Written by Jim Welsh
Macro Tides Monthly Report 02 August 2021
Four Components of Inflation
The four components of the current inflationary push – Base Effects, Supply Chain problems, Service inflation, Wages – were reviewed in the June Macro Tides. If inflation is going to be transitory there should be visible progress on each of these components.
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Base Effects is merely a 12 month rate of change calculation so it doesn’t really provide much insight into actual progress in real time. The current year over year numbers are dependent on values from 12 months ago as much as current prices. The majority of price inputs recorded their Pandemic lows in the second quarter of 2020 and then rebounded. The big rebound last year is why Base Effects are going to contribute to a decline in headline inflation in coming months. This will give the impression that inflation is subsiding. But this could be a misleading conclusion, if the inflationary pressures from Supply Chain disruptions, Service inflation, and Wages aren’t also improving.
In the June Macro Tides this graphic was used to approximate the time frame each of the four components was expected to follow. So far not much has changed to alter the timeline presented in June.
Inflation Impulse Time Line
“Although Base Effects will temper headline inflation after July, strong demand will keep goods prices elevated. Supply Chain disruptions are likely to persist and also offset some of the unwinding of Base Effects. The computer chip shortage will last at least another 4 months and could endure to some extent into 2022. This will limit the increase in the supply of cars and trucks, which will keep demand for used cars and trucks high and prevent prices from falling much. Service inflation will trend higher even as headline inflation recedes. Sectors hurt by the Pandemic will increase prices in response to the surge in demand, and higher rents will lift Owner’s Equivalent Rent. Many industries are struggling to find workers and have increased wages or offered bonuses to attract new hires. If this continues more firms will be forced to increase wages in order to retain existing workers. There are many dynamics at work in the labor market that could sustain wage increases or lead to a higher plateau of annual wages increases.”
Supply Chain Problems
In June the headline Consumer Price Index (CPI) increased to 5.4% from June 2020 and was the highest since 2008. In the last three months the CPI has risen at an annualized clip of 9.7% which highlights how intense the surge in price increases has been. Airfares in June were 24.6% higher than a year ago and hotel prices were up 16.9%. However, both items remain below where they were in June 2019 so higher prices are likely. New cars are about 5.1% above where they were two years ago, but Used car prices are up 41.3%. In June new car prices were up 2.0% from May while used car prices soared 10.5%.
In June the Core CPI jumped 4.5% from June 2020 which was the highest level since September 1991. Of the 0.9% increase from May, 0.7% came from New and Used car prices, lodging away from home, and transportation services. So the large increase was concentrated in four categories. Analysts were quick to note that if the prices for New and Used car prices were excluded from the Core CPI in June, the increase in the Core CPI would have been 3.0% versus the 4.5% reported.
This was validated by Chair Powell:
“Unless we think there’s gonna be a multi-year, many-year shortage of used cars in the United States, we should look at this as temporary. We very much think that it is.”
For those in the inflation will be transitory camp this is Exhibit A. It appears that Powell now defines transitory as anything less than many years, which will guarantee that Powell and the FOMC will be right! Overlooked was an assessment of how quickly New and Used car prices are likely to fall in coming months.
The surge in Used Car prices occurred as the production of new cars was slowed by a computer chip shortage and car rental firms buying used cars. After the economy was shut down in the spring of 2020, Hertz and other car rental firms sold cars to raise cash so they could weather months of little or no revenue. As vaccines made it possible to travel again, car rental firms were not prepared for the big increase in demand and were force to buy used cars. The demand from car rental companies will wane after inventories are rebuilt, but a meaningful increase in new cars may be delayed.
In March the lead time for the computer chips that drive the technology in new cars was 16 weeks but increased to 20 weeks in July. Prior to 2020 the average lead time for computer chips was 12 weeks. This will make it difficult for automakers to increase production much. Through the first half of 2021 auto production is 14% below where it was in 2019 when the chip lead time was 40% faster than it is now.
Dealerships around the country have been dealing with inventory levels that are more than 50% below the average dealers have carried since 1993. In absolute terms inventory is the lowest since 1968, when there were 207 million people compared to 330 million now. Those who are looking for a popular car or truck better be prepared to pay more than the list price and wait for months to get the vehicle.
This is why so many consumers have defaulted to purchasing a used car. Used car prices are going to come down but the current dynamics in the car market suggests the decline will be gradual until new car production is back to normal. No one knows for certain when that will be, but it isn’t likely before the end of 2021.
Congestion at shipping ports in China and the U.S. has played a big role in disrupting supply chains, which are dependent on precise and synchronized schedules. If congestion at the major ports had improved in the last two months, the cost of shipping containers would have fallen. Instead shipping costs are continuing to climb. The cost to ship a container from Shanghai to Los Angeles is up 450% from the first quarter in 2020 and is up more than 400% on goods shipped to New York from Shanghai.
The Pandemic surge was followed by a big Back-to-School increase. According to the National Retail Federation parents were forecast to set a new record in outfitting their kids. Another survey by Deloitte found that parents were expected to spend 16% more this year than in 2019.
The logjam of ships waiting to be off loaded at the Port of Los Angeles and Long Beach peaked in January, February, and March with more than 30 ships.
As congestion eased the number of ships waiting to unload fell to less than 10 in late June, which was more than double the levels in the third quarter of last year. Since the low in June, the number ships waiting have more than doubled. The congestion at these high volume ports is getting worse, which doesn’t bode well for improvement as holiday volumes increase.
The strong demand outlook for retailers was further supported by the Evercore ISI survey of Retailers released on July 23, which hits its highest level since 1994.
The cost to ship goods around the world is not likely to fall much and delivery times can’t be expected to improve materially in the next few months. As demand jumps in preparation of the peak holiday selling season, retailers will continue to struggle to rebuild inventories and raise prices. These forces will only put more strain on the global supply chain and inflation.
Those expecting inflation to be transitory love to point to the sharp decline in Lumber prices as proof positive the cost of all raw materials has peaked. This is would be great news since companies wouldn’t have to raise their prices or allow profit margins to be squeezed, if raw material prices fell. The rise and fall in lumber prices is stunning as lumber soared from $420 in January 2020 to $1710 in early May this year, only to plunge to $500 on July 19.
This is good news for homebuilders but Lumber doesn’t reflect what’s happening in many other important commodities.
Copper prices are holding near their highest price since 1989.
Hot rolled steel is double its 2018 high and shows no sign of peaking.
The price of tin is 75% higher than it was in 2019 and hit its high last week.
Zinc is below the high in 2018 but is near its high in 2019 and up 60% from its low in 2020.
Nickel prices reached a new high last week and the highest price since 2007.
The Commodity Research Bureau’s Raw Material Index reached its highest level since 2011 last week. It is up almost 20% above the 2018 high and up 50% from the low in 2020.
Durable goods are items that last more than 3 years like appliances, home and office furnishings, lawn and garden equipment, consumer electronics, toys, small tools, sporting goods, photographic equipment, jewelry, motor vehicles and motor vehicle parts, turbines, and semiconductors. On Tuesday July 27 the Commerce Department reported that in June new orders for products meant to last at least three years increased 0.8% from May. The May figure was revised up from April to show an increase of 3.2% rather than 2.3% originally reported.
Taking into account the revision, the increase for June relative to April was even stronger. Orders for Durable goods have increased in 13 of the last 14 months and show no signs that demand is about to decline. Strong demand for finished non-defense durable goods should at best limit price declines for many raw materials before the end of 2021.
A meaningful increase in supply of raw materials isn’t likely until 2022 or later. In the last 30 years, domestic business investment has dropped during each business expansion. Many commodities peaked in 2011 and prices languished at low levels for many years, as the above commodity charts illustrate. Companies responded by keep a lid on investment.
With raw material prices so high, the cost to add capacity is a big headwind and many companies can be expected to take a wait and see approach. The lead time for new capacity or launching a new mine to dig for raw industrial metals is years, so new supply isn’t coming on stream anytime soon. Semi Conductor firms are rushing to add to capacity but the new plants won’t add to supply until late 2022 or the first half of 2023.
Feeder cattle prices are hovering at the highs of the past 5 years so your next barbecue is not going to cost you less.
Your next cup of coffee is going to cost you more as the worst cold snap in 25 years in Brazil has potentially wiped out 25 % of its coffee trees, which will hurt the 2022 harvest.
Other than agricultural products and WTI oil, which have pulled back modestly, the majority of commodity prices are near multi-year highs. The one exception is lumber which has plunged, but lumber is hardly representative of the bigger picture.
Shipping delays in the supply chain have on balance have worsened since June and won’t contribute to a significant decline in inflation in the next few months, as shipping costs hold well above fourth quarter levels.
Service Inflation
A number of small categories within the CPI have made outsized contributions to inflation in the past year. Energy increased 24.5% from June 2020 to June 2021 primarily due to the 44% jump in oil and gasoline prices. Transportation services were up 10.4% from June 2020, as Airline fares rose 24.6%, vehicle insurance was up 11.3%, and Transport was up 20.6% due to the 45.2% increase in Used Cars. Combined, Energy, Transportation Services, and Transport comprise 15% of the CPI.
Shelter represents more than twice as much as these categories. Even as prices within these smaller categories drop, shelter inflation could offset most of the decline. In June Shelter inflation was up just 2.3% from a year ago, but that’s going to change significantly in the next year.
In May the S&P Case-Shiller National Home Price Index in 20 major metropolitan areas across the nation rose 17.0%, up from 15% in April. Price growth accelerated in all 20 cities and May’s increase was the largest since 1987 when data collection began.
The Federal Housing Finance Agency reported that home prices increased 18% in May from a year earlier, a record in data going back to 1991. The National Association of Realtors reported that in June its index of home prices rose by 23.4%, as the median price reached a record high of $363,300.
Historically, the Owner’s Equivalent Rent (OER) component within the Core CPI follows changes in home prices with a lag of about 18 months. The lag in this cycle may be shorter given the dynamics within the housing market. OER turned up in June and, given the magnitude of the increase in home prices, OER will begin to play catch up in the next six to twelve months.
Whenever the moratorium on rent payments is ended (President Biden has asked Congress to extend it beyond July 31.), the drag on OER will flip from being negative to a positive contributor. This change will accelerate the increase in OER and allow it to rise progressively faster over time.
The year-over-year comparisons for Core CPI almost guarantee a sharper increase in the last four months of 2021, as discussed in the July 19 Weekly Technical Review:
“The Core CPI increased by 0.54% in July 2020 and 0.32% in August. Those increases will limit how much the Core CPI rises in the next two months and are likely to contribute to a drop, if the Core CPI rises by less than 0.52% in July 2021 and 0.32% in August. After August the hurdle rate drops since the Core CPI in 2020 rose 0.18% in September, 0.08% in October, gained 0.05% November and December, and 0.10% in January 2021. These small takeaways will make it easier for the Core CPI readings in the last four months of 2021 to add to the Year-Over-Year increase. This is why the Core CPI is expected hold near 3.5% and far above the FOMC’s target of 2.0%. Will the markets be willing to give ‘transitory’ such an extended life? Maybe, but I doubt it.”
Apartment rents, which are 7.7% of the CPI, are also going to contribute more to the Core CPI in coming months. According to Bureau of Labor Statistics the apartment market is the tightest it has been in the last 20 years.
The Tightness Index leads apartment rents by 12 months, so apartment rents are likely to rise sharply in coming months. This conclusion is reinforced by Zillow’s estimates of future Apartment Rents and the Zillow Observed Rent Index (ZORI) which lead changes in Owner’s Equivalent Rent.
In 2019 ZORI (orange) fell below OER (black) and within a few months OER trended lower. The Apartment List Estimates (blue) led changes in ZORI and OER in 2018, 2019, and since the lows in 2020. The Apartment List Estimates and ZORI indicate OER will trend higher and lift the Core CPI through the end of 2021 at least.
Wages
As of June there were 6.8 million fewer employed workers than in February 2020 and the Participation rate was 61.6%, 1.7% below February 2020. On the surface it would appear that there is a fair amount of slack in the labor market. A more accurate assessment will be possible in September and October after schools reopen and unemployment benefits end on September 6.
There are three factors that imply the labor market may have less slack. More than 1.1 million older workers left the labor market through retirement and aren’t coming back. This will make it difficult for employment to return to the February 2020 level. There appears to be a skills mismatch between what employers need and the skills many applicants possess. This may be due to some workers leaving sectors that were hurt the most for other sectors that appear to provide more stability flexibility.
The large increase in wages in Leisure and Hospitality, Retail, and other Services indicate employers wiliness to increase pay to attract workers. The increase in hourly earnings for workers in Transportation and Warehousing, as Amazon and its competitors raised their minimum wage to $15.00, pulled some workers away from their former job which paid less. Compared to February 2020 private sector wages are up 5.9%.
Another indication of labor market tightness is the Labor Market Differential. In its monthly survey of Consumer Confidence the Conference Board asks consumers whether jobs are plentiful or hard to get. The Differential reached its second highest level in the last 43 years in July, which indicates the labor market is tight.
It will be instructive if the differential drops and by how much when schools reopen and unemployment benefits end. If the Labor Market Differential doesn’t decline materially, it would suggest the labor market doesn’t have as much slack as the FOMC thinks.
Small businesses are having a tough time finding workers even after raising wages or offering bonuses.
According the National Federation of Business (NFIB), more than 25% of small businesses plan to increase wages in coming months to hire workers, highest in 15 years.
The prices for raw materials respond to supply and demand so they will decline when supply and demand become balanced at some point in the next 6 to 12 months. Wages are responding to an imbalance of demand and supply now, but wages won’t fall once the balance is reestablished. Companies will have to raise prices, or allow profit margins to shrink to offset higher labor costs.
In recent weeks companies across a broad spectrum of industries have said they are raising prices to offset rising costs. Kimberly Clark (toilet paper products), Harley Davidson (motorcycles), Whirlpool (large appliances), General Mills (food), and Constellation Brands (beer and booze) have recently announced price increases under pressure from cost increases.
On July 29 Nestle, Anheuser-Busch, Danone, Unilever, and Procter Gamble all said they were raising prices to recover some of the cost increases they incurred for ingredients, packaging, and transportation. As the CEO for P&G said,
“Commodities and cost pressure have escalated significantly.”
As noted months ago, companies don’t have to worry about losing market share if they raise prices since every firm in their industry is experiencing the same cost pressures. The number of companies mentioning inflation on their earnings calls has soared to the highest level in the past 20 years. A survey of 606 U.S. businesses across many industries by 451 Research and S&P Global Market Intelligence, found that 33% said they were raising prices while only 4% were lowering prices.
Since many commodity prices are either making new highs or holding near multi-year highs, the pressure on firms to raise prices will continue.
FOMC Is Behind the Inflation Curve
At the December FOMC meeting the median estimate for the Core Personal Consumption Expenditures Index (PCE) for 2021 by FOMC members was 1.8%. At the March meeting the estimate for 2021 was increased to 2.4%. In April the PCE was up 3.6% from April 2020 and in June it jumped to 4.0%. In 6 months, the December 2020 estimate was off by more than 100% (4.0% vs. 1.8%) At their June meeting the members of the FOMC polished their crystal ball and increased their median projection for PCE inflation in 2021 to 3.4%.
This certainly resembles a dog chasing its tail. In June the Core PCE reached 3.4% which is the highest since July 1991. In the second quarter the annualized increase in the Core CPE was 6.1%, which suggests the Core PCE may continue to push higher in the third quarter.
In the press conference after the July 28 FOMC meeting, Chair Powell was frank in addressing how inflation hasn’t conformed to the transitory narrative. A few months ago the FOMC was confident that supply bottlenecks would improve, but to date they haven’t. Powell noted that
“Supply bottlenecks have been larger than anticipated.”
Based on the December PCE projections, the FOMC has underestimated inflation by a wide margin and Powell acknowledged it.
“Inflation is running well above our 2% objective, and has been for a few months, and is expected to run certainly above our objective for a few months before we believe it’ll move back down toward our objective.”
The FOMC was too optimistic about supply chain problems and how hot inflation would run, but is certain that inflation will fall to its long run target of 2.0%. When asked how soon the decline in inflation would begin, Powell was unusually honest for a central banker:
“We don’t have much confidence in the timing.”
It could happen in 3 months, six months, or sometime after that, and it would still meet the evolving definition of transitory.
Powell did say that improvement in the labor market was the key as to when the FOMC would be ready to seriously consider adjusting monetary policy:
“I think we’re some way away from having had substantial further progress toward the maximum employment goal. I would want to see some strong job numbers. And that’s kind of the idea.”
If job growth is good in July (released on August 6) and August (released on September 3), those reports probably won’t be enough for the FOMC to announce a decision on tapering at the September 22 meeting. After schools reopen in late August or September and employment benefits end on September 6, there should be a significant improvement in job growth. This may be confirmed when September employment report is released on October 8. This suggests the FOMC will likely make a taper announcement at the November 3 meeting.
In the next few months expect to hear more speeches by FOMC members preparing financial markets for this announcement, if job growth is strong in July, August, and especially in September.
There is a chance, after a surge in job growth as schools reopen and benefits end, the labor market remains tighter than the FOMC anticipates. Baby Boomers retired at a much faster pace due to the Pandemic than they had been prior. More than 1 million Baby Boomers are no longer in the labor market and an unknown number of workers have changed career paths and won’t return to their old job. This will affect some industries more than others. More workers may reenter the labor market in the next few months, but not enough to satisfy the demand for employees or workers who possess the appropriate skills. This would be the worse outcome as it would keep upward pressure on wage growth and core inflation, as more companies are compelled to raise prices to offset higher labor costs.
If the Core CPI and Core PCE inflation continue to run far above the FOMC’s 2.0% inflation target though 2021 as expected, the financial markets will eventually get the message: Inflation will not be transitory. Improvement in job growth in the next three months will shorten the FOMC’s runway as to when they will announce when they will taper the monthly purchases. The end of the FOMC’s ultra accommodative policy is expected to lift the Dollar and Treasury yields. If Treasury yields approach or exceed the highs in March, a correction in the stock market is expected.
Dollar
The Dollar was expected to set an important low in late May and then rally. After bottoming in late May, the Dollar rallied in a 5 wave pattern, which suggests the trend of the Dollar has reversed up. The Dollar has been trending down since January 2017. In the short term the Dollar is expected to fall to 91.00 – 91.50 and then rally above the late July high of 93.19. Over the next year the Dollar has the potential of approaching the January 2017 high of 103.82.
The Federal Reserve will be tapering its QE purchases well before the European Central Bank and that should provide a tailwind for the Dollar. The Euro represents 57% of the Dollar Index and as the Euro declines in the next 6 to 12 months, the Dollar will get a nice boost.
Treasury Yields
The 10-year Treasury yield fell from a high of 1.765% on March 30 to a low of 1.128% on July 20. Most of the decline occurred after June 20 when it fell from 1.545%. Chair Powell has convinced the Treasury market that inflation will be transitory, even though it is running far higher than anyone expected. Concerns about the Delta variant and the risk that it could weigh on economic growth in the U.S. spurred some buying and a lot of short covering. Technical issues also played a role in helping Treasury yields to fall.
In March the Treasury had $1.6 trillion in funds sitting at the Federal Reserve. This huge balance has allowed the Treasury to fund Congress’s spending, without having to increase the size of its weekly auctions. In the last 4 months the Treasury was able to roll over expiring debt and not issue much new debt. The Federal Reserve’s monthly purchases of $80 billion of Treasury debt absorbed almost all the auctioned debt.
The Treasury’s balance with the Fed is approaching $500 billion and will fall to $400 billion in the next two or three months. Once the balance has hit the Treasury’s floor, the size of auctions will include debt being rolled over and new debt to fund future federal spending. As the amount of Treasury paper issuance increases the proportion purchased by the Fed will shrink, which will put some upward pressure on Treasury yields. After the FOMC tapers its purchases in early 2022, the upward pressure on yields will intensify. If markets lose faith in the transitory narrative, as supply increases and the Fed tapers, Treasury yields could jump in the next 6 to 9 months.
Treasury yields are expected to exceed their March 2021 highs, with the 10-year Treasury yield rising above 1.765% and potentially hitting 1.90%. The 30-year Treasury yield is expected to rise to 2.70% or higher, once it clears the March high of 2.505%.
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Stocks
A rising tide lifts all boats which has certainly been the case for most stocks since the market’s low in March 2020. The NYSE Advance – Decline Line measures how many stocks are up minus down each day and then creates a running total of each day’s activity. Since the bottom in March 2020 the A-D Line has trended higher and is well above the green trend line and higher than the red 89 day moving average. The rising tide in the A-D Line shows that most stocks have been advancing on a daily basis and suggests the major trend in the stock market is still positive.
The A-D Line weakened (Chart below – as noted by the red down sloping trend lines on the A-D Line) in May 2020, June 2020, and August and September of last year. These periods of weakness occurred while the S&P 500 was correcting and is exactly what normally happens when the S&P 500 declines during a correction.
The A-D Line has been weakening since early June (chart below). As the S&P 500 rallied to a new high in early July, the A-D line went sideways and failed to move to a new high with the S&P 500. Since the low on July 19, the S&P 500 has rallied to a new high, but the A-D Line is decidedly lower. This is the first time since the low in March 2020 the A-D Line has negatively diverged so much with the S&P 500 recording a new high.
In February 92% of stocks were above their 200 day average. When the S&P 500 hit a new high in June, the percentage had dropped to 84%. As the S&P 500 hit another new high on July 29 the percentage was just 71%. Since February the percentage of stocks below their 200 day average has increased from 8% to 29%.
The near term weakness in the A-D Line and the falling percent of stocks above their 200 day average suggests the stock market is vulnerable to a period of correction, if negative news appears. In the short term, the Delta variant would likely be the culprit as cases mount and the specter of potential shut downs loom. Rather than shutdowns, the more likely risk is that concerned people alter their behavior and fewer of them go out to dinner, attend a movie or sporting event, or choose not to get on an airplane.
The U.S. has followed the pattern in Britain during the Pandemic with a lag of about a month. Cases in Britain peaked on July 20 with a seven day average of 47,451 and have fallen 41% to 27,828 on July 30. In January the number of COVID cases peaked at 59,417, so the recent surge is 20% lower.
The sharp decline in cases since July 20 Britain is likely due to a high rate of vaccination (70% of adults are fully vaccinated) and natural immunity in those who have not been vaccinated after contracting COVID. In January the 7 day average of hospitalizations was 38,434 versus 5,738 on July 29, so it is 85% lower than in January.
The numbers for the U.S. are similar with cases down 70% from the high in January (254,082 vs. 76,386 July 29) and hospitalizations lower by 75% (January 129,090 vs. 32,527 July 29). If the pattern of the U.S. following Britain continues, cases in the U.S. should top out before the end of August. The pattern also indicates that cases and hospitalizations are going to climb in the next few weeks before topping.
The near term weakness in the A-D Line and the falling percent of stocks above their 200 day average suggests the stock market could fall by 5% to 8% in the short term. The S&P 500 is expected to drop below the July 19 low of 4233 and potentially test the June 18 low of 4165. If the S&P 500 closes below 4165, a further decline to 4060 – 4080 is likely. If the Delta variant follows its pattern and peaks before the end of August, the S&P 500 could subsequently rally to a new high.
Investors want to believe that Chair Powell will be right and inflation will be transitory since that would delay any tapering. Powell said the FOMC members want to see improvement in the labor market before seriously considering the timing for tapering of monthly QE purchases. Based on the timing of their meeting schedule and jobs reports, the FOMC will need two or three more months before deciding at their November 3 meeting. This might allow the S&P 500 to quickly correct 5% to 8% in the next few weeks and rally to a new high before the FOMC decision on November 3. The stock market could be vulnerable to a correction of more than 10% after October, if the expectations that core inflation will remain higher for longer and Treasury yields surpass the highs in March are realized.
Gold
August is a seasonally favorable month for the precious metals and, if the Dollar pulls back to 91.00 – 91.50 in the next few weeks, Gold has its best opportunity to rally. The expectation is that Gold can rally to $1860 – $1880 and potentially test $1900 – $1920. A close above $1920 would open the door for a retest of the August 2020 high of $2070, but is not expected.
Silver
A close above $26.42 would allow for a quick pop to $27.75 – $28.00. There is still a good chance that Silver will test or exceed the August 2020 high of $29.75, if inflation is sticky.
Gold Stocks
If Gold rallies as expected GDX should rally at least to $36.73 to close the gap from July 16 and potentially test the blue trend line near $37.40. As noted in the July 26 Weekly Technical Review, GDX needed to close above $33.85 which it did on July 28. A close above $35.20 is now needed to increase the odds that GDX will rally to at least $36.73.
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