October Investment Comments
U.S. Covid statistics have lately shown a frustrating rebound. Total infections are running at about two-thirds the previous peak, with total deaths about half their previous peak. Overall, the curve appears to have leveled off since late August. Some public health officials have predicted that Covid will continue to recede, and climb, and recede in a series of progressively weaker echo waves. This could prove to be the crest of a significant wave.
Life is getting back to normal across the pond. The United Kingdom has been a world leader in achieving vaccine access and popular acceptance. The data we have seen argues that serious outcomes are very rare for vaccinated persons, and the UK’s numbers agree. A recent resurgence in cases has been accompanied by a much lower fatality rate compared to the United States. The UK’s health minister recently proclaimed that no more lockdowns are expected for this wave or future waves.
Probably owing to the recent Covid rebound and the exhaustion of stimulus checks, August’s employment report was a dud. Only 235,000 jobs were added, far short of estimates. The worst-performing industry was retail trade. The unemployment rate declined by 0.2% to 5.2%, but labor force participation was flat at 61.7% and remains more than 1% below its pre-Covid equilibrium. This is a huge gap, and we note those missing participants are not included in the unemployment numbers quoted above. It will be interesting to see whether the return of in-person schooling allows more parents to reenter the workforce, as virtual schooling was often blamed for the high rate of labor force dropouts.
GDP growth seems likely to follow the job market’s signal and decelerate substantially in Q3. After GDP increased 6.6% in Q2, Goldman Sachs was previously forecasting 6.2% in Q3 but recently cut that estimate to 5.7%. The Atlanta Federal Reserve had been forecasting more than 6%, but that estimate was walked all the way down to 3.7% before being suspended on the grounds that the model simply does not reflect current trends. You can drive a bus between Goldman’s 5.7% and the Atlanta Fed’s 3.7%. Has modeling ever been so difficult or the results so imprecise?
While our domestic economy is growing a little slower than desired, China may face a major challenge. Bankruptcy reportedly looms for Evergrande Group, a Chinese real estate developer with $300 billion of published liabilities. It is hard to imagine that Evergrande could default without causing major follow-on problems for its various creditors. Will they all take payment in unsold property? This is a rapidly evolving situation but one that we cannot let pass without comment. Expect more fireworks to come from the Evergrande case.
Turning our attention back to the U.S., in 2021 no Investment Comments can be complete without a study of recent inflation data. August’s Producer Price Index (PPI) increased 8.3% for the past twelve months, its fastest increase since annual data collection began in 2010. The Consumer Price Index (CPI) rose a more modest 5.3%, a little slower than July’s 5.4% increase. Core inflation was measured as “just” 4.0%. Monetary doves cheered the CPI release as evidence that inflation has peaked and will now recede.
There is reason for skepticism. That punchy PPI statistic corroborates what we are hearing from business executives on earnings calls—that cost inflation is a mounting problem squeezing margins. It is rare to hear an earnings call that does not mention pending measures to raise prices. In this respect we would expect the PPI to lead the CPI.
Then there is also the question of whether the fundamental data is accurate. Shelter costs represent about 40% of the core CPI statistic but are notoriously difficult to measure accurately. The CPI shows a 12-month shelter price increase of 2.8%. Meanwhile, the independent CoreLogic Home Price Index recently showed a 12-month increase of 18%. The two index methodologies are clearly as different as apples and oranges. We leave it up to the reader which is more appropriate.
We also need to read the inflation data in the context of the current economy, which we noted above looks a little tired at the moment. We would generally expect such disappointing economic data to correlate with lower levels of inflation. Less activity means less spending. The surest way for consumer prices to remain relatively tame is for the economic recovery to lose steam. We should not root for this outcome.
The Fed believes elevated inflation will prove transitory. This could have two different meanings. A sudden price increase followed by a quick decline would be transitory. Imagine transitory plywood and bottled water inflation before a hurricane. One could also stretch the idea of transitory inflation to describe a sudden jump followed by a long plateau. Item by item, this is what seems to be going on in the CPI. Call it popcorn inflation. First cars go pop. Then housing pops; then food pops; then energy pops. You wind up with a persistent, not transitory, path of inflation comprised of a string of sharp, transitory instances. The Fed may whiff embarrassingly on its prediction by any definition of the word.
We said above that the surest way to keep a lid on prices may be to throw cold water on the economy. From a certain perspective the Federal Reserve’s credibility over inflation may rely on the economy sputtering. This is one heck of an incentive problem.
Speaking of incentives, the Federal Reserve presumably wants to help keep the government funded, which helps explain its reluctance to stop printing dollars and buying debt. Congress is debating spending an additional $400 billion annually on new entitlements, green energy, and traditional infrastructure investments. The spending would be partly financed by tax increases on corporations and high earners. These revenue measures could slow the economic recovery. Even if the overall bill proved worthwhile in the long run, its costs might manifest quicker than its benefits.
What is an investor to do? Try to pay fair prices for assets that can more than keep up with inflation. Stocks have historically been a good inflation hedge. Many valuations look stretched, and stock prices could be doubly harmed by higher taxes along with lower multiples paid for the subsequent reduced earnings. Nonetheless we are finding some opportunities where it appears investors are already accounting for these risks.
Miles Putnam, CFA