Bursting at the Seams
In these unprecedented times, changes in the economy have occurred very quickly. Last year, the pandemic suddenly decimated large numbers of businesses and entire industries globally while throwing many out of work. The ensuing rapid recovery has made those tragic events feel like a lifetime ago. With multiple tailwinds, economic growth has been very strong and accelerating. While today’s torrid pace of expansion will soon slow to a more normal level of growth, its momentum bodes well for the future. This has not gone unnoticed by the stock market. Through the end of August, the S&P 500 gained over 20% year-to-date.
The economic expansion has become self-sustaining. Consumer incomes, savings and net worth, as well as corporate sales and profits, are all surging. More people are going back to work every day. Foreign economies are also on the mend, boosting growth here in the U.S. State and local government revenues are rising, enabling them to increase spending. GDP adjusted for inflation grew by an annual rate of 6.6% in the second quarter, up from 6.3% in the first quarter and 4.3% in the last quarter of 2020. This tremendous growth, however, is likely to slow in the second half of this year and into next year.
The sudden post-pandemic heightened level of consumer demand for numerous products and services has occurred more quickly than many businesses could accommodate. Service providers found themselves short-handed and unable to rapidly hire, while goods suffered from low inventory levels and fragile supply chains straining to ramp up, often in some foreign land. High demand and low supply naturally lead to increased prices, with the latest Consumer Price Index (CPI) reading for July showing a rise of 5.4%compared to a year ago. Excluding the more volatile components of food and energy, core CPI still rose a hefty 4.3% over last year, a slight deceleration from June’s 4.5%.
The jump in prices was expected. The big unknown is whether these inflation readings are transitory or here to stay. Digging into the CPI data, it is clear that a significant portion of the price increases will not be ongoing. Categories such as new and used vehicles, airfare and lodging have been influenced by explosive increases in demand, supply disruptions or travelers making up for a lost summer. Some items that have seen the greatest increases in prices versus last year have already begun to decline, like lumber and used cars, as backlogs clear and consumers delay purchases. The duration of these transitory price increases, how much is actually transitory and the impact they have on everything else remains to be seen, along with the new normal level of inflation once supply catches up with demand.
The labor market is on the mend, but is also part of the problem with inflation. Payrolls increased by 235,000 last month, with the unemployment rate falling to 5.2% from 5.4% in July, yet there remains a record 10.9 million job openings. Generous unemployment benefits, fear of catching Covid in the workplace, lack of available or affordable child care, career transitions and early retirement are just some of the many factors keeping potential job-seekers from rejoining the workforce. With employers desperate to fill vacancies, wages are rising despite the still sizable number of people available to hire. Increases in productivity can eventually offset higher compensation costs, but not in the near term. This type of inflation is unlikely to be transitory.
Although inflation has been higher than they anticipated and more persistent, the Federal Reserve expects price pressures to begin to ease later this year as bottlenecks unwind. The Fed plans to maintain interest rates near zero and continue with its monthly purchases of $120 billion in government-backed bonds until it is confident inflation will hold at its 2% target and the labor market is at maximum employment. The Fed views those goals as still off in the distance but may already begin tapering its bond purchases later this year. Fed officials feel that it would be a mistake to act prematurely to raise interest rates to address one-time price increases of a small group of goods and services that have surged due to the reopening of the economy. If, however, inflation stays too high or leads to expectations of future inflation, which can be self-fulfilling, then the Fed won’t hesitate to raise rates.
The economy is growing at an elevated rate. Inflation has broken out in certain pockets, some of which is temporary. The Fed doesn’t want to interfere and possibly derail a recovery that is likely to throttle back on its own, despite the risk of inflation gathering momentum. Global forces, however, have dragged inflation lower for years and the Covid Delta variant also reduces the odds of the economy overheating. Normal times where GDP grows 2-2½% with sub-2% inflation are not yet in sight. It is possible that this post-pandemic environment with inflation running a percentage point or so warmer than in the past may be with us for a while. Most investors won’t be surprised if that materializes and stocks can continue to do well even then.
Holger Berndt, CFA
Director of Research
hberndt@rssic.com
