Macro Markets Podcast Episode 41 Transcript: Quarterly Macro Themes for Q3 2023
U.S. Economist Matt Bush, Investment Strategist Maria Giraldo, Investment Strategist Chris Squillante, and Economist Jerry Cai join Macro Markets to discuss the latest Quarterly Macro Themes, which takes a deep dive into issues helping shape our baseline economic views.
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. We are recording this episode on September 15, 2023. Joining us today on Macro Markets are four members of our Macroeconomic and Investment Research Group, who contributed to our new publication, Quarterly Macro Themes. The Quarterly Macro Themes, or QMT as we call it, features research topics and areas of inquiry that go into the development of our macro and market outlook. You can find the new issue on our website at guggenheiminvestments.com/perspectives. It’s also in the podcast show notes. So, without further delay, let me welcome the authors of this quarter’s QMT: Matt Bush, Managing Director and U.S. Economist, Maria Giraldo, Managing Director and Investment Strategist, Chris Squillante, Director and Investment Strategist, and Jerry Cai, Vice President and Economist. Welcome everyone, and thanks for taking the time to chat with us today.
Maria Giraldo: Thanks Jay. Happy to be here.
Jay Diamond: Okay. Well, let’s begin. Matt, our QMT begins with our Macro Outlook and in this issue, it’s titled “Reaccelerating U.S. Economy Is Not a Sustainable Outcome,” and it’s tightly connected to our first theme, which is titled “Factors Supporting U.S. Economy’s Resilience Are Set to Fade.” So, to begin, why don’t you walk us through our current outlook?
Matt Bush: So our outlook acknowledges that there are some conflicting signals in the U.S. economic data right now. On the one hand, you have strong gross domestic product (GDP) growth numbers and some signs that consumer spending remains pretty resilient overall. But on the other hand, you have weakness across a number of labor market indicators and a continued warning signs for some of the traditional leading indicators of a recession. So our view is that the economy is slowing and will continue to slow, but if we’re wrong and the economy proves to be resilient or even reaccelerate, we think it’s going to be short-lived because the Fed will need to step back in. The Fed has made it clear and recently been emphasizing that it’s not enough just to see inflation readings come down. To be confident it will stay down over the medium-term, they want to see weaker economic growth and a softer labor market. So, in our view, the ultimate destination for the economy is really not up for debate. It’s just a question of whether we’re heading toward a downturn in the next few months or if it will take another couple of rate hikes from the Fed to get there.
Jay Diamond: Thanks for that. Now, did you derive any meaningful insights from the consumer price index (CPI) print we got this week?
Matt Bush: At a high level, the CPI numbers for August really just highlight the broad theme of disinflation is continuing. For the core CPI, we saw month-over-month inflation rise a bit, but the three-month rate fell to 2.4 percent on an annualized basis, which is the lowest since early 2021. On a more detailed basis, we did see services inflation outside of shelter heat back up, which highlights that while supply side healing can help goods prices come down further and lagged rental prices will continue to push down rental inflation, the more labor market sensitive services sector is going to be more difficult to get under control. And so it goes back to this idea that a weaker labor market and lower wage growth is going to need to happen for the Fed to be confident that inflation has finally been defeated.
Jay Diamond: Matt, you also contributed to our first theme, which is a deeper dive into some of the tailwinds that have supported the U.S. economy over the last several quarters. What are these tailwinds and how have they helped keep the U.S. economy afloat?
Matt Bush: We look at three big tailwinds that help explain why the economy has held up even in the face of recession expectations earlier this year and aggressive rate hikes by the Fed. So the first of these tailwinds is lower inflation. We point out that headline CPI, which is what consumers actually experience, was 9 percent in the summer of 2022, with gas prices surging back then. But by June of 2023, that number had fallen to 3 percent with outright declines in energy prices. So inflation is still a problem at 3 percent, but it’s not nearly as much of a problem, and we think the easing of inflation pressure provided an important boost to consumer sentiment and, by extension, consumer spending, as we saw real incomes increase. So, it’s been one tailwind for the economy. Another has been fiscal policy. We’ve seen the federal fiscal deficit go from 4 percent of GDP in mid-2022 to over 8 percent currently. That’s a pretty massive expansion that’s bigger than the more we see in most recessions. And not all of that is straight up fiscal stimulus, but we do think that the larger deficit has helped support the private sector. And then the last tailwind is what’s going on in the labor market and what we’ve seen there is a unwind of distortions that built up during the pandemic. In 2021 and 2022, we saw a big jump in average hours worked per employee. We saw big backlogs of unfilled orders build up. So even as new business growth has cooled since then, businesses have been able to avoid layoffs, instead reducing the elevated hours worked by employees and by working down the backlogs that were previously built up.
Jay Diamond: Now these have been fairly persistent tailwinds. How long do you expect them to persist before they start to fade?
Matt Bush: Right, so the reason we lay these tailwinds out is because we think they’re not going to last much longer, and that’s going to have meaningful implications for the U.S. economy. Inflation can continue to come down, but 3 percent to 2 percent is much less of a boost than 9 percent to 3 percent, especially with energy prices now rising again, which consumers tend to be the most responsive to. On the deficit, we should see some narrowing there, with fiscal headwinds already emerging as we’ve seen a surge in student loan payments even before the official restart in October. And we should also see tax payments pick up as the delayed tax deadline in California draws near. And then on the labor market, we’ve now seen average hours fall toward the lows we saw in the last cycle. And business surveys show there’s fewer backlogs to work through. And so there’s growing signs of weakness in the labor market from declining temporary-help payrolls, to more negative consumer views, to the unemployed taking longer to find new jobs. So we think we’re well past the peak of the stimulative effect from these tailwinds and we have more headwinds on the horizon.
Jay Diamond: So Matt, pulling this all together, the macro outlook and this theme about the tailwinds fading, what’s your thought on possible recession timing?
Matt Bush: So as these tailwinds fade, as the headwinds from tight monetary policy, tight credit conditions become more and more important, we see the most likely start date for a recession as of the first quarter of 2024. But I should also say we continue to see the recession as being relatively mild, given that a lot of the weakness has been spread out over time rather than occurring all in one or two quarters.
Jay Diamond: Thank you for that, Matt. Now let’s move on to Maria. You wrote the theme called “Corporate Savers Win Even as Bankruptcies Pick Up.” So what are you observing in corporate bankruptcies right now? Where are they most concentrated? What are the drivers of distress, things like that?
Maria Giraldo: Yes, so we’re seeing that corporate bankruptcies are on the rise. Through the end of August, they actually outpace the annual bankruptcy figures from 2021 and 2022, and it actually looks like we might be on track for annual volume comparable to 2020, which was a year that was most severely affected by the global pandemic. But depending on how things shape up for the rest of the year, we could actually see the highest volume in corporate bankruptcies since 2010. And I think we will, because in 2020 the remainder of the year after August benefited from several stimulus programs that helped interrupt the upward trajectory for bankruptcies. We don’t really have that effect this year, and instead we have the effect of borrowing costs remaining high. So what’s happening on the corporate front is really years in the making. Many companies had the benefit of interest rates going lower and lower for years., so every time they needed to free up some cash because of challenges in generating organic earnings growth, they would just go to the market and refinance that debt at a lower rate. Sometimes even took on a little more debt in that process. We also had a relaxation in lending standards since the Global Financial Crisis because interest rates were so low and competition was so high among lenders and investors to get the highest yields achievable. So one way to compete was to make terms easier for borrowers. This resulted in overlevered companies that were more dependent on a declining interest rate environment than a sustainable business model that could have weathered multiple cycles. So once that low interest rate environment disappeared, combined with a challenging backdrop where costs were rising broadly, they were left with few alternatives but to file for bankruptcy. We’ve seen the most notable volume in consumer discretionary and in industrials. It’s also been followed by healthcare and financials, but as I describe in my commentary, no industry has been spared. Given that the driver has been the inflationary environment which increased costs broadly coupled with high borrowing costs and lenders pulling back, these are factors that are going to affect operators across all industries.
Jay Diamond: Now you mentioned borrowing costs. You make the observation in the theme that the Fed’s interest rate hikes have significantly boosted interest expense for levered companies, but paradoxically, interest coverage ratios are actually improving. What’s going on here?
Maria Giraldo: Yes, the most interest rate sensitive borrowers are most directly affected. And so that’s going to be borrowers that have either shorter maturity liabilities, like they’ll tend to issue commercial paper, for example, or those with floating rate liabilities like leveraged loan issuers. For them, the central banks rate hikes boosted interest expense for the U.S. economy as a whole, though by our estimates the corporate world has become less interest rate sensitive because they’ve extended the maturity of their liabilities and at the same time locked in low borrowing costs. So that’s especially true in the investment-grade rated universe, where the average coupon for corporate bonds outstanding has declined from 7 percent in the year 2000, to 6 percent in 2010, to just 4 percent currently. And today, an average new issue high-grade yield, so if an investment-grade rated company goes out to the market and wants to raise new debt, that yield is going to be between 5.5 to 6 percent. So that would significantly increase their cost of debt and that’s why we’re really not seeing a lot of new borrowing activity. Meanwhile, you asked about interest coverage ratios improving, so in the aggregate for the U.S. economy, cash balances held among non-financial corporations are still really elevated. So a lot of companies are taking advantage of rates by parking that cash in vehicles that earn attractive coupons, like money market funds. So once we step back to look at the sector as a whole and not just the most interest rate sensitive pockets, the Fed’s financial accounts data shows that net interest expense, which represents interest expense minus interest income, is declining for the nonfinancial corporate system. So when you couple the decline in estimated net interest expense with corporate profits and cash flows that have benefited from high nominal growth rates, what you get is an improvement in interest coverage, which is the ratio of cash flow to annual interest expense. That ratio is at the best place it’s been since 1960.
Jay Diamond: So what’s the bottom line if you’re a credit investor right now?
Maria Giraldo: Well the bottom line is that while we are seeing bankruptcies rise and the credit environment is more strained generally, it’s not necessary to reduce the allocation to credit. We actually would argue that it’s not prudent to do so given where current yield levels are. Actually, the fundamental data shows that large, high-quality corporate fundamentals are just fine, and even in many cases, companies with robust liquidity in the form of cash holdings are benefiting from higher interest rates. Yields, as I mentioned, are really attractive in this space, with the average investment-grade rated coupon yielding about 5.8 percent. So, we hope that’s an encouraging feature for investors, signaling that there are places to invest where investors can take refuge without giving up income.
Jay Diamond: Thanks for all that, Maria. Now Chris, please walk us through the third theme titled “Bonds Meaningfully Outperform Stocks During and After Fed Pausing Cycles.”
Chris Squillante: Sure Jay, I would be happy to. First of all, I’d like to thank you for having me on the podcast. I’ve always enjoyed listening to what my colleagues have to say, so I’ve been looking forward to joining you here today. But back to your question. As you know, through conversations with my colleagues, we’re always monitoring the macroeconomic backdrop and always forming opinions as to how the Federal Reserve will react to changes in the economy. And right now, it appears that the Fed is nearing an end to its current hiking cycle and that they may soon pause their hiking of interest rates. So we want to take a look at other pausing cycles in recent decades to get a sense of what to expect. How long does a pausing cycle last? How do risky assets and safe haven assets perform during these so-called pausing cycles?
Jay Diamond: Well great. So you looked at the patterns of these hiking, pausing, and easing cycles over the past 30 years. Tell us more about the pausing cycles.
Chris Squillante: This is interesting and there are some strong similarities between today and other historical periods leading up to a pause in the hiking cycle. For example, near the end of past hiking cycles and leading up to previous pausing cycles, the economy, like today, was usually still exhibiting some strength. Growth, like today, was positive and the labor market was firm, like today, with low unemployment. We also found that the Fed normally holds rates steady for several months before cutting rates. This means that we should expect the pausing cycle to last maybe 5 to 8 months and that the Fed [will] likely hold rates steady for this amount of time to see how the economy continues to react to the lagged effects of tightening they’ve already done.
Jay Diamond: So the next step you took in this analysis is you compared the performance of so-called risky assets and so-called safe assets over the course of these different periods. So what is risky and safe is in this example, and what did you find?
Chris Squillante: So as a proxy for risky assets, we looked at the total returns of the S&P 500, but I’ll note that there is a high correlation between the returns of the S&P 500 stocks and other risky asset classes like high-yield bonds. For safe haven assets, we reviewed the total returns of an index comprised of U.S. Treasurys. But again, I’ll highlight that the conclusions we make from the U.S. Treasury market could be applied to other high-quality fixed income asset classes, like highly rated investment-grade corporate bonds. So we then took a look at the returns of these different asset classes, and we found that stocks or risky assets tend to do better than safe haven assets during a hiking cycle. This makes intuitive sense since the Fed is raising rates in reaction to a strong economy that is supporting positive sentiment and earnings growth for corporations. We took a look at easing cycles, which we note that the Fed was cutting rates because a recession was usually underway already. In these scenarios, it’s no surprise that bonds or high-quality fixed income, or safe haven assets outperformed risky assets. Now, when we look at pausing cycles, we actually found that both stocks and bonds performed well once the Fed stopped hiking rates. Stocks performed well because investors no longer expected a further tightening in financial conditions, and bonds performed well because short-term interest rates were no longer rising. The interesting thing about pausing cycles was that risky assets performed well above average during their early stages, let’s say the first three months or so of a pausing cycle. However, stocks actually wound up producing negative returns during the final months of the pausing cycle. This is likely because the stock market and other risky asset investors were starting to realize that a recession was around the corner. During these final months of a pausing cycle, bonds performed quite well and outperformed stocks.
Jay Diamond: So what’s the investment takeaway from this analysis?
Chris Squillante: Well Jay, with an upcoming Fed pause, history would suggest that both stocks and bonds will perform well in the near term. This should provide an opportunistic window to continue rotating out of riskier assets and into high quality fixed income.
Jay Diamond: Okay something to look forward to. Last but certainly not least, Jerry, tell us about your theme, “Beijing’s Competing Priorities Will Exacerbate China’s Economic Downturn.” So what is some of the evidence of China’s economic downturn and why is it happening?
Jerry Cai: So we’ve seen a significant slowdown in certain things like factory production, exports, and fixed asset investment, and among major economic indicators, property sector data looks particularly bad. Real estate investment has fallen 7 percent on a year-over-year basis and daily home sales in major cities have plunged to only 30 percent of what they used to be before the pandemic. And aside from housing, we have seen a slowdown in retail sales and services activity, which suggests that the last remaining engine of growth is running out as well. So this economic downturn that China is facing is really an inevitable adjustment after years of overinvestment and accumulation of debt, and policymakers have been doing too little to cushion the impact of this adjustment due to their competing priorities.
Jay Diamond: So what are some of these competing priorities that might prevent the central government from coming to the rescue of the economy and how do you see this economic crisis developing from here?
Jerry Cai: Yeah, so policymakers are really preoccupied with de-risking and preparing for possible conflicts with the West. As a result, they are really leaning toward under-stimulating the economy. For example, the central government is hesitant to rescue indebted developers and local governments due to moral hazard concerns. It has also rejected a U.S.-style stimulus program for the household sector. They deemed it imprudent when China’s priority should be enhancing its industrial capabilities and reducing dependence on foreign technologies. And to your question about how China’s economic crisis will develop, first of all, without more forceful policy support, growth will likely slow further in the coming months. But we don’t think China’s economic crisis will unfold in the conventional textbook manner experienced by Western economies, given the Chinese government’s pervasive control over the financial system. So instead of a single event triggering a domino effect, China’s downturn will likely be a slow creeping phenomenon. It’ll be widespread, initiated from various points and permeating different sectors.
Jay Diamond: So why should U.S. investors or investors in other parts of the world care about something that’s happening in China domestically?
Jerry Cai: Well the Chinese yuan could easily drop another 10 percent because of China’s economic problems. That may widen U.S. current account deficits. And also, rapid depreciation of the yuan and other emerging market currencies could prompt central banks to intervene. That would potentially unsettle U.S. financial markets. And China’s downturn could also trigger global economic instability and would weigh heavily on commodity exporters and developing countries that rely on Chinese markets and investments. Moreover, Beijing may adopt a more confrontational foreign policy to sort of distract from internal tensions. They may take bold moves in contentious areas like the Taiwan Strait or the South China Sea. So, China’s downturn could trigger geopolitical instability as well.
Jay Diamond: Well thank you very much for that, Jerry. Now, before I let you go and thank you all again, is there any final message you’d like to share with our listeners?
Maria Giraldo: Well if we’re identifying a common theme across the four different topics that we decided to talk about today and we highlighted in our Quarterly Macro Themes, I think our listeners and the readers will find that we are approaching the current investment landscape quite cautiously. So, as the economy moves along, as things develop, we’ll continue to highlight some of the themes as we see them evolving and how they’re impacting our investment direction. So more than anything, we’re really hoping that our listeners find this useful as well in their own investment allocations. So thank you for reading and thank you for listening to us today.
Jay Diamond: Well again, thanks to all of you for your time. Please come again and visit next quarter with the next Quarterly Macro Themes. 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, Chris, Jerry, or any of our other podcast guests, please send them to firstname.lastname@example.org and we will do our best to answer them on a future episode or offline. I’m Jay Diamond and 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 the Quarterly Macro Themes, visit guggenheiminvestments.com/perspectives. So long.
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