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Inflationary Supply Shocks – Will the Fed’s “Largely Transitory Inflation” View Prove to Be Transitory as Well? COVID Health Risk Gap – White-Collar Health Risks Compared to Blue Collar Workers – Will It Lead to Structural Changes in Job Markets?

Date Posted: October 21, 2021

Worker and Product Shortages — the Outcomes Will Help Determine How Long “Largely Transitory Inflation” Will Last

This year provided investors with extremes of euphoria and worry. With 2021 moving into its final weeks, the outlook for 2022 will play an increasing role in near-term financial market performance. The fallout from the pandemic, including backlogged supply chains and worker shortages, will heavily influence, at least, the first part of next year. Our Commentary examines these issues and their influence on the economic and investment outlook.

Supply Chain Backlogs Will Likely Last for an Extended Period

Speedily rebuilding depleted retailer inventories will likely prove key to meeting the Fed’s expectation for “largely transitory inflation.” Shipping products from Asia represents one friction point in that outcome as Asian air and ship ports close periodically due to outbreaks of COVID. At the same time, a lack of sufficient workers and equipment results in ships backed up waiting to enter jammed U.S. ports. Then shortages of trucks and drivers at the ports delay hauling out incoming freight. For example, shortages of intermodal chassis force freight shipments to be shifted from rail to trucks. That shift shows up in declining freight volumes and increasing freight costs — adding to inflationary pressures (see Figure 1). Complex dynamic supply chain frictions will not face quick solutions. Figure 2 shows corporate expectations for the persistence of such supply chain disruptions will likely take an extended period of time — in reality, those forecasts reflect no more than guesswork.

Figure 1
Bottlenecks Bite

Source: Cass Transportation Index Report

 

Figure 2

Corporate Expectations for Supply Chains Returning to Normal

 

 

Resolving Supply Chain Complexities Will Add to Economic Growth Later in the First Half of 2022

Supply chain bottlenecks and their resulting shortages will likely temper economic growth at least into the first quarter of 2022 — and likely longer. Once unraveled, shipments for unmet end users’ demands will likely add to economic growth. Despite that possibility, economists reduced their 2022 economic forecasts (see Figure 3). Current experiences with supply chain bottlenecks will likely lead importers of parts and components to regionalize more of their production and distribution facilities. These decisions will occur when making new capital investments — to the benefit of North American locations.

Figure 3
Bloomberg Consensus U.S. 2022 GDP Growth Forecast

 

 

Holiday Spending Predicted to Increase – Will Depend on Product Availability — Big Box Retailers Will Likely Gain Market Share with More In-Stock Items Than Competitors

According to the PWC Holiday Outlook 2021, projected holiday spending looks to increase about 20% compared to last year (see Figure 4). With product deliveries held up by global supply chain bottlenecks, consumers may periodically face empty store shelves during the holiday season—leading to empty holiday stockings (see Figure 5). As a workaround, big-box retailers chartered container ships to bring goods more speedily in through smaller, less congested ports. Their actions will likely gain them market share at the expense of smaller competitors. Therefore, divergent holiday earnings performances will likely result. The strongest retailers could report pleasant surprises while their smaller competitors disappoint. The long-term post-pandemic result will likely lead to greater market share concentration among big-box retailers and their product suppliers. With even greater retail market share concentration, the smalls will either merge or disappear. The long-term impact for other competitive industries—post-pandemic—will likely show similar disruptive shifts.

Figure 4

 

Figure 5
Holiday Gift Outlook

Worker Shortages, Unless Ending Soon, Will Likely Dampen Growth in Service Industries and Prolong Supply Chain Backlogs

Post-pandemic worker shortages, until resolved, will likely reduce service industry growth — an industry that represents roughly two-thirds of GDP — and continue to disrupt supply chain operations. Supplemental federal unemployment insurance payments ended in September while, at the same time, children returned to school. Employer expectations assumed that opened schools would free parents to return to work. Economists expected to see improved September employment numbers. Instead, non-farm payrolls grew at a rate one-third of their forecasts. This shortfall occurred despite high levels of unfilled job vacancies (see Figure 6). At the same time, since April, over 15 million workers quit their jobs without new employment (see Figure 7). The surprising job market statistics also show up in the slow recovery for the labor force participation rate (see Figure 8). How this workforce shortage ultimately resolves could influence long-term wage inflation, the outlook for labor-intense services such as restaurants and hotels, and how quickly supply chains loosen up. If these structural changes prove long-term, corporate America will be forced to adjust. Such adjustments could include increased employee training to broaden the available labor pool and capital substitution for labor. Both changes should improve long-term U.S. productivity and speed economic growth.

Figure 6
Total Unfilled Job Vacancies or the U.S.

Figure 7
Number of Workers Leaving Their Jobs Voluntarily by Month

 

Figure 8
Labor Force Participation Rate (2000-2021)

COVID Health Risk Gap—White-Collar Health Risks Compared to Those of Blue-Collar Workers—Does It Lead to Structural Changes in Job Markets?

The COVID health risk gap spotlighted the differences between white-collar workers who could work “safely” from home with blue-collar workers that faced greater health risks commuting and working away from home. Many blue color workers’ anger and reaction to this COVID health risk gap may be one force leading to structural job market changes. The obvious question, without traditional employment, is how workers will fund their day-to-day living expenses. One answer may come from the gig economy. Families also have another possible income source from the 2021 $3000/$3600 per child fully refundable tax credit. Next year that amount drops to $2,000 per child, partially refundable, unless Congress renews current tax credits. These child tax credits may prove sufficient to enable one parent to remain at home, abandoning the job market. Then the record number of new business formations, nearly fifty percent higher than pre-pandemic levels, could partially provide another income substitute. Sone of these new businesses may be operated from home. Finally, the COVID health risk gap and its impact on attitudes towards the workplace might increase union organization efforts. In the short term, the labor shortage will prolong inefficient supply chain operations at their many steps. Longer-term, broadening labor supply to fill specific job needs will require rethinking by American businesses.

Profit Margins Could Suffer If Producer Costs Continue to Increase Faster Than Consumer Prices—a Particular Problem for Consumer Package Companies—Pricing and Market Power Will Prove Key to Protecting Margins

Figure 9 shows producer cost inputs rising faster than consumer prices. If the ‘70s repeats itself, consumer package product companies and other consumer-facing producers will likely experience profit margin pressures. The ultimate profit margin protection will be their pricing power from brand awareness, market share, and operating efficiencies. Similar to the big box retailers, the dominant package good producers chartered container ships to speed up imports of their products and supplies. Competitors without that capability will likely face eroding profit margins or market shares and most likely both. Once again, post-pandemic, bigs will get bigger while smalls will likely disappear.

Figure 9
Month Over Month CPI and PPI Price Increases (% Change)

Potential 2022 Changes in Fed Membership Could Affect Speed of Hiking Funds Rate — If Inflation Runs Hotter, a Fed Funds Rate Increase Will Likely Happen Sooner

With rising concerns about inflation, futures markets exhibit a high probability that two Fed funds rate increases seem likely in 2022 (see Figure 10). Potential changes in Federal reserve board membership next year might make that forecast less likely. President Biden will shortly determine whether to reappoint Fed chair Powell — or not. The President will also nominate two new vice-chairs plus a replacement to fill an empty seat on the seven-member Fed board of governors. In addition, two recently resigned regional Fed bank presidents will be replaced by their local boards. In appointing new board members, the President will likely emphasize a more diverse dovish board. More dovish board members will likely bring greater focus on social and climate change issues. They would also likely push Fed funds rate hikes further out than current board members and futures markets expect. No doubt, higher inflation than the Fed currently expects might force their hand and raise rates sooner. If two Fed funds rate increases occur next year, as future markets suggest, that would likely shock the markets.

Figure 10
Market-Based Probability of Two Rate Hikes in 2022 (%)

 

Investment Conclusions

Fixed Income and Alternatives — In our view, inflation will likely prove higher and last longer than the Fed expects. Therefore, the Fed’s “largely transitory inflation” may prove to be transitory as well. Nonetheless, interest rates will remain historically low for some time, 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, fixed-income investments remain unattractive with low nominal and negative real interest rates and should only be used to protect capital. Investors should primarily focus on a diversified group of alternative investments for that portion of the portfolio historically committed to fixed-income securities.

Mini-Cyclical Rally — The delta variant slowed third-quarter economic expansion, but its influence will likely diminish as vaccines, and importantly booster shots seem ready to provide appropriate protection. Such protection will enable consumers to prudently go on about their lives. Sizeable untapped consumer savings and growing employment levels will help increase economic growth. As the variant becomes less of a factor, inventory rebuilding will likely speed up if, and a big if, supply chain bottlenecks can begin to open up. Inventory rebuilding would then add to economic growth. As the economy regains momentum in this quarter — experiencing mini-cyclical growth – so-called value/cyclical stocks will likely benefit. Beyond that period, with a more cautious economic outlook, quality stocks will likely pick up market leadership.