An impending fiscal cliff, a recession in Europe that threatens to dismantle the Eurozone, a stubborn unemployment rate … these are just a few of the scenarios on the horizon that have the potential to cause more upheaval on the economic front. At the same time, asset-based lenders seemed to have weathered the worst economic downturn in 70 years relatively unscathed. At ABL Advisor, we wondered to what extent will these macro issues affect the industry going forward. We decided to ask two experts.
And who better than Gus Faucher, senior macroeconomist at The PNC Financial Services Group and Bill Kosis, president of PNC Business Credit? In what follows, Kosis and Faucher speak to both the complexities of the global economy and their impact on the way asset-based lenders might best approach the marketplace in the coming year.
Where We Stand Today
To begin with, Faucher’s assessment of the recovery that began nearly three years ago (at least technically) is best characterized as soft. Faucher notes, “People are disappointed with the pace of recovery primarily because of the job market. When we look at the GDP … that’s back above its pre-recession peak. But in terms of jobs, we are still well below that peak. And even though the unemployment rate has fallen to 7.9% as of October, it’s still well above what we would expect to see in a well-functioning economy.”
Faucher continues, “The economy remains susceptible to headwinds. If we get a shock of one kind or another, this economy is vulnerable to falling back into recession and right now there are two major concerns looming out there. The first is the so-called fiscal cliff. We have the Social Security Payroll Tax and the Bush tax cuts set to expire at the end of this year. At the same time we have big spending cuts that will be implemented automatically and if all three things take place without any action by Congress, I don’t think the economy is strong enough to withstand all of that fiscal tightening.” While he is confident that the re-elected president and Congress will likely take action to avoid steering off the fiscal cliff, accidents can happen. “I think they’ll be smart enough to avoid that but things can go wrong and people can miscalculate. If that happens, that could be bad news. And while that’s not included in our baseline forecast, the possibility is certainly out there.”
The second major concern is one that won’t be resolved by elected officials in Washington, D.C. With that in mind, Faucher is watching the severity of the recession in Europe closely. He notes if conditions move from a recession to a full-fledged financial crisis, the U.S. economy will experience the shock. Faucher warns: “If the Eurozone breaks up in a disorderly way, that causes all sorts of problems in terms of reduced U.S. exports, lower stock prices and reduced credit from Europe to the U.S. Since growth here is OK but not fantastic, a big hit from Europe could be enough to trigger another recession.”
Industry Sectors: Who’s Leading, Who’s Lagging Behind?
We asked Faucher to take a look at some of the traditional asset-based lending borrower sectors to determine which managed to turn out a notable performance during this less-than-dazzling recovery. “I think manufacturing has led the recovery and there have been a few drivers of that. One driver has been the strong demand for automobiles. Another has been exports … that growth was very strong coming out of the recession. ”
On the ABL side of the house, Bill Kosis notes that’s been a good thing. He explains, “Right now we still have a large piece in manufacturing and that sector has had a tremendous comeback the last couple of years. The automotive sector has been a real standout and we finance a lot of suppliers. They’ve had a great run after a very soft period at the end of 2008 and 2009. There’s been a lot of M&A activity, a lot of add-ons and expansion finance in that area.”
Beyond automotive suppliers, Kosis says PNC Business Credit has financed borrowers in the derivative manufacturing sectors – both plastics and metals – although he’s observed some softening in metals manufacturing in recent months. Also of note are food manufacturers. “All these folks have done well,” he adds.
Will the manufacturing sector maintain the top spot as the leading sector of the recovery into 2013? Faucher has his doubts. “Business investment growth has also been a major driver of manufacturing growth as businesses have been holding the line on hiring by investing in plant and equipment. But business investment growth, while continuing to expand, is doing that at a slower pace. And I think the global economy, between the recession and Europe and slower growth in Asia, is going to be a drag on manufacturing.”
Instead, he sees housing as “the next big thing” as we head into 2013. Faucher explains, “We’re seeing a turnaround in the housing market. There’s a lot of pent up demand out there for homes and with the Federal Reserve's efforts to keep interest rates low, the fundamentals for this sector are good. If job gains continue and income growth picks up a little, we’ll continue to see stronger home sales, stronger starts and higher home prices in 2013. And that will support economic growth.”
How has all of that translated for Kosis and his colleagues at PNC Business Credit? According the Kosis, he’s seen the correlation. He says, “Of course, housing was in free fall and we have always financed the supply industries: roofing, lumber yards and building products. We took some losses, but we’ve already seen a pretty significant turnaround in these suppliers. As a group, they have brought their costs down and are running their operations extremely well. Some have even made pretty good money this year.”
Elsewhere, Faucher expects renewed signs of life in the commercial construction space. He explains, “That’s an area that has lagged and is down significantly from where it was prior to the recession. Nothing in the way of a full turnaround, but I think we will see more significant gains in commercial construction in 2013.”
On the flip side, Faucher doesn’t see the government sector keeping up with overall economic growth in the months to come. “We’re still in for a period of continued fiscal austerity even if an agreement is reached to push off spending cuts and tax increases. Local governments will face difficulties because it takes a while for lower property taxes to work their way through the valuation cycle. I think government will continue to be a drag on the economy for at least the next two years,” Faucher warns. However, at the state level, revenue flow looks less bleak.
He says, “The states are starting to see revenues turn around. Their revenues are tied closely to the business cycle in terms of income and sales taxes. So there could be a positive there, but it’s more than likely to be offset by continued losses in local governments and increased losses at the federal level as deficit reduction continues to take hold."
All Over the Map
From a geographic standpoint, Faucher expects the Midwest to begin losing its leading edge bolstered by the relative strength of the manufacturing sector. On the other hand, he expects the Southeast to lead the recovery in 2013. “It’s poised to do well with the region's low business costs, strong population growth and inexpensive housing,” he notes.
As for the rest of the country, he surmises the Northeast will trail behind other regions primarily due to its heavy ties to finance. “The current regulatory environment along with heightened scrutiny will weigh on profits … I think it’s likely to lag. In the meantime, Florida and the West are working off some of the excesses in the housing market, so those regions will experience slower recoveries in the near term. But I think they’ll be poised for growth in the second half of next year.”
Kosis also says the Midwest has been particularly strong. He says, “That whole area throughout Chicago, Cleveland and Pittsburgh has been a great market for us and continues to be strong.” In line with Faucher’s expectations, Kosis notes, “The Southeast has had its challenges, again due to the building products industry and housing issues. But it’s starting to come back and our portfolio has performed well. In the Northeast, we do a lot of business with the M&A firms and that’s been a good channel for us in one-off financings. That economy has performed reasonably well.”
Kosis explains the Southwest fuelled by the energy sector has been a bright spot over the last few years and notes PNC Business Credit has been active in financing service companies to that sector. And Kosis is quick to point out that his team in Canada is particularly active also due in part to the energy sector. “Canada has a very strong economy and we’re doing some M&A as well as financing service companies to the energy sector up there. Our retail and manufacturing activities are also doing well … it’s an extremely strong economy.”
Monetary Policies – Help or Hindrance?
We asked Faucher to weigh in on the efficacy of the Fed’s monetary policies. Have the Quantitative Easing and low interest rate programs helped, hindered or had little effect? Faucher responds without pause, “I think they’ve helped … that’s why housing has started to turn around. The low interest rates have made automobiles more affordable. And while the Fed survey indicates that credit is still tight, it is beginning to ease. If businesses can get access to credit, the lower rates are reducing their borrowing costs. So, that’s spurring investment.” As such, Faucher expects the Fed to stay the course by keeping the Fed Funds rate low through the middle of 2015. And with a third round of Quantitative Easing announced, he points out the Fed’s stance is clear on that program as well.
With more than a few potentially impactful scenarios left to be played out, Kosis remains optimistic about what the future holds for PNC Business Credit. He concludes, “There’s a lot going on out there and I think the positive economy has increased the number of participants in the lending market. We’re seeing a few more non-bank and bank competitors than we did in the downturn, but I think the market has come to the realization that the institutions that have lent through all of the past recessions add tremendous value. We’ve had great support from PNC Financial ... the company has remained committed to the asset-based lending product in all cycles. And we have great customers who have supported us through these cycles as well.”