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BirdsEye View

 The longer-term economic environment for financials continues to brighten while in the short-term there are remaining shifting sands. The ultimate positive is the likelihood of ongoing stimulus and, more importantly, the possibility of infrastructure spending. These also argue for net interest margin benefit from rising interest rates, partly from growing yet moderate inflation, and partly from enormous deficit financing, which will reduce net interest margin pressure. Inflation is expected to spike a bit early this year from pent up consumer demand fueled from savings. The primary negatives are lackluster credit demand and a stricter regulatory pressure under a Democratic government.

The nearer-term environment, certainly for the first half of 2021, is less sanguine. The chief impediment is again the lack of organic credit demand and latent credit risks lurking beneath an ongoing flow of stimulus. Features of the current underlying economy are largely unknowable or invisible while artificial stimulus is prevalent and likely to continue. Expectations for lossreserve release is not a high quality fundamental driver and reserve adequacy remains arguable in the short term.

Low overall valuations tie both time frames to an overweight posture. Relative (to S&P) prices in relation to book values are still close to historic lows.

While one can get lost among the dissonant economic variables, we remain primarily focused on just two: Credit demand and credit risk.

There are two kinds of pervasive support to the American economy. The first is filling-the-hole assistance mandated by COVID damage, which by its nature has to be temporary or time limited. The second is true infrastructure spending, which is key to long term growth.

The tug-of-war nature between these two, time frame dependent arguments is hard to separate. It is hard to ascertain correctly weighing the pros and cons. Our view is that infrastructure spending can break the tie. This is because growth in the U.S. economy has been constantly declining for decades, largely owing to inexorable demographic headwinds. Our oft-cited graphic for this is the average GDP growth between recessions, clearly stair-stepping down after each.

Left to this evidence, once the pandemic is under control the economy is likely to surface, post-downturn(s) at lower momentum. Despite some ups and downs, the average momentum for GDP was only 2.1% per annum after the Financial Crisis and before COVID interruption. It is easy to see faster growth initially during a final recovery from this deadly period, but longer term core momentum is unclear. It seems likely to be sub-2% from the below exhibit. Without help, underlying trend growth is biased for disappointment by 2022.

This is where infrastructure spending comes in - or doesn’t. Stimulus spending from the CAREs Act and CAREs 2.0 is not lasting stimulus. It is swallowed during a recovery. It is only a bridge over the valley designed to repair damages. Infrastructure spending is ongoing stimulus. As we all know, infrastructure needs are heroic in America.

Most infrastructure packages are considered over a much longer time period, usually on the order of ten years. Being overly simplistic, the current rumor of a $3 +/- trillion package, while actually less than the expected overall CAREs and attendant monetary support over a much shorter period could linearly amount to $300 billion per annum on a ten-year scale, which is about 1-1/2% incremental GDP growth. This would not only break the unappealing picture above but assure stronger employment demand.

However, there is one caveat to this. The makeup of an infrastructure package must adhere to true infrastructure repair and modernization. It must not be diluted by indirect aid to state and local budget deficits. The political support for repairing state and local finances is now stronger than before and such dilution is a real possibility. This would not be the first time a stimulus bill became a “repair” bill. In the Obama administration, the $800+ billion so-called stimulus package included only slightly more than $100 billion for infrastructure and thus had little long-term positive effects.

For perspective it is also worth considering how far we still are from the economic trend line. There are many measures of this. Simplistically we are barely half way there. Perhaps the most startling statistic is in the Participation Rate data, which takes us all the way back to the levels of the 1970s as seen below. Participation Rate decline had finally stopped by 2015 but sharply declined last year and that decline is barely half reversed. Another perspective on full recovery shortfall is in jobs data itself, where the rebounding current level almost takes us back to the 2007 pre-crisis level.

Credit demand is likely to remain soft while CAREs lending continues, which at least will influence the first half of this year. Credit demand will also follow the soft cycle of business spending and investment that has been with us for at least two years, preceding its dive during COVID. While well less than 18% of direct GDP composition, private direct investment drives employment. Nonresidential fixed investment is still off nearly 5% from year ago levels. However the residential side is continuing to expand, up $86 billion annually and offsetting the $135 billion decline in nonresidential through the most recent, third quarter data. This is the only area of our economy that has benefited from COVID inspired migration to the suburbs. But for now, commercial loan growth remains weak.

second, the largest deficit remains in Leisure & Hospitality which indicates a 47% shortfall since February and increasingly viewed as facing the largest hurdles to restoration. We are recovering to a different economy than we once had, and this is an example. Travel has already leaned in favor of business and more toward only leisure. Business models have changed and are unlikely to completely revert. There are other examples but our ongoing view is still that a large part of the remaining jobs will not fully recover. We will not see these model shifts until well after COVID is behind us and social and behavioral norms stabilize.

Which brings to mind the credit risk issue. Most of us have become relieved and optimistic that the loss cycle can be contained, as we wrote previously. However, it is too soon to be releasing reserves in our view and investors are not going to reward it.  Our underlying economy, including consumer and commercial balance sheets is still largely invisible under the cloak of massive support measures. These are clearly going to be extended until March, if not longer, which means a credible read on credit damage is very unlikely until the second half of this year.

We should add interest rates to our outlook. Most expect little change from the Fed, but possibly a gradual rise in long term rates. We cannot strongly disagree with this assessment but we are nevertheless cautious and would not embrace interest rate risk in either direction. Our thought is that abnormally low rates can self-correct and, given the choice, we would lean toward expecting some rise in 2021, possibly more than expected.

There are two reasons for this. First, the net supply of new Treasuries at auction has now doubled and, second, that CAREs and CAREs 2.0 will be followed by another assistance package and hopefully the beginnings of an infrastructure spend based on our shift in political balance, pushing Treasuries supply to an extreme. An almost unified Democratic government will likely attempt more spending on both, driving supply even higher.

The first sign of this shift is in the sheer size of assistance so far. We completely agree with the need for this and more. However, we note that in 2020 the level of Federal outlays, relative to GDP, exceeded that during World War II, as shown above. The supply/demand exhibit below does not include this additional supply, which can prove to be even more mammoth than it already has been. Is this the final “tipping point?” There is the $900 billion Coronavirus Relief Bill signed in December, up to another almost $1.3 +/- trillion for CAREs round three under the Biden Administration, and the mooted $3 +/- trillion infrastructure package that would add close to another half trillion per annum. The total approaches well over $5 trillion and almost $3 billion of it could occur during 2021. Such largess, however needed, would drive the “Forecast” bars shown above literally off the chart! If bond vigilantes actually exist. This will be their year.