Transcript: Q4 Commercial Outlook 2022

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[Q4 Commercial Outlook 2022]

[Bob Frentzel

President, US Commercial Banking]

>> Bob Frentzel: Hello everyone. Thanks for joining us today. I’m Bob Frentzel, co-head and president of US Commercial Banking for CIBC. I’m delighted to be hosting another quarterly outlook for our commercial clients. Economically, plenty has taken place domestically and globally since our last outlook, and we look forward to breaking down the past, the present, and the future. We’ll dig into recession concerns, Fed policy, inflation, supply chain disruption, energy costs and certainly labor challenges. 

To get us started, I’m pleased to welcome Katherine Judge, senior economist and director with CIBC Capital Markets. Following Katherine’s presentation on the economy, Bruce Denby, head of Asset Based Lending and Equipment Finance at CIBC, will join Katherine and me for a short discussion.

Welcome, Katherine. Thanks for being here. I’ll turn it over to you.

>> Katherine Judge: Thanks, Bob. So I’m going to be going through what we’re seeing in the US economy today, and clearly the topic on everyone’s mind right now is this elevated inflation we’re seeing, and of course, the Federal Reserve is hiking interest rates aggressively to try to control it. So they’re really walking a fine line where they could very realistically tip the economy into recession.

There’s two paths that the economy could take right now. One, the Federal Reserve hikes even more aggressively and causes a recession, and then we return to faster growth in 2024, or we could have two years of prolonged slower economic growth of below 1%. So, that’s the camp that we’re in. We don’t think that an outright recession is in the cards at this point, and we are starting from a very unique starting point in terms of household balance sheets are relatively healthy given what we saw throughout the pandemic, in terms of fiscal stimulus and deferred spending on services.

[Graph: Core inflation boosted by supply chain issue]

But if you look at inflation today, relative to where the unemployment rate is, which is what the Federal Reserve would look at to judge where inflation will be a year from now, there’s a very prominent disconnect. So the unemployment rate’s at about 3.5%, which is where it was back in 2018, 2019, but you were not seeing inflation of this degree at all. So what that tells us is that a lot of this inflation is due to supply side factors rather than domestic factors. So, that’s making it very challenging for central bankers globally to get this inflation under control because, of course, their only tool is demand side and targets domestic economic activity. So what you’re seeing is they’re having to overcompensate for these supply side factors that are happening due to COVID lockdowns and due to strong demand and goods that we saw throughout the pandemic, which cannot be targeted directly by central banks, and of course, the increase in commodity prices that we’ve seen as well.

Now, luckily we are starting to see some signs of these supply side factors abetting, shipping costs have eased off, so that’s a positive sign. There is some uncertainty around oil and gasoline prices with OPEC plus limiting production, but of course, there’s the talk of the cap on Russian oil prices. So there a lot really depends on what’s done with Russian supply and can any supply deficit be filled in by other countries.

[Signs of slowing, but the labor market is still too hot to meet 2% inflation target next year

Graph: Job openings rate (%)

Graph: Atlanta Fed wage growth tracker (y/y% change)]

Now, I mentioned that the Fed looks at the unemployment rate to really determine where inflation will be a year from now, because their job is really to achieve 2% inflation a year from now. What you’re seeing in today’s inflation rate, these reflect the change over the last 12 months. So a lot of this does still reflect the stimulus during the pandemic and the supply chain issues as well that are fading right now that’ll start to show up in inflation in the quarters ahead.

So the central bank is really concerned with what we’re seeing in the labor market and what you’re seeing is still very strong hiring. When you’ve hiring of above 200,000, that’s resulting in tightening in the labor market, which implies inflationary pressures in the future. So really the Fed is looking for hiring of below 200,000 to prevent that tightening. It’s likely that what we’ve seen is a lot of businesses were understaffed at the start of the year and now they’re just adequately staffed with slower demand, so you’re not necessarily seeing the layoffs that you might typically see at this stage with interest rates at this level. So you are starting to see job vacancies, pullbacks, sectors that were booming during the pandemic are slowing, and of course, interest sensitive ones, and as well wage growth is slowing.

So these are positive signs for the Federal Reserve because it suggests that the interest rate hikes are starting to cool economic activity, but by no means are we there yet. So we think that the federal funds rate will have to reach 4.5% on the upper bound of the Fed funds range, so that’s roughly in line with the Fed’s projection. It’s a little below, but it’s below what the market’s predicting of 5%. So I’m sure you’ve heard monetary policy works with long and variable lags, which means we aren’t seeing the full impact of rate hikes today. It can actually take up to six quarters to see the peak impact of a rate hike. So if you actually look back in history, there are instances where the Fed has stopped hiking or even cut interest rates while inflation was elevated. So they’re really forward looking, and again, the best gauge of that is what the unemployment rate’s doing. So we think that interest rates at 4.5%, you’ll see enough signs of a slowing in the labor market to get the Fed to pause.

[Table: Fed needs to take interest rates further into restrictive territory to contain inflation]

Now, one other difference with our forecast versus what market participants are expecting is markets are pricing in interest rate cuts as early as mid-2023. We don’t think we’ll start to see cuts until 2024. Now, I mentioned the healthy balance sheet position heading into this hiking cycle, which differentiates it, and at the same time, if you get inflation down to 2% next year, which is our forecast, you’ll start to see growth in real incomes. So up to this point, wage growth had not kept pace with price growth, which of course means purchasing power is being eroded and demand is being eroded. But if that reverses next year, you’ll prevent an outright recession and growth, which suggests that interest rates can remain at that restrictive level for the entire year.

Now, interest rates above 2.5% is really restrictive territory, it’s above the so-called neutral rate of interest. So it clearly cannot stay at that level forever. And that’s why the Fed’s starting to cut towards 2.5% in 2024. 

[Table: Monetary policy tightening to cause slow growth in 2023-24, but an outright recession could be avoided]

So if you look at our economic forecast, we could see a negative quarter of growth at the start of next year, but we’re not looking for anything that would indicate a full blown recession. You’ll see the unemployment rate rise, but employers this time around might be more likely to hold on to employees just given the challenges that they face with staffing after the pandemic really started to fade. So we’re certainly in for a few years of slow growth, but not an outright recession. And of course, the yield curve right now is inverted, which indicates markets expect a recession. But if the Fed doesn’t achieve 2% inflation next year, you would expect to see longer term yields start to ease off, and if the Fed doesn’t hike as much as the market expects, shorter term yields could also ease off, so by 2024, we expect the yield curve will un-invert.

And in terms of the US dollar, of course, it’s been extremely strong due to the aggressive Fed and just the safe haven bit it’s got this year. So if the Fed does really undershoot market pricing for rate hikes, you could see the US dollar give up some strength next year. So that’s our view in a nutshell, really. And now I’m going to pass it back to Bob for some questions.

>> Bob Frentzel: Thank you, Katherine. Well, the Fed certainly has got a lot of work ahead, and hopefully they can find the soft landing and get inflation under control. Really appreciate your insights and analysis. And now I’d like to explore themes from a middle market business context. Let’s bring in Bruce Denby, our head of Asset Based Lending and Equipment Finance in our US operations to get a discussion started. Welcome, Bruce. Thanks for joining the conversation today. Let’s start with some initial commentary from you on how companies are navigating the economy and the higher commodity costs and interest rates.

>> Bruce Denby: Thanks, Bob. Yeah, I think the best context is to take a step back and look at what some of these clients had to deal with through COVID. And fortunately for many of them, they were able to get some government stimulus from PPP and ERC, and as a result, and I don’t know if we can say it came out of COVID, doesn’t seem like we’re ever out COVID, but came out of COVID in fairly good position from a liquidity standpoint. Over the last 12 months, as Katherine alluded to, we’ve saw a number of shocks to the system in the form of supply chain disruptions, higher freight cost, higher commodity cost. And as a result, a lot of our clients felt the need to bring in inventory sooner because of the longer supply chains, the inventory costs more, and as a result, inventory on the balance sheets have ballooned up quite a bit. And this is obviously strained liquidity a little bit, despite a fairly strong position at the outset.

The reality is that they’re entering this phase right now, where now we’re starting to see the revenue side of the equation drop a little bit with higher inventories than they’d like. We’ve read a lot about the discounting that’s occurring at the major retailers, and so, we see that in our client base as well. There’s certainly a difference between a consumer discretionary client today and an industrial client.

The industrial clients appear to be holding out pretty good. The backlogs are still pretty good. There’s been a lot of talk about the suppressed demand that’s in the automotive industry due to the fact that they just couldn’t get the cars out due to the chip issues. So some of that may carry industrial a little further, but in the last couple three months, we’re definitely seeing a reduction in some of the revenue side with our consumer discretionary clients.

>> Bob Frentzel: Well, thanks, Bruce. Yeah, it’s an issue of, at first we saw the significant demand and now the question is what’s going to happen with supply. So very, very much appreciate those insights. Katherine, how should clients be thinking or preparing for maybe not a recession, but certainly a fairly anemic growth over the next 24 months?

>> Katherine Judge: So I think one theme that started during the pandemic was this dichotomy in activity between goods and service sectors. And now as interest rates are rising, you’re clearly seeing the slowdown in residential construction, but I think as Bruce alluded to, there could be pockets of strength within non-residential construction. So there’s opportunities for infrastructure still, and with energy transition, there could be some opportunities for growth within alternative or clean energy. So I think just being aware of the differences across sectors that you’re seeing. And then of course, realizing there’s a lot of discussion about a recession being inevitable. But really if you look back to 2018, the Federal Reserve showed interest rate hikes in their projections that never materialized. So you do have to take that with a bit of a grain of salt. We might not see borrowing costs get quite as high as people believe right now, but at the same time, we won’t see them come lower until 2024. So those are very important in terms of financing perspectives.

>> Bob Frentzel: Thank you, Katherine. Yeah, as you think of any challenge, it’s how you react to the challenge, it can create opportunity. Bruce, how is your team viewing these challenges and helping clients manage through them on an ABL side? Now we talk about ABL, which is Asset Based Lending, maybe give a little bit of understanding for the viewers what Asset Based Lending means and how it really can help clients as they prepare to build and grow their business?

>> Bruce Denby: Sure, Bob. So Asset Based Lending is really just a form of commercial lending, but our focus is much more on the assets and less on the cash flow. So the reality is it gives clients that are in a fairly high growth mode, i.e. the ones that have experienced large increases in raw material cost and commodity prices, or are seeing disruptions to earnings because of the fact that the revenue side of the equation has fallen off a little bit the ability to focus more on asset support and less on cash flow. And generally our covenant package reflects that with a fairly easy or low amount of covenant. So, that’s really what we’re focused on in ABL or Asset Based Lending.

We had a number of clients that, because of the disruptions in the supply chain, came to us and looking for help on the inventory side, and we were able to accommodate most all of them by increasing the lines of credit on the inventory side, as well as because of the lengthening supply chain of the need to help them with their own transit inventory as a lot of these folks import items. So, that was one way we accommodated.

The other was we were coaching our clients a year ago about the danger of where interest rates may go given what was the early signs of inflation back then. And we just have a fantastic team here at CIBC on the capital market side, Keith Rofrano and his team, and Todd Liska and Charlie Cashman that help our clients in a number of ways in that regard. And first was interest rates, and obviously we’ve seen what’s happened with those, and we’ve got quite a few clients that have locked in their interest rate for the period of time. I’m very happy with that right now. And then clearly with the disruption in the commodity prices, I mean, we’ve seen everything from diesel fuel hedging to natural gas hedging, to copper and aluminum hedging, which we’re quite good at at CIBC and helping them out with that. So by helping give clients direction to talk to their proper resources within our organization and give them the opportunity to lock in their cost, if you will, has been extremely helpful to our clients through this period of volatile raw material cost.

Well, thank you, Bruce. Katherine, I’d like to turn over to you. Over the past two years, I think, labor has been an Achilles’ heel for literally every industry service sector, industrial manufacturing distribution. I remain perplexed by the low participation rate. Where did everyone go and when do you think they’re coming back?

>>Katherine Judge: Right. So, that’s an issue that even the Federal Reserve itself was stumped by. They kept expecting this rebound in participation, which really never materialized. And part of the story is long COVID. The other part is the acceleration in retirements over the pandemic with the aging population. So you’re looking at long COVID holding millions of people out of the workforce. There’s just early data on this topic, but if you compare amongst countries, those that had more relaxed restrictions on activity, including the US are now seeing a higher instance of long COVID keeping people out of the workforce. So, that’s been an issue.

The US also has relatively slow immigration, so that hasn’t helped. And then on top of that, you have the acceleration in retirements, as well some people have switched industries during the pandemic, where their skills would’ve been transferable, maybe a retail worker could have switched to an online fulfillment center. So what you’re starting to see now is sectors that are slowing now that we’re doing well during the pandemic should free up some labor supply to move into other industries. And I mentioned earlier, now, a lot of businesses were understaffed at the start of the year, and now there’s a lot slower demand. So now they’re just adequately staffed. You’re not seeing layoffs, which is why hiring is still above that 200,000 mark that the Fed would like to see it get below, really.

>> Bob Frentzel: Okay. Well, thank you, Katherine. Bruce, anything to add with regard to the workforce conversation and staffing within your portfolio?

>> Bruce Denby: Yeah, I would echo what Katherine just said. The reality is that our clients are still telling us that they are short people, they’re not overstaffed, so they’re still out looking for additional resources and bringing people in. And so, through this period of time, we’ve seen a move towards a lot more CapEx trying to find a way to automate processes that maybe before didn’t make economic sense, but due to the lack of labor force, they’re looking at today. And there’s been a lot of change on the robotics side. I mean, it used to be when you added robotics to your warehouse, you needed to take a huge amount of space because of the safety issues with a robot moving in all different directions. So now there’s robotics out there today that allow clients with a touch, they can just literally touch the arm or touch the machine anywhere and it stops moving. So now they don’t need as much space within their warehouse to get these robotics set up.

And we recently added our equipment finance group, which is a tremendous opportunity in this regard because those folks can add the ability to bring in equipment with 100% financing, and to the extent that you can’t find the labor, bring in the equipment to replace that and allow you to still produce without the people. So, that’s been a nice change from that perspective.

>> Bob Frentzel: Well, as we said before, it’s just about trying to adapt given the market conditions we face. I think we’ve got a little time for one more question. I’m going to throw it to you, Katherine. As we have the benefit of having thousands of commercial clients that we’ve been working with for many years and very grateful for those relationships, everyone’s trying to anticipate or trying to figure out what indices that they should be looking for that gives them an indication that things are settling down, or conversely, what are some of the indices we look at that ultimately may mean that there’s some turbulent times ahead?

>> Katherine Judge: So that’s clearly a very valid question with all the uncertainty and rhetoric around, is a recession coming? I mean, a lot of it really depends on how much the Federal Reserve has to hike interest rates. If they have to go higher than 4.5%, then there’s a real risk that they cause a recession. So in order to determine whether or not the Fed could have to hike more than we’re expecting, you’ll want to keep a close eye on the employment data, is hiring still at above 200,000 in the next few months, and as well core inflation. If you look at the core inflation data, it’s been very strong and not just because of supply chain issues, you’re starting to see a lot of pressure on the service side of the economy. So you’re seeing broad price pressures, which is very worrisome because those are sticky and the Fed has to lean against those.

So another metric would be inflation expectations are consumer or business inflation expectations getting dislodged above 2%. And that would imply the Federal Reserve would have to be much sterner in their language and interest rates, which of course, increases the chances of a recession happening if they have to hike more and more.

>> Bob Frentzel: Okay, Katherine. So let me just repeat. So we’ve got 4.5% Fed funds, we want to make sure that we continue see employment of the 200,000 and then inflation or expectations of 2%. Is that right?

>> Katherine Judge: So you want to see hiring actually a little below 200,000 because that’s the level where you’re preventing a further drop in the unemployment rate that could lead to above target inflation in the future. So they’re looking for this slowing in the labor market, and as I said, you’re seeing signs of that. You’re seeing wage growth looks like it’s peaked. You’re seeing employment growth slow, it’s just not slow enough, and job openings have also fallen. So you’re seeing early signs of it. And we are hopeful that as interest rate hikes work their way through the economy because it can take six quarters to see the peak impact, the Fed won’t have to go above our 4.58% target, hopefully.

>> Bob Frentzel: Right. Okay. Well, thank you, Katherine. Much appreciated. Bruce, what are you advising clients from an ABL and equipment finance? Are there any numbers or ratios they should be thinking about?

>> Bruce Denby: Well, the reality is, it’s interesting times because we talked earlier about what’s happened with the whole freight situation. And with gap accounting, what you do is you’ve got higher cost inventory. Now, while Katherine alluded the fact that that has reversed itself and we’re back to pre-COVID times from a standpoint of freight, the inventories of a lot of our clients reflect that. So there are likely in a period of declining revenues to experience some losses or declining margins at the very least. We’re advising clients, “Look, if you got the liquidity, you can stay the course great, but liquidity is king. So make sure that to the extent that you need to push this higher cost product out, get it out the door.” We’re helping clients out that are struggling a little bit with the liquidity side of things, bringing in some outside help, from a forecasting side, to see what things are going to look like in the coming three months out, 13 weeks, if you will.

And an ABL solution works well during those timeframes because it’s a much more flexible type of lending. So we’re trying to give our clients the proper guidance to work through. If this does, Katherine pointed out that we’re not expecting this to turn into really a horrible recession, but to the extent that revenues do drop, to give them the wherewithal to get to the other side where they’ll have the lower cost inventory and be able to show the profitability they historically have.

>> Bob Frentzel: Yeah. Okay. Thanks. Well, you had mentioned as far as equipment finance, that there’s opportunity to get 100% financing, which certainly helps cash flow. And I know that your team has always worked very well with clients in helping them navigate in advance rates with receivables and inventory as we go through this. So I very much appreciate your insights there, Bruce. And Katherine, thank you. We’re out of time for the day and I just want to thank you for your time and the insights you shared with everyone today. And I also want to thank all of you for joining us. We hope you took away some achievable insights. We value our relationship with you and always are available to help manage you and your business and distill the various information that’s coming at you. Our contact information can be found below and have a wonderful day.

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