Goldilocks? Overheating? Stagflation?
Or how about, ‘none of the above’?
Last week, investors waded through the data deluge that crests during the first week of each month. The numbers included purchasing manager indices of manufacturing and services, European inflation and various employment reports from major economies.
What did we learn? Is the world economy restoring growth without inflation (‘Goldilocks’), overheating or succumbing to stagflation?
The data had something for everyone. Most indicators of demand and production, such as global purchasing manager surveys of manufacturing and services or Japanese household spending, came in above already-high expectations. Fans of ‘Goldilocks’ or the inflation thesis saw what they liked in those numbers. But weaker-than-expected US job gains (for the second consecutive month), dismal German retail sales and lackluster US auto sales offered stagflation adherents ammunition for their case. And both the inflation and stagflation camps cited an array of supply-shortage anecdotes in the Federal Reserve’s Beige Book, as well as the stronger-than-expected jump in US average hourly earnings and an uninspired US labor force participation rate, to argue that bottlenecks in markets for goods, services and labor are contributing to accelerating price and wage inflation.
Investors were more decisive. By week’s end, falling bond yields and rising share prices emphatically proclaimed faith Goldilocks. Bullish markets were buoyed by strong statements from central bankers quick to dismiss price and wage increases or supply shortages as ‘transitory’.
For equity investors it is all Goldilocks. Growth is deemed strong enough to support already high earnings expectations, but a sluggish US jobs recovery will keep the Federal Reserve manning the monetary pumps for longer. Friday’s Treasury market rally brought investors flocking back into long-duration growth and information technology shares.
But are things really that clear? Can fears of overheating or stagflation really be put aside?
In the short run, yes. The coming weeks offer mostly second-tier economic releases. One exception is this Thursday’s US consumer price inflation release. The consensus of economists forecasts a 0.4% month-on-month jump in the core measure (which excludes more volatile food and energy prices). Yet judging from the bond and stock markets’ dismissal of other recent price and wage pressures, it probably would take a large and widespread acceleration of core consumer price inflation to change their Panglossian mindset.
But it remains premature to draw firm conclusions for more than a few months. Stretched stock and bond valuations don’t offer much latitude for either growth or inflation shocks.
The biggest uncertainties reside on the supply side. In normal circumstances, surging demand temporarily boosts prices and wages, thereby signaling to firms and individuals to shift production and labor supply to where it is most needed.
But there are reasons to question how quickly supply will respond to soaring demand. For one, as the Fed’s Beige Book or the ISM surveys revealed, bottlenecks are widespread in the US and elsewhere. Auto sales are constrained by chip shortages. Lean global supply chains are stretched, precipitating unprecedented delays of two weeks or more for cargo ships trying to dock at ports along the US west coast. Construction is impaired by shortages of materials and labor. The Institute for Supply Management has reported its largest order backlog since it began collecting data in the late 1980s.
In job markets, recalcitrant workers enjoy bargaining power, evidenced by widespread reports of signing bonuses to lure back employees. Anecdotes abound about employers conceding to work-from-home demands. Still, the market is sluggish to respond—US labor force participation and employment-to-population ratios remain well below pre-pandemic levels. That’s a big reason why US average hourly earnings rose at a 0.5% clip month-on-month in May, following a 0.7% advance in April. And that’s even after taking into account that the biggest source of job gains in recent months has been in low-wage sectors, such as hospitality, leisure and travel.
Partisan politicians blame generous transfer payments and unemployment benefits. If that were the case, worker reticence would be short lived, as those ‘freebies’ run out.
But emergency measures may not be the primary reason for labor market rigidity. Pinch points can be found worldwide, with shortages of intermediate and final goods or skilled workers reported in Europe, Asia, and South America. Indeed, most economists cite other factors for the reticence of workers to go back on the job, health concerns, the high monetary and time costs of commuting, or the inability to find adequate childcare. Those rigidities might prove more enduring.
The Federal Reserve, and most other central banks, are betting that supply-side stickiness will be short-lived. Investors, as noted above, are heartily drinking that central bank Kool-Aid.
There are, however, at least two reasons to resist extended Bacchanalia.
First, the pandemic has exposed uncomfortable truths about the world economy. Corporate managers, shareholders, suppliers, customers, employees, regulators and other stakeholders have become acutely aware of the vulnerabilities of relying on extended global supply chains and just-in-time inventory management. Yet re-shoring production or building in redundancy is costly. Those costs must be passed along or absorbed in profit margins. Neither outcome is factored into today’s ebullient share prices.
Second, if it takes longer for supply to adjust, then rising prices and wages could become embedded in inflation expectations. If there is one thing economists (and central bankers) agree on, it is that inflation begets inflation. Once entrenched, expectations for rising wages and prices are difficult to dislodge and begin to affect economic behavior. Consumers no longer recoil from ‘sticker shock’, workers demand annual wage increases, and businesses more readily pass along higher costs to each other.
Remember, it is now stated Fed policy that inflation should exceed its 2% target in this cycle. But if that policy, combined with the reality of higher inflation, begins to condition agents’ actions, then the Fed may have to tighten forcefully, inducing a sharp market correction, recession or most probably both.
The markets have rendered their verdict. They are relishing Goldilocks. But markets are fickle. Investors can quickly change their minds. Goldilocks? Overheating? Stagflation?
Prudence dictates, ‘none of the above’.
