In this episode of William Blair Thinking Presents, macro analyst Richard de Chazal discusses key economic indicators, the elusive “r-star” interest rate, trends in the housing market, the inflation outlook, and the market’s “fear of missing out” sentiment.

Video Transcript

[00:00:24] Chris Thonis: Hi everybody. On today's episode of William Blair Thinking Presents we welcome back macro analyst Richard de Chazal. He's here for our July Monthly Macro episode. Richard, thank you for joining me again. It's great to have you here. It's been another busy month. I figure we can kick this off with some of the more significant economic indicators and Fed actions that have occurred this month, at least, thus far. In particular, I wanted to touch on one of your most recent Economics Weekly reports where you focus on the ongoing question, will rates be higher for longer? One thing in this particular report, you draw attention to what is seemingly this elusive r-star. You define it as a Goldilocks interest rate, the rate at which the economy and inflation are not too hot and not too cold. Do you mind just digging into that a little bit? This r-star, what is it? What has been driving it and maybe where do you think it's heading?

[00:01:19] Richard de Chazal: Sure. Thanks. Hi Chris and obviously thanks very much for having me back. I'll try and keep this relatively brief. I think effectively r-star is the rate at which all central bankers are trying to achieve in terms of the ultimate goal when setting their policy interest rates. I think from that perspective it's usually defined as the real short-term neutral interest rate for the economy.

So that's the interest rate the economy should be at when it's in perfect equilibrium. It's the natural rate when the economy is at its full potential growth and low and stable rates of inflation. I think for central bankers, they typically kind of see this as their guiding light.

[00:02:07] It's the kind of the anchor interest rate for the economy. It's the tractor beam in the sense that it pulls the Fed policy rate towards that so if the Fed's policy rate is above this r-star rate, policy is deemed as being restrictive in which case you'll typically start to see inflation coming down.

You'll see weakness in financial markets and the economy gets pulled back to this more natural rate and conversely then when policy is below or the policy rate is below r-star, policy is viewed as being accommodative. So that's when you might start to see the economy overheating a bit, inflation picking up, and financial markets become overstimulated and then the Fed is typically forced to try and push up rates to kind of restore that stability. So, I've kind of labeled it as the Goldilocks rate. It's the rate the economy should be at when things are just right. Now that's all fine, but I think there are at least two major problems with this natural rate.

[00:03:19] The first is that it's unobservable. So, we don't actually know what this rate is and estimates of it vary amongst various economists and bodies like the IMF or the Fed, which means that for the Fed and for financial market participants like investors, they are spending a lot of time looking at the various bits of economic data trying to figure out just how accommodative or restrictive policy is at the moment relative to that neutral rate. It's a bit like aiming for a goalpost when you can't actually see those goalposts out there but you know they're there somewhere. I think that's one problem. You can't see it. The second problem, I think, is that it's not necessarily stable. It's not always the same.

[00:04:07] It potentially changes over time but not very quickly because it's largely driven by structural factors which can push it higher or lower. Some even argue that there might even be two or more r-star rates, so our shorter-term equilibrium rate and then a longer-term one. That kind of complicates things a little bit.

[00:04:29] I think what's interesting at the moment is the debate now for the market, and economists, and central bankers is whether this r-star rate has changed since the pandemic. Are we now in a higher for longer interest rate environment or are we moving back into a lower for longer, which was what we were in pre-pandemic?

I think in the old world, in the pre-pandemic world, this r-star rate was really low, perhaps even negative. Larry Summers was famous for talking about this. He dubbed this as a return of secular stagnation. It meant that this rate was going to stay low for quite some time. I think most investors and financial market participants and central bankers pretty much accepted this view. Today, since the pandemic, we've experienced a number of potentially structural changes, which suggests that this no may no longer be the case.

[00:05:37] I think a couple of these factors, which you would typically look at as drivers of this natural rate, are pointing to low-ish rates and maybe a couple would suggest that maybe it's a little bit higher. I'll give you a couple of examples.

[00:05:55] On the lower side, we have demographics and by that, I mean two things that are really driving the narrative here. One is an aging population. When you have aging populations, they tend to save more. You have more savings over investments that typically equates to lower interest rates. You also have declining population growth rates, pretty much across the developed and developing worlds, bar Africa.

So again, that would be something that would drag down potential growth rates for your economy i.e., you have fewer people working, slower population growth means less consumption and slower pace of consumption as well. That's a drag on activity and a drag on rates.

[00:06:42] The other factor there could be energy. If we are moving to more of an energy-scarce world where energy is no longer cheap and plentiful, that could act again as a significant drag on growth. That could help pull down inflation and could be more of a disinflationary or deflationary world, again, pulling rates down on that side.

On the flip side, which is what people in the market are more concerned or growing concerned about is some of the factors that could be pushing it up. So those are things like fiscal policy. I think in the post-COVID world, government seem to have rediscovered the power of the purse. We're now spending more on things like wars, both hot and cold. We've got the war on climate change. Healthcare spending has certainly accelerated after COVID and we know that's going to rocket ahead in the coming years with the aging population and that increases government spending. If that government spending is not supported by higher taxes or lower spending elsewhere and if the interest rate paid on the debt starts to creep above your productive growth rate of the economy, that can push up that natural interest rate for the economy.

[00:08:07] I think the second potentially more positive factor boosting r-star is that we could be in the early days of a bigger productivity boost, say a structural productivity boost, driven by this innovation wave. We're seeing AI being the latest iteration of that and that could help to push up real potential GDP growth and in turn the speed limit of the economy. So that's typically a good thing. It doesn't necessarily mean a higher natural rate of interest is a bad thing. I think in a nutshell we're probably now in a world where not all of the forces that were pushing r-star downwards pre-pandemic are really there anymore.

[00:08:53] It's really a question of what degrees are those downward factors offsetting? Maybe some of the ones that are now leaning towards pushing it up. My guess would be that we might be fractionally higher on that rate, but probably not enough to write home about. What the Fed is saying, John Williams at the New York Fed, he's published some recent notes about this. He doesn't think it's changed. In fact, he thinks it's probably still heading lower. The IMF has also done a bit of work on this. Two things, this rate is going to remain low, but obviously, there's a lot of uncertainty around this kind of unknown variable. It's a fun topic to discuss but I think it's an interesting and important one.

[00:09:39] Chris T: Yeah, you're right. We really could have spent the entire episode on that. That's great. So, interest rates. Since we're on the topic, it's a good segue to I think the housing market, as one tends to influence the other. Powell seemed pretty optimistic in June. He was quoted to say we now see housing put in a bottom and maybe even move up a little bit.

So it seems that as rates continue to increase that the opposite would happen. But then, you know, recent data on new home sales and housing starts has, as you said in your report, far surpassed expectations to the upside, and then somehow, homebuilder confidence has shifted back into positive territory.

What would you say is happening here exactly?

[00:10:20] Richard de Chazal: Yeah, I think it’s clearly a bit of a weird situation and not one that I've experienced in my career. I mean, I think if I was to just, again, put it into a bit of a nutshell, I'd say the story really revolves around the fact that you have this dichotomy between existing homeowners and new homes for sale.

The existing homeowners don't want to sell their house because if they do, they're going to have to switch from their nice two to 3% mortgage rate to a 7% one. They're not putting their homes on the market up for sale which means that the inventory of existing homes on the market is or has completely dried up.

So, all of the inventory of homes for sale that's out there is really for new homes, and these are the ones that the home builders have on their books and they're keen to get rid of. So that's great for them. I think at the same time, we're in this situation where the economy still hanging in there.

[00:11:27] The consumer still seems to be in pretty good shape. Balance sheets are in good shape. We have a low unemployment rate and they're still keen to buy homes and anyone who then wants to buy a home really only has a choice of the new ones that they can choose from. So, for the home builders that's great because they've got the supply.

[00:11:50] There's no competition from existing homeowners and I think as a result, that's why we're starting to see their home surveys of home builder confidence have starting to move up again. So, at the moment, I think we're in this equilibrium, a bit of a stable equilibrium, but my concern would be to what extent that might be a bit of a false equilibrium.

[00:12:16] What could potentially upset this? I think a couple of things. One is that supply chains have cleared so the builders can now pretty much get all of the material they were short of during the pandemic. So that's the windows, the steel trusses, the lumber, that kind of thing. I think that's important because they also have a lot of unfinished homes or homes under construction which are in the pipeline.

I think as those are completed, they'll obviously start to add inventory to the overall supply. I think we're mostly talking about multifamily homes here, so flats and apartments as opposed to single-family homes where the inventory is much tighter. I think that's where the home builders are now shifting their attention quite wisely.

[00:13:09] I think the second thing that would potentially destabilize this is what if these existing homeowners start to put their homes on the market and then adding to that inventory and what might cause that to happen? Well, rates could come down. I think it's unlikely that they're going to come down that quickly in the next year or so.

[00:13:31] But, a couple of other factors in the near term could be that we start to see a rising unemployment rate. That could happen if rates start to finally bite and companies decide they no longer want to hoard labor and start to shed workers, in which case we start to see delinquency rates moving up and then people are sadly forced to sell their homes or they could add to inventory for various other reasons like they get a job in a different city or divorce rates increase or household formations increase. I think the narrative here is one of an unstable equilibrium in the near term. I think it's something the home builders are definitely excited about because there's a lack of competition but there's a risk that existing homes do start to come to the market as well. I think ultimately, we do start to see further cyclical weakness.

[00:14:26] Then, just to confuse things perhaps, I think there's also a structural narrative. I think that's the cyclical narrative, but structurally, I think there's actually a pretty good story there in the sense that we still have this ongoing secular shortage of homes more generally. So, if you look at vacancy rates, those are still extremely low on the supply side, particularly for affordable housing. Then on the demand side, you increasingly have millennials, which are now coming into their prime home-buying year so demand is increasing there. So, net-net, again, I think there's room for some cyclical weakness, but there's this good structural floor or foundation there if you will, that can provide some longer-term support for the housing market. So, going back to where you're talking about Powell and the Fed, I think it suggests that the Fed has to be a little bit careful here in terms of how it interprets the housing market data and how high it feels that it can push rates before potentially upsetting this stable or unstable equilibrium.

[00:15:40] Chris T: Moving in another direction, let's talk about inflation for a moment. You were relatively pessimistic after last month's headline on CPI. Things seemed a little more positive from this month's print. It came in, of course, lower than expected. Did anything really surprise you coming out of the June data?

[00:15:58] Richard de Chazal: I think clearly this last report was good news. I think we're clearly making more headway or more progress on inflation. Even the core rate came down to 4.8%, so that's great. That's encouraging. I think it is heading or will continue to head in that direction. I would say a couple of minor caveats perhaps. We have been facing some pretty easy comps through May and June, so if you remember last year, commodity prices were skyrocketing through those months following the Ukraine invasion.

So, as we start to move into July, August, and September those comps start to become a little bit more difficult from a year-over-year perspective and quite clearly we're still not yet at 2%. From the fed's perspective, I think they're not comfortable that we're definitely on that trajectory just yet.

[00:16:55] I think we're close and I think all the leading indicators which I look at are still pointing in the same direction and that's down. So that's things like the NFIB small Business Pricing Intention survey. If we look at raw commodity prices, I think in the last week we've had a bit of a blip there from Russia again.

[00:17:16] But the economy's leading indicators are still pointing to growth weakness, and I think that's consistent with further weakness in terms of pricing. I think we still need to see some further progress on the important core services, less housing front, which is mainly driven by wages. Wage growth has still been a little bit strong, so that's proving a little bit stickier.

I think the market was obviously pleased with this report, so much though that it's again, revived talk of quote-unquote this immaculate disinflation where inflation is coming down without the need for a recession. I'm a little bit less convinced that we can avoid a recession altogether but definitely things are looking better and let's hope that continues.

[00:18:06] Chris T: Immaculate Disinflation. I don't think I've heard that before. I like that. I would like to turn our attention now toward the markets. One of your most recent weekly market monitors got my attention. You were referencing the recent stock market rally following the better-than-expected CPI print and then the small increase in initial jobless claims saying that the rally has also quote-unquote increased “FOMO.”

You described this particular FOMO as a strong feeling by investors that after having been bearish through the first half of the year they feel like they can't afford to miss out on any potential future rally through the second half. As a result, the worry that supported the market through the first half of the year is rapidly dissipating.

Do you mind explaining this a bit more?

[00:18:53] Richard de Chazal: Sure. I think that's exactly right. I mean, I think at the start of the year, sentiment was definitely pretty bearish. I think a lot of investors were sitting out of the market. They were on the sidelines. We were all expecting bad news and there was a reluctance to participate.

From that perspective, investors weren't fully invested and the market wasn't overbought. Bull markets are typically built on what we call a wall of worry, which means that once all investors' concerns are gone, it would suggest that everyone is then fully invested so there are no new buyers to come into the market.

[00:19:35] So then the rally starts to lose momentum as there's no new money coming in. I think that's when you should start to be a little bit more nervous about the market. I don't think investors were necessarily wrong with that view, per se. So even though the market was up 16% on the S&P 500 in the first half of this year, I'm not sure I'd call it a healthy or broad-based rally.

In reality, it was just this large handful of large-cap tech stocks which were pushing the market higher and if you look at the S&P 500 on an equally weighted basis, it was actually only up 6%. So, it wasn't a broad base rally and I think now what might be happening is investors are thinking, well, we missed the first half rally.

[00:20:29] Inflation's now coming down. Maybe this sort of immaculate disinflation narrative is taking hold again. We can't afford to miss out on any rally in the second half so there's this sort of FOMO starting to build and we're seeing this as well in surveys of investor confidence, bulls/bears surveys, which are getting pretty bullish at the moment and they could be right if we do start to see the rally broadening into other names and breadth improving across the market.

[00:21:01] I think what you're definitely seeing is this wall of worry, which I guess was helpful for the first half of the year that is starting to be lowered, where the risk is that this is happening just at a time when these long and variable lags from previous rate increases that we've seen over the last year start to kick in. There's a concern that maybe you would be jumping into the market at the wrong time. So, I think it's a little bit cautious on that one. We're starting to see some of the meme stocks performing well again. That's always a little bit of a concern and certainly while I would doubt that’s something the Fed wants to see given that its financial conditions are one of the main channels through which Fed policy acts. So, I would be a little bit cautious on that front.

[00:21:58] Chris T: Okay. Got it. While we're still on the topic of markets, Q2, corporate earnings season is now in full swing. Anything specific you're looking for from a macro perspective?

[00:22:09] Richard de Chazal: Yes, so Q2 is underway. I think definitely from my perspective, without crunching too deep into the bottom-up type of numbers, I think from a macro perspective, I would be looking at three or four things. First, what's happening with the banking system.

Remember that Silicon Valley Bank only took place in early March and then we had Credit Suisse, so most of the second quarter we should have been feeling some of the aftershocks from that banking system turmoil. We know that bank lending standards have increased substantially. We can look at the bank lending data and see that has come down significantly, particularly for C&I, or commercial industrial loans.

[00:22:57] We also want to look at what's been happening in commercial real estate. Are banks and companies starting to feel a little bit more pain there? Are we getting a sense of that as a potential area of risk? How has that been impacting the banks and what's happening with their net interest margins?

We saw some deposit flights from the smaller banks. Are they starting to have to raise their deposit rates? Is that squeezing those net interest margins and is that getting offset by other areas? Then what about the companies that were borrowing? If they're no longer getting access to credit, how is that starting to show up?

[00:23:39] So I think so far we've seen some of the financials or the bigger bank financials have actually looked pretty good but even CEOs like Jamie Diamond have struck a more cautious tone about the future. Second thing is clearly on the inflation side. If inflation really is now cooling what's happening with this so-called greed-flation? Companies have been raising prices over the last few years to maintain margins. But today, we are seeing some slowdown in the volume or unit volume of activity and if that's falling as prices are coming down do we start to see margins getting a little bit more squeezed there?

Perhaps lastly, do we start to see margins coming in on the back of companies hoarding labor? I think one of the more unusual dynamics that we're seeing during this economic cycle playing out is that companies have been slow or less inclined to immediately lay off workers because they've been so hard to recruit, train, and costly to compensate and retain. At what point does that start to put greater pressure on the cost side, on corporate profit margins and at what point do investors start to push back and say, okay, margins might get squeezed enough?

[00:25:12] My feeling is we don't see a ton of that just yet, maybe that's more Q3, Q4 story, but that's certainly something we'll be looking at in the coming months. I think net what we have seen over this quarter has been that earnings growth has been slowing but prices have been moving up. So, what we have seen, which again, I don't think I would've expected that the start of the quarter has been multiple expansions. If you look at the PE on a forward basis at the start of the quarter it was 17.8 times. Then at the end, or today, it's almost 20 times and on a 12-month trailing basis, that's gone from 18.5 to basically 21. So, interesting there. I think those are some of the factors I think I'll be paying most attention to.

[00:26:07] Chris T: Great. Well, Richard, as always, thank you so much for joining. It's been a pleasure catching up with you. Let's connect again next month and good luck with the next few weeks. We'll talk soon,

[00:26:18] Richard de Chazal: Great. Thanks Chris. It's been a pleasure.