The last week’s market highlights:
Each week, we present our featured topics in the context of the major themes listed below from Nuveens 2021 Fourth-Quarter Outlook:
- U.S. economy: Stimulus wearing off but growth remains solid. More workers needed.
- Global economy: Slowing from its fastest pace in decades even as parts of Asia and the emerging markets are set to reopen.
- Policy watch: Policy is shifting from “extremely accommodative” to merely “quite accommodative.”
- Fixed income: Income generation remains a challenge as rates rise gently from very low levels.
- Equities: Valuations have come down but remain high relative to history; earnings growth will be key to returns.
- Asset allocation: Balance the risk of hotter inflation with that of slower growth.
Quote of the week:
“The mystery of life isn’t a problem to solve, but a reality to experience.” – Frank Herbert, “Dune”
What does “transitory” inflation mean at this point?
With the barrage of headlines about supply-chain disruptions and rising commodity prices, it’s easy to overlook a key point: in the U.S., monthly inflation as measured by the Consumer Price Index (CPI) slowed considerably in the third quarter compared to the second.4
On a year-over basis, however, September’s CPI inflation rate was still among the steepest since the 1990s.5 Yet the Federal Reserve has shrugged off higher prices throughout most of this year as “transitory,” a term used so often and for so long that it has become something of a punchline.
Our single-sentence definition: inflation is transitory if it eventually fades or reverses on its own without tighter monetary policy.
Rapidly rising inflation isn’t just a U.S. phenomenon these days, not by a long shot. In the eurozone, for example, inflation hit 4.1% (annualized) in October, the highest rate since before the 2008 global financial crisis.6 Such elevated inflation levels reflect the inability of economies to generate supply sufficient to match unleashed pent-up demand resulting from a combination of massive government stimulus and economic re-openings.
Put simply, the global economy as currently constituted isn’t built to handle demand growth on the scale we’ve seen in 2021, especially when that growth is goods-intensive and therefore susceptible to supply chain disruptions.
But here’s the good news on the inflation front: the speed and magnitude of demand growth for goods from the first half of this year is unsustainable. Supply chain stress will ease because (1) a reopening “boom” happens only once; (2) U.S. households have already spent much of the additional cash they received from the government’s massive fiscal aid programs; and (3) consumers are reducing their outlays on goods in favor of services. For all these reasons, we believe the spike in goods inflation from the spring is…yes…transitory.
What could change our mind about the transitory nature of inflation and require the Fed to accelerate its tightening timetable? Here’s one potentially unpleasant scenario: if the current worker shortage calcifies into a permanently smaller prime-age labor force, that could drive a premature wage-price spiral, with employers competing for remaining workers by having to raise wages and pass that cost onto consumers. Such a situation, were it to occur, would play out over the next several quarters, and quickly rip the “transitory” tag off of inflation. Higher interest rates from the Fed would be the likely result.
A further rise in energy prices could also lead to “sticky” inflation, but we’d still consider such a jump as transitory. High energy prices act as a tax on consumption and are therefore more a threat to growth than to price stability. For example, home heating costs represent a nondiscretionary expense for most households — not something they can defer until later, like a new car or television. So we doubt the Fed would raise rates if, say, crude oil prices topped $100 and real spending growth stagnated.
Fortunately, inflation is far from spiraling out of control at the moment. On the contrary, peak monthly inflation readings are almost certainly in the rear-view mirror. Where inflation ultimately lands once the effect of last spring’s deflationary readings fall out of the year-over-year calculation matters quite a bit. If annual core CPI inflation, which excludes food and energy costs, eases back to 2% or so from its 4%-4.5% levels over the past few months, the Fed will almost certainly not hike in 2022, and the economic cycle and equity market rally will run longer.7 But if core inflation averages 3% or thereabouts next year, tightening would indeed be the likely result, which would be bad news for markets. We’d expect yields to rise — sending bond prices lower — and stocks to stumble, with bottom lines hurt by higher borrowing costs.
U.S. growth slows in the third quarter, but consumers surprise on the upside
The advance estimate of third-quarter U.S. GDP growth, released last week, told us what we already knew: the pace of economic expansion slowed during the three-month period. But even with increased COVID-19 risks from the Delta variant contributing to already overwhelmed supply chains, the economy didn’t grind to a halt.
While below expectations, the 2% annualized rate of growth was well above the “whisper” number of closer to zero. The Atlanta Fed’s normally accurate GDP tracker pegged the economy as essentially flat for the quarter, so we breathed a sigh of relief when the figure came in as high as it did. Without any supply-chain constraints, output would have likely registered around 4%-5% — slower than in the first half of the year but still strong by any measure.8
What stands out most from the report is that the Delta variant failed to slow the dramatic shift away from consumer spending on goods (-9.2% for the quarter) and toward spending on services (+7.9%).9 Americans continued to spend more on “having fun” relative to buying “stuff,” taking a further step closer to pre-pandemic norms. The decline in goods consumption was due entirely to durable goods like cars, which (a) have risen in price considerably in 2021 and (b) have been in short supply due to manufacturing and delivery delays. No matter. People still found a way to spend money over the summer.
Other takeaways from the GDP release:
- Private investment grew after contracting for two quarters, driven largely by intellectual property (e.g., software) investment while the other categories (i.e., structures and equipment) detracted.10
- Inventories notably did not grow in the quarter, but their slower rate of decline compared to the prior quarter added 2.1% to GDP.11 At some point, restocking will be required to replace the historic drawdown from the last several quarters.
- Trade (-1.1%) was a significant drag. This was to be expected, given that the U.S. trade deficit in goods hit a record high of $96.3 billion in September as exports shrank and imports grew.12 Imports are consumed domestically but produced abroad, so they are subtracted from consumption in the calculation of overall GDP. Exports, which are produced in the U.S. but sold abroad, are added to overall GDP. With import growth positive and export growth negative, GDP took a hit on both sides of the trade equation.
- The measure we normally prefer to gauge domestic demand — final sales to private domestic purchasers — increased at a 1.1% rate in the period. (This metric tracks how much U.S. residents actually spend, regardless of where the product or service is produced.) The third quarter marked the first time this number has trailed overall GDP growth since the recovery from COVID began in the spring of 2020.13
- But the brightest spot in the GDP report was the better-than-expected personal consumption growth, the largest component of demand. And consumer spending rose 0.6% in September, as the government reported on Friday.14
The U.S. economy has grown 4.9% over the past four quarters and is now comfortably above its fourth- quarter 2019 peak.15 Even so, the recovery is far from over. Households, even those in lower income brackets, still have considerable excess savings, which, combined with rising incomes, should continue to support above-average consumption growth through 2022. It won’t be the 11%-12% rate of growth (net of inflation!) generated in the first half of this year, but even a 2%-3% annual growth rate would bring the economy back to its relatively strong (and normal) rate of expansion from 2018.16 That seems achievable to us.