FOURTH QUARTER ECONOMIC OUTLOOK – November 30, 2021
Our Economy in an Inflationary Environment
There has been much talk about stagflation in recent months but the underpinnings of the US economy look strong with most key indicators that economists (and we) watch are in the green. We would argue that we are not headed for stagflation but are rather in the midst of an inflationary boom where both new orders and prices paid are above average. Factors that supported consumers before the Delta variant hit remain in place: forced savings, missed experiences, and pent-up demand. There is also still an ongoing surge in adoption of technology which as Microsoft’s Chief Executive stated this week while detailing their blowout quarter, “Digital technology is a deflationary force in an inflationary economy,” “Businesses – small and large – can improve productivity and the affordability of their products and services by building tech intensity.”
Stagflation is an environment of low or no growth (stagnation) with persistent high inflation. The most common measure of growth is GDP – Gross Domestic Product. Bear in mind that while estimates for continued GDP expansion in the US, Europe, China, UK, and Emerging Markets have dropped as we have gotten long in the year 2021, the figures for GDP are far above average.
The average US GDP in this century is only 1.37% and has not exceeded 3.5% since 2005. The latest estimates peg US 2021 GDP to be around 6% and to fall to between 3.5 – 5.2% in 2022. Europe should return to pre-pandemic growth of 5% this year and drop to 4.0 – 4.3% next year. China’s tremendous growth of past years which has averaged 8.7% during this century, will drop to around 8 – 8.5% this year and to between 5.0 – 5.6% next. The UK 6.8 – 7% this year, down to 5.0 – 5.5% next year, and EM 7.0 – 7.2% this year, down to 6.3% next year. Aggregate output for the advanced economy is expected to regain its pre-pandemic trend path in 2022 and exceed it by 0.9% by 2024. When COVID hit, the entire world economy shut down, resulting in broad-based supply, demand, financial and external shocks. Most developed countries around the world invoked stimulus payments to stave off their economies being crushed which has resulted in inflationary behaviors and circumstances. Personal savings rates have fallen only slightly from their ultra-high levels (stimulus) and are still at near the highest since mid-’90s. There is still so much cash on the sidelines and pent-up demand, household spending far exceeds income growth.
Subsequently, economists have revised US baseline inflation forecasts upward due to employment and supply chain constraints that should persist into 2022. Estimates forecast CPI (which strips out food energy prices) to end this year just below 4.5% then head down in 2022 to just above 3%. Headline inflation will continue to be volatile. In the past few quarters, it was dominated by lumber and used car prices, and currently spiking crude oil prices which are rising to levels last seen 7 years ago hold our attention. The recent low $80’s is higher than the average $66.18 over the last 10 years. Rising oil prices can increase inflation and reduce economic growth as they directly affect the prices of goods made with petroleum products. Increases in oil prices can depress the supply of other goods because they increase the costs of producing them. As the work transitions away from fossil fuels, this becomes less of a threat.
The Fed Reserve has given notice that they think inflation is of greater concern than employment and believe tapering the pace of asset purchases may be warranted. Chairman Powell has indicated that liftoff won’t occur until after tapering concludes yet the market has already priced in a rate hike in June 2022. We always keep in mind that the market is a bad predictor of rates and inflation over longer periods of time.
Status of the Economy – The Argument for a Bright Future
During the darkest days of the pandemic, consumers were able to consume goods but not services. This is very different from what is typically observed during periods of economic stress – nearly all of the reduction in consumer spending during the 2008 financial crisis came from a reduction in spending on goods, whereas during COVID, 67% of the reduction in spending came from services. Reopening the economy made it easier to consume services, but consumers continued gobbling up goods at a rapid clip.
As inventories were drawn down it became increasingly difficult to rebuild them. Southeast Asia has seen many governments maintain a zero-COVID policy, leading factories to temporarily shut down whenever a worker tests positive. Furthermore, entire crews are forced to quarantine outside of port if somebody on a shipping vessel tests positive for COVID, and even once cargoes are unloaded it can be difficult to find workers to transport these goods to their final destination. Below are some numbers that help quantify what is happening.
Furthermore, freight and cargo costs have jumped more than 50% since the pandemic began. At the end of September, the ratio of loaded containers to empty containers at the Port of Los Angeles stood at 1.5X (its lowest reading in the past 20 years) The cost of shipping a 40ft container has risen 15.1% since the start of the third quarter and 121.8% since the start of the year. At the same time, the number of specialized truckers in the United States has fallen from 473,000 in December 2019 to 451,000 in August; the number of long-distance truckers has fallen from 784,000 to 770,000 over that same time period.
Below is a heat map showing supply chain issues in multiple categories from December 2019 to September 2021 to give a sense of the building issues. (Source: Bureau of Labor Statistics, Drewry, FactSet, Port of Los Angeles, Susquehanna Financial Group.)
Through the COVID crisis, semiconductors have come into focus as one of the best examples of the supply constraints faced by the global economy. Although it is unclear how long it will take for the semiconductor shortage to resolve itself, it looks set to remain an issue well into next year.
In normal times, manufacturing a simple semiconductor wafer takes an average of twelve weeks. However, this can take up to twenty weeks for more advanced chips. Additionally, once the chips are manufactured, they must then go through a process known as assembly, test, and packaging (ATP) which can take another six weeks. This means that even with the right processes in place, it can take anywhere from 4-6 months from when an order is placed until the chips are delivered.
Ongoing commentary from automakers continues to highlight that chip shortages significantly weighed on production in 2H21, and companies in the industrial sector acknowledged that while things are improving, semiconductor supplies are still constrained. With semiconductor companies working to increase production and capacity, the consensus view seems to be that chip shortages will persist through the first half of 2022 before beginning to improve during the second half of the year.
As a supply-constrained economy has direct implications for profit margins and earnings, rising costs pose a risk to profitability next year. Firms have been able to preserve margins thus far by controlling certain costs and increasing prices, but this strategy predicates itself on demand remaining robust. While demand was healthy at the start of 3Q21, it appears to have weakened towards the end of the quarter.
Despite softer consumption, however, profit margins have remained resilient. After hitting an all-time high of 13.6% in the second quarter, we are tracking 3Q21 margins of 13.4%. While supply chain disruptions continue to drag on activity and support above-trend inflation, managements seem to be addressing these challenges through a combination of higher prices and a focus on productivity. This should help support margins as we look ahead to 2022.
Consumption should reaccelerate into the end of the year on the back of a further decline in COVID cases, low consumer debt service costs, and a surge in stock market wealth. Meanwhile, we expect an uptick in capital spending due to strong profits and labor shortages. This, coupled with a restocking of inventories, will push economic growth back above its long-term trend. As a result, we believe there is an opportunity particularly among those companies with a leaning towards growth opportunities in technology and health care over the long run that have room to increase prices coupled with lower operating costs. Investors should use profits as a guide, as rising interest rates could put multiples under pressure and leave earnings as the main driver of returns.
INFLATION UPDATE: TRANSITORY OR PERMANENT
The US consumer has been grappling with higher-than-average inflation for some time now as we emerge from the global pandemic, with the most recent CPI figure coming in at over 4%. It’s easy to see why this is worrisome since inflation impacts the way we live our day-to-day lives. No one enjoys paying more for gasoline, automobiles, food, and healthcare. How long will this last and what are the potential risks on the horizon?
It is first important to understand the difference between sticky and flexible inflation and their potential impacts on the economy. Sticky inflation tends to exhibit longer staying power and includes categories such as rent, insurance costs, and medical expenses. This category makes up 2.6% of annualized inflation. Flexible inflation includes categories such as food, energy, and cars. These prices tend to be more volatile with shorter staying power. This category has climbed to nearly 14% – the highest since the 1970s.
Flexible inflation categories have spiked due to pandemic-related shortages, a lack of available labor, and supply chain disruptions. While a quick resolution to these challenges remains unlikely, it is expected that we return to more normal conditions during the second half of 2022. On the other hand, sticky inflation tends to be more permanent and is the most dangerous. Yet, there is no evidence that suggests we will see high inflation within this category.
Another risk that is making headlines is the growing threat of stagflation, which is a mix of inflation, slow economic growth, and high unemployment. It is an issue that is weighing heavily on investors. J.P. Morgan released a survey in October 2021 showing that 42% of respondents believe the U.S. is careening toward a stagflationary future. Stagflation also hurts stock market performance. According to Goldman Sachs, since the 1960s, there have been 41 quarters of high inflation and weak economic growth. During those quarters, the S&P 500 index averaged a -2.1% real total return, well below the 2.5% average gain for all quarters. It is true that growth is slowing due to the disruptions caused by the Delta variant and the prospect of withdrawing stimulus, but it is not too low to cause stagflation concerns. Unemployment rates are falling, global inventories are being restocked, commercial real estate construction is rebounding, financial conditions are still quite loose, and consumers have emerged from the pandemic with high levels of savings and strong balance sheets which should all support growth moving forward.
Increased uncertainty about inflation highlights the importance of building a globally diversified portfolio, which gives investors exposure to regions with differing inflation environments. Furthermore, there are many investments that have a positive correlation with inflation that can be utilized to protect portfolios, such as various fixed income instruments (i.e. bank loans and inflation-protected bonds), real estate, and equities. We continue to monitor inflation and interest rate forecasts and will rebalance portfolios accordingly.
With COVID cases rapidly falling and inflation heating up, many investors are focused on Federal Reserve policy. Monetary policy will need to walk a fine line between tackling inflation and financial risks and supporting the economic recovery. The Fed, Central Banks, and governments will need to act with clarity and consistency to avoid making policy errors that will roil financial markets and set back the global recovery. Congressional brinkmanship around the debt ceiling, government funding, the bipartisan infrastructure agreement and President Biden’s social infrastructure plan all risk increasing market volatility to even roiling the financial markets. China’s problems revolve around disorderly debt restructurings in their property sector to escalating cross-border trade and technology tension which their recent common prosperity initiative makes more critical to be resolved.
Leslie, Matt, Ryan & Ashlee