It was all eyes on the FOMC (Federal Open Market Committee) meeting. The FOMC convenes on set dates and their statement gives important clues to what they are thinking about the economy. The FOMC is watched closely and analysed stringently – especially given all the chatter around interest rates and their likely next move and timings. This one did not disappoint. The main points to emerge from it were:
They chose to leave target interest rate range (known as the Fed Funds Rate) at 5.25% to 5.50%.
They acknowledged growth has been expanding at a “solid” pace (contrast this with “slowed from its strong pace” back in November ’23).
The risks to its employment and inflation goals are “moving into better balance”.
They removed the reference to a tightening (rates) bias and replaced it with “the Committee does not expect it will be appropriate to reduce the target range until it has gained greater confidence inflation is moving sustainably toward 2%”.
Were they right to retain a cautious stance? Based on the January employment release, absolutely! The US posted a stellar employment gain of +353,000, far outperforming all forecasts. Furthermore, December 2023’s number was revised up strongly to 333,000 (a +117,000 upward revision to what was originally reported). So too was November 2023’s figure which was revised up to 182,000 (+9,000 higher). Average hourly wages rose +0.6% m/m - almost double what had been estimated! Wages are rising 4.5% y/y (the forecast was for: 4.1% y/y). The rise in wages was driven by a decline in average hours worked of -0.2 hours (to 34.1 hours). Job gains were widespread: Professional & Business Services +74,000, Healthcare +70,000, Retail Trade +45,000, Government +36,000, Social Assistance +30,000 and Manufacturing +23,000.
Quite aside from the above, there’s more to justify the Fed’s reticence over cutting rates just yet (remember, next month, March, was when the first, rate cut was expected). Job openings remain elevated with the JOLTS (Job Openings and Labour Turnover Survey) showing a ratio of job openings to each person unemployed at 1.44. The latter has been rising the past two months. Inflation, as measured by the Fed’s favourite indicator – the PCE or Personal Consumption Expenditures index – rose +0.2% m/m in December. This index best measures the impact on consumers of price levels on services. The result was in line with expectations but the fact that it remains “sticky” is a cause for concern for the Fed. Last, but not least, December retail sales rose a healthy +0.6% m/m. This was not expected and demonstrates a resilient consumer who is not short of a dollar or two when it comes to spending.
It's not just a US phenomenon either. Manufacturing data is showing signs of stabilisation and now the beginnings of a recovery. Activity is measured as an index. Over 50 means expansion. Under 50 means contraction. In the US, January manufacturing stands at 49.1. While this marks the fifteenth month in a row of contraction, it is starting to rise and represents a big improvement on December. A look at the underlying components (or sub-indices), such as new orders which is a forward-looking indicator, it is firmly into expansion (at 52.5, a big jump on December’s 47.0). The Eurozone is also showing signs of change. Though still in contraction territory, the key forward-looking indicators are showing signs of recovery. Remember, Germany is some 20% of the EZ economy. It too is starting to show some green shoots of recovery. The German parliament approved the 2024 budget and the issuance of €39bn in new debt. Outside of Germany and France (the two dominant EZ countries), the economies of Spain and Italy are showing good recovery signals. In Asia, for all the negativity around China, the latter’s manufacturing is in expansion mode (at 50.8). China’s economy is weak but, compared to where it stood pre-covid, has seen big improvements. Financial conditions remain tight when comparing its negative inflation vs still high Lending rates. It has the ability to inject substantial liquidity if it so choses. Unless the Politburo there has somehow taken its eye off the ball, it must be sufficiently satisfied that it can afford to take a cautious approach. Lastly, across the wider Asian region, we’re seeing a clear pick up in manufacturing activity in South Korea & Taiwan – both indicators when it comes to exports across the Globe. India saw a substantial rise in its January manufacturing activity boosted by domestic demand.
Is it all really that rosy - what storm clouds are lurking that we should be worried about?
I think the biggest challenge still, for Central Banks, especially the Fed, remains the Regional Banking sector and the potential for systemic risk. Last March, there was a real danger of systemic risk following what happened with SVB and other Banks. SVB faced a run when depositors started withdrawing their money because they could obtain better rates elsewhere (e.g. US Treasuries). Basically, SVB had financed long-term, illiquid lending through short-term borrowing (depositors). It’s a classic mismatch in the banking world which works under normal market conditions but poses a huge, macro risk when rates become skewed in favour of the shorter end. That’s what happened back then (hence the constant reference to the inverted Yield Curve). Since then, the curve steepened. Today, it is taking on an inverted form again e.g. US Treasury 1m yields 5.39%, US Treasury 1y yields 4.84%, US Treasury 2y yields 4.38%, US Treasury 10y yields 4.04%. The Fed has quite a balancing act between setting an interest rate range that just about keeps the dampeners on the economy while ensuring it doesn’t result in another bank run! The regional banking sector is huge.
The other concern is contagion risk. When SVB bank needed rescuing, its woes fuelled a run on another regional bank, Signature Bank (SB). If you have enough of these, it triggers contagion. Thankfully, the Fed, FDIC and the Treasury all stepped up to the rescue and managed to get a grip on things. Not totally understood though is that another bank – NYCB (New York Community Bancorp) – bought SB’s assets. In so doing, it tipped its balance sheet to over $100bn triggering capital adequacy & liquidity rules which meant it had to severely cut its dividend to bolster cash. NYCB’s share price is down -45% in just two days as a result of the hit to its profitability as well as some soured loans amounting to $185mn and, now a fresh worry, the impact of high Fed rates on its commercial real estate holdings. It’s not alone on the commercial property front prompting the KBW Regional Banking Index to fall -6% on Wednesday and then another -3% on Thursday. Now, a Japanese bank – Aozora Bank – expects to post a loss of some $200m and its shares are down over -20%. It is Japan’s 16th largest bank by market value. These losses are tied heavily to its commercial real estate book. South Korea is also expecting a wave of bad loans due to office space exposure. Aozora has also had to cut dividends for the same reason as NYCB so as to meet its capital adequacy and liquidity requirements. Aozora’s US Office exposure stretches to NY, Washington DC, Chicago, LA, SF to name a few. Total non-Performing Loans amount to $719mn with an average LTV (Loan To Value) ratio of 177% i.e. the Loan book is 1.77X for every unit of property value!
Property – specifically commercial property – is at the heart of many bank portfolios’ woes for reasons such as Work-From-Home and higher interest rates. Not all loans have reset yet – but property has to be (re)valued – and with falling values, losses are being incurred. That impacts capital adequacy and liquidity. That affects the ratio between Loans and property value (i.e. the LTV) which, in turn, can force a sale. If you have enough of these exposure in the system – it’s not difficult to see contagion spilling into systemic risk. The MSCI World Real Estate Index (in US$) is down over a third since the start of 2022 to Oct. 2023. The US is over 70% of this index and some $1.2tn of US Commercial Real Estate debt is marked as “potentially troubled”. The value of office space has fallen from -22.4% (Prague) to -58.7% (San Fransico). In between, you have Chicago, Miami, Seattle, NY and LA all down in excess of -40%. A group of European cities (Frankfurt, Dublin, Paris, London, Madrid, Stockholm and Milan) are all down between -30% and -40%. Why does this matter? Because unless you are cash-rich and can afford a rescue package, it leads to markdowns and defaults on an investors balance sheet. The size and scale of these ownership channels matter.
So, given that Commercial Real Estate exposure is mostly in the US, it will once again come down to a conjuring trick performed by the Fed/FDIC/Treasury. If they can pull off one of their illusions again, they should be able to kick the can down the road for a few more years. It really depends how many of these players there are out there holding portfolios of CRE. In the meantime, anything that drives up inflation again (e.g. energy prices), and we’re in for problems. At the other end, if global growth carries on picking up as we are seeing so far, that too is inflationary. Forecasts of rate cuts have now been pushed out to May (previously March). If we have another revision to this come May, markets could see red.
For w/e 31st January, Global Equity Funds attracted $7.43bn in inflows with Asia leading the way on $3.7nm followed by Us ($1.83bn) and Europe ($1.14bn). $1.98bn went into Tech funds maintaining a third, successive weekly trend. Global Debt Funds drew in $12.5bn with HY seeing $4.25bn of inflows and Government Bonds $1.5bn.