By Justin Pawl, CFA, CAIA, CFP®
As we enter the second half of 2021, we find ourselves with a booming U.S. economy along with an oversupply of vaccines and job openings. These conditions are a far cry from where we were at the beginning of the year, let alone twelve months ago. The differences between then and now are innumerable, but at least one thing remains the same: we continue to be involved in the greatest stimulus policy experiment ever.
Last week our investment committee met to discuss the state of the economy, our expectations moving forward, investment opportunities in light of those views, and risks to our outlook. What follows are a few of the key takeaways from a multi-hour discussion and debate.
The Labor Market Conundrum. How is it that unemployment is ~4% higher than before the pandemic, but companies have difficulty hiring workers? This is an important question to answer because it impacts our inflation outlook. If the labor shortage is permanent, companies will need to offer ever higher wages to attract workers. Rapidly rising wage rates can accelerate inflation, requiring the Fed to react more quickly than is currently expected by the market. On the other hand, if the labor shortage is temporary in nature, the potential for a wage spiral is low, and the Fed can continue to follow its current monetary policy strategy. Our view is that several factors are leading to a shortage of labor, but that the majority of these factors are temporary:
- Pandemic-forced School Closures. The lockdown forced schools to close nationwide, requiring additional parental oversight at home as children engaged in various forms of distance learning. For many parents, continuing work was not an option as their children were at home all day and required additional help. With widespread vaccine availability, schools will be re-opening in the Fall. Parents that were previously tethered to their homes will have the ability to work once again when their children return to school campuses.
- Immigration. Covid brought immigration to a standstill last year, but the number of workers entering the U.S. is rebounding in 2021. Indeed, worker-related visa issuance has recovered to ~30% of the pre-pandemic level and appears to be accelerating. A recovery in immigration will increase the size of the U.S. labor pool.
- Generous Unemployment Benefits. Approximately 11 million people are receiving some form of pandemic-related unemployment assistance. For workers at the low-end of the wage spectrum, the benefits exceed what they would otherwise earn by working, incentivizing them to stay at home. However, these benefits expire in two months on Labor Day. Congress will be on recess when the benefits expire, so an extension is unlikely, meaning these people will need to look for work soon.
Source: FHN Financial
Bottom Line: Labor supply is tight, but we expect it to improve following Labor Day. Job openings are at an all-time high of 9.3 million, but there will soon be 11 million potential workers no longer receiving unemployment assistance. Their re-entry into the labor market will help alleviate the labor supply/demand imbalance and reduce the pressure for business owners to raise wages to attract workers. Thus, we foresee a steady decline in the unemployment rate accompanied by moderately rising wages.
Consumer Strength. Consumers have an enormous reserve of dry powder thanks to residual fiscal stimulus combined with continued employment gains. Although fiscal stimulus is now waning, multiple rounds of government spending (see green-colored spikes in the graph below) combined with lower expenditures on services have created $2.5 trillion of excess savings, representing about 17% of pre-pandemic annual consumption levels. Even if households only spend 1/3 of their extra savings, that still equates to ~6% higher consumption than if the fiscal transfers hadn’t occurred.
Even when excluding the stimulus effects, as laborers return to work and wages improve, households (on average) are spending far less than they have historically. The chart below illustrates Personal Consumption as a percentage of Disposable Personal Income (DPI). Historically, the average household has spent approximately 93% of DPI, with a relatively tight range of 91% to 96% of DPI. As this chart makes clear, household consumption levels remain well below their historical average.
Bottom Line: Fiscal stimulus more than offset the decline in household income during the pandemic. Since then, lower unemployment levels and higher wages have further increased household savings. The consumer is in an incredibly strong position. As consumption makes up ~70% of annual GDP, any slowdown in economic growth should be contained.
Inflation and the Federal Reserve. From an investment perspective, it’s essential to distinguish between an acceptable level of inflation and a level that forces the Fed to act unexpectedly. The former is good for economies and financial markets. The latter, however, can be devastating because if the Fed falls behind the curve and is forced to catch up quickly, a recession typically ensues along with high unemployment levels and depressed asset prices.
Recent inflation readings are higher than what the market is accustomed to seeing, but at this point, they are not overly concerning. In our view, the high readings are a combination of reflation (prices returning to pre-pandemic levels), base effects (comparing today’s prices to depressed prices from a year ago), and supply bottlenecks as the economy transitions from a near standstill back to normal operating conditions. Indeed most of the price increases are in those areas most severely impacted by the pandemic, such as airfares, hotels, and new and used vehicles. Interestingly, inflation is actually below the pre-pandemic trend when you strip those inputs out of the Core CPI calculation
According to multiple consumer and business surveys, elevated current headline inflation levels are creating higher future inflation expectations. For example, the most recent University of Michigan survey revealed a significant spike in consumer inflation expectations for the coming year. According to the survey, “Consumers anticipated the overall inflation rate to be 4.6% in the year ahead, with twice as many consumers expecting an inflation rate of 5% or higher rather than 2% or below”.
Source: Federal Reserve Bank of St. Louis
Higher inflation expectations, if left unchecked, can create a positive feedback loop leading to ever-higher inflation. This occurs when consumers increase demand for products today to avoid higher prices in the future. Excess demand leads to higher prices today, which results in even higher immediate demand, and so on. This phenomenon is known in economic circles as an “unanchoring of inflation expectations” and is difficult to resolve without a heavy-handed Fed response.
While survey trends are worth monitoring, the prices of financial instruments tied to inflation expectations are a more reliable predictor of future inflation levels because they represent capital at risk. And at present, market-based inflation indications are not unanchored. For example, at the end of the first quarter, the 10-year US Treasury yield was 1.7% but has since plummeted to 1.3%. Moreover, the 5-year, 5-year forward inflation expectation rate has rolled over in recent weeks. The “5-year, 5-year forward” is an estimate of inflation for the 5-year period beginning 5 years from today. The metric is calculated by comparing the yield on Treasury Inflation-Protected Securities (TIPS) to nominal Treasury yields, and it’s signaling a future inflation level that’s consistent with the Fed’s long-range 2% target.
Sources: Federal Reserve Bank of St. Louis and Covenant Investment Research
Bottom Line: Inflation is likely to remain above 2% for a couple of years, but it is unlikely to rise significantly higher. The Fed has repeatedly said it intends to allow the economy to run hot, so inflation above 2% should not come as much of a surprise. A lack of rapidly accelerating inflation means the Federal Reserve is likely to stick to its accommodative monetary policy, which would include a start to QE tapering in early 2022. Once the Fed has completed the tapering process in late 2022 or early 2023 (i.e., they are no longer expanding their balance sheet), they could begin to raise interest rates in late 2023 or in 2024.
Risks. The primary risks we see to our baseline forecast are Covid mutations and higher than expected inflation. Should an existing or future Covid variant prove resistant to vaccines and highly contagious, we will find ourselves in a similar situation to early 2020. Only this time, government debt will be starting from a much higher level.
The risk of higher than expected inflation that forces the Fed to raise rates faster than anticipated is difficult to handicap. We are in the midst of a grand monetary and fiscal policy experiment taking place at a global level. In the U.S., the government has spent trillions “papering over” the pandemic to keep households flush with cash. Meanwhile, the Fed has been purchasing bonds hand-over-fist, significantly increasing the size of its balance sheet. As a result of hyper-stimulative fiscal and monetary policies, there are massive levels of liquidity in the economy, and demand for products and services is booming. As we’re already seeing, it’s more challenging to open an economy than to close it, and shortages are leading to higher prices in some segments of the economy. What we don’t know is whether the supply chain bottlenecks are temporary or more permanent in nature. At this time, we believe it’s the former, but again, we are in uncharted fiscal and monetary policy territory, so humility around forecasts is warranted.