Second Quarter 2021 Client Newsletter

In this quarter’s update, we take a deep dive into the economy’s health and present our third (and far from final) installment of our inflation series.

As always, if you have any questions or concerns, please do not hesitate to reach out.

• Kyle

Economic Health Check

Baseline statistics are critical to describing the status of a thing relative to itself.  Absolute analysis measures a thing versus a qualitative estimation of good/bad, acceptable/unacceptable, or simply normal/abnormal.  Conducting these types of studies helps us understand the world around us.

For economic data, pre-pandemic levels serve as the baseline of where we started.  Extrapolated trends from the 2010-2019 expansion make for a visual of where we would now be, had the pandemic never occurred.  We’ll make the leap of faith that, on an absolute basis, the prior trend was favorable.

Has the data recovered its baseline?  Is the economy back on track?

A Few Notes on the Data

Economic data is great – but it has limitations.  So before we get into the actual data, let’s review a couple of caveats.   

• The first limitation is timing.  It takes time to collect, refine, and publish data.  Typically, governmental data is reporting on a period that occurred 1-3 months ago.  
1. Last year, that data lag made economic data essentially useless.  This year, it’s less of an issue.
• The second limitation is seasonal adjusting.  To make month-to-month and quarter-to-quarter data comparable, statistics publishers will typically apply a seasonal adjustment.  
1. The canceled spring/summer in 2020 and subsequent staggered reopening(s) in the fall/winter/spring will continue to cause distortions in seasonally adjusted data for quarters to come.
• The third issue at odds with our faultless review is what economists call ‘base effects’ – a fancy way to say that if you measure something against a previous period with a depressed value (base), measurements taken off that base will be distorted.   For example, if you had 2 apples a year ago and now have 4 apples, you can confidently say that you doubled your apples.   Great news!  But, what if one year and three months ago, you had 7 apples…?  Your 100% apple growth looks impressive, but you’re still missing quite a few apples.  
1. Base effects are starting to run their course, but be wary of them (especially in the media) for the remainder of the year.  

We’ve taken great care to limit these distortions from our analysis.  

The Headline Data

As economic data sets go, the ‘granddaddy of them all’ is unquestionably Gross Domestic Product (GDP).  It is the most inclusive measure of a country’s productive might.  The end of 2019 represents the last unadulterated piece of data we had before the pandemic.  In that period, the US economy produced $21.7 trillion in goods and services.   If the economy were to have continued the 2012 - 2019 trend of +4.2% annual growth, 2021 would have delivered a GDP of $22.6 trillion (dotted trend line).  Amazingly enough, 1st quarter GDP recently logged a reading of $22.0 trillion (green line)

So, just one year after the sharpest economic decline in our lifetime, the United States economy, in the aggregate, has exceeded its baseline year (2019) and is on track to regain its previous growth trend by the end of the year.  Note that activity after the past two recessions (2001 and 2008) was only ever able to recover their baseline – not its pre-recession trend.

German GDP is having trouble regaining the previous high and previous trend.  The rest of the Eurozone is not dramatically different.  The conventional wisdom is that additional measures to curb the spread of the virus dampened consumer spending in Europe.  Much of the data in Europe closely resembles that of the United States from about 6-8 months ago.

GDP in China has fully regained the pre-pandemic baseline and is making progress towards the previous trend.  A lack of broad consumer restrictions and a global supply chain starved for inventory have provided China with an excellent opportunity for growth.  While it is unlikely the Chinese economy will fully revert to the +11.1% nominal growth trend that persisted over the past decade, it’s tough to view their current trajectory negatively.

United States Retail Sales

The US Consumer is an awe-inspiring force.  When they’re happy, they spend.  When they’re sad, they spend.  Heck, even when they’re dead broke, they spend.  So, it should be no surprise that when you hand US consumers money – they will spend it.  

And spend it, they did.  US Retail Sales regained their 2019 peak before the end of 2020 and are now nearly $1 trillion above the previous trend.  Direct payments from the CARES Act(s) were the main driver of the consumption boom.  We expect a reversion towards the previous trend in the coming months, although stable wages and unemployment statistics should keep that reversion from turning into a dramatic contraction.  When you hear headlines of ‘falling’ consumer spending in the coming quarters, remember this trend line.  

Financial Position

The statistics above are nominal or income statement type accounts – they measure $ spent, things made, etc.  And they start at 0 at the outset of every new period.  Measurements of financial position are additive – they are constantly adjusted by increases/decreases in nominal statistics.   The following data relates to the ongoing economic standing of the US Government, Corporations, and Consumers.  

US Labor Market – Total Persons Employed

Relative to the last two recessions, the labor market has experienced a violent recovery.  Demographic trends may limit our ability to resume the 2010-2019 trend in employment.  However, the census has estimated that the US working-age population will exceed 180 million people in 2030.

Lingering pandemic impacts on employment include early retirement, enhanced unemployment benefits, and child/elder care.  While it’s disappointing that a full employment recovery has yet to occur, let’s be mindful of silver linings.  First, slack in employment can fuel future economic expansion (and we’re headed the right way).  Second, since the Federal Reserve is almost solely fixated on getting back to full employment, they are more likely to keep interest rates low – which is a fundamental prerequisite to financial stability.    

US Debt

As a country, we have a lot of debt.  Over the past 50 years, we’ve grown our country’s debt at roughly +10%/year.  While this can be an angsty and politicized topic, it cannot be omitted.  The tough love of the situation is this: both political parties have contributed to the ever-expanding obligations. Here’s the data:

Since the pandemic, the US Government has increased its total outstanding debt by roughly $7 trillion.   Yet after an increase of that magnitude, you may find it surprising that the cost of servicing that debt is lower now than at the end of 2019 (red line below).

The weighted average interest rate on the current debt is about 1.5%, effectively an all-time low.   However, if interest rates went to 5% on the outstanding debt, interest costs would exceed $1T/year (top blue line).  If it feels like we’re emphasizing interest rates excessively in these notes, this is why – things get ugly in a hurry if borrowing costs spike.

In the face of pandemic-related uncertainty and low interest rates, companies also joined the credit binge – taking total borrowings to $11T from just under $10T in 2019.  

Just like the Federal Government, companies secured extremely low interest rates.  But unlike the Federal Government, many large companies had pandemic-related windfalls and are sitting on vast piles of cash and liquid assets.

Relative to those liquid assets, large companies have never been in better financial shape.

We’ve already established that the US consumer has been spending like crazy, but how are their balance sheets?  Did they load up on debt during the pandemic? Surely some folks did, but consumers used the pandemic to upgrade their financial position in the aggregate.  

Consumer credit remained stable throughout the pandemic, while balances on credit cards/lines were paid down.  Banks around the country are also reporting fewer delinquencies and fewer charged-off accounts.  Relative to disposable income, the cost to service outstanding debts has never been lower.

In response to a question about the health of the US consumer in JP Morgan’s 2nd quarter conference call, Jamie Dimon feverishly responded:

“The pump is primed. The consumer, their house value’s up, their stock value’s up, their incomes are up, their savings are up, their confidence is up. The pandemic is kind of in the rearview mirror, hopefully nothing gets worse with it. And they’re rearing to go.”

Conclusion

When it comes to economic data, the pandemic was, in many ways, the recession that never happened.  Typical recessions arise from a deleveraging economy as corporations and consumers default on debts and production/employment/consumption fall.   Unchecked, a vicious self-sustaining cycle can occur, much like what happened in the aftermath of the Great Financial Crisis.

Instead of allowing consumers and corporations to bear the immense burden of economic shutdowns, the government absorbed the liabilities of the private sector.  Late last year, we dubbed this new financial regime the era of Policy Coordination.  And whether you love it or hate it, it’s where we are, and so far, it has worked.

Low interest rates are the main prerequisite for continued economic stability.

Inflation - Part III

We continue to keep a close eye on inflation readings.  Higher inflation rates could derail accommodative central bank policy and potentially raise long-term borrowing costs.  In our last newsletter, we closed our inflation segment by pondering the future path of prices.

As the year progresses, wholesale price increases will filter through to consumers, at which time we will enter the next chapter of our inflation experience. By then, our main question will likely have evolved from "How long will commodity/supply chain issues linger?" to "How sticky/permanent will consumer price increase be?"

Wholesale price increases have certainly made their way through to consumers, but supply chain inefficiencies and shortages are ever-present.  Consumer Price Index (CPI) charts below show the decomposition of monthly data. Pandemic-related items are driving the truck.

Speaking of trucking… Freight rates are a great way to track supply-chain inflation related to inventory restocking.  

The good news is that we’re probably near the beginning of the end on supply chain issues, and the calendar will start to be a bit more forgiving on year-over-year comparisons.   That means that inflation rates may be in the process of peaking.  What it does not mean is that prices will broadly revert to pre-pandemic levels.   

Whether that soothes you or not is a good litmus test for whether you’re an economist or not.  Economists focus on the rate of inflation.  Normal people tend to be more interested in how much money it takes to buy goods and services.  

Below, an 80 year history of the yearly change in inflation (upper chart) and the actual price level (lower) is segmented by different inflationary regimes. 

You’ll note that previous transitory ‘bumps’ in inflation occurred immediately after recessions/shocks, which makes the Federal Reserve feel better about this spike.   You’ll also probably notice that the trend in the consumer price index is steadily higher over time, which likely makes you feel worse.