Inflation is now the biggest worry for investors. We think these supply-driven price pressures should dissipate by year-end and will not move the Fed.
So should we be worried? We are in a period in which the incoming data is being compared to 2020’s recessionary depths, which makes for skewed year-over-year measures – and the market seems to acknowledge that. But supply bottlenecks in various areas of the economy are also making for cautionary headlines about inflation. Below, we focus on three segments – the labor market, commodities, and semiconductors – and offer up our thoughts on what it means for the bigger inflation picture and Fed policy.
The labor market
The latest U.S. jobs report showed that the economy added only 266 thousand jobs in April versus expectations of nearly one million. The same report also showed a tick up in average hours worked, which was especially pronounced in sectors like Leisure & Hospitality. Last week, the Job Opening and Labour Turnover Survey (JOLTS) told us that job openings shot up by nearly 600 thousand to a record high 8.1 million. Taken together, the data is telling us that if anything is holding back the jobs recovery, it’s workers’ willingness to get back into the labor force – not a lack of businesses wanting to hire.
This is due to a few reasons. There are ongoing fears around the virus, many people have the ability to collect unemployment insurance that’s been beefed up by fiscal stimulus, and the ongoing burden of childcare may exist, given many schools and daycare facilities are yet to fully reopen. United States jobs data due out in the next month should offer us more clues. On one hand, it’s possible that the April report was completely anomalous and we see a big jump in jobs added next month. Or, our key factors could stretch this out. It could take a few more months until we make more progress towards herd immunity in the U.S., people may hold back from the workforce given that supplemental unemployment benefits expire in September, and many more may be forced to wait for the commencement of a new (in person) school year.
Either way, we think the risk of broad and permanent labor market scarring is minimal (although technological disruption catalyzed by compressing corporate margins poses a risk) and still expect the unemployment rate to continue to fall to around 4.7% by year-end. Certain sectors may see some degree of upward wage pressure (currently, Financials and Leisure & Hospitality are the standouts, but they account for only around 15% of the total jobs market), but not all due to the amount of slack. There are still about 10 million fewer people employed versus what the pre-pandemic trend would suggest, which leads us to believe that wage inflation will remain relatively contained.
Corn, soy, and pigs. Lumber. Copper. It seems like most areas of the commodities complex are facing supply shortages as the impressive bounce back in global demand outpaces resumption of production. For example, the new orders component of the ISM Manufacturing Index has been stronger than the production component in nine of the past 11 months.
We can’t quite paint the picture for all commodities with one broad brush. For many agricultural commodities, the story centers on weather-related factors (e.g., droughts in South America; winter storms in the United States) or a massive swell in demand (e.g., China asking for all the corn it can get to feed hogs and replenish supply following the pre-pandemic African Swine Fever outbreak).
For lumber, it’s not so much about the trees themselves being expensive, but more about the confluence of heightened demand (think housing boom) and saw mills not yet back to operating at full steam (nearly one third of U.S. lumber production went offline during the pandemic). For copper, the metal used in a wide variety of applications, the surge in prices reflects the broad-based global recovery and is augmented by the rise of “green demand” – see our note on copper from a couple of weeks ago for more.
For most commodities, we think prices can normalize by year-end, as supply ramps up to meet the elevated demand. Market pricing reflects this assumption: many commodities have deeply downward sloping futures curves (i.e., they are in backwardation), meaning that the supply/demand balance is tight right now but that prices are expected to be lower in the future than they are today.
Copper may be a different story. It takes years to add capacity at existing mines and close to a decade to establish a new one. There is some more copper supply coming online in the next couple of years, but not much more planned beyond that. Add in existing inventories that are already depressed, and the declining quality of copper ore. It seems most likely that copper prices stay supported in the near-term, and potentially move even higher in the years ahead given incrementally increasing demand amid global decarbonization efforts.
Pretty much every end-market that uses semiconductors – from smartphones to televisions to dog washing booths – is feeling the pinch of a shortage. Looping back to the CPI print we discussed at the start of the note, it’s probably a major factor contributing to the spike in used car prices. New vehicle production has felt particular strain…you get one guess as to what allows your car to sense another in its blind spot, or what’s enabled its improved fuel efficiency versus the same model from ten years ago.
Over the years, many companies outsourced the manufacturing of chips in search of cheaper production to capture fatter margins. Note that chipmakers in Taiwan now account for 60%+ of global foundry manufacturing. That was fine at first, but then the pandemic slowed production down. As demand came roaring back, suppliers didn’t have enough lead time to prepare. Disruptions stemming from Texas’ winter storms and a factory fire in Japan didn’t help either.
The issue is compounded by the advancement of semiconductor technology that requires sophisticated processes along the production chain to make chips more powerful, smaller, and cheaper. Everyone wants the latest and the greatest (it’s real nerdy stuff, but google EUV lithography if you’re interested), but there’s really only one company in the world – ASML – that does it right now. Good for those shareholders, not so good for the semiconductor production pipeline.
Our best guess is that it takes somewhere between six to 18 months for the semiconductor imbalance to normalize. CEOs from Ford, Cisco, Intel, Dell and others echo that sentiment. Others have pointed out that shifting or expanding production capacity is a process measured in years (which is to say, that won’t solve the near-term issues). This one is more likely to resolve itself as demand stops booming and comes back down to meet supply.
Tying it all together
With a few exceptions (e.g. copper), the supply squeezes seem mostly transitory in nature. As reopening brings more production capacity back online and the demand boom cools off, it seems likely that the bottlenecks will clear by year-end. When it comes to the implications for Fed policy, it’s important to remember 1) that the labor market and housing rental prices are still the key drivers of the inflation basket they monitor; and 2) that they’re looking for a sustained inflation overshoot to bring longer-term average inflation levels around their 2% bogey. Despite the scary headlines, the market’s pricing of inflation expectations is actually consistent with that framework.
All market and economic data as of May 17, 2021 and sourced from Bloomberg Finance L.P. and FactSet unless otherwise stated.
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