Stocks gave up some ground on Friday but still finished the week with decent gains. Trading remained volatile. Leadership rotated between growth and value stocks several times depending on the economic news of the day and trends in interest rates. The week ended with 10-year Treasury yields crossing the 1.60% barrier for the first time since spring.
It truly was a busy week for news. On Friday, we learned that less than 200,000 new jobs were created in September as the Covid-19 Delta variant still created some uncertainty. Vaccine mandates probably hurt as well. Supposedly, the end of extended unemployment benefits were expected to motivate some to return to the workforce. Maybe September was too soon to judge, but clearly there was no sudden burst. In fact, those actively seeking work declined as did the labor participation rate.
We may know more next month. Covid-19 cases are now in decline. Most schools are fully reopened. While the government continues to hand out money (e.g., food stamps, rent assistance, child credits) and savings are high, less disease and less unemployment pay should evidence themselves in the October data.
However, there is no doubt that the economic rate of growth is slowing more rapidly than anticipated. The Atlanta Fed, which posts a real-time survey, now projects Q3 growth of less than 2%. In July, the number was over 6%. The problem isn’t a slowdown in demand. It’s the inability to meet the demand that exists. Thousands of containers sit at U.S. ports without adequate trucking capacity to take them to destinations. Hundreds of ships wait offshore for days or even weeks to unload. There is no room to offload. Everyone points the finger somewhere else. So far, Washington has stepped back and watched.
The debt ceiling was an early week concern. The problem got deferred until December as Republicans allow Democrats a couple of months to finish up their legislation. As for the legislation itself, Speaker Pelosi was forced to defer a vote on a bipartisan supported infrastructure bill by members of her own progressive wing. They still want to pass a $3.5 trillion spending bonanza, but a handful of moderate holdouts in both the Senate and House prevent that. The progressives moan that 90%+ of the Democratic caucus want to pass these bills, but 90% of Democrats isn’t 90% of Congress nor do they represent 90%+ of the electorate. Indeed, President Biden’s polling numbers keep falling. With Covid now in retreat, it is evident that Americans appear to be souring on his handling of other issues. Indeed, the problems at our borders, the messy exit from Afghanistan, and now the inability to get any legislative initiatives passed so far, all weigh on his popularity. Democrats may still coalesce around a large spending bill but it’s price tag will almost certainly end up a lot closer to $3 trillion (including infrastructure) than $5 trillion. Progressives will need to decide whether half a loaf is better than no loaf at all. At the moment, they are not ready to concede. Don’t expect any legislation to pass before Thanksgiving. The possibility that nothing passes isn’t remote any longer. Both moderates and progressives are meeting and there has been a bit of movement, but they remain far apart still. Election Day is coming up. There aren’t many important elections. The governor’s race in New Jersey appears to be a foregone conclusion but the race in Virginia has gotten very close. Should Republicans win or even get very close, there will be a message from a state that Mr. Biden took by 10 points. That could affect the outcome of pending legislation.
Then there is the concern about inflation. There is little doubt that some of the supply chain issues spill over to inflation. The whole world was startled by the speed of economic recovery. Factors like lockdowns in exporting nations such as China, and weather conditions in Europe, have contributed to the acute supply shortages which, in turn, ignited inflationary pressures. Some of these will disappear once all the containers stacked in the key ports get moved to their destinations. The problems only get accelerated by double ordering. The random shortages we all witness everywhere are clearly tied to the thousands of filled containers sitting on docks or waiting to get unloaded. It isn’t an unsolvable problem, but one that requires coordination. That may need to come from Washington. Perhaps a shockingly low GDP number for Q3 will wake someone up, especially as the problem gets more acute.
As for inflation itself, it would seem logical that once everything gets delivered, growth and inflation should normalize, but that ignores the persistent inability of the labor participation rate to recover. The data says there are still 5 million fewer workers than there were pre-pandemic. Perhaps half or more of that total represent those who have left the work force permanently. Over 2 million retired. Some may be doing part-time work from home on a freelance basis. Some, unfortunately, died from Covid-19. That leads to a suspicion that, despite the Fed constantly talking of an employment gap, we may be a lot closer to full employment than the Fed believes. If so, buying $120 billion in bonds per month to stimulate more demand, makes little sense. Neither do massive Federal spending programs which, with the singular exception of infrastructure spending, will have rather little impact on long-term GDP growth. It may be a great idea to have universal pre-kindergarten or free two-year college programs, but in a full employment economy who is going to fill all the jobs necessary. In September alone, there was a big drop in the number of workers in education. K-12 jobs can’t be filled. Who’s going to fill the rest?
So where does that leave us?
On the positive side, the Fed is still buying supporting further rise in asset prices. Bond prices may be falling but other asset classes continue to rise from homes to bitcoin. Second, no one is questioning demand. If stores and businesses have the stock, there are buyers everywhere. Even the most optimistic predictions say the supply constraints won’t fade away until mid-2022 or later. Car dealer lots may not be full until 2023. Every public home builder has an expanding backlog but can’t get product to the customer for the lack of lumber, appliances or whatever. Some are going to the extreme of delivering homes without some appliances.
On the negative side, the longer the supply chain is in gridlock, the slower GDP growth will be in the short run. In addition, it means inflation will run hotter for longer. If the Fed starts tapering in November and finishes in mid-2022, what happens if inflation is still well above 3%? What happens if the 11 million unfilled jobs today is even a higher number eight months from now? It wasn’t long ago that consensus had the first hike in the Federal Funds rate happening in 2023. Now some suggest two hikes in 2022 are likely.
The Fed has a bad history of falling behind the curve at economic inflection points. We are clearly at one. Inflation is rising and GDP growth is slowing. The Fed is correct that some of the factors creating the logjam and inflationary pressures are transient. But are all of them? Will inflation in two years revert to 2% or lower? Until recently, the bond market said “yes” in a resounding fashion. For the past few weeks, of all major asset classes, only bonds have had a persistent absence of buyers. High multiple NASDAQ stocks have reacted. Those multiples won’t stand up if rates continue to rise persistently. That isn’t a condemnation of the quality of these companies or their growth prospects. For the past decade or more, it has been a perfect storm for stocks; rising earnings and lower interest rates. Earnings are still rising. If interest rates have bottomed and inflation is going to rise slowly but surely, stocks will enter a new era where rising earnings and higher rates fight against each other.
Ultimately, rates will reflect a true rate of inflation post the supply chain issues. One must remember that we are not coming out of a recession with lots of slack that suppresses any inflationary pressures. Rather we are in a strong economy with very strong demand. Even when supply and demand rebalance, there will be little wiggle room. Pricing power is moving toward the seller even with all the deflationary forces of the Internet in place. Until the supply chain heals, we won’t know the long-term inflation rate. There is a good chance it will be higher than the Fed’s 2% target. If that proves true, it is hard to expect 10-year Treasury yields to stay below 2%. Yes, if central banks worldwide keep printing money, then can, artificially, keep rates low, but more stimulation will only aggravate inflationary pressures. It’s a game they can’t win.
They could, one day, step on the brakes, raise rates, lower the pace of growth, and recreate slack in the economy. That would stop inflation but also create an economic slowdown. Simply said, the good choices are fading. Can the economy grow at 2-3% without inflation? It has done so in the past, but right now, that path is narrowing. Time will tell.
Today rapper Cardi B is 29. Former Phillies outfielder Pat Burrell is 45. David Lee Roth turns 67.
James M. Meyer, CFA 610-260-2220
