By Brett Patten and Kent Musbach
By the time you happen upon this article in the August edition of the Wisconsin Banker, we will all know whether the U.S. economy has fallen into the 14th recession since the end of World War II. In fact, the Atlanta Fed GDPNow suggested in early July the recession had already started. This recession will be (or is) largely because of unintended consequences of massive monetary supply increases and a collective underestimation of resultant inflationary pressures. On cue, the truth-telling yield curve has pushed yields aggressively higher in 2022. And perhaps most importantly, since early July, the curve has changed its posture towards a recessionary warning, as the U.S. Treasury yield curve inverted between the 2-year and 10-year maturities — a historically pertinent predictor of imminent recession. All this aside, what matters to community bankers isn’t so much defining whether we are technically in a recession — but rather focusing today on taking action as stewards of your institution to prepare your stakeholders for potential recessionary impacts.
The first issue to consider is the health of the consumer because of the reliance our economy has on their spending. While it is true the labor market is very strong and employees are commanding higher compensation levels in nearly every industry, real person incomes are actually falling, meaning inflation is increasing faster than those incomes. Stock market losses thus far in 2022 have also provided a one-two punch to consumer confidence. At the same time, home affordability has taken its largest drop since 2013 as mortgage rates have nearly doubled and median home prices have surged. Already, these consumer stresses have manifested into increased revolving debt balances (up 16.8% in Q1 2022 over 2021) and declining savings rates (5.4% May 2022 vs. an 8.6% 10 year average), both negatives for liquidity in the banking system.
The decline in home affordability portends a host of issues from a large drop off in mortgage activity already being seen by originators, potential increased delinquencies and the decreased spending which comes along with a slowing housing market. Given these trends, a resurgence in home equity lending seems to be quite plausible; perhaps this will again be an area of growth to target — but only if you can get comfortable with seemingly elevated real estate values.
Next consider commercial credit. Despite seemingly being in the late stages of a growth cycle/beginning of a recession, the current environment across much of our state is one of historically tight credit spreads. Loan rates have generally not kept pace with the rising risk-free rates of Treasuries. Commercial collateral valuations, like the residential market, are also towards their peak. Could it be the newest deals currently being priced and placed on balance sheets (tight spreads, higher loan to value ratios than existing loans along with elevated collateral prices) turn out to be the most problematic in a recession?
Investment portfolio decisions today are especially important. The Fed historically has been late to the party, having to raise rates quickly to catch up to a forward-looking bond market only to quickly reverse policy as the economy stalls. If this happens once again, optionality in the portfolio will come into play —in a negative way with accelerated cashflows from pre-payable bonds. Having securities that accomplish the goals of both extension protection (in case rates continue higher due to inflation) and prepayment protection (in case rates crater after the Fed goes too far) could lead to outperformance. Finally, going into a recession now could be difficult on margin. Cost of funds may not elevate to levels high enough to provide any meaningful lift to margin in a downturn. At the same time, loan demand will likely weaken placing downward pressure on overall asset yield. Indeed, we could be heading into a stormy period with several headwinds, but if you are able to address these challenges early and successfully, your institution may have the opportunity to outperform.
Patten is vice president and Musbach is senior vice president and team lead with BOK Financial Institutions Group, a WBA Gold Associate Member.
The opinions expressed herein reflect the judgment of the author(s) at this date, and are subject to change without notice. The information provided has been obtained from sources believed to be reliable, but not guaranteed. Forward-looking statements contained herein are based on current expectations and the economy in general, and are not guarantees of future performance. Likewise, past performance is not a guarantee of future results.
Bank dealer services offered through Institutional Investments, Bank of Oklahoma, which operates as a separately identifiable trading department of BOKF, NA. Services may be offered under our trade name, BOK Financial Institutions Group. BOKF, NA is the bank subsidiary of BOK Financial Corporation. Some services may be offered through BOK Financial Securities, Inc., member FINRA/SIPC, and an affiliate of BOKF, NA. Investment products are: NOT FDIC INSURED | NO BANK GUARANTEE | MAY LOSE VALUE