June 2021
“Change is hard.” My father, a creature of habit, used to say this when my mother brought home a different brand of oatmeal or toothpaste. Fortunately for my father, these occurrences were rare and short-lived, so he usually just had to persevere for a week instead of truly change. For investors, change has arrived in the form of inflation and labor market shortages – two concerns that rarely presented themselves during the past two decades. When they did occur, they did not last much longer than my father’s new brand of oatmeal. For better or worse, today’s changes in the economic climate likely require more than just a week or two of perseverance.
Transitory vs. Sticky
As Fed Chairman Jerome Powell has noted, the economic recovery has been “uneven.” There are still 8 million jobs lost during the pandemic that have not been replaced, and the official unemployment rate is near 6%! Those are incredibly deflationary signals. Conversely, there are many inflationary signals including used car and home prices — up 30% and 13%, respectively, over the last year. The broader and widely followed Consumer Price Index (CPI) rose 5.0% in May from levels a year earlier, the largest annual increase since September 2008.1
These mixed signals add to the intrigue, making it easy for many in media and politics to grab a few of the relevant data points and dumb them down. They then attempt to convince viewers, readers and followers alike that this change is unequivocally “good” or “bad.” We believe this approach is fundamentally flawed given the complexities of this investing environment — one that is far different from any we have witnessed since the Financial Crisis.
Most of the inflationary episodes since 2000 were led by energy, which tends to be volatile and follows an under/oversupply pattern. In other words, the price of oil goes up and either demand subsides as substitutes emerge or producers pump more oil, thereby increasing supply, and the price falls. In contrast, today’s rising prices appear to be caused by supply chain disruptions and pent-up consumer demand. Also, the cost of labor seems to be an important aspect of the equation.
As opposed to commodities like a pound of bacon (up 19% year over year) or a gallon of gas (up 56% year over year), the price of labor tends to be “stickier.” It is easier for management to raise/lower the price of just about any good or service than it is to lower one’s wages (we have found most folks are quite amenable to pay increases). As a result, wage inflation tends to take longer to surface (right now, wages are up only 2% year over year1), but lingers much longer than commodity inflation once it appears. Moreover, labor costs feed into a wider array of goods and services than commodities. So, you can think of wage inflation being more of a permanent change, versus commodity inflation, which tends to be more transitory.
Fear Not the Friction
Hopefully you will notice that we have not yet used the word “problem” when speaking of inflation. Despite what the talking heads may tell you, higher inflation does not have to be a scary development for investors. Stocks can perform well (and usually have historically) in periods of higher inflation and rising interest rates. In fact, this development represents a return to normalcy, historically speaking. The U.S. economy has rarely achieved 2% inflation since the Financial Crisis, and as a result, bond yields have gradually trended towards zero. That is the real anomaly – not the norm – despite the fact we have become accustomed to it. At the same time, we are not concerned about inflation levels similar to what was witnessed in the late 70s and early 80s. We offer an aging demographic, comparatively low international bond yields, technological innovation and the effectiveness of Federal Reserve policy to name a few reasons why.
Changes are underway in the labor market as well. Lower wage employees have not had much negotiating leverage since the Financial Crisis but now do. There are shortages everywhere and companies have begun offering higher wages and sign-on bonuses to entice workers to come aboard. Despite these incentives, not much hiring has yet occurred. Many have latched on to this phenomenon and claimed the free market of the U.S. is broken, and/or the stimulus has ruined the labor market. We believe this analysis is a gross oversimplification of what is going on.
We recall that roughly 22 million people lost their jobs last year due to Covid-19. Millions of the current job openings differ from those originally lost as many segments of the economy fundamentally changed — particularly in restaurants, retail and construction to name a few sectors most impacted. We should not expect these jobs to be refilled in a frictionless manner. Job openings need to be authorized, interviews need to be conducted and pay/benefits need to be negotiated.
Additionally, there are plenty of people who are in no hurry to rejoin the labor force. That does not mean all these folks are unwilling to work. We believe the issue is more nuanced. There are many people who stockpiled savings during last year’s lockdown when they did not travel or go out to eat. Many folks still have no good childcare solution until schools fully re-open in the fall. Others know that job openings greatly outnumber job seekers (so they can be choosy). In addition, concerns about the virus and vaccine hesitancy have differed greatly by community. Last but not least, stimulus checks are still going out to individuals, replacing some of the lost wages. Consequently, it is no surprise that resurrecting the job market has been bumpy. The combination of children returning to school, stimulus support ending, wages moving higher, savings being spent and the passage of time should “normalize” the labor market and eventually constrain the aforementioned wage inflation.
Sense over Sensationalism
The British novelist Arnold Bennett once wrote, “Any change, even a change for the better, is always accompanied by drawbacks and discomforts.” That applies to the U.S. economy, but perhaps even more so when these changes are complex and a departure from what investors have experienced over the past decade or more. While words like “complicated” or “multi-dimensional” are not as sensational as “hyperinflation” or “labor wars,” we do think they offer a more accurate representation of what is transpiring in the world.
Though one can never be sure what unexpected challenges lie ahead, we do not anticipate impending financial doom from these specific issues. There is plenty we like (rising corporate profits, low interest rates) and plenty that worries us (valuations, speculative activity). Parts of the playbook for what we believe is likely to work best over the next several years (such as interest rate sensitive stocks, companies with pricing power) will likely differ from what has worked in recent years (companies that benefit from falling interest rates). Other aspects of the playbook such as our focus on high quality companies will not change. Since this environment is new to us all (a pandemic followed by a historic amount of stimulus), we will remain open-minded and observant to what trends may work well in years to come. Change is hard, but it does not have to be bad.
1) Source: Bloomberg