Economic Outlook

Growth Trend Continues, with Some Headwinds

• US growth hits a Delta variant speed bump (GDP 6.6%).
• Supply problems and logistical bottlenecks limiting economic acceleration.
• Mismatch between jobs open and talent available (unemployment 5.2%).
• Inflation – transitory or not (CPI all items 5.4%)?
• Market valuations remain stretched (34.8 PE on S&P 500).
• Plenty of upside for economy and earnings if services take off, and supply issues get resolved.

Written by Philip Rich, Chief Investment Officer

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Real GDP grew at an annual rate of 6.6% (second estimate) in the second quarter of 2021, after growing 6.3% in the first quarter.  The US economy continues to grow and repair the damage done from a brief, but brutal, COVID-induced recession.  Most recently some headwinds to that recovery have developed, or been exacerbated, as the Delta variant has caused another wave of infection in several parts of the country.  The base theme of growth is intact, but investors and decision-makers need to be cognizant of current indications that a return to our full economic potential is facing some meaningful obstacles, both in the near term and beyond.  Among these are: a slow return to full employment, logistical challenges, supply shortages, and inflation.

New cases of COVID in the US recently averaged just over 160,000 per day, after declining to a low of about 12,000 per day in June.  The peak last January was just over 200,000 per day.  In some states, the peak of the current wave actually exceeded the January high.  The latest wave, driven by the Delta variant, has shown some very recent signs of having already peaked.  A potential obstacle to sustained economic growth is the possible proliferation of other COVID variants and whether currently available vaccines will be effective against those variants.  Such developments are as difficult to predict as the original occurrence of the pandemic itself.

The US economy had been accelerating toward sustainable growth when the Delta variant hit.  While still displaying positive growth, the most recent data indicate a moderating pace.   Overall consumer spending increased a tepid 0.3% in July with spending on goods, both durable and non-durable, posting outright declines.  Spending on goods had been a bright spot during the worst of the COVID lockdown, with consumers spending on electronics, furniture, appliances, home improvement and sports equipment.  As is frequently the case, the surge in spending on durables brought forward some demand, and now spending on such items is flat to down.  Consumer spending remained positive overall, however, thanks to increased spending on services.  This is an important part of the growth picture, because spending on services is by far the larger part of the overall economy.  It must also be pointed out, however, that services are more directly impacted by surges in COVID since the delivery of so many services require personal contact.  One theme of this recovery is the ongoing rotation from spending on goods back into spending on services.  While that theme is intact, for the time being it is being restrained by the Delta variant.  Many analysts are downgrading their estimates for Q3 spending, yet the vast majority of forecasts remain in positive territory.

Over the next several months, spending will be impacted by the phasing out of the fiscal stimulus put in place during the COVID recession.  While some level of spending will be supported by the implementation of the new Child Tax Credit, this benefit pales in comparison to the supplemental unemployment payments that have now ended.  At their height these may have supported as much as three quarters of one percent of GDP.
Supply constraints continue to curb the rate of growth in this recovery for both goods and services.  In mid-August there were 37 cargo ships at anchor off the port of Long Beach waiting to be unloaded.  While down slightly from the high of 40 in February of this year, this backlog is emblematic of the logistical problems that continue to limit our economic potential.  Shortages of chips continue to constrain production of autos, appliances and electronics.  Shipping backlogs have the additional effect of contributing to the scarcity and cost of shipping containers and their movement around the globe.

One of the important takeaways from the COVID-induced recession is that it is much easier to shut down something as large and as interconnected as the global economy than it is to get it back up and operating at its full potential for growth and efficiency.  The best evidence for this is found in our global logistical challenges.

Payrolls grew by a disappointing 253,000 in August, less than half the rate of the average monthly job growth so far this year.  And yet, unemployment still ticked down 0.2% to 5.2%.  The unfortunate reason for these incongruous results is that both the labor participation rate and employment-population ratio are below pre-COVID levels, suggesting that additional workers have dropped out of the labor pool and may not be seeking work at this time.  Today 8.4 million workers remain unemployed; 5.7 million were unemployed prior to the COVID downturn.

Job openings rose to an all-time high of 10.7 million in July.  There are meaningfully more job openings than there are unemployed workers per BLS statistics, which begs the question: “Why the persistence in high unemployment?”  The main reason appears to be poor matches between the skills sought by employers and those available amongst job seekers.  Employers report ongoing problems finding qualified workers for the positions they have available.  Many of the unemployed are from the hourly-wage end of the services sector.  These workers are not easily retrained for the jobs available.  Worker mobility may be a factor.  High rent and housing costs are making it more difficult for job seeker to “go where the jobs are.”  Many of the areas that have job openings lack the affordable housing needed to relocate workers.  Finally, some of the most generous supplemental unemployment insurance ever provided in a time of high unemployment may have impacted the urgency with which job searches are being pursued.   

COVID has impacted the employer-employee in relationship in myriad ways, few of which seem supportive of worker loyalty.  The pandemic has magnified the challenges of balancing work with child care, elder care, healthcare and self-care.  Lockdowns and work from home also seem to invite consideration of job alternatives and retirement decisions.  This is a difficult environment for both employers and employees.

The CPI “all items” index was up 5.4% for the twelve months ending in July – the same result recorded in June; “core” CPI (minus food & energy) was up 4.3%, a slight decrease from the prior month.  Both reads are now well above the 2% level targeted by the Federal Reserve.  Keep in mind that the Fed has articulated a new policy that will apply the 2% benchmark to much longer periods of time.  Since inflation remained below 2% for so much of the last economic expansion, the Fed is set to tolerate above-trend inflation in the current expansion for longer than it would have under prior guidance.  The central bank is not doing this to encourage inflation per se; it has simply shifted its emphasis in the application of its “dual mandate” to full employment.

Almost all of the outsized price increases are coming from housing, vehicles and energy, but these are central to the American lifestyle and it is impossible to deny that resurgent inflation is now an important part of the economic landscape.  The more contentious issue is whether this inflation is “transitory” or part of a pernicious new cycle that will degrade our purchasing power for years to come.  Evidence for both sides of this argument can be found in the current situation. 

We mentioned above that a key constraint limiting the current pace of growth are the myriad logistical and supply problems impacting both services and manufacturing.  This constraint falls on the supply side of the economy, it is not caused by any issue with demand.  Similarly, the difficulties employers are having finding qualified workers to fill positions is a supply problem, even though we still have millions out of work.  Price is the classic regulator for supply-demand imbalances, so in an economy with improving demand, beset by supply constraints, prices will go up.  In the aftermath of the COVID lockdown, housing, home improvement and furniture sales boomed.  Sawmills struggled to keep up with demand, even though there was plenty of standing timber available to be cut.  Exploding prices initially operated to balance supply with demand.  Lumber rose 300%.  Today, the price of lumber is back closer to pre-pandemic levels, sawmills have increased capacity and some of the COVID-induced demand for housing has been met.  Supply and demand are in balance at a lower price point and certainly the worst of the recent lumber inflation has proven transitory.  Many supply problems have a way of resolving following periods of elevated prices.  This seems to be especially true with respect to the traditional commodities.
Other supply issues may not be so easily resolved.  Shortages of semiconductor chips are constraining auto production, driving up the cost of both new and used cars.  However meaningfully expanding the global supply of chips is much tougher than improving throughput at domestic sawmills.  A chip factory can take two years to design, build and put into production.  Similarly the mismatch between available labor and open jobs engages issues of worker mobility, affordable housing and the feasibility of retraining a portion of the workforce.  So the rising hourly wages and signing bonuses may be with us for a while.

It must be pointed out in this connection that the Federal Reserve’s extraordinary response to the COVID crisis may also provide meaningful fuel for future inflation once the crisis has passed.  When the Fed purchases bonds, it creates new money.  It has been buying bonds at the rate of $120 billion per month since the onset of the crisis.  During that time its balance sheet has grown by $4.2 trillion.  That is a good indication of how much new money has been created by this emergency action.  Fiscal stimulus in the form of forgivable PPP loans and enhanced unemployment insurance also add to the monetary base.  Milton Friedman taught us that inflation is “always and everywhere a monetary phenomenon.”  We might think of the new money created through these emergency responses to COVID as a vast pile of volatile fuel.  One good spark could ignite the inflationary fires.  Mind you, the Fed took similar actions during the last Financial Crisis and inflation never got any traction in the subsequent recovery.  That is because most of the new liquidity created during the Financial Crisis was absorbed in the repair of bank balance sheets that had been severely damaged by loans and investments connected to real estate.  This time around, bank balance sheets came through the COVID downturn largely undamaged.  The enhanced asset and capital controls imposed after the last crisis worked.  We cannot recall a recession where banks were so little impacted by such a sharp (albeit brief) downturn.  Where has the additional liquidity been absorbed this time?  Well, it has certainly had an impact on stock, bond and real estate prices.  If it finds its way into general price inflation for goods and services, it could prove to be a terrific challenge to policy makers and participants in this economy.  The Fed has tools to combat inflation, but they are somewhat brutal and have engendered recessions in the past.

So how will we know whether the current surge in inflation is transitory or the beginning of a pernicious wage-price spiral, similar to the one experienced during the 1970’s?  Only time will tell with certainty, but we would recommend keeping a watch on wage inflation.  We don’t begrudge anyone a well-earned raise, but persistent wage inflation can be indicative of a completed feedback loop between rising prices and household incomes.  Some of the logistical challenges presently impacting prices will get worked out, and many of the disinflationary mega-trends – globalization, ageing demographics – are still intact.  It may be premature to sound the inflation alarm until efficiencies are restored to the supply chain, but this is well worth watching.

The Federal Reserve has kept its target for Fed Funds at 0-0.25% since March of last year.  We do not foresee any Fed rate increases for 2021, and the FOMC’s own projections don’t indicate any such increases.  The Fed continues to buy $120 billion in bonds every month.  These purchases are the more impactful part of their stimulus policy, since the bond purchases pull down interest rates across the maturity spectrum while simultaneously flooding markets with new money.  At some point, the Fed will begin to prepare markets for the inevitable taper of bond purchases.  We would not be surprised to see the Fed announce its intention to very gradually taper the bond purchases in Q4 of 2021, with the actual reduction in purchases to begin in early 2022.  The gradual reduction of bond purchases should move interest rates higher.  However, that process may be quite gradual, even if it is characterized by increased volatility in both rates and the bond markets.  One policy constraint on the terminal level of interest rates following the phase-out of monetary stimulus is the accumulated national debt and the ongoing Federal deficits.  The US can scarcely afford to finance is current level of debt at unfettered free-market rates.

The 10-year Treasury note yields 1.35% at this writing – down from its recent high of 1.74% at the end of March - but meaningfully higher than where it was at the start of the year (0.93%).

The media are crackling with predictions of a market downturn – there is a veritable bull market in bear market predictions.  These stories are always out there, but they proliferate after a long bull run, and we are entering the traditional season of increased volatility.  Many such stories are sponsored by entities that will also be happy to sell you an antidote to the fear they propagate.  In reality, short-term moves in markets are notoriously difficult to predict.  With so many trying, somebody will occasionally get lucky, few ever repeat.

There can be no doubt that stocks are richly valued.  The current price/earnings ratio (PE) of the S&P 500 is 34.8 the long-term average is 15.9, so prices are elevated relative to earnings.  We hasten to point out that low interest rates can justify paying more for a future stream of income, however, these valuations are stretched by any measure.  The averages mask a broad dispersion of valuations.  Some companies with little or no earnings are trading at the richest valuations, some with long track records of solid earnings are only slightly above long-term averages.  None of these observations, by themselves, are a reliable argument for or against holding stocks.  High valuations can persist for a long time, and valuation is not a reliable forecasting tool.  It is possible that the next several months will include some type of correction in the equity markets, but it is also possible that improving earnings will provide some additional support for these elevated prices longer term.  All of the real challenges described above are also business opportunities.  Every social and economic crisis has the power to germinate the seeds of new, profitable solutions to our challenges.  Many of the toughest challenges of the past year have forced enterprises to find ways to do more with less, to find new levels of efficiency, to embrace virtual collaboration.  Many service industries have had to reinvent themselves to serve customers with less contact.  Our logistical problems will get worked out, we may even find our way to higher efficiencies in the supply chain.  A dynamic, adaptable economy does not stay down for long.

If you have any questions or concerns on the foregoing, or if you would like to discuss your portfolio, please do not hesitate to contact us.