Moody's Talks - Inside Economics - Slowcession Delayed

Episode Date: December 19, 2023

The U.S. economy surprised to the upside in 2023 as consumers shrugged off a number of headwinds. With inflation abating and the Federal Reserve facing less pressure to hike interest rates, recession risks are fading. But they can’t be fully discounted given high interest rates, geopolitical turmoil, declining savings, and political uncertainty. Slower growth with somewhat higher unemployment is the most likely outcome. Call it a slowcession. Follow Mark Zandi @MarkZandi, Cris deRitis @MiddleWayEcon, and Marisa DiNatale on LinkedIn for additional insight. Questions or Comments, please email us at [e-mail]. We would love to hear from you.  To stay informed and follow the insights of Moody's Analytics economists, visit Economic View. Hosted by Simplecast, an AdsWizz company. See pcm.adswizz.com for information about our collection and use of personal data for advertising.

Good day, everyone, and welcome to the Moody's webinar, slow session delayed. Today's webinar is being recorded to ratings, financial reporting analysis, projections, and other observations, if any, constituting part of the information contained herein are, and must be construed solely as statements of opinion and not statements of fact or recommendations to purchase, sell, or hold, and securities. We ask that no one record this conversation without Moody's explicit written permission. And lastly, no one has permission to quote and if the comments made are questions asked with the webinar audience. Please note that the following presentation has been authored by Moody's Analytics, which operates independently of the Moody's Investor Service Credit Trading Agency. If you would like to ask a question during the webinar, please enter it in the Q&A box in the lower right corner of the webinar presentation screen. I would now like to turn the call over to Mark Zandi for Moody's Analytics.

Please go ahead. Thanks, Kath. Good day, everyone. I'm joined today by two of my colleagues, Chris D.Reedy's, Deputy Chief Economist, and Marissa D. Natali, a senior economist that manages much of our forecast function. And we're going to be talking about the U.S. macro economy, the prospects for the economy over the next year or two. And we're going to do it a little differently than we have in the past. I'm going to give you a sense of our.

kind of baseline outlook, kind of in the middle of the distribution of possible outcomes, most likely outlook. Won't spend a lot of time on that, but just want to give you kind of a sense of it. And, you know, bottom line, the outlook looks pretty good. We've been long saying the economy would avoid a recession. Feels like that is likely to happen that the economy is going to be able to navigate through, and we'll talk a little bit about that. But we're going to spend most of our time on the question posed here, what could go wrong?

And to that end, we conducted a survey of folks that were registering for this webinar and ask the question, what are your top five concerns? What's keeping you up at night? What could go wrong? And so we're going to discuss the answers that came in at the top of the top of the time. top of the list, top six risks. And we've had a fair number of responses. I think we had at least 125, 150 folks kind of weigh in here. And all of these concerns that we're going to discuss had at least 30 percent of the responses. So I think I have a pretty good sense of what people are

nervous about. And we'll walk through that in just a few minutes. The webinar is scheduled for an hour. I'm pretty sure we're going to go over. I apologize. You know, you will have a tape. This will be taped and you can see it if you're not able to stay on for the entire time. And the last thing I want to say is questions. Fireaway. You know, you see the, you can pose questions here. Please feel free to do that. I already noticed we've got a couple already coming in. And that's great. And I know we've got a lot of questions at registration, and we're going to answer most of those, if not all of them, along the way here. Okay. So with that as preface, the baseline, I'm feeling good about things.

You know, a year ago this time, I think my angst was at its about the economy's prospect was probably at its apex. Of course, the consensus view was pretty dark at the time. I think the majority, vast majority of economists were expecting a recession at some point in 23 going into 24. The consensus has shifted. I think people still are a little bit more nervous than I am, but I'm feeling pretty good about things. Even so far as to say, I think we might be able to call this a soft landing. I thought that that might be a bit of a misnomer. Even if we avoided a recession, that the economy would feel more uncomfortable.

And I'm sure there's going to be points in time here in 24 going to 25 when we are going to feel uncomfortable about how things are going. But I think at this point, soft landing might be a pretty good description of what might unfold over the course of the next 12, 18 months or so. At the root of this optimism, this sort of relative optimism, and I don't want to be polyanish. I mean, recession risks are still elevated. I'd put them at, you know, 25%, 1 in 4 for a recession starting at some point in the next year. Unconditional probability of recession is probably about 15%. So that's still high. It's still uncomfortable.

But moving in the right direction. And the number one reason for this more sanguine view is inflation is just doing what we needed to do. It's coming in back to the Fed's target. And you get a clear sense of that here. This is consumer price inflation. The overall CPI index, and you can see here I'm excluding the shelter component, and I'll come back to that in just a minute. But the overall CPI X shelter is the green line. This is percent change year ago.

This is data from the start of 2018 through October, the last historical data point from BLS, Pure Relief Statistics. The blue line is the core CPI, that's excluding food and energy. And I've also, as you can see, excluded shelter. The point is pretty obvious. Inflation outside of the cost of the growth in the cost of housing services, the cost of shelter, is back to the Fed's target, even beyond the target, you know, even a little bit lower than that. So all very encouraging. And thus, the key here to getting inflation back completely in the bottle back to the Fed's target is the cost of shelter. growth in the cost of shelter, and all the trend lines here look pretty good.

You know, at the end of the day, the growth in the cost of housing services is tied to market rents, and you can see that with a long lag, just because of the fact that leases roll over generally over a period of a year, so it just takes a while for the shifts in rents to kind of translate through in terms of what it means for the cost of housing services. But you can see here in this chart that rent growth has really come in very dramatically. That's the green line left-hand scale. It's growth in rents as measured by Yardy and basically flat year over year. There's obviously other data sources here.

Apartment list. Chris sent me a release from them yesterday. is showing, and this day, data through November, that year-over-year apartment rents are down about one, a little over 1%. So let's say flat to down over the past year. You can see, given the lags or about a year, it would suggest that in the coming year, that blue line, which is the consumer price index for shelter, will continue to move south and, you know, get back close to something that would be more consistent with overall inflation getting back to target. So, you know, there's a lot of other cross currents here in terms of the inflation.

numbers. I think the cost of health care will probably accelerate, particularly for health insurance, given the way that's measured. But, you know, new vehicle prices just recently started to roll over. I would expect to decline more substantively going forward. So you kind of take it all together and add it all up. It feels very likely at this point that inflation is going to get back to the Federal Reserve's target by this time next year. I feel quite kind of. confident at this point in that economic forecast. So reason number one for optimism around the soft landing baseline is inflation. It's coming back in reasonably gracefully. Reason number two, given the fact that inflation is coming in and the economy is moderating, growth is, at least in the

labor market, job market moderating in a kind of a slow, steady, consistent way. I think interest rates have peaked. You can see that here in this chart. It shows a number of different interest rates, data back to 2015. You can see I give them a little bit more forecast here through the end of 2025. And I think it's pretty clear at this point. The Fed is now finished raising interest rates. The funds rate target, the black line, is now at its so-called terminal rate, somewhere between five and a quarter and five and a half percent. You'll notice that, you know, rates, I don't expect rates to, the Fed to cut rates quickly. I think it'll only be when it's clear to the Federal Reserve that Zandis forecast about inflation is correct and that inflation is going

to get back to target by the end of the year that they will start cutting rates. And that probably won't be until mid next year. In fact, in our forecast, which is shown here, the first rate cut by the Fed is at the June FOMC meeting. It's a slow set of series of cuts. After that, you know, and I just one quick point of interest, you know, obviously next year is an election year. And I think all else being equal, I think that the Reserve would like to not have to move interest rates very much one way or the other. Just don't want to get caught up in the politics that are going to be pretty awkward, I think, and ugly in 24. And I think they will cut, but I think they'll be reticent to cut too much, just given, you know, the political backdrop. You also note that other interest rates also, I think, at peak.

the 10-year treasury yield. I don't know if you've been watching that recently, but wow, the 10-year treasury yield now down back, I think last I look was 4.1%. If you go back just probably six, eight weeks ago, it was flirting with five and felt like it was going to go north. We're back down to four. And that's very consistent with where we think long-range 10-year treasury yield should be in the long run. They should be roughly equal to the nominal potential growth rate of the the economy and that's where they are, you know, somewhere between four, four and a quarter, maybe as high as four and a half percent, you know, something like that. So I think we're there. I don't think we're going to see any further, you know, obviously rates go up, they go down,

they go all around. So they're not going to, this picture is definitely going to be wrong, but, you know, roughly speaking, coming through the volatility, and I think rates, 10-year treasury yields are pretty close to as high as they're going to get. And that's good news. in terms of mortgage rates, the 30-year fixed, you know, obviously got as high as 8% back when the 10-year was at 5. It's now come in a bit. We're now closer to 7, and you can see, you know, over time here, the difference between mortgage rates and the 10-year yield will narrow. Probably around the time it's clear that the Fed is going to start lowering interest rates and some of the volatility in the bond market will come out. It's the volatility in bond yields that's adding to the prepayment risk in those mortgage securities,

and adding to the spread and that should start to come out. Even longer run, I would expect the 30-year fix to kind of settle in around six, maybe a little south of that, five and a half to six percent, something like that. So that's also moving the right direction. One other quick point, and I'll move on. You will notice that the federal funds rate target is higher than the 10-year treasury yield throughout the period shown here through the end of 25. That means the yield curve, the difference between long-term and short-term interest rates

will be inverted. The Fed funds rate is above the 10-year. It's much less inverted than it was, but as you can see, we expected to remain inverted. And that's a pretty uncomfortable place to be if you're a financial institution, just because the yield curve is very important to net interest margins, what banks lend the rate they lend at compared to their funding costs, and their net interest margins are going to be under some pressure, and we'll come back to that in the context of the risks.

But broadly, more broadly, good news here. I think we can be increasingly confident that rates have peaked, they're going to start to come in, and that's another positive. Third positive point is that, and this is critical, consumers are hanging tough. They're doing their part. They're not spending with abandon. They're not spending hair on fire. that you know that would be a problem because that would mean the economy is growing too quickly inflation would be a would be an issue but they're you know doing exactly what you'd expect

them to do and that's the point of this chart this shows real consumer spending so consumer spending after inflation index to equal 100 in february of 2020 so right before the pandemic showing you data back to 2018 and the last data point is for october of 23 that black dotted line represents the trend growth in real consumer spending pre-pandemic and you can see actual overall spending today the blue line is precisely where you would have expected to be if the trends prior to the pandemic continued on to the current period so consumers are they're doing their thing lots of good reasons for that lots of jobs low unemployment wage growth is now stronger than inflation so real purchasing power

has improved there's still plenty of excess saving for high income middle income households not so much low-income households. That's where the stresses are most pronounced. But they, it's the high-income, middle-income households that account for the vast bulk of consumer spending. People are a lot wealthier than they were pre-pandemic. You know, stock prices are back up. Housing values are backup. You know, net worth is now as high as it's been in history and, you know, continues to rise. You know, it feels good. Consumer sentiment is a bit of an enigma, particularly if you look at the University of Michigan survey, but I think that overstates the kind of pessimism. I think the better barometer of sentiment, at least as in terms of what it means for what

people are actually doing, spending, is the conference board survey, and that's pretty close to its long run average. You know, it's not like people are really feeling great about things, but they're not feeling, you know, as pessimistic as the University of Michigan survey suggests. So I think sentiment is certainly fragile in the risk, but I think it's a very very strong. It's just fine. So bottom line, I think I can go on, but I don't want to. I do want to get to the risks.

Bottom line is, it feels pretty good. The economy is going to navigate through next year. Just to give you a number, we have real GDP growth in calendar year 24 of 1.8 percent, you know, kind of one and a half to two. Similar kind of growth in 2025. And just for context, the economy's potential rate of growth. growth is probably around two, although given recent developments on the supply side of the economy, labor force growth, productivity growth, I'm inclined to think that the underlying trend

GDP growth might be actually a little bit higher than two, but let's just go with two. So, and that would mean that job growth is going to slow, get south of 100K per month here as we move into 2024 into 25. Unemployment is going to notch a little bit higher. We're at 3.9, we have it kind of settling in the low fours, you know, 4.1, 4.4.4.2. to maybe 4.3 for a month or two, something like that. But pretty, pretty sanguine economic outlook. Now, of course, there are lots of risks, and this is now we're turning to the meat of the matter, and I'm going to shortly turn the conversation over to Chris and Marissa

to guide us through some of these risks. But as I mentioned earlier, we did conduct a survey of participants to the webinar and asked what they're worried about, and they show up for the most part here. This is our risk matrix. You've seen this before. I just love this because it kind of makes it a lot easier to get your mind around the things that might go wrong. These are all downside risks, obviously. The X axis, the horizontal axis, is the severity of the risk.

Kind of like I think of it like a present value of economic loss if the risk were to take place. So it accounts for the hit to the economy when it occurs, but it also accounts for the timing of that hit. If it's further into the future, it's more to the left. excuse me of the axis. The Y axis, the vertical axis is the probability of the threat. And, you know, obviously you want to focus on the risks that are kind of in the northeast part of the chart. And the risks that are highlighted in red are the risks that you identified as being your top concerns. A little surprising to me at the very tippity top of the list, commercial real estate collapse.

That was your number one risk. So interesting. I thought that was, you know, pretty insightful. Number two, geopolitical threats. Number three, the Federal Reserve missteps. Okay, now you're back in line with kind of our thinking. Number four is the banking system seizes up again. Number five, this is a little bit of an error.

It should say you see that 2024 election strife, that is risk number five. It's kind of a catch-all for what you might call social and political unrest. And that goes to, you know, well, Mercer's going to explain this, but it goes to the, you know, the potential problems that we're going to face as we go lead up to the, and then the 24 election in November. And the final, finally, House prices crash. And all these are risks that at least 30% of the respondents said was a problem for them. So this kind of gives you a sense of things. So with that, one more point before I move on and hand the baton to Chris to talk about the commercial real estate market, I would say for the first time in a long time that the risks aren't solely to the downside,

that you can now construct upside scenarios. And I alluded to that earlier with regard to the supply side of the economy. it does feel like the supply side, labor force growth, labor productivity growth, has some real kind of fundamental life to them. And if that's the case, that means we can grow more strongly, you know, more GDP, more income, more profits, higher stock prices, you know, all else being equal, higher real estate values without inflation picking up. And that would be very encouraging.

It's not our baseline. We still have potential growth at two, but nonetheless, the risks are now no longer one-sided. They are double-sided. Okay. With that as a preface, let me now turn the conversation. We're going to go through each of these risks that you've identified in some detail, and let me turn the conversation over to Chris. Chris, before we move on, any key questions that came up that you want to dispose from the audience?

or should we just keep moving forward? You know, there were a lot of questions about the Fed and Fed policy, but I think you're going to get to that later, so maybe we just hold off on that. And I think you answered a number of the questions throughout your talk track, so why don't we move ahead, because we've got a lot of material,

and we can circle back to any additional questions. Sounds great. Fire away. Okay. All right, so commercial real estate, as you mentioned, Mark, was at the top of the list in terms of the concerns, at least the concerns that folks in the audience wanted to hear about. Maybe that may that might differ from what folks would actually rank as the top

concern in absolute. As you saw in our risk matrix, it's not it's not at the top of our list. But it is certainly identified as a potential threat. And certainly if you're in the commercial real estate industry, if you have properties or you're a lender, obviously collapse in commercial real estate matters a lot. And I think the nexus or just to underscore why there is so much concern when it comes to commercial real estate right now is that clearly prices are under pressure, right? Commercial real estate is undergoing a secular shift in the aftermath of the pandemic, clearly with more work from home, you have folks not utilizing office space to the degree that they did in the past. That's certainly putting downward pressure on offices. But even more

fundamentally or more broadly, you do see shifts throughout the entire industry when it comes to lower or potentially higher unoccupated or lower vacancy rates or I'm sorry higher vacancy rates that might push down prices so on the chart here you can see our Moody's analytics commercial real estate price index right this is a an index based on transactions that we've constructed and you can see quite clearly the the run up in prices in the early days of the pandemic from 2020 to say 2022 and then more recent recently the declines. And in some cases such as multifamily, the declines have already been quite appreciable. You do see declines across the board with the exception of hotels,

which are up modestly at about 2 percent since the recent peak. What also you can see here is that clearly there is some downward pressure when it comes to offices. And on top of the that you do see that there is even downward pressure in industrial properties, which have been getting some more interest as more and more firms have moved to reshore their operations. So you do see an industry that is underweight or under threat due to some of those structural changes, as well as the higher interest rate environment. That's really adding a greater concern in terms of the risks of a more substantial commercial real estate collapse. And the reason for that, if we turn to the next slide here,

is that there are quite a few loans on CRE properties that are coming due over the next five years. So in the chart here, you can see the volume of CRE loans that are maturing by year and then broken out by property type. So you can see that through 2027, we have something in the neighborhood of $400 to $500 billion a year of loans maturing in this environment where interest rates certainly are high and are projected to remain relatively high throughout this period, certainly much higher than they were during

2020 or at the very bottom of the market. So that's certainly going to put more and more pressure on property owners who need to refinance their loans as they come due and potentially puts more pressure on the banking system as well as we see more and more of these properties potentially going into delinquency and ultimately into default. So I think this underscores a lot of the concern when it comes to commercial real estate, just that we do have this ongoing set of loans that are going to be coming due. But I think a little bit of context is needed. And if you look at the box in the upper right hand corner, one thing to note is that although office gets a lot of attention

and is expected to see some pretty substantial price declines, over the next few years here. It's not the bulk of a commercial real estate property. It's about 20% or so of the loans coming due over the next couple of years. So clearly having an impact, but not necessarily representing the entire industry. You would have some strength in the form of industrial properties,

some retail properties, and even hotels. So important to bear in mind that there is a bit of a mix here in terms of the property. types. There's also mixed within property types as well. So if you look at retail might be certainly concerned about retail operations in center city cores, but other strip malls in more suburban areas seem to be doing just fine and even are seeing price increases. So there is some heterogeneity here that's going to offset some of the potential risk here. The other thing to note is that there's a lot of concern about CRE because of the exposure of banks. And I

I think Mark will get into some of this detail later. Certainly banks do have exposure, but again, as you can see in the chart, they are not the dominant holder of a lot of this credit. You have pension funds, life insurance companies, hedge funds, a lot of other investors that are backing these loans as well. So in terms of the macroeconomic impact, certainly banks could be harmed, but the chances of that really spilling out into a broader financial crisis or broader economic downturn are more limited, right?

They're not zero, but the fact is that the banks don't have quite the exposure to all of this CRA debt, as we might otherwise think. So this hopefully encapsulates the reason why we don't have CRE crashes built into our baseline and not even at the top of our list in terms of risks. But nonetheless, we are mindful that there are a potential, scenarios here that could cause a CRE decline in prices or decline in CRE prices to trigger a broader macroeconomic effect. So back in September, we actually produced a CRE so-called doom loop scenario where decline, significant declines in CRE prices start to trigger additional loan defaults,

which cause prices decline further, which trigger more defaults and so on and so forth. So we wanted to examine what the potential impact could be if we had a significant decline in CRE prices and a very acute decline, right? Under the baseline, we assume that prices are going to adjust or gradually over, say, the next three, four years. In our CRE doom loop scenario, we assume that the correction occurs much more violently, much more acute. So in the chart here, you can see some of our assumptions for CRE prices under different

scenarios. Under the baseline, we assume a 15% peak to trough decline across the entire industry. Under the CRA crash scenario, we're assuming a 30% which is on par with what we have for our scenario three. So those of you who use our scenarios, that's our 90th percentile scenario, so quite similar, but not quite as severe as what the Fed envisioned in their stress test, severely adverse scenario back at the start of this year. That scenario envisions a 36% decline in CRE prices, but also adds a number of other negative shocks to the economy as well. It's really not just the CRE impact on everything else as well that causes the economy to falter even more. We ran the scenario, and I won't go into details today.

If you're interested, we certainly have paper and scenarios are available. But in terms of the macroeconomic impact and the risk that we should be could be, concerned with, the CRA crash certainly would lead to a recession. Unemployment rate would rise to about 5.7 percent under our scenario. So clearly something we want to watch out for. There is risk here and risk of spread, but not quite as severe scenario as we might have it envisioned under our scenario three or that Fed stress test scenario. So for this reason, It's important to have this on the radar screen, but one of the perhaps saving graces of the CRE market today is that the risks do appear to be well known.

This is all out in the open. Banks are aware of these potential risks, and they are taking steps to mitigate many of the risk factors here. But nonetheless, if we were to get hit with another type of shock on top of the CRE declines here, that certainly would be water for recession. stop there, Mark, maybe turn it back to you. Any questions? Yeah. So it feels like the concerns about this were higher, I'd say, three, four, five months ago. When we ran the doom loop scenario back in September, it felt like that that was, the concerns around this were much more heightened.

And, you know, as we've gotten more, there's been, you know, more time to evaluate what's going on and get a sense of how things are going to play out. The concern has moderated to some degree. Would you characterize with that kind of thinking? I would. I would. I think there was a lot of uncertainty. Some of the data wasn't as visible as what we have now. And we bank certainly after the banking crisis earlier this year have taken a closer look at their portfolios. I think they have a much greater insight into the various positions that they have. So I think we're able to size the problem up a bit better. There was a lot of uncertainty, and that certainly creates a lot of anxiety. So again, I think there's still lots of

reason for some concern, but I do see lenders taking steps to try to mitigate some of this risk. And certainly as the interest rates are moderating here, at least in the short term, that should help to improve the outlook. as well. So I'm going to put you on the spot, just to give people context. What do you think the probability is of some type of crash scenario? I guess it doesn't have to be this severe, but something that's materially worse, and you can define that however you want, materially worse than our kind of baseline expectation, because even in our baseline, we're expecting price declines in the CRA market. We are expecting delinquency and defaults to increase on CRA loans,

but something meaningfully worse than that, what kind of probability would you put on that? Yeah, I think it's relatively low. I'd say 10, 15%. Okay. And this is talking nationally, right? Certainly certain markets. Yeah, nationally.

Yeah. There is going to be more pain in certain markets, but in terms of a national crash that starts to put, real pressure on the financial system. I think that's, no, not immaterial, but it's not, it's not the highest probability I would assign to some of the risks. Okay. So if you were signing up for this webinar and was asked, top five concerns, would CRA be one of those top five? Probably not. Close call. Probably not. Okay. Probably number six.

Got it. Hey, one last question, and what kind of a more technical question? I'm turning the slides back to this. lots of kind of questions around the price data this is our repeat sales CRE price data and you see multifamily down six already down 16% from the peak which was late last year but office down only 1.9 that this feels unconcruous doesn't with kind of people's thinking around multifamily and office so what do you think's going on here yeah a great point I think well a couple things to note is that our index is based on closed transactions, right?

And we know transaction volumes are very low at the moment. To the extent property owners can hold on and ride this thing out, that seems to be what they're trying to do. Banks are working with their mortgages as well to try to mitigate. They don't want to repossess properties if they can avoid it. So I think that's holding off some of the price discovery that we might see if we had a healthier market here. Then in terms of, well, why is multifamily down so much more than office?

I do think there's a compositional effect here in terms of the actual property owners as well. Offices are large. They tend to be held by large corporations, right? They're not inexpensive properties. Multifamily, right, although they can be very large, you have a little bit more heterogeneity here. You could have smaller investors of potentially owning apartment buildings. I think in terms of liquidity concerns or other factors impacting the ability to pay and folks having to go delinquent or defaulting, I think it's reasonable that we do see some of that showing up in the multifamily sector first. So that's my rationale, but I think we have to wait and see as these, as the transactions actually come in, we'll get a better picture.

And this is a repaid sales index. There could be revisions here that showed that perhaps office was down more than what we were seeing at this point. Got it. Got it. Okay. Well, let's move on to risk number two. And that is threats posed by what's going on geopolitically. And goodness knows, there's a lot of things going on geopolitically that are kind of uncomfortable to watch.

And to kind of guide us through that part of the conversation, let me turn the baton over to Marissa. So Marissa, the Paton is yours. Thanks, Mark. So this was your second risk that you listed wanting to hear about today. This risk for us is kind of, if you go back to the risk matrix that Mark showed, it's sort of in the lower left quadrant. So under the middle line going through. So we think it's actually probably less likely than you think it is, maybe, and a little less on the economic severity matrix. So let's talk about what this could mean.

I mean, as Mark mentioned, there's a lot going on. So we had Russia's invasion of Ukraine in late February of 2022. Most recently, we had the attack on Israel by Hamas in early October. We've had ongoing tensions with China for, quite a while now. So there's quite a bit that we could talk about. I think when we think about the risk of a geopolitical event right now, we're thinking of this mostly in the context of how this might set the U.S. economy on a recessionary path, and we think the most likely way that that would happen would be through higher oil prices. And actually not only higher oil prices, but a return to

problems in global supply chains that would send both energy prices higher as well as, you know, prices of other goods. So that's the way we're thinking about it. And for those of you that consume our forecasts every month, you know that in addition to a baseline forecast, we put together alternatives around that baseline. We have a couple of upside scenarios and we have a large number of downside scenarios. One of those scenarios right now is the so-called S-6 scenario number six scenario. This is what we're calling a stagflation scenario, and this is what we like to point clients to when they're asking about the risk of a wider, broader geographic involvement in either one of the conflicts, either in the Middle East or with Russian, Ukraine. So if we think about this in the

context of these conflicts widening, right? So with Israel Hamas, it could be pulling other countries directly into the conflict. The most likely, I think, thing that we're worried about is retaliation, either the U.S. or other countries retaliating against Iran for backing Hamas. Iran is a large oil producer. They've recently, in the past several months, up to their output of global oil production pretty significantly. And so either sanctions against them or even the conflict widening geographically and disrupting supply routes for oil could send oil prices higher there. On the Russia-Ukraine front, it could be more sanctions against Russia. Russia for its actions in Ukraine.

Russia is one of the largest oil producers in the world. We've already seen how this has affected natural gas prices early on in the invasion back in early 2020 for Europe, which is highly dependent on Russia for energy. So there again, actions taken against Russia could send energy prices higher, could disrupt supply chains even further. We saw major disruption in supply chains when Russia first invaded Ukraine in in early last year. So that's the way we're kind of framing this and thinking about this. You can see here what our baseline forecast looks like relative to this S-6 alternative forecast. And I should

mention that a bunch of our alternative forecasts have probabilities attached to them. These are mostly used by financial institutions that have to do stress testing or for CISL or IFRS9. The S-6 is one that does not have a probability attached to it. So these are scenarios that we call thematic scenarios, where there is a story and a narrative behind it, but we don't explicitly attach a probability here. So here you can see our outlook for oil prices on the left hand part of this slide. So oil prices right now, the last I looked right before this webinar, WTI prices were at about $69 a barrel, I think, just under $70. a barrel. So they've come down quite significantly since September when they peaked. A lot of that

decline in oil prices has been because despite cuts by OPEC and supply, U.S. oil producers have really ramped up production and filled that hole there. So we've seen oil prices come down from their peak, which was in the 80s for WTI to about $69 a barrel today. You can see that our forecast here has prices coming down further over the next couple of years as the economy weakens and become softer and demand weekends here. Now, I should say this forecast that I'm showing here is our November forecast. We're right in the middle of finalizing our December forecast. That's going to be released early next week.

And we are lowering our outlook for oil prices over the next couple of years in that new forecast. So you'll actually see even lower oil prices and what I'm showing here by a few bucks a barrel. Oil prices are important for the U.S. economy because consumers are extremely sensitive to oil prices. So every one cent increase in the price of gas at the pump, a price of regular unleaded at the pump, translates to consumers spending about a billion dollars on an annualized basis over the course of a year. So it's a large part of consumer spending. It's a part of consumer spending where there often isn't a lot of substituteability. Consumers can try to drive more fuel-efficient cars or use public transportation more.

They could take fewer airline trips where we see the price of jet fuel increase. But there's not a lot that consumers can do to really untether themselves from the price of gas at the pump. So with oil prices and supply chains and inflation kind of rear. its head again in this S-6 scenario, the U.S. economy falls into a recession, and you can see that here on the right-hand side of this panel. So this recession in this scenario lasts about a year. It's about four consecutive quarters. And the peak-to-trough decline in GDP would be about 3.4%. Excuse me. So if you consume any of our other scenarios, you know that this is a milder recession than, say, S4 scenario where GDP falls for longer and much more deeply than this scenario. So this has a,

you know, real consequence that would lead to a situation where the Fed is facing higher inflation because the price of oil rising as high as it does leads to rising prices for a bunch of other goods. Also, supply chains lead to gummed up supply chains lead to rising prices for other goods as well. So the Fed's facing a scenario here where economic growth is slowing, demand is declining, and inflation has reared its head yet again, and they're faced with having to fight inflation at the same time that the economy weekends. So when we think about this particular risk, this is how we're thinking about it in the context of oil prices and their impact on the U.S. economy. And again, this is the S6 scenario. So for those of you that want a scenario where either

one of these geopolitical events widens, this is where we would point you to. So I'll stop right there and see if there's any questions, Mark, or any other. Yeah, sure. I'll have to say, I don't ever recall a period where it just feels like there's so much stuff going on all over the world and not registering at all in oil and the dollar and interest rates and credit spreads and equity prices. You know, markets are just, they're saying no big deal. I mean, things change obviously can change very quickly, but so far, very surprising. And you can see it in the oil price. I mean, you can see, look at that, look at our,

baseline oil price forecast that was a month ago and we're already as you said we're down to 70 bucks on wTI i mean obviously that goes to as you said u.s production is up uh we're getting more production from Brazil and guiana you can see the the opec plus isn't able to keep its production quotas intact people are cheating not surprisingly uh and demand from china has been you know soft because the chinese economy is and all that great but you know it's just just incredible to me that we've not seen more fallout from these geopolitical threats on the rest of the on the rest of the financial markets. Do you have a similar kind of perspective? Yeah. Yeah. I mean, investors have largely shaken this off. If you look at the trajectory of oil prices over the past

couple months, there was a brief spike, right, when Hamas attacked Israel. But then after a few days, that came back in. So it has not persisted. So investors clearly aren't that worried about a widening conflict affecting oil prices. And you're right. I mean, volatility is everywhere you look, I think, right now. So one question that came in was that, you know, at what oil price would there be real damage to the U.S. economy? I mean, we're sitting at 70. Clearly, that's good. I mean, that's a plus because gasoline prices are at 70. If we stay at 70 bucks a barrel, we could see gas at $3 a gallon, which would be a big plus. So what price do you think would result in significant damage?

It would materially change our baseline. And I guess what price would have pushed us into recession, all else being equal? I have a sense of that, but I'm curious if you have a sense of that. I think if we hit 90, that's bad news. So if it's between 90 and 100 for a significant period of time, so if you go back a year, right, we saw oil prices in the upper 80s, and at that time, we were fearful that they would go above 90 for a significant period of time. So that's sort of what I'm thinking is that the 90 threshold is scary. And if it persists, and if we're looking at a $100 barrel oil for, you know, a month or two,

then I think we're staring at a recession. Yeah, okay. That's very consistent. If you translate that into gas prices, I'd think. At 90 bucks a barrel, you're pretty close to $4 a gallon. That gets to be uncomfortable. It starts to have way on the economy. If you're over 100 headed north, then you get, you know, $4.50, at $125, your barrel, you're at $5, kind of where we were in the wake of the Russian invasion. We're toast. I think we're going, you know, we're going to go into recession. So kind of, I think it's a good benchmark. Okay, well, thanks, Merissa. I'm going to move forward to risk number three, and that is the potential that the Federal Reserve makes a mistake. And, you know, I think it's fair to say the Fed has, you know, done a reasonably good job here. I mean, they had a tough

task. They had to raise rates high enough, fast enough to slow growth and quality inflation, but not so high, so fast. It reminds the economy pushes us under recession. And historically, they've never pulled that off or rarely pulled that off. In previous historical episodes of high inflation and the Fed on high alert, we almost invariably land in recession. So, you know, in that respect, we have to be at least so far respectful of the way the Federal Reserve has kind of managed things. But there are risks. And as I said earlier on our baseline, we expect the Fed to pull this off. They've finished their rate hikes. We're going to start cutting mid next year, slow reduction in rates after that.

I do think, and I'll just throw this out, and if there's questions we can go into more detail, but I do think the federal funds rates ultimately settles the so-called equilibrium fund rate, the R-Star, the rate that's consistent with policy, neither supporting or restraining economic growth, is probably somewhere around three. You can see that in our forecast.

So I think we go from, you know, right now five and a quarter of five and a half on the funds rate down to about, three over the course of a couple by the end of 2025. That's our baseline and that the Fed is going to get this right. But, you know, there is some reasons to be nervous about this, given how difficult it is. And kind of motivating that nervousness is this chart. The blue line represents the actual federal fund rate target, the so-called effective federal fund rate target. This is a data from January 2019 through the most recent kind of an average for December

and it's averaging 5.33 to be precise in December. The Green Line represents the funds rate as derived by a so-called reaction functions, an econometrically estimated reaction function. You know, it's kind of a tailor rule that I don't want to use too much jargon, but the idea is that the Fed sets the rate consistent with a number of different criteria, unemployment relative to the full employment, unemployment rate, inflation, relative to its target, inflation expectations, financial conditions, you know, like equity prices and credit spreads, the value of the dollar, underwriting standards.

That's because the translation of monetary policy to the real economy runs through the financial system and whether the financial system is tightening or not can mitigate or reinforce the efforts by the Fed to move the economy in a certain direction. And, of course, global economic conditions is represented by the dollar. And just a couple things I'll point out. Take a look at the green line back in the middle of the pandemic, when the pandemic hit in the shutdowns in early 2020. The model, the economy's good estimated reaction function, said,

hey, we need a negative 4% fund rate target. The world is pretty bad, and we got a real problem. Unemployment's going north. We've got to really step on the accelerator here. Of course, the Fed didn't want to go negative on the funds rate. rate, didn't adopt negative interest rates, and therefore, that's when it really started to QE buy long-term treasury mortgage securities to help bring down long-term interest rates. And it was,

combined with everything else, you know, very successful, 10-year treasury yields got down. I think at one point they were below, like a half a percentage point or some outrageous, you know, levels. It got really, really quite well. So they kind of simulated a negative funds rate target with their quantity of using. The other point in time I want to call out is early, early 2022, this is right before they started raising interest rates. And you can see, and this is obviously before Russia invaded Ukraine and oil prices and commodity prices went north. But you can see at that point, the model was saying the economically estimated reaction function was saying, hey, you guys, we need a funds rate of 2.5%. By the way, 2.5% is at that point in time,

the what was estimated to be the equilibrium yield, that so-called R-star. And you guys got to start moving really fast here. And of course, I don't want to be too critical about not moving quickly enough because given the uncertainty at the time, pandemic and efficacy of vaccines and all the things that were going on, the policy 101 says if you've in a world of uncertainty, you should err you, the Fed, or you fiscal policy. policymakers should err on the side of doing too much. And they did a lot. And of course, in hindsight, that was a mistake. We were on the other side of the pandemic. The economy was starting to rip

roar. We had the American Rescue Plan with all the fiscal support. And the Fed was just too slow to start raising interest rates. And I do think in the long list of reasons for why inflation got out of hand here, one of the reasons on the list, not the top, but somewhere on the list is the fact that the Reserve made a mistake. Okay, now fast forward to the current point in time. You can see the model says the economically estimated reaction function says, hey, it's not screaming, you know, that rates are too high, but it's kind of saying, hey, guys, rates are a little bit high,

given everything that we're observing, with regard to the unemployment, with regard to inflation. Yes, rates should be high relative to the equity and yield, because inflation is still above target, but, you know, unemployment is pretty close to the full employment, unemployment rate, financial conditions are about where you want them, the value dollars relatively, you know, it's kind of on the strongest side. So, you know, be careful here. Now, I don't, you know, this is a kind ofmetically estimated equation, so lots of reasons not to buy into it

completely, but I do think this does illustrate the point that, you know, the Fed could make a mistake. The gap here between the blue line and the green line is about 75 basis points. Again, not a screaming problem, but if the Fed were, for whatever reason, to start raising interest rates, or was too slow to start lowering interest rates, you know, as we move into next year, as inflation comes back to target, then that could be a problem, could undermine the economy, particularly in the context of what I said earlier about the shape of the yield curve. The yield curve is inverted. The fund rate target is above the 10-year yield.

And that's, again, a very uncomfortable place for the banking system to be in. So, you know, our baseline is that the Fed's going to pull this off. They seem to be kind of getting it just right. But I do think there's some reason to be nervous here that they could make a mistake. Chris, I'm going to bring you into the conversation here. You know, you've been the one kind of pounding the drum on this one, that you're fearful that the Fed, and I hope I'm not mischaracterizing your perspective on this. Correct me if I'm wrong.

Yeah. So do you want to kind of flesh out your views on this a little bit more before we move on? Sure. So I would, I guess my concern is that what happens if we're in the gray zone, right? If we have an unemployment rate that is rising, let's say it's at four and a quarter, four and a half, and the inflation rate is still at 3%, right, doesn't seem to be moderating, it seems to be stuck, maybe even starting to rise, then what happens? Which poison does the Fed take at that point?

And there, I think we do run the risk of a recession. I think the Fed is committed to inflation first in that environment. That certainly could cause the Fed to take actions that, push us into recession, right, hiking rates essentially to continue to get inflation down, right? So that's, I don't, again, I don't, that's not my base case, but it's one I'm concerned about when we're in that, in that grace. I think in your chart here, yeah, you could go back to 2022 and say, well, obviously they were late to the game, but now, let's say we're in this, in this position where, you know, it's not clear what, what action they should should be taking

given the trends in unemployment and inflation. Got it. The other thing I'm not, is, of course, the data is subject to revision. They're working with a limited set of facts when they make these decisions, right? Easy to say in hindsight, but when you're in the heat of it and you're looking at data that might subsequently be revised, you know, I think the probably of making a mistake is elevated. it got it got it um you were monitoring the questions as they were coming in anything and you mentioned there were some up top was there anything you wanted to this put forward now before we push forward

on the presentation yeah there's one about um have markets fully uh felt the effects of 525 basis point jump right this i think this goes to the long and variable lags uh argument of the fed And maybe it goes also dovetails on whether the Fed may be potentially making a mistake if they are either under or overestimating the effect of the lagged effects. Any thoughts on whether markets have fully digested? They've turned quite optimistic now that there's going to be a cut soon. Yeah, I think the markets, you look at futures markets for Fed funds, I think fully discounting what the Fed is. has said it's going to do and what it will do. I mean, I say that with some intrepidation because it depends on what day you look at the futures markets

because they're moving all over the place. It wasn't long ago that they were still thinking, well, it was not long ago that they were right on the same page, I think, with the Fed in terms of the rate that higher for longer rate, we might see a rate cut next year or two, but it's going to be a slow path downward to back to equilibrium. they're a little bit more optimistic today. But I think in general markets, financial conditions have done a pretty good job discounting kind of monetary policy. So I think that is one reason to suspect that a lot of the economic impact of the Fed rate hikes are,

we felt them or we are feeling them, at least in terms of the impacts on the rate of growth. You know, there's still going to be negative effects of the rate hikes going forward, but they become less and less significant as we move forward. The other thing to consider, and this is one reason why I think the equilibrium rate, the R-star is probably higher than it has been, you know, at least before the pandemic or during the pandemic, is households and businesses have done a non-financial corporates have done a very good job blocking in the previously low interest rates,

at least in aggregate. Household debt service burdens are low and stable. That's the percent of income that households have to devote on their debt to remain current on it. It's very low and stable. and if you look at the corporate interest expense, you know, being paid out, that's about as lows. I think it's as lows it's been, if you look at it as a share of cash flow, kind of an interest coverage ratio, I think it's as lows it's been in the data we have back to World War II, and that's through Q3, 20203.

So, you know, those debt coverage, interest coverage ratios, those debt service numbers are going to change over time as debts roll over and they roll over at a higher interest rate and new debt has originated at a higher interest rate. out about it, but I think it's going to play out over a longer period of time, a long period of time. And so the kind of the headwinds that that creates the economy are, you know, I'd say manageable, you know, digestible, you know, not going to be a big deal. And it makes it maybe even a little easier to calibrate policy, you know, because you're always, if you're in a mark in an economy where, like in many other parts of the world, where you have a lot of adjustable rate that adjusts quickly with market rates, very difficult to gauge, you know, what the kind of the impact on the economy is going to be. It could be very sharp, very severe, and do a lot of damage, but much

less so in here in the U.S. in the current context, because, again, households and businesses have done a pretty good job, you know, locking in things. Okay, because we've got three more risks to go, and we've got a half hour to do it in. Let's push forward, and let's go to risk number four, and I'll take this one again. And the banking system falters again, again, obviously refers to the SBB crisis, the Silicon Valley Bank crisis back in March of this year when SBB failed along with a signature bank and created a sparked a bank run, forcing the Federal Reserve to establish a credit facility to help the banking system kind of navigate through, provide it with liquidity against its securities portfolios.

And also we saw the FDIC and other regulars kind of step in and insured depositors, whether they were below the deposit insurance limit or above. You know, obviously in our baseline, we're expecting the banking system, and let me say the financial system more broadly, including the non-bank part of the system, the so-called shadow system, to kind of hang tough here and navigate through, without another event, or if there is another crack in the financial system somewhere, that it will be relatively easily dealt with so that it doesn't become a broader problem

for credit flows, which is ultimately what matters in terms of economic activity. But having said that, the system is the operating environment for the financial system, the banking system, and the non-bank is, I'd say, uncomfortable. It's a tough operating environment, pretty vexed. you know, again, in the context of an inverted yield curve with high short-term interest rates, you know, the banking system is experienced competition for deposits. You know, obviously deposits are critical to funding loan growth and credit creation, credit growth from the retail money market funds. And that's the point of this chart. This shows the amount of cash sitting in those retail account money market funds and billions of dollars.

You can see how that has taken off here, $1.6 trillion in money market funds, you know, almost just about double what it was just prior to the pandemic. And it looks like it's going straight north. And the money funds are paying a good interest rate, a very competitive interest rate, which is making it very difficult for the banks to kind of manage their deposits and their liabilities. The other thing to consider is the money funds also have a kind of a line back into the federalized. reserve a kind of reverse repo line that really gives them a kind of a competitive advantage here, because if they ever get into trouble, they can call on that line and really help to support their activity. So I do think this is a formidable competition. The other aspect of the operating environment that's difficult is lending growth. That is slowing. In the wake of the banking

crisis back in March, banks have tightened down under underwriting. I didn't show a chart here, but all of you are aware of the senior loan office survey that's conducted by the Federal Reserve every quarter, and it clearly shows a sharp tightening down of underwriting standards. And you can see it in terms of loan growth, the growth in credit, particularly in CNI lending, commercial industrial lending, that's lending by the banks to businesses, more small mid-sized companies. You can also see it in terms of consumer credit growth. I mean, the growth in consumer finance has come to a standstill retail card, even bank card,

which is still growing relatively strongly. We're seeing pretty sharp slowing in growth here most recently. So weaker net interest margins, slower loan growth, weakening credit quality. This goes back to CRE commercial real estate. While the banking system as a whole feels like it's in a pretty good spot relative to its exposure to commercial real estate mortgages and to commercial mortgage-backed securities and to CNI lending to real estate companies like REITs. You can see here that smaller banks, banks with assets of below $10 billion, that's the second bar in the chart, are highly exposed

to CRA that their CRA exposure is much greater than their tangible common equity in such and such as such they are, you know, quite vulnerable to any weakening in an underwriting environment in terms of delinquencies and particularly default. And I would not be surprised if we do see a number of small banking institutions, again, kind of in the billion dollar range, maybe $10, $20 billion range that actually don't make it through this period that will actually fail. Now, in my baseline optimism about the economy, that should not be systemically important, not SIFI, shouldn't generate, you know, a run on the banking system. But, you know, probably would have said that, too, if you told me a bank the size of SVV failed. It was a $200 billion

bank, good size, but that wasn't considered to be systemically important, either a SIFI institution. And, you know, given that depositors are already on edge, given the ease of withdrawing funds and moving them around through online banking, given social media and the impact that can have on people's expectations, you know, I don't think we can roll out the possibility of another event in the banking system. You know, I've got this kind of this image in my mind that the system is kind of like an engine, and it's shaking violently under the pressure of these higher interest rates and then converted curve and all the things I just described. It blew a gasket, you know, back in March and the Fed and FDIC and other regulators kind of got the gasket back in and taped it all up,

but the system is still, the engine is still shaking violently and something could break. And so I view this as a material risk to my optimism. I don't have a good sense of timing or exactly where the gasket is going to blow, but I do think it's something that needs to be on the radar screen. And I did also want to say it's not only about the banking system. I know that was what the participants in this webinar called out. It's also in the non-bank part of the system, you know, what's going on with regard to particularly lending to non-financial corporates, and that's being done in lots of different ways, showing you one way here, the so-called leverage lending.

This is kind of bank loans that are syndicated more broadly. And in this case, these are leverage loans that are going into CLO's collateralized loan obligation. And the point I wanted to make is this is only, you know, a bit of the elephant called the non-banked system. So we're just touching a part of the elephant. But you can see the growth rates here. It's just incredible. I mean, the latest data I have is there's $900 billion in outstanding leverage loans and CLOs. And that's more than double what it was, you know, just back, you know, prior to the start of the pandemic.

That's a lot of growth. And you can see I've broken it down in the in the in the, in the, in the, in the, in the, in the, table there by industry you can see the size of the amount outstanding in the first column and then the growth over the past decade and that's pretty heady growth i mean take a look at construction and building that's a pretty cyclical obviously business and 35.5 percent annualized growth that's that's not inconsequential small dollar amounts but nonetheless and this is just again a part of the elephant this doesn't include the leverage loans that are not going into CLOs but into the kind of the nether world of the shadow system does not include private credit, which is about $1.6 trillion

that's going to similar non-financial corporates of financing a lot of private equity deals, that kind of thing. It doesn't include straight up C&I loans that the banks are doing to small businesses. So you add it all up or the junk corporate bond market for that matter of fact. So that's all the things I just mentioned are credit going to non-financial. businesses that are below investment grade. They're less credit worthy. They've got some kind of issue and less vulnerable if anything else goes wrong. So again, I don't have something specific to point out and say that's a problem, but this feels like all of the ingredients, all the fodder for something going off the rails here are in place. And, you know, it could very well be ignited

if interest rates don't start to recede here, at least according to our baseline script. If they stay higher even longer than we're anticipating, something could break in the system and undo the system and ultimately undo the economy. Okay. Mercer, Chris, any questions about that from the audience before we move on? I guess one related question is how significant would the 2025 to 2020s haven't speculative-grade maturity well? refinancing at higher rates be for U.S. economic prospects.

Yeah, I mean, that's a great question. So if you look at the maturity dates of all this debt I just described, we've got really good data on the junk corporate market, for example. It doesn't look overwhelmingly worrisome to me. It's one reason I take some solace in the economy's prospects, because the maturities, the amount that's coming due this year, 24, 25, into 25, relatively modest. It gets to be more after that, but, you know, lots of things are going to happen between now and then, and a lot does depend on the interest rate environment.

I mean, if interest rates do remain much higher than I'm anticipating into that period of time, then we've got a problem. But hopefully, and I think reasonably to expect rates will start to come back down, normalized to a more significant degree. And as a result, you know, these loans will be able to be rolled over at a rate that isn't so onerous that it results in these companies being forced to make some tough choices about investment, hiring, paying their debt, so forth and so on. So I'm not overly worried about it. I mean, I think that's one reason to be reasonably optimistic about things, but nonetheless,

I don't want to dismiss that as an issue. Okay, let's move on, and I'm going to, we've got two more risks to cover, and the next one is a bit thorny, thus we gave it to Marissa to handle. Best of luck with this one. This is, this is, you know, I don't think we can discount this. So what do you define what this means in your thinking and, you know, how this might manifest in the economy. Sure.

Yes, this is a thorny one. So social and political unrest has been on our risk matrix for a while. This could mean a lot of different things, right? I mean, we just went through a period starting in late 19, sorry, late 2019 into 2020 with COVID, the pandemic. We had the 2020 election. We had Black Lives Matter and a number of, you know, social issues come to the four. So all of these things resulted in a lot of social and political unrest. back in 2020 and we're staring down another election next year, which looks like it could very

well be Donald Trump versus Joe Biden. And there's a lot of angst around what the results of that will be and how those results will be taken on the losing side. Right. So that's kind of the way we're thinking about it. And in fact, compared to the last risk I presented, we think this is actually a little bit more likely to happen. So let's talk about how we're thinking about that. So I think when people answer this question, you know, I think they are thinking about this mostly in terms of the 2024 election coming up, right?

And what that could mean. We've already got a couple questions about what the Fed may or may not want to do in 2024 right before an election. So let's just, look at, you know, some indicators here. This is Mark, your favorite, the University of Michigan Consumer Sentiment Survey. And as you mentioned at the top of the talk, we've really been discounting this when we look

at how consumers feel because there's been very notable divorce happening between what consumers say they feel about the economy versus what they're actually doing. Mark, you showed consumer spending, chugging along at the same pace we would have expected in the absence of the pandemic. Yet when we look at consumer sentiment surveys, they're terrible. The conference board's survey of consumers is more sanguine than this one, the University of Michigan. There's probably a couple reasons for that. One, the conference board survey is more focused on the job market, prospects in the job market, prospects for wages and earnings. The University of Michigan asks more questions about prices and inflation and gas prices.

And we know inflation is top of mind for people when they answer questions about the economy because it's what they're facing on a day-to-day basis and often take little solace in the fact that inflation is down significantly from its peak because prices are still high, right, relative to where they were a few years ago. But one interesting thing to note in the University of Michigan survey is they ask people to identify their political affiliation, whether Democrat, Republican, independent, or something else. And what we've seen since the inception of this survey is that the responses have been, become much more partisan and much more swayed by how people identify politically. So you can see back when the

survey was started back in 1980, and we had two back-to-back Republican administrations with Ronald Reagan and George W. Bush. There wasn't a huge difference, right, between the way Republicans and Democrats saw the economy. I mean, you did see Republicans thinking the economy was better than Democrats during these two administrations, and then that flipped during President Obama. But you've seen something really different happened, starting in 2016, with the election of Donald Trump. So coming off of Barack Obama's administration, you see this huge gap open up in terms of how people say they view the economy, depending on whether there's a Democrat in office or a Republican in office. And you can see this is continued through President Biden's administration, not expecting this to get any better anytime soon, right? So we are not a surprise to anyone extremely politically divided in terms of the way we see the economy

and in the way we see the world. And the result of this, we've seen actual results of this, right? We saw we just went through a period where the House was unable to elect leadership after ousting Kevin McCarthy. And that had real implications for what the government can and cannot get done if they cannot elect a leader. And so we've seen that this has real consequences, right? The partisan infighting can bring the government to a standstill. So how do we think about this or process this in terms of the economy? Well, there's a couple ways we can look at this. One is that we have

a country risk service that's relatively new and is really interesting. We look at every country in the world, even those that we don't directly forecast. And we rate them on a number of risk factors. You can see what those risk factors are here on the right-hand side panel. So we give them an overall risk score, but it's based on economic risk, business risk, financial risk, social risk, et cetera. So we've seen for the U.S. that social risk has risen quite a bit in the last few years. Now you'll note this is the blue line on the left-hand side. You'll note right now it's not really much higher than it was, right, in the mid-20 teens, but you can see that huge spike in 2020, as I mentioned, some of the factors working there.

And then you see it rising again since the start of 2022. And if we look at the contributing factors to what's driving that social risk score higher, the main factors are distrust in the political system. rising income inequality, rising crime rates and some major cities across the country. And then even looking further out, perhaps the adoption of artificial intelligence could disrupt, you know, the job market significantly and lead to people losing jobs, right? So there has been a lot more social angst that we can measure. And a lot of this, a lot of these surveys that try to measure this do so by looking at web searches,

looking at news articles on various topics and kind of comparing that to a baseline average or a medium. So we can see that this has becoming more of an issue. Now, why, again, what does this have to do with the economy? Well, as I mentioned earlier, if we can't have effective leadership, if some sort of constitutional crisis were to happen next year or early 2025,

we're looking at a government that's sort of paralyzed and unable to do anything significant. We know that right now the debt to GDP ratio is right around 100% in the U.S. The Congressional Budget Office, who updates forecasts for our fiscal situation, is forecasting that by 2050 we're looking at a debt to GDP ratio of about 180%. And at that point, especially given that we're facing higher rates, of higher interest rates, right? And we expect interest rates, as Mark just talked about, to remain higher for longer.

We're looking at a much larger share of our fiscal revenue going toward debt service. So when you go out to 2050, you're looking at the CBO projecting that about 7% of our GDP will be going to debt service alone. And if we don't address this, then eventually the government's gonna have to make some tough choices.

They're not going to want to default on the debt. But with all of that money going toward debt service, that means there's less money to fund other programs, social programs, defense, you know, essential services. So we're looking at potentially a pretty dire situation as we move out. And if we have some sort of, you know, crisis where there's a lack of leadership or simply there's just very partisan divided government for a long time, and these issues don't get addressed. We don't address long-term entitlement programs. We don't address discretionary spending or defense spending. We fight over whether or not to raise or lower taxes. Then this does present a real risk, although I think this is probably a longer-term risk when we talk about the debt to GDP ratio.

But certainly with the 2024 election, this could make things even less likely to get done over that time period. So I will stop it there, Mark, because I know we're low on time and just see if there's anything you want to add or any questions. No, that was great. We are running low, and I do want to get to the last risk. And that's a pretty thorny one. And we are going to weigh in more on that going forward. We have, as you know, a model that at the Electoral College level that predicts who's going to win. We're working on updating that now. We'll present those results in early January before the Iowa primary. and use that as a basis for starting to talk about the kind of things that you brought up here in a little bit more details. And we will probably, in all likelihood, run another scenario or two through our models to try to put some numbers to some of these concerns that I think are valid.

I think it's going to be a – it could be the number – ultimately end up being the number one risk for 2024. So with that happy note, unfortunately, let me turn it over to Chris to kind of bring. us home on house prices. Great. Thanks, Mark. So, yeah, so the audience also indicated house price crash is a potential risk factor here, kind of high on the list. Certainly not terribly surprising, given our history, right? We had house price crash last time around during the Great Recession. And so given the recent path of house prices in terms of a 45% growth in how home prices from 2020 to today, I think that naturally would bring, perk up the ears of any risk manager who was

looking at this market and wondering, could house prices actually correct? I'd characterize the housing market today is fairly unhealthy, right? It's largely frozen. The number of existing home sales is at a multi-decade low, lower than it was during the Great Recession or the pandemic. right and you have some opposing forces going on here with high mortgage rates making it very unaffordable for home home buyers particularly first-time home buyers younger adults so they're moving to the sidelines finding or identifying other housing arrangements whether that's renting or staying with parents or roommates and so that demand is coming in and at the same time you have low inventories of of homes for sale because many existing

homebuyer or homeowners are locked into their their mortgages, right? And even if they desired to move that wanted to trade up, the financial costs that they would bear from going from a, say, 3% mortgage to a 7, 7.5% mortgage is just too high for them to make that transition. So you don't see the supply of homes on the market. And so as a result, you're having this tug of war between supply and demand here. And right now, the supply is kind of winning. You can see that in the house price index on the left hand side of the slide here. House prices were decelerating over the last year or so back in 2022. But then more recently you've seen a pickup in those home prices as those low inventories have caused those few buyers who are out there to continue to bid up prices.

So then the question is, well, what happens next? And I think in the short term, this activity is likely to continue. you probably will see prices bouncing around here for a while. There will be some support. But longer term, if you look at the existing sustainability of home prices, I think the question becomes much more ambiguous. On the right hand side of the slide here, you can see some key house price ratios that we typically look at to identify whether or not the housing market

is in equilibrium or in a sustainable place. And today, you can see that the median price to income ratio is just a, under 5.5 times. It's much higher than it was during the housing boom back in the 2000s and substantially higher than the typical kind of realtors rule of thumb of say three and a half to four times income being the threshold for a home purchase. So from that standpoint, it looks as though prices are certainly rich relative to incomes. Prices are also rich relative to rents. And that's what you can see from the green line with the right hand scale here, right? price to rent ratio right around 23 times is also elevated compared to history.

You can think about this as being analogous perhaps to a stock market PE or a price to earnings ratio. And so 23 on a PE basis tends to be quite high. We would expect something closer to maybe 20, 21 to be more of an equilibrium level. So I think that has these types of statistics have perked up the ears in terms of a potential housing market correction or crash here. Now, our baseline outlook calls for a more gradual return to equilibrium. So on the slide here, I'm showing you the same Moody's Analytics House Price Index,

back to 2013. You can see the sharp rise in prices since 2020. Our expectation is that prices move more or less sideways with a little bit of a downward shift in order to bring us back to more of a trend level of house price growth. So to get back, to get those price to income or price to rent ratios back to equilibrium, we need really three things to happen. We need incomes to continue to grow, right? So as long as the labor market remains relatively healthy, you get some wage growth,

although it's moderating, that should help to over time bring prices and incomes back into alignment. Declines in mortgage rates that Mark outlined earlier will also help with affordability, bring down those monthly mortgage payments, and that certainly would help to get the housing market moving again and bring us closer to more of an equilibrium level from affordability standpoint. And then we do believe you need some price declines here in order to really get us back to this equilibrium

in a relatively short order. If we don't get those declines, as you can see in our upside scenarios here, we could certainly get back to an equilibrium, but it would take much longer. So to get back to an equilibrium within, say, a two, three-year period here, you'd need a combination of all three of those factors. There is downside risk here, though. You do see our scenario four here calls for a 21% peak to trough decline in home prices.

This is a scenario, though, that does envision a 10% unemployment rate. There are a number of shocks going on to the economy here that really make it very difficult for potential home buyers and even existing homeowners would feel much more pressure in terms of payments. you'd see a sharp rise in delinquencies and foreclosures, and that would be the catalyst for that decline. So it's possible. It's certainly a scenario we consider.

Not very likely, though, today relative to the Great Recession, given some key changes to our economy or our housing markets in terms of much stronger lending standards. So today's homeowners have much more equity in their homes. They have locked in a very low mortgage rate to a large degree, so easier to afford these mortgages on a go-forward basis. You also have a demographic shift here with much more demand for housing underlying the market here. So if we were to start to see some price declines, provided the labor market is still hanging in there,

you would likely see some more home buyers stepping up to prevent prices from really collapsing. So it is a scenario to consider, but I don't see this as the most likely scenario that would take us into recession at this point. And with that, I'll stop, maybe turn it back to you, Mark. Okay, well, thank you. We've got a ton of questions. I'm afraid, though, we have no time. But we answered a boatload along the way, and we answered some in the chat function. The remaining will probably record another podcast-like webinar thing where we go over the questions and post that for people so that they can see all the questions and they can see the answers to all the questions.

So we'll get back on all of those. And if you have any other questions, you know, please feel free to fire away. I do want to end unfairly, though. Chris, Marissa, if you had to pick one more risk, what would it be? What one thing else would you have called out that we didn't call out so far? I'll go to you first, Chris. Oh, gosh. You know, I can easily go to the dark side.

So I'm worried about more of those geopolitical risks creeping in. or kind of the known unknowns or even the unknown unknowns, something that comes out of nowhere, spooks consumer, spooks the economy, causes a significant reaction. So, you know, it could be anything from a conflict between other nations or the U.S. that suddenly arises potential terrorist attacks, right? There are all sorts of things that, you know, as risk managers, you have to be aware of that just pop out of nowhere. Marissa?

Maybe some credit risk on the consumer side. Oh, okay. Higher delinquency rates or just credit deteriorating faster than we're expecting. Right, because some of the data there look pretty soft. Not great, yeah. Yeah. Right, okay. Okay, I was going to say cyber.

We're running a scenario as kind of a bit of an ad for a cyber scenario that we're going to be releasing in the next few weeks around a attack on the nation's ACH system. This is the payment system. And I think people will find that quite interesting and sobering. And we work very closely with the folks over in the rating agency that do a lot of work in this area and BitSight, which is a really cool firm that things. thinks about cyber for their living, and so we've been working closely with them. So we'll be back with you and talking about that. So with that, you guys must be exhausted out there. An hour and a half.

I can't believe it. I think most people hung on. I couldn't believe that they did, but you did. And hopefully you found it of some value. And, again, if you have any questions, just fire away. And we'll see you soon. Take care now.