LIVING WITH COVID VARIANTS—BOTH LONG-LASTING AND MORE MINI-CYCLES

The economic outlook for 2022 and its future path depends, in part, on the likelihood of unpredictable breakouts of new covid strains such as Delta and Omicron. Such outbreaks will lead to more mini-cycles. At the same time, we continue to live with the impact from earlier covid strains. (see Figure 1.)

FIGURE 1

WAVES OF VARIANTS IN THE U.S

SOURCE: N.Y. TIMES

TRANSISTORY OR PERSISTANT—HOW LONG WILL IT TAKE INFLATION TO RETURN TO LOW 2%?—SUPPLY—GOODS AND LABOR KEY

Over a 10 month period, beginning in the Spring of 2020, Congress authorized three income replacement acts sending checks, totaling roughly 25% of U.S. GDP to American families, businesses, and state and local governments. With that consumer demand accelerated as rapidly as a Tesla Series S plaid sedan using launch control. As a result, according to an Oxford economics forecast, consumer spending will likely increase about 8% in 2021.
This will produce the fastest growth for consumer spending since World War II (see Figure 2.) The resulting accelerated aggregate demand for products and components, unmet by limited supplies of goods and labor, produced the higher inflationary pressures we now face.

How long it takes for supplies of goods and labor to catch up will determine when inflation consistently returns to the mid- low 2% level. That timeline will determine whether inflation proves transitory or not.

FIGURE 2

CONSUMER SPENDING SINCE WW II (% CHANGE)

SLOWING SECOND HALF 2022 GDP SHOULD MODERATE GOODS INFLATION

With the record increase in consumer spending on goods, supply chains choked up and continue to hamper inventory rebuilding. Morgan Stanley Research forecasts that real private inventory levels will not recover to pre-pandemic levels during 2022 (see Figure 3.) At the same time, moderating GDP growth, likely in the second-half of 2022 will likely
pull back pressures from durable goods inflation–particularly compared to the 2021 base (see Figure 4.) With that, inflationary pressures from shortage of durable goods inventories will likely begin to subside sometime in 2022.

FIGURE 3

CUMULATIVE SHORTFALL IN REAL PRIVATE INVENTORIES ($BN)

FIGURE 4

BLOOMBERG U.S. CONSENSUS ESTIMATES 2022

EXCESS ORDERING OF PARTS COULD LEAD TO AN INVENTORY GLUT AND DOWNWARD INFLATIONARY PRESSURES

Unavailability of parts, components, as well as finished goods in 2020-21 more than likely forced many businesses to seek out secondary and tertiary sources to meet their needs. If supply chains likely loosen up in 2022, inventory gluts may arise when their over ordering of supplies finally arrive. Potential excess inventories would then lead to price cutting and one-time inventory write downs at year-end 2022. Both would lead to downward pressures on inflation.

HOME CONSTRUCTION UNDERBUILDING—SHORTFALL OF SUPPLY

The outlook for shelter supply and costs will likely contribute to persistent inflationary pressures more so than durable goods during 2022– and possibly longer. Prior to the 2000s, a more typical period for home construction, construction grew 1.78% annually. In the past decade it grew just 0.78% annually. Based on U.S. household growth, the underbuilding gap in the past 12 years (2008-2020) totaled 7.2 million housing units— leading to increasing shelter costs. Underbuilding and the likely long-term housing demand should prove positive for those companies constructing new homes and those supplying to the home improvement market.

FIGURE 5

GROWTH U.S. HOUSING STOCK

RAPIDLY INCREASING SHELTER COSTS COULD PROVE A PERSISTANT INFLUENCE ON INFLATION FOR 2022

Shelter costs —rents and owners’ equivalent rent (housing)—contributes roughly 35% of Consumer Price Index (CPI) weightings and about 15% for the Personal Consumption Expenditures Price index (PCE.) Historically, the impact of higher shelter prices lead their impact on these two price indices by nearly two years. Shelter price increases in 2021, therefore, could influence the CPI and to a lesser extent the PCE in both 2022 and 2023 (See Figure 6.)

HIGHER HOUSING AFFORDABILITY PRESSURES COULD LEAD TO HIGHER WAGE DEMANDS

More specifically, since the beginning of the year, rents increased over 16%.. Admittedly, current rent increases reflect the period past the Covid rent moratorium. Despite that, the Apartment List National Rent Report shows that the actual national medium rent increases exceeded their pre-pandemic rent trend (see Figure 7.) Similar to rents, home
price increases reached new highs in 2021. According to FNMA, median new home prices increased 17% so far this year with existing home prices increasing nearly 18%. For 2022, FNMA forecasts median new and existing home prices will increase over 11%. Rapidly rising shelter costs brings housing affordability pressures on the average worker. Such pressures will likely lead to higher wage demands—influencing prices and thereby 2022 inflation.

FIGURE 7

APARTMENT LIST NATIONAL MEDIUM RENT

UNUSUAL MIX OF LABOR MARKET SUPPLY AND DEMAND LEADS TO FASTEST RISE IN U.S. EMPLOYMENT COST INDEX IN A DECADE

Employment costs—principally wages—account for roughly forty percent of U.S. public company costs. Despite nominal GDP shifting into an expansionary phase this year, employment remains more than six million jobs short of pre-pandemic job growth trends .At the same time, the quits rate continues to increase reaching a record 3% in
September while job openings exceed those counted as unemployed (see Figure 8.) Despite that favorable employment environment, the labor force participation rate (LFPR) or supply declined sharply (see Figure 9.) With tight labor markets, persistent wage increases resulted in the fastest rise in the U.S. employment cost index—for a 12 month period—since 2001 (see Figure 10.) Undoubtedly, businesses will transfer all or part of that labor cost increase into higher prices.

SUPPLY INFLUENCE ON 2022 JOB MARKET—WORKING PARENTS RE-ENTRY INTO JOB MARKET –PRESSURES WAGE COSTS

Concerns about additional Covid variants will likely further postpone improving the LFPR, particularly for service jobs requiring face-to face customer contact. Additionally, improving LFPR will depend on working parents re-entering the job market. According to a Brookings Institute study, working parents, with minor children, account for both nearly
one-third of the work force and 70% of those that lack potential caregivers. To encourage their re-entry will likely require confidence that schools will remain open without interruption—a concern likely to grow if Omicron spreads. Helping to postpone their reentry, parents will continue to receive fully refundable tax credits of $3,000/$3,600 per child—whether or not they work.

SUPPLY INFLUENCE ON 2022 JOB MARKET–“EXCESS” RETIREMENTS ACCOUNT FOR HALF OF THOSE THAT LEFT THE WORK FORCE—UNLIKELY TO RETURN

Covid caused a boom in new retirees. Figure 11 from Economic Synopses compares predicted percentage of Baby Boomer retirements (red dashed line) with the actual percentage (blue line)—so called excess retirements. These excess retirements represented roughly half of the over four million who left the work force since the start of the pandemic until the 2021 second quarter. Increasing retirements may prove more persistent an influence on inflation. Experienced workers retiring reduces the availability of skilled labor leading to premium wages for such skills.

FIGURE 11

PERCENTAGE OF RETIREES IN THE U.S. POPULATION AND BABY BOOMER RETIREMENT TREND (PERCENT OF U.S. POPULATION)

POTENTIAL FOR MORE CAUTIOUS FED IN 2022 THAN FINANCIAL MARKETS EXPECT

The uncertain Omicron threat, at this time, could lead to a more cautious Fed at its December 15th meeting. In 2022, the Fed may prove more dovish as the President will nominate three new members to fill vacant seats on the Fed’s seven member Board of Governors. To pacify progressive Senators who opposed Chair Powell’s renomination, the President will likely nominate dovish candidates focused more on social policy issues. The more dovish governors then could push out further into 2022 the number of rate hikes recently priced in by the financial markets or likely from the current Fed. Adding to their caution, many economists look for growth to begin slowing later in 2022.

INVESTMENT CONCLUSIONS

More Variants—More mini-cycles: The first news of a worrisome virus variant— Omicron—from South Africa–pounded the financial markets. Without knowing the degree of its impact as of this writing, it does underline that we will be living with unpredictable new virus variants for some time. With the likelihood of more variants, investors could face a rolling series of mini business cycles when new variants become intrusive. Nonetheless, investors will likely see opportunities when these cycles arise. Therefore, the Delta variant may offer some basis for making judgement on Omicron’s impact. With also a more cautious economic outlook, quality stocks will likely pick up market leadership.

Equities—late cyclicals attractive—labor intense companies less attractive: Increasing wage pressures reduces investment attractiveness of labor intense companies particularly in selected service industry groups. At the same time, tight labor availability and the resulting higher labor costs will work to the advantage of capital goods suppliers. Substituting capital for labor will improve both the productivity and profitability particularly of service oriented companies. Adding to the attractiveness of capital goods suppliers, recent global supply chain interruptions could see greater investment in North American production facilities. The current year shows the strongest growth in capital investments since the 1940’s—this should continue. Economic forecasts calling for slower GDP growth later in 2022 which also fits in with the attractiveness of capital goods companies as late cycle stocks

Fixed Income and Alternatives —In our view, inflation will likely prove higher and last longer than the Fed expects. Nonetheless, interest rates will remain historically low for some time—no matter whether moving up or down. With inflation materially higher than nominal interest rates, this combination results in negative real interest rates—inflation less nominal interest rates—for fixed income investors. Therefore with both low nominal and negative real interest rates, fixed-income investments remain unattractive and should only be used to protect capital. For that portion of the portfolio historically committed to fixed income securities, investors should primarily focus on a diversified group of alternative investments. In addition, stretched equity valuations also increase the attractiveness of alternatives for diversified portfolios.