Monthly Macro with Richard de Chazal—June 2023

In this episode of William Blair Thinking Presents, macro analyst Richard de Chazal discusses the latest CPI data, the ongoing impact of the Federal Reserve’s inflation fight, and his economic outlook for the near and long term. In addition, Richard provides listeners with macro highlights from William Blair's 43rd Annual Growth Stock Conference and shares insights into attending management teams' assessment of the macroeconomic landscape.

Podcast Transcript

[00:00:24] Chris Thonis: Hi everybody. On today's episode of William Blair Thinking Presents, we welcome macro analyst Richard de Chazal. With over two decades of experience analyzing the U.S. economy and financial markets, Richard routinely provides timely insights and commentary on a broad range of economic trends, including the various high-frequency economic indicators that are released each month.

He also, of course, covers the actions of the Federal Reserve and financial markets, and his analysis tends to be broken up between three core reports including his Economics Special Report, Economics Weekly, and Weekly Market Monitor. With that, Richard, thank you for joining the show. It's good to have you here.

To kick this off, I'm hoping you can take us on a walk back to some of the more significant economic indicators in fed action that occurred in June. In particular, we'd love to start with the most recent CPI data, which I know didn't necessarily provide the news we wanted this time around. What would you say were the most important takeaways coming from this month's reading?

[00:01:21] Richard de Chazal: Sure. First of all, Chris, I would just like to say thank you very much for inviting me on your podcast. On the inflation front, I think the basic premise or the prism through which I'm looking at the economy right now is really that this is more of a textbook economic cycle that's playing out; sort of Economics 101 type thing.

We had the pandemic. We had the global financial crisis in ’08, ’09. I think right now what we're seeing, from a very big picture perspective, is on the inflation front we had covid. We had a lot of stimulus. We had too much money chasing too few goods. We had prices skyrocket. Those were edging down a little bit and then we were hit by the Ukraine invasion. So, commodity prices were soaring - grains, metals, oils, and, in particular, gas and now those are kind of dissipating, but we're still left with this stickiness from a very tight labor market.

[00:02:24] Consumers still have pretty good balance sheets. They still have excess savings. So those are diminishing but not quite fast enough. I think what we saw in the May CPI report, which was just released a couple of weeks ago, is that story playing out. So, encouragingly, we did see a deceleration in headline inflation. That fell from 4.9% to 4%.

[00:02:51] That's a pretty tangible, significant fall. Unfortunately, a lot of that weakness came in food and energy prices, which tend to be a bit more volatile. If you look at the core rate, which excludes both of those, the sequential month-on-month gain was still 0.4%. That's kind of been the trend for quite a few months now and the annual rate of change really just nudged down a bit from 5.5% to 5.3%. So, encouraging but not quite there yet.

[00:03:24] If we look at what Powell likes to look at, [it] is the four buckets of inflation. There’s food and energy prices, there's durable goods prices, shelter prices, and shelter or services less shelter. All of those, again, tell this similar economics textbook 101 story where higher interest rates are slowly filtering through to the economy.

[00:03:50] They're having a dampening effect but they're moving through in this dominos-type pattern. Durable goods prices, the first thing you would expect to get hit from higher interest rates, those are coming down. Those are now negative year over year. That's significantly helpful.

[00:04:07] If you look at shelter prices. Those have been higher but if you look at what actually drives those rental prices and shelter, it accounts for about 35% of the CPI basket. We know those lag, feet on the ground, real rental price changes in the real world by anywhere from eight to 14 months.

[00:04:30] We know those rental prices are coming down and those should start to decelerate and be a negative drag on the CPI in the coming months. It's really that final bucket of services, less shelter, which again is as Powell likes to say, more driven by wages and salaries. That's the kind of stickier aspect.

[00:04:55] I think a good example of this is the price of haircuts. The major cost of a haircut is really the labor, the barber, coiffure puts into their cuts. Those are still elevated so haircut prices are still year over year about 4.9%. That services-less-shelter component is still at 4.2%.

[00:05:17] I'm optimistic that we're seeing improvements. We've seen supply chains that are clearing. If we look at more forward-looking data, so sentiment from small businesses on their pricing plans, those have come down quite sharply and the leading economic indicators of general economic growth are also down quite sharply. Those would all be good indications that pricing should start to come down more tangibly in the coming months.

[00:05:47] Chris: I'd love to really dig into where the Fed currently stands. Obviously, they are seeing the same data you are. You just mapped this out a little bit and you know, right now, we hit a little bit of a neutral point. They didn't raise the rates.

In your last Weekly Market Monitor you said that there's still potential for one or two more rate increases before a definitive pause so this current pause is not necessarily great news. What does that mean for the near future in terms of market participants and what could change as we move towards the second half of the year?

[00:06:22] Richard: There are probably two ways you can look at it, what the Fed is doing at the moment. There’s probably how I'm looking at it and how the fed's looking at things. It's obviously only the Fed's view that matters but I'll tell you my view anyways.

I think from my view there's pretty clear evidence that growth is slowing. I think it's very likely that we'll have a recession in the coming 12 months and that inflation is going to moderate. So, if I were on the FOMC, which obviously I'm not, I would be looking to pause here and not raise rates again later this year.

[00:06:57] I think one other thing to note on this front too is that even if you pause here, as long as inflation is coming down, you're still tightening policy. Your, real rates are still increasing and that's the rate that actually matters, the rate after inflation.

[00:07:15] The Fed actually has to start cutting rates for policy to remain neutral as long as that inflation is coming down. If you look out into next year, assume the consensus forecast is right. So, in 2024, by the end of the year, the consensus is looking for inflation to fall to two and a half percent. If you don't lower rates, you're actually raising rates by about 150 basis points just by pausing as it were. That's something to think about and that also ignores what the Fed is doing on its balance sheet with Q2. I think the Fed right now is following this opportunistic disinflation period, which Greenspan did in the 1990s.

[00:08:02] That would be my message. I think that's not what the Fed is telling us. What the Fed is telling us is that it's taking a breather. It paused in June, but it fully expects to raise rates again in July and maybe even again in September. I think what the Fed is doing is this sensible risk management approach.

[00:08:26] A disaster would be if it stopped raising rates and then inflation takes off again. That's essentially what happened to Volcker the first time around in 1980 when he felt that the economy was in recession, inflation was coming down, he could bring rates down and he brought them down quite significantly.

[00:08:47] But then inflation wasn't quelled, and he had to crank them up again back to 22%. The Fed today, I think, is deathly afraid of making that mistake. It’s adopted the post-Volcker mantle of making sure it doesn't happen or keeping at it to keep inflation down and policy tight. Which, from their perspective, means being overly cautious, overly hawkish, risking a recession, but definitely getting that inflation down to try and regain some of that credibility that we've lost. Powell is basically playing that they're in risk management mode and they've also been telling us that, in contrast again to market expectations, they actually don't plan on cutting rates for another two years.

[00:09:37] That’s something that was a new thing that the markets hadn't really been thinking about. That is what Powell revealed at the last FOMC meeting. I think from the market's perspective, it was expecting about 50 basis points in cuts through the rest of this year.

[00:09:52] Those have now been completely wiped off the table. The market is still expecting about 125 basis points of cuts in 2024, which Powell is kind of pushing back against, but the market really doesn't seem to be buying into that view just yet.

[00:10:15] Chris: Beyond the Fed, what would you say are some of the other economic indicators that have caught your attention lately? I would love to know are there any big surprises in the positive sense? Anything that makes you hopeful for the near future?

[00:10:25] Richard: I have to admit I'm definitely a little bit less optimistic about the near-term cyclical outlook. Where I'm most positive about is the structural or secular story right here. I think that's where we're seeing the weird market behavior.

[00:10:44] I think that's slightly confusing investors right now. They're trying to balance this more gloomy, near-term, cyclical outlook, more expected volatility, and a bit more noise with what looks like a more positive, structural, secular economic growth story. I think we can see that in a number of different areas.

[00:11:08] In housing, for example, we're going through a bit of a near-term cyclical weakness in the housing market. But structurally, I think there's a structural undersupply of homes. There's structural demand coming from the millennial demographic, et cetera. So that's perhaps one example.

[00:11:25] I think another one is on the whole productivity front. This is where I differ from a bunch of other economists. I think most people are pretty pessimistic right now about the overall productivity outlook and I think with some justification because it's been terrible for the last few decades. But, if you try and assess what actually caused that weak productivity, I think one of the biggest contributors was this supply glut of labor. We had an excess of labor from the opening up of former Soviet countries, the opening up of the emerging markets, free trade, all this kind of thing where labor was cheap, plentiful, and for companies it made sense to take on more workers.

[00:12:15] You could hire and fire them easily and take on less capital. I think what's changed or what is changing at the moment is labor markets now seem much tighter. We've got adverse demographics. We've got aging populations and we've got slowing population growth. We have some de-globalization or perhaps decoupling.

[00:12:38] I think that puts further upward pressure on labor costs, particularly relative to capital. I think companies, if they want to maintain these elevated margins that we've seen for quite some time, are going to have to put more emphasis and more weight on that capital investment part of their business like investing in automation to try and yield some of those productivity gains.

[00:13:06] I think on the positive side, there's actually a decent case that we could be at the early stages of a capex boom going on. The capital stock- companies haven't been investing in this for years so it's about as old as it has been since the 1960s. I think you're in the midst of a major innovation wave. You can call it the fourth industrial with AI, et cetera. Then on top of all that, you have all the incentives that the Biden administration is throwing at you through the Inflation Reduction Act, the Investment in Infrastructure and Jobs Act, and the CHIPS Act. I think there's a pretty good story there for a longer-term structural thing, which hopefully puts a little bit of a floor under some of the cyclical weakness that we see coming through.

[00:13:59] Chris: Right. I'm going to shift this conversation a bit here but still, economics-focused. You and I just had a great time at William Blair's 43rd Annual Growth Stock Conference.

You always do this phenomenal recap of the event in your economics weekly report. You call the conference “a good window into the real economy” with most companies typically providing some kind of assessment of the macroeconomic landscape. Do you mind digging into some of this year's macro highlights from the event? I know you broke it down between a few. I think it was aggregate economic growth, consumer health, manufacturing strength, views on the labor market, and then consensus among companies on inflation and pricing.

[00:14:43] Richard: That was a couple of weeks ago. I love the Growth Stock Conference. I think it's still one of the best on the street. It's a broad-based conference, which you don't get much of these days, so it gives you a really good view across the economy of what companies are saying really from the bottom up.

[00:15:04] I think embarrassingly it's the 22nd I've been to. If you want to compare and contrast it to last year, I think last year’s investors were pretty pessimistic but the message then from companies was if there's a recession out there, we really just don't see it. It was pretty firm.

[00:15:26] This year it was a little bit different, a little bit more nuanced. I think the message was “We're not currently in a recession, but we're a little bit worried about these huge increases in interest rates that have taken place over the last year and how are those going to start to filter through to the rest of the economy?”

[00:15:48] I think some companies were still very optimistic. Others. Not so much. No one I found, while these companies are never particularly negative, was overly pessimistic so it was a little bit more mixed. I think probably the most optimistic were the consumer-related companies.

[00:16:08] I think a good example was one of the big global credit card companies. These guys have a super-deep database. They have great insights into the health of the consumer and they were very clear. They said we're seeing a very resilient consumer. I think that was the message we got across a lot of companies whether it was restaurant companies or consumer discretionary companies. They were not yet seeing a whole lot of weakness.

[00:16:43] They see strong consumer balance sheets. They see delinquency rates, which have picked up a bit, but also this normalization back to 2019 levels, which was already, pretty low historically. On the consumer side, generally, it was still  positive.

[00:17:00] Where there was a little bit more pessimism or a little less optimism was on the manufacturing side. I think companies there are more at the forefront of rate impact. They're feeling further along or earlier in the chain. They're seeing some inventory de-stocking and they're starting to see that impact from rates starting to come through as well.

[00:17:26] I’ll just add two final observations that were interesting and perhaps different from past conferences. I was keen to hear what companies were seeing about the banking system. Had there been any longer-term impacts from the Silicon Valley, Signature Bank failures, et cetera? No one was really talking about that. I thought there would be more talk about tighter lending standards and banks not being as ready to loan. Nobody was really mentioning that too much. They  see it as a bit of a blip and we moved on from that.

[00:18:04] I think the second thing which was really interesting was how much companies are distancing themselves from China these days. Whereas in the past, you'd listen to these companies falling over themselves trying to tell you how big their TAM was going to be from China and once they expand that market. Today, the view seems to be “Let’s just not mention China or if we're going to talk about it, let's talk about how we're sort of diversifying away from it.”

[00:18:35] I think companies are starting to be a little bit concerned, obviously about the geopolitics there, but a little bit more concerned about investors that are starting to think about having to attach a slightly higher risk premium to those companies where they see elevated China exposure. I think that was a really new observation that has appeared over the last few months.

Chris: Awesome. Well, Richard, thank you so much for joining.