History Shows Virus Impact Greater After the First Year — Global Variant Snarls Supply Chains — Slows Inventory Rebuild — Inflationary Impact — Consumer Caution Slows Service Industry Return — Impacts Employment Growth — Variant May Delay Fed Tapering or Slow Its Rollout

Delta Variant Increases Inflationary Pressures—Supply Chains Snarled

Most recently, the growing spread of the COVID-19 Delta Variant forced China to curtail cargo operations at both air and container ports. According to ship operators, global supply chains could remain snarled and not clear up until the first of the year, with the obvious impact on global growth (see Figure 1). With increased supply chain bottlenecks, freight costs skyrocketed – ultimately leading to increased inflationary pressures (see Figure 2). Longer-term this will likely lead to less commitment to just-in-time manufacturing and therefore resulting in increased inventories and working capital costs—inflationary.

Figure 1

Container Shipping Disruption

Number of Ships Waiting for Berth at Port, As of August 13

Figure 2

Delivery Time and Baltic Dry Index (BDI)

Source: SkyView Investment Advisors — Nick Dai — Federal Reserve Data

History Shows Global Pandemics Biggest Impact in the Following Years

Unfortunately, the deadliest periods for a global pandemic come in the following years, not the first (see Figure 3). Based on this history, supply chains may experience more unpredictable delays and stoppages in the next one-two years. Therefore, supply chains and their associated businesses outside the U.S. will likely suffer whenever the virus reappears. In contrast, in this country, the periodic introduction of booster shots should continue to control the seriousness of any further outbreak. The experience with uncertain global supply chains will likely speed up the development of regional supply chains to serve developed markets. Conversely, the likelihood of a lengthy pandemic/endemic should benefit those firms providing protection and treatment against the virus.

Figure 3

Global Pandemics — History

Eye on Inventories – Key to Transitory Inflation Length

As the virus spread early in 2020, businesses sharply shaved their inventories (see Figure 4). Then a series of massive Federal pandemic stimulus programs produced an explosion of consumer spending beginning in late spring 2020. When consumer demand exploded, greatly reduced inventories could not meet demand — remember the toilet paper shortage. This resulted in higher prices/inflation, which the Fed now expects to be transitory.

Figure 4

U.S. Business Inventories-to-Sales Ratio

Source: Oxford Economics/Haver Analytics, Daily Shot

Delayed Inventory Rebuilding – Economic Momentum May Carry Further Into 2022 — Then Overstuff Fed Inventories — Reverse Supply Chain Backup Could Result

The current global supply chain bottlenecks created by the spreading Delta Variant will likely delay inventory rebuilding. That delay could lengthen the period of transitory inflation for selective products. The possible longer period of inventory rebuilding would also carry the economic expansion further into 2022 — albeit at a slower growth rate. Later next year, rebuilding will inevitably lead to overstuffed Fed inventories as end-users, desperate for products, doubled and tripled orders using other than their normal suppliers. The result could produce a reverse supply chain backup. The effect would force manufacturers to cut back production. With excess inventories likely later next year, more of the growing end demand will be supplied out of inventories rather than production. That possible shift would result in lowered GDP forecasts sometime later in 2022.

Producer Price Inflation Greater Than Consumer Price Inflation — Margin Pressure Could Result – Advantage to Price Leaders

Inflation, transitory — or not,  still remains an open question. The most recent Consumer Price Index (CPI) showed a high level of inflation but lower than the prior month (see Figure 5). At the same time, the Producer Price Index (PPI) hit a multi-year high (see Figure 6). With consumer price inflation moderating at the same time producer price inputs reach new highs, a profit margin squeeze could result. In that circumstance, those businesses with price leadership will dominate their weaker competitors. In selected sectors, lacking the ability to differentiate their products or services, a commodity like pricing then results, and margins would suffer. At the same time, lower-priced products — store brands — could grab market share.

Figure 5

Consumer Price Index — All Items — Urban Consumers (1/21-7/21)

Source: U.S. Bureau of Labor Statistics — Fred.Stlouisfed.Org

Figure 6

U.S. Producer Price Index (PPI) M/M

Inflation Expectations Affects Timing of Fed Funds Rate Increase

The Fed seeks to anchor inflation expectations (see Figure 7) around its 2% average inflation target. Rising gasoline prices heavily impacted recent consumer inflation expectations. Goldman Sachs's economic research recently indicated a high correlation between gasoline prices and the University of Michigan Consumer Inflation Expectations survey. If the recent decline in oil prices carries over to gasoline pricing, it will likely lead to a pullback and help anchor consumer inflation expectations. That outcome would likely push back the timing of a Fed funds rate increase.

Figure 7

University of Michigan Consumer Survey 5-10 Yr. Inflation Expectations

Delta Variant—Increased Consumer Caution—Likely Delaying Service Industry Recovery—Pushing Back Employment Growth

The spreading Delta Variant in the U.S. will, at the margin, increase consumer caution (see Figure 8). That caution will likely dampen the service industry recovery — roughly two-thirds of the U.S. economy. The service industry growth will prove key to the future momentum of the economy, particularly for employment. Similar to the slower inventory recovery, delayed but continued service industry growth could extend the economic recovery further into 2022. Considering these possibilities, economists recently lowered their forecasts for the upcoming quarters in 2021 but made few adjustments to their 2022 forecasts. More specifically, Bloomberg consensus economic forecasts showed a recent decline for 2021 U.S. GDP growth from 6.5% to 6.2%. At the same time, consensus GDP forecasts for 2022 increased slightly to 4.3%. The unpredictability of virus outbreaks next year will likely lead to greater volatility for 2022 economic forecasts as the year progresses.

Figure 8

Share of Respondents Comfortable Going Out

Source: Morning Consult

Powell Speaks this Week – Investors Will Debate His Words

This week the Federal reserve bank of Kansas City’s symposium on important issues facing the U.S. and world economies convenes virtually. Jay Powell, chair of the Fed, will speak at this year’s symposium. Investors will listen closely to nuances in his speech concerning adjustments to the Fed’s asset purchase programs — tapering. Currently, the Fed purchases $120 billion monthly of treasury debt ($80 billion) and mortgage back securities ($40 billion). Figure 9 shows the rapid increase during the latest purchase programs compared to past programs. Tapering could lead to reversing downward trends of real interest rates. If that reversal occurs, it could prove a negative for real assets such as real estate.

Figure 9

Federal Reserve Asset Holdings

Source: Federal Reserve Via St. Louis Fed, The Wall Street Journal

Fed Tapering—When? How Fast?

The recently released July Federal Open Market Committee (FOMC) minutes showed that: “all participants assessed that the economy had made progress toward the committee’s maximum-employment and price-stability goals.” Therefore: “it could be appropriate to start reducing the pace of asset purchases this year.” Reduced asset purchases cannot be implemented until a month after the Fed’s announcement. Therefore, November would be the last meeting month to announce such a change this year. The committee also made it clear that the “standards” for tapering differ from those determining when to raise the Fed funds rate. With the recent economic caution resulting from the spread of the Delta Variant, year-end goals for tapering may be pushed back. A second option would be to taper at a slower pace. That slower pace would likely push further out a Fed funds rate increase.

Investment Conclusions

Increased Market VolatilityInvestors face the last part of 2021 with growing question marks. These include the economic impact from the Delta Variant, a potentially less accommodative monetary policy, greater volatility for the 2022 economic outlook, and higher tax rates that could diminish next year’s corporate earnings outlook. This will likely produce greater market volatility between now and year-end than recently experienced.

Min-Cyclical RallyThe Delta Variant will likely slow economic expansion near term, but its influence will likely diminish as vaccines, and importantly booster shots seem ready to provide appropriate protection. Such protection will enable consumers to prudently go on about their lives. Sizeable untapped consumer savings and growing employment levels will help drive the economic expansion further. As the variant becomes less of a factor, inventory rebuilding will likely speed up again as supply chain bottlenecks begin to open up. Later in the year, as the economy regains greater momentum—experiencing a mini-cyclical expansion---stocks in that category should positively respond.

The “New Century”—Increased Productivity Key In the past, we labeled the post-COVID period the “New Century.” We did so because we expect businesses will exploit new technologies and systems that came forth during the pandemic. The opportunities include but not limited to information and bio/pharma technologies. To stimulate future economic growth, using these tools to improve overall economic productivity will prove critical to offset historically low workforce growth.

Fixed Income and AlternativesInterest rates will likely continue to remain low for some time—no matter whether moving up or down. With little current income, fixed-income investments should be used to protect capital. Therefore, that portion of the portfolio, historically committed to fixed income securities, should primarily be directed towards a diversified group of alternative investments.