Monthly Macro with Richard de Chazal—October 2024

In this episode of William Blair Thinking Presents, William Blair macro analyst Richard de Chazal discusses the latest economic trends, including third-quarter earnings, rising Treasury yields, and the impact of recent Fed rate cuts. He also delves into consumer sentiment and the paradox of strong retail sales amid a “vibecession.”

Podcast Transcript

00:20
Chris
Hi, everybody. It's October 24th, 2024. I'm here with William Blair macro analyst, Richard de Chazal, for another episode of Monthly Macro. Richard, lots to talk about, as always, with Q3 earnings season upon us. We've got a wide range of conflicting data that shows a tepid consumer yet strong economic growth. We've got, you know, a ten-year yield that won't stop rising. And then of course, ongoing uncertainty about these rate cuts and what the Fed plans to do next.

So, with that, Richard, let's jump in. To start, why don't we talk a bit about what has happened since the Fed cut rates by 50 basis points in September. Given the data you've seen since, do you feel like this is the right move and where do you where do you think we're going on rates now?

1:03
Richard
Yeah. Good question. And. Yeah, definitely a lot going on. We haven't even got to the election yet. That's, still coming up.

1:09
Chris
It's coming. It's coming quick.

1:11
Richard
It's coming quick. It's busy. But, yeah, obviously, that's the key question. I think there's been a lot of looking through the rearview mirror following that, kind of surprise, 50 basis point cut, which actually feels like a while ago now. And I think you know, looking back through that, you know, mirror, what we have seen is that the data has continued to surprise to the upside.

So, you know, if you look at aggregate measures like economic surprises, indices, those have really moved back up into positive territory. So, you're seeing a lot more of the data coming out above what economists were expecting, you know, and that's included things like retail sales, those in the last report were up like 0.3%, which is quite a bit higher.

But even the control group was sort of a subsegment of that retail sales report but is actually the part that's used for the personal consumption data in the GDP report. That was up like really strong 0.7%. And I think because of that, you've seen these GDP estimates for the third quarter, they've just gone up and up and gone up to 3.4%, which is which is pretty strong - stronger than the potential.

And, again, it seems like a bit of a while ago, but we saw that non-farm payroll data that increased by 254,000, which was well above what was expected. We've seen initial jobless claims being really low. The unemployment rate is 4.1%. So yeah, I think, you know, you're right in asking I think the market has been right in asking, you know, looking back, why did the Fed kind of feel this need for a panic. Almost 50 basis points cut when the market, remember, was totally comfortable with 25. But I think the Fed didn't need to do that. I think I think it probably did. So, I was on board with a 50 cut. I think there was a lot of bad communication around this. Like they should have been prepping the market beforehand. And maybe Powell internally had a bad communication with his with his team. But I think the story is still that, you know, we had a policy rate that was really set for higher inflation. So that was set when inflation was up, you know touching 9%. And thankfully since then we've come back to, you know, 2.4% on the CPI.

So it no longer feels that that policy rate is still fit for purpose. It obviously has to come down. And I think what Powell and the Fed really, really want is to make sure that they're not hanging out at those high policy rates for too long and actually provoking a recession, you know, which historically they often have.

So, Powell really wants to underwrite this this perfect soft landing. You know, and that's a pretty respectable goal. So it needs to come down. Exactly to where is the debate. But I think most people in the market would agree that five and quarter to five and a half was too high and something in the range of cuts of maybe 150 to 250 basis points – so quite a wide range, admittedly, but, you know, it needs to come down something like that. So, I think the Fed probably figured let's go for 50, let's get the ball rolling and then sort of do any fine tuning a little bit further down the road, which I which I think is actually fair enough. And remember that we actually are seeing some softening in the economy in a number of areas.

So aggregate hours worked is actually moderating. So we're still hiring people, but we seem to be cutting their hours worked. And remember that, you know, one of the things I'm still worried about, but seemingly fewer and fewer seem to be is that I don't think we've actually fully absorbed all of the lags that are in the data or coming through into the data from those higher rates. That's because households locked in mortgages for longer.

I think, you know, a certain segment of the population with mortgages had locked them in. They've really been insulated from this tightening cycle. And the same goes for a lot of larger companies who can lock in duration in the debt market as opposed to the smaller ones who can't. So, I guess my point is, is that while 5% was high, the Fed got there really, really quickly.

You know, it was one of the fastest tightening cycles that we've seen in history. And I think many parts of the economy just haven't really felt it yet. So, you know, this is in Milton Friedman's old shower analogy that when you twist the knob of the shower dial to hot water, it takes a while for that water to actually, you know, heat up and start hitting you.

And I think that the Fed twisted that dial pretty quickly. And many parts of the economy, for various reasons, are still, you know, not feeling that heat or starting only starting to, to warm up. So, it never really got to a scaldingly hot measure. What the Fed is now trying to do is seeing inflation coming down. And now it feels like it can move from restrictive, but not too accommodative. It's not trying to halt to a recession, but it can move from restrictive to neutral. And in my mind, that's still around 3% and not as high as 4%, which I think, you know, some people are talking about. I still think, you know, those lags will come through and we missed getting the full impact of the 5% because of those. And the natural rate is still probably closer to that 3%.

8:00
Chris
So the rate cut has also done little to appease treasury yields, with the 10 and 30-year rising to their highest level in three months. Not necessarily something the real estate market has wanted to see either. What has been driving that exactly?

8:15
Richard
Yeah. So good question. We've seen ten-year yields back up above 4%.So if you break up that yield, I guess the first part is you would expect to see longer-term Treasury yields rising if you're seeing better economic news. And I think because of that, you know, where we just talked about the retail sales, payroll data, that kind of thing, I think the market has been reassessing the extent of the slowing that we're seeing. And, you know, that's being reflected in expected future short rates. So, a ten-year yield is the sum of expected future short rates and a term premium or inflation premium. And those expected future short rates are really a reflection of the real economy and what's happening there. And definitely seeing a lower risk of a recession and a higher risk of that softer landing. So, I think that's getting reflected there.

I think the second reason or possible reason is maybe a reflection of what's happening on the election landscape. So, you know, I think what we've seen in the last couple of weeks that's coincided with this move in rates has been, you know, Trump has, I think, noticeably, started to move back up ahead of Harris again in the polls. So that's for a whole variety of reasons we won't get into. But I think you've definitely seen that in the betting markets,and there's a whole debate of, if those are manipulated or notI think for the most part they're actually not. Maybe one or two there were some big bets, but, on the whole, if you look at them, I think they've been pretty consistent.

But you've also seen that in the actual polling data. So, the aggregators like RealClearPolitics, that kind of thing, you're still seeing Harris maybe slightly ahead in the popular vote. But as you know, it's the Electoral College that actually matters. And Trump is, you know, tangibly ahead there. Maybe a slight beside, if you will, because I thought this was interesting. When I was looking at that at the polls earlier, it’s not just the White House that matters. It's who wins Congress. And what you're seeing there is the potential for the House to flip from Republican to Democrat and the Senate to flip from Democrat to Republican. Which, I didn't know this, but this would be the first time that that's ever happened in 230 years where each of the two chambers both flipped.

So I think, you know, Trump's moving ahead there for the White House and then for Congress, you know, the Senate tends to matter more. I think if you're getting the Senate moving to the Republican, the GOP, I think that's quite powerful as well. And then you start to think about what are Trump's policies? So higher tariff, weaker dollar, tax cuts, more deregulation and all of those look a little bit more inflationary than Harris's platform, which is sort of, you know, tax increases, more regulation. So, I think that’s, you know, also starting to be reflected in those yields as well.

And maybe a third potential area, and I think none of these are kind of mutually exclusive, but, you know, could be that the market's also starting to get worried about what's coming down the pipeline in terms of future Treasury debt issuance in 2025. And that's pretty much regardlessof who's actually in the White House. So remember we discussed in the past this kind of Operation Twist where the Treasury was issuing more short duration debt than long duration debt and they have to twist back probably later next year. So, it's possible that that is starting to weigh on the bond market a little bit. So maybe that's a small factor. It doesn't seem to be fully being priced in yet. But I think generally, the upshot of what we're sort of seeing is stronger near-term growth, maybe starting to price in a bigger inflation premium on the back of a Trump win and potentially some concerns on the supply side, as well.

13:13
Chris
So let's now shift the conversation a bit to the consumer. Sentiment has been pretty weak. So some are calling this a “vibecession.” But we've seen retail sales have been quite solid, which is a paradox of sorts. What's going to be driving the consumer and is that likely to persist going forward?

13:32
Richard
Ya I think for the most part, the consumer is in pretty good shape. You know, balance sheets are pretty healthy. So debt ratio issues are low across a number of different gauges that you want to look at there. As we just said, the unemployment rate is 4.1%. The labor market is still pretty tight and inflation is back below 3%. So, you know, what's not to like.

And I think as you mentioned, you've sort of got this ‘vibecession’ people are talking about where spending has improved but consumer sentiment is still pretty low. So, what's the problem? Why aren't consumers feeling it? And I think they are not comfortable. I mean, I think you can see that in measures of sentiment, you can see that in politics and, you know, talking to consumers, you can see it in the dockworkers strikes. There's more strike action going on. So, people are not as happy as you would expect them to be looking purely, at the numbers.

And, and I think really, that's still the ongoing hang over from the high inflation that we saw. So even though, you know, inflation's back below 3% and your income growth or real income growth after inflation is positive again, you know, the reality is the level of your real income, which, you know, collapsed, that's only improved a little bit. You know, it's still only back to 2016 levels if you look at the employment cost index and inflation-adjusted terms. So, we're a long way back from where we were pre-COVID. And I think for the consumer, they're feeling that. They feel that their real purchasing power hasn't recovered. And it's still going to take a while to get back to where they were before Covid.

So, it's a bit of this classic case of rates of change versus level. And I think, you know, what we look at in financial markets is we always, you know, spend probably too much time just looking at the rates of change because that's what's most important for financial markets. And almost a second derivative is more important, the rate of change of the rate of change.

But, you know, if you're talking to consumers, you know, they're not so interested in that. They're out there looking at the level. It's the level that that matters for them. They still think we have a lot of catching up to do. So, you know, what's going to be driving them going forward? One potential option that is surprising, is actually credit growth. And I think what's interesting about this cycle so far is consumers haven't really been taking on much credit. And I think that's important. I think it's important because, you know, a credit and a non credit-driven recovery tends to be more sustainable.

And I think it probably also helps to explain why the consumer has been feeling a little bit less sensitive to those rate increases this time around. So, I think I think that's interesting. You know, right now, I think the risk of a big surge in credit is actually still pretty low. So even though they have the capacity, maybe they don't have the willingness to take on more credit. So banks are still kind of reluctant to start lending to consumers. We're seeing a little bit of stress in lower income areas. We're seeing some rising delinquencies. That consumer sentiment, as we noted, is still pretty low. And I think what's also interesting from maybe a bigger picture perspective is that you have this kind of demographic weight, I think on credit growth in the sense that you've got one of the largest cohorts of the population, the baby boomers, that are moving into retirement.

And, you know, they've got all the stuff that they need. And I think the last thing, you know, 70- and 80-year-olds want to do is: A) buy more stuff and B) take out credit to buy that stuff. So I think from that perspective, you know, there's limited gains in the aggregate level of credit even though you could see some cohorts, you know, increasing their credit growth.

And I think one other, or maybe two other positive areas where you might see some support for the consumer is one, starting to see a little bit of the wealth effect kicking in. Now, this was sort of big in the late 1990s on the back of the stock market gains. Alan Greenspan spent a lot of time sort of studying the wealth effect. And then we saw it again in the next cycle in the lead up to the global financial crisis where we saw the housing market was leading to a wealth effect. And this is kind of the sentiment where consumers feel like the gains they’ve made in these markets is kind of doing the savings for them, if you will. And, you know, research shows that consumers for every dollar increase in the stock market, that has led to sort of 3 to 5 cents of spending and then every dollar gain in the value of your housing portfolio or your house, you know, that's resulted in about 5 to 8 cents increase in consumption. That's fairly significant. So, I think that's interesting. We're starting to see that kick in a little bit this time around whereas we didn't in the expansion following the global financial crisis where everyone got their finger burnt and didn't want to engage in that.

And one other final thing perhaps worth mentioning that's been important for consumer spending is really one that maybe doesn't often get mentioned in a positive light as a positive contributor and that's the huge impact of immigration. Now, you know, that's something I've written about before, and I think immigration is really great for all kinds of reasons. Of course, there are some drawbacks, but I think it's really important that what we've seen over the last three years is net immigration, according to the Congressional Budget Office statistics, we've seen a net immigration increase of 10 million people in total over the last three years including 2024. So just for comparison, that's more than we saw in all of the ten years from 2010 to 2019. So pretty big. And I think if you're adding over 3 million to your population per year, that's clearly a lot more mouths to feed, shops to fill, houses to build. And unsurprisingly, that's going to have quite a supportive impact on economic growth.

And then, of course, the flip side to that is you need to think quite closely, what happens if, you know, you do decide to deport 20 million workers. So, you know, there's clearly a reverse effect there, and it's, you know, something to think about as with everything in economics, it's all about trade-offs.

So I think that's what we're seeing now. We're seeing a pretty good consumer situation. Maybe, you know, the savings are gone. Real income gains are doing okay but there's still that faulty sentiment but nothing's kind of pushing them off a cliff. And that's not really going to happen until you really start to see big declines in employment, which is not something we're seeing at the moment.

22:03
Chris
All right, which brings us to Q3 earnings season, which we are now in the thick of. It kicked off last week. How is it shaping up thus far and then what do you expect to see these next few weeks?

22:15
Richard
Well, I mean, it's still early, but so far so good. I think what we're seeing right now has fit the historical pattern to a tee in the sense that, you know, thankfully, what we're seeing is nothing terribly unusual. And that's basically the same sort of pattern we always see that at the start of the quarter. Companies downplay their expectations to analysts and the market. Analysts then downgrade their own earnings estimates throughout the quarter. And then, you know, when reporting period happens, lo and behold, the company announces, a surprise earning. So, I thinkwhat we're looking at now is you start to look at the degree of the surprise. Is the surprise higher than it normally is? Are we seeing more surprises? And I think again, here, generally, things have been pretty good. The earnings or EPS surprise has so far been pretty much in line with what we've seen in the past few years. The sales surprise factor maybe a little bit lighter on that top line. So that's been a little bit on the low side.

But I think, you know, looking forward, and again, from my bigger picture macro point of view, and thinking about what's driving these. If you think well, inflation has come down,so what's happened there? Well, we've seen retail prices. They've been decelerating. But importantly, that's been at a slower pace than wholesale prices. So at least you're still getting that pricing margin.

But what's interesting is we've also seen, and as I mentioned earlier, those employee hours of work have been falling which is maybe not great for the economy. But what you've also seen accompanying that is that output has actually still been pretty strong for the quarter with GDP up over 3%. So, what kind of solves that puzzle, where you're getting fewer hours worked but still getting strong growth in output is stronger productivity growth and you know, that's great for corporate profitability. What's driving that? A little bit hard to tell at the moment. I think, you know, is it AI? We're reaping the rewards for all of this AI we've been seeing suddenly coming in and resulting in higher productivity? It feels a little bit early for that.

I think some of that's still in the pipeline. Maybe on a slightly darker side, if you look at that consumer sentiment, maybe there's that feeling that their purchasing power has been eroded and maybe we're just seeing workers having to work harder because they still feel like they need to catch up to regain that purchasing power. So, they're just being more productive. So, I think on the whole, I mean, what we're seeing is a pretty good quarter for earnings. I think that's likely to continue and there we are.

25:37
Chris
Well, that's all the time we've got for today. Thanks again for joining, Richard. I'll chat with you again next month of course.