Fourth Quarter 2021 Write-Up
The equity markets were very strong in 2021. Throughout 2021, investors looked forward to a post-pandemic economic recovery, flush industrial and consumer balance sheets, solid earnings growth and aggressive fiscal and monetary stimulus. The Dow Jones Industrial Average added 18.7% for calendar 2021, the Standard & Poor’s 500 Index surged 26.9% and the Nasdaq gained 21.4%. Sometime in January, the optimistic outlook embraced by the market last year was reassessed. Inflation readings have remained above the rate anticipated by both the Federal Reserve and most Wall Street economists, opening up the prospect of rising interest rates, tightening monetary policy and ineffective inflation-fighting responses. Supply chain constraints and bottlenecks, very tight labor markets, elevated cost pass-throughs and a new Covid-19 variant added to the more sober reassessment. Through yesterday, the Dow was down 5.4% in 2022, the S&P declined 7.5% and the Nasdaq declined 11.4%. Many of the best performing stocks of the last few years seemed to be especially targeted, as investors re-thought appropriate PE levels in the face of higher background inflation rates. We do fear that the Federal Reserve is seriously behind the curve with regard to likely inflation rates, and that this could make for a rocky year.
Let’s look at two of the most prominent inflationary contributors, shipping delays and surging energy prices. The maritime shipping industry is teetering, especially on our west coast. While port and shipping bottlenecks are evident throughout the world, they are nowhere as severe as in California. Average ocean fulfilment times have doubled from pre-pandemic levels worldwide. Trans-Pacific cargo can take over three months to be delivered. The Ocean Timeliness Indicator, reported by the freight forwarder Flexport, measures transit times from warehouse to destination port exit. The OTI has increased from a winter pre-pandemic average of around 50 days to a recent reading of 114 days, an increase of 57% over last year’s levels and up 125% from 2020 levels. The OTI is retrospective, in that it records the total days that cargo travels once it has left its shipping warehouse. So, the recent January reading reflects cargo that left a Chinese warehouse in October, when American ports were in much better shape.
Shifl, a supply chain management platform, records another shipping metric: the China-to-U.S. ocean transit time. A recent reading of 34 days was double the 17-day transit time from last May. Ships, due to port congestion and transportation (ships, railways and trucks) and warehousing bottlenecks, are forced to reduce transit speeds and increase “linger time”. This forces up fuel costs and increases the number of days that a contracted ship must be rented. Higher fuel costs, higher day-rates and increased transit times are all adding dramatically to transportation costs.
Given the state of congestion in ports, once improvement begins, it will still take weeks or possibly months to get back to more normal transit times. Industry commenters suggest that congestion and bottlenecks are still getting worse, not stabilizing or improving. In California, improvement might come more slowly than at other ports. In addition to pandemic-caused bottlenecks, the state has very strong longshoremen unions, restrictive work rules, onerous environmental regulations, strict and time-consuming land-use regulations and zoning procedures, an aging transportation workforce, an embarrassingly poor port productivity history and a legacy of under-investment in port and transportation infrastructure. As congestion creates more congestion, transportation costs are likely to remain elevated, and feed into inflation expectations.
The U.S. Energy Information Administration estimates that global oil consumption averaged 96.9 million barrels per day (b/d) in 2021, up by 5.0 million b/d from 2020, when consumption fell significantly because of the pandemic and related shutdowns. The EIA estimates that global oil consumption will average 100.5 million b/d in 2022, exceeding 2019’s heretofore record demand. In the last year, oil demand has surpassed oil supply, leading to persistent inventory withdrawals over the last six consecutive quarters. The EIA, and most industry experts, believe that inventory restocking will add to demand levels in 2022. Consumers withdrew oil at an average rate of 1.4 million b/d in 2021, and the EIA expects stockpile additions of 0.5 million b/d in 2022 and 0.6 million b/d in 2023. The EIA expects supply and demand to be closely matched in 2022. The EIA’s international counterpart, the International Energy Agency (IEA) tallies international consumption and production, and checks these results against actual OECD inventory stocks. Here, we encounter a data disconnection. The IEA’s production and consumption estimates suggest that inventories should be 800 million barrels higher than physical stockpile reports are indicating. Possibly, the oil is being stored by countries like China and Russia that are not reliable reporters of stockpiles, especially if there is a geopolitical advantage gained by obfuscation. Either way, we should not expect that current oil inventories can provide much of a cushion in the event of a supply shock.
We would also be cautious about both the IEA and EIA’s oil production forecasts. Both depend on healthy supply increases by both U.S.-based shale producers and OPEC+ (that is, the OPEC nations and Russia). In the U.S., shale wells typically encounter steep production declines in the first few years after completion. Because of this, much investment is necessary just to keep production flat. Furthermore, shale well investors are now demanding cash flow discipline and debt repayment from their investees. We are somewhat skeptical about estimated near-term shale oil volume increases. As for OPEC +, the market is expecting them to gradually replace the production volumes of oil that were withdrawn during the global slowdown in 2020. OPEC+ agreed to increase production 400,000 b/d in February, and is expected to agree to another 400,000 b/d increase in March. However, since August 2021, OPEC+ has been unable (or unwilling?) to completely meet its medium-term production commitments. As a group, OPEC+ is producing 740,000 b/d less than its target quota. Russia, the largest underachiever (along with Nigeria), is only producing 70% of its allowed quota. The best predictor of production growth in oil & gas is trailing investment. Shale oil investment, and likely also that of OPEC+, has been meager lately. We would expect oil prices to remain elevated, and feed into inflation expectations.
We believe that the Federal Reserve is well behind the curve in mounting a credible defense to surging inflation. On Wednesday, Fed Chair Jerome Powell said that he believed that price increases have been primarily because of “dislocations tied to the pandemic.” He added, “We are attentive to the risks that persistent real wage growth in excess of productivity could put upward pressure on inflation.” We would note that, if adjusted for inflation, after-tax personal income has declined for five straight months, and for eight of the past nine months. At this point, it is inflation that is surging, not real wages. The U.S. employment-cost index was up 4.0% year-over-year in the fourth quarter. This compares with a 4.9% increase in the Fed’s favorite inflation indicator, the core personal-consumption expenditures price index (which excludes gasoline and food costs) and a 5.8% increase in the PCE, which includes gas and food prices. The core PCE reading is the highest since September of 1983, while the PCE reading is the highest since 1982.
We think that a little more introspection by central banks would be appropriate. Central bank balance sheets grew from $15 trillion in assets in 2019 to $26 trillion at the beginning of 2022, an increase of 73%. The U.S. money supply has surged 40% in the last two years. To put that in perspective, during the first two years of the Great Financial Crisis (2008-2010), the money supply grew 6% cumulatively, and never grew more than 10% during that period. Doctor, heal thyself. Tighter monetary policies work with a time lag of 9 to 14 months historically. Actions taken today have a long lead time. So far, the Fed has only just started to signal coming hawkish moves, rather than actually taking hawkish actions. Will jawboning work? We have reservations. For one thing, a major factor in surging structural inflation is consumer inflation expectations, and these tend to lag during early periods of inflationary growth. For instance, a few of the major components of the Consumer Price Index are shelter (32%), food (14%), transportation (8%), energy (8%) and medical service (7%). Food, transportation and energy are repricing higher. Perhaps even more concerning is the cost of shelter. Of the 32% of the CPI that shelter represents, 8 percentage points represents rental costs for a primary residence. This is a reasonably timely metric that does a decent job of reflecting current surging rental costs. However, the bulk of CPI shelter costs (24 percentage points) represents a contrived metric called “owners’ equivalent rent” that tries to estimate what a homeowner would pay to rent his furnished home. This is a seriously lagging indicator: through last November, the OER component of CPI tallied a 3.2% annualized increase, while home prices surged 18.8% during the same period. Here, consumer costs are greatly understated. The CPI might not reflect the cost, but consumers can see it, and it will show up in higher consumer inflation expectations.
Fixing inflation is usually painful for investors in the short-term. Not fixing inflation is much more damaging to investors in the long-run. We believe that the Fed should embrace concrete actions sooner, rather than later. Winston Churchill once said, “If you are going through hell, keep going.” We would suggest to the Fed, “If you are going to have to go through hell, get going.”
Sincerely,
Your Team at Baxter Investment Management