The equity markets paused in the third quarter of 2021, but retained most of their gains from the first six months of the year. Through September 30th, the Dow Jones Industrial Average advanced 10.6%, the Standard & Poor’s 500 Index surged 14.7% and the Nasdaq Composite gained 12.1%. During the third quarter, the Dow and Nasdaq declined 1.9% and 0.4%, respectively, while the S&P 500 added 0.2%. September was the worst month for the S&P 500 since March of 2020, with the index losing 4.8%. All but one of the S&P’s eleven sectors had a down month in September (Healthcare was up just over 1.0%). Inflation was evident in the quarter, with Nymex natural gas prices surging 60.7%, cotton rising 28.3%, coffee gaining 21.7% and sugar, orange juice and cocoa all gaining double-digit percentages. Breakfast got expensive in the third quarter. After the close of the quarter, the DJIA, S&P 500 and Nasdaq all tacked on an additional 4.5% - 4.8% of gains as the equity markets apparently took their cues from the somnolent bond market, ignoring growing concerns about economic activity, supply chain disruptions and stubbornly high inflation. We will explore some of our concerns.
Inflation and economic activity are hard to separate in today’s economy. Although second quarter GDP logged in a 6.7% gain, expectations for third quarter GDP growth declined considerably during the quarter, declining from the +7% level early in the quarter, to ~3.5% estimates today. All of this must be taken in the context of soaring CPI inflation readings. In June, headline CPI recorded a 5.4% increase, with core CPI (which eliminates the volatile food and energy components) tallying a 4.5% gain, well above Wall Street expectations. And, we might add, well above Federal Reserve expectations. Things did not improve during the succeeding months, with July, August and September scoring increases of 5.4%, 5.3% and 5.4%, respectively. Core inflation backed off a bit during the period to the 4.0% level. Unfortunately, wholesale prices, as measured by the Producer Price Index by the Bureau of Labor Statistics, are also surging. The PPI final demand index rose 8.6% for the 12 months ended in September, the largest advance since 12-month data were first calculated in November 2010. Prices for PPI final demand less food, energy, and trade services moved up 0.1% in September after increasing 0.3% in August. For the 12 months ended in September, the index for final demand less food, energy, and trade services rose 5.9%. Price increases look to be locked in the pipeline to the consumer.
As we have done for the last few quarters, we list some of the year-over-year outliers adding to CPI inflation: rental cars +43%; gasoline +42%; used cars +24%; bacon +19%; hotels +18%; beef +18%; pork +13%; eggs +13%; televisions +13%; children’s shoes +12%; furniture +11%; electricity and gas utilities +9%. Overall, food inflation, as measured by the CPI, is up 4.6%. It should be noted that this is not one of the “base effect” phenomenon mentioned by Federal Reserve officials in the spring. Food prices are currently up 8.8% over September 2019 levels, before the pandemic and lockdowns occurred. The current rate of inflation is having an effect on both consumer inflation expectations and sentiment. The University of Michigan Sentiment Expectations readings have reverted back to pandemic lows in the 70-range, well below pre-pandemic readings typically in the 90-100 range. And this sentiment could be bleeding into the real economy. U.S. Industrial Production came in at 4.6% growth year-over-year in September, well below expectations of 5.7% growth and August’s reading of 5.9%. Capacity utilization also declined unexpectedly to 75.2% from 76.4%. Industry could also be feeling the effects of worsening supply chain constraints and one of the oddest labor markets that we have ever seen.
First, the labor market is in disarray. On the surface it looks like a recovering economy’s improving labor market, with a 4.8% unemployment rate that is slowly declining. However, under the surface, things start to look strange. In February of 2020, before the recession, the unemployment rate was 3.5% with a labor force participation rate of 63.3%. The current employment-participation rate of 58.7% is 1.7 percentage points below pre-pandemic levels. There are currently 7.7 million unemployed Americans in the labor force, up from 5.7 million in February of 2020. So far, all looks pretty normal for a recovering economy. However, once we look at the governments JOLTS report (the Job Opening and Labor Turnover Survey), everything gets out of whack. Employers reported 10.4 million job openings in September, down from 11.0 million in August. Remember, there are currently 7.7 million unemployed in the labor market, or roughly 1.4 available jobs for each unemployed worker. There are also approximately 5 million fewer jobs in America now versus February of 2020. But what makes the situation really strange is the quit rate to new hire rate. For example, in September 4.3 million workers quit, equal to a whopping 2.9% of all workers. Also, in September only 194,000 new employees were hired, well below economists’ expectations of 500,000 new hires. The same was true in August. So, workers appear to be quitting, but not getting a better or higher-paying job, despite the large number of job openings. Is this because of a mismatch in skills versus available jobs? Is this because some combination of expanded unemployment benefits, a strong housing market and stock market, high levels of personal savings and/or increased rates of self-employment has emboldened potentially available employees to be more discerning in job choice? Or have we broken the traditional American labor market? Time will tell, but the economy is now growing at a slower rate than it could because of the current state of the labor market.
There is no doubt that dislocations in the labor market are exacerbating supply chain bottlenecks, and as Fed Chair Powell claims, this is adding to price inflation. But, to paraphrase Leo Tolstoy from Anna Karenina, “All happy supply chains are alike, each unhappy supply chain is unhappy in its own way.” Let us look at the L.A. Port bottleneck. The Los Angeles and Long Beach Port Terminals together have a maximum physical capacity to load and unload containers. From 2012 until 2018, the combined ports saw peak monthly volumes ranging from 650k containers to a peak of 842k containers handled. By May of 2020, volumes declined to about 600k containers during the month. Previous high-volume months were mostly followed by slower-volume months, allowing the ports to dig out of the problems that created small backlogs. Since the recovery began (and demand exploded), the dual ports have been handing 850k to 950k containers per month, every month. To make matters worse, the ancillary infrastructure supporting port operations never recovered to pre-pandemic peak levels. Even if a container is unloaded, it cannot clear the port without coordinated services provided by entities outside of the port’s control. There is a trucking shortage at the port that has been exacerbated by strict California environmental regulations; there is a shortage of chassis fleets to put the containers on; there are warehouses with inadequate staff and working hours; there are insufficient intermodal railroad cars available for loading out containers; there is insufficient acreage to store the peak container volumes awaiting ground transportation. And there is a backlog of incoming containerships waiting to add to the chaos. But moving to 24/7 operations at the ports won’t alleviate the bottleneck unless the ancillary truckers, railroads, container owners and warehouses move to 24/7 operations, as well. And that takes independent investment, and most operators do not think it is profitable to build redundant operations based on a stimulus-induced capacity peak. So, for now, we have Lucille Ball at the bonbon factory conveyor belt, unloading chocolates as fast as she can with nowhere to put them. It will get sorted out eventually, but it will first require costs to go up to 1) reduce incoming shipments and 2) make capacity capital investments profitable for the disparate ancillary players.
Last quarter, we noted that in previous episodes of ramping inflation, we had seen several themes: oil shocks, large amounts of deficit spending, and inappropriately loose monetary policy. The evidence here is certainly still mounting. This quarter, we will note that fixing fragile or dysfunctional supply bottlenecks almost always means building more redundancy, lower capital returns and, usually, lower volumes. This is not a great recipe for earnings growth. Stagflation is a greater possibility now than even last quarter, and we will try to invest accordingly by finding durable businesses that can pass-through increased costs to customers. We must also stress appropriate asset allocation, for both your investment goals and stage of life. We will also keep fixed income investment durations low, as we think that interest rates are likely to chase inflation rates, rather than anticipate them.
We would be remiss if we did not at least mention Covid-19. Anthony Fauci, the Director of the National Institute of Allergy and Infectious Diseases recently said, “If you are fully vaccinated, you can enjoy the holidays with your family.” Really? We are pretty certain that Dr. Fauci has never met our family. That being said, our best wishes to you and your family for a healthy and happy holiday.
Your Team at Baxter Investment Management