Bankers see pockets of strength amid recession indicators

Business owners and the bankers who lend to them are increasingly concerned about the impacts of rising interest rates and festering inflation on economic activity. By extension, the specter of loan losses looms large, and banks are beginning to pull back from the most vulnerable sectors, including residential mortgages and office properties.

The U.S. economy expanded at 2.9% annual rate in the final quarter of 2022, the Commerce Department said last week. However, that marked a slowdown from 3.2% in the third quarter, and bank economists said rising rates and still-lofty inflation curbed demand and threatened to stall momentum in the first half of this year.

The American Bankers Association's Economic Advisory Committee downgraded its forecast for economic growth this year from 0.6% to no growth. Some members of the committee, composed of bank economists, still anticipate modest expansion this year, bolstered by an overall resilient job market. But this was offset by others who anticipate at least a mild recession.

"Bank economists are split on whether a recession will occur this year, underscoring the uncertainty that permeates the current economic climate," said ABA Chief Economist Sayee Srinivasan.

The ABA's Credit Conditions Index, which is separate from but related to the Economic Advisory Committee's forecast, generated a reading of 12.5. A sub-50 reading indicates the economists expect credit market conditions to deteriorate over the next six months as the Federal Reserve continues to raise rates. 

Adobe Stock

When rates rise rapidly — many consumer loan rates doubled in 2022 — borrowing costs increase and loan defaults tend to follow. The Fed is boosting rates to tame inflation, but it is a gradual process. Inflation in 2022 peaked at 9.1%. It finished the year at 6.5%, down notably but still three times the level that Fed officials say is healthy for the economy.

The combination of high rates and lingering inflationary pressures historically has tilted the economy into recession. The ABA's credit index found that economists expect both consumer and business credit quality to worsen in the first half of 2023. They also expect credit availability to weaken, meaning banks will pull back on lending to steer clear of vulnerable borrowers.

"Lenders are adjusting to economic conditions and preparing for increased financial stress among consumers and businesses this year," Srinivasan said.

For example, BayFirst Financial Corp. in St. Petersburg, Florida, began shuttering its national mortgage business in late 2022, citing rapidly dropping demand after rates soared. The $930 million-asset bank posted a fourth-quarter profit, but its net income was half the level it was a year earlier. The bank previously reported a third-quarter loss.

"With the discontinuation of our nationwide residential lending business, we expect to return to more normalized levels of profitability in 2023," BayFirst CEO Anthony Leo said in the company's earnings report. However, Leo added, economic "deterioration during 2023 could adversely affect our financial performance and condition."

On the commercial side of real estate, bankers are particularly nervous about office properties, given increased remote work in the pandemic era and rising vacancy rates.

River City Bank in Sacramento, California, reported company-record fourth-quarter results and strong asset quality. But the $4 billion-asset lender's president and CEO, Steve Fleming, conceded he is "cautious about the impact to the office segment of commercial real estate" — approximately 20% of the bank's CRE portfolio — "due to the reduction in demand as employers provide work-from-home opportunities."

A business sentiment index produced by Citizens Financial Group in Providence, Rhode Island, dropped from above 50 to 48.5 in the fourth quarter. This snapped a streak of eight consecutive quarters in growth mode above 50, amid mounting skepticism about the trajectory of the economy, the $227 billion-asset bank said in a report.

"This quarter was a turning point for sentiment as we saw heightened impact from the Fed's policy actions," said Eric Merlis, managing director and co-head of global markets at Citizens. "The process is ongoing, but reducing inflation remains at the top of the economic agenda."

Even so, Merlis said there are few signs of a severe recession on the horizon, given the job market overall continues to post gains, supported by strength among middle-market businesses.

Employers added 223,000 jobs in December, the Labor Department said. It marked a slowdown from prior months — and a hint of waning momentum amid layoffs in the technology and finance sectors — but 2022 overall proved a robust year for hiring and created a solid foundation for 2023.

In all, employers added 4.5 million jobs in 2022, marking the second-biggest annual gain on record.

Raymond James Chief Economist Eugenio Alemán said that for all of 2022, the economy grew at a 2.1% rate, down "considerably" from the 5.9% expansion in 2021, but still moving forward. With increased employment countered by inflation and high borrowing costs, he expects further slowing but nothing approaching a sharp crash.

Still, the Fed's aggressive rate actions are likely to have lasting impacts and could influence the economy — and credit conditions — well into next year.

"We believe the Fed's intention is to keep the economy weak in 2023 and 2024, so it can bring the average rate of inflation to 2% over the longer run," Alemán said.