Pence Perspective | Q4. 2021
Bottom Line Up Front
A wave of stimulus, a wave of savings, and a wave of demand are about to collide with a wave of COVID-19, a wave of supply chain and labor disruptions and a wave of inflation. We will frequently hear about waves, surges, and many other analogies but the bottom-line is that a rising tide lifts all boats. $5.4 trillion in stimulus since the start of the pandemic, plenty of excess savings, and the newly signed $1.2 trillion infrastructure bill offer a rising tide of sorts. The next normal is abnormal, and the next 24 months will be different than the last 24 months.
Governments will still attempt lockdowns in response to COVID-19, but populations will adapt more quickly. Supply chains may get worse before they get better, but they will get better, while prices of certain goods will spike before they normalize. The next normal is abnormal. That does not mean that things are generally bad, just different. With cool heads and objective reasoning, it’s an environment that favors those with a calm hand on the rudder and a clear vision of the horizon.
There’s a flood of money in the economy and jobs are more plentiful than at any time in recent memory. Household net worth is at records, homes listed for sale are typically purchased in a week at a median sales price of 100% of asking, and global Mergers and Acquisitions (M&A) activity in the year through September is at all-time highs. However, as capital markets are thriving, three-quarters of Americans rate current economic conditions as “Fair” or “Poor”.
The “There Is No Alternative” (TINA) theme is still intact and we continue to view equities as the best place for risk-adjusted returns – with real rates at extreme lows and the very high likelihood of rate hikes next year, we see bonds as a lackluster investment.
Exposure to equities is strengthened by the fact that corporate performance has been stellar. Third quarter earnings reports have shown that companies have had no issues passing along price increases and profit margins are at all-time highs – which have been a key source of strength for markets. But there are still question marks, namely that the supply chain looks to be impacted for some time, the shortage in the labor market continues to persist, and the “transitory” narrative around inflation has lost conviction with policy makers.
The biggest risk remains a policy mistake by the Federal Reserve, that a prolonged easy money environment results in an inflationary picture that necessitates stepping on the brake harder and faster than expected. Markets are now positioning towards up to three rate hikes by the Fed next year, and we would not be surprised to see a rate hike as early as June, especially if the inflation picture fails to moderate as we enter 2022. We also continue to expect another wave of COVID-19 as cases in the Northern United States and Europe are rising again. Germany is at record case levels, the United Kingdom has put a potential return to restrictions on the table, and the Netherlands has already instituted a lockdown despite an 85% vaccination rate. With the current trend in cases a winter wave comparable to that of last year is far from out of the question.
In our view, the risk from a potential wave is tilted more towards negatively impacting a supply chain that is already under immense pressure. There have been a number of recent examples of a stark overreaction by policy makers causing major issues for the supply chain with long term ramifications. The recent draconian lockdowns in Vietnam’s Ho Chi Minh City have resulted in the exodus of tens of thousands of migrant workers from an area key to apparel manufacturing and setting companies like Nike and Lululemon months behind in production, while New Zealand was placed into nationwide lockdown over a single virus case.
China’s pursuit of “Zero COVID” also continues in earnest, with one case at Shanghai Disneyland resulting in the quarantine of over 30,000 attendees. In August, a major terminal was closed at Ningbo-Zhoushan Port over a single COVID-19 case, just months after China shut down Yantian port after 5 members aboard a container ship tested positive for the virus. As long as global policy makers pursue a COVID-19 policy of elimination as opposed to management, speed bumps are likely to persist on the return to a more normalized supply chain.
Domestically, the continued lack of child care is having an outsized impact on the labor recovery. A survey by NAEYC found that 80% of child-care centers were experiencing shortages in staffing, and 50% of them were serving fewer children as a result. And while schools have largely reopened across the country, they are doing an abysmal job of keeping children in school. An analysis by The Hill found that just weeks into the school year more than 90,000 children in 19 states had been required to quarantine after either contracting or coming into contact with someone who tested positive for COVID-19. Los Angeles Unified School District had 6,500 students miss at least one day of school in the first week of school alone.
This has huge ramifications. Household survey data released in October by the Census Bureau showed that nearly five million adults who aren’t working reported that they were caring for children not in school or daycare. A continued focus on halting the spread of COVID, regardless of vaccination rates, is having dramatic impact on the labor shortage and the supply chain – each of which are large drivers of the inflation picture. While details are scant on the Omicron variant, it is showing vaccine evasive properties but very mild symptoms. We think that, given the lack of information at this time, the primary risk from the variant is that policy makers will continue to target elimination and thus overreact with aggressive restrictions prior to knowing if they are truly warranted.
At this stage, data is suggesting that COVID-19 is now both endemic and seasonal – the longer we focus on elimination, the more likely the new normal stays abnormal.
Markets were very much in a downtrend in September, with the inflation picture accelerating, growth slowing, job additions being well below expectations, and economic data missing estimates almost across the board. While economic data of late has been lackluster, corporate execution has been anything but and has served as a key source of support for indices to return to records. Reports from the Big Banks that showed a continued ability to release loan loss reserves, early signs of growth in demand for borrowing, and a robust M&A market assured investors of the near-term outlook allowing equity markets to return to records.
Given the general worries about the effects of inflation and rising wages, stable profit margins were a sign to investors that companies were having little issues passing along price increases, and that the ground level economic performance hadn’t deteriorated as much as feared. Investors continued to have the backdrop of record profits, record profit margins, consensus expectations of another year of strong growth, and historically low real rates. The result was 8 successive days of record closes for the S&P 500, the longest streak since 1997.
The picture changes a bit going forward however, in our view, and we think investors should prepare for the prospect of lower future returns. If performances hold, the S&P 500 is on track for its third straight year of price returns in excess of 10% – the last time that happened was in the buildup to the dot com bubble. While the last several years have had the combination of low rates, immense levels of simultaneous global stimulus, and a synchronized global recovery – that theme is changing markedly.
With the inflation picture not moderating in a way that policymakers had expected at the start of the year, markets are now looking a dramatically different environment – one with higher interest rates, limited stimulus, and higher inflation. The Federal Reserve still expects the Core Personal Consumption Expenditures (PCE) Price Index to decrease to a 2.2% rate next year. Street consensus is higher than the Fed’s estimate, but a decline in the rate of inflation is also expected.
It’s important to note, however, that estimates of future inflation – as noted by Alan Greenspan in 1999 – have “generally been off”. In January, Street consensus for consumer price inflation was just 2.2% – the ending number will probably be pretty close to 6%. As a result, we think investors should prepare for a new phase in market dynamics – one where inflation is elevated, but not hyper. Higher inflation is certainly a change compared to the previous decade, but a Dimensional analysis of inflationary periods going back to 1927 shows a surprising outcome given the general level of investor malaise around inflation – most stocks do fine.
While some categories of equities outperform others, all categories outperformed bonds – which is a large reason why we continue to overweight equities or hold higher levels of cash. Inflation is poison for bonds, eroding the fixed payments they offer, causing rising yields and falling prices. For equities, growth stocks typically underperform their value counterparts as valuations are based more around future profits, which inflation depreciates the value of. Value stocks typically own assets like factories, equipment and real estate whose value should grow as prices rise, and valuations are less reliant on tomorrow’s earnings.
As value stocks are more inflation resistant, more domestically oriented, and have the added bonus of the new $1.2 trillion infrastructure bill an increase in their allocation to portfolios is wise in our view. We also favor large technology companies with high margins, high current profits, and valuation multiples in line with the broader index.
Overall, we think the direct risk is not in higher inflation, rather that a miscalculation by the Federal Reserve results in them having to step on the brakes – and drastically altering the risk pricing model in current markets. While fundamentals are overall very positive, there are segments of the market that continue to extrapolate significant future profit growth which we see as most susceptible to a repricing.
The largest concern around markets in our view is valuations. In 2019, the Uber and Lyft Initial Public Offerings (IPOs) were abject failures largely because they weren’t making money and didn’t look like profits were going to happen soon. Recent months have seen a number of companies conducting IPOs with no revenue and attracting valuations larger than titans of their industry with track records going back decades. Markets are entering a phase with slowing global growth, higher rates, and declining consumer confidence – while using history’s most expensive bond market as a reference for why equities seem cheap.
Given the divergence between consumer confidence and global markets, there’s a distinct disconnect between Wall Street and Main Street. While we believe equities are still the place to be given the inflation and interest rate picture, we think investors should be prepared for lower returns going forward – especially considering that the chief worries of markets – supply chain issues, higher inflation, and the labor shortage – are all themes we see persisting for some time.
The Labor Market
With the expiration of enhanced unemployment benefits in September initial claims for unemployment have dropped substantially, with new claims hitting their lowest number since 1969 in November. Continuing claims, the number of people filing for benefits after having already filed an initial claim, stood at 2.4 million on November 6 when including pandemic compensation programs, down from just over 11 million in early September.
On a payroll additions level, however, the result has not matched up to expectations. Comparing the total growth in payrolls of the 26 states that elected to end benefits early and those that opted to keep them until their expiration in early September yields a surprising result: both groups of states have seen essentially the same rate of growth in payrolls. The expiration of enhanced unemployment benefits has not resulted in the boost to hiring that most anticipated earlier in the summer.
To compound the lack of job additions, September also saw a record number of employees quit their jobs at 4.4 million for the month. Visier estimates that so far this year 1 in 4 employees has quit their jobs, with another quarter of US employees telling a Principal Financial Group survey they were considering quitting or retiring in the next 12-18 months. LinkedIn has seen a 20% jump in searches related to quitting, and an October survey by the National Federation of Independent Businesses (NFIB)found that 49% of small business owners struggled to find workers to fill open positions. 94% of those surveyed reported few or no qualified applicants for the positions they were trying to fill.
More than a year and a half into the pandemic, around 4.3 million workers are absent from the labor force compared to pre-pandemic labor force participation rates. Federal Reserve researchers estimate that over 3 million Americans took advantage of elevated equity and housing values to retire early, while Opportunity Insights’ Economic Tracker shows that through August 10, employment in the low wage categories is still more than 25% below pre-pandemic levels and has stayed stubbornly low.
An analysis by the National Bureau of Economic Research found that about two-thirds of enhanced unemployment benefit recipients were eligible for benefits larger than their lost earnings, with one in five eligible to double their earnings. This is in the context of a 2019 Gallup survey covering job satisfaction showing less than half of all workers considered themselves in “good jobs”. For workers in the bottom 20% of wage earners, a segment that saw a disproportionate level of layoffs, 72% reported having a “Mediocre” or “Bad” job. This suggests a large number of people both lost a job they weren’t fond of and received a raise to do it.
With the combination of sky-high consumer demand and an extreme shortage of workers, the US labor market is in a position strength that hasn’t been seen in decades. Despite 3.9 million fewer jobs in the economy and an unemployment rate a full 0.7% higher compared to pre-pandemic levels, US employees are quitting in numbers higher than ever. Every month between April and September of this year has seen quits in greater numbers than at any pre-pandemic point since the Bureau of Labor Statistics began collecting data in December 2000. Dubbed “The Great Resignation” it has also been accompanied by a wave of strikes across the country – most notably at John Deere, where strikers rejected an offer that would have been the largest wage increase negotiated by the United Auto Workers since at least 2018. The real question, in our view, is why exactly people are quitting. Is it because they found a better job? Or is it because they no longer have to work?
For many of the people left behind with the shutdowns the reservation wage is vastly different than it was pre-pandemic, leading us to believe that the issues in the labor market are two-fold. Namely, that there is a labor shortage, but that there is also a shortage of businesses offering wages or benefits that are viewed as acceptable by those on the sideline – the extensive aid families received during the pandemic has likely given many the financial position to be more selective about a return to the workforce. The dislocations from COVID-19 and the government response to it likely changed the nature of work more than most realize. Time will tell if the natural rate of unemployment is different than it has in the past.
The Supply Chain
With the issues in the supply chain, it’s important to note that – similar to the labor market – there isn’t one specific point of failure. Certain areas are more logjammed or short-staffed than others but in general it’s a problem from the top down. Global supply chains spent 40 years perfecting a fine-tuned, just-in-time system, but global lockdowns, “Zero COVID” policies, varying country restrictions, and sporadic COVID outbreaks combined with a flush US consumer during a fallow period in the service sector have created a backlog of historic proportions.
The positive is that this is almost entirely a supply issue, as there is no shortage of demand – Snapchat flagged weakness in its advertising business in its most recent quarterly report because marketers aren’t planning to advertise for products that they can’t sell in the first place. A demand side imbalance would be a much larger problem but it’s important to note that while there have been improvements in the supply chain, an increasing number of retailers are expecting the supply chain to be delayed for some time. In June, just 8% of Retail Businesses told a Federal Reserve Bank of Dallas survey they expected a year or longer for their supply chain to return to normal. In September over 33% of businesses expected disruptions to last for over a year.
The ports of Los Angeles and Long Beach are responsible for about 30% of US imports and the Biden Administration has gotten a commitment from them and major shippers or retailers to operate 24/7. This helps, but it’s far from being the solution as the shock to the supply chain has exposed flaws that have gone unaddressed for years – many of which are not materially improved with longer operating hours. In a 2020 ranking of world ports by IHS Markit and the World Bank, the LA/Long Beach complex stood as some of the least efficient ports in the world – 328th of the 351 ranked. Even before the pandemic-induced shock, the ports were operating well below the desired standard.
This has been compounded by a number of idiosyncratic factors, namely a shortage of truck drivers (which the American Trucking Associations estimates at over 80,000 truck drivers currently, increasing to 160,000 by 2030); a dearth of available containers or warehouse space; and a dire lack of chassis to load containers on for transport to their final destination. Individually, these are not new problems, but never before have they been so pronounced at the same time – each individual issue is the result of years of cost cutting and lack of foresight.
Historically, chassis have been owned by shipping companies and leased to truckers, who knew based on what vessel they were unloading which specific chassis they needed to use. But in the aftermath of 2009 elevated costs and burdens for maintenance and storage resulted in shipping lines selling their inventories to leasing companies – now just 3 companies lease the majority of chassis in the United States and Canada. Compounding this is the Trump Administration’s trade war, which imposed a 25% tariff on the largest Chinese chassis manufacturer, China International Marine Chassis (CIMC) in 2019. This was followed up by the Biden Administration assessing a 188.05% dumping rate in May of this year.
Today, an imported Chinese chassis carries a tariff rate of 221.37% while domestic manufacturers claim a 2018 glut of imports to avoid the trade war resulted in large levels of excess capacity for US production and left them unprepared to jump start production when needed. The American Trucking Associations estimated in 2019 that domestic producers can satisfy less than 10% of annual chassis demand. These issues are a negative spiral – things getting worse makes everything else worse, resulting in a deeply disjointed supply chain. Nike claims it now takes over 80 days to move products from Asia to North America (more than twice as long as before the pandemic) and a container can now take over 22 days to unload from an anchored ship at the most important ports in the United States, while costing twice as much to ship compared to January.
These problems will not last forever, but they are also extremely difficult to solve with policy. A return to a normal supply chain – similar to the ordered treadmill – is simply going to take longer than expected. However, in the same way that disruptions in global trade have caused a supply demand imbalance and pushed prices higher, a return to normalcy in the supply lines is disinflationary – as transit times normalize and consumers continue to shift spending to services rather than goods, prices are likely to go down in our view.
Inflation and the Federal Reserve
While the high inflation numbers we were seeing over the spring and summer were largely due to one-off factors such as low year over year comparisons and extraordinary markets for used vehicles due to factory closures, inflation prints in the fall – which had much more normalized yearly comparisons – have been significantly more broad based and higher in magnitude as well. The “transitory” narrative of global policy makers – based on pandemic-fueled “base effects” and short-term supply constraints – has not held true. There’s a materially different environment today although we view hyperinflation or stagflation as unlikely – namely because the economy is largely expected to post solid growth numbers next year, a number of exogenous factors are driving headline numbers, and there are still deflationary pressures in the economy. However, higher inflation is here and it’s looking more likely that it’s here to stay for some time.
The Federal Reserve’s Survey of Consumer Expectations shows that US consumers are anticipating a continued inflationary environment, expecting inflation close to 6% a year from now, although the three-year-ahead expected inflation rate has remained relatively anchored at 4% for a few months. And while inflation is increasing on a month over month basis, a large proportion of it continues to be reopening categories and energy prices. The used autos market is a direct result of a shortfall in vehicle production, while the energy market saw a previously unthinkable disruption – on April 20, 2020 the price of a barrel of West Texas Intermediate went below $0 as lockdowns sapped demand and storage facilities filled to capacity. At time of writing, California gas prices are just pennies off of record highs.
That’s a huge swing in 18 months and gas prices, along with grocery shopping, are some of the strongest channels through which people form inflation expectations. They are regular expenses that individuals cannot actually skimp on purchasing, meaning higher food and gas prices typically result in spending cuts on other categories. They are also excluded from the Federal Reserve’s preferred inflation measure, as those categories are very subject to outside pressures and can skew a “Core” inflation number. So while food prices are rising high enough to impact consumer views on long-run inflation – and causing food banks to struggle – they do not factor into the Federal Reserve’s overall views on inflation.
What worries us is that higher home prices are starting to feed through to shelter costs in the index, with costs increasing at their highest rate month over month since June. Home prices are a leading indicator for rent inflation, which the Federal Reserve Bank of Dallas expects to remain historically elevated for the next several years. Shelter costs are both the largest singular components in PCE and CPI and one of the “stickiest” categories. Rents typically do not go down unless the economic picture materially diminishes – lending credence to the idea of elevated inflation for some time.
However, the Federal Reserve has shifted to a more hawkish stance – announcing an official beginning to a reduction in bond purchases of $15 billion a month, which we anticipate to increase in pace and likely results in an end to purchases sooner than June. Officials have been resistant to committing to interest rate hikes, citing a continued view of transitory inflation, “average” inflation targeting and a labor market that is still some way from pre-pandemic definitions of full employment.
Globally, many central banks are taking a different tune. While the European Central Bank (ECB) has committed to no interest rate hikes in 2022, the Bank of England and the Bank of Canada have stepped up the timeline on rate hikes. Australia’s central bank is also expected to be on the table for rate hikes in the near future. For the last year, global central banks have had simultaneous easy money policies, that theme is noticeably changing.
The positive is that interest rates are relative and generational changes in composition of the US consumer sector and labor market mean the concept of “high interest rates” are very different than they have been in the past. Since 2016, the millennials have been the largest generation in the workforce – this is a generation that came of economic age in a markedly different interest rate environment than the generation they are replacing.
If you ask a millennial how they feel about a 5% mortgage, the word they will use to describe that rate is likely “stratospheric”. Pose that exact same question to somebody who bought a house in the 1980’s – a decade in which the average rate on a 30-year fixed was 13.3% – and they will probably look at that as a huge discount. Generational spending patterns are defined by their economic environments and for almost the entirety of the millennials’ time as an economically viable age group interest rates have been at historic lows. They are conditioned to view as normal what older groups view as bargains.
The Federal Reserve uses interest rates to influence behavior – lower interest rates stimulate the economy, while higher interest rates slow it down. Given so much of the economy is currently driven by younger cohorts, this would suggest that the Fed can get the reaction it wants at a much lower absolute interest rate. We think that ultimately limits the extent of interest rate increases, especially in comparison to past rate cycles.
There is much going on as the world enters into a multi-speed recovery from COVID-19. Inflation, which has been dormant for a very long time, will now be an investment consideration going forward. We see the markets as both volatile and positive over the longer term which offers continued opportunity. The last two years have generated out sized returns, and we anticipate positive returns going forward but at a potentially lower rate as the world begins to adjust and stabilize in to a post-COVID world. Adaptability will be key and companies that adapt most readily to the changes in consumer demand will be those that benefit the most. We will be ready.
For our clients with Strategic Asset Management (SAM) accounts where we manage with full discretion. Depending on your individual situation, objectives and type of accounts, we may lean towards building slightly higher cash or near cash equivalent positions as we evaluate both volatility and values in line with our current outlook. This will give us an opportunity to mitigate volatility and take advantage of opportunities around our generally positive outlook for the second half of the year.
For our clients who hold brokerage accounts, if you are interested in a similar fee-based strategy, please contact your advisor.
If you are not yet a client and are interested in learning more about our services, please contact our team at (949) 660-8777 or firstname.lastname@example.org to schedule an appointment.
We appreciate your trust and the opportunity to be of service.
All the best,
The Investment Team