October 2021 Market Update

Below is a modified transcription from our October 2021 Market Update virtual event that was held on October 22, 2021. 

George Clark: In the last week or so it seems the level of discussion about the ongoing supply chain disruption and its impact has just reached crescendo levels among corporate executives investment pundits, investors, policy makers, just everyone. The development obviously plays a role in the return of inflation post the return of the recovery or the recovery as well as for how long. As well as it’s dredged up this term, stagflation, you know, which is this period of higher than expected inflation accompanied by a period of lower than expected economic growth. Unless you’re of a certain age, you know, this stagflation in terms has been limited to glossing over the term in a college economics textbook.

So to properly address the current dynamic, how we got here, how it’s going to be sorted, including the term of the inflationary impact. So we’re pleased to have Alejandra Grindal, who’s the chief economist at our partners, Ned Davis Research, this morning and so I want to welcome her. And she recently published an insightful read into this very topic, so we look forward momentarily to her remarks. 

Alejandra Grindal: These supply chain issues, I think they’ve really not only to you all, but to our clients, this is really one of the biggest conversations we’ve been having because it’s having not only so many implications on the United States, but also the entire world and inflation and GDP. Definitely a very hot topic. So in today’s presentation, I attempt to cover three main questions that we’re getting from clients. One is, why is this happening? What are the causes? Because if you understand the causes, you can maybe try to figure out, you know, what we need to be watching for solution or for change. So that’s one.

Number two, what are the consequences? So we talked about inflation, we’ll talk about that. But there’s also other consequences. And then number three, the burning question that we all hope we have the right answer to is, when will this be resolved? So hopefully fairly soon, but I’ll talk a little bit about that. So just flipping to this very first slide to show you the extremity of the situation. What I’m showing right here are two shipping indexes, global shipping indexes. You may have all heard of the Baltic Dry Index. This is an index or the cost of shipping raw materials, whether it’s very big ones or grains it’s very global index. And then we also have the Case Freight Index right here, which some people are not always as familiar with, but it’s the cost of shipping freight in North America and this includes raw materials and finished goods.

And what this chart right here is plotting is the year-to-year change in the price, and both of them are either at or near record levels. So the price of shipping is going up significantly. So this is sort of stating the obvious, but showing it to you in chart form. Ultimately the real question is, is why is this happening? And really, it’s a pretty simple answer with sort of complex explanations, but it’s just huge shifts in supply and demand. And you have an economist here when you say supply and demand, we get really excited because we get to talk about it. So I’ll spend some time talking about that, but a lot of these supply and demand shifts are really instigated by the pandemic. So first let’s talk about the demand change.

There’s been a huge increase in demand in the United States, but also in huge chunks of all of the world, but I would say more the United States and the developed world. I would say there are two main reasons for this one is that the COVID pandemic really brought upon unprecedented fiscal and monetary stimulus. Now a lot of people talk about the fiscal stimulus. A lot of households received checks, unemployment compensation, tax rebates, et cetera. But monetary stimulus also played a pretty big role too, because what did it do to asset prices? It boosted them up. So we saw stocks go up, crypto go up, housing prices. So people not only were richer, they felt wealthier and they had demand to unleash, right? They had plenty of things to spend.

And what was also rather interesting is because of the pandemic, we were spending differently. We were now at home. We couldn’t leave our houses. So we stopped spending on services and instead started spending more on consumer durable goods. So things like computers, game consoles, televisions, and you can actually see this pretty clearly on this chart. This is looking at durable goods spending as a share of personal consumption and expenditures. Look at that, shot up. And then you look at services. It was at the expense of that. So not only did we have the money to spend, but we dramatically changed the way in which we spent. In fact, just to kind of give you an idea of this change in demand, there’s been a 20% increase in container volumes into the US right now, compared to pre-COVID levels. So we are buying more stuff. And then what you do is you balance that out with a decrease in supply.

Think about those curves, shifting back and forth, if you remember your Econ 101 classes, if you took them. Unfortunately supply is being affected by many, many things, most of which are COVID related. But others sort of already happened in advance and then they culminated into this perfect storm of factors. So first to talk about the COVID factors, why supply has decreased, is just at least from the forefront supply cannot adjust as quickly as demand can. In other words, it’s much more inelastic, so think about a rubber band. So for example when everything’s shut down, I had to homeschool my kids. So could decide from one day to another, they each needed a laptop. Suppliers can’t do that. It takes quite a bit of time for them to adjust to these changes and preferences, which happened so quickly, especially when you’re thinking about complex durable goods, which again were the types of things we were buying.

Another thing that caused issues were incorrect forecasts. So I would say the perfect example of this is what happened with U.S. and European automaker. Back in March, April, May of 2020, they were anticipating apocalypse. I mean, just really, really poor economic outcomes. We were in lockdown. And things didn’t quite end up as bad as we had thought, the recession was very deep, but it was very short. We got a lot of the fiscal and monetary stimulus that I mentioned before. And then actually the demand for vehicles increased because people wanted to drive around as opposed to taking public transportation. But unfortunately the automakers dramatically cut down their orders for inputs. One of the more famous ones being semiconductors. And instead they went to these other durable goods such as the TVs the computers, and they were kind of left without anything, so they were kind of behind just from the get go. So that was another issue.

COVID also created a lot of organizational challenges. So just, if you run a factory, you have to have more safety measures, more social distancing, more PPE. So it just made that a little more costly and then added in the fact that global supply chains inherently are global, hence, the term. So if there was a COVID outbreak say in China. So China, you may or may not know has a zero COVID policy. So one person gets COVID everyone’s quarantined, so everything shuts down; they’re a big chunk of global supply chains. And then we also saw issues in Southeast Asia where they didn’t quite have that zero COVID policy, but they have much lower vaccination rates. So they actually had to shut down factories because so many people got sick. So again, that all has this multiplied effect.

Another issue too, which I think a lot of people forget is there was a huge production, or there has been to this day, a huge production in air transportation. And by that business, vacation, just all of this overseas travel and believe it or not 50% of air cargo actually came in the belly of passenger planes. So we have so many fewer of those planes and even fewer going to Asia. I mean, we can’t even, as far as I know, we can’t go to China unless we have a Chinese vaccine. This is going to take some time to resolve. And then the other side of things are worker shortages. You’ve probably heard a lot of discussions about why the US has worker shortages. Other parts of the world are dealing with the exact same issue, whether it’s extra stimulus, having to care for kids, people are scared to go back for work, improper job mismatches. But what’s happening is, and you’ve probably heard stories about this is there’s ships accumulating at the port of Long Beach in California. There aren’t enough workers to unload the ships and there aren’t enough truckers and trucks to take that merchandise and take it to other places. So ultimately a lot of that stuff is just sitting there – full ships. So the worker shortages are playing into this.

And then you also have non-COVID factors that, you know, sort of started even before the pandemic. One is protectionism and tariffs particularly toward China, big chunk of supply chains increase the cost of production. Those tariffs are still in place. It’s not just the United States. Australia did some very similar things as well, and that’s sort of culminating into other issues. Another thing that’s happened is a move toward cleaner energy. So you probably heard of power outages in Europe, as well as in China. If you have a power outage, things shut down, factories shut down. And again, that sort of leads to more of these supply chain issues. And a lot of this was based on this move toward cleaner energy. So either less dirty energy, such as natural gas, or just switching over to all of the renewal energy and away from coal.

So, what happened is that when there was an energy shortage, there wasn’t enough coal to be able to especially in the case of China, to be able to create energy for factories and homes and they ended up having to shut down. So again, this is something that happened before COVID. And then natural disasters and climate change. We’re seeing a lot more of that and it can have lasting effects. So case in point, the freeze in Texas in February of 2020, earlier this year, is still having an impact on supply chains. But it’s not just something that’s happening in the United States. They’re heavy floods in China, heavy floods in Germany. Most recently in the United States, we have hurricane Ida, we have droughts. So you can just imagine all of these factors are coming together and leading to this leftward shift or this decline in supply.

I know I spent a lot of time on the explanations, but I feel like once, you know, that that gives you a really good idea of what we need to see in order for things to get better. So on these next few slides, I just sort of wanted to give you some global perspective. On this chart right here, the top clip, this is looking at supplier delivery times from the global market PMI. And whenever the supplier delivery time index is lower, a lower number, that means that the length is getting longer and longer. It’s taking longer to deliver things. And you look at this chart, I mean, it’s at record levels. This is historically pretty intense, even worse than during the shutdowns during the COVID crisis. And as you can see in this breath chart right here, pretty much every country in the world is experiencing these supply chain issues. So it’s not just a US phenomenon, you’re seeing it everywhere, but then that culminates into even being a bigger US problem.

Looking at just comparing developed versus emerging markets, developed markets are seeing a much bigger issue. They’re seeing much, much greater delays. The fact that this number is below 50 emerging markets are seeing issues as well, but it’s definitely more of a developed market phenomenon. And again, two reasons, one is developed markets were more likely to engage in very generous monetary and fiscal stimulus. So there was more pent up demand to be unleashed, right? So that earlier slide I had there. And then also there was a bigger shift in preferences because if you look at developed markets, traditionally, they are more services oriented than developed markets. So when they had to switch to be more consumer goods oriented or manufacturing oriented, that caught them off guard and it was harder for them to adjust. So you can clearly see the issues right here. A lot of what’s bringing down this number, it’s the United States, but also Europe and also actually great Britain has a pretty low number because Brexit is another added layer that’s causing supply chain issues in their country.

So, in this next section, I wanted to take some time just to talk about, well, what are the consequences? So one major consequence is just higher prices. If you have an increase in demand and you have a decrease in supply, both the consequence of both of those shifts in that curve is higher inflation. So that’s what we’re seeing right here. And so this is looking at the relationship among countries. And so what we have found is that countries with longer supplier delivery times have tended to see higher input prices. And you can see it’s sort of concentrated in the developed world, particularly countries that focus a little more on manufacturing in the developed world, such as the US, Great Britain and Germany and then down on this end, you have the emerging markets, which are generally faring a little better. Japan notoriously did a slightly better job with its economic forecast and was able to get its supply chain in order a little better. Some of the more services oriented economies in Europe have been faring a little better as well, because they are more services oriented. You can definitely see the big shift. The one point I wanted to make about inflation because George, you had mentioned stagflation. I think one key difference is when you have stagflation, it is strictly a supply shock. So in other words, you’re just getting that leftward shift in the aggregate supply curve, you’re seeing just decline in supply. Whereas what’s really interesting with what’s going on right now, it’s a dynamic of two factors. It’s a huge increase in demand and also a decrease in supply, but arguably the increase in demand is greater than the decrease in supply. So that’s why at this point we wouldn’t quite call this a stagflationary environment, at least not yet. But we are watching inflation expectations, how long this lasts, and that could ultimately determine whether we do end up in stagflationary scenario. But at this point in time, because it’s so demand driven we don’t think that’s the case.

If this supply chain issues do last for a prolonged period of time, you start seeing a reduction in output. Companies literally cannot produce things because they don’t have the inputs for it. And if you look at this chart right here on the left, you’re already starting to see output growth slow. But if you look at backlogs, if you look at future output, it remains near records levels. So what that’s telling you is that the demand is still there, just suppliers still aren’t able to pick up. And if you look at the chart on the right, suppliers and businesses are also depleting inventories. So this chart on the right is looking at the business inventories to sales ratio and it’s at a record low. So both of those are affecting output. And then ultimately if we want to see the impact on assets, and specifically equities and businesses; if costs go up and we can’t make it up through higher prices through inflation then that hurts company margins and that could ultimately have an impact on equities. For the time being we’re still in that happy spot where inflation is still higher than costs, but if the costs remain high for an extended period of time, then clearly we can have long term issues, but we’re not there yet.

So, the final section I wanted to talk about is when will things get better? So this is the big golden question. So, you know, ultimately in our view, it’s not going to get much better in the near term or at least through the winter season. One is these logistical issues can’t be resolved overnight. That supply is just much more inelastic, but we’re also reaching a bunch of seasonal headwinds. So as we move closer toward the holiday, toward a Christmas season, you tend to see an increase in demand. So you can see this with the seasonality of the Baltic Dry Index, which is that shipping index I showed at the beginning of the presentation. It tends to have some pretty robust readings right before the holiday season. And perhaps this year might even be more robust because we have so much of this excess wealth and income that we’re ready to spend.

Another issue that happens in the winter is colder weather. So again, I mentioned those energy shortages that we’re seeing in China, as well as in Europe. Well, they’re likely to get worse as the weather gets colder and then if it gets colder than expected then we have a bigger problem. So those energy shortages could also culminate into a new round of blackouts, which could also cause further supply chain issues. So I sound pretty negative, but I do feel that there is a light at the end of the tunnel and ultimately the most important development to watch is COVID. So that’s why I so much time talking about the explanation as to why we’re in this situation, a lot of it is pretty COVID related. So if we, hopefully at least at some point get back to some sort of normal we would anticipate that things would get better. And yes, I think we are reaching a turning point. My famous last words, right.

But if you look at the chart on the left, this is looking at world weekly growth in COVID. And as you can see, this is that August, September period, where we saw that sort of nasty wave caused by the Delta variant. And then now we’re starting to see both new case growth and death rates start to at least grow at a slower pace. So that second derivative is slowing down. But I think one of the more promising developments is we’ve seen vaccination rates rise significantly in the emerging world. Remember the emerging world is a big chunk of those supply chains. And in particular in South Asia where somewhere between a third to half of the population now has at least one dose of the COVID vaccine. And even Latin America is now beyond that. So we’re definitely moving in the right direction, because one that helps eliminate some of these organizational challenges we’ve had, but also in the developed world, if we start sort of feeling a little more normal, we’ll buy less durable goods and move back to services. And that might also ease some of these supply chain issues that we’re seeing on the manufacturing side. As I mentioned before, our economy just wasn’t set for such a dramatic change in demand.

There’s also some talk that the government wants to step in and help to have the port of Long Beach now open 24×7, subsidized workers to get those ships unload. Companies are also very smart and they’re adapting. Companies are now engaging in more cost efficient and smaller packaging so that they can ship more items in individual freight ship. So that’s happening too. Again, you can’t forget the innovation. But there’s still a lot of long term issues that need to be resolved. So a lot of it is you know, a reconfiguration of supply chains away from China. This is something that’s likely going to happen, but it takes some time. So maybe a few years down the road, we’ll be buying a little more from Southeast Asia and Latin America, but it’ll take some time. Also there’s been huge orders for new container ships. But those also take a long time to build. In fact, they probably won’t be done until 2024 or 2025. It takes some time.

And then for some of your more complex manufactured goods, such as semiconductors, those might even take longer to reach equilibrium. In fact, the CEO of Daimler recently said that he doesn’t expect the semiconductor issue to be resolved until 2023. So it’ll take some time for that. And then you have the ongoing concerns of cleaner energy, climate change, protectionism. Those likely aren’t changing anytime soon. So we do expect things to get better, you know, given the improving COVID situation, but there’s still a lot of headwinds that we’ll face for a long term resolution. 

George Clark: So I think the first questions is the term of inflation. So this eventually wanes what we’re experiencing now. There’s a give and a take in various components of the CPI or the deflater whatever indicator you use. If you had to take more of a longer term, say a three year outlook on inflation, you have thoughts there?

Alejandra Grindal: Next year base effects will make next year look a little better. So just like base effects lifted the number this year, base effects will actually reduce the number next year. So we might actually get to a decent Fed friendly number just for mathematical reasons. But going two to three years out, I am slightly concerned that inflation will be higher than what it was pre-pandemic. I don’t think we’ll have the issue of stagflation where we’re going to get to that constant three to 4%. So the type of inflation that we’re seeing right now, or even 5%, but I do think it’ll be higher than it traditionally has been. And I told you, George, I had added a few inflation charts in here. And I think it goes back to looking at what are the long term disinflationary factors that we’ve been seeing over time and how are they likely to change? These are all long term factors that have kept inflation anchored. And the two I’m most concerned about dissipating is globalization, which is something I talked about before is if you have a decrease in globalization, it reduces competition and that increased costs. And I think we’re moving in that direction. So that could be one reason and I think COVID accelerated that.

And then the other concern, and this is more of the wild card is inflation expectations. Because I think for quite some time, people have had pretty anchored inflation expectations because they trust that the Fed is doing the right job and we’ve seen this long term trend downward in inflation. The worry is that if these supply chain problems do end up lasting longer than we anticipated because they actually have. I think we thought they would be resolved sooner and they weren’t. Then it gets into people’s heads and they start expecting higher prices, higher wages and it creates this feedback loop of higher inflation. So one thing that we’re actually watching pretty closely, which is in this previous chart, is the Common Inflation Expectations Index from the fed. So what they do is they put together various measures of inflation expectations, whether it’s market based or survey based and seeing if that’s picking up and it’s picked up a little bit, but it’s still within a fairly comfortable range. But if we do see an upshoot of that, then that could be a sign that this is no longer anchored and we could see higher inflation in the long term.

George Clark: Terrific. So Westin, tell us the difference between stagflation, inflation and then secondly, why is the market not reacted negatively to the elevated inflation?

Westin McEntire: I think at least to the difference between inflation and stagflation. Inflation is more of the higher prices or lower prices as measured by all these government statistics that measure in various different ways. You can strip out energy, your housing, but it essentially measures the increase in prices and it’s a year over year figure. Whereas stagflation is more of a general economic term to refer to the phenomenon of having slowing growth in the economy as measured by GDP growth or you could look at PMI slowing, and then comparing that to the potential for higher expected future inflation. And so that combination of, you know, higher prices expected in the future with slower growth can be, at least historically, a recipe for concern in the equity market or even in the bond market.

I think one of the another question that we’ve received and we talk a lot about internally, is how to balance this interplay between potential higher inflation and what to do and how to invest in the bond market. Because the bond market for most of the bonds that are investors and our clients invest in, are fixed rate bonds. So you buy a bond and you lock in a rate of interest that you will earn throughout the duration of that bond. And if you have this potential for higher inflation, that can erode your purchasing power or that future cash flow that you receive from that bond. And so this concern that has crept into the market psyche over the last 12 months of higher inflation and higher interest rates as the Fed starts to think about tapering is a real concern for our clients and how they approach investing in bonds.

One of the things that we’ve done at Venturi and it’s pretty unique is looking at private credit. Within private credit, you’re not necessarily invested in high quality treasury bonds. You’re in these areas of the market that are less publicly traded, but you can receive a floating rate of interest, which will adjust higher if we get rising interest rates. You also can be positioned higher in the capital stack or kind of the capital table of a company to protect you from potential issues of default. That’s an area in the bond market that you can receive a much higher interest rate than traditional bonds and be protected from some of these inflationary forces that manifested itself through higher interest rates.

 

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