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BirdsEye View

 My friend Steven Martin from RMA is an insightful observer of our industry. When I shared the article below with him, this is what he wrote:

Good Banks do well in every part of the cycle, but the best banks not only know what's fueling their profits, but know how to adjust as things change. And what never seems to go out of style is the blocking and tackling - such as full relationship banking for long-term customer relationship. No hot-money deposits, no rate shopping loan-only customers, or other tricks to bulk up balance sheet, only to see profits vanish

Predictions about our economy have been murkier than usual lately.  Reinterpretations of the word “recession”, from its technical definition to manifestation in reality, are everywhere, from our Secretary of Treasury to the humblest economic professor.  When in doubt, I look for my friend Robert Albertson, Chef Strategist for Piper, Sandler,  to help decipher the most opaque picture of the near and medium term future we’ve had in quite some time.  Here is what he said.

Recession odds are increasing.  Some might argue we are already in one.  Robert looks deeper, though, at the elements of the decline in GDP.  Consumption grew only at 1% linked quarter, barely half of the prior quarter and lower since the pandemic.  The forward performance of GDP looks weak at best.

Robert goes beyond opining on recession to express concern about about Private Fixed Income, which has plummeted  to a 13.5% decline from a 5% growth the previous year.  Such weakness doesn’t bode well for bank loan growth, which has been surprisingly robust the first half on 2022.  Others aspects of bank financial performance are highly dependent on the economic cycle, which brings us back to recession:  will it be deep? Shallow? Sustained?  Even Robert Albertson isn’t sure which way is the economy going.  The market has already partly priced in a shallow recession, but a stickier inflation will cause the Fed to tighten further, thus contributing to the severity of an ensuing recession.

After the 75bp rate hike in May it became clear that the fed is chasing commodity prices, those that drive headline inflation, which are also those over which we have no direct control.  CPI continues to rise in the following months, while monetary policy is clearly committed to further increases without inflation relief in sight.

This scenario greatly increases the likelihood of the Fed overshooting again, thereby putting a stranglehold on the economy and contributing to the likelihood of recession.  Any further decline in demand will likely drive economic growth into negative numbers in an environment replaced with already weak economic prospects (one excellent example is the Purchasing Managers Index, indicating business spending,  inventory levels and anticipated demand, which cratered in July).

Confidence has also eroded meaningfully.  Consumer confidence has declined all year, and small business optimism has dropped further to a recent low.  The latter contributes to the declining trend in Private Fixed Investment as well.  

The Fed holds many of the cards to the country’s economic performance for the second half of next year.  Should inflation expectations not decline meaningfully enough, the Fed is determined to continue raising rates at an eye-popping speed.  Note that the rate hikes to-date have not had enough time to be fully absorbed into the economy and take full effect on dampening demand.  In reality, no one can accurately evaluate the effectiveness of these past rate hikes, and yet the Fed is still raising rates into the future.  The full effect will only be felt next year, as most of our members, and Robert as well, anticipate Fed Funds at 3.5-4% by year end.

Another data point to consider is that, for the first time since COVID, deposit balances are in decline.  Consumers are running down their excess liquidity, municipalities are withdrawing funds and deposit mix is turning into time deposits and away from the beautiful core accounts we have enjoyed for the past few years.  

Robert concludes that uncertainty still prevails; we are facing too many unknowns, including external risks such as the Ukraine War, supply-driven inflation and COVID-related risks.  My “take”:  too many and too rapid rake hikes will tell the tale.  Even if our economy can right itself through market mechanisms and improvements in productivity and the Participation Rate, the Fed can successfully rein in inflation but significantly impact the economy in the process.  

Note:  Bank performance continues to show strength, which, in my mind, confirms that we have not seen the full effect of the recent Fed actions.  Most regional and community banks are still showing solid loan growth, driven primarily by C&I, rapid net interest margin expansion and earnings generally exceeding expectations.  Credit quality remains exceptional as well.  The forward view, however, is much less rosy.  Banks are anticipating economic headwinds ahead, and using reserves and moderated earnings expectations to reflect these concerns.