Economic and Interest Rate Outlook Second Quarter April 2018

Transcription

1 Economic and Interest Rate Outlook Second Quarter April Route 206 Gladstone, NJ P: (908)

2 Today s webinar will cover three main discussion topics... Economy and Interest Rate Outlook Key Global Risks Impacting Community Banks Key Strategies for Community Banks 1

3 Economic and Interest Rate Outlook 2017 FinPro, Inc. 2

4 Since our last economic webinar there have been a few items of note as of March 31, Import Tariffs have been placed on imported steel to the U.S., which could lead to a trade war between nations. China already putting tariffs on 128 imports including pork and fruit (agriculture). Fed Raising Interest Rates as a part of the March 2018 meeting with an expected 2-3 additional increases in Chairman Powell indicating that equity market volatility will not stop rate hikes. Parallel Shift in the Yield Curve Fed funds rate 1.75% Prime rate 4.75% 10 Year Treasury Rate 2.74% Equity Market Volatility has hit the entire market hard since the end of January inclusive of financial services stocks. Focus on Liquidity as regulatory agencies have been completing focused liquidity exams across the country in the wake of rising deposit costs. Tax Reform Many banks had to book DTA adjustments in the fourth quarter of 2017 for the recently passed tax reform hampering profitability. Banks should now be able to reap the benefits of a corporate tax rate moving from 35% to 21%. However, this tax reform may impact collateral values located in high-tax states like, New Jersey, New York, Illinois and Connecticut. Growing National Debt and the increasing cost of servicing that debt. Continued Pressure on CRE Select commercial real estate segments- luxury market and segments. Cap rates remain at historic lows and continue to decline. 3

5 FinPro maintains that the economy continues to gain momentum but remains delicate. Projected growth of the economy will be dependent upon the continued success of Trump administration's implementation of key policies... The Positives Full Employment Pro-business and growth administration Corporate tax policies Consumer spending continues to increase Real wages have grown Interest rates remain low by historic standards price values continue to move upwards Mortgage delinquencies continue to decline The Unknown Regulatory changes across industries Outcome and impact of midterm elections in November Worldwide economic health/stability Natural disasters The Negatives Rising and flattening yield curve Geo-political risk Tariffs and trade wars Unintended consequences of tax policies - Cap on State deductions - Service S Corps - State and Local Tax Policy Potential for continued rate volatility on the long end of the rate curve Consumer sentiment is high but declining Durable goods down Personal savings decreased 4

6 Consumer spending remains strong... Consumer Spending increased rapidly at a 3.8% annualized rate in the last quarter of 2017; fastest in three years. Personal Income increased 3.1% in 2017 from 2.4% in But, the growth in spending came at the expense of savings. Savings dropped to a 10-year low of 3.4% in 2017 from 4.9% in Source: Reuters 5

7 Retail sales have plateaued in 2018 and savings rates have declined to pre-recession levels... Sources: Bloomberg 6

8 Gas prices have steadily increased since June Increased gas prices and rising interest rates will reduce consumer spending power without a corresponding increase in wage growth... Sources: Bloomberg International Energy Association 7

9 The Yield Curve: Year-over-year, we have seen a flattening of the yield curve, while quarter-overquarter shows a parallel shift across the curve... The Banking Impact: Over the quarter, the yield curve experienced a parallel shift upwards as intermediate and longer term rates increased relatively in line with the shorter end of the curve. Intermediate and long term rates spiked to nearly 3.00% in February 2018 in anticipation of a Fed move in March However, the longer end of the curve has retreated over the past several weeks due to negative news events (trade war, global instability, data security). Source: Zero Hedge 8

10 The spread between short / long term treasury rates continues to hover around 1.00%. Spreads moving below 1.00% has historically predicted an economic recession... Currently, we are seeing a more gradual rise in short term rates. 9

11 The change in the yield curve has resulted in a steady rise in cost of funds over the past three quarters. Net interest margin was held flat in the fourth quarter of

12 The Federal Reserve is projecting more rate increases over the next two years with two additional rate increases in March Economic Projections 2018 median 2.1% 2019 median 2.9% 11

13 While short term rates are projected to rise, the movement in intermediate and long term rates will be based on the following key events... Inflationary pressure Increase in national debt and rising cost of servicing debt Tariffs and trade wars (China, Mexico, South Korea, etc.) Equity market volatility November 2018 Mid-term elections The outcome of these events will drive the direction of long term Treasury rates, and ultimately the economy, over the next 24 months. 12

14 Current state of inflation... The Federal Reserve worries about inflation. They have a state goal of seeking 2% inflation by their preferred measure. Inflation has been rising in recent months and the Federal Reserve feels compelled to increase short-term interest rates to make sure inflation doesn t rise too much. After many years of low inflation, there are troubling signs starting to emerge, suggesting that inflation may pick up further, forcing the Federal Reserve to be more aggressive in increasing interest rates. - Oil price increases, due to stronger international economies. - A weakening dollar against major foreign currencies makes imports more expensive. - Tariffs imposed by the U.S. on foreign steel and aluminum will increase prices for U.S. consumers. - Ironically, the data also suggests that rising interest rates are inflationary as well. (Note, this is the opposite of what the Federal Reserve thinks.) - Strikes by teachers across the country are reminiscent of earlier attempts of workers in the U.S. to overcome the effects of inflation. 13

15 A survey of economists also project a moderately strong economy for Source: Reuters 14

16 CPI has been increasing over the past 12 months and is near the Fed s 2% benchmark. However, the Fed has also increased interest rates as CPI is near historical lows, resulting in spread compression between long term Treasury rates and Fed Funds rate... 15

17 One of the reasons for the rise in CPI is due to the rising cost of oil. The price of crude oil in now back to pre-recession levels (approximately $60/ barrel)... 16

18 A historical view of CPI versus interest rates demonstrates that today s rise in rates should be gradual (as opposed to the rapid rise in the 1980s) as CPI and wage growth is significantly lower. During the 1970s, CPI and wage growth was well north of 4% versus 2% today... Source: CNBC 17

19 As interest rates increase, the cost of servicing our national debt will also increase resulting in a significant threat to the overall health of our economy... In September 2017, outstanding U.S. debt equaled $20.24 trillion In Fiscal Year 2017, the federal government spend $296 billion on interest on this debt held by the public. In Fiscal Year 2017, the federal budget deficit total $665 billion, which represented 3.6% of GDP Estimates by the Committee for a Responsible Federal Budget suggest that the federal deficit will reach $1.1 trillion in fiscal year 2019, and will reach $2 trillion by The deficit in relation to GDP will likely rise sharply. CONCLUSION: If the federal deficit continues to increase and if the level of interest rates rises, interest expense on outstanding U.S. government debt will comprise an increasing portion of federal revenue unless the federal government increases federal revenue beyond that currently projected. 18

20 The U.S. Federal debt burden will increase... Moody s rates U.S. debt as Aaa Moody s outlook: If the U.S. pivots toward less trade and immigration, that may swing the balance of risks for long-term growth to the downside. In 2017, interest payments represented 8.1% of federal revenue; this is low compared with 15% - 18% in the 1980 s and 1990 s. With the increase in Treasury debt outstanding and likely increase in the level of interest rates across all maturities Moody s estimates that interest will reach 21.4% of revenue by If this is true, Are other expenditures crowded out? Will taxes be raised? Data Source: Preeminent Financial, Economic Position Offsets Weakening Government Finances, Moody s Investors Service, February

21 Interest on U.S. Debt as a % of Federal Revenue is projected to increase above 20% by 2020s... 20

22 The impact of increased tariffs on U.S. exports will impact certain regions of the U.S

23 Three possible scenarios of U.S. and China engaging in a trade war... A win-win scenario: Both the parties agree to a mutually beneficial way to reduce trade disputes. Limited impact to the economies. USD/CHF has depreciated and broken a range that it held for more than a month. Trade war would hurt US more than China as US wants more access to China s market. This has, probably, caused Yuan to gain recently, in addition to the launch of Yuan-denominated oil futures. Yuan s advance will slow down if there is more certainty, as it is already highly appreciated. A lose-lose more scenario: Trade disputes stay constant, however, two parties cannot reach a deal to avoid major tariffs. This will lead to a series of tariffs attack between both the countries. US will be deviated from its eventual end goal push China to become a market-oriented economy, instead of state-led economy, which will help US exporters attain more access to the Chinese market. US Dollar could lose more than Yuan. A lose more-lose more scenario: Matters get complicated due to involvement of political issues; like China-Taiwan relationship gets impacted due to political moves by US. This will be a consequence if scenario 2 occurs. China will withdraw its investments and start selling Yuan. This vicious circle will hurt both the parties more in the long run. 22

24 FinPro Interest Rate Forecasts 2017 FinPro, Inc. 23

25 In the Economic Growth- Short Term scenario the economy is strengthening as a result of the success of the short term success of the recent tax reform. The Fed continues to raise rates, but longer term rates rise slower. Gridlock increases in Washington due to the mid-term elections and the economy begins to enter into a recession... 24

26 In the Economic Growth- Sustained scenario the economy is strengthening as a result of the success of the current administration s success in passing tax reform. The Fed continues to raise rates and longer term rates experience continued compression. The 10 Year Treasury passes the trigger point.. 25

27 The Flattening Yield Curve scenario is caused by continued uncertainty surrounding the health of the overall economy and concern that rising short term interest rates will eventually lead to a recession. This scenario results in a flattening yield curve... 26

28 Global Risks to Community Banks 2017 FinPro, Inc. 27

29 The chart above illustrates the CAMELS+ components and the overall regulatory focus on each component. Over time, each of these components shift based upon the overall projected banking environment Asset Quality Operational Capital Strategic Management Earnings Reputation BSA Sensitivity Legal & Liquidity Regulatory CRA IT Valuation Corp Governance Compliance Risk Management 28

30 1. Liquidity: Liquidity risk is increasing due to four major factors Competitive Pressure: Most community banks have started to increase rates on core deposits Customers are becoming increasingly demanding for rate Most strategic plans are now focusing on deposit growth as opposed to loan originations Banks that are growing deposits are often paying up for them 2. Alternative Funding Risk: Listing service deposits rates are now above the national rate caps Borrowing costs continue to rise Banks have utilized portions of their contingent funding sources (less availability) 3. Funding Concentrations: High levels of money market accounts Increasing levels of high average balance accounts Concentration of municipal deposits Other hot money concentrations 4. Interest Rate and Economic Risk: Fed Funds increases will have a material impact on Beta values Funding mix shift towards CDs and higher cost funding Disintermediation of deposits Unwinding of Quantitative Easing (Less demand) 29

31 1. When looking at the third quartile of community banks by region, some alarming trends are occurring regarding loan to deposit and loan to asset ratios... The loan/deposit and loan/asset ratio has increased in all regions of the country. The regulators are concerned this trend may be a result of management reaching for credit. Source: SNL (Banks, Savings Banks, and Savings Institutions with Assets less than $10 B in MRQ) Note: data represents the third quartile 30

32 1. Third quartile regional trends also show increased utilization of wholesale as well as increased money market accounts and deposits over $250 thousand... The Borrowings + Listing Service + Brokered / Deposit ratio is increasing in all regions and is above 20% in the NE region for 3rd quartile banks Money market accounts levels are high and increasing as are deposits > $250k Level of retail time deposits as compared to total deposits are declining as more wholesale funding is used and core deposit specials are listed. Source: SNL (Banks, Savings Banks, and Savings Institutions with Assets less than $10 B in MRQ) Note: data represents the third quartile 31

33 1. To begin the stratification process, the Bank should follow the recent supervisory insight... Funding Sources 32

34 1. Conduct detailed forward looking stress tests that are specifically developed for your institution... Defendable assumptions that are used for each scenario based upon the Liquidity Matrix Stress testing conducted on forward projections (i.e. budgeted financials) not point in time. Stress testing of high probability/low impact scenarios all the way up to low probability/high impact scenarios Other items to be stressed should include: removal of brokered capacity, increase in unfunded loan commitments, removal of unsecured funding, increase in problem assets, reduction in borrowing capacity, reduction in high money market concentrations. Stress Tests: 1) Stage 1: Shorter-term risk situation testing A. 5.19% deposit shock run-off over a 3 month time frame 2) Stage 2: Moderate risk situation testing B % deposit shock run-off over a 6 month time frame C. 25% decline in borrowing capacity over a 6 month time frame D. 50% draw down on all unfunded loan commitments over a 6 month time frame 3) Stage 3: Distressed/Severe Risk (long-term) situation testing E % Deposit shock run-off over a 12 month time frame F. 100% loss of access to borrowing lines (other than the FRB) over a 12 month time frame G. 100% draw down on all unfunded loan commitments over a 12 month time frame H. 100% loss of access to brokered deposits Mitigation Strategies: 1) Stage 1: Shorter-term risk situation testing A. Draw down fed funds and cash position B. Increase utilization of brokered deposits C. Utilize borrowings at the FHLB 2) Stage 2: Moderate risk situation testing D. Draw down fed funds and cash position E. Increase utilization of brokered deposits F. Utilize borrowings at the FHLB 3) Stage 3: Distressed/Severe Risk (long-term) situation testing G. Draw down fed funds and cash position H. Borrow at FRB I. Sell unpledged investments J. Pledge additional loans at the FRB for additional borrowings, sell unpledged loans, or stop originating loans. Additional possible action not shown in the liquidity stress test table: Raise deposit rates, while maintaining the rates below FDIC rate caps, to bring in additional deposits or utilize listing service deposits. 33

35 2. Bubble Watch: With one of the longest bull economy in US history, bubbles across the country in different sectors have formed. Economic data remains strong to moderate and market interest rates remain low by historic standards... 34

36 2. FDIC Examiner s Credit and Consumer Products/Services Survey results from 2017 indicate that agriculture lending presents a high credit risk for 2017 and a moving forward based upon the completed surveys from FDIC supervised institutions... 35

37 2. Total inflation adjusted farm debt is only 6% below the 1980 s peak... Farm real estate debt is 11% above its prior peak in the 1980s Historically low interest rates seem to make the debt service manageable. 36

38 2. Agricultural/ Farm Bubble... The following data from the U.S. Department of Commerce indicates the potential impact of the steel tariffs will have on countries that import steel to the U.S. and the resulting level of agriculture exports from the U.S. that may be in jeopardy of additional tariffs from the countries listed above. 37

39 3. Black Swan: Black Swan events could have a significant impact on the U.S. economy in 2018 with many uncertainties... Trade Wars: With import tariffs being placed on imported steel to the U.S., we could see the start of a long drawn out trade war between the U.S. and many nations such as China, South Korea, etc. China already putting tariffs on 128 imports which is an estimated $3 billion worth of U.S imports. Natural Disaster: With hurricane season starting in June, The U.S. could face another natural disaster that cripples a region as seen last year by Harvey, Irma, and Maria. Areas in Puerto Rico and the U.S. Virgin Islands are still recovery from the hurricanes of 2017, so areas already hit are vulnerable to the upcoming season. War: With mutual threats and hostility between the U.S. and North Korea, there is a potential for war between nations in War with North Korea could have a material impact on the economy and other aspects of society as whole if current situations were to escalate. 38

40 4. Political: With elections for both the House of Representatives and the Senate, there is chance for a political swing in With the Republicans having majority in both the House of Representatives and Senate, the elections in 2018 could have a huge political impact this year. The Republicans currently hold 238 seats in the House, to Democrat s 193 seats, and 50 seats in the Senate, to the Democrat s 47 seats. With all 435 seats in the House up for election and 34 of the 100 seats in the Senate also up for election, there is a chance we will see a political shift in Republicans have held majority in the House since 2011 and Senate since If Congress swings democratically in the November, this could potentially cause political lock up between the President and Congress. 39

41 5. Skilled Labor Shortage: In 2017 and 2018, there has been a shortage in skilled labor in certain geographic regions of the U.S.... Businesses, both big and small, are having trouble finding workers. A Federal Reserve survey released in 2018 found labor shortages all over the country. - Businesses are having no choice but to pay more to attract and keep talent. - However, companies are also losing out on business due to this shortage. - The Federal Reserve survey showed labor shortages increased significantly at the end of last year. Examples: - New England Region: - Wait staff and cooks - Manufacturing labor - Software engineers - West Coast: - Farmers - Factory labor - Bankers Ultimately, this lack of skilled labor has been causing prolonged job vacancies and searches for qualified candidates. This has led to lost revenue by many companies which will have an economic impact in the long run. Source: CNN 40

42 Strategies for Community Banks 2017 FinPro, Inc. 41

43 Based on the predicted rise in interest rates and overall strength of the economy over the next 24 months, community banks should do the following... Stay short on investment duration Move investments from AFS to HTM to avoid capturing unrealized losses in book value. Go long on loan duration if you get paid for it. Don t go too long on funding. The sweet spot for funding duration is 2-3 years. Lock in before short term rates increase again in Mitigate the rise in cost of funds. Those who can control the rise in cost of funds will win the game! - Create new products to capture incremental cost of new deposits. - CD specials and new non-maturity products that differentiate themselves from existing products will help mitigate the inevitable rise in costs. - Know your depositor base. Conduct deposit loyalty studies to price deposits appropriately Breakout your core and non-core deposits and identify volatile funds. Design contingency funding plans based on forward-looking assumptions, not static. Do not stretch on credit quality. Consider counter-cyclical approach to underwriting. Evaluate staffing levels for expected decline in mortgage origination volume. Review overall noninterest expenses to offset projected decline in net interest margin. 42

44 Thank you for participating in today s conference... For more information, please contact us directly at: Donald Musso, President Scott Polakoff, Executive Vice President Scott Hein, Director Tim Koch, Director dmusso@finpro.us spolakoff@finpro.us 2016 FinPro, Inc. 43