Transcript: The 2021 economic outlook for middle market companies

[2021 CIBC Commercial Outlook]

[mid tempo music plays]

[David L. Donabedian, CFA US Private Wealth Management]

Welcome to our 2021 Outlook for CIBC US commercial clients. My name is Dave Donabedian, I'm the Chief Investment Officer for CIBC Private Wealth in the U.S. 

[Macro economy]

[stocks and bonds markets]

In the time ahead, my colleagues and I will walk through some of today's key business trends and what they mean for companies and corporate leaders.

[Key takeaways]

Before that discussion, I'm going to set the table with a quick look at our outlook for the economy and financial markets. So let's start with the economy.

[PowerPoint slide showing a bar graph of 2021: Fastest economic growth expected since the 80’s]

Certainly, as this stands today, the economy has lots of problems. As you can see on this chart of annual economic growth, we saw a big drop in GDP last year due to COVID, and we know there's almost 10 million fewer people employed versus a year ago.

So problems, but when we look forward, we actually think 2021 will end up being the fastest year of economic growth since the 1980's. 

The red bar here represents the consensus economic forecast for this year, and it's for 5 and a half percent real GDP growth as you can see that would be the strongest since 1984. 

We also think that if this consensus forecast is wrong, it may well be too low. So consider the current situation we have economic reopenings happening in virtually every state. The vaccine rollout is accelerating, and this combination probably means that the economy is sort of getting ready to launch on its own. 

Yet we're about to have a 1.9 trillion dollar front-loaded COVID relief package injected as well. We've never seen this before, and it could lead to growth well above that 5 and a half percent consensus forecast. So with the transition from 2020 to 2021 may feel a bit like economic whiplash. 

[PowerPoint slide showing a graph of Bond yields rising: good or bad thing?]

We can see on the next slide that some of this whiplash is already playing out in the bond market. What I've circled in yellow is the more than 50 basis point rise in the 10 year treasury yield that's happened over the last couple of months, and we pose the question here is that a good thing or a bad thing?

Well, so far, I'd say mostly it's a good thing because it's signaling economic recovery and a move away from the deflationary risks that have existed for much of the pandemic. 

And the bond yield level, of course, is still quite low. You can see they remain below where it was pre-pandemic. I think what we need to watch here is the rate of change. Obviously, if bond yields keep going up, 50 basis points every 2 months, we can all agree that would be a problem, but that's not what we expect. 

We think the 10 year treasury will spend most of the year in a 1 and a half to 2% range. So while there will be a net upward drift in bond yields this year, we don't think yields will go high enough to really be a show stopper for the economy or the stock market.

[PowerPoint slide showing a line graph of Stock Market – Volatile, but supported by likely profits boom]

And on the topic of equities, the stock market, we're cautiously optimistic here. Yes, valuations are full. Yes, there are signs of speculation for certain risk assets. But, if our forecast is right on a strong economy, we're likely to see a profit boom this year with further gains next year. 

The chart here shows annual profits per share for the S&P 500 companies. You can see there was a dip in 2020, but analysts expect a 24% recovery surge this year and double-digit gains again next year. So this is profit power we think will lead to a positive year for U.S. equities. Not as positive in terms of strength as what we saw the last couple of years, but positive nonetheless.

[PowerPoint slide showing summary of investment themes]

[Strong economic growth projected in 2021]

[Monetary policy should remain supportive]

[Longer-term interest rates should be subject to some upward pressure]

[We expect stock market to advance in 2021 — mid-to-high-single digits for S&P 500]

The last year is really just a summary of our key themes. First, we're headed for a very strong year of economic growth, we believe. Second, we think the Federal Reserve will be supportive of this growth and will tolerate a moderate rise in inflation. As a result of that we expect only a moderate rise in bond yields. And finally, we think stock prices will end the year higher than with more subdued returns than what we've seen in either 2019 or 2020. Mid to high single digits seems to us like a reasonable expectation for equities. 

So, to help put this outlook and analysis into context for businesses navigating this year, we're joined by a panel of leaders from across our commercial lines of business. With us today is Bob Frentzel, Managing Director and Co-Head of CIBC U.S. Commercial Banking; Jackie Barlow, Managing Director and Regional Manager for CIBC U.S. Commercial Real Estate; and Keith Reno, Managing Director and Head of U.S. Middle Market Solutions for CIBC Capital Markets. So thank you all for joining us, and let's jump right in.

I used the word inflation a couple of times in my earlier comments, but let's sort of take that from the macro-level down to the company level. And I'll just ask a question, really for all of you. What are driving costs for a client today and as we look ahead over the rest of the year? Keith, maybe we'll start with you.

>>Keith: Yeah sure, thank you, Dave, and welcome everybody. I'm going to key in on a word that you used a couple of times as well, Dave, and that's whiplash. When I think about what's going on in the foreign exchange markets clearly there was a long-term stronger U.S. dollar trend in play. So, for example, from 2018 through 2020, the U.S. dollar on an index basis and appreciated somewhere in the neighborhood of 15 and 16% . The whiplash starting with the pandemic from March, and then the following 9 months, the dollar sold off on an index basis of nearly 14%. So from a client's perspective, that is a seismic shift in the directional trends for our importers and exporters, depending on which side of the equation that you fall on.

So in terms of costs and what clients are concerned about in 2021 is how do we adjust to this whiplash, right? And so there's a couple of things that come along with that. The first is there are some indirect costs that are starting to show up now that maybe weren't so obvious before. For example, importers from China tend to do business in U.S. dollars when the Chinese renminbi, right, or the Chinese yuan feels the exchange rate changes that have taken place at ease stronger against the U.S. dollar. What that means is, they reprice goods and services for our client base, and often times, almost nearly all the time, what we see are price increases in dollar terms that far exceed what the exchange rate moved by. So these are some of those indirect costs that clients face, and helping them work through that is really important for 2021.

The other thing, and by far the most important, is what this whiplash and pandemic has created is cloudiness, cloudiness in supply chains, cloudiness in forecast ability. And so when you get the choppiness in your expense base or your revenue receipts, those pre-existing foreign exchange exposures show up in a stronger way than they would in times where business is more normalized.

[End of editorial review for 7 min mark]

Absolutely Bob, Jackie, anything to add here?

Well, you know to feed on what Keith had talked about, you know, it's going to come down to being able to meet the demand. You know we look at just before COVID took place, there's a lot of discussion on tariffs, and what was happening with the tariffs between the US and China, and many of our clients were looking at their supply chains and moving some of the sourcing from China to other markets. Well then, we hit COVID, and now the demand was much less they were trying to figure out what countries would be able to produce goods and services. And now we have a situation with so much stimulus into the marketplace that I think many companies are trying to figure out can their suppliers give them the product they need to meet the demand?

So as we think about what's going to be driving costs, is can I get everything that I need, recognizing there is going to be other countries that are going to be going through the same. We're not the only ones that have created some stimulus in the economy. So I think we're going to see the access to product is one. 

How to get the product from point A to point B, I've been reading a lot of things and talking with our clients about shipping containers right now there's a shortage of them. So the fact of the matter is we think that 1.9 billion dollars of additional capital comes in, there's going to be a demand for more products, but we can't get it to the places we need. And so, the traditional supply chains the people were relying on, and really had needed to take, you know, a lot of effort over the course of the last eighteen months. In the next six months, those supply chains are really going to be put to the test. 

And then, the next element you look at supply chain it's going to belabor. There's going to be a war on talent while we have unemployment very high most of those are unskilled labor. For skilled labor, access to those people, and the demand for those people are going to be something we haven't seen for a while. So I really I think between the choppiness as Keith had mentioned as far as what our economic policy is going to be, the ability to get the products from point A to point B, and then the ability to attract and retain talent is going put some pressure on our costs into 2021. 

You really bring up a great point Bob, and that is how do we get everything from point A to point B, and that's the biggest part that's hitting the real estate industry. We cannot build distribution space fast enough. Everything from the million-plus square-foot distribution centers for Amazon or whomever, outside of major urban areas, to the last mile distribution facilities that are dropping all those boxes off at consumer’s houses. They just can't build it fast enough. 

The other thing that's happening is trying to build it where they can get to the labor, where they have the right labor, at the right cost, to be able to man those facilities and then to deliver the goods to the consumer. So definitely a driving force in commercial real estate, and seeing the way that Covid really accelerated trends that were already taking place. 

I would add we're seeing a big big increase in the cost of raw materials. Just anecdotally speaking with some of our clients, the cost of lumber and steel has skyrocketed. It's at levels that haven't been seen since the great financial crisis, just before the great financial crisis actually. Some folks are saying that their steel costs have doubled in terms of what it's costing to get the decking down to get started on these buildings, and lumber I’m hearing starting at 25% increases. So that's huge in terms of being able to meet the demand for those supply chains.

Yeah, I think we're seeing that economy-wide, and it's due to rising demand across the commodity complex, and you also have financial buyers purchasing commodities as a potential inflation hedge it's been a noticeable trend in the last, especially the last three months.

So we've had this remarkable year of occurrences and then remarkable policy responses to those occurrences and just sort of a broad question about how we put all those factors together. So how has pandemic cost-cutting federal stimulus and extended periods of unemployment position companies and really the broader economy as well over the course of this year?

So maybe I'll start with that, Dave. When we think about and what I see through my lens here in Capital Markets is the question of how clients deal with interest rate risk. Right for years, we had a flat yield curve that has recently changed in a major way. And so when we think about what's happening now that, you know, the two big stakeholders right the Fed is sitting on the front end of the yield curve and highly accommodated, right? And a fairly recent policy change where they've acknowledged letting the economy run hot; i.e. above 2% average inflation. Now we don't know for how long or to what distance they'll let that run, but we know that 2% or greater is not a bad thing through the Fed's eyes.

The market is starting to tell us a different story, right? We're starting to see all the elements of brewing inflation. Jackie mentioned right out of the gate, an increase in commodity prices across the board, right? We're seeing break-even rates on inflation starting to creep up. We're seeing real rates, albeit it's still negative, but they've crept up, and as everybody knows by now that the yield curve has steepened quite a bit.

So the market is telling us that there is a concern about inflation, and they seem to be more concerned than the Fed. What that means for a client right now is there's a decision to make, and it's what do I do to prepare for the eventual rise in interest rates and what that means for my interest expense. I would be remiss if I didn't acknowledge the amount of clients that have put on swaps in the last ten years and have found, you know, either rates going lower or rates going sideways for a period of time, and perhaps some have built up a view of this has cost me money. And what I would kind of gently remind folks to think about is, anytime you enter a hedge of any kind, be at foreign exchange, be at interest rates, be at commodities, it is not about producing a favorable cash outcome, it's about producing stability and certainty into your financials.

So that's true when it's a flat yield curve, that's true when it's a steep yield curve, that's true when it's an inverted yield curve, but here we sit today and the choice is what do I do or the decision is what do I do to prepare? And so, the mantra that we are looking at in 2021 is not what to do when rates, it's what am I doing now to be prepared, and what are some of the choices? What are some of the solutions? And believe it or not, there are plenty. So regardless of your market view of interest rates, if you are a hedger and you prefer to have certainty, there is a solution that can be customized to fit any particular view that a client has in the market. So our dialogue is more centered around what are the choices to prepare and what are the different paths that you can take to provide that certainty for a potential increase in interest rate expense.

So in building off the key side, you know if I look at our commercial clients, many of us in working with them are very encouraged by what we're seeing with the amount of capital in the market. Obviously, disposable income is probably at the highest level it’s seen access to capital. You know, if we look at private equity firms, I think 2021 is likely going to be the largest fundraising year of all time. Why is that? They're obviously looking pension funds, and others are looking to deploy capital and in the bond market right now doesn't look as appealing certainly, there's some things on the long end of the curve that may change that, but the fact is we've got some tailwinds relative to disposable income. Most of the companies we've worked with have done a good job in retaining their people. The PPP programs from the SBA have worked well in retaining talent and so now it's about how we can then adjust to the demands, utilizing the supply chains we talked about, and opportunistically investing, opportunistically in building platforms, opportunistically on showing some of the manufacturing that they were using to offshore prior to that. And so we see a number of opportunities out there, and while there may be some inflation I think still, the relative cost of access to capital is significantly lower than what they've historically seen. And the fact people are very cognizant of their costs. I can tell you over the course of the last 18 months, we've seen our clients really react much quicker to the economic downturn, when Covid struck last March, than what we saw in 2008-2009 in the Great Recession.

People know their costs, they're doing 13-week cash flows, they're modeling out different scenarios. That wasn't something that was top of mind, you know, 15 years ago, so the fact is people know their cost well they're willing to pay more in certain situations to meet demand. One of the headwinds, though, is certainly uncertainty of the new administration is going to come with different regulations, a different potential tax policy, and those policy changes will ultimately create some uncertainty. So I think we're going to see a number of people try to execute before there’s change and then try to react to those changes over the course of the next 24 months.

Interesting points there, I think that you hit it right on when you talked about the impact of inflation is going to be there, but I don't think it's going to drive as much other than the interest rate piece of it, and the pent-up dollars. It's interesting because when I think about how consumers and consumer behavior impacts commercial real estate, you have a lot of people who have this pent-up demand, they’ve been saving a lot of money over the past year because they haven't been out there taking trips and things like that, so they're investing those funds. Then you have the people who've been scraping by, but they're getting a lot of stimulus right now, and the job outlook is looking pretty good for them in terms of coming back. So I think that's going to be a major piece in continuing to drive that recovery that we're talking about here and the case of that recovery.

The other thing I would say is that in the amount of liquidity in the market right now is driving up the prices on quality assets in commercial real estate to really unthought of kind of levels. But, people aren't going out the risk spectrum into the asset classes that have been most impacted or that have a higher degree of uncertainty. For instance, office space, who knows what the future of offices look like right now. We all think we're coming back, but how are we coming back? So that's having a big impact. Hospitality may actually recover faster than people think because of that liquidity and that pent-up demand. So I think there's a lot of opportunity there.

The other thing that we're hearing from our clients is that the fact that it's gotten to be so expensive to build new buildings so the cost of raw materials going up. They're seeking more acquisitions and redevelopment opportunities because we're hitting that point where the replacement cost makes sense. So I think there's going to be more opportunity that we see there this year. 

I’d like to see, Jackie about, you know, kind of your views on inflation, and I get what we're talking about is, there's ample money supply, right, there's more than ample money supply, not just in the US, but globally.

One of the other elements necessary for inflation is velocity of that supply. And so to Bob's point, right, talking about unlocking some of that savings, right, that record 50-year savings, that percent of disposable income that the US consumers at right now is going to be critical and it's going to be really interesting to see how that shakes out between the demand on labor and the demand to pay higher labor costs versus where the clients potentially benefit from being able to price their goods at a more favorable you know sort of price point based on the inflationary pressures. So it really is going to be an exercise in who is managed well, who understands their cost base and the demand and the supply chain going into this, right, versus you know, those that don't and then how well is it managed when inflation starts to show up regardless of whether it's 1.8 or 4% inflation or 10% inflation, it's really just about how prepared are you and understanding where does the inflation impact touch my business.

It kind of gets back to what you said earlier Keith in terms of when people are concerned that they hedged in the past and rates kept going down, it's not about the dollar cost, but removing the uncertainty. And that's what we need right now is to remove that uncertainty for some parts of the economy and I see that with the employment numbers in particularly and as I think about that part of the economy, the folks who have been scraping by when they get to that point where they're reliably employed and they have a predictable income that changes the dynamics for the whole economy. Would be a good thing to see.

And that just goes back to scenario planning you know this is a playbook we really haven't seen. We've not seen this type of this type of government stimulus in a long long time if ever ,and certainly, if there's some additional stimulus that comes in possibly through infrastructure spending, which will also impact employment, we've really got to think about not that the challenge of having too much growth. Which is sort of the irony right, you think about it not enough growth creates problems, but the reality is and certainly, we've seen this with our clients, too much growth actually causes problems, more problems than not enough growth. So as companies are looking forward, talking to their banker, talking to their attorneys, their accountants, their suppliers, what are they doing in anticipating a 20% growth in revenue, 30%? You know we were doing modeling is you know, okay, you're going to 10% loss in revenue, 20% loss in revenue. Go on the other side and where are going to be your pain points and what can you do to mitigate those pain points if there's too much growth?

Absolutely, it's been I think economy-wide, it's been a long time since we've faced that, but it may well be coming so Bob, Jackie, Keith, I want to thank you for such a great conversation. I think there are a lot of takeaways and insights for business leaders, so Bob, I'll turn it back to you and just ask what can someone do to get in touch with us if they'd like to further discuss these topics?

Well Dave, thank you very much for facilitating this and to share your insights in the economy. I want to take this time first to thank our listeners for joining Dave, Jackie, Keith, and me. We're very grateful for your time and our relationship. We hope you found our conversation useful.

It's our goal to share our perspectives to help you manage your business and wealth. We have a very experienced team that has worked together through many economic cycles. While we may not have all the answers to your questions, I'm confident between our commercial banking relationship managers, our wealth advisors, and our business leaders, including Dave, Jackie, Keith, and me. We can find the right individuals to assist you and your team.

We are very excited about ways that we can put our resources to work for you, and at the end of the conclusion of this video, we will have contact information that you can use to get in touch with us. So thank you all and best regards and be safe.