“Leaving Normal… Heading for Who Knows Where”

Coupe Driving on Country Road in Vintage Sports Car
November 19, 2021

Weekly Summary: November 15 – 19, 2021


Key Observations:

  1. Rebounding economies accompanied by persistent inflation and high levels of employment lead us to believe that we are “leaving” the most recent state of a global “normal” characterized by slowing growth, persistent inflation and lower levels of employment.
  2. We are encouraged that robust economic growth will be durable well into next year due to many factors. These factors include: signs of easing supply chains, need to rebuild inventories, strong underlying U.S. housing demand, strong underlying demand for goods and services, strong upward trajectory for capex.
  3. We are convinced that inflation will be persistent well into next year and maybe beyond, at least partly due to some potential structural changes.

The Upshot: Although recent increases in COVID-19 infections – most notable in Europe – are of great concern, we suppose that vaccination rates will prove to be high enough to lessen dramatically the probability of general lockdowns and substantially lower mobility. Hospitalization rates also have been increasing, but at lower rates than those experienced pre-vaccines. Lockdowns become increasingly likely to the extent hospitalization rates begin to strain a hospital’s resources, especially their intensive care unit beds. The expected approval of “COVID-19 pills” developed by Merck and Pfizer could reduce even further the negative effects of increased infection rates. We expect that these worrisome trends will not be able to derail significantly projected robust economic growth.


You Call this Normal?

We suspect the Cowboy Junkies got it right: once you are “leaving normal,” you’re “heading for who knows where.” We are arbitrarily defining “normal” as anything that lasts for at least one year. For more than this past year, the world has lived through pandemics, supply chain constraints and/or disruptions which have led to higher inflation rates and eventually slower economic growth rates, longer delivery times, very strong consumer demand for various goods, weak demand for services, very easy monetary policy from many major central banks, and the list goes on. Unfortunately, this has become the world’s current version of what’s normal. It is our contention that people adapt to new circumstances to the point of developing a new sense of normal. Once habits or expectations form, they can become entrenched. Perhaps the most worrisome set of expectations is the anticipation of increasing inflation. Central bankers especially are wary of such expectations becoming entrenched. It is generally accepted by economists that, once entrenched, these expectations have a tendency to increase actual inflation as consumers change their behavior.


Rebound in Economic Growth

We are of the opinion that the world has already begun ‘leaving [this new] normal.” The most evident sign of this nascent new direction is the confidence that economic growth rates seems to be on the rebound. Announced this week, both the stronger-than-expected U.S. October retail sales data and the surprisingly strong October industrial production increased the confidence level of the economists at J.P. Morgan (JPM) and Goldman Sachs (GS). This recent data was sufficiently strong for JPM and GS to raise their Q4 U.S. GDP forecasts. According to their respective reports from November 16, JPM raised its GDP growth forecast from a previous estimate of 4.0% to a growth rate of 5.0% quarter-over-quarter and GS revised its own estimate from 4.5% to 5.0%. However, we should note that the October retail data is not adjusted for inflation. This means that the unit volume of retail sales was probably much lower than the headline would suggest. Moreover, at least some holiday sales were pulled forward, most likely due to the well-publicized fear of insufficient product inventories due to supply shortages and constraints.



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Source: Citi, US Economics – Retail sales show goods demand strong as prices rise (11/16/2021)



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Source: Citi, US Economics – Industrial production rebounds after hurricane drag (11/16/2021)


Consumers Spend

But, in spite of the supposed decline in consumer sentiment to its lowest level in a decade as we outlined in last weeks’ commentary, consumers still were willing to spend. Online sales were especially strong. Citing Bank of America data, a November 16 CNBC report revealed strong U.S. consumer spending. The data showed that October debt and credit card outlays were about 27% higher than they were two years prior in October 2019. Instead of looking at October 2020, the evaluation against a comparable pre-pandemic period two years ago is probably more relevant in this case.


Signs of Easing Supply Chain Constraints

Another very powerful sign that economic growth rates are rebounding are encouraging signs that supply constraints are easing. According to JPM on November 17, the Los Angeles Port chief indicated that the number of containers sitting on docs had declined by 29%, and that freight rates from Shanghai to LA were significantly lower as well. The Baltic Dry Index referred to in last week’s letter showed an even greater decline. Probably the most publicized and dramatic supply chain shortage was that of semiconductors needed in the production of motor vehicles. The recent loosening of COVID-19 related restrictions in Southeast Asia undoubtedly helped ease this shortage. The wider availability of semiconductors enabled U.S. auto manufacturing to propel to an 11% increase in October, which in turn contributed to the strong October industrial production data. According to a GS November 16 report, these latest auto production levels were the highest since July, but still about 6.5% below January 2021 levels.


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Source: Goldman Sachs, Introducing the GS Supply Chain Congestion Scale: Week 1 (11/15/2021)


Need to Rebuild Inventories

Our confidence in a global economic rebound beginning in Q4 is buttressed by the need to rebuild inventory levels. The Federal Reserve Bank of St. Louis shows that the inventory-to-sales ratio for business inventories was 1.26 at the end of September 2021. The pre-pandemic level in both January and February 2020 was 1.42, and the ratio was at the 1.35 level in September 2020. We postulate that before the pandemic many companies operated under a “just-in-time” inventory policy, which requires the leanest possible inventory levels. However, in light of their recent experience, we imagine that many companies might now even choose to carry excess inventory whenever possible. This should help enhance economic growth well into next year. Upward deviations from just-in-time inventory policies would be more expensive and could become a structural increase in inflationary pressures. We have cited many surveys in our previous weekly commentaries where firms expressed their dissatisfaction with carrying lower-than-wanted inventory levels due to materials shortages and supply chain issues.


Housing as a Source of Future U.S. Economic Growth

The U.S. Commerce Department’s release this week of lower-than-expected housing starts for October was accompanied by a better-than-expected building permits increase. These reports further encouraged our conviction of strong underlying demand for housing. CNBC reported on November 16 that building was hampered by shortages of materials, as well as land and labor scarcity. Once again, supply chain issues were constraining economic growth. The demand side of the equation remained vigorous. It is well known that increasing housing activity enhances economic growth prospects in general.


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Source: Citi, US Homebuilding – Single-Family Rental – How Excited (Nervous?) Should Homebuilder Investors Be? (11/19/2021)


Capex as a Driver of Economic Growth

But perhaps the most important factor in our optimism for robust global economic growth is our faith that capital expenditures (capex) should continue to grow for the foreseeable future. According to a Morgan Stanley report from November 14, the recovery in U.S. investment spending has been the fastest since the 1940’s. This has been in sharp contrast to the relative dearth of capex spending in the decade leading to 2020.The focus of this U.S. capex has been on equipment spending and intellectual property. Europe, U.K. and Japan appear to be laggards in their recovery of capex. In China, stronger infrastructure and manufacturing capex is expected to offset at least partially slower property activity. We share Morgan Stanley’s assumption that a capex-led economic recovery could be very durable – especially if the new capex leads to technological advances that would improve productivity. The biggest expected push in capex is expected from efforts related to the world’s decarbonization efforts. On November 17, GS revealed that its analysts expected close to $60 trillion of capex globally on “green” technology by 2050, which is significantly higher than approximately $3.5 trillion of Chinese capex investments in 2000s.



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Source: Goldman Sachs, Global Equity Strategy – 2022 Outlook: Getting Real (11/17/2021)



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Source: Morgan Stanley, Sustainability in 2022: Broader Thematics (11/16/2021)


U.S. Economic Data Confirms Growth

Virtually all of the U.S. economic data released this week was very reflective of robust economic growth. Both the Empire State Manufacturing survey released by the Federal Reserve Bank of New York and a similar survey conducted by the Federal Reserve Bank of Philadelphia were especially noteworthy in this regard. Both surveys compiled early-November data from manufacturing executives in their respective areas, and both handily beat expectations of business activity in their districts.


What about Inflation? Pricing Power?

In spite of a robust global economy, we still expect inflation to be rather persistent and at elevated levels. Many companies’ new-found pricing power could become a permanent fixture and could add to inflationary pressures. This week, the U.S. equity market showed what can happen when a company does not fully utilize its pricing power to protect and/or enhance its profit margins. Even though Walmart and Target exceeded earnings and revenue expectations, they both traded lower when it became evident that these companies tried to preserve their value orientation on behalf of their customers, instead of more fully preserving their profit margins. Selective stock picking anyone?

Although supply chain constraints have eased somewhat, they still persist. We are generally encouraged by the trajectory of the resolution of supply chain issues, but persistent risks remain.


Recent Rise in COVID-19 Infections Could Slow Growth and Raise Inflation

The rise in COVID-19 infections continues to be a concern. Particularly troublesome is the recent rise in European infections. A November 19 CNBC story indicated that Austria, with only 65% of its populace vaccinated, has announced a nationwide lockdown effective November 22. The lockdown could last a maximum of 20 days but would be re-evaluated after ten days. Austria is the first European country to announce a nationwide lockdown since the spring. It is also the first European country to mandate vaccinations, which will be required as of February 1. Austria’s “original plan was to place unvaccinated people under lockdown once coronavirus patients occupied 30% of ICU beds in hospitals – a move that came into force on Monday.” Germany, with 70% of its population having received at least a first vaccination shot, recently experienced its highest rate of infections during the entire pandemic. On November 18, GS compared this rate to the U.S. rate of 68% for first shots. Hospitalization rates also have started to increase. Chancellor Merkel was quoted by the BBC on November 18: “We need to quickly put a break on the exponential rise” in coronavirus cases and intensive care occupancy. Germany has already imposed restrictions on its unvaccinated populace. It has hinted that restrictions could increase further. Likewise, many other European countries have recently imposed new restrictions, often targeting the unvaccinated. The U.S. rate of infections has started to increase recently as well. It is notable that the U.S. vaccination rates are lower than in Germany. The U.S. tends to lag Europe in its coronavirus trends.


Vaccines and Forthcoming COVID-19 Pills Should Mitigate Effects of Rising Infection Rates

The prevalence of vaccines in many parts of the world has mitigated the probability of wide-spread lockdowns that would restrict mobility, curtail services spending and further disrupt supply chains. The pharmaceutical companies Pfizer and Merck recently announced they developed “COVID-19 pills” that are meant to treat patients who are already sick with the virus. The U.S. Food and Drug Administration is currently reviewing both drugs. CNBC reported on November 17 that the U.K. already approved the use of Merck’s drug on November 4. It is even possible that one or both of these drugs could be approved in the U.S. before year end. Dr. Griffin, an infectious disease doctor at the Columbia University Medical center stated, “All the excitement around these medications is warranted.” To a large degree, these pills would put the pandemic behind us. One note of caution – both drugs’ trials were conducted on unvaccinated people, who are roughly 29 times more likely to be hospitalized when compared to fully vaccinated people.


Lingering Supply Constraints

As we have previously discussed in our weekly commentaries, energy shortages and interruptions could cause supply disruptions at any time, but especially during the winter months. A relatively cold winter might amplify these effects. It appears that the tight U.S. labor market could be a major constraint for supply chains as the U.S. Labor participation rates remain stubbornly below pre-pandemic levels by approximately 1.7%. The open question remains whether this is a more permanent structural change in the U.S. employment profile.


Possible Structural Changes? More Persistent Inflation

Our weekly commentaries have stressed that high wage increases, robust shelter costs, and increasing inflation expectations all could cause inflation to be more persistent at elevated levels. Very strong demand has also played a large role in goods inflation. JPM observed on November 15 that spending on goods was more than $700 billion above pre-pandemic trends, while spending on services remained $300 billion below trend. These demand discrepancies led to an 8% rate of inflation for goods and a 3% prices increase for service. This “excess” demand for goods further strained supply chains. Many economists expected that goods demand would diminish as economies opened. But goods demand remains strong. Could this be another structural change that would add to inflationary pressure? Yet another possible structural change that we assume will have a permanent upward pressure on inflation is that companies should be more inclined to consider the resiliency of their supply chains. At the margin, we posit that this added consideration will result in increased supply chains costs when based on many factors other than costs.


Transition to Renewable Energy = More Persistent Inflation

We saved for last a discussion about what we think will be the most obvious cause of future higher and more persistent sources of inflation. Strangely enough this is rarely mentioned in discussions of whether inflation will be “transitory.” We believe that the transition from fossil-based sources of energy and electricity will be “messy,” unpredictable and expensive. We have little doubt that these inflationary forces will persist for many years. The anticipated more severe weather patterns due to climate change will only add to inflationary pressures as they will affect supply chains sporadically. The well-publicized under-investment in fossil-fuel energy will be another inflation-prone factor. The pandemic has highlighted this influencer of a more structural and persistent source of inflation.


Bottom Line

In our opinion, most central bankers have been reluctant to rein in their very easy monetary policies for fear of halting their economies’ growth rates, which often lost momentum in Q3. They generally chose to assume that most of the factors that led to inflation were “transitory” in nature and so there was no need to “act.” We now believe that, as central banks become more able to share in our conviction of robust and rather durable economic growth, they will choose to revise their risk/reward assessment of inflation and the need to act sooner rather than later. If Powell remains as Federal Reserve (Fed) chair, we have little doubt that the Fed’s announced tapering schedule will be accelerated to enable interest rates to rise more quickly than generally anticipated. This assumes that the negative effects of rising coronavirus cases will be well contained. We expect that the recent dramatic rise in coronavirus infections will only act as a pause to robust economic growth going into 2022.

If our assumptions are correct, interest rates should continue higher – most likely on an irregular pattern. Interest rate volatility was especially on display this Friday as rates traded lower on headline news that European infection rates spiked higher. In general, such an environment should be beneficial especially for Value and Cyclical type stocks. But central banks acting too aggressively and raising interest rates at a pace in excess of financial market expectations could disrupt equity averages. We further chose to characterize the current equity environment as a “stock pickers’ market.”

We believe that financial markets are in a transition “heading for who knows where.” We have little doubt that during such periods, a great dose of humility would be helpful with a focus on individual stock picking and diversification. We continue to assume market volatility. It is our opinion that market volatility will be exacerbated if Lael Brainard is nominated as the next Fed chair.


Charts of Interest


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5y5y is the average inflation rate over a 5-year period starting in 5 years’ time, as implied by U.S. rates.
Source: Goldman Sachs, Global Equity Strategy – 2022 Outlook: Getting Real (11/17/2021)



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Source: Morgan Stanley, Sustainability in 2022: Broader Thematics (11/16/2021)


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Source: J.P. Morgan, US: IP jumps 1.6% in October as storm disruptions fade (11/16/2021)


November, 19 2021 ICE Formulas


KBW Nasdaq Bank Index (BKX): The KBW Bank Index is designed to track the performance of the leading banks and thrifts that are publicly-traded in the U.S. The Index includes 24 banking stocks representing the large U.S. national money centers, regional banks and thrift institutions.

MSCI EM Value Index: The MSCI Emerging Markets Value Index captures large and mid cap securities exhibiting overall value style characteristics across 27 Emerging Markets (EM) countries.

MSCI EM Index: The MSCI Emerging Markets Index captures large and mid cap representation across 27 Emerging Markets (EM) countries.

NASDAQ: The Nasdaq Composite Index is the market capitalization-weighted index of over 2,500 common equities listed on the Nasdaq stock exchange.

PCE: Personal Consumption Expenditures (PCEs) refers to a measure of imputed household expenditures defined for a period of time.

Russell 1000 Growth: The Russell 1000 Growth Index measures the performance of the large-cap growth segment of the U.S. equity universe. It includes those Russell 1000 companies with higher price-to-book ratios and higher forecasted and historical growth values.

Russell 1000 Value: The Russell 1000 Value Index measures the performance of the large-cap value segment of the U.S. equity universe. It includes those Russell 1000 companies with lower price-to-book ratios and lower expected and historical growth rates.

S&P 500: The S&P 500 Index, or the Standard & Poor’s 500 Index, is a market-capitalization-weighted index of the 500 largest publicly-traded companies in the U.S.

VIX: The VIX Index is a calculation designed to produce a measure of constant, 30-day expected volatility of the U.S. stock market, derived from real-time, mid-quote prices of S&P 500® Index (SPX℠) call and put options.

Z-Score: A Z-score (also called a standard score) gives an idea of how far from the mean a data point is. It is a measure of how many standard deviations below or above the population mean a raw score is.



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