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Second Quarter Outlook 2021

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Fed Reacts to Inflation Surprises

Little Confidence In Fed Inflation Forecasts Based on Past Record
While still expecting inflation to be transitory, the Fed recently moved its timing forward for potential rate increases. This shift reflects concerns, based on recent data, for potentially higher than expected inflation. Last year, the Fed moved to its Flexible Average Inflation Target (FAIT) of 2%. The policy shift reflected the Fed’s past inability to forecast future inflation. Those forecast errors led to proactive past policy mistakes. Based on the past record, there seems little reason to expect either the Fed or economists and financial markets to make more accurate future inflation forecasts. With that caveat, the resulting downward shift in the 10 YR/2 YR spread after the Fed’s hawkish statement suggests fixed income investors also still expect future inflation to remain tame.

Core CPI Understates Inflation

Faced By Consumers
The Fed’s “hawkish” move reflected the Consumer Price Core Index (CPI) upswing in May. The CPI upswing continued in June which – excluding food and energy – increased 4.5% over the last twelve months. In our view, that increase may understate the inflation that consumers face daily. Specifically, the CPI Headline Number which includes food and energy, increased faster – 5.4% – over the same period. This was the fastest rate since the 5.8% increase in August 2008.

Consumer Price Index

Surprise Increase, Wild Price Swings, Transitory
With low inventory levels (see Figure 4) and the economy reopening, end demand shot up as consumers spent some of their salted away savings. Resulting upward price swings created a short but wild ride for some product prices. Those will prove transitory.

Increased Inflation Expectations

Medium Term
The sense of rising prices also produced a sharp increase for one year inflation expectations in the University of Michigan’s Consumer Survey. If faster price momentum continues, then increased inflation expectations will likely transfer to both higher corporate pricing decisions and workers’ wage demands—both could prove more than transitory.

Low Inventories

Expanded Suppliers List Results in Over-ordering, Transitory
As product demand shoots up, with current low inventories, producers will face shortages of parts and components to meet their requirements. Computer chips represent the headline example. As a result, producers will do what they normally do – over-order – by seeking out secondary and tertiary parts suppliers. Prices shoot up in response. This will prove transitory, with some lag. As an example, lumber prices declined sharply from their recent highs.

Fed’s Transitory Inflation

Durable Goods Prices Pulling Back, Transitory
The Fed expects future inflationary increases, beyond its two percent average inflation target, will prove transitory. Its outlook rests on forecasts that the demand surge placed on barebone inventory levels coming out of the pandemic will ultimately be more than satisfied as inventories rebuild and then overbuild—timing uncertain. No doubt, prices will pull back as peak goods demand recedes in response to higher prices. As the tide of spending on goods gradually recedes, those naked to transitory price increases will be exposed. Will prices eventually pull back to their prior levels or will they retain some or all these increases? This will prove to be the true test for the Fed’s transitory price outlook

Over-ordering of Components

Results in Moderate GDP Growth Late Next Year, Medium Term
Probably sometime later this year or early next year, producers will likely reach the point of “over-stuffed”
inventories relative to their needs. Cancelled orders will follow. Component and parts prices will drop sharply. This will likely show up sometime later this year or in early 2022. With excess inventories, end demand then will be met by drawing down inventories rather than from production. At the macro level, meeting end demand out of inventory rather than from production will likely moderate GDP growth later next year. At the micro level, particularly for high tech components that obsolete quickly, investors will likely see inventory write-downs beginning at year-end 2022.

Services, Influenced By Wages

May Prove Important to Inflation Outlook Over the Next 18 Months
Services represent about two-thirds of GDP. With the service industry now opening up, pricing for this sector will likely prove more important, directly and indirectly, than durables to the inflation outlook over the next eighteen months. For many services, labor represents a much higher percentage of total costs than for manufacturing and industrials. Therefore, future service price movement will importantly reflect potential increased labor cost pressures—and more likely stickier than durables as wage increases also prove stickier.

Wages, Major Business Cost

Population Growth Slowing, Potential Cost Push Inflation, Long Term
Upward wage pressures may also result from diminished population growth facing this country – as well as many other major economies. The recent 2020 decennial census showed that the U.S. population grew 7.4% over the last decade; the second slowest growth rate ever, and roughly half the growth rate of the 1990s.

Slowing Labor Force Growth

Leads to Substitution of Productivity Tools, Long-Term
Economic growth simplistically reflects work force growth plus productivity improvement. With slowing labor force growth (see Figure 8), unless productivity increases faster than in the recent past, economic growth will likely slow past the COVID recovery. Potentially offsetting these concerns will likely be the accelerated use of technology and productivity tools. That trend could eventually lead to future productivity improvement, thereby boosting economic growth.

Increased Regionalization of Supply Chains

Inflationary, Long Term
The World Trade Organization admitted China in 2001. Since then, China exported low-cost labor to the world in the form of products. That change brought down long-term global inflation rates as well as wages. As a result of supply chain problems experienced during the pandemic, at the margin, producers will likely regionalize supply chains. Increasing costs from that shift could lead to stepped up long-term inflation trends globally.

Investment Conclusions

Equities
By the end of this year, assuming inflation remains within expectations, production and demand will likely be in greater balance resulting in declining cyclical momentum. As economic momentum slows, equity markets may show increased volatility later this year as the economic outlook for the second half of 2022 may show less clarity. With that, investors will likely look more favorably toward growth stocks. As part of that transition, investors should look beyond those growth stocks that benefitted them in the last decade. New sources of growth including broadly med/health tech, will likely appear in the “New Century” post the pandemic as old sources of growth ebb.

Fixed Income
The Fed’s most recent “hawkish” statements will likely lead it to speed up reducing its balance sheet and raising the funds rate. With that likelihood and an uncertain inflation outlook, investors should stick with shorter-term duration fixed income investments. This will avoid the price risks that longer-duration debt faces from potentially rising interest rates.

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