate. All they have had to worry about is inflation that is shifting as we move into 2024, inflation has come off the boil and now we're starting to see some potential downside risk to labor and I think they're going to have to respond to that.
So I think it's really an adjustment process. I don't see it as a hard landing. Oops, we better cut very quickly to get back to accommodative territory. It's really preventative. You heard Mike before describe it as preventing a hard landing rather than responding to one.
- 13:26 Fed balance sheet policy
Larry Grafstein
That’s a really key point, that last point that the Fed's worried and should be worried more about downside risks as part of its higher interest rate policy as we move into 2024. And it relates to obviously to the political dynamics of 2024 as well. I mean I don't think even though the Fed is independent, I don't think they want to trigger an unexpected significant downturn before we head into November next year. I want to follow up with something about the dynamic between the Fed's balance sheet and quantitative tightening on the one hand and the rise of interest rates on the other. The Fed has not said anything other than it's going to continue to shrink its balance sheet. How does that play into the dynamic for both economic growth and rates from your perspective?
Blake Gwinn
Yeah, and Larry, you mentioned that there's a lot of discussion about rate policy and not a lot about balance sheet policy. That's exactly the way the Fed wants it. They want rates to be seen as the primary policy tool. They want the balance sheet wind down to be like watching paint dry. They don't want to be moving it back and forth and changing the pace and really being kind of active on that side. But it does provide some amount of tightening into financial conditions. And I think one thing that gets lost a lot of times when people talk about balance sheet wind out is you can't just look at what the Fed is doing because it really matters what kind of securities are replacing the ones that the Fed is allowing to run off.
Now Treasury has a decision here. They could issue all treasury bills with three month maturity or they could replace the Fed with all 30 year securities. Those have very, very different implications for markets. They have very different implications for financial conditions and how much tightening is provided to the economy. Generally, I would think that the more longer dated stuff that the Treasury issues, the more you're going to see rates rise, the more tightening that is going to provide to the economy versus the more shorter run they do, the less impact or follow through to the economy that that's really going to have.
So you kind of have the two pieces. You have the fact that the Fed is going to continue winding down their balance sheet. But then you have this other piece of how is Treasury replacing the Fed as a holder of Treasuries and at least what we've seen so they're willing to be a little bit lighter on that duration side, on that long duration side than markets may have been expecting. They've done a lot of bill issuance, They are starting to issue some longer dated coupons over the last two quarters. But even there, I think that has underwhelmed markets a little bit this last time, this last quarter. They actually pulled back a little bit versus what the markets were expecting for long end issuance and I think they showed some willingness to rely on bills a little bit more if we start to see long end rates picking up. So that kind of takes away a little of the teeth.
- 16:00 Housing market overhangs
Larry Grafstein
I want to follow up briefly with I think one of the points you made Blake is that how the Fed replaces the maturing debt matters. And I'd ask maybe Michael a question because the Fed isn't just replacing Treasuries as they mature, they're also replacing mortgage-backed securities is that going to actually be a little bit of an overhang on the housing market, Michael?
Michael Reid
Yeah, I think that could certainly be an overhang in the sense that we already have a rather tight market in terms of sales. So for those folks who are left inactively looking for homes at this stage, I think you'll see the risk increasing. Certainly we noted the slowing wage growth. We know as well that with mortgage rates where they are, even if the Fed does cut, they're certainly not going to move down to a place where we saw in 2020 and certainly nowhere near close to where most existing homeowners are locked in. So the market's going to stay really thin and I think that just means a lot more volatility in that particular market.
- 16:55 Markets bet on adjustment cuts
Vito Sperduto
As we take all of this into account and think about the market specifically, how much of this outlook is already priced into the market? I mean clearly, Blake, you just talked about the fact that we can leave the terminal rate discussion in ‘23 in terms of any further increase, but how much is baked in terms of cuts and could there be some upside in the market depending on what happens?
Blake Gwinn
I mean, I mentioned before that we've long thought that the last hike was in July. We had this call for quite a while that the first cut would be in June of next year, that it would be this kind of adjustment type of cuts, a gradual return to something close to neutral. It was very out of consensus for a while and I think market pricing even up to about a month ago, market pricing was very far from that.
There had been a big desire by markets to kind of fade the Fed cuts that were priced into ‘23. We were getting a lot of strong data in Q3 of this year, and I think in general the crowded trade was to basically say, ‘Hey, there's no way the Fed's cutting next year. Let's lean against that pricing.’ I think the consensus has kind of come to us. If you look across, you're hearing more Fed speakers kind of talk about this idea of adjustment cuts.
You're seeing it more and kind of the media and I think the pricing has started to reflect that more so right now, if you look at Fed pricing, we have come back to something more in line with our call, which is for five twenty-five basis point cuts in 2024. Even if we realize this call, even if we move into next year and we start to see signs that the Fed is going to cut in that kind of June timeframe that we expect, even though that's what's priced for the front end and the pricing of the Fed already has that accounted for, I still think there's the ability for rates to rally by a much bigger degree and for the curves to continue to steep it, even if it's priced in as you get close to there.
- 18:39 Getting back to equilibrium
Larry Grafstein
And we've seen that whole market dynamic play out certainly in 2023 and back into 2022. But Blake, when you talk about the push and pull of markets and the Fed, do you feel that we're coming to a logical equilibrium, or do you expect next year to be choppy again as we've sometimes seen in the past year or two?
Blake Gwinn
I think we've all kind of gotten used to this idea that when the Fed says something, it's almost kind of a commitment or it is for guidance. And I think we're actually in a period now where when the Fed is talking, it's really more a snapshot in time. And I think Powell had been a bit frustrated by that and you saw that in recent press conferences where he basically said: ‘Look, these things that we're giving you this communication about where rates are going, this is just a point in time and it can change tomorrow. If the data changes, we will change our view.’ So I think in that kind of framework to the question that you're asking, I'd like to think that we're kind of moving towards an equilibrium, but I think the Fed is going to be very reactive to data. They're not going to be beholden to any kind of communication they're giving today about what they're going to do. So I think there's still going to be some volatility as markets learn to process a Fed that is not spoon feeding them where the next move is going to be.
- 19:49 Destabilizing dynamics
Larry Grafstein
Michael, what are some of the geopolitical curve balls that could upset your forecasts or change your forecasts for 2024 in terms of the overall outlook?
Michael Reid
Yeah, Larry, I mean things can always happen out there and some of the issues we've been seeing in the Middle East could add to oil price pressure certainly moving up as well as the ongoing conflict with Russia and Ukraine there. Keep in mind, Ukraine is one of the largest exporters of food in the world, so any continued or prolonged conflict there would certainly add to food inflation continuing to be sustained here.
Blake Gwinn
Larry and I would just say one thing too, I think this year more than many others in my career, looking at what those risks might be, I'm coming up with very little, to be honest with you. But I think in general, if you're looking for signs of over-leverage or really kind of worrying signs across the data or in financial markets just imbalances growing, whether it's in funding or other types of markets, it's really tough to see them.
Vito Sperduto
Do you think some of that is related to a confidence in being able to manage through those environments based on their experience over the last 3, 4, 5 years? And so I wonder if in terms of geopolitical items or the election or things like that impacting the markets and monetary policy and rates just kind of feels like out there, there's a confidence that we can get through this because we can manage through it, not necessarily a confidence that we know it's going to go lower. Is that how you think about it?
Blake Gwinn
I think some of the risks, particularly for your issuers when we're thinking about rate levels and I think a lot of the questions around, are they going to go higher? We've had a lot of false starts. But I don't worry so much on that front as far as a discrete type of risk, like a geopolitical event or an election. I think our view has been that the market in many cases has been mistaking some still kind of idiosyncratic pandemic effects in inflation with some kind of secular shift. And I think as inflation continues to come down as it has that view that we are in some kind of new, let's call it 4% type of inflation environment from here on out, that has started to break a bit. And I think with it, those risks of the Fed having the hike to 6% or above or of ten-year yields going to 7%, those type of tail risks have really started to come off. And I feel very confident that we have seen that high and that those fears have really started to come down more permanently as we head into ’24.
Michael Reid
Still Blake one of the things we've talked about is perhaps the shift in narrative the Fed takes in terms of their approach to inflation. And what we've seen through this hiking cycle is that they're very much focused on getting core inflation back to 2%. It's probably worth highlighting over the course of 2024 we do see inflation coming down as we noted, but at your end, we're expecting core inflation to land around 2.5%. So I think the question becomes starting next year, how does the Fed change that narrative from perhaps saying we want to get back to 2% to accepting something between say 2% and 3% in terms of core inflation.
Vito Sperduto
Michael and Blake, it's been a great conversation and as we've gone through a lot of detail in terms of expectations for ’24. First, I would highlight the fact that it's great to see the rest of the market get to where we were earlier in the year and have been driving from a view perspective in terms of our expectations for ‘24. So congratulations on that. But give us one final thought. What are you most focused on? What are you looking at in terms of all these different items that are sort of a key metric or a key thought, especially as we're heading into twenty-four, which is going to be a fairly interesting year? So Michael, why don't you start us off?
- 23:30 Key themes for 2024
Michael Reid
Sure. Vito, I think for us again, the key theme is the consumer here. Consumer spending accounts for about 66% of GDP growth. So as we head into ‘24, we have a weakening labor market where you're expecting to see wage growth slow. And this is just going to add to that pressure the consumer is seeing in terms of that growing debt burden.
Blake Gwinn
Yeah, I think the thing I'm looking at most or going to be watching the most early in 2024 is just progress towards that first cut. We've seen some of the Fed officials already start to kind of get a bit more relaxed in talking about when they might start to cut. And if we see that start to broaden out, see Powell himself starting to mention that, I think that will very clearly signal an end to the, or I should say a high point in yields. We will know that that has already been hit and should open the door to further rally and curve steepening. So I just really am watching that Fed communication around the cut and waiting to see if they start getting a little bit more comfortable with starting the adjustment process that we're talking about.
Vito Sperduto
Well, Blake and Michael, thank you for joining us today. It was a great conversation regarding what your U.S. Outlook for 2024. I'd encourage the listeners to take advantage of the report that was just put out a couple of weeks ago in terms of their view on the forward outlook for 2024. There's a lot of detail that adds to a lot of the content that we've talked about today. So stay tuned for more insights in future episodes of Strategic Alternatives. And thank you everyone for joining us today.
Larry Grafstein
Thanks very much, Vito. Great chat.
Vito Sperduto
You have been listening to Strategic Alternatives, the RBC podcast. This episode was recorded on December 4th, 2023. Listen and subscribe to Strategic Alternatives on Apple Podcasts, Spotify, or wherever you listen to your podcast. If you enjoyed the podcast, please leave us a review and share the podcast with others. Thank you.
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