(AAMA) What happened to the right side of the “V”?
Since the dawn of the pandemic-induced economic shutdown, we’ve heard about and hoped for a sharp and steadfast recovery. The pain was supposed to be short lived—a brief, yet steep economic decline followed by an equally swift rebound.
While the recovery was in fact the fastest in our history, newly released economic data seems to suggest the “V” is losing momentum.
From a persistently variating virus to lingering supply-side disruptions, we seem to be running into a kink in the final stages of economic recovery; challenges that will be felt not just in the lives of every American, but also in the portfolios of every investor.
Here’s our review of the deteriorating economic backdrop in which advisors and their clients find themselves today (read to the end for a summary of what this means for your investors).
What's Pulling GDP Expectations Down?
At the time of this writing, third quarter GDP forecasts are at 3.6%1, significantly lower than initial expectations and nearly half that 2021’s first two quarters.
What’s pulling the GDP forecast down? There are a number of contributing factors that we can roll into two main categories:
1) Lower Consumption – First and foremost, consumption is slowing down. The Delta variant has filled our headlines and our hospital beds, and fears are weighing down retail spending. We now expect consumption for the 3rd quarter to be somewhere between 2-3% on an annualized basis, significantly lower than originally projected.
Retail sales were up 0.7% in August2, which actually beat expectations. Most headlines have held fast to that positive note, but it really does not tell the whole story. The resurgence of coronavirus concerns drove down in-store spending and stalled the already fragile restaurant and bar recovery. Auto sales also collapsed (-3.6%) amid continued supply shortages. Remember that retail sales are not adjusted for inflation. If they were, unit sales would indicate a more significant decline. A dollar of sales at gas stations today indicates 20% fewer gallons purchased than a dollar of sales one year ago.
Additionally, July retail sales were initially reported at 1% month-over-month decline. That number was revised in August to a 1.8% decline2.
The increase in August looks less rosy in the proper context. And consumers can feel it.
The Michigan Survey of Consumer Expectations came in at 65.1 in August. That’s down more than 17% from July, and only marginally higher than August of 2020 (in the heart of the pandemic). Meanwhile, consumer expectations regarding future inflation spiked to 4.7% – the highest level since 2008.
2) Reduced Stimulus – While the government continues to purchase Treasuries and Mortgage Securities, the third quarter marks the end of multiple stimulus programs. Any boost in consumer spending that was achieved through these multiple efforts is likely behind us. Many of the moratoriums enacted during the pandemic (student debt repayment, evictions, etc.) are also set to expire, which would further dampen consumption.
What's The Story Behind Inflation - Transitory Or Cyclical?
As we expected, inflation moderated somewhat in August, with CPI up 0.3% month over month3. This supports the Fed narrative that the second quarter spike was transitory. However, we feel that we are entering a new era of cyclical inflation that will be higher than the historical lows of recent decades.
Why?
Inflation will be driven by a combination of supply-side shortages and pricing pressures driven by rising wage costs due to widespread labor shortages.
On the supply-side, things are pretty cut and dry. We’re seeing significantly higher prices in certain segments market of the market, with demand outpacing supply. Supply chain disruptions due to the Delta variant are continuing, and transportation costs are crippling.
The cost of a new car has risen 7.6% over the last 12 months (real inflation is likely higher, but hedonic adjustments are used to offset rises in price with increases in technology / value)4. Auto manufacturers are facing massive bottlenecks from chip shortages. There simply isn’t enough inventory to meet demand. And inflation expectations are only spurring consumers to grab what they can now, further stressing the market and accelerating inflation.
We’re seeing similar stress in the oil and gas market. OPEC has ratcheted back production, sending prices at the pump higher and higher. The national average for a gallon of gas was $3.14 at the end of August. That’s up nearly a dollar from the year previous. Natural gas prices have climbed nearly 40% in the last month alone5.
Let’s also take a closer look at the Housing market.
We saw the price of lumber skyrocket in 2020. There simply wasn’t enough supply to meet the demand. But that’s not the case anymore (for the most part). Lumber is still elevated, but not nearly as much as it was. But the cost to build a house is still significantly elevated. The high cost is driven by three main factors: elevated demand, lack of supply, and labor shortages.
In fact, the average price to buy a new house in July of 2020 was $329,800. One year later, that price has increased to an all time high of $390,500—more than 18% higher6.
There are 10 million unemployed Americans today. We expect to see an improvement in the employment landscape as enhanced benefits expire. But the realty is we are likely facing a higher “natural” unemployment rate. The pandemic shutdown might have driven a large swath of Baby Boomers to early retirement. When the economy shuts down and you’re near the end of your work life, it’s not a stretch to think that many workers simply “hung it up” early.
We also saw a much broader demographic enter the realm of unemployment. We could see a permanent departure from the labor market for those that are having their needs met in unemployment, or who have expectations of continued protection through expanded government programs. Only time will reveal the true nature of unemployment, post pandemic.
What Do These Economic Challenges Mean For Advisors And Investors?
Oddly enough, less economic optimism is probably good news for the markets, at least in the short term.
Economic challenges give the Fed reason to delay tapering, which means the market will continue to enjoy the benefits of synthetic liquidity and low interest rates.
But the reality is the Fed can’t keep pumping the system full money. And though the economy isn’t booming like we’d hoped, the case for continued stimulus is waning.
Consequently, we find ourselves in an odd situation. Inflation is high and the bond market is full of risk, which would typically push investors toward equities. However, equities face their own risk from rising rates. Equities are also generally overvalued (and behaving as such).
In line with our sector valuation work, we feel the inflation environment and prospects for tapering bode best for companies with inelastic demand and pricing power.
We’ve touted the relative attractiveness of Healthcare recently, and that aligns with the overarching economic conditions as well. Healthcare demand is relatively inelastic and is less overvalued than most other sectors today.
Additionally, Materials looks relatively attractive from a value standpoint, with improving earnings projections supported by high demand.
On the flip side, we feel Financials face uncertainty at the moment. Reduced loan demand has reduced the prospects for earnings growth in the sector. While a rising rate environment would improve earnings growth, the financial sector faces unique political and regulatory challenges that should be monitored. We’ll remain underweighted here until analyst forecasts for earnings growth materialize (likely over multiple quarters).
On the fixed income side, we feel the risk needed to produce outsize yields is simply too high. We are approaching fixed income more as a risk management lever than a contributor to portfolio returns. That means we’re seeking short duration and high quality bonds.
In Summary
The V-shaped recovery might not be panning out as many hoped, but that doesn’t mean we can’t find value in the market and make wise decisions—rooted in black and white statistics of market pricing and sector valuation—to guide clients along the way. We’ll continue to keep a watchful eye on the markets and the economy, providing regular updates to keep you informed as economic developments unfold.
Want to learn more about fundamental market pricing and sector valuation strategies? Click here to contact us today. We’d love to discuss your portfolios and clients’ investment goals.
