In this episode, Richard discusses the latest in macroeconomic news for March, including the latest FOMC dot plot, stubborn inflation, stock markets, and the real estate pain being felt by banks.

Podcast Transcript

Chris Thonis (00:00:23 - 00:00:58)

Welcome back, everybody. We are already nearing the end of March, which means it's time for another episode of Monthly Macro, featuring macro analyst Richard De Chazal. Richard, happy to have you back. To kick things off, let's talk a bit about the latest FOMC meeting. So while rates in the projections for three rate cuts this year remain steady, the projected dot plot, the core PCE inflation and then the change in real GDP did not. Do you mind first and foremost, just breaking down what has changed and then maybe what the new expectations and forecasts are now that, you know, we've got this and as we move forward.

Richard de Chazal (00:59 - 00:07:57)

Hello, Chris. Nice to be back. Yeah, we just had the latest March FOMC meeting, and I think if you remember this was the one back in December that everyone was expecting the Fed to start cutting rates, we rolled into January and Powell kind of nixed that one. So, those rate cut expectations shifted further back to sort of June or July, which is I think where we still are at the moment. As background coming into this FOMC meeting, we had two or three inflation prints which were a bit harder than expected. Employment growth, at least on the surface, has also continued to be pretty solid. I think there's a little bit of trepidation from the market about what happens to rates if the Fed raises both those growth and inflation forecasts. Do they also sort of back out of expected rate cuts in that dot plot? And in the end, there is clearly a sigh of relief from the market that the Fed didn't do that or at least didn't do that for 2024.

What they did do was they did raise broke both the growth and inflation forecasts in their quarterly summary of economic projections. So, the inflation forecast was nudged up from 2.4% this year to 2.6%. And then they also pushed up the growth forecast, which back in December they had for 2024 was 1.4%. They moved that up to 2.1%. So, a bit of a chunky, chunky move there.

And then when it came to the dot plot, what they did was they kept those penciled-in three rate cuts, sort of 75 basis points of 25 each cuts for this year. So, the market took that message as you know, the Fed is pretty determined to start lowering rates and is possibly even willing to tolerate a little bit more inflation in the process of getting there, as long as it believes that the path of least resistance is still back to that 2%, which the Fed clearly does. And the market was obviously very happy with that message.

What they also did, which actually the market didn't pay that much attention to, is if you look a little bit further out on that dot plot, they backed out one rate cut for 2025. So instead of rates next year coming down by what the dot plot had put in December of a full percentage point, they're now expected to come down by 75 basis points. So maybe that could be viewed as, you know, a nod to slightly higher or stickier upside risks to inflation still hanging around that kind of thing. It could be because the Fed sees growth and more importantly, productivity growth as a little bit stronger. What they also did was they fractionally pushed up their longer term, I guess you call it the neutral rate or nominal neutral rate, which they also include in the Dot plot. So what they did is they moved that from 2.5% to 2.6%. The market kind of estimates that that's sort of between 2.5% and 3%. But if the main policy rate is, say, five and a quarter between five and a quarter and five and a half and that neutral rate is 2.6%, it means that there's still quite a large gap between where we are today and where we are, where that neutral rate is.

So we're still firmly in restrictive territory, but I think what's interesting is that if you look at what the terminal rate is expected to be from both the Fed and the markets, so when we get all this kind of easing cycle out of the way, where do we actually end up down the road? How much are they going to ultimately cut rates to? The market is pricing in a low of 3.6%. And then the Fed gives a guidance of a range of 2.6 to 3.4.

But I think both are really suggesting that policy is going to stay moderately restrictive for the foreseeable future. So it's not going to get down to that neutral rate. And the market rate expectations of 3.6%, that's still pretty high compared to that neutral 2.6%. So that means not only is the market not pricing in a recession, it's maybe not even pricing in a soft landing. It's kind of heading toward this no landing type scenario. So, I think that's interesting. I think what else, Powell on inflation basically told us that we're heading in the right direction. Inflation is slowing, it's coming down. But the Fed really doesn't want to take the risk of getting caught out by lowering rates too soon, then seeing a bit of a bump in the road that's maybe more than a bump in inflation flares up again, which then kind of forces the Fed to backtrack. That damages their all-important credibility, which in turn impacts their ability to fight inflation going forward.

I think as long as things progress as they are, we'll probably see the Fed cutting rates in July. Maybe even as soon as June. But in my view, we're still tilting the risks towards keeping rates a little bit too high for too long, being maybe overly restrictive there. And obviously, the longer you keep them there, the higher the risk that you overdo it.

And maybe just on the meeting, one last thing that I was expecting to see a little bit more discussion around, but didn't actually happen was, you know, some new news on QT. So back at the last meeting, Powell told us that the Fed year, the FOMC was going to have a discussion on QT at the March meeting, which he said they did, but he said that was it and they would probably start that pretty soon this year. I suspect, we'll probably hear more about that at the May FOMC meeting. So maybe that would be a good topic for discussion for the May episode.

Chris Thonis (7:58 - 8:17)

All right, perfect. Well, while we're on this topic, let's talk a little bit about inflation. I know the recent CPI and PPI data still was not exactly where everyone wanted it. But what was communicated by the FOMC? Is there anything that concerns you or do we feel like we remain on a solid path as it relates to inflation?

Richard de Chazal (8:17 - 12:06)

Yeah. I mean, listen, the last two CPI reports were a little disappointing, as was the PPI Report. Powell again mentioned that at the meeting that the Fed thinks a lot of the January increase was due to what's called residual seasonality or what you and I might just call a bad combination of freaky weather and the growing trend over the last few years of New Year, new prices, which is kind of throwing off the seasonal adjustment factors. But clearly, if we continue to get a bunch of these kind of recurring one-off factors, if you will, you know, inflation will end up being stickier and higher than we and the Fed wants.

And that comes with the risk that inflationary expectations could then start to become unanchored, which of course the Fed is worried about. But so far that's not what we're seeing. Expectations are pretty well anchored at the moment as it stands. You know, if you break up inflation into Powell's, you know, three favorite buckets, goods, prices, and they're still negative, so they're still deflationary. There is, a not insignificant risk that that could change. So if we get another supply chain shock or if companies really want to start rebuilding inventory quite quickly in a big way, you could start to see those prices increase a bit. So far that's not really happening. And then if you look at services and shelter prices, which are really the ones that are kind of the problem or the most sticky, service prices mainly driven by wages, most evidence shows the labor market is moderating and wage growth is also slowing. And then on the shelter side, the BLS was messing around with the basket weightings for shelter in January.

And this is what kind of caused a lot of the above-expected increase in the CPI. And what they were doing is they kind of switched the shelter component or the weighting that they put on single-family homes. They increased that weighting as opposed to multi-family homes, which tend to be sort of more rental homes. And the problem with that is that rental prices, which are more weighted towards these multifamily homes, have been coming down a lot because there's this big oversupply on the market and there's a lot more in the pipeline.

But then if we look at the single-family housing market, those prices are still pretty high. They're not really falling because there's not this inventory or supply on the market because a lot of these existing homeowners just don't want to sell their home because they're going to have to jump on to this higher mortgage rate. So, they're still sitting on the sidelines and you're waiting more to obviously a component with higher price increases.

So, I think the good news is that we should start to see these prices coming down a bit. We just saw a big increase in existing home sales for the month of February. So that's indicative of more supply coming to the market. And I think that's a positive. Yeah. So, I think progress is being made. And again, Powell told us this past FOMC meeting that the direction of travel is still 2%. That road could be a little bit bumpy. And I think I would agree with him on that.

Chris Thonis (12:06 - 12:20)

And the market seems to be okay with where we're at. At least economically, with the major averages reaching new highs this week. It begs the question, are we beginning to move into stock market bubble territory? What would be your thoughts there?

Richard de Chazal (12:21 - 15:55)

Yeah, tricky question. Is it a bubble? You know, I recently wrote a note about this, so perhaps listeners might want to look at that for some sort of deeper insights. But, you know, I think clearly we've seen some pretty extraordinary things going on. For example, it's pretty incredible that the price of a mega-cap stock can go up 16.4% in a single day back in February. So just to put that into context, that jump was the equivalent of the total market cap of the 29th largest company in the S&P 500.

So obviously you see these gains and you have to think, what the heck is going on here is, you know, is this a bubble? Well let's go back and look at how do you define a bubble?

I don't think there's any strict definition of that. Charles Kindleberger, who's kind of the guru economist on bubbles. He said, a bubble is a systematic deviation of market price of a stock from its fundamental value, which is characterized by an acute rise for a certain period followed by a sharp fall.

So if you break that sentence down a bit into its components, you basically need three things. You need prices diverging significantly from their fundamental value. You need an acute rise for a certain period, but you also have a crash. If there's no crash, there was no bubble before that. And I think from that definition, they're obviously, harder to spot or easier to spot after the fact. Clearly not so helpful for investors today. But I think what we can try to do is look at those two first components to try to get a sense of what's going on.

And I think what we're seeing is valuations are pretty high so that the market is definitely not cheap. You can look at various backward-looking valuation metrics. So say for example, the Q ratio, which is total market cap divided by net assets valued at replacement cost. So effectively, what's the price you're paying on the value of the company's assets?

Or another popular one is the cape ratio, which is the cyclically adjusted PE ratio. So the price today compared to earnings over the last 10 years; [it] gives you kind of a normalized PE if you will. And both of those are really high, but both of those have been high for about a decade now. So, they're not terribly good timing indicators. And if you were actually to strictly adhere to those for your portfolio, I think you'd probably be pretty disappointed by the returns you've got.

But they do give us a good sense of overall longer-term kind of general valuation. They are high. I don't think they're in bubble territory yet, but they're not as high as they were during the 1999 Internet bubble when things were really crazy.

If you look at, say, the CAPE ratio back then, the CAPE at its peak was 45 times, whereas today it's 34 times.

Chris Thonis (15:53 - 15:55)

So still up there but just not as crazy. Yeah.

Richard de Chazal (15:56 - 19:14)

Exactly. Yeah

So some people are saying okay well how about it's higher than 2008? Yeah, but 2008 you're not necessarily comparing apples to apples. Because 2008 wasn’t a pure stock market bubble. It was really a housing bubble. Financial services. Not a pure internet crazy bubble. I think the other thing to know is that the cape ratio also seems to have structurally increased, but in the same way that corporate profit margins have also structurally increased.

So I think the market to some extent has probably realized that if margins are going to be structurally higher, it's fairly reasonable that we're also paying a structurally higher moral market multiple for those better earnings. And, you know, the obvious caveat is what happens if those margins mean revert? The answer is clearly you would suffer a pretty painful rerating of that of that multiple to that new lower margin growth territory. And that's certainly possible over the coming decade or more. But it's definitely not something that's happening overnight and sort of bubble-esque.

One more thing, maybe if we look at sort of more forward-looking valuation metrics, which, you know, should kind of take into account these structural regimes, we can look at something like the implied equity risk premium, which is a forward measure because it's based on earnings growth expectations over the coming years. And that's kind of a metric which is meant to show how much extra yield investors are demanding for taking on the risk of owning that, or any particular equity relative to the safety of just sitting in cash or buying a Treasury bond.

So if they're demanding a lot more or a lot less in compensation, they're probably quite bullish and potentially opening themselves up for disappointment if they're excessively paying a high price for those expected returns, which could then disappoint.

So effectively, a low equity risk premium implies you're not giving yourself too much margin of error if something goes wrong. And I think what we can see from the latest readings is that the current implied equity risk premium is 4.3%, which actually exactly matches the average looking back to 1962. So, if we compare it to the average over the last decade, at the low end of that band over the last decade, but not since 1962.

I think it says, again, markets are kind of expensive, [but] not crazy bubble.

What was a crazy bubble was back in 1999 when investors were demanding an equity risk premium of 1.4%. And that was back in the days of Dow 36,000, which you may or may not remember.

Chris Thonis (19:14 - 19:20)

I do not remember it, but yes, I've heard of it.

Richard de Chazal (19:20 - 20:18)

That was the book that came out in 1999 by James Glassman and Kevin Hassett, who incidentally, was just in a Wall Street Journal article as one of three proposed next Fed chairman to depose Powell if Trump actually gets elected in November.

But the point is, what those guys were writing back then was that, if it's true that stocks always outperform over the long run, then there's really no justification for having a risk premium at all. So, they said if this kind of unnecessary risk premium was removed, and if you properly valued the Dow, it would move up to 36,000 over the next five years from its current or at the time level of 10,000.

You know, needless to say, they got that entirely wrong.

Chris Thonis (20:18 - 20:18)

Yes, they did.

Richard de Chazal (20:19 - 22:02)

The equity risk premium went back up and the market didn't actually hit that 36,000 until two decades later. So I think that's interesting on the valuation side. And just one last thing on the part of that, sort of Kindleberger definition of, the acuteness of the run up in the stock. How much of a run up have you had over a short period of time?

How much is too much? How much how fast is too fast? And, you know, one definition sort of says that any price increase that is a run up of 100% or more in the space of 1 to 3 years is typically synonymous with a bubble.

And if you go back and look at, periods where that's happened, that has sort of pegged ‘87, ‘99, that kind of thing. And that's not where we are today, though. So back in 2021, you did have a pretty rapid rebound, an 82% rise from the low. But that was from that COVID pandemic panic-related collapse in the market.

And today, if you look at where we are relative to the three-year low, the market's only up 37%, which is again, in line with the historical average change there. So, I think from that acuteness part of the definition, it's not really all that extreme. So bottom line, I think, you know, expensive, yes. Investors should definitely be a little bit wary, pursue some active strategies, take precautions, but bubble, probably not at this point.

Chris Thonis (22:02 - 22:20)

Okay, great. This will be the last question. We weren't able to touch on this last month, but I still think it's relevant. Let's talk a little bit about the recent issues around the real estate pain being felt by banks. So the recent blowup of NYCB. You’ve got the Japanese Aozora, which I'm sure I just butchered the name. I know they've been making headlines. Would you say that these issues are idiosyncratic issues or would you say they're more systemic issues? And then how worried should we be about another regional banking crisis?

Richard de Chazal (22:33 - 24:59)

We did try and touch on this, but we didn't quite get to it. But I think that's exactly, what is happening. This is kind of this slow-motion car crash and maybe we can talk about it again next month. And in fact, we've been talking about it for a year now. I mean, I wrote about this CRE issue back exactly a year ago in March last year. The point is, it's very much being an unknown known. And I think what that's meant has been that the so-called ‘at risk’ entities so the lenders in the CRE space that are really exposed to the weak spots, which is central business district office space in places like New York and San Francisco. They should have by now had plenty of time to do whatever they can to insulate themselves as much as possible from any expected impact. And I saw the former Dallas Fed president Robert Kaplan speaking not too long ago. And I think he was exactly right when he said that basically the boards of every bank over the last year have all been asking the same questions. You know, how are we exposed here and what have we done to mitigate any exposure? So this is not a shot straight out of the blue. Banks have been taking loan loss provisions already. But that's not to say that there aren’t potential implications to growth. So lenders, if they see this or smell this, and there’s risks in the air, they're going to be conservative in their lending practices. Lending standards are going to be a little bit higher. So that's going to moderate any growth there.

But overall, I would say that nobody wants to get caught out using the word ‘contained’ anymore after Bernanke's famous comments. But, I'd say we're watching it closely. You know, delinquencies are increasing and those could continue to do so in the coming months. So it's obviously an area of concern. Could act as a drag on growth. But it doesn't seem like it's a major systemic banking issue at the moment. So, you know, probably more idiosyncratic, as you put it.

Chris Thonis (25:00 - 25:04)

Okay. Got it. All right. Well, Richard, appreciate your time as always. Anything else we should touch on before you go?

Richard de Chazal (25:04 - 00:25:25)

Just to reiterate, there’s a lot of the stuff that we do talk about here that I do publish notes on, and those are available from William Blair. Just contact your William Blair representative.

And I do have a distribution email list. So they'd be more than happy to put you on that as well. So that's probably it for me.

Chris Thonis (25:25 - 25:31)

Perfect. Great. Thank you for that shout-out. I don’t think we do that enough. All right, Richard, thanks again. We'll talk soon.

Richard de Chazal (25:31 - 25:32)

Thanks, Chris.