Dalls Fed President Robert Kaplan: Expect a severe economic contraction in the Q2

severe economic contraction Dallas Fed president Robert KaplanImage source: CNBC Video Screenshot

CNBC transcript: Dallas Fed President Robert Kaplan Speaks with CNBC’s Steve Liesman on “Squawk on the Street” today on expecting a severe economic contraction in the second quarter

 

From CNBC’s “Squawk on the Street

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Q4 2019 hedge fund letters, conferences and more

 

Dallas Fed president: Expect a severe economic contraction in the second quarter

 

STEVE LIESMAN: Yeah. Maybe the perfect guest to have right after that news from Joe Kernen from the President there. Robert Kaplan, President of the Dallas Fed, thanks for joining us this morning.

ROBERT KAPLAN: Yeah, good to talk to you, Steve.

STEVE LIESMAN: I guess I should start with the news. You have been following the -- you are in the oil patch -- you are almost the Federal Reserve President for the oil patch given your position in Texas. Tell us what you think the impact of the production cut from Saudi Arabia and Russia might have.

ROBERT KAPLAN: Well, it’s obviously welcome, it will be very welcome by the industry in the short-run. As long the coronavirus continues, there’s just a substantial amount of excess capacity being generated every day. As you know, so much excess supply being generated every day. So much so that we’re starting to worry about storage capacity for it. So, this, this will be extremely helpful.

It will be particularly helpful as we come out of this virus, and it will speed the time where the supply-demand for oil can get into balance. But we’re a long, long way from that. And people had warned even with the substantial move from Saudi Arabia and Russia, we’re going to be spending a substantial amount of time working off a high level of oversupply. That’s still true, but this obviously helps.

Severe economic contraction detailed

STEVE LIESMAN: President Kaplan, I want to ask you a question about the outlook for the economy. We went into this with the general belief this was going to be very painful in the second quarter with a rebound in the third quarter. I’m wondering if that’s your view or if there’s growing concern that what’s going to happen or what’s happening right now might be something that would create lingering weakness in the third quarter, such that the rebound may be further out this year?

ROBERT KAPLAN: Well, so we’re, like everyone else, we’re looking at various models of when the curve begins to flatten. And, you know, still based on our models our judgment is severe economic contraction in the second quarter. Probably some negative GDP at the start of the third quarter. And then a rebound. The issue is what’s the strength of the rebound? And, the reason we’re trying to come to grips with that into the third and fourth quarter is, as you and I have talked before, business fixed investment for the last couple of years has been sluggish. Manufacturing has been sluggish. The bright spot of the economy, the underpinning, has been the consumer.

And clearly, the consumer is going to come out of this weakened from what we’ve had in the past. We’re going to have, we think, we’re going to have unemployment that’s going to get in the low to mid-teens. We will likely end the year though, we believe, below 10% unemployment. Probably closer to 8%. But then it is going to take a while to work it off. And so, the consumer is going to be much more cautious for obvious reasons. So, there’s just an open question about what the strength of the consumer is going to be once we get past this virus, and we get into the fourth quarter and we get into 2021. And I think that’s a big challenge and question mark for the economy.

Severe economic contraction and unemployment

STEVE LIESMAN: President Kaplan, in light of that, I know the Federal Reserve has done a lot, but in the department of what have you done for me lately, I wonder if you can discuss additional things the Fed might be considering at this point. There’s a main street lending facilitate and there’s talk about state governments being in really severe problems right now. For example, New York State, not getting very much income. I imagine states across the country are going to have problems. What else is the Federal Reserve considering here that might be able to help the economy right?

ROBERT KAPLAN: So, I want to be cautious about what I talk about. But obviously, the Main Street Lending Program, the Fed is working at breakneck speed to get it up and running. It’s essential that we get that running as soon as possible. Because small businesses are desperately depending on assistance, and we want to preserve as many jobs and also, have as many small businesses come out of this as possible. So, that’s one thing. But that’s public information.

Regarding municipal securities, municipal situation, we’re buying commercial paper municipalities. It’s clear as you said, municipalities need assistance. They have to balance their budgets every year. They’re not getting tax revenues. And so, it’s -- for investment-grade municipalities, creditworthy municipalities, it’s understandable why that is a topic in the same way that we’re already buying investment-grade corporate bonds.

SARA EISEN: President Kaplan, Sara Eisen. Great to talk to you.

ROBER KAPLAN: Great to talk to you.

Lending

SARA EISEN: Just help us understand how you think about initial jobless claims number like we got today. 6.6 million Americans filing for unemployment. How has that changed our economy? How many of those are jobs lost for good? And hw should we be thinking about the damage that this is doing from a jobs perspective and a broader economic perspective?

ROBERT KAPLAN: Okay, so the way I think about that, roughly speaking, there’s the workforce of the United States is 160 million workers. And so, I mentioned earlier that it’s our view at the Dallas Fed that we’re going to get into unemployment in the low to mid-teens. So, I may not be a good judge of the pace of getting there will be, but I feel pretty strongly we’re going to get to that.

And so, if that’s the case, it means something like low to mid-teens percentage of 160 million workers are, for at least some period of time, going to be unemployed and sit on unemployment claims. The 3 million last week and the 6 million today is consistent with that. Probably not going to be a great judge of what the pace of it is going to be, but I think that’s where we’re heading.

SARA EISEN: Yeah. It’s depressing numbers. I wanted to also ask you about the markets. I mean, obviously the Fed has taken on the role of firefighter and chief. You mentioned intervening in the immunity markets, the credit markets, foreign exchange markets. I mean, we’ve seen a lot of blockages and issues out there. What’s your issue as to how effective the Fed has been in stepping in and are you pleased that it’s freeing up some of these systems well enough at this point?

Severe economic contraction and local governments

ROBERT KAPLAN: Yeah, and it’s -- this is -- it seems like years ago, but it was just a few weeks ago we started with the Treasury Market and then mortgage-backed securities markets and now have intervened and have programs that are either working or about to be activated for a whole range of other markets, corporate bonds. We’re already doing commercial paper. Money market funds. Municipal community paper. And by and large, the markets now are working reasonably well. There’s still some stresses we’re seeing. And it is notable that with everything we’re doing, though, credit spreads are wider, including for investment-grade debt.

Even though we’ve got a program for investment-grade debt, I think since the start of this crisis even credit spreads for triple Bs are 250 basis points wider and obviously much wider than that for less than investment grade.

So, that’s not a market function issue. That’s a pricing issue. And there have been some strains, which have been well discussed in aspects of the mortgage market. And so, we’re also aware of that and focused on that. But I think, by and large, the markets are working reasonably well. We’re watching very carefully for stresses. But while they’re working well, the cost of credit, particularly for corporates, has increased.

Leverage

STEVE LIESMAN: President Kaplan, along those lines, the Federal Reserve yesterday reduced easement of some leverage ratios. Should the banks get more relief on some of the Dodd Frank leverage and capital ratios to help them play a bigger role in aiding the economy? And on the flip side of that, should the banks be forced to stop paying dividends, in your opinion?

ROBERT KAPLAN: So, we are asking a lot of the banks right now, in that a number of the programs that we’re implementing right now, the Main Street program is an example, and obviously what the SBA is doing is going through the banks. A number of programs are going through the banks. And we’re asking the banks to exhibit forbearance on credit situations. And so, I think changing the leverage ratio in a crisis is quite appropriate.

We want the banks to have as much latitude as possible because we’re working a lot of these programs through them. I’m well aware that the UK banks have suspended their dividends, and I’m not going to comment on that here. We will be doing stress testing coming up and I think we have a regime in place where we make judgments about share repurchase and capital returns based on stress testing. And I still think that’s a good method and we should continue to follow that.

CARL QUINTANILLA: President Kaplan, you’ve made -- we all know that the emergency patch is ground zero for the retrenchment in Capex. And it was already coming in and you’ve talked a lot about that. When we think about the lingering effects of the virus, beyond Q2 and Q3 and the longer-term impacts on overall Capex, what does that do to economic potential in this country over the next couple of years?

Severe economic contraction and Capex

ROBERT KAPLAN: I mean, it is a concern in that coming out of this I can tell you Capex in the emergency patch is going to be lower. Even before the virus, we thought Capex in the emergency patch would be down 10% - 15%. It’s now, we believe, going to be down much more than that. And energy Capex is a big part of business investment. And so, unless there are other programs or -- left as it is, you should expect business if I canned investment is going to be weak.

Again, it really -- the consumer has been the underpinning of the economy. The service sector has been the underpinning of the economy. And we know that because of this shutdown, the service sector is going to come out, I think, more challenged, and the consumer is going to come out more challenged. So, that’s on the fiscal side, away from the Fed, it means there’s going to have to be more fiscal action to deal with that.

What’s been done so far has been essential, but I would put it in the category of relief. It’s basically made sure individuals continue to be able to sustain, small businesses can continue to sustain, markets continue to function. But beyond that, I think we’ll need stimulus from here. It’s not surprising that’s beginning to get discussed. That’s not a Fed decision. That’s a Congress fiscal authority decision. But it’s going to be needed.

Oil prices

DAVID FABER: President Kaplan, it’s David Faber. If I could come back specifically to the energy industry, which you started the interview discussing. And we should point out by the way oil prices are now up almost 30% on Joe Kernen’s reporting on the conversation he had with the president and I believe his tweet as well about a $10 million barrel reduction in production from the Russians and potentially the Saudis. But to your point, President Kaplan, the global oversupply continues. I think it’s 24 million barrels a day. 6 million barrels in the U.S. What are your predictions for the energy industry given that, even with this potential 10 million barrels not coming to market every day, it would seem it is a very difficult industry to be in?

ROBERT KAPLAN: It is. And so, we do widespread surveys and we talk to contacts throughout the industry. And, you know, at a number even in the low 30s, it’s challenging for many producers, drillers to make a profit.

So, we would expect that a number of -- with this amount of oversupply that’s going to go on, there’s going to be a consolidation in the industry. There will be some producers that are going to struggle to make it through. And then you have the service providers that provide them services. They will struggle to go through this. Some of them are highly leveraged. And so we would expect you’re going to see lower Capex, restructure, fewer players on the other end and there’s lots of discussions about how to preserve as much of the Permian basin and infrastructure and producers there and service sector as possible. But that’s going to be a challenge even with this move today that you’re describing. Because the oversupply is so substantial.

STEVE LIESMAN: President Kaplan, I’m wondering if beyond the oil business which is a big part of your district, but not the only part of it, what else are you hearing from companies, small businesses, large businesses, medium businesses, how long can they sustain this shutdown in the U.S. economy before we start to effect real challenge or permanent damage to the economy?

Small businesses in times of a severe economic contraction

ROBERT KAPLAN: Well, I can tell you among small businesses they are going through the calculation of how to manage their employees, whether or not to take the government assistance, whether they can realistically keep their employees on the payroll, whether they can survive. And that debate is going on across small businesses, I can tell you in this district, but my guess is nationwide. And then, for larger businesses, they’re trying to determine what’s the size of their business going to be coming out of this, and then, how much demand will be there be, what will be the nature of their customers, what’s the right sizing for their business?

So, everybody is having those discussions. And the issue that comes out of that is, as I mentioned, we’ll get to low to mid-teens in unemployment and hopefully in the year below 10% or in the neighborhood of 8%. The issue is how fast can we work it down when many companies that employ people won’t be employing people. I was just looking at the statistics yesterday and something like, let’s put it this way, a significant percentage of jobs and new jobs come from small businesses. I think that’s going to be a real challenge.

And then for bigger businesses, they just have to determine how big their business is going to be and how many people they’re going to employ. And so, I think the managing down the unemployment rate is going to be a big challenge, and the consumer not being as strong as he or she was going into this crisis, that’s high on the list, top of the list of challenges coming out of this crisis.

STEVE LIESMAN: President Kaplan, thank you for joining us. We look forward to continuing the discussion both as we hit the peak of this crisis, and then on the other side on the way back up. Thanks again.

ROBERT KAPLAN: Good to talk to you.

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Jacob Wolinsky
Jacob Wolinsky is the founder of ValueWalk.com, a popular value investing and hedge fund focused investment website. Jacob worked as an equity analyst first at a micro-cap focused private equity firm, followed by a stint at a smid cap focused research shop. Jacob lives with his wife and four kids in Passaic NJ. - Email: jacob(at)valuewalk.com - Twitter username: JacobWolinsky - Full Disclosure: I do not purchase any equities anymore to avoid even the appearance of a conflict of interest and because at times I may receive grey areas of insider information. I have a few existing holdings from years ago, but I have sold off most of the equities and now only purchase mutual funds and some ETFs. I also own a few grams of Gold and Silver

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