September Investment Comments
The economy is at a stage when comparisons to year-ago quarters frequently produce ridiculously high numbers because last spring and early summer were depressed. The same observation applies when reviewing results for companies. Increasingly, we compare 2021 figures to 2019 on a two-year “stacked” basis. We found it more productive to bridge over 2020 as problems last year were widespread, not representative, and generally not a company’s fault.
Many economic figures are reported on a year-over-year basis and must be understood in the context of the “base year” (the prior year against which current figures are being reported). Inflation appears to be running hot at the moment, with the Consumer Price Index (CPI) rising 5.4% in both July and June compared to the previous year. However, inflation ran well below the Federal Reserve Board’s 2% target last summer. On a two-year stacked basis, the CPI was up 3.2% (annualized) in July and 3.0% in June. This suggests increasing price pressure.
Other statistics are reported on a month-by-month or quarterly basis, sometimes annualized and sometimes not. Gross Domestic Product (GDP) is measured as the quarterly rate of growth, but annualized as if the same growth applied for four quarters. Quarterly measures like GDP growth aren’t exaggerated by comparisons to weak year-ago levels, but still are impacted by an outsized recovery from the deep hole we found ourselves in last spring. On an annualized basis, second quarter GDP grew 6.5% in the U.S. and we actually eclipsed the previous high level of GDP from the second quarter of 2019.
The 19 countries using the euro as their currency posted stronger growth in the second quarter, but lower on a stacked basis. Second quarter growth of 8.2% left eurozone economies slightly smaller than two years ago. Japan continues to struggle while China’s rebound has been the strongest of all major economies.
U.S. retail sales are typically reported as a percentage change from the previous month. With stimulus payments, shortages of many products, and consumers’ ability to purchase services again, the monthly variation in retail sales can be misleading. U.S. retail sales fell 1.1% in July, but rose at a 9% annualized rate on a two-year comparison. This is a drop from the 10% growth rate recorded in June compared to two years ago. Both figures are too strong to be sustained.
Unemployment is also a monthly figure, adjusted to smooth out typical seasonal patterns like a hiring surge preceding Christmas. Until July, huge job growth in recent months was mostly satisfied by a growing workforce such that the unemployment rate came down slowly. The unemployment rate in July was 5.4%, down 0.5 percentage points from June. Unfilled jobs reached 10.1 million, ironically greater than the 9.5 million people looking for work. Both data points support observations that employers are struggling to find workers.
The Delta variant of the SARS-COV2 is having an impact on the economy, but not like previous waves. The prevalence of vaccinations, especially among the elderly, seems to be protecting the most vulnerable. Hospitalization and death rates are lower as younger and healthier people seem to be less prone to the virus’s worst effects, although there is considerable regional variation. The stock and bond markets suggest little economic concern about the recent rise in infection rates.
If economic growth remains strong and prices stay elevated amidst shortages of labor and supplies, the Federal Reserve may need to reign in its ultra-accommodative monetary policy. While Fed Chairman Jerome Powell said in late July that the Fed was “a ways away from considering raising interest rates” and terms rate hikes as “something that is not on our radar screen now,” some Fed governors are starting to hedge their bets. Several have publicly observed that Fed criteria for raising rates is starting to be met. As a prelude to raising rates, the Fed would most likely reduce its $120 billion of monthly bond purchases on a gradual basis, known as “tapering.” Fed officials seem to be floating trial balloons of this nature to gauge market sentiment and avoid repeating the ”taper tantrum” when markets went into convulsions as the Fed reduced bond-buying in 2013.
Rising interest rates are an eventuality and a sign of good health that the economy can finally stand on its own again. However, bond markets will not be happy with the tapering of bond purchases and higher interest rates. The stock market typically doesn’t react well to repeated interest rate hikes either, but starting from zero gives quite a bit of room before higher rates are likely to harm the economy in the short run. Eventually, however, the Fed will take away the punch bowl and the party will come to a temporary end. That is how most economic expansions exhaust themselves and new ones begin. Historically, the stock market has anticipated the end of an economic cycle 6-9 months in advance. Given that interest rates have declined in recent months, we should not be anticipating an end to this economic cycle anytime soon.
Scott D. Horsburgh, CFA