MARKET COMMENTARY

Is It Time to Worry About Inflation?

11.17.2021 - Douglas Tommasone, CFA

Policymakers faced an unprecedented world following the spread of COVID-19. In 2020, governments largely decided to plug gaps in household budgets resulting from the crisis with enhanced fiscal support, including extra unemployment benefits as well as personal checks in some instances. This bump in individual income led to an increase in consumer spending, with the surge in consumption averting what seemed a likely US recession. However, it came with a cost—today’s heightened level of prices, i.e., inflation.

Today’s Inflation Picture                                                  

The debate over whether the increase in inflation in 2021 will persist or prove temporary has gripped many investors. Some have also focused on “stagflation,” a concept born in the 1970s describing a climate of boom or bust economic growth combined with higher prices. However, today’s inflation, in our opinion, is not likely a repeat of the Carter years.

During the peak of the COVID-19 global pandemic in 2020, millions of Americans received stimulus checks and enhanced unemployment benefits that supplied income replacement, and in some cases raises, as the government tried to slow the spread of the virus. These policy decisions allowed economic growth to ensue, and a recession was avoided. However, the effect to the economy turned up in an unprecedented increase in demand.

Chart 1: Government Support Alleviates Pandemic-Driven Slowdown in Consumption

Index of real personal consumption expenditure components

(February 2020 to September 2021)

Source: Bloomberg, as of October 2021.

During the shutdown, consumers tended to prefer goods over services, with a spike in durable items such as refrigerators, air conditioners, televisions, and autos (Chart 1).[1] This increased demand ignited a flurry of purchases that still persists today.

Pressure Remains on Supply Chains

Periodic heightened interest in consumer goods can normally be accommodated by global supply chains. However, the shock to those systems from COVID-challenged suppliers was further compromised by bottlenecks such as component shortages, surging prices of raw materials, labor shortages and transportation backups at every step of the supply chain. Carefully built logistical processes designed to be very lean while operating in calm conditions have been pushed to the brink of failure.

Where Do Prices Go Now?

While inflation is clearly heightened, looking more closely at supply and demand dynamics can be helpful. Prices, which balance supply and demand, are one way to find out about relative changes in the scarcity. That lesson has proved to be painful to consumers this year as more money chasing the same (or even fewer in the case of cars) products has pushed prices higher.[2] We believe that maintaining this overall level of consumer demand will not likely be accompanied by a surge in government assistance. That puts pressure squarely on an uneven labor market recovery to help support increased consumer consumption.

Labor May Be the Key

The job market and employee behavior have both undeniably changed, largely as workers left their jobs en masse due to searching for new vocations, concerns over Covid or desiring new lifestyle choices, thus creating significant shortages for businesses. Many workers lost their jobs when the backdrop seemed less favorable and remain on the sidelines today. Reasons for non-participation include lingering fears over the virus, challenges over childcare, or a change in lifestyle. Other workers are quitting jobs at record rates, particularly those in non-work-from-home jobs that felt the brunt of the COVID era precarity in sectors like manufacturing and retail. However, not to be overlooked is that some workers may now be pursuing different careers, perhaps never returning to their former professions. There is some evidence of this trend shown by the number of new businesses being created (see Chart 2).

Chart 2: New Businesses Are Growing

US Business Formation Statistics Applications US, semiannual

(November 1, 2011 to October 31, 2021)

Source: Bloomberg, as of October 31, 2021.

Undoubtedly, this mass migration out of the work force impacted supply chains as companies have struggled to regain former employees and retain overworked ones, as delivery times have lengthened. It might be helpful to consider noneconomic factors in addition to economic ones such as work from home becoming more common for many white-collar workers.

While the labor picture may still be unfolding, the October jobs report, which finally exceeded market expectations, could suggest that people are returning to the work force, perhaps due to declining Covid cases, rising personal expenses and used-up pandemic savings. Also, job growth picked up in industries in which employers have suggested that unemployment benefits made hiring challenging, i.e., nursing homes and home healthcare.

To our team, this climate implies that more workers can reenter the job market and find employment. The popular media narrative, that the record high[3] supply of jobs has not kept pace with hirings, was largely due, in our opinion, to higher wage demands during the shutdown supported by heightened levels of government funding. However, the labor market, while it may have lost some of its prior dynamism, may be widening its appeal. Although higher wages demanded by workers may have led to less hirings, recent data suggests that companies have increased hiring as pandemic-level wage supports have disappeared (Chart 3).

Chart 3: Unemployment Rate Continues to Fall

(October 2019 to October 2021)

Source: Federal Reserve Bank of Saint Louis, as of October 31, 2021.

Has a Turning Point Been Reached?

Since September, a tipping point seems to have been attained. Enhanced unemployment benefits have expired across the US. Also, additional state-related pandemic support has gradually been removed by lawmakers. Any shortfall for consumers will mainly need to be addressed by their savings.

Chart 4: Savings Rates Returning to Normal

December 2018 to September 2021

Source: Federal Reserve Bank of St. Louis, as of September 2021.

In fact, pandemic savings are now being used to support current consumer spending. Evidence of this shift can be found in credit card outstanding balances, which after dramatically falling during the shutdown, have once again begun to grow (Chart 4). [4]

What May Lie Ahead

The wage gains seen during the shutdown may provide some insight about what comes next. Enhanced unemployment benefits effectively increased the minimum pay that a worker would take to accept a new job rather than remain outside the work force. We believe that with this temporary support now removed, companies will return to their prior hiring practices, pressuring wage gains lower. Such a trend could act to slow inflation.

On the other hand, consumers have been facing increasing price pressures on food, energy, and shelter. Strong global demand and the litany of pandemic-related supply chain constraints have resulted in bottlenecks and traffic jams surrounding food in particular. Oil prices have skyrocketed since the summer, as Americans have faced higher prices at the pumps. Residential rents have risen with the slow, tentative reopening finally attracting residents to apartments. These factors could drive inflation upward.

Prices have remained higher longer than we originally expected, but we still believe this episode of inflation is temporary. The US economy has navigated an unprecedented path coming out of the shutdown. Labor markets have been challenged, with government enhanced support for demand ending and supply chain struggles continuing. Heading into 2022, we expect a slowing inflation environment in the broader market as consumers carefully choose what they buy. By avoiding a severe recession, the US effectively kicked the proverbial can down the road. Higher inflation, hopefully temporary, may be one cost to face as a result.

How Are Portfolios Positioned?

While higher inflation has certainly hurt consumers’ checking accounts, investment activity remains robust. Equity prices are near all-time highs as bond yields have hovered at all-time lows. As new economic data emerges that may shift perceptions about the path of inflation, we will adjust portfolios accordingly. For now, our team thinks the current portfolio allocation, with an overweight to equities and a meaningful underweight to fixed income, combined with a mindset of treating the current inflation episode more as a fallout of a trying time, remains the best option.

 

 

[1] Source: US Bureau of Economic Analysis, Personal Income and Outlays, as of September 2021.

[2] Source: U.S. Bureau of Labor Statistics, Consumer Price Index, as of October 31, 2021.

[3] Source: U.S. Bureau of Labor Statistics, Job Openings and Labor Turnovers, as of 10/30/2021.

[4] Source: Federal Reserve Bank of New York press release, “Total Household Debt Climbs to Over $15 Trillion in Q3 2021, Driven by New Extensions of Credit”, as of November 9, 2021.

MARKET COMMENTARY

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