What’s on tap for the rest of ’23?

Transcription:

Chip Barnett (00:03):
Hi, and welcome to another Bond Buyer podcast. I’m Chip Barnett and my guest today is Eric Merlis, managing director and co-head of global markets at Citizens Bank. And we’re going to be focusing on the economy, financial markets and the Federal Reserve. Welcome to the Bond Buyer, Eric. 

Eric Merlis (00:21):
Thank you, Chip. Glad to be here. 

Chip Barnett (00:23):
Could you first tell our listeners a little bit about yourself? 

Eric Merlis (00:26):
Sure. As you mentioned, I’m co-head of global markets at Citizens Bank. We’re one of the oldest and largest banks in the United States. Based in Providence, we have full retail and commercial bank capabilities. Our team specifically partners with clients to provide solutions that hedge their foreign exchange interest rate and commodity risk. We’re committed to helping our clients in this increasingly complex market and we have a strong record of helping our clients succeed. 

Chip Barnett (00:52):
Ok, thanks. Let’s get started. What shape is the overall economy in right now? 

Eric Merlis (00:59):
I would call it stable and resilient with some potentially unknowns around the corner, but I think the potential unknowns around the corner, that’s always the state of the economy and I think on the stable and resilient side, it’s been a far stronger economy than I think most people would’ve predicted. Certainly at the beginning of the year when everybody was projecting a recession, at least at some point in 2023. So it’s a pleasant surprise that the unemployment rates managed to stay where it is. Job growth in the overall economy, again, stable, not growing gangbusters, but in a good place. 

Chip Barnett (01:39):
What’s the economic data telling us right now? 

Eric Merlis (01:42):
Let’s try to break that down into what I would call three categories. Of course there’s many more, so I’ll give you the highlights, a comment and some facts to try to back that up. And then please feel free to interrupt me whenever you’d like. So unemployment, I’d say it’s weakening, but definitely not weak. June non-farm payrolls were weaker than expected. It was the smallest increase in private jobs since December of 2020. Temporary workers were down for the last five months. The manufacturing work week is at a cycle low for the third month in a row. Now that’s the negative side. On the positive side, we’re sitting at 3.6% unemployment. Real wages are finally positive as average hourly earnings didn’t fall last month. The participation rate is steady at 62.6% and at the highest level since March 2020. And while claims are off their lows, they’re still in a range consistent with the positive payrolls and GDP. 

(02:40)
That’s my take on the employment side of the economy. On inflation — falling but not forgotten, inflation hasn’t historically remained at peak levels. So as you know, we peaked near 9.2%. It tends to retrace the similar pace that it increased. So if we look at CPI now year over year we’re at 3%, we’re down from 4%. Interestingly though, we did tick up from 0.1% to 2.2%, so an uptick on the month over month basis, ex-food and energy, which the Fed is far more focused on, that’s down to 4.8% from 5.3% and that is declining on a month over month basis from 0.4 to 0.2, couple little areas to break down in the food and energy. Food is the second largest weighting in the CPI. It has started declining, but it’s overall decline tracks very well with fertilizer prices and it’s about a half year lag. 

(03:39)
And if you look at fertilizer prices over the last prior six months, they’ve dropped to their lowest levels since 2021. So I would say that’s constructive for a further fall in the food and energy component. Owners equivalent rent, another big piece of of CPI actually the largest component that slid substantially since last year. And I think we should finally start to see the impacts there on the headline CPI. And of course the super core, which Powell really focuses on, that’s core CPI less housing. The CPI super core is up just 1.4% on an annualized basis over the last three months. The PC supra core should follow suit and give the Fed what I would say is confidence that their strategy is working, but I don’t think it gives them the laurels to rest on that they can ignore looking at inflation in the future. 

(04:33)
And then on the consumer side, if you’d like me to keep going, I would say the consumer is still standing, but showing some signs of pulling back. Cooling inflation has definitely resulted in increased consumer confidence. I believe I read a survey by Deloitte. It showed that consumer confidence since inflation has fallen, has really peaked. You can see that in the University of Michigan sentiment, you can see it on the small business and consumer confidence board surveys. On the household debt side, the debt service ratio is at 9.7%. That’s well below the 2007 peak and it’s below the pre pandemic peak of 11.2%. As I said earlier, wages are outpacing inflation and on the downside, delinquency rates on credit card loans have been increasing all year, but they’re still at historically low averages. So again, the consumer not strong, not weak, maybe retrenching. I would say a lot of the post-Covid, ‘I’m ready to go out and spend travel, dinners’ I think we’re winding down from that level of growth to get into what looks like a more normal pre-Covid economy. 

Chip Barnett (05:52):
Thanks for that summary. That’s very interesting, especially with taking a look at the inflation. Looking ahead, you looking a little broader, how do you look at the federal government and maybe the states — how are their finances faring right now?

Eric Merlis (06:11):
Government debt does continue to climb — total state tax supported debt levels did remain relatively flat in ’22. So I would say that’s a positive sign. The decline was mostly attributed to the quick rising borrowing costs from Covid and record reserves coupled with federal Covid-19 relief stimulus. Reserves and pandemic relief funds provided states with an alternative to debt financing. Inflation significantly increased the cost of many of those capital projects. That is starting to wane in terms of if you look at longer term yields and the cost to to issue longer dated debt, while it is up certainly from pre-Covid levels, it doesn’t match the short dated debt. So as long as the government continues to issue in that longer end, that’s I would say more beneficial for the longer term finances and stability of the government. Now of course they do have to issue short term debt and they are paying more for that, but there does seem to be plenty of demand for that. 

(07:13)
So we aren’t in an issue rate spiral where we have failing auctions and we really need to worry about the overall level of debt that the United States government has that we’re currently at. On the state side, state debt metrics, they remain moderate to low by most measures and will likely remain within that range. Debt levels I would say are sustainable for most states with median debt to government expenditures, expenditures, and debt per capita viewed as moderate. And the five states with the most debt outstanding are California, New York, New Jersey, Massachusetts, and Illinois. They do hold 38% of the state tax supported debt outstanding and about 26% of the U.S. population. So again, increased debt, but manageable and let me follow on one point to that. With unemployment at 3.6% and federal tax revenues still consistent, I think that lends itself to more stability for the federal government in its debt structure. 

Chip Barnett (08:26):
Okay, thanks for that and we’ll be right back after this important message. And we’re back talking with Eric Merlis of Citizens Bank. You know, you were speaking inflation earlier. Where does the Federal Reserve stand on that right now? 

Eric Merlis (08:43):
Okay. Well, if we look at the July 26th meeting, there’s a 90% chance of a 25 basis point increase. The Fed hasn’t signaled any likelihood that it will pause during that meeting, so I would look for the July hike. I do the market’s pricing at a terminal rate. As I came in this morning, I believe it was roughly 541, which to me suggests the market’s unclear if there’ll be another tightening after the July meeting. What’s most interesting to me though is that we have four and a half priced in the 2024 that suggests to me a rapidly deteriorating economy and not just to decline of inflation back to the Fed’s target. So again, I would say you have conflicting market data, which ties directly into the value that we were able to provide for our clients. Different clients will have different views of the economy. We spend a lot of time working with our clients on how to either synthesize those views, become more crystal clear and their viewpoint. We don’t try to guide our clients into the market’s going to do this or the market’s going to do that, but if a client has particular exposure that they want to manage, we talk them through and advise them on the best ways to hedge that. And as you can see, the market’s unclear right now. 

Chip Barnett (10:07):
Exactly. What’s your opinion on the outlook for the near term? 

Eric Merlis (10:17):
Oh, sure. If by near term the remainder of 2023, I think we’ll be in a low growth, strong unemployment position. I think as the summer winds down, we’ll see a little bit less travel expenditure, but that’s normal. I believe we’ll see a little bit of consumer retrenching, especially after roughly a year and a half of significant expenditures. You can see that on some of the prices paid and services components, you get this post-Covid and heard about this for probably 18 months now —the travel, airlines, restaurants. I do believe after the summer that’s not going to be nearly as strong. I don’t think that signals a recession. I think that’s okay. We were at home for 18 months, we traveled for 18 months. Now let’s get back to the normal ‘We go out once a week, twice a week. we go on a vacation once, twice a year,’ and we get back to that pre-covid 2018-19 economic cycle. And I think that’s a good thing. I don’t think it’s completely predictable, but what I’m not looking for is a collapse in the economy. I’m looking for sort of steady as she goes. 

Chip Barnett (11:41):
Okay. How about farther out, maybe a more long term look into 2024, which is a presidential election year? 

Eric Merlis (11:50):
Apart from the politics, which I think are extremely difficult to predict at this point, I do think there are some headwinds in the economy longer term that could potentially lead to a mild recession next year. Again, I don’t know if it’s my base case yet, but the market’s aware of the commercial real estate debt refinancing. I believe we’re looking at a trillion and a half dollars over the next three years. The Fed balance sheet roll off, quantitative tightening, that has yet to really take hold in the economy. But in another six to nine months of 95 billion a month rolling off, that could potentially have a negative impact. And at the end of the day, the worry that we faced in the beginning of the year, to me it doesn’t look nearly as imposing as it did in January of 2023. Again, I don’t think we’re poised for gangbuster growth. I think we’re poised for that 1% to 2% longer term stability with what could be a hiccup or two here, there next year that could lead to a quarter or two of negative growth. But again, I don’t see anything catastrophic on the horizon. 

Chip Barnett (13:08):
Do you have any last thoughts for our listeners today? 

Eric Merlis (13:11):
Listen, we understand it’s a very challenging environment to navigate. As we’ve discussed, there are competing narratives, certainly with market participants. Our clients face continually difficult decisions in terms of refinancing with higher yields. Energy prices have been up and down all year. The dollars shown some recent weakness lately. These are all components of what our group provides for our clients. We provide the discussion, the advisory services to help them manage these challenges. 

Chip Barnett (13:53):
Eric Merlis of Citizens Bank, thank you very much for being here today. 

Eric Merlis (13:58):
Thank you. Have a great day. 

Chip Barnett (14:00):
And thanks to the listeners of this Bond Buyer podcast. Special thanks to Kevin Parise who did the audio production for this episode. And don’t forget to rate us, review us and subscribe at www.bondbuyer.com/subscribe. For the Bond Buyer,  I’m Chip Barnett, and thank you for listening.