Clearly, the US economy is doing better today than it was just one quarter ago.  People have returned to work and sectors like housing and rail traffic are actually booming.  This is great news, however, for community bankers, this remains an incredibly challenging environment.  With the Fed growing its balance sheet and the government giving out a large stimulus package, banks are flooded with excess liquidity.  Worse yet, its liquidity with no maturity date. 
                            
      

Another great challenge we are/will continue to face is the fragile condition of small businesses.  Equity indexes have recovered all the losses suffered during the initial impact of shutting down the US economy, however, it is only a few, very large companies driving the indexes higher.  Small business earnings remain in a steep bear market.  As you can see in the following chart, small business earnings are in critical condition.
 
        

This presents a big challenge to banks because it is difficult to underwrite companies that have no earnings.  Second, and most importantly, as the next chart shows, the number of “zombie” companies, defined as companies where profits are less than debt expense for the last 3 years, are near an all-time high.  It would appear that trouble in the credit cycle is just beginning.
 
     

From a risk management perspective, our risks seem well defined for us.  Rates are incredibly low (we can’t change this), margins are under pressure (we can change this) and credit conditions are difficult (we can still find good loans to make).  These are difficult times no doubt, but with a plan and the will to execute the plan, this too, shall pass.  Next year looks much better than this year.  There are some very promising vaccine candidates on the horizon which should allow the economy to really open up late next year.  If you need help developing ALCO strategies Luke and I are here to help.  If you need help putting excess liquidity to work, please call your UBB Securities representative, they have products that will help limit some of the margin pressure you face.

What has occurred in the last two months has been stunning, historic.  When a $20 trillion economy is shut down, it just isn’t pretty.  The monthly data is finally starting to reflect the reality of our situation.  The April employment report was the worst in modern history with 20,500,000 people losing their jobs.  The unemployment rate, which was “gentle” in my opinion, came in at 14.7%.  Why “gentle,” because if you don’t use the government fudge factor in the math, the actual unemployment rate was 23.7%.  I am not going to take you through the laundry list of other awful economic data that came out in April, but I do think it is necessary to make some important distinctions in what I think is about to unfold.  It really is good news, bad news.

Because the fall-off in economic activity was instant, I have moved to relying on my “high frequency” economic model in my discussions with community bankers because it is as close to real-time as I can get.  My weekly model is designed to reflect the start and end of recessions (major distinction) and give a hint about the severity of the recession, relative to recessions in the past.  But with this model, it defines a recession, not the “real feel” of our economy, or in other words, how is the recovery going.  The chart below clearly shows the distinction we need to understand going forward.  It shows my weekly economic model (blue line) vs my “Real Feel” economic model (orange line).  It clearly shows that just because a recession (contraction in economic activity) may be over, it does not mean the economy is now fully recovered.  If we measure the time (noted in the chart) between when a recession ends (blue line crossing above zero) and when the economy enters an actual expansion phase (orange line crossing above zero) you can see the bad news I was hinting about.  First, the good news.  My weekly economic model bottomed on April 16^th and has been getting less negative. 




That means that we should start to see less negative economic news going forward.  This however does not mean the economy is about to enter a fresh expansion.  This is a key distinction for community bankers.  On average, it has taken 20 months from the end of recession to the start of a fresh expansion.  As the chart shows, the time between the end of recession and the start of expansion has been taking longer and longer and longer.  With the Fed now targeting asset prices with monetary policy (Alan Greenspan started this in the 90s), more and more of the Fed’s monetary resources have been diverted to pushing up asset prices, not pushing up economic leverage.  BIG DIFFERENCE.  Therefore, actually, economic progress has taken longer to happen.  

To sum this up, the good news is, this is likely to be the deepest, shortest recession in history; the bad news is, the economic recovery is likely to be a long ways off from the actual end of this recession.   

I realize desperate times call for desperate measures.  What has happened in the last 60 days qualifies as desperate times for sure.  The Fed has done everything in its power (and outside its power) to try and add some stability to these desperate times.  We absolutely cannot have a financial collapse, I think we all agree on that.  However, the path the Fed has chosen to deal with this crisis will likely change market risk messaging for a long, long time.  

In the banking world, we simply have three broad tasks as it relates to risk management; identify our potential risks, have policies to trigger risk mitigation when necessary, and have some reliable, forward looking information that can help identify business cycle turning points.  These turning points can turn our potential risks into actual problems.  With the Fed basically socializing market losses via its various asset purchase programs, the Fed has wiped away risk pricing in financial markets.  This is a whole new risk in risk management.   Rather than going on forever about this and showing 100s of charts proving my point, I have put together one that highlights the danger the Fed has brought to risk managers everywhere.  The chart below shows two different models, the black one is based on financial market indicators (soft data), and the orange one is based on hard economic data.  The soft data model includes equity sectors like real estate, retail sales, consumer cyclicals/staples, bond spreads (including junk bonds) and swap curve data.  The hard data model includes actual employment, actual retail sales, actual production, etc.  As you can clearly see, with the Fed (and all central banks for that matter) directly interfering in the markets, market pricing no longer seems to represent the reality of our current situation.   



I know what is being done has to be, we need a financial bridge to the other side of this because it will eventually pass.  I just thought it prudent to highlight how market risk pricing, at least for now, has lost its way as a risk management tool about community bank reality.