Stocks rose sharply Thursday and Friday, putting the bulls back into the driver’s seat. We often see one-day rallies within downtrends, but two strong days back-to-back usually signify a change in investor emotions. What drove the change? Good initial third quarter earnings, and finally, energy from Washington to force steps to reduce supply chain logjams at key West Coast ports.
Most of the good earnings reports last week came from banks, despite low interest rates and anemic loan demand. As for President Biden’s efforts to accelerate the unloading of ships and get truckers focused on moving product from port to market, his resources to do something are limited. Both Long Beach and LA, where 40% of imports coming by ship disembark, have moved to 24/7 operations. Ship unloading has accelerated, but the backlog of ships in the harbor won’t resolve itself overnight. At the moment, the problem is most acute because (1) it is peak season in front of Christmas, and (2) Chinese ports were shut down due to Covid-19 in the Summer and early Fall. They are now catching up. I use a highway analogy a lot. In shipping terms, it’s 5 pm. Rush hour. Say what you may, there is going to be a traffic jam. Of course, it is worse this year. And I recognize you cannot create 50,000 new truckers overnight. It will take time to untangle the logjam, but greater focus and prodding from Washington won’t hurt. Higher wages won’t hurt either. The reality is that the shortage in truck drivers is only going to be solved by higher wages. Drivers still must be trained, but if the pay is high enough, the number of drivers willing to do the job will rise.
Let me step back a bit and look at supply chain issues and the market more in a 30,000-foot view. Stocks look ahead. Generally, they look ahead about 6-9 months. With that in mind, let’s think for a moment what the world is likely to look like in the summer of 2022. Here are my thoughts.
1. I will start with Covid-19 because that has been the root of so many problems. I am not a doctor or a medical specialist. All I am applying is some logic. By next summer, we will have been well past the Delta variant. The number of people vaccinated or with natural immunities (i.e., they have already been infected) will be higher than today. While it is possible that a new variant can surface resistant to all vaccines, that is a red herring risk, not a likely one. Two plus years after the pandemic began, by mid-2022, it should be fading significantly. We still may be wearing masks in close quarters, but life will generally be getting back close to normal.
2. The supply chain issues will not be fully resolved, but they will be unwinding. Bare store shelves will start to fill up again. Chip shortages may last until 2023, but the ports will be operating better, having been in 24/7 mode for almost a year. Higher wages will bring another 2 million or so back to work. Offices won’t be as full as in 2019, but they will be getting there. Now they are less than 50% full. By next summer, 75% sounds like a more logical number, maybe higher. Covid will no longer be keeping people away. Rather it will be workplace changes that allow more flexibility. Thus, while offices may be less full, it will only mean employees are working from elsewhere.
3. As supply chain logjams start to resolve themselves, companies will begin to rebuild inventories. For a quarter century, there has been a trend to something called just-in-time inventory management. That means about what it says. Inventories tie up capital, and keeping them as low as possible without disrupting business is ideal. But if they are too low and demand suddenly rises, there are real problems. That is exactly the cause of the dilemma we see today. There will be a return to just-in-time inventory management, but the base inventory levels are likely to be higher once normality returns.
4. Add two years of inventory rebuilding to normal demand growth, and you have a world of above average growth probably well into 2023. Thus, as demographics and normal productivity gains suggest normal growth might be 2% or slightly higher, growth in 2023 and 2024 will be above average just based on the need to catch up. In 2021 our auto industry might produce about 12 million cars. Normal is closer to 16-17 million. For the next two years, production should be 18 million or more. It will take that long to refill dealer lots. Note that at some point, some products may end up getting oversupplied. In some industries, where shortages are acute, buyers are double and triple ordering. Thus, order books for some products are a bit overstated. Right now, we are seeing rising prices accompany rising demand. As shortages unwind and supply catches up, however, prices will normalize. Some may sink further than expected if producers don’t adjust to real demand quickly. That is particularly true for commodities and basic materials.
5. Inflation will also be working in our favor. Many of today’s spikes accompany shortages as I just explained. As demand equalizes, prices will fall back. Gasoline, now pushing $4 per gallon will recede to something closer to multi-year averages. The same holds for virtually all basic materials. Wage growth, however, is likely to stay elevated for some time.
6. If the Fed has missed something along the way, it may be that it has underestimated the size of our labor force. The male labor force participation rate topped out in 1952 at 87%. For several years, prior to the pandemic, it had flattened out at 69%. Now it is about 67.5%. With more rapid retirements from the baby boomer generation, I suspect it may never get back to 69%. The female participation rate topped out at 60% around the start of 2000. It fell to a bit below 57% in the middle of last decade before rallying a bit into the start of the pandemic. It crossed the 57% threshold again just before the pandemic but now is 56.2%. Some of the unemployed women were forced to stay at home when kids were going to school virtually. Some will reenter the workforce in the months ahead, but in some cases, two-worker families may revert to one. Why? The need for a second wage earner may not be so acute. Look at the rise in net worth and the elevated savings rates. Yes, higher wages will entice some back, but not all. The net is that more demand over the next two years and a smaller workforce has shifted the supply/demand equation in the workers’ favor. That means elevated wages. It means more strikes. It means better working conditions.
7. It means that companies that have pricing power will be able to pass along higher labor and freight costs, while those that lack pricing power will suffer margin squeezes. This will vary from company to company and industry to industry.
8. The Fed will be winding down its tapering program. My guess is that interest rates will be slightly to moderately higher than they are today, meaning the 10-year Treasury yield may be about 2%. A rapid recovery in tax receipts and less Covid- related relief spending from Washington will keep Treasury needs moderate over the next 6-9 months.
9. The safest assumption is that Democrats resolve their bickering and complete some sort of spending and tax package by year end. U.S. corporate taxes will rise to about 25%, a cost that those who can, will pass through to consumers. Most of the associated spending will be done in Fiscal 2023 and beyond. Which of the new entitlements make it into law and which don’t remain in doubt. For my purposes, it isn’t relevant from 30,000 feet, although it will matter industry-to-industry.
10. Thus, profits will be elevated for two more years as supply chain problems unravel. Investors now see that. It is the root of the rally that started last week. Markets don’t look at what is happening today, they look ahead. The exception is when markets get spooked. Then they react to what they see. As store shelves emptied and ports backed up, worries increased and markets wavered, but these issues will resolve. On the other hand, some inflationary pressures won’t ease, notably labor. Home prices are not likely to fall back. The acute price increases of last Spring have led to rapid rises in rents. The future rates of increase will moderate (that is what will show up in inflation data), but new home buyers and renters will be paying a higher percentage of income on shelter going forward than they have in the past. Even with higher wages, inflation will moderate. Whether it falls back to 2% or less is uncertain. But to investors, direction matters.
11. Profits will likely exceed estimates for the next two years until inventories normalize. Interest rates should stay relatively stable with a modest upward bias. Over time, they should normalize as well. That suggests solid underpinnings for equities.
12. I can’t close without saying three things about non-economic factors. First, no one knows when the next world problem will erupt or the next pandemic begins. These unknowns can’t be factored in today. When they happen, markets will react. Second, there is a mid-term election in 2022 and there will be a lot of focus on that in the summer of 2022. Today’s logic says Republicans retake the House and possibly the Senate, but we all know that 12+ months is an eternity when it comes to predicting politics. Third, and perhaps most important, is China. China is moving away from an open society. It is flexing its international muscles. In many ways, its world views and ours contradict each other. Taiwan will become a critical focus, as China still considers Taiwan part of its own. The rest of the world doesn’t accept that. The largest semiconductor contractors in the world are in Taiwan. Politically, nothing is more important than the future of US/Chinese relations.
Today, Zac Efron is 34. Skier Lindsey Vonn is 37.
James M. Meyer, CFA 610-260-2220