Inflation: Demand creates its own supply

Rosenberg Research and Associates Founder and President David Rosenberg in The CBQ

The point has to be made that while we clearly have a stickier inflation situation on our hands, the entire story relates to the pandemic and the impact this has had on impeding the supply side of the economy. This is not a demand story one iota, which means that the Fed really is not at all well equipped to deal with this sort of inflation without driving the economy into recession.

We have a highly inelastic aggregate supply curve on our hands. In some industries, it can be argued that the supply curve has turned vertical in shape. What that means is that you don’t need incrementally strong demand to generate these wild increases in prices — even small moves can do the trick. For now, and the near-term, but not indefinitely. My view is that the supply curve will resume its normal shape of sloping upward from left to right on the price-output chart, even if we have to wait longer. But what I don’t see changing is the secular softness in demand, which was a principal feature of the 2009-2019 economic cycle.

The principal risk to my view is if the price action feeds in a broad-based manner into wages, and we embark on a wage-price spiral. A few headline contract disputes and strike action will have to broaden out to cause a shift — so far, many measures of wage growth are contained among the youth, uneducated and unskilled in some of the public-facing cyclical industries, like retail and leisure/hospitality.

Let’s look at the auto sector, which has been a poster child for this inflation surge. Production has plunged 25% in the past year and retail inventories have plunged 18%. At the same time, sales are down 20% and new orders have fallen 10%. Auto-buying intentions are down to four-decade lows. The story here is that as weak as demand has been, the supply shortage has dominated and as such we have a big inflation surge in this key sector. A case, again, of supply being weaker than demand. But demand is weak and that is a key point and when the supply does come back, demand is bound to lag behind and the price action will reverse. This is likely to be a theme in 2022 but not yet appreciated.

Of course, at the root of this supply situation is what has happened to global supply chains for key inputs, and particularly for semiconductors. But I am seeing an impressive supply response already taking place. Domestic production of micro processing chips has risen 9% from year-ago levels. The onshoring of production is already taking hold. And we also see that imports of electronic components from abroad are seeing a sharp rebound — finally — as they are up 23% on a year-over-year basis.

And let’s face it — if the chip shortage was some sort of long-lasting phenomenon, someone has to tell that to the sector stock index, which is hovering near all-time highs. You will not find this in the morning papers where inflation has reached a feverish pitch and is a key selling topic for the readership.

Meanwhile, for all the talk of a reversal in globalization, exports out of Singapore are up 23% YoY, up 19% in Korea, up 20% in Taiwan and up 24% in China. In fact, it is my contention that, with the property market in disarray and retail sales in a deep funk in China, the next big theme will be an export boom out of China because this will have to be the offsetting safety valve to prevent the economy there from slipping into recession. This will be another theme ahead — China again becoming export-dependent and this will actually be a deflationary force on the global economy. Again, who is writing about this?

We also see a similar situation in the energy market as with autos. Supply is being constrained and the only reason why OPEC+ has remained stringent is because it sees demand softening in the coming year. But as with autos, demand is below pre-pandemic levels across all segments — while real consumption has obviously rebounded from the 2020 lows, whether you look at gas usage volumes, miles driven or air travel, they are all significantly below pre-COVID-19 levels — which was a time when WTI was sitting at $53 per barrel, not $83 per barrel. If production wasn’t set to recover before too long, I doubt that we would be seeing the mid cap auto manufacturing stocks not just carving out a bottom but up nearly 10% so far in November (ditto for the small cap parts producers, which are up more than 9% month-to-date and are at all-time highs).

Food has been a big problem and, again, this is not due to demand. It is part transportation costs (and fuel for farmers) and part disrupted supply chains for food producers. But it is mainly the fact that violent climate shifts, such as droughts and floods in key food producing regions both within North America and abroad, have wreaked havoc with supplies. Demand for food tends to be very stable and people don’t shift their appetites this quickly. So the big food inflation in the CPI data reflects all this and with a lag from the prior surge in the commodity pits. But we have recently seen a thaw in the price action at the early farming stages and this too will filter next year into some much-needed relief. Food prices rose with a lag, and they will come down with a lag. Nothing here is permanent — any more than the doubling in agricultural prices in the mid-1930s with the “Dust Bowl.” In 1934 alone, that caused a massive 800-basis point swing up in the headline inflation rate! Somehow, when all was said and done, nobody seemed to recall that, because of a supply shock in the context of the Great Depression, we did have a two-year inflation shock to deal with. Those who believed the Fed would respond and bond yields would soar were surely disappointed.

Now for the housing aspect to this story. Yes, the dominant rental components, including OER, are filtering through with a lag. This will likely persist into 2022. But the Fed has never before reacted to this force within the inflation data, and I doubt that Powell (or whoever may replace him) will bother to respond to the rental influence on the data. The key, as I said before, is the extent to which all of what we are seeing will feed into wages. So far, let’s just say that wages have lagged behind prices in six of the past seven months, during which real work-based pay has contracted at nearly a 3% annual rate. We shall keep an eye on this since this is the area that would cause us to shift our view on inflation being “non-permanent.”

Again, the supply front is showing some verve. With the rental vacancy rate at a 35-year low of 5.8% and quoted rents running hot at +12.5% YoY (was +0.2% a year ago!), the real estate developers are springing into action. The story here is that it isn’t just demand — but until recently, new supply was dormant. So much so that apartment unit completions as of September were down 42% to their most depleted levels in two years!

But now we are seeing rental building permits up 16% YoY to their highest level in six years; multi-family starts have soared 38% YoY; and units under construction — and soon to hit the market — are up more than 6% and 714k units (the highest they have been in 45 years). To be sure, it takes 12-18 months (versus 7 months for single-family) for a high-rise building to morph from start to completion. But what lies around the bend, nonetheless, is a return to either a better balance in the rental market or a move back to excess supply. Whether it is a 2022 or 2023 story, the future is one of supply playing catch-up; and we will no longer be talking about rampant rental inflation in the CPI data.

David Rosenberg is the Founder and President of Rosenberg Research and Associates,

Prepare for a post-pandemic spending boom & bust

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If you ask anyone in the market why they are bullish for 2021, they will tell you right away that they see a light at the end of the Covid tunnel. And indeed, with the multiple vaccine news we have received since the beginning of November, there is a light. There may be many potholes, with the coronavirus cases, hospitalizations and fatalities on a disturbing upward trajectory, and a very tough winter staring us in the face, but there is a light that we can now all see. To have vaccines developed and now distributed in such volumes and with such tremendous efficacy levels, and done so quickly, does indeed make one tempted to believe in miracles we thought were only saved for the bible stories.

So what lies ahead for the coming year. A very rough first quarter for the economy. And then a better second quarter. And quite likely boom-like conditions in the second half of the year as substantial amounts of pent-up demand get released. You speak to most people, and the first thing they want to hear upon getting the jab are the words “please fasten your seatbelts”.  Travelling, mall browsing, bar hopping, eating out, dare I say, socializing, will be all the rage. It is called “pent-up demand” for a reason. And this will be the single dominating force driving the economy in 2021, barring any unforeseen setbacks (as in, not enough of a vaccine take-up to achieve the Holy Grail of herd immunity. No central bank will dare tighten monetary policy even if inflation rears its (pretty?) head and one can be reassured, especially in Canada with a federal government that would make Tommy Douglas blush, that the fiscal spigots will remain turned on in a major way. Interest rates, by hook or by crook, will not be allowed to rise as they have typically done in past aggressive economic recoveries. If you are a policymaker today, the last thing you will be doing is upsetting any apple carts.   

So the economic outlook for 2021 is perhaps the easiest one to make that I can recall in my 35 years in the forecasting business. There will be a post-pandemic spending boom. It’s only a matter of how big and what quarter it begins. That light, indeed, does shine bright. Much of this good news, as an aside, is priced into every global financial asset you can probably name.  Even the previously beaten-up airline, casino, retail and hotel stock you can think of has priced in the light at the end of the tunnel.    

But, you see, from a financial markets standpoint, just as the economy booms next spring and summer, even into the fall, investors will at some point in 2021 have to confront what life is going to be like once we get past the light. At some point next year, I guarantee everyone that just as the markets were soaring during the darkest of hours during the pandemic in 2020 because of the light they saw at the end of the tunnel, these same markets will be beyond that light even as we all go out and have fun again. That’s the thing about markets – they move earlier and more quickly than people do. 

All that said, I do think from an economic standpoint, there will be an economic recovery of epic proportions. But the recovery beyond the end of 2021 will be muted and frustratingly slow, and it could take at least three years before all the economic damage from the virus and the lockdowns are ultimately recouped. Then think of a future with massive public deficits, debts, and government intervention and regulation. Then we have to consider, when we get to the other side, how these massive central bank balance sheets will get dealt with. Will the debts get monetized or not? And a world of reduced globalization and more localized supply chains, an end to-just-in-time inventories, and what the future holds for taxation. I don’t know about you folks, but it is crystal clear to me that in this period of heightened uncertainty, it will be capital, and not labor, that defrays the cost of the rescue packages, and that means higher tax rates on capital gains and corporate income. The current surge in the deficit is not about shovels in the ground with some hope of future multiplier effects on the economy – it is simply a transfer from some future taxpayer to today’s household and business who are out of work and for some reason had no cash, savings, or liquidity to get through even a few months of shutdown for public health purposes. 

What the world looks like when the crisis ends is truly anyone’s guess but I will say with 100% clarity that it is going to look a lot different than it did before. Not just the question over government policy, but at the individual level, months of isolation and distancing, and fear of a return of the pandemic are going to fundamentally alter lifestyles, and will have a profound influence not just on the way we live but how we conduct ourselves in our personal and commercial lives. For example, working from home is certainly going to be a more dominant force even once we move beyond the light at the end of the tunnel, with obvious negative implications for commercial real estate but positive implications for internet infrastructure, computer hardware and video conferencing. There is going to be a sharp reduction in travel to work, travel in general, and this means fewer cars on the road, there is nothing here that is very good for the auto sector, and the future therefore is really clouded for office REITS and commercial real estate in the large densely populated urban areas. But there are some bullish themes that emerge too. As we  go into an era of elevated personal savings rates where people are going to focus on what they need, not what they want. This means to screen all of your equity exposure for “utility-like” characteristics – and that includes anything related to ecommerce, cloud services, delivery services and wiring up your home to become your new office. What lies beyond the light at the tunnel is a secular shift in economic behavior that took place during this grim period of history; shifts I believe are secular in nature, that tell me to focus on areas of the market, consumer staples, health care and even big tech, that have morphed into essentials. 

No doubt, the investment community is paying more for duration today than they ever have in history but since we can anticipate rates to stay low for years to come, this valuation driver becomes the dominant issue that will be driving the market and prospective returns. This is exactly why growth investing trounced value for much of the past decade, even before the pandemic. Ultimately, the growth-versus-value decision depends on what the world will look like once Covid-19 is in the rear-view mirror. But even with a vaccine, if we return to the pre-Covid world, when you think about it, it actually means a return to a slow-growth, low-interest-rate, and low-inflation world, which means growth will remain the place to be because they are the longest duration stocks in the equity market. For cyclicals and value stocks to work, you want faster economic growth, signs of inflation, and higher interest rates. There’s been a move recently into the value trade and it does make sense since these stocks are dirt cheap and deserve to be rerated positively for a post-pandemic world. But at the root, this is really just a mean reversion trade, and it may have more legs to it. But that is why it is referred to as the ‘value trade’ and not the ‘value trend’; for the same reasons value unperformed growth 80% of the time and by more than 3 percentage points per year during the 2009-2019 bull market expansion.

The major point I need to emphasize right out of the gates is that it can’t possibly be lost on anyone that what we had was a health crisis that morphed into an economic crisis and then somehow managed to morph into a financial crisis that was ten times worse than anything we saw in the Great Financial Crisis and forced the Fed and the Bank of Canada to probe the outer limits of monetary intervention. We simply refuse to stop these cycles of redressing debt crises by adding more debt, which merely compounds the adverse effects from the recession that is inevitable, and yet at the peak of the cycle nobody ever seems to be prepared for one.

The vaccination process is no reason to believe we are not in some form of economic depression that has only been disguised by unprecedented policy stimulus. Just because your kid has training wheels doesn’t mean he (she) knows how to ride the bike. And we have an economy on our hands that could not survive without large-scale deficit finance and central banks suddenly acting like hedge fund managers. This is why it’s going to be a depression because what comes next is a secular change in attitudes towards credit and towards savings. I mean, seriously, over half of American households didn’t have enough cash on hand to even get through three months of a job loss — quite remarkable when you consider we went into this mess with a 50-year low unemployment rate of 3.5%. Not to mention the corporate sector where, for some reason, the word “liquidity” became a dirty nine-letter word this past cycle. Now every business has working capital they have to cover with a fraction of last year’s cash flow. And this got me thinking about how the future will be one of treating “savings” as sacrosanct.  Beyond the quarter or two of pent-up demand release in 2021, frugality is going to emerge as the primary theme. It’s not the end of the world, either, unless you’re an advocate for a sustainable and vigorous economic expansion.  

In a narrow view, the markets are telling us that the ‘new normal’ will be a ‘reversion to the mean’ where life goes back to normal. And to that I say not so fast. People will surely go back to restaurants, hotels and airplane travel in due course, but don’t think for a second that there will not be residual impacts. The narrative emerging from the recent trading action in the equity market tells us that we are going back to our old lifestyles and that is what I would bet heavily against. I have seen, and continue to see, secular shifts in behavior that will transcend a couple of quarters of pent-up demand release, that we will be stuck with a permanently higher equilibrium personal savings rate and a permanently lower labor force participation rate. And if we do somehow revert to the old normal, remember that the prior ten-year period was one of low growth, low inflation and low interest rates. I don’t see that changing because the secular forces of aging demographics, massive debt burdens and extreme income and wealth inequalities, if anything, have become accentuated by the pandemic. 

What the world looks like when the crisis ends is truly anyone’s guess, but I will say with 100% clarity that it is going to look a lot different than it did before. I sense that some of the structural changes in our economy could be long-lasting. Global supply chains could shrink, and in some cases we might see the full repatriation of manufacturing in certain industries, for instance in pharmaceuticals, food and high-tech like semiconductors. Areas deemed to be in the realm of national security. Before the pandemic, the emphasis was on “just-in-time” production, with parts being delivered just when they were needed in the manufacturing process.In the post-pandemic period, the emphasis could shift, to some extent, to “just-in-case” supply chains, emphasizing proximity and certainty of delivery. And then beyond the question over government policy, we have to consider at the individual level, how months of isolation and distancing and in the future, a fear of mutation of the pandemic, are going to fundamentally alter lifestyles, and will have a profound influence, not just on the way we live, but on how we conduct ourselves in our personal and business lives.

Then we have to consider, when we get to the other side, the massive government debts we will have built up and how that, along with even more bloated central bank balance sheets, will get dealt with. Will the debts get monetized, or not? Or God forbid, will taxes have to go up on the middle-class? Just some things to contemplate in 2021 as we get our booster shots and then race to the local brasserie. The stock market is not the economy so don’t believe for a second that record equity prices means the road ahead isn’t going to be a bumpy one.

David Rosenberg is the Founder, Chief Economist & Strategist of Rosenberg Research & Associates,