Moving Toward Realignment: A One-of-a-Kind Moment in Time

12.21.2021 - Ronald J. Sanchez, Chief Investment Officer

Where We Are Today
As we emerge from the global pandemic, we continue to navigate truly unusual times. The economy has followed a certain course of events—the onset of Covid, a strong monetary and fiscal policy response, a vaccination rollout, and now we are in the first phase of an economic recovery. Although everyone is eager to return to a bit of normalcy, we are reminded daily that despite having developed a vaccine, the pandemic isn’t over yet and restarting the global economy is, unfortunately, not like flipping a light switch. However, a reopening has happened, albeit an unusual one, and the world remains a long way from normal.

Today may be one of those rare periods in history when a sudden surge in demand has collided with severely constrained production. Usually, an economy experiences capacity constraints and upward price pressures during the late stages of a recovery when it is running well above its average long-term growth. However, this dynamic is now occurring in the early stage of the US economic recovery. That is, the spread of the virus has created an imbalance between the demand and supply sides of the economy.

A prime example of this unusual imbalance has been demonstrated by used and new car prices. The demand for cars has remained strong, while the supply of new cars has been challenged, most notably due to a semiconductor shortage. The result has been that a surge in demand for used cars that has led to their sales prices being equal to or even more expensive than new cars.

An astounding number of similar imbalances stemming from the pandemic have been observed in 2021.

Chart 1: Market Imbalances Experienced in 2021

To try and understand this unique moment in time, as the economy attempts to recover from the unprecedented steps taken to alleviate the impact of a global pandemic, we consider these unusual supply and demand imbalances, and their influence on inflation as we near a more realigned world.

Part 1 – Demand: Surge May Start to Fade Soon
Consumer demand has been robust this year. Personal consumption for goods has increased 11% higher than its pre-pandemic trend.1 One-time direct payments to consumers, expanded unemployment benefits, along with low interest rates and strong vaccine rollout, has allowed consumption to snap back, and in some instances, even surpass pre-pandemic levels. Due to this surge in demand, companies are seeing new orders reach historic highs.

We view this level of demand as temporary and unsustainable. The stimulus from government policy and pent-up demand from lockdowns was a one-time occurrence. Now, with consumers having spent much of their excess savings, and outstanding credit card balances starting to increase again, we believe this will lead to a moderation in demand.2 

Part 2 – Supply: Still Facing Limitations
Supply imbalances have been well reported in the media, as the term “supply chain” has become a household term. The supply side of the economy has been slower to bounce back, and demand has simply outpaced the ability to produce goods. While the recovery progresses, remnants of the pandemic remain as shortages of raw materials, assembled components, and labor continue to keep manufacturing facilities from operating at full capacity. These supply bottlenecks continue to cause rising backlogs and declining inventories. In fact, inventories have reached historically low levels, emphasizing the complex nature of global supply chains in a “just-in-time” inventory world.

Beyond supply chains, similar constraints can be seen in the labor market, as currently seen in the largest gap on record between the demand and supply of labor. The pandemic has caused many to reevaluate their personal and professional life resulting in record retirements, career changes and other challenges related to re-entering the work force. This labor shortage is evidenced by the historically high number of job openings, while hirings have barely budged.

As supply chains work through disruptions, and bottlenecks moderate, we believe backlogs will ease, and inventories will be rebuilt. While the labor picture may still be unfolding, the latest readings of jobless claims could suggest that people are returning to the work force, due to a combination of increasing vaccination rates, rising personal expenses and used-up pandemic savings. We anticipate these production and labor constraints will peak and then moderate in 2022.

Part 3 – Inflation: The Product of Supply and Demand
The supply and demand imbalances, seen in the economy today, have manifested themselves in the form of elevated pricing. After hovering around 2% for the decade preceding the pandemic; inflation has almost tripled over the last year. This has been one of the quickest and largest increases since the 1970’s.

While nobody needs to check the official CPI data to appreciate the increase in prices at the gas pump, grocery store, realtor’s office, or local restaurant, these prices currently reflect increases in raw material costs, shipping costs, wage increases and other input charges. We view these dramatic price changes as a direct result of imbalances currently seen in supply and demand data.

The economy is navigating an unprecedented path to recovery and the resulting imbalances have caused prices to remain elevated and more persistent than many would have expected. Slowly, businesses are adapting to this rising price environment, and while many corporations have been able to pass along these prices, they are also identifying other levers to control costs. It is important to not forget the structural adoption of technology and other productivity enhancements that could curb a further rise in inflation. Heading into 2022, as demand likely moderates, and supply constraints potentially ease, we expect inflationary pressures to abate.

A Final Word
The evolution of supply, demand, and inflation has led the conversation during 2021. We feel these factors will also help guide markets through 2022. Today, we believe that the economy has moved beyond peak demand, is currently approaching peak levels of supply constraints and, consequently, we expect to see upward price pressures peak.

Chart 2: The Near-term Timeline for the Economy

While still healthy, demand should continue to moderate in 2022. This moderation should alleviate the burden on supply chains and provide some resolution to supply chain constraints moving forward. Given the peaking and subsequent moderating nature of these factors, it is our expectation that inflation will also crest during the middle of next year.

The economic challenges encountered this year have been significant, however, we see the fundamental backdrop as healthy and expect these challenges to moderate in 2022. The Federal Reserve has said as much with its recent statements regarding reducing their support of financial markets. However, significant challenges, such as supply chain and labor constraints resulting from the shutdown, need additional time to work through before the economy is fully in sync. The economy, in many ways, is out of balance and slowly moving to realign itself.

1. Source: Bureau of Economic Analysis, as of 10/31/20212 Source: Bureau of Economic Analysis, as of 10/31/2021

This communication is intended solely to provide general information. The information and opinions stated may change without notice. The information and opinions do not represent a complete analysis of every material fact regarding any market, industry, sector or security. Statements of fact have been obtained from sources deemed reliable, but no representation is made as to their completeness or accuracy. The opinions expressed are not intended as individual investment, tax or estate planning advice or as a recommendation of any particular security, strategy or investment product. Please consult your personal advisor to determine whether this information may be appropriate for you. This information is provided solely for insight into our general management philosophy and process. Historical performance does not guarantee future results and results may differ over future time periods.

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