Santa vs the Two Grinches, Again

December 20 (Monday)

YRI Monday Webinar. There won’t be a webinar today, but please join Dr. Ed’s live Q&A webinar on most Mondays at 11 a.m. EST. You will receive an email with the link to the webinar one hour before showtime. Replays are available here.

Strategy I: The Two Grinches. Late last week, the Santa Claus rally ran into some turbulence as investors turned more risk averse. They were clearly spooked again by the two Grinches—the Omicron variant of Covid-19 and the hawkish variant of the FOMC. Consider the following developments:

(1) Fast-spreading Omicron variant. Might Santa be an asymptomatic carrier of the Omicron variant of Covid-19? That’s unlikely since he never gets sick this time of year. Others aren’t so lucky: In recent conversations with friends, we have been hearing that quite a few have contracted the variant but have either no symptoms or minor ones. And, yes, a few of them have been fully vaccinated, including with booster shots.

The media is onto the story, with lots of ominous headlines. Rarely mentioned is that Omicron seems to hit hardest mostly the unvaccinated and that it may be spreading herd immunity. If so, it may bring the pandemic to an end sooner rather than later. We know that the variant is spreading like wildfire. Initial reports were that it is far less dangerous than previous variants of the virus, especially to people who have been vaccinated. Recent accounts have raised some doubts about that conclusion. In other words, we don’t know very much about where the virus is taking us.

We should know more in coming weeks by comparing new cases to hospitalizations and deaths. In the US, there has been an upturn in both in recent days from recent lows (Fig. 1). The number of deaths continues to decline from its recent high (Fig. 2). Somewhat encouraging is that the recent jump in the count of new cases in the UK—to a pandemic-era record high—has yet to significantly boost hospitalizations (Fig. 3). New cases have been soaring in continental Europe too, but hospitalizations remain relatively low (Fig. 4 and Fig. 5).

It’s interesting to see that after a huge spike in India’s new cases during the spring of this year, the cases there have remained remarkably low in recent weeks (Fig. 6). Might that suggest some degree of herd immunity?

China’s new cases have remained extraordinarily low since the government imposed its zero-tolerance policies after the initial breakout of the pandemic over there during January and February 2020. However, the new Omicron variant may prove more challenging for China to contain. China has administered at least 2.6 billion doses of its killed-virus Covid vaccines, covering some 94% of the population. An October article in Nature noted that immunity from a double dose of the killed-virus vaccines wanes rapidly and that the protection given to older people may be limited. The Chinese vaccines aren’t as effective as mRNA vaccines.

(2) More hawkish FOMC variant. Last Wednesday, the FOMC turned more hawkish. The committee’s statement noted that the “path of the economy continues to depend on the course of the virus” and that progress on vaccinations should keep the economy growing. “With inflation having exceeded 2 percent for some time,” the FOMC decided to speed up the monthly pace of tapering its bond purchases from $15 billion to $30 billion starting in January. That presumably will set the stage for hiking the federal funds rate earlier next year.

Indeed, the Fed’s dot plot, released after the FOMC meeting on Wednesday, showed that all 18 members of the FOMC now expect at least one rate hike in 2022, up from only nine in September’s forecast. Moreover, 12 of them now see at least three quarter-point hikes during the year, and two think four increases will be necessary.

Contributing to Friday’s stock market selloff was Federal Reserve Governor Christopher Waller’s characterization of inflation as “alarmingly high” in a speech to the Forecasters Club of New York. He added that March’s FOMC meeting may be “a live meeting,” i.e., one in which a rate hike would be on the table.

Strategy II: Many Happy Returns? Santa’s sleigh is loaded with bags full of liquidity. The financial markets are trying to ascertain whether he has enough to drown the Grinches. Joe and I think so. Consider the following financial market reactions to the two Grinches this past week:

(1) Stock market rotating, again. You need a neck brace to trade the stock market these days. The S&P 500 was up 3.8% two weeks ago, led by a 6.0% increase in its Information Technology sector (Fig. 7). This past week, it was down 1.9%, led by the Energy (-5.1), Consumer Discretionary (-4.3), IT (-4.0), and Industrials (-2.8) sectors. Cyclicals got whacked by renewed fears of the rapidly spreading Omicron variant of Covid. Defensive sectors outperformed as follows: Health Care (2.5), Real Estate (1.6), Utilities (1.2), and Consumer Staples (1.2). (See our Performance Derby tables for the S&P 500 sectors and industries over the past week.)

The S&P 500 peaked at a record high of 4712.02 a week ago Friday. It was down every day this past week except for Wednesday, when a big jump took it almost back to Friday’s high. That was surprising since the FOMC announced on Wednesday a faster pace of tapering and signaled three rate hikes in 2022. Coincidently, there was also news suggesting diminishing odds of Congress’ passing Biden’s Build Back Better (BBB) bill. That might be viewed as bullish for stocks to the extent that more fiscal stimulus would push inflation even higher.

(2) Yield curve flattening, again. The flattening yield-curve spread between 10-year and 2-year Treasury notes suggests that three rate hikes next year might be enough to lower inflation, especially if Congress can’t get enough votes for yet another round of fiscal stimulus (Fig. 8).

(3) Commodity prices peaking. Slower global economic growth, especially in China, and more hawkish central bank policies seem to be capping the CRB all commodities index and the CRB raw materials index (Fig. 9). The same can be said about the price of copper (Fig. 10).

US Fiscal Policy: No Xmas Gift. The Senate adjourned for the year early Saturday morning and will return to Washington on January 3. My vote is to let the senators stay home for 2022. The Hill observes that “leaving for the holidays officially punts both President Biden’s climate and social spending legislation and voting rights legislation, which would require a change in the Senate rules, into next year.”

On Friday, Senate Majority Leader Charles Schumer (D-NY) acknowledged that Biden’s BBB legislation won’t be enacted this year. He is expecting that Biden will negotiate a BBB deal with Senator Joe Manchin (D-WV), a key vote, by early next year. Manchin would like to hold off on another round of fiscal stimulus because it would add to the current bout of inflationary pressures.

Jim Lucier, our good friend at CapitalAlpha, is one of the most astute Washington watchers. He currently believes that a streamlined version of BBB could eventually get done, but probably not until February at the earliest. He expects it to be reduced to $1.5 trillion and to maintain the 21% corporate tax rate as well as other positive features of the Trump tax reform. He attributes this expectation to the actions of Senator Kyrsten Sinema (D-AZ). To get her vote for BBB, she has demanded no corporate rate hike, no individual rate hike, no capital gains rate hike, and no broad based tax increase of any kind. The result would be a bill with $1.5 trillion in other revenue raisers.

However, as Jim observes, “The problem is that progressives and the Biden administration are not happy with $1.5 trillion paid-for and still want to cram $5 trillion worth of stuff in a $2 trillion package.” A December 10 letter from the director of the Congressional Budget Office (CBO) responded to questions from a couple of members of Congress about BBB. They wondered what the impact would be if “specified modifications … would make various policies permanent rather than temporary.” The response stated that it would increase the deficit by $3.0 trillion over the 2022–31 period.

Late-breaking news: On Sunday morning, CNBC reported that Senator Manchin said he won't vote for Biden’s Build Back Better Act, likely killing the bill for now.

China: Disappearing People. People who have criticized China’s Beijing regime often vanish for several months, during which time they are interrogated in a nondescript government building, according to a recent article in The Telegraph. They are abducted under the Chinese regime’s program of “enforced disappearances,” known officially as “RSDL,” or “Residential Surveillance at a Designated Location.” Many then “re-emerge in society with an outwardly different personality, their plucky mode of resistance replaced by a supine deference to Beijing authorities.”

Chinese tennis star Peng Shuai went missing for more than two weeks after claiming in a social media post that former Vice Premier Zhang Gaoli had forced her to have sexual relations with him. She briefly returned to the public eye when she spoke to the president of the International Olympic Committee during a 30-minute video call on Sunday, November 21. She insisted that she was safe and well at her home in Beijing.

Also gone missing is China’s working-age population (Fig. 11). This development likewise can be attributed to the Chinese Communist Party’s (CCP) authoritarian policies, particularly the one-child limits imposed on families from 1980 to 2015. The result has been a drop below the replacement fertility rate since the second half of the 1990s (Fig. 12). Rapid urbanization also contributed to the drop in fertility, which now is rapidly converting China into the world’s largest nursing home.

The Chinese government reversed course in 2015, eliminating the one-child policy in an effort to boost population growth. The CCP wants China to be a global superpower. That’s hard to do while the nation’s demographic profile is turning increasingly geriatric. Consider the following:

(1) China’s birth rate dropped to a new low in 2020, confirming the demographic challenge facing the government as it tries to deal with a shrinking labor force and growing population of elderly people. There were 8.5 births per 1,000 people last year, the lowest in data back to 1978, according to the latest yearbook from the National Bureau of Statistics.

(2) The number of newborns may decline again this year from the 12 million born in 2020, a health commission official said in July. Some demographers estimate that China’s population could have started falling this year. Critics of the CCP have charged that Beijing is disproportionately reducing births among its Muslim minority in the Xinjiang region as part of an ethnic-cleansing crackdown.

(3) We believe that the combination of urbanization and the one-child policy is weighing heavily on Chinese consumers. Just think about all those young adults who are the only children of two elderly parents. In China, children have a social responsibility to take care of their aging parents. That’s a heavy burden for only children. A married pair of only children has four older parents to support.

This certainly helps to explain why the growth rate of inflation-adjusted retail sales has plunged in recent years. Every month, the Chinese government releases data on the y/y growth in nominal retail sales and the CPI. A few years ago, we realized that we could easily calculate real retail sales using the two series (Fig. 13). During November, retail sales rose only 3.9%, while the CPI increased 2.3%, resulting in a 1.6% increase in real retail sales.

To better see the underlying trend in real retail sales growth, Debbie and I track the 24-month percent change in the 24-month average of real retail sales at an annual rate (Fig. 14). It shows a calamitous plunge in real retail sales growth from about 18% ten years ago to ZERO as of November!

(4) That’s very bad news for China’s economy, especially now that China’s speculative property bubble is bursting. On Friday, S&P Global Ratings downgraded China Evergrande Group to one of its lowest possible ratings, a cut that means the world’s three largest credit-rating firms all now judge the giant developer to be in default. The December 17 WSJ reported: “Failures to repay investors are piling up in China’s property sector, as real-estate companies buckle under the strain of falling home sales, government curbs on borrowing and a massive bond-market selloff that has made it difficult for many firms to raise fresh funds.”

The government is trying to engineer a soft landing. The People’s Bank of China lowered reserve requirements by 50 bps on December 6 (Fig. 15). Yet a soft landing is a tall order because the ailing property market accounts for between a quarter to a third of annual GDP growth in China. Again, the CCP’s aspirations to make China a superpower may flounder along with its economy.

Movie. “Spencer” (+) (link) is described as a fable based on what really happened to Princess Diana, admirably played by Kristen Stewart. It’s an intense psychological look at her life focusing on three days over Christmas 1991 at Sandringham, Queen Elizabeth’s estate in the UK. The biopic suggests that she might have hit bottom during those three days near the end of her unhappy marriage to Prince Charles. She did her best to spend as little time as she could with him and the other royals. Diana is clearly miserable, as shown by her eating disorder and visions of Anne Boleyn, who was beheaded by her faithless husband, King Henry VIII. This Christmas film is a depressing antithesis of “It’s A Wonderful Life,” and should be watched after the holiday season.

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Will 2022 Be Better Than 2021?

December 16 (Thursday)

Strategy I: Countering the Bears. It seems like another lifetime, but only a year ago we would bundle up and gather with friends, appropriately distanced, around newly purchased outdoor gas heaters on sunny winter days. Makeshift opportunities for cautious socialization had to do. There were no extended family gatherings. There were no vacations. The Grinch stole Christmas 2020.

Things aren’t perfect this year, but they’re a heck of a lot better. More than 60% of Americans are fully vaccinated, and many are lining up for boosters. The S&P 500 has risen 23.4% ytd through Tuesday’s close, and GDP growth looks to be on track to rise 5.0% in Q4.

We’re hopeful that the economy will continue to reopen in 2022 and that the slow but steady return to normalcy will drive the market higher. However, the arrival of the Omicron variant may mean that we’re about to take one step back after having taken two steps forward.

But the bears seem too pessimistic. Let’s take a look at why we dismiss some of the bears’ arguments before looking at which areas of the economy and the stock market appear ready to rebound:

(1) Buybacks are at record highs. According to the preliminary data released by S&P in early December, S&P 500 companies bought back $234.5 billion of shares in Q3-2021, topping the previous record of $223 billion purchased in Q4-2018 (Fig. 1). The record amount marks a rebound from the meager repurchasing done during the height of Covid-19’s rampage in 2020, when economic uncertainty compelled companies to conserve cash. Rather than being a bearish signal, we believe buybacks often rise with the markets because rising markets increase the attractiveness of paying employees with stock grants. The dilution from the grants then is offset by buying back shares, we observed in our 2019 Topical Study “Stock Buybacks: The True Story.”

(2) Insider sales break records too. CEOs and corporate insiders have sold $69 billion of stock in 2021 through the end of November. Insider sales are up 30% from 2020 and up 79% above their a 10-year average according to InsiderScore/Verity data quoted in a December 1 CNBC article. Amazon’s Jeff Bezos, Tesla’s Elon Musk, Facebook’s Mark Zuckerberg, and Walmart’s Walton family account for 37% of this year’s sales. Microsoft CEO Satya Nadella’s sales were also notable: $285 million, or nearly half of his Microsoft shares.

While high stock prices undoubtedly were one reason insiders sold, taxes may be another. The CNBC article noted that by selling now, Nadella and Bezos will save on taxes because the state of Washington is imposing a 7% tax on capital gains over $250,000 starting in 2022. And there are also threats of higher taxes on high earners coming from Washington DC.

(3) Households own lots of stock. Equities represented 24% of household assets at the end of Q3, topping the last peak hit in Q4-2000, reported a December 13 Money article citing Wells Fargo data. That amount of exposure to stocks may suggest that individuals are acting rationally this time, unlike during 2000’s tech bubble frenzy. The S&P 500 dividend yield is 1.38%, almost as much as the 10-year Treasury bond yield of 1.47%, and stocks are one of the few assets considered to be a hedge against inflation (Fig. 2).

(4) The Fed is on the move. The Federal Reserve has done a good job preparing the market for higher interest rates. Even after it accelerated the end of its asset purchases and implied that there could be three interest rate hikes next year, the stock market managed to rally yesterday. There have been instances historically when stocks have rallied during parts of Fed tightening cycles. The S&P 500 rallied throughout 2016, when the Fed began a tightening phase that started on December 16, 2015 and lasted until August 1, 2019. The S&P 500 climbed 43.8% from December 16, 2015 through July 31, 2019 (Fig. 3).

Strategy II: What Could Go Right in 2022? Looking ahead, there seems to be plenty of room for the economy to continue to reopen, though different industries and sectors may benefit in 2022 than did so this year. Many employees still need to return to offices, where they’ll buy lunches and go out for happy hour. Business travel and trade shows have just started to resume. And the number of weddings this spring and summer is expected to surge.

Now let’s lay out some of the reasons why the stock market’s rally should continue:

(1) Covid is under control. We are in a much better position regarding Covid than we were even a few months ago. The Centers for Disease Prevention and Control (CDC) finds that 72.2% of all Americans have at least one Covid vaccine dose, 61.0% are fully vaccinated, and 27.2% have booster shots. But the situation is even better than those figures imply in the sense that “all Americans” includes children under five, who can’t receive a vaccination. Among Americans 18 or older, 84.5% have had at least one vaccine dose. Even more importantly, among those considered most at risk—folks who are 65 years or older—95.0% have had one dose, 87.2% are fully vaccinated, and 51.9% have received booster shots.

That said, Covid cases have risen as we’ve headed indoors for the winter. The seven-day average was 117,890 as of December 13, up from a low of 64,152 in October but less than half of January’s case load. Those who are vaccinated appear to be getting mild cases and staying out of the hospital.

The CDC tracked 43 cases of Covid-19 attributed to the Omicron variant in a December 10 report. The bad news is that 34 of the cases (79%) occurred in people who were vaccinated, and 14 of those infected (33%) had received an additional or booster dose. The good news is that only one patient was hospitalized, for two days, and no deaths were reported. The most common symptoms were cough, fatigue, and congestion or runny nose. More data is certainly needed to draw conclusions about vaccination efficacy against the variant; but so far, so good.

In the same vein, Pfizer reported that laboratory studies suggest that its anti-Covid pill should work against the Omicron variant. In studies before the emergence of Omicron, hospitalization and deaths were reduced by nearly 90% in patients who took the Pfizer pill within three to five days of the onset of symptoms.

(2) Still pockets of opportunity. The S&P 500 has had a great year, with every sector up by percentages in the double digits. Here’s the S&P 500 and its sectors’ ytd performance derby through Tuesday’s close: Energy (45.8%), Real Estate (34.6), Financials (31.4), Information Technology (29.6), S&P 500 (23.4), Materials (20.4), Consumer Discretionary (20.2), Health Care (18.7), Communication Services (18.5), Industrials (16.2), Consumer Staples (12.0), and Utilities (10.1) (Fig. 4).

Where could there possibly be room for improvement? Traveling, particularly among the business set, hasn’t entirely rebounded yet with Covid still circulating, and many travel-related stocks have not recovered, as shown by the ytd performances of these S&P 500 travel-related industry price indexes: Casino & Gaming (-17.5%), Airlines (-7.6), and Hotels Resorts & Cruise Lines (8.3).

American Airlines plans to hire 18,000 workers in 2022 after hiring about 16,000 employees this year to bring its workforce up to about 130,000 currently, a December 14 CNBC article reported. Southwest plans to hire more than 8,000 employees in addition to the 5,000 hired this year.

The S&P 500 Restaurant index gained 17.9% ytd, but if restaurant companies can manage wage and goods inflation, their businesses should keep improving over the next year.

(3) Will Boeing finally revive? The S&P 500 Aerospace and Defense industry stock price index gained only 8.0% ytd, dragged down by Boeing’s 8.7% decline (Fig. 5). The company has started to fly straight again after a terrible few years when plane crashes weighed on its operations.

Boeing delivered roughly 302 planes this year, almost twice the 157 it delivered in 2020 but still below the 380 delivered in 2019. Deliveries of its giant 787 Dreamliner are still suspended due to manufacturing flaws. And while the 737 Max has returned to the air in the US and most other countries, it remains grounded in China.

Wall Street analysts see the company’s earnings moving from a loss this year to $4.59 a share in 2022 and $7.67 in 2023. As for the entire industry, analysts are calling for revenue growth of 10.7% and earnings growth of 30.3% in 2022 (Fig. 6 and Fig. 7). And the industry’s forward P/E, which topped out at 22.3 in early June, has fallen to 17.3 (Fig. 8). (The forward P/E is the multiple based on forward earnings, or the time-weighted average of analysts’ consensus earnings estimates for this year and next.)

(4) 2022: The year of the wedding. Covid-19 meant putting event plans on hold, and weddings were no exception. The number of weddings fell from 2.1 million in 2019 to 1.3 million in 2020 before climbing to 1.9 million this year. But get ready to party next year, when pent-up demand is expected to push the count to 2.5 million, the most since 1984, according to The Wedding Report.

This wedding bubble is good news for catering venues, florists, limo rental companies, wedding planners, jewelry stores, and, of course, dress makers. It might even help out companies that provide wedding registries, like Tiffany, Macy’s, Amazon, Target, Bed Bath & Beyond, Crate & Barrel, Pottery Barn, and others listed in this October 26 Brides’ registry ranking.

As large events like weddings and trade shows resume, we are going to need new clothes. Yet the S&P 500 Apparel Retail industry’s stock price index has risen only 8.1% ytd, while the S&P 500 Apparel, Accessories & Luxury Goods index has climbed even less, 4.8% ytd.

We’d also expect the masses to see a movie or two and throw back a pint or more next year. Yet this year, the associated industries have been decidedly out of favor: The S&P 500 Movies & Entertainment stock price index is down 4.9% ytd, and Brewers is up only 1.5%.

(5) Another good year for energy? The rise of Omicron could slow the recovery in oil demand; but with broad economic shutdowns not expected, further improvement in the demand picture should continue.

“The impact of the new Omicron variant is expected to be mild and short-lived, as the world becomes better equipped to manage COVID-19 and its related challenges. This is in addition to a steady economic outlook in both the advanced and emerging economies,” OPEC said in a recent report, according to a December 14 Oilprice.com article. OPEC kept its demand growth forecasts for 2021 and 2022 unchanged.

World crude oil production remains 8.4% below year-end 2019 levels (Fig. 9). And US inventories are far below 2019 and 2020 levels (Fig. 10).

Meanwhile, US supply remains below pre-pandemic levels. “For the U.S. to bring supply back up to levels that we saw pre-pandemic, it’s going to take to July of 2023. So I think there’s going to continue to be upward pressure on the price of oil,” Nancy Tengler, CEO of Laffer Tengler Investments, told CNBC on December 9.

Disruptive Technologies: Autonomous Trucks Arrive. In the upcoming year, it looks like autonomous trucking may roll into the mainstream. Walmart is testing autonomous trucks using Gatik software, UPS is testing autonomous truck routes in Texas, and TuSimple’s autonomous trucks are cruising across the southern US states. Progress in autonomous trucking may even be passing progress in autonomous passenger vehicles, in part because trucks often drive predictable routes and can avoid the tricky situations cars may encounter.

Venture capitalists are watching. “In the year through Dec. 6, total investment activity for self-driving logistics vehicles leapt fivefold to $6.5 billion from $1.3 billion in the same period in 2020, according to startup data platform PitchBook. Investment activity for robotaxi firms, meanwhile, fell 22% to $8.4 billion from $10.8 billion over the same period,” a December 9 Reuters article reports.

Here's Jackie’s look at some of the autonomous truckers hitting the road:

(1) Walmart tests last-mile autonomy. Walmart announced last month that it has been using two autonomous box trucks on a seven-mile loop in Bentonville, Arkansas—without a safety driver behind the wheel since August. The trucks shuttle between a fulfillment center and a Walmart store.

The retailer is working with Gatik, a startup company that focuses on the business-to-business market and short-haul routes like transporting retail goods from warehouses to stores. Gatik’s autonomous trucks drive day and night as they’re being tested on dense urban roads with traffic lights and intersections, a November 8 press release stated. Unlike autonomous taxis, they generally are able to avoid left turns across oncoming traffic, blind turns, and any other complicated driving, as well as schools, hospitals, and fire stations.

Founded in 2017, Gatik has raised $114.5 million and is backed by Koch Disruptive Technologies, Innovation Endeavors, Wittington Ventures, and others, and it has partnered with Ryder, Goodyear, Isuzu, and others, the press release stated.

(2) UPS tests handsfree trucking. UPS plans to test Waymo’s Class 8 autonomous trucks for long-haul deliveries between Dallas-Fort Worth and Houston, but the truck will have humans behind the wheel. The two companies have been working together, with UPS testing Waymo’s self-driving minivans for local deliveries, a November 17 article in The Verge reported.

Waymo announced this summer that it’s working with JB Hunt Transport Services on hauling goods in a Class 8 autonomous truck for one of JB Hunt’s customers between Fort Worth and Houston. The trucks will be supervised by Waymo employees in the cab. Waymo is also working with Daimler, which plans to use Waymo’s autonomous technology in its heavy-duty Freightliner Cascadia semi-trailer trucks, a June 10 article in The Verge reported.

Waymo is perhaps best known for the trials of its autonomous taxis in the suburbs of Phoenix without a safety driver and in San Francisco with one. A December 8 Reuters article questioned whether the company was losing its lead over others with similar ambitions. Ford Motor’s Argo AI says it will partner with Lyft to run robotaxis in Miami before year-end with a safety driver present, and General Motors’ Cruise hopes to have permits next year for a middle-of-the-night driverless taxi offering.

(3) Texas welcomes autonomous trucks. Waymo isn’t alone in Texas. Embark Trucks, another autonomous trucking software developer, next year plans to haul freight in its autonomous trucks between Houston and San Antonio, a December 9 FreightWaves article reported. The trucks will have backup drivers in the cabs.

Embark is working with development program members Werner Enterprises, Mesilla Valley Transportation, and Bison Transport. The company, which didn’t say how many trucks were involved, went public through a merger with Northern Genesis Acquisition Corp. in a November deal that valued Embark at roughly $5 billion.

TuSimple also has autonomous trucks on the Texas roads. Its 50 trucks with safety drivers on board are driving across the southern US. The company plans to have a national network crossing US highways by 2024.

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Behind the Inflation Curve

December 15 (Wednesday)

Fed I: The Dot Plot Thickens. What will the FOMC decide at its meeting today? Fed Chair Jerome Powell gave us all a heads-up about the possibility of the Fed’s speeding up the tapering of its asset purchases back on Monday, November 30. That’s the day that, in congressional testimony, he mutated from the dovish variant to the hawkish variant of Powell.

Testifying before a Senate committee, the Fed chair said he thinks reducing the pace of monthly bond buys can move quicker than the $15 billion-a-month schedule announced earlier in November. “At this point, the economy is very strong and inflationary pressures are higher, and it is therefore appropriate in my view to consider wrapping up the taper of our asset purchases … perhaps a few months sooner,” Powell said. “I expect that we will discuss that at our upcoming meeting.”

The Fed was on course to wrap up its tapering by mid-2022. A few months sooner than that would be consistent with doubling the monthly pace of tapering to $30 billion, thus ending bond purchases by the end of March. Consider the following related issues:

(1) FOMC rate forecasts. The decision on the pace of tapering could be a surprise, but it probably won’t be. More surprising might be the FOMC’s Summary of Economic Projections (SEP). In March, June, September, and December of each year, the Federal Reserve Board members and regional bank presidents submit their economic projections for the current and next couple of years. These include their latest forecasts for the federal funds rate, which are plotted on a chart that has come to be known as the Fed’s “dot plot.”

Both June’s and September’s dot plots showed the Fed’s 18 anonymous dots all in a row, suggesting expectations near a zero percent rate for 2021. For 2022, June’s plot showed seven dots indicating the opinion that a rate rise would be appropriate. In September, two dots crept up, as nine dots showed expected rate increases in 2022. Many more dots undoubtedly will join those nine in today’s SEP. The only question is: How many will be projecting one, two, or even three 25-bps increases in the federal funds rate next year?

(2) FOMC inflation forecasts. Also interesting to see will be the FOMC’s consensus forecasts for the PCED inflation rate. For 2021, the committee projected 1.8% during the December 2020 meeting. This year, that projection rose to 2.4% at the March meeting, 3.4% in June, and 4.2% in September. The FOMC continued to project inflation around 2.2% during both 2022 and 2023. Odds are that it will raise both the 2021 and 2022 projections. (See our FOMC Economic Projections tables.)

Fed II: Catching Up with the Inflation Curve. The Fed is well behind the inflation curve. The spread between the federal funds rate and the yearly headline CPI inflation rate was -6.7% during November, the most negative reading on record (Fig. 1 and Fig. 2). For that matter, the 10-year US Treasury bond yield is also well behind the inflation curve. The spread between the bond yield and inflation was -5.2% during November, also the most negative reading on record (Fig. 3 and Fig. 4).

As Debbie and I have previously observed, the yield-curve spread between the 10-year US and 2-year US Treasury notes has declined from a recent peak of 159 bps on March 29 this year to only 77 bps on Tuesday (Fig. 5 and Fig. 6). The 2-year yield was 0.67% on Tuesday, implying three 25-bps hikes in the federal funds rate next year. The 10-year yield has been hovering around 1.50% all year, implying that two to three rate hikes in 2022 might be enough to bring inflation down (along with other factors) (Fig. 7).

In other words, it might not take many hikes in the federal funds rate for the Fed to catch up with the inflation curve. That, of course, assumes that inflation itself moderates next year. That’s likely to happen if, as we expect, demand for durable goods moderates next year while supply increases, as we discussed in yesterday’s Morning Briefing.

That’s our expectation mostly because pent-up demand for durable goods should be more than satisfied by H2-2022. Durable goods prices have been leading consumer price inflation higher, as we discussed yesterday. So we are assuming that supply-chain disruptions will mostly be behind us after mid-2022, as discussed below.

For now, the latest inflation news remains disconcerting:

(1) Inflationary expectations. The Federal Reserve Bank’s November survey of consumers’ one-year-ahead inflationary expectations rose to 6.0% (Fig. 8). The latest CPI and PCED inflation rates are 6.8% and 5.0%.

(2) PPI inflation. November’s PPI for final demand was up 9.6% y/y, with goods up 14.9% and services rising 7.1% (Fig. 9). November’s PPI for personal consumption was 8.8% compared to 6.8% for the CPI and 5.0% for October’s PCED (Fig. 10).

(3) Small business owners. November’s survey of small business owners conducted by the National Federation of Independent Business found that 59% of them are raising average selling prices and 54% planning to do so (Fig. 11). The former is the highest since the 1970s, the latter the highest on record. Furthermore, a record 32% of small business owners are planning to raise worker compensation (Fig. 12).

Global Supply Chains I: Durable Woes. The Fed’s December 1 Beige Book provided a good overview of where the kinks persist in supply chains. Several Federal Reserve districts reported strong demand and positive outlooks overall, but with growth constrained by supply-chain disruptions and labor shortages.

When the supply challenges are expected to subside is uncertain, with some Cleveland contacts saying they expect disruptions into 2022, some Chicago contacts citing H2-2022, and some Atlanta transportation contacts not anticipating supply-chain normalization until late 2022 or 2023. The widespread consensus seems to be mid-2022.

Here’s more on the bottlenecks, according to the Fed districts:

(1) Durable goods. Most impacted by weak supply chains are the availability of durable goods, especially autos. Boston contacts noted that overall consumer spending was steady but that sales of durables are restrained by severe supply shortages. Mostly due to a lack of supply, new vehicle sales continued to weaken, reported New York contacts. In Philadelphia, auto sales held at low levels as supply-chain issues “continued to plague auto dealers.” Persistent supply-side disruptions and related higher prices are causing some customers to put off spending until these pressures abate.

For some types of machinery, material and equipment lead times could be up to 10 months, Dallas contacts said. In New York, supply disruptions have caused “scattered stockouts,” particularly for furniture.

(2) Input & inventory shortages. Many of the goods that are held up are not getting through the production line because key components are missing. Auto manufacturers are producing well below capacity mainly because of the ongoing microchip shortages, two major St. Louis manufacturers observed. Nevertheless, a few Cleveland contacts suggested that the availability of semiconductors, a key constraint in the production of many goods including autos, had “increased somewhat over the prior two months.” However, auto dealers suggested that sales will remain weak until inventory levels recover. Atlanta auto dealer inventories remained challenged by supply-chain issues.

That’s not just the case for autos: Minneapolis retailers reported missed sales due to supply-chain-related inventory shortages. Chicago’s manufacturing contacts said that “for sale inventories rose slightly but were still tight, and there were shortages of a wide range of inputs including certain metals, chemicals, resins, foam, adhesives, pallets, paper, and electrical components.” Supply-chain disruptions or delays remained widespread, with many Dallas firms noting that the inability to secure raw materials was affecting their ability to meet demand.

Kansas City contacts noted a shift in their approach to managing supply-chain disruptions toward a strategy of holding larger inventories, which was further pressuring the demand for key inputs. San Francisco manufacturers were stockpiling raw materials despite reduced availability and rising costs for inputs. Some San Francisco contacts additionally mentioned increased investment in new technologies “to improve resilience in the production process.” Some St Louis firms aimed to get around the input challenges by working to manufacture their own electric vehicle components rather than relying on global supply chains.

(3) Logistics. Even once goods are produced, the challenges aren’t over: It’s been tough to get them where they are going. Richmond ports and trucking companies “saw modest to moderate increases in volumes from already high levels, and they had difficulty meeting demand due to capacity and labor constraints. Shortages of transportation equipment and warehouse space led imports to dwell at the ports for longer times, causing congestion. Contacts noted that many empty containers were being shipped back to Asia before they could be loaded with exports as ocean carriers could get higher rates for import cargos.”

(4) Real estate. In addition to durable goods, real estate is another market plagued by supply constraints. Demand for homes remains strong in Philadelphia, the district reported, but sales are constrained by higher prices and longer delivery times. Also in the region, construction activity remains busy, but efficiency is challenged by supply constraints and contractor availability. Cleveland contacts noted increased lead times for new homes as weak supply-chains hindered construction activity. Chicago’s residential and nonresidential construction growth was held back by materials and labor supply challenges.

Global Supply Chains II: Downer Dashboard. Several key economic indicators, including inflation rates, may hold clues to whether the supply disruptions are worsening or improving. Among those besides inflation that we’re monitoring are the following:

(1) Purchasing managers. The most recent survey of manufacturing purchasing managers showed that in recent months the new orders index has eased back toward the production index, with both at a robust reading of 61.5 (Fig. 13). The M-PMI supplier deliveries and backlog of orders remain elevated but continue to come down from their record highs during the early summer (Fig. 14). The M-PMI customer inventories index remains near recent record lows (Fig. 15).

(2) Regional business surveys. Like the M-PMI, indexes of unfilled orders or delivery times in the five regional business surveys conducted by Federal Reserve Banks also remain elevated during November but down from recent highs (Fig. 16). Price pressures remain intense, with the prices-paid measure of the five districts at a new record high in November, while the prices-received measure held at record highs (Fig. 17).

Global Supply Chains III: How it Ends. Only time can fix the supply chain is the conclusion of logistics expert Michael Rentz in a December 6 essay for Law & Liberty. He says supply chains won’t normalize until demand finally tapers. Until then, the industry will be playing catch-up. “The system itself is overstressed. It is being asked to perform beyond its capacity with extreme constraints on space, equipment, and labor,” he says.

“What happened in 2020 was that the industry as a whole reduced capacity and shut down at the beginning of the pandemic. When the massive demand hit, the industry hadn’t started back up, and the capacity was already gone. The industry transitioned from a ‘Just-in-Time’ methodology to a ‘Just-in-Case’ one,” he writes. As a result, the Bullwhip Effect took place: Retailers realized that consumers were buying more goods than ever, so “they placed more orders than ever with wholesalers. When wholesalers received more orders than ever from retailers, they placed even more orders than ever with manufacturers.”

Suppliers couldn’t handle these unanticipated demand surges, Rentz explains, because supply-chain systems haven’t changed much since the container was invented in the mid-1950s. Consumer expectations have increased exponentially in all industries, but the supply chains in place to meet them have remained brittle.

Melissa and I think that problem is the reason that big money has been swooping in to revamp supply-chain systems with technology.

A December 2 article in Freight Waves was titled “Supply chain tech VC investment exceeds $7B for 3rd straight quarter.” That number—which is solely for the US and Europe—has dropped since a peak during Q1 but is still up more than 100% y/y. The article noted that median late-stage rounds are 94% larger compared to 2020. “At the same time that more capital is flowing to bigger companies, earlier-stage categories like drone logistics, augmented reality tech for warehousing, and ultrafast delivery are being populated with waves of new entrants.”

There’s another bright spot in the supply-chain story. As we wrote in our October 27 Morning Briefing, Amazon deliveries never skipped a beat as the rest of the world’s supply chains were shutting down. Why is that? A December 4 CNBC article explores how Amazon basically took control of its own supply network by “making its own containers and bypassing supply chain chaos with chartered ships and long-haul planes.”

Not unusually, Amazon started a trend: “This season, a handful of other major retailers—Walmart, Costco, Home Depot, Ikea and Target—are also chartering their own vessels to bypass the busiest ports and get their goods unloaded sooner.”

These trends are hopeful signs that broken supply chains will be fixed at some point with help from technology investment and retailers’ taking tighter control over the journey goods take from manufacturer to consumer. When that might happen is far from certain, but the good news is that passively waiting for supply-chain disruptions to end isn’t the only solution.

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Does Covid = Y2K For Earnings?

December 14 (Tuesday)

Reminder. Check out a replay of Dr. Ed’s latest Monday morning webinar here.

Strategy I: Nasdaq Has Bad Breadth. It has been widely reported that the Nasdaq’s technical picture has been deteriorating in recent weeks, with most of the index’s gains coming from just a handful of large-capitalization stocks. Some technical analysts see a similarity to the tech bubble of the late 1990s. A few have asked rhetorically whether Microsoft might be today’s Cisco. They warn that the Nasdaq’s technical deterioration could spell trouble for the broad stock market.

Joe and I disagree. We believe that the broad market as measured by the S&P 500 and Nasdaq 100 will continue to rally through at least 2022. However, we agree that certain areas of the Nasdaq that are already in a bear market may remain depressed through next year. That’s because the Nasdaq includes lots of unprofitable small tech and biotech companies that might have been viewed as pandemic plays and not very many that are viewed as re-opening ones.

During the late 1990s, technology companies received big earnings boosts from the widespread scramble to avert the Y2K problem by spending more on new technology hardware, communication equipment, and software. As a result, during the year 2000 such spending fell, sharply depressing tech earnings and stock prices.

Joe believes that the boom in tech spending during 2020 and 2021 in response to the pandemic might be followed by surprising weakness in earnings in 2022, whether the pandemic abates or we continue to live with it. That’s a good point and might explain why many Nasdaq stocks that attracted investors from the onset of the pandemic might now be stumbling as the prospects ahead look less propitious for them.

However, I believe that technology businesses will get an even bigger boost in their sales and earnings from companies that are scrambling to increase their productivity in the face of chronic labor shortages. By the way, the Nasdaq composite is up more than threefold from its 1999 peak. That’s mostly because Nasdaq companies are more profitable than ever, especially the larger ones.

Let’s take a deeper dive into this issue:

(1) Different strokes for different stock indexes. As we observed yesterday, the S&P 500 bottomed on December 1 at 4513.04, down 4.1% from its November 18 record high. On Friday, it was back up to a new record high of 4712.02 (Fig. 1). The equal weighted S&P 500 hit a record high on November 16 and subsequently declined 6.5% to its bottom on December 1. It’s still down 1.6% from its record, and has been underperforming the market-cap weighted S&P 500 since June 3 (Fig. 2).

The Nasdaq includes over 3,600 stocks currently (Fig. 3). This index hit a record high on November 19. It was 2.7% below that peak on Friday after falling as much as 6.1% by December 3 from its record. The Nasdaq 100 hit a record high on November 19 and was still down 1.5% from that peak on Friday. On December 3, it had been down 5.2% from its record. The Nasdaq price index relative to the Nasdaq 100 was at a record low again on Friday, and has been underperforming the Nasdaq 100 since March 12 (Fig. 4).

(2) Tech’s winners and losers. Admittedly, a wide swath of tech names has run into a buzz saw since March 2021, with some of the hottest names absolutely creamed. The ARKK Innovation ETF is a good proxy for those names—it’s down nearly 40% from the February top.

On the other hand, the S&P 500/400/600 Information Technology sectors are up 33.9%, 10.5%, and 22.8% ytd through Friday’s close (Fig. 5). The LargeCap sector rose to a new record high on Friday.

(3) The Magnificent 8. The Magnificent 8 represents Alphabet (Google), Amazon, Apple, Meta (Facebook), Microsoft, Netflix, NVIDIA, and Tesla. They are all in the S&P 500 and the Nasdaq 100. The Mag-8’s market-cap rose to $12.2 trillion on Friday, accounting for 26.3% of the market cap of the S&P 500 on a free-float basis (Fig. 6 and Fig. 7). On a ytd basis through Friday’s close, the former is up 38.7%, while the latter is up 25.5%. Excluding the Mag-8’s free-float market cap, the S&P 500’s market cap is up 22.4%.

The Mag-8’s collective forward P/E (i.e., based on forward earnings, which is the time weighted average of analysts’ consensus estimates for this year and next) was 34.8 on Friday (Fig. 8). Excluding the Mag-8, the forward P/E of the less magnificent 492 stocks in the S&P 500 is around 18.0.

Strategy II: Profit Margins Peaking. Joe and I were impressed by Standard & Poor’s release recently of S&P 500 revenues per share and earnings per share. Both rose to record highs, but the y/y growth rates slowed from Q2’s latest peak rates. The former’s growth rate dropped to 13.9% y/y in Q3 from 21.8% y/y in Q2, while the latter fell to 39.3% from 88.6% (Fig. 9 and Fig. 10). Both of these growth rates are likely to decline further from their cyclical peaks in Q2 but should continue to grow through 2023. Here are our projected growth rates for S&P 500 revenues and earnings during 2021 (18%, 50%), 2022 (3, 5), and 2023 (3, 7). (See YRI S&P 500 Forecasts.)

We can use the two series to calculate the profit margin of the S&P 500 (Fig. 11). Before the pandemic, the margin peaked at a then-record high of 12.5% during Q3-2018. President Donald Trump’s corporate tax cut was a big booster of the margin that year. As a result of the pandemic, the margin fell to 8.9% during Q2-2020, but that was well above the 2.4% low during the Great Financial Crisis. The margin rebounded from last year’s low to a record-high 13.7% during Q2 but ticked down to 13.6% during Q3.

The S&P 500 quarterly profit margin continues to impress us, but Q3’s slight decline from Q2’s record high was not surprising with labor and commodity costs continuing to rise. Another factor to consider is that the S&P 500 Financials sector saw less of a boost from loan-loss reversals in Q3 than it did in Q2. Using S&P’s operating earnings data, the S&P 500’s quarterly profit margin excluding Financials rose to a record-high 12.2% in Q3 from 11.8% in Q2 (Fig. 12).

Here are the latest developments for the S&P 500’s 11 sectors:

(1) Margins. Calculated using Refinitiv’s less conservative EBBS (earnings excluding bad stuff), otherwise known as operating earnings, the S&P 500 margin slipped in Q3 for the first time in five quarters even though the margins of seven sectors improved q/q, with two sectors, Information Technology and Utilities, reaching record highs. That was down from seven sectors’ margins improving q/q during Q2, when Materials’ and Tech’s margins were at record highs.

Here’s how the S&P 500 sectors’ margins stacked up during Q3 compared with their Q2 margins: Real Estate (30.7% [four-year high], 30.6%), Information Technology (25.5 [new record high], 24.7), Financials (18.7, 20.4), Communication Services (17.7, 18.5), Utilities (18.0 [new record high], 15.0), S&P 500 (13.6, 13.7), Materials (13.4, 14.7), Health Care (11.6, 11.4), Industrials (9.3 [two-year high], 9.1), Energy (9.2 [10-year high, 6.5), Consumer Staples (7.7, 7.7), and Consumer Discretionary (7.4, 7.8) (Fig. 13).

(2) Revenues. S&P 500 revenues per share hit a record-high $394.98 during Q3. Also hitting record highs were the revenues per share of Consumer Staples, Health Care, Materials, and the recently revamped Communication Services sector. Energy’s and Utilities’ revenues hit seven- and three-year highs, respectively, while Industrials’ was at a nine-quarter high. The revenues of Consumer Discretionary and Tech were at three-quarter highs, and those of the Financials and Real Estate sectors declined q/q from record highs in Q2 (Fig. 14).

Looking at their y/y revenue growth rates in Q3, it appears that the S&P 500 and eight of its 11 sectors peaked during Q2. The three exceptions—Financials, Tech, and Utilities—did so during Q1. During Q3, just three sectors failed to post double-digit percentage y/y revenues growth.

Here are the sectors’ Q3 y/y revenue growth rates along with their Q2 readings: Energy (62.5%, 97.0%), Materials (31.9, 36.9), Information Technology (18.8, 22.1), Industrials (17.6, 28.6), Communication Services (16.6, 27.2), Real Estate (14.3, 18.7), S&P 500 (13.9, 21.8), Health Care (12.6, 19.0), Consumer Staples (10.7, 13.0), Utilities (8.5, 9.5), Financials (3.4, 5.9), and Consumer Discretionary (-2.6, 15.3).

However, Consumer Discretionary’s revenues didn’t really fall y/y. That’s because S&P’s index methodology does not adjust historical per-share data for index changes. Using Refinitiv’s pro forma data—which assumes that Tesla was in the Consumer Discretionary sector during both years although it wasn’t—the sector’s y/y revenues growth rate was 10.9% in Q3 instead of -2.6%, down from a peak of 35.2% during Q2 instead of 15.3%. Also according to Refinitiv, Energy boosted the S&P 500’s revenue growth rate by 3.4ppts to 17.0%.

(3) Earnings. Earnings growth rates peaked during Q2 due to base-period effects in 2020 when the US economy was largely shut down. During Q3, the y/y earnings growth rates weakened q/q for the S&P 500 and seven of the 11 sectors. Energy’s rebounded from a year-earlier loss. The weakening was primarily due to base effects, as the US economy emerged from lockdown during Q3-2020.

Here’s how the Q3 y/y operating earnings-per-share growth rates of the S&P 500 and its sectors stacked up versus their Q2 growth rates: Energy (675.8%, 169.7%), Materials (109.1, 141.2), Real Estate (107.1, 86.0), Industrials (93.9, 316.8), S&P 500 (37.6, 94.3), Communication Services (56.9, 99.4), Information Technology (46.5, 51.0), Health Care (41.3, 25.5), Financials (6.5, 108.1), Consumer Staples (-0.5, 14.1), Utilities (-2.5, -17.4), and Consumer Discretionary (-10.8, 173.5) (Fig. 15). Notably, S&P’s version of Consumer Discretionary’s results were impacted by Tesla’s addition.

Refinitiv’s earnings measure shows similar slowdowns for the S&P 500 and most of its sectors (all but Energy). Here are Refinitiv’s y/y earnings growth rates for the index and its sectors during Q3 and Q2: Energy (2295.5%, 249.4%), Industrials (86.8, 522.1), Materials (84.4, 133.0), S&P 500 (39.3, 88.6), Information Technology (39.1, 46.3), Communication Services (34.7, 73.1), Financials (33.9, 157.4), Real Estate (30.8, 38.1), Health Care (22.4, 22.7), Utilities (10.9, 12.9), Consumer Staples (7.1, 18.7), and Consumer Discretionary (-3.9, 202.2).

According to Refintiv, Consumer Discretionary’s y/y earnings growth rate with Tesla in the sector during both years would have been 19.4% in Q3, down from 380.5% in Q2. Also according to Refinitiv, the S&P 500’s earnings growth rate without Energy would have dropped to 34.3%.

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Santa’s Sleigh & Biden’s Helicopters

December 13 (Monday)

Great Stocking Stuffer. May I suggest the perfect gift for your family members and friends? Why not give them a copy of my new book, In Praise of Profits!? I wrote it for liberals, who may be surprised to find that I share some of their views and shed new light on others. Whether you are a liberal or a conservative, you will be praising profits and entrepreneurial capitalism more than ever. Complimentary downloads of the book are available here.

YRI Monday Webinar. Join Dr. Ed’s live Q&A webinar on Mondays at 11 a.m. EST. You will receive an email with the link to the webinar one hour before showtime. Replays are available here.

Santa Watch. Joe and I believe in Santa Claus. In our December 1 Morning Briefing, we wrote: “The Santa Claus rally started early this year. The question is whether it is over already.” The rally started on October 4 with the S&P rising 9.4% to a new record high on November 18. Just after Thanksgiving, investors started to worry that two Grinches were about to steal the Santa Claus rally, i.e., the Omicron variant of Covid-19 and the more hawkish variant of Fed Chair Jerome Powell. Like true believers, we wrote: “We aren’t giving up on Santa Claus.”

The S&P 500 bottomed on December 1 at 4513.04, down 4.1% from its recent high. Santa was back at the reins on Friday when the S&P 500 rose to a new record high of 4712.02 (Fig. 1). Ho-Ho-Ho!

Having the merriest time last week was the S&P 500 Tech sector, which rose 6.0% to a new record high (Fig. 2). Joe reports that it was the only sector to beat the S&P 500’s 3.8% gain. Looking at the available weekly data since 1991, that has happened only twice before, i.e., the weeks of February 4, 2000 and January 19, 2001. (Don’t spoil our merriment by reminding us that those years are associated with the bursting of the tech bubble.) Consider the following related developments:

(1) Performance derby. Here is the festive performance derby of the S&P 500 and its 11 sectors last week: Information Technology (6.0%), S&P 500 (3.8), Energy (3.7), Consumer Staples (3.5), Materials (3.5), Health Care (3.2), Industrials (3.0), Communication Services (2.9), Real Estate (2.7), Financials (2.6), Utilities (2.6), and Consumer Discretionary (2.5). (See table.) Besides Tech, the only other sector to hit a new record high on Friday was Consumer Staples.

(2) Valuation multiples. The forward P/E of the S&P 500 remains above 20.0, bouncing back to 21.3 on Friday. The forward P/Es of the S&P 400/600 remained relatively depressed at 16.1 and 14.8 (Fig. 3). The forward P/Es of S&P 500 Growth and Value rose to 29.4 and 16.0 on Friday (Fig. 4).

(3) Yield curve. The Tech rally to a new record high is especially impressive given that the 2-year US Treasury yield rose to 0.67% last week, implying three 25-bps hikes in the federal funds rate next year (Fig. 5). However, the 10-year US Treasury bond yield remained below 1.50%. The “10-2” yield-curve spread has narrowed dramatically from a 2021 peak of 159bps on March 29 to 81 bps on Friday (Fig. 6).

The “5-2” yield-curve spread has been relatively flat around 70 bps over the same period. Both suggest that investors don’t expect the federal funds rate to rise by much more than the 75 bps currently expected for next year during the upcoming monetary tightening cycle. In other words, right or wrong, they expect that inflation will abate! That would be more “Ho-Ho-Ho!” for stocks!

Inflation: Biden’s Helicopter Money. “Bidenflation” was unleashed by the $1.9 trillion American Rescue Plan (ARP), which was signed by President Joe Biden on March 11, 2021. It was passed in Congress by Democrats using the process of reconciliation, which did not require support from Republicans. In the House, all but one Democrat voted for the bill and all Republicans voted against the bill. In the Senate, the final vote was 50-49, with all Republicans voting against the measure and all members of the Senate Democratic caucus supporting it.

The ARP in combination with the Fed’s QE4 has been a textbook example of “helicopter money.” The ARP package provided direct stimulus payments of $1,400 to individuals, extended unemployment compensation, continued eviction and foreclosure moratoriums, and increased the Child Tax Credit while making it fully refundable. It provided $350 billion to state and local governments.

The ARP was entirely deficit financed. The Fed added to the inflationary consequences of the ARP by monetizing $80 billion per month of the federal government’s debt during the first 10 months of the year. The Fed continues to do so but at a slower pace since November.

In a February 4 Washington Post op-ed, economist Larry Summers, who served as a top economist in the Clinton and Obama administrations, trashed Biden’s plan. He said it’s too stimulative and too inflationary and includes overly generous unemployment benefits that would disincentivize the unemployed from taking jobs. Sure enough, the ARP created a demand shock that overwhelmed and disrupted the global supply chain. It exacerbated labor shortages, which clearly are structural. The ARP has been a major cause of the rebound in inflation in the US.

In congressional testimony on November 30, Fed Chair Jerome Powell pivoted by conceding that inflation isn’t transitory, but persistent. This increases the odds that the Fed will speed up the tapering of its asset purchases and start raising the federal funds rate before mid-2022. Surging inflation also increases the odds that Biden’s American Families Plan might not have enough votes to pass.

Debbie and I expect that tightening monetary policy and an amelioration of the supply-chain disruptions will reduce inflationary pressures by the second half of 2022. We also expect that businesses will respond to chronic labor shortages by spending more on technology to boost productivity. So we are predicting that the headline PCED inflation rate will hover between 4.0% and 5.0% through mid-2022 and then decline to 3.0%-4.0% during the second half of next year (Fig. 7). Now, consider the following related developments:

(1) Jobless claims and job openings. There now is mounting evidence, including the latest initial unemployment claims, that Summers was right about the ARP’s effect on the labor market. The federal jobless benefits provided by the plan, which was enacted on March 18, did provide a disincentive to work. The overly generous federal unemployment benefits (an extra $300 per week) did keep many of the unemployed from taking jobs. Initial unemployment claims fell below 300,000 in early October after the benefit was terminated. Jobless claims fell to 184,000 during the December 4 week (Fig. 8). That’s the lowest in 52 years!

Total job openings remained in record-high territory at 11.0 million during October, while the number of unemployed fell to 6.9 million in November. Quits remained near September’s record high at 4.2 million during October.

(2) Demand and supply shocks. November’s 6.8% y/y CPI reading was the highest in nearly 40 years (Fig. 9). Leading the way higher has been the CPI durable goods component, which was up 14.9% during November, while the CPI nondurable goods component rose 10.7% and the CPI services component rose 3.8% (Fig 10).

Durable goods prices have a long history of mostly deflating. This suggests that the rebound in inflation isn’t all Biden’s fault. The pandemic clearly disrupted global supply chains. Nevertheless, the ARP exacerbated inflationary pressures by boosting the demand for goods well above trend (Fig. 11). The demand shock overwhelmed the production and transportation systems for goods, thus causing the supply shock and boosting inflation.

As we noted above, improvements in the global supply chain, tighter monetary policy, less fiscal stimulus (assuming as we do that the American Families Plan doesn’t have enough votes to pass), and satiated pent-up demand collectively should moderate the pace of inflation by the second half of next year.

(3) Latest CPI and next PCED. The next important inflation data point will be November’s PCED inflation rate, which will be released on December 23 along with personal income and consumption. The core PCED inflation rate tends to be lower than the core CPI inflation rate (Fig. 12). That’s mostly because the PCED durable goods inflation rate and the medical care services inflation rate tend to be lower than the comparable CPI components (Fig. 13 and Fig. 14).

(4) Powell’s inflation. Again, Biden doesn’t deserve all the blame for the rebound in inflation. The Fed has made a major contribution with record-low mortgage rates that caused the median single-family existing home price to soar 30.3% from January 2020 (just before the pandemic) through October of this year. Many would-be home buyers have been priced out of the housing market and have boosted the demand for rental units. The CPI’s rent-of-shelter component was up 3.9% y/y during November, the highest since April 2007 (Fig. 15). It bottomed at 1.5% during February.

(5) Global inflation. Another reason that all the blame for the recent surge in inflation can’t be pinned on Biden is that other countries are also reflating. The OECD CPI inflation rate was 5.2% y/y through October, with the core rate at 3.5% (Fig. 16).

Here are the headline and core CPI inflation rates for some of the major Eurozone countries during November: Germany (6.0%, 4.1%), Eurozone (4.9, 2.6), Italy (4.0, 1.4), and France (3.4, 2.1). Policymakers in Germany haven’t provided as much fiscal and monetary stimulus as those in the US. Germany’s high inflation rate suggests that supply disruptions are contributing to global inflationary pressures.

(6) Yellen defends Build Back Better. Treasury Secretary Janet Yellen recently sent members of the US Senate a memo titled “Fiscal Responsibility and the Build Back Better Act.” She reassured them that the American Families Plan (AFP), if passed, won’t be fiscally irresponsible. On the contrary, it “will leave our nation’s budget in an improved position.” Moreover, AFP “will not add to near-term inflationary pressures.” Then again, she didn’t anticipate the near-term inflationary consequences of ARP.

By the way, a December 10 letter from the director of the Congressional Budget Office (CBO) responded to questions from a couple of members of Congress about BBB. They wondered what the impact would be if “specified modifications … would make various policies permanent rather than temporary.” The response stated that it would increase the deficit by $3.0 trillion over the 2022–31 period.

Strategy I: Real Earnings. Q3 revenues and earnings are out for the S&P 500. Joe and I will examine the data closely tomorrow. For now, we can report that revenues per share rose 13.9% y/y and earnings rose 39.3%. Most impressive is that the profit margin (which we calculate from the revenues and earnings data) ticked down only 0.1pt to 13.6% from Q2’s record high of 13.7% notwithstanding rapidly rising costs, labor shortages, and supply disruptions. That implies that companies overcame these problems by raising their prices and/or by boosting their productivity.

In other words, the increases in revenues and earnings are somewhat less impressive when adjusted for rapidly rising prices. During Q3, on a y/y basis, the CPI, PCED, and nonfarm business price deflator (NFBD) rose 5.3%, 4.3%, and 4.4%. We prefer the NFBD as a measure of the prices received by businesses, but it doesn’t differ much from the PCED (Fig. 17). We prefer not to use the CPI because it has a well recognized upward bias (Fig. 18).

In any event, using S&P 500 reported earnings-per-share data (which are available since 1935), we find that the series has tended to grow in a volatile fashion at a compound annual growth rate around 6.0% since 1947 (Fig. 19). Adjusting for inflation using the PCED (which is available since 1947), the rate tends to be around 3.0%.

While pricing power in an inflationary environment is a positive attribute for individual companies, collectively it tends to perpetuate wage-price spirals, creating a lose/lose/lose situation for companies, workers, and consumers.

Strategy II: Real Earnings Yield. Run for the hills! The real earnings yield turned negative during Q3 (Fig. 20). Since 1945, eight of the 11 bear markets in the S&P 500 were associated with declines in the real earnings yield (using reported earnings per share). It dropped to -0.84% during Q3. It is clearly something to add to investors’ worry list given its track record. However, Joe and I aren’t ready to give up on either the Santa Claus rally or a continuation of the bull market through 2022 and 2023.

Historically, the nominal earnings yield has always been positive with the exception of during Q4-2008. In other words, rising inflation has been the swing factor that caused the real rate to turn negative. In the past, rising inflation has also caused the Fed to tighten monetary policy in an effort to bring inflation down. That process won’t even start until the spring of next year, assuming that the FOMC ends QE4 by March of next year and votes to start raising interest rates during the May 3-4 meeting of the committee. It’s premature to conclude that the Fed’s next round of monetary tightening will end in tears and a recession.

Strategy III: Valuation and ETFs. There’s lots of controversy about the stock market’s valuation multiple. Everyone agrees that stocks aren’t cheap. The forward P/E of the S&P 500 is high. It has been hovering between 20 and 23 since the second half of 2020. On Friday, December 10, it was 21.3.

The debate is whether it is overdue for a fall. The question is: Why it has stayed so high in 2021 despite the surge in inflation and increasingly hawkish guidance from the Fed? There are many possible answers. The one that makes the most sense to us is that ultra-easy monetary and fiscal policies have produced at least $2 trillion of excess liquidity, which is boosting valuation multiples. (See the November 29 Morning Briefing.)

Some of that excess liquidity has been flowing into equity funds. They’ve attracted $385.5 billion over the past 12 months through October, with net inflows of $707.4 billion into ETFs and net outflows of 321.8 billion from mutual funds (Fig. 21). Buyers of equity ETFs tend to be much less focused on valuations than are mutual fund portfolio managers whose mandates force rebalancing out of stocks that gain too much market weight. This may explain why valuation multiples have been so high and might remain so in 2022 despite Fed tightening.

Movie. “West Side Story” (+ +) (link) is based on the classic 1957 musical conceived by Jerome Robbins with music by Leonard Bernstein and lyrics by Stephen Sondheim. This film is fondly directed by Steven Spielberg. I have fond memories of the play because it marked the beginning and end of my acting career. I played Chino in the 1967 production at New Rochelle High School. The music is eternally great, and the choreography is really wonderful in this remake of the original 1961 film starring Natalie Wood.

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China, Wall Street, and the CIA

December 09 (Thursday)

China: A Week of Headaches. We’ve always believed that actions speak louder than words. And no matter how often China’s leadership says all’s well, recent actions indicate otherwise. Evergrande, the country’s largest property developer, took one step closer to bankruptcy this week. Hong Kong residents are heading for the exits, and some external organizations have started to call out China’s tyranny. Let’s review what’s been a rough week for China’s leadership:

(1) Property sector unraveling. Evergrande failed to pay on Monday an $82.5 million debt payment that will likely result in an official default that pushes the large property developer to restructure its debt. The news is not a surprise, with the price of Evergrande’s dollar-denominated bonds below 20 cents on the dollar and the company’s shares each trading south of HK$2.

It’s widely known that Evergrande has roughly $300 billion in outstanding debt. Less understood are the guarantees the company has provided on other issuers’ debt. This week, the company unexpectedly revealed that “it has been asked to honor a debt guarantee of around $260 million, without providing further details,” a December 6 WSJ article reported.

Evergrande isn’t the only property developer in China having problems. There have been 11 defaults this year, land sales have fallen 55% y/y, and housing sales dropped 25% in October, according to JPMorgan data cited in a December 7 Reuters article.

Some of the specific companies in trouble were discussed in a December 6 Reuters article. Kaisa Group Holdings saw trading in its shares suspended Wednesday after it announced that bondholders rejected an exchange offer; Kaisa has $11.6 billion of dollar-denominated bonds outstanding. Sunshine 100 China Holdings defaulted on a $170 million dollar bond on Monday. And creditors of China Aoyuan Property Group have demanded repayment of $651.2 million in response to credit-rating downgrades—which it may be unable to pay due to a lack of liquidity.

The property sector’s problems appear to be weighing on the economy. The November manufacturing purchasing managers index came in at 50.1, just barely above the 50.0 mark indicating expansion; but a number of the index’s components—including new orders (49.4) and employment (48.9)—were in contraction territory (Fig. 1). China’s central bank responded by cutting the bank reserve requirement on Monday by 50bps, its second cut this year (Fig. 2).

(2) Hongkongers hitting the road. The exodus from Hong Kong continues in the wake of the Chinese government’s changes to the city’s laws and clampdown on citizens’ freedoms. Nearly twice as many students and teachers have left 140 of Hong Kong’s secondary schools in the 2020-21 school year, a December 5 article in the South China Morning Post (SCMP) reported. Commenting readers blamed the lack of freedom and Internet censorship in Hong Kong now that the city is under Chinese control.

Separately, a survey by Oxford University’s Migration Observatory found that a third of British nationals living in Hong Kong are considering moving to the UK and 6% have already applied to do so. The survey polled 1,000 Hongkongers with British National (Overseas) status—which roughly 5.4 million of Hong Kong’s 7.5 million residents have, a December 3 SCMP article reported. Respondents wanted to move to the UK, then Taiwan, Australia, and Canada.

(3) US and China sparring. The US is not winning any friends inside China by inviting Taiwan to the Summit for Democracy, a virtual gathering this week of more than 100 democratic governments. The move counters China’s requirement that no country or company recognize the island as an independent nation. Zhao Lijian, a Chinese foreign ministry spokesman, warned: “Playing with the fire of ‘Taiwan independence,’ you will eventually get burned,” a November 24 WSJ article reported.

The Biden administration followed that jab by announcing that administration officials won’t be attending the Beijing Winter Olympics, citing the Chinese government’s “ongoing genocide and crimes against humanity,” referring to its treatment of Uyghur Muslims. Canada, the UK, and Australia followed the US’s lead and also announced a diplomatic boycott of the games. Athletes of the nations, however, will attend the Olympics. China’s Foreign Ministry said it would respond by taking “resolute countermeasures.”

The US is also working to thwart China’s attempts to expand its military presence around the world. Most recently, US diplomats have been trying to persuade Equatorial Guinea, on Africa’s west coast, not to allow China to build a military base there, according to a December 5 WSJ article, even though Equatorial Guinea already has a Chinese-built deep-water port. China already has a military base in Djibouti, on the east coast of Africa. And it has been building a military base at a Chinese-run commercial port in the United Arab Emirates (UAE), which the Biden administration has lobbied the UAE to halt.

(4) Finally taking a stand. Companies, organizations, and even basketball stars have been quick to ask for forgiveness whenever they’ve insulted or criticized China or supported Taiwan. But recently, some smaller entities have shown backbone, which may embarrass larger organizations into following their lead in the future.

The US Women’s Tennis Association (WTA) pulled all of its events out of China after it couldn’t confirm the wellbeing of Peng Shuai, a former doubles player ranked number one in the world and three-time Olympian. She posted an online message that said she was sexually assaulted by China’s former Vice Premier Zhang Gaoli and remains in China. Many elite tennis players supported both Peng and the WTA’s actions.

NBA Celtics player Enes Kanter Freedom has been an outspoken critic of the Chinese government, calling President Xi Jinping a “brutal dictator” and wearing sneakers during games painted by a Chinese dissident that read “Free Tibet.” Another pair of his sneakers implored China to “Free Uyghur” and yet another pair criticized Nike’s manufacturing policies in China by stating “Made With Slave Labor,” a December 7 New York Post article reported. Celtics games aren’t being shown in China.

Even little Lithuania has stood up against China by allowing Taiwan last month to open a diplomatic office there, and Lithuania plans to open its own in Taiwan. China condemned the move as a violation of its “One China” policy and downgraded its diplomatic presence in Lithuania from ambassador to charge d’affaires. Last week, some of Lithuania’s exports to China were blocked by a computer system; officials are investigating whether it was an isolated glitch or systemic retaliation. Access to the Chinese market was restored this week, a December 7 SCMP article reported.

These moves might have packed a larger punch if made by the NBA, LeBron James, and the US or UK instead of the WTA, Freedom, and Lithuania. But small moves today may presage bigger ones tomorrow.

Financial Services: Jumping into China Despite the Risks. In the Trump administration’s 2020 trade deal, China agreed to accelerate the removal of foreign ownership limitations on Chinese investment banks and brokerages and to allow US firms greater access to China’s financial markets—including those involved in banking, insurance, asset management, payments, and fund management.

The opening of China’s financial markets comes as its economy is slowing. Q3 GDP growth was just 3.5%, down from 14.2% in Q3-2020 and 6.6% in Q3-2019 (Fig. 3). It also comes as President Xi Jinping has been flouting capital market rules and imposing his will on industries as diverse as gaming and tutoring and as large as Ant Financial and Didi. And the distress in China’s real estate market discussed above is reflected in its ailing stock market: The China MSCI stock price index has fallen 20.3% ytd through Tuesday’s close, making it the world’s third-worst-performing stock market this year (Fig. 4).

Nonetheless, the Wizards of Wall Street are ignoring these red flags, perhaps at their peril, as they race to tap China’s $40 trillion financial sector. Let’s take a look at what they’re up to:

(1) Investment bankers taking ownership. US banks and investment banks are rapidly increasing or taking full ownership of their joint ventures in China. As they do so, their executives have had to tread lightly on Chinese sensibilities and face criticism at home.

JPMorgan and Goldman Sachs have gained full ownership of their Chinese brokerages and are expanding their debt and equity underwriting business, trading, and cross-border merger and acquisition advisory work in China. Goldman has a relationship with ICBC Wealth Management, a local firm with 26 million personal customers and 730,000 corporate clients, a November 15 NYT article states. Bank of America plans to apply for permission to set up a brokerage in China, while Morgan Stanley has asked for approval to increase its ownership in its Chinese securities firm to 90% and its stake in a fund-management joint venture to 85%.

JPMorgan CEO Jamie Dimon found himself in hot water last month after noting that both JPMorgan and the Chinese Communist Party had been around for 100 years and betting that the former would outlast the latter. Chinese officials weren’t amused. Dimon apologized.

(2) Asset managers raising funds. Asset managers are jumping into the pool too. BlackRock finished raising $1 billion in September from Chinese investors for the country’s first mutual fund run by an asset manager that’s wholly owned by a foreign firm. Fidelity International and Neuberger Berman have received approval to set up mutual fund arms in China, which Schroders and VanEck seek as well.

BlackRock launched its $1 billion fund for Chinese investors just weeks after it recommended that investors triple their allocation to Chinese assets. Those who took BlackRock’s advice and invested in the Chinese MSCI index since that August 16 recommendation have lost 6.9% as of Tuesday’s close and those who invested in the Hong Kong MSCI index have lost 9.4%, while investors in the US MSCI have gained 4.0%.

Additionally, BlackRock has come under criticism for advocating for ESG (environmental, social, and corporate governance) investing in the US yet not holding the Chinese companies in which it invests to the same standards.

Bridgewater Associates, a hedge fund, has had a license to raise funds in China since 2018 and last month raised the equivalent of $1.25 billion in its third investment fund. Bridgewater’s founder Ray Dalio prompted a Twitter storm last week after he compared China to a “strict parent” when asked about the disappearance of dissidents. Senator Mitt Romney (R-UT) countered that Dalio’s “feigned ignorance of China’s horrific abuses and rationalization of complicity investments there is a sad moral lapse.”

(3) But what’s at risk? In a September 6 WSJ editorial, investor philanthropist George Soros laid out the risk the US faces as its financial services firms jump into the Chinese markets. He describes BlackRock and other asset managers as helping China and its repressive government win the “life and death conflict” the country is in with the US and democratic nations.

“The BlackRock initiative imperils the national security interests of the U.S. and other democracies because the money invested in China will help prop up President Xi’s regime, which is repressive at home and aggressive abroad,” Soros wrote. “Congress should pass legislation empowering the Securities and Exchange Commission to limit the flow of funds to China. The effort ought to enjoy bipartisan support.”

If US firms help China establish a more sophisticated stock market, it could attract funds that otherwise might have been invested in US markets. The divisions have started to form. Last week, Didi Chuxing, a $39 billion ride-sharing company, announced that it plans to delist its US-traded shares just six months after listing in the US. At the same time, the SEC adopted rules that require Chinese companies with US-listed stocks to further open their books to US accounting firms, which may send the audit-averse among them packing. The money at stake is big—nearly 250 Chinese companies representing $2.1 trillion in shares trade on US exchanges, a December 2 NYT article reported.

Disruptive Technologies: Investing for the Spooks. In-Q-Tel (IQT) isn’t exactly a household name; but with a website, it isn’t top secret either. The not-for-profit firm invests in startup companies on behalf of the CIA and other government organizations, looking for technologies that the government’s national security arms need now and in the future. The firm says it averages one investment per week, has more than 500 investments in its portfolio, and attracts $18 in private-sector funding for every $1 it invests.

IQT helps companies understand and access the government. The firm often invests in firms involved with digital intelligence, infrastructure, robots, intelligent connectivity, data analytics, AI and machine learning, and IT platforms. Winning investments include FireEye and Plantir.

IQT’s Who’s Who of a board is roughly split between venture capital giants and former military/intelligence brass. Investors include David McCormick of Bridgewater Associates; James Barksdale, former CEO of Netscape; Peter Barris of New Enterprise Associates; Howard Cox of Greylock; and Ted Schlein of Kleiner Perkins Caufield & Beyers. In the military camp are A.B. “Buzzy” Krongard and George Tenet, both former CIA chiefs; Jeffrey Smith, former CIA general council; Jami Miscik, former CIA deputy director for intelligence; and Admiral Mike Mullen, former chairman of the Joint Chiefs of Staff.

The US’s technological competitive advantage is eroding, write IQT CEO Christopher Darby and EVP Sarah Sewall in the March/April edition of Foreign Affairs. The US needs to set technology R&D priorities and increase funding, particularly in areas that don’t attract venture capital dollars. China’s share of global technology R&D spending has grown from under 5% in 2000 to over 23% in 2020, putting it on track to overtake US spending by 2025. Global leadership in technology is as powerful as military global leadership, they contend.

Some of IQT’s recent investments include:

(1) IQT was one of a handful of investors that invested $25 million in Q-CTRL, a Sydney based startup that “provides infrastructure software that improves quantum computing performance by addressing …hardware error and instability,” a November 30 TechCrunch article explained. The company also develops quantum sensors and exploration technologies for the Earth, the moon, and Mars.

(2) IQT was part of a group that invested $26.4 million into Fleet Space Technologies, another Aussi startup, that has designed, built, and launched commercial nanosatellites, and plans ultimately to have a 140-satellite constellation. It aims to have satellite coverage of the planet to connect the millions of industrial devices that make up the Internet of Things, according to a November 16 article in Space News.

(3) GreyNoise Intelligence received a “seven-figure investment” from IQT last spring. GreyNoise has developed software that makes security operations more efficient by separating out important threats from the background noise. In addition to funding, IQT gives GreyNoise feedback on the software from its contacts in the intelligence community.

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The World vs the Virus

December 08 (Wednesday)

Strategy I: The Boy Who Cried ‘Variant!’ The S&P 500 has rebounded 3.8% from its recent low on December 1 through Tuesday’s close (Fig. 1). It is down just 0.4% from its November 18 record high. CNBC’s market report yesterday observed: “Stocks jumped for a second day, continuing their rebound from a recent rough patch, as investors grew less fearful of the potential economic impact from the new omicron coronavirus variant.” Rebounding smartly have been our three favorite sectors, namely Information Technology, Financials, and Energy. Travel, hospitality, and casino stocks linked to the reopening continued their climb as well.

On Friday, November 26, the day after Thanksgiving, the S&P 500 dropped 2.3% on news about the new Omicron variant of Covid. In the Monday, November 29 Morning Briefing, Joe and I wrote:

“Friday’s sell-off was probably a buying opportunity. Let’s remember that the emergence of the Delta variant triggered a selloff, similar in magnitude to what we saw on Friday, of 2.9% in the S&P 500 from July 12 through July 19. The 10-year US Treasury bond yield fell below 1.50% in early June and bottomed at 1.18% in early August. Both stock prices and bond yields headed higher over the rest of the summer through a few days ago, as investors concluded that the available vaccines worked to combat the Delta variant. We should learn in coming weeks whether they’re any match for Omicron.”

We were encouraged that Friday’s reactions to the Omicron news included announcements by America’s three major Covid vaccine manufacturers suggesting that they are prepared to play Whac-A-Mole with the latest Covid variant.

We asked our in-house, self-trained virologist and epidemiologist, Melissa Tagg, to follow the latest variant. Below is her current assessment. The bottom line is that variants happen and that life will go on as we’ve known it since the start of the pandemic. With that relatively happy thought in mind, we will review global stock market developments in the next section. On balance, they’ve done very well this year despite the pesky variants. On Monday, November 29, we dubbed Friday’s selloff “Panic Attack #71.”

Strategy II: Staying Close to Home. Joe and I continue to favor a Stay Home investment strategy rather than a Go Global one. That means overweighting the US and underweighting the rest of the world (ROW). Consider the following:

(1) US vs ROW stock price indexes. The ratios of the US MSCI to the All Country World ex-US MSCI in both local currencies and in US dollars rose to new record highs last week (Fig. 2). Both have been on solid uptrends since the start of the bull market way back in 2009.

This year, the US MSCI is up 20.8% through Monday’s close, while the All Country World ex-US MSCI is up 8.0% in local currencies and 2.3% in dollars. The currency ratio used by MSCI is up 5.6% ytd through Monday (Fig. 3).

(2) US vs ROW forward earnings. Some of the outperformance of the US is attributable to much faster forward earnings growth in the US than in the rest of the world. The ratio of the forward earnings of the US to the All Country World (in local currencies) has nearly doubled from about 3.5 in early 2009 to over 6.6 currently (Fig. 4).

Here is the performance derby of forward earnings since March 1, 2009 through November 25, 2021: US (231.4%), Emerging Markets (77.2), All Country World ex-US (69.6), UK (35.7), EMU (33.2) (Fig. 5). Here is the same since April 30, 2020: US (53.7), EMU (42.6), UK (42.3), All Country World ex-US (40.4), and Emerging Markets (35.3) (Fig. 6).

(3) US vs ROW revenues and margins. Since early 2009, the forward revenues of the US MSCI was trailing only that of the Emerging Markets MSCI, but has been ahead of the pack since the start of the pandemic (Fig. 7). The forward revenues of the EMU and UK haven’t grown at all since 2009! Amplifying US revenues has been a much higher profit margin than prevails in the rest of the world (Fig. 8).

Virus I: Just Another Strain. If Omicron “dominates” and “overwhelms” the world in three to six months like this Singapore doctor forecasts, does it even matter much to financial markets? If a “colossal” outbreak were to occur, as a China study recently warned is possible, should investors care? Recent evidence suggests that the rates of Covid-19 infection should not matter much to investors, implying that even the arrival of super-transmissible Omicron may be a nonevent for the broad stock market outlook.

The New York Post’s editorial board issued the following public service announcement on December 3. It posited that Covid-19 infection rates may no longer be worth worrying about if the new strains are highly transmissible but mild. Even hospitalization data may no longer be headline-worthy if treatments are effective. After all, the Covid-19 death rate is much less than 0.001% of the population and, in recent weeks, represents mostly the unvaccinated.

Here’s why we agree that Omicron may be something to sneeze at:

(1) Cold snippet. Omicron likely acquired at least one of its mutations by picking up a snippet of genetic material from the common cold virus, according to a study done by Cambridge researchers. That suggests that while the variant transmits more easily than most forms of Covid, it causes only mild or asymptomatic disease.

(2) Important report. A report released on Saturday by the South African Medical Research Council suggests that the strain could indeed cause a milder infection than previous Covid-19 strains, CNBC reported. The Council also observed that more younger people were being hospitalized with the Omicron strain, but that could be due to lower rates of vaccination among younger groups. It noted that “57% of people over the age of 50 have been vaccinated in the province compared to 34% in the 18-to-49-year group.”

(3) Incidental findings. Most of the Omicron-positive patients were “incidental Covid admissions,” i.e., admitted to the hospital for reasons other than Covid-19, and not dependent on oxygen treatment. These findings support anecdotal evidence from the first doctor who identified Omicron, saying that she had seen extremely mild symptoms from this strain.

(4) Cases in children not severe. The significant number of infants admitted with Covid last month in South Africa raised concerns that the newly identified Omicron could pose greater risks for young children than other variants, reported Reuters. One public health specialist there said that 113 of 1,511 hospitalized Covid-positive patients were under 9 years old, a greater proportion than seen with previous Covid strains, but that the children mostly have mild disease. No Covid-related pediatric deaths were observed among the patients observed by the South African Medical Council.

Virus II: Vaccines Still Effective. The earliest known case of Omicron in South Africa was diagnosed on November 9. It was deemed a variant of concern by the World Health Organization on November 26. Omicron’s genetic code has some deletions and more than 30 mutations from the structure of Covid-19’s Alpha variant (one of the first detected). Covid cases are increasing rapidly in the Gauteng province of South Africa. Omicron has now been detected in several countries. It was first detected in the US on December 1. Nevertheless, the Delta variant remains the dominant variant driving the fourth wave of infections around the globe.

While not enough clinical data exists yet to determine the characteristics of the new variant, authors of a December 3 article in The Lancet make helpful claims about what is known. The bottom line is that the deletions and mutations in the Omicron variant likely confer increased transmissibility and higher antibody escape from both natural infection and vaccines. But vaccines probably prevent most serious cases that would lead to hospitalizations and deaths. Existing treatments, except for certain antibody therapies, are expected to be effective too. So the authors recommend the continued use of vaccinations in combination with public health measures such as masking “as a pathway to viral endemicity.”

Here’s a bit more:

(1) Higher transmission present in South Africa. In the Gauteng province of South Africa, the early doubling time in the fourth wave is higher than that of the previous three waves (see authors’ chart). Omicron is soon expected to replace Delta as the dominant variant in South Africa.

(2) Reinfections evident despite immunity. Omicron is rapidly spreading despite high levels of natural immunity to the Delta variant. Increasing cases of reinfection are evident from data on positive PCR (polymerase chain reaction) tests in previously infected South Africans.

(3) Vaccines may reduce severity. Because Omicron has more mutations than previous variants of concern, the “potential impact of omicron on the clinical efficacy of COVID-19 vaccines for mild infections is not clear.” However, the authors observe that most Covid vaccines have remained effective in preventing severe infection, hospitalization, and death for all previous variants. That’s because vaccine “efficacy might be more dependent on T-cell immune responses than antibodies.” The authors conclude that “people who are vaccinated are likely to have a much lower risk of severe disease from omicron infection.”

(4) Current treatments expected effective. Except for certain antibody treatments, the authors doubt “that current COVID-19 treatment protocols and therapeutics would no longer be effective.”

By the way, Pfizer’s Covid-19 treatment pill due out in a few months is anticipated to be effective against Omicron.

Virus III: Not Much Intervention from Biden. During a December 2 speech titled “Remarks by President Biden on the COVID-⁠19 Winter Plan,” Biden quipped: “I’ve seen more of Dr. Fauci than my wife. …Who’s president? Fauci!” Based on the available evidence, maybe Biden can start spending more time with his wife again. Here is the US administration’s reaction to the variant so far:

(1) More travel bans. Three weeks after lifting the blanket travel ban on more than 30 countries, the Biden administration decided on November 29 to restrict travel from South Africa, Botswana, Zimbabwe, Namibia, Lesotho, Eswatini, Mozambique, and Malawi amid an explosion of the new variant. On Sunday, however, the White House’s chief medical advisor Dr. Anthony Fauci said that the Biden administration “feels very badly” about the impact caused by the travel restrictions imposed and is reevaluating the ban. Fauci added that early data on Omicron was “encouraging.” Good to know, President Fauci!

(2) No more lockdowns. Instead of using lockdowns to prevent the spread of Omicron, the administration will push for vaccine boosters, free at-home testing, and restrictions for foreign travelers. “We’re going to fight this variant with science and speed, not chaos and confusion,” Biden promised, “just like we beat back Covid-19 in the spring and more powerful Delta variant in the summer and fall.”

(3) Booster shots for Christmas. In his speech, Biden laid out his plans to get booster shots to 100 million Americans amid the identification of Omicron in the US. Biden seemed to concur with the conclusions from The Lancet article noted above: “Even though we don’t have a lot of data on it, there’s every reason to believe that kind of increase that you get with the boost would be helpful at least in preventing severe disease of a variant like Omicron.

“Last Christmas, less than 1% of adults were fully vaccinated; this Christmas that share will be 72%, including more than 86% of elderly people. More than 20 million children have been vaccinated—though under-fives still await approval—and 99% of schools are open,” reported The Guardian on December 5.

(4) Testing taking off. A senior administration official recently told reporters, according to The Guardian, that tightening testing requirements for pre-departure travel will help catch more cases of Omicron. Air travelers flying to the US from abroad, including US citizens and foreign travelers, will now need to show airlines proof of a negative Covid test result that was taken within one day of departure before being allowed to board. Tests are not required upon arrival, but the Centers for Disease Control and Prevention is offering free testing upon arrival to help screen for variants.

Furthermore, at-home testing is now reimbursable for more than 150 million people with private insurance; others can get the tests through health centers and clinics.

(5) Continue to mask up! Finally, the masking requirement on domestic travel will be extended on travel from January through mid-March.

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Taper Tantrum 4.0

December 07 (Tuesday)

Replays. I’m happy to report that I will continue to do the Monday morning webinars because we are getting very good turnouts. We get even more viewers of the replays, which can be found here.

Strategy I: A Very Brief History of Taper Tantrums. There have been four taper tantrums in the stock market since 2013 including the latest one. So far, it hasn’t been as severe as the previous three, but it has the potential to last well into 2022. The Fed backed off from tightening in response to the previous three tantrums. This time, the Fed may have no choice but to continue tightening monetary policy into next year because inflation is much more troublesome now than it was during the previous three episodes.

The first tantrum was during the spring of 2013, when the index fell 5.8% (Fig. 1). The second occurred in late 2015 through early 2016, when the index fell 13.3%. The third was during the fall of 2018, when it fell 19.8%.

The latest one is a work in progress. It started last week on Tuesday. Testifying before a Senate committee, Fed Chair Jerome Powell said he thinks reducing the pace of monthly bond buys can move quicker than the $15 billion-a-month schedule announced earlier this month. “At this point, the economy is very strong and inflationary pressures are higher, and it is therefore appropriate in my view to consider wrapping up the taper of our asset purchases … perhaps a few months sooner,” Powell said. “I expect that we will discuss that at our upcoming meeting.”

The financial markets were shocked to hear that Powell is now in the same camp as other hawkish FOMC participants who’ve been suggesting a faster pace of tapering. The next FOMC meeting will be held December 14-15. The committee will probably decide to double the pace of tapering from $15 billion per month to $30 billion per month, setting the stage for a rate hike before mid-2022.

During the previous three tantrums, Fed officials were spooked by the stock market selloffs. They responded to these tantrums by backing off from their hawkish stance. Their dovish talk calmed the markets, allowing the bull market to continue. This time, Fed officials may be more spooked by the jump in inflation than by any tantrum in the financial markets. Consider the following related developments:

(1) The FOMC undoubtedly will have a close look at November’s CPI report, which will be released on Friday. The index was up 6.2% y/y during October. It is likely to be higher in November, led by rising auto prices and rents (Fig. 2). While the price of crude oil dropped sharply during November, the retail price of gasoline continued to rise (Fig. 3 and Fig. 4).

(2) On Friday, the 2-year US Treasury note yield rose to 0.60%, and the 12-month federal funds futures rose to 0.56% (Fig. 5). Both are clearly signaling two, and possibly three, 25bps hikes in the federal funds rate next year. Keep in mind that this implies that the federal funds rate should end 2022 at either 0.50% or 0.75%—not exactly levels that would kill the bull market in stocks.

(3) The yield-curve spread between the 10-year US Treasury and the 2-year US Treasury continues to narrow significantly (Fig. 6). It is down from a recent peak of 129bps on October 8 to 75bps on Friday.

In our 2019 book The Yield Curve: What Is It Real Predicting?, Melissa and I concluded that narrowing yield-curve spreads tend to predict financial crises, which can morph into credit crises, which cause recessions. So the yield curve is currently suggesting that once the Fed starts to raise interest rates next year, something could break in the credit markets. Presumably, that could be a big threat to the bull market in stocks.

Strategy II: Mounting Nervousness. Sentiment seems quite bearish in the stock market. The CBOE Equity Put/Call Ratio jumped to 0.74 on Friday, the highest reading since April 2, 2020, when much of the economy was still in lockdown. It’s very unlikely that the government will try that response to the pandemic again.

Sentiment in the stock market is neither overly bullish nor overly bearish according to the Bull/Bear Ratio compiled by Investors Intelligence (Fig. 7). It was 2.00 during the week of November 30. Bullish readings tend to be around 3.00 and higher, while bearish ones tend to be around 1.00 and less. Contrarians tend to view overly bullish ratios as sell signals and overly bearish ones as buy signals. They don’t have much to work with when the ratio is 2.00.

The recent selloffs in US tech stocks, Chinese stocks, and cryptocurrencies suggest that investors are becoming more risk averse. That’s evidenced by the rally in the Treasury bond market too.

From a contrarian perspective, on balance, these sentiment developments are more bullish than bearish for quality stocks, at least over the near term, in our opinion. SMidCaps are especially cheap relative to LargeCaps, as we discussed in yesterday’s Morning Briefing.

Strategy III: Betting on Earnings Growth and Liquidity. There’s mounting chatter about a major correction or even a bear market now that the Fed is likely to tighten monetary policy at a faster pace in 2022. Joe and I are still in the bullish camp. As we noted yesterday, economic growth remains strong, and the outlook for earnings growth remains upbeat. We are concerned that the S&P 500’s valuation multiple continues to be elevated; however, it may remain so given that there is so much liquidity in the financial markets. Consider the following:

(1) The stock market equation is simply P = P/E x E. The P/E is mostly cyclical and trendless. S&P 500 earnings (E) tends to grow along a 6% long-term trendline within a range of 5%-7% long-term growth (Fig. 8). That determines the trend growth rate in the S&P 500 stock price index (Fig. 9).

(2) The yearly percent change in the S&P 500 stock price index, on a monthly basis, is highly correlated with the y/y growth rate in S&P 500 earnings, on a quarterly basis (Fig. 10 and Fig. 11). The growth rate in earnings undoubtedly peaked during Q2 at 88.5%. It fell to 39.1% during Q3 and should be down to 19.0% during Q4, according to the analysts’ consensus. Next year’s quarterly growth rates are likely to be in the mid-single digits.

(3) Bear markets are caused by recessions, which tend to be caused by credit crunches and/or soaring oil prices. Debbie and I don’t expect a recession in 2022. We do expect that the S&P 500 will rise at rates in the single digits in concert with earnings growth.

Strategy IV: The Growth vs Value Rollercoaster. Growth stocks tend to outperform Value stocks during periods of relatively slow growth, when both inflation and interest rates are relatively low. Value is supposed to outperform when inflation and interest rates are rising. This playbook hasn’t been very helpful this year. Consider the following:

(1) Growth has been the winner so far. Since the start of the latest bull run—i.e., after the market bottomed during March 23, 2020, through Friday’s close—the S&P 500 is up 102.8%, led by a 122.3% increase in Growth; Value has lagged Growth with a gain of 79.7% (Fig. 12). Since the S&P 500 rose to a record high of 4704.54 on November 18 through Friday’s close, the S&P 500 is down 3.5%, with Growth down 4.1% and Value down 2.8% since then.

Since the start of the bull market on March 9, 2009, the S&P 500 is up 570.8% with Growth up 788.2% and Value up 376.9% (Fig. 13).

(2) Sources of outperformance. The outperformance of Growth relative to Value has been fueled by faster forward earnings growth for Growth (Fig. 14). Without a doubt, even more important has been the spread between the forward P/Es of Growth versus Value. It widened from close to zero at the end of 2008 to 13.4 during the November 25 week this year (Fig. 15 and Fig. 16). That’s the highest since January 2001.

(3) Rollercoaster ride. Since the pandemic started, Growth stocks have been viewed as the winners when lockdowns and social-distancing requirements weighed on Value stocks, which have been viewed as “reopening trades.” As a result, the waves of the pandemic have caused a rollercoaster ride for investors, which can been seen in the ratio of the stock price indexes for Growth to Value (Fig. 17).

(4) Sector performance since the peak. Since the S&P 500‘s record peak on November 18 through Friday’s close, there has been much chatter about the relative underperformance of Technology and other S&P 500 sectors with relatively high valuation multiples. After all, Growth stocks should underperform at times when inflation is heating up, which typically mean rising oil prices, a weakening dollar, and rising interest rates.

The catch is that these conditions don’t currently prevail despite rising inflation. The federal funds rate will probably remain near zero through March, and the bond yield has been falling rather than rising lately. In addition, the price of oil has been weak, and the dollar has been strong lately.

Furthermore, the performance derby of the S&P 500 and its sectors since November 8 through Friday doesn’t confirm the conventional chatter. Here it is: Utilities (0.6%), Consumer Staples (-1.0), Real Estate (-1.4), Health Care (-2.6), Information Technology (-2.9), Energy (-3.1), S&P 500 (-3.5), Financials (-3.6), Materials (-3.8), Industrials (-3.9), Consumer Discretionary (-5.6), and Communication Services (-6.2). (See table.)

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The Economy Is Booming

December 06 (Monday)

YRI Monday Webinar. Join Dr. Ed’s live Q&A webinar on Mondays at 11 a.m. EST. You will receive an email with the link to the webinar one hour before showtime. Replays are available here.

US Economy: Some Problems, But-A-Boom. While stock investors are singing “Should I Stay or Should I Go?” by The Clash, the US economy is going strong. This suggests that profits growth, which undoubtedly peaked during Q2 on a y/y basis, should remain strong.

It also suggests that FOMC members at their December 14-15 meeting will vote to accelerate the Fed’s pace of tapering its bond purchases. Instead of doing so by $15 billion per month, they might do so at $30 billion per month. They’ve already tapered their $120 billion monthly purchases by $15 billion per month during November and December. At the faster pace, they would be done tapering by the end of March. That would allow the FOMC to signal a rate hike at the March 15-16, 2022 meeting and to vote for it at the May 3-4 meeting.

So the answer to the question in the song is “yes.” Investors should stay because profits are likely to remain strong, but they should go if they fear that tighter monetary policy will depress elevated valuation multiples. We are inclined to advise staying. The S&P 500 peaked at a record high of 4701.70 on November 8. It was down 3.5% to 4538.43 as of Friday’s close. We are still targeting 4800 by the end of this year, 5200 by the end of 2022, and 5500 by the end of 2023.

Let’s focus on the latest US economic indicators before turning to S&P 500/400/600 corporate earnings and valuation multiples:

(1) GDPNow. The Atlanta Fed’s GDPNow model showed that Q4’s real GDP was tracking at a 9.7% annual rate through December 1. That’s up from Q3’s increase of 2.1%. The “nowcasts” of Q4’s real personal consumption expenditures growth and real gross private domestic investment growth increased from 7.9% and 12.5%, respectively, to 9.6% and 13.1%, respectively, while the nowcast of Q4’s real government spending growth decreased from 2.9% to 2.5%. Those are all impressive numbers.

Debbie and I thought that supply-side issues that disrupted real GDP growth during Q3 might continue to do so during Q4. But that doesn’t seem to be happening. We are raising our Q4 GDP forecast from 2.0% to 5.0% (Fig. 1).

Real GDP was up 4.9% y/y through Q3. It is highly correlated with the y/y growth rate of the Index of Leading Economic Indicators, which was up 9.3% through October (Fig. 2).

(2) Boom-Bust Barometer. The CRB raw industrials spot price index has been in record-high territory in recent weeks (Fig. 3). Initial unemployment claims dropped below 300,000 during the week of October 9 and recently has been hovering around 200,000. As a result, our Boom-Bust Barometer, which is the ratio of the CRB index to jobless claims, has been soaring to all-time highs in recent weeks (Fig. 4).

(3) National purchasing managers surveys. The national M-PMI compiled by the Institute for Supply Management edged up to 61.1 during November (Fig. 5). That’s a relatively high reading, especially since supply-chain disruptions have been challenging many manufacturers. Even more impressive, but not surprising, is that the national NM-PMI jumped to a record 69.1 last month (Fig. 6). Widespread vaccinations have allowed for more widespread business activity in the services sector of the economy.

The M-PMI survey suggests that supply-chain disruptions may be easing, but not by much. The backlog of orders index fell from its record high of 70.6 during May to 61.9 during November (Fig. 7). The production index is no longer lagging the orders index. However, the customer inventories index fell during November, matching its record low during July.

On the other hand, actual durable goods shipments excluding transportation are keeping pace with new orders (Fig. 8). Motor vehicle sales remain depressed because the automakers have been struggling with shortages of semiconductors (Fig. 9).

(4) Employment and income. Our Earned Income Proxy for wages and salaries in the private sector rose 0.8% m/m during November as aggregate weekly hours rose 0.5%—reflecting a 0.3% increase in average weekly hours and a 0.2% increase in private payrolls—and average hourly earnings rose 0.3% (Fig. 10).

The 210,000 increase in nonfarm payrolls during November was well below expectations given that the ADP measure for private payrolls jumped 534,000 during the month (Fig. 11). On the other hand, the household measure of employment, which counts the number of people employed (rather than the number of jobs, as the payroll measure counts), soared 1.14 million during November, led by a 954,000 increase in full-time employment to the best reading since February 2020 (Fig. 12).

The increase in household employment outpaced the 594,000 jump in the labor force during November. As a result, the unemployment rate fell from 4.6% during October to 4.2% last month (Fig. 13). The short-term unemployment rate fell to 2.9%, while the long-term unemployment rate fell to 1.4%.

(5) Consumer optimism. Notwithstanding the improvement in the labor market, our Consumer Optimism Index—which is the average of the Consumer Sentiment Index and the Consumer Confidence Index—has dropped sharply from this year’s high of 107.2 during June to 88.5 during November (Fig. 14). The problem is that the Misery Index, which is the sum of the inflation rate and the unemployment rate, has increased in recent months as the jump in the former outpaced the drop in the latter.

(6) Wage and price indicators. The downside of all this good news is that inflationary pressures remain elevated, as evidenced by November’s prices-paid indexes in both the M-PMI and NM-PMI surveys (Fig. 15). The same can be said about the average prices-paid and prices-received indexes of the regional business surveys conducted by five of the Federal Reserve Banks (Fig. 16).

Rising prices and labor shortages continue to push up wage inflation. The average hourly earnings (AHE) for all workers rose 4.8% y/y during November (Fig. 17). That compares to 3.0% during January 2020, right before the start of the pandemic. Interestingly and not surprisingly, during November on a y/y basis, the AHEs of lower-wage versus higher-wage workers rose 5.9% and 2.5%. The former workers account for about 82% of payroll employment and are described as “production and nonsupervisory workers” (P&NS) in the monthly employment report (Fig. 18).

Here is the performance derby of the percent changes in the total versus P&NS AHEs for the major industries on a y/y basis and in current dollars through November: information services (0.3%, 2.2%), utilities (1.8, 3.0), natural resources (2.3, 5.8), manufacturing (4.0, 4.9), wholesale trade (4.1, 4.0), retail trade (4.4, 5.2), construction (4.8, 5.3), all workers (4.8, 5.9), financial activities (5.0, 4.3), education & health (5.6, 7.4), professional & business services (5.8, 6.7), transportation & warehousing (6.8, 10.4), and leisure & hospitality (12.3, 13.4).

The data confirm what we all know: There are severe shortages of truck drivers and restaurant workers.

We are not convinced that a widespread wage-price spiral is underway. We expect productivity to avert a 1970s-style spiral. But we continue to monitor the situation closely.

Strategy I: S&P 500/400/600 Revenues, Earnings, and Margins. Confirming the strength of the economy are the S&P 500/400/600 indexes’ forward revenues and forward earnings (i.e., the time-weighted average of analysts’ consensus estimates for this year and next) (Fig. 19 and Fig. 20). All six measures rose to new record highs during the November 25 week.

Notwithstanding rising costs, labor shortages, and supply-chain disruptions, the forward profit margins (which we calculate from forward earnings and revenues) of the S&P 500 and S&P 600 rose to record highs of 13.3% and 6.9%, respectively, during the November 25 week (Fig. 21). The forward margin of the S&P 400 has been hovering around a record high of 8.5% recently.

Strategy II: S&P 500/400/600 Valuation. The forward earnings of the S&P 400/600 SmallCap and MidCap indexes (“SMidCaps”) have been rising faster than the forward earnings of the S&P 500 since mid-2020. However, so far this year, the S&P 500 stock price index has been mostly outperforming the SMidCaps indexes, which have been mostly flat.

As a result, the forward P/Es of the S&P 400/600 continued to dive to new 2021 lows of 15.7 and 14.4 on Friday (Fig. 22). The forward P/E of the S&P 500 fell to 20.6 on Friday. It has mostly remained above 20.0 since last summer.

Our Blue Angels framework shows that both the S&P 500’s price index and its forward earnings have been making new record highs this year while its forward P/E has been relatively stable, between 20.0 and 22.0 (Fig. 23). The same cannot be said about the S&P 400/600 SMidCaps stock price indexes: They’ve been going sideways this year as their strong forward earnings growth to record highs has been offset by falling valuation multiples. SMidCaps looked cheap before last Friday’s drop. They look even cheaper and more attractive now.

Movie. “House of Gucci” (+ +) (link) is a docudrama based on the life of Maurizio Gucci, who badly mismanaged his dysfunctional family and his family’s fashion empire. His ambitious wife contributed to his rise and fall. He is played by Adam Driver. Lady Gaga’s performance is outstanding as his wife Patrizia, whom the Italian press dubbed “La Vedova Nera,” or “the Black Widow.” The cast includes Jeremy Irons and Al Pacino as Maurizio’s father and uncle. Jared Leto also stands out as his cousin, Paolo, who was a certifiable idiot, the Fredo Corleone of the Gucci family. The film, which is based on the 2001 book The House of Gucci: A Sensational Story of Murder, Madness, Glamour and Greed, by Sara Gay Forden, covers all the bases mentioned in the title.

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Consumers & Fusion

December 02 (Thursday)

Consumer Discretionary: Ringing in the Holidays. Retail sales data over the Thanksgiving weekend weren’t entirely jolly. Some data services reported that sales were up. Others said they fell slightly. Consumers have been actively consuming over the past two years, satiating pent-up demand and making a huge pop in retail sales unlikely this holiday. That said, we don’t believe the mixed data are a sign that we’re about to have a grinchy holiday either.

This year, friends and families are gathering, and that should drive purchases of clothing, decorations, and food. Meanwhile, consumers’ financial position remains healthy, with jobs plentiful and debt-service levels low, giving them the means to spend. In fact, it’s widely believed that consumers began holiday shopping sooner this year, prompted by dire headlines about snarled supply chains leading to empty shelves and delayed holiday gift deliveries. That’s sure to muddy the data and require looking at it over a longer period.

Of course, all bets are off if the Omicron Covid-19 variant leads to mandated or self-imposed shutdowns. News of the first case in the US arrived yesterday; a person in California who had visited South Africa had mild symptoms despite being vaccinated. While we await additional data on the virus, let’s take a look at some of the recent retail sales headlines and data on consumers’ financial health:

(1) Mixed messages. As we mentioned, the data about retail spending over the holiday weekend was mixed. In the positive category, Mastercard SpendingPulse reported that US retail sales during the Thanksgiving weekend rose 14% y/y and 5.8% from 2019 levels, according to a November 30 WSJ article. And Salesforce.com reported that shoppers spent $11.3 billion online in the US on Cyber Monday, up 3% y/y.

In the negative bucket, the number of shoppers declined this year, according to National Retail Federation data. Some 179.8 million shoppers hit the stores or shopped online between Thursday and Monday, down from 186.6 million in 2020 and 189.6 million in 2019, the WSJ article reported. A second negative datapoint came from the Adobe Digital Economy Index, which reported that US shoppers spent $33.9 billion online between Thanksgiving and Cyber Monday, a decline of 1.4% y/y. And a Placer.ai blog post said mobile phone data indicated that indoor mall traffic rose 83.5% y/y on Black Friday but was down 8.5% compared to pre-pandemic levels.

The Jackie Doherty traffic index indicates that all is fine. It took almost an hour to exit a Long Island Tanger Outlet on Friday afternoon.

(2) Money in their pockets. Lots of people having jobs always helps boost holiday shopping, and the US employment picture was robust last month, according to the latest data from ADP. The number of private-sector jobs increased by 534,000 in November, with services jobs representing 424,000 of those, ADP reported (Fig. 1).

The YRI Earned Income Proxy has also been on an upward path since bottoming in April 2020 (Fig. 2). The proxy multiplies the average weekly hours worked by the average hourly earnings of total private industries and annualizes the result. In October, the YRI Earned Income Proxy rose 9.3% y/y.

Retail sales growth historically has tracked the changes in the YRI Earned Income Proxy closely. But over the past two years, retail sales growth has been higher than the YRI proxy, bolstered by government remittances during Covid-19. As the benefit from the government payments fades, retail sales growth should more closely track the YRI proxy once again (Fig. 3).

(3) Household balance sheets steady. US household debt was at a record high in Q3, but low interest rates and higher incomes mean payments remain manageable (Fig. 4). Household debt balances were boosted by home mortgage debt, which has continued to rise since Q1-2017, when it first exceeded the mortgage debt peak that occurred before the housing bubble began to burst in 2009 (Fig. 5). But mortgage debt as a percentage of the value of household real estate remains low at 32.3% in Q2 compared to 54.0% at its peak in Q1-2012 (Fig. 6).

Auto loans and student loans outstanding continue their rapid increases (Fig. 7 and Fig. 8). Their ascent is somewhat offset by the decade-long decline in home equity loans (Fig. 9). And credit card balances remain flat to down slightly through Q3 (Fig. 10).

Despite peak levels of consumer debt, the household debt service ratio—the ratio of debt service payments to disposable personal income—is near its recent low, helped by the low interest rate environment (Fig. 11). In addition, personal savings remains elevated (Fig. 12).

(4) Retail stocks rally. Investors appear sanguine about the consumer’s ability and willingness to spend. The S&P 500 Consumer Discretionary sector was the second-best-performing sector in November, up 1.9% compared to the broader index’s 0.8% decline. The Consumer Discretionary sector has also modestly outperformed so far this year, rising 24.1% ytd through Tuesday’s close compared to the S&P 500’s 21.6% return (Fig. 13 and Fig. 14).

The S&P 500 Consumer Discretionary sector’s ytd momentum has been propelled by industries related to housing and cars: Automobile Manufacturing (63.1%), Home Improvement Retail (51.3), Automotive Retail (46.1), and Homebuilding (33.5) (Fig. 15).

The Consumer Discretionary Retail Composite has had a tougher time of things, up 20.1% ytd, held back by Amazon, which is up only 7.7% ytd. Excluding Amazon, the Retail Composite would be up 46.6% ytd, Joe calculates. Within retail, the S&P 500 Specialty Stores industry has outperformed, rising 45.2% ytd, as has General Merchandise Stores, up 25.7%. Conversely, Apparel Retail (4.4%) and Internet & Direct Marketing Retail (10.0) have been drags on the sector’s overall performance (Fig. 16).

The financial picture for the S&P 500 Consumer Discretionary Retailing industry looks favorable, with analysts forecasting consensus revenue growth of 17.5% in 2021 and 8.6% next year (Fig. 17). Earnings are forecast to post even stronger gains of 29.7% this year and 11.2% in 2022 (Fig. 18). This, of course, presumes that Omicron doesn’t deliver a lump of coal in the next few weeks.

Disruptive Technology: Nuclear Fusion Heats Up. Nuclear fusion has long been the Holy Grail of the scientific world. It replicates what happens on the sun, where small atoms combine to make one larger atom and produce tons of energy in the process. In theory, nuclear fusion on Earth would produce vast amounts of energy without throwing off the CO2 produced by burning fossil fuels or the nuclear waste produced by nuclear power plants. The energy would be available on demand and without the intermittency problem of solar or wind energy.

When we first wrote about nuclear fusion in the August 1, 2019 Morning Briefing, we introduced some of the largest players in the industry, which are still working to make nuclear fusion a reality. Unfortunately, the problem we highlighted two years ago remains a problem today: The amount of energy required for nuclear fusion exceeds the amount of energy it produces.

That said, scientists are excited by several recent advancements, and a number of companies believe they will solve the net negative energy problem and build working plants sometime in the next 20 years. The growing buzz surrounding the industry has led to articles about fusion popping up in non-scientific publications, the formation of new startup companies, and increased venture capital funding.

There are at least 35 fusion companies around the world, 18 of which have received a combined $3.7 billion in private funding. “Of the 23 companies that responded to the survey, more than half were founded in the past five years,” an October 27 FT article reported. Four companies have received the bulk of private-sector funding: Commonwealth Fusion Systems, California’s TAE Technologies, Oxford-based Tokamak Energy, and Canada’s General Fusion. Let’s take a look at what they hope to achieve:

(1) World’s strongest magnet. Commonwealth Fusion Systems (CFS) was spun out of MIT’s research labs and still works with the university. In a major sign of confidence in its technology, CFS recently raised more than $1.8 billion from George Soros, Google, Marc Benioff’s TIME Ventures, venture capital firm DFJ Growth, and others, a December 1 WSJ article reported. Prior funding came from the likes of Breakthrough Energy, which is Bill Gates’ consortium of billionaires, along with Italian oil company ENI. CFS hopes to develop a demonstration plant that produces net positive energy by 2025 and a commercially viable plant by 2030 that supplies energy to the grid. The plant’s estimated cost is $3 billion.

To make nuclear fusion occur on Earth, huge amounts of energy are needed to heat up the atoms north of 100 million degrees kelvin. At those temperatures, matter becomes plasma and must not touch anything solid. CFS and some others create magnetic fields inside a container called a “tokamak” to control the plasma and provide thermal insulation. CFS has developed a new magnet that’s both super strong and super thin. It believes this magnet is the key to developing a fusion plant that generates net energy.

CFS uses high-temperature superconductors, made of a new material that can “carry a lot of current even when embedded in strong magnetic fields. Until now, all fusion magnets have been made with copper conductors or Low Temperature Superconductors which limit the strength of [the] magnetic field that can be produced,” an MIT primer explained. CFS’s high-temperature superconducting electromagnet reached a field strength of 20 tesla, the most powerful magnetic field ever created. It’s 12 times stronger than a traditional MRI and 400,000 times stronger than Earth’s magnetic field.

The new superconducting material is commercially available and comes in a flat, ribbon-like tape. The thin material “makes it possible to achieve a higher magnetic field in a smaller device, equaling the performance that would be achieved in an apparatus 40 times larger in volume using conventional low-temperature superconducting magnets,” a September 8 article in MIT News reported. The new material allows CFS’s fusion plant to be smaller, so it can be built faster and less expensively.

If the magnets work as expected, CFS believes that twice as much fusion energy will be produced by the plasma than is used to generate the reaction. But it’s unclear whether the amount of electricity the plant produces will be more or less than the amount required to run the entire plant and convert the heat energy into electricity.

Tokamak Energy is also using high-temperature superconducting magnets in a tokamak it developed that’s smaller and shaped more like an apple than the donut shape many companies use. The Oxford, UK-based company has raised $200 million in mostly private capital. It plans to achieve 100 million degrees Celsius in stable plasma this year, which would be a key milestone, a July 17 article in Energy Digital reported.

(2) Using pistons. General Fusion, a Canadian company backed by Jeff Bezos and others, will begin construction next year on a demonstration plant in the UK that it plans to open in 2025. The company announced on Tuesday that it raised $130 million to help fund the plant’s construction. The company aims to license its technology and provide core, proprietary components to those who want to build the plants, a November 30 Globe and Mail article reported.

General Fusion’s method of achieving fusion—magnetized target fusion--is different than CFS’s approach. General Fusion has built a cylinder that rotates and is surrounded by pistons. As the cylinder rotates, liquid metal inside of the cylinder is pushed to the walls and hydrogen plasma is injected into the middle of the cylinder. The pistons then push into the cylinder and the liquid metal, compressing the hydrogen plasma and causing fusion to occur. The fusion heats the liquid metal wall, which is then pumped through a heat exchanger to generate electricity via a steam turbine. A company video explains the process.

(3) Harnessing a collision. TAE Technologies, based in California, announced in April that it produced stable plasma at more than 50 million degrees with a new machine it calls “Norman.” At each end of the machine, it heats hydrogen gas to form plasmas. The two plasmas then are propelled to collide in the center of the machine and particle beam accelerators hold the two plasmas together so that fusion occurs, a CNBC article explains.

For the system to create net energy, the plasma must reach temperatures higher than 100 million degrees Celsius. That’s the goal of its next machine, dubbed “Copernicus.” The company plans to have a demonstration power plant online by the late 2020s.

The company raised two rounds of financing earlier this year, totaling more than $400 million, which brought the company’s total funding from investors to $880 million. Investors include Vulcan, Venrock, NEA, Wellcome Trust, Google, the Kuwait Investment Authority, the family offices of Addison Fischer, Art Samberg, and Charles Schwab.

(4) Government-funded research at work too. The most ambitious nuclear fusion government project is being developed by ITER, which is supported by 35 countries around the world including the US. The organization is building a fusion reactor in southern France with a price tag of $22 billion. Testing is scheduled for 2025, and full operation is slated for 2035, a November 17 article in Nature reported.

The plant is expected to generate 500 megawatts of power, while the plasma uses just 50 megawatts. Those figures don’t include the energy needed to run the plant or the energy lost when the fusion heat is converted to electricity. The plant requires 440 megawatts to operate, and the amount of energy it produces shrinks to about 250 megawatts once it’s converted to electricity, Sabine Hossenfelder points out in this “Science without the Gobbledygook” video. By focusing only on the energy used by the plasma in this project and many others, scientists and investors are underestimating what it will take to make these projects commercially viable.

Countries including China and South Korea as well as those in the EU also are expected independently to build their own reactors. Experiments at the Lawrence Livermore National Laboratory in California used lasers to trigger a fusion reaction that generated almost as much energy as was used by the lasers, reported a November 30 article on the American Physical Society website. (Privately funded Marvel Fusion in Germany is also using lasers.) The Chinese Academy of Sciences heated its plasma to 120 million degrees Celsius and held that temperature for a minute and a half.

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Follow the Money

December 01 (Wednesday)

Strategy: Santa vs the Grinches. The Santa Claus rally started early this year. The question is whether it is over already. The S&P 500 dropped 5.2% from 4535.43 on September 3 to 4300.46 on October 4 (Fig. 1). From there, it rose 9.3% to a new record high 4701.70 on November 8. Its level was virtually the same on November 24, the day before Thanksgiving, at 4701.46. It dropped sharply on Friday, the day after Thanksgiving, rallied on Monday, and dropped again yesterday to close at 4567.00. It is now down 2.9% from its recent record high.

Did Santa come early this year to avoid the supply-chain disruptions? Might there be no Santa Claus rally between Thanksgiving and New Year’s Day? On Friday, the markets discounted the possibility that the Omicron variant of Covid might be the Grinch who stole the Santa Claus rally. Yesterday, Fed Chair Jerome Powell became the Grinch.

Testifying before a Senate committee, the Fed chair said he thinks reducing the pace of monthly bond buys can move quicker than the $15 billion-a-month schedule announced earlier this month. “At this point, the economy is very strong and inflationary pressures are higher, and it is therefore appropriate in my view to consider wrapping up the taper of our asset purchases … perhaps a few months sooner,” Powell said. “I expect that we will discuss that at our upcoming meeting.”

In Monday’s Morning Briefing, Melissa and I observed: “As inflation has been heating up, more Fed officials have been hot to trot when it comes to speeding up the tapering of the Fed’s bond purchases.” We noted: “In the months leading up to the FOMC’s decision to start tapering, made at its November 2-3 meeting of the Committee, Melissa and I suggested that the Committee should move faster to do so. We figured that with inflation heating up, the Fed might need to raise interest rates sooner than officials were expecting. That’s the conclusion they finally reached as well according to the minutes of their November 2-3 gathering.”

Nevertheless, the markets were shocked yesterday to hear that Powell is now in the same camp as other hawkish FOMC participants who’ve been suggesting a faster pace of tapering. The next FOMC meeting will be held December 14-15.

We think the FOMC is behind the inflation curve, and we see the committee’s attempt to get ahead of it as a positive development. However, stock investors’ knee-jerk reaction may continue to be to take profits before the end of the year. Nevertheless, as we discussed on Monday, there is plenty of liquidity available to drive stock prices higher as dip-buyers enter the market. We aren’t giving up on Santa Claus.

Corporate Finance I: Following the Fed. Thanks to the flood of liquidity provided by the Fed since the start of the pandemic last year, a credit crunch as severe as the one that occurred during the Great Financial Crisis (GFC) was averted. As a result, debt delinquencies and defaults have been remarkably low during the Great Virus Crisis, as we discussed in our April 28 Morning Briefing. Corporate bankruptcies have fallen to historic lows in 2021, according to a more recent report from S&P Global. There has not even been a mild credit crunch. On the contrary, corporations have been able to raise record amounts in the bond and stock markets to fund their businesses and refinance their debts at record-low interest rates.

Investors have been contributing to this development in the capital markets by reaching for yield in the bond market and chasing momentum in the stock market as well as alternative markets. While Melissa and I are concerned about the elevated valuations in the capital markets, we also see some very positive consequences of these “animal spirits” gone wild. For one, more and more investors are getting wealthier and diversifying their gains to fund more and more innovations, especially in technology.

Looking ahead, it’s possible that tightening monetary policy could threaten distressed companies’ ability to find financing. But with all the money that’s flowing around, it could take longer than usual to curb the enthusiasm in the capital markets. How fast and by how much market enthusiasm tapers may depend on how quickly the Fed tapers its bond purchases, as we discuss above.

Corporate Finance II: Following Corporate Issues. Corporations have been raising lots of money in the bond and stock markets this year. While the rates of total new corporate issuance have cooled in both markets over recent months, they remain near record highs in the bond market and well past record highs in the equity market. Consider the following:

(1) Bond issuance. Over the past 12 months through September, companies raised $2.15 trillion in the bond market (Fig. 2). Over this same period, nonfinancial corporations (NFCs) raised $1.01 trillion, while financial ones raised a record $1.14 trillion.

Corporations used some of the proceeds to refinance outstanding bonds at record-low yields. They’ve also paid down some of their bank loans. A portion of the remaining proceeds financed capital spending and stock buybacks or are sitting in liquid assets.

Based on the difference between gross and net bond issuance, which is available quarterly, NFCs refinanced a record $1.0 trillion during the four quarters through Q2 (Fig. 3 and Fig. 4). Commercial and industrial loans peaked at a record high of $3.4 trillion during the week of May 6, 2020. They are down $0.8 trillion since then through the November 17 week of this year (Fig. 5). On the other hand, quarterly data on “other loans,” which consists mostly of leveraged loans, rose to a record $2.1 trillion during Q2 (Fig. 6).

(2) Stock issuance. Corporations raised a near-record $424.3 billion in the stock market over the past 12 months through September (Fig. 7). Data available through June show that the bulk of the nonfinancial corporate issues were seasoned equity offerings (SEOs) rather than initial public offerings (IPOs) (Fig. 8). SEOs have cooled somewhat in recent months, while IPOs continue to take off.

Corporate Finance III: Following VC Money. Many of the disruptive technologies that Jackie covers on Thursdays are developed by small enterprises funded by venture capitalists (VCs). “The venture industry has continued to prove its resiliency in 2021—a year marked by outsized funds, numerous mega-deals and the soaring interest of multistage investors looking to back younger startups,” according to a PitchBook note covering its latest US VC Valuations Report.

According to IMARC Group’s latest VC investment report summarized on LinkedIn, the global venture capital investment market reached a value of $197.7 billion in 2020. Looking forward, IMARC Group expects the market to grow at a cumulative annual growth rate of around 16% during 2021 through 2026.

For a point of reference, US venture capital deals totaled $108 billion in 2019, the third-largest year ever, according to a Q4-2020 MoneyTree report by PwC and CBInsights. Funding was down slightly from 2018’s $118 billion and from the record year of 2000’s $119 billion.

Thanks to all the Fed-given liquidity floating around, public money is getting into VC too. “High demand from public market investors is [a] factor pushing VC valuation growth to new heights,” according to PitchBook.

Three big VC themes that we have spotted coincide with three broader market trends that we have seen this year: pandemic driven interest in early biotech innovations, climate-change driven interest in technologies to combat it, and productivity driven interest in enterprise technology.

Here’s more:

(1) VC more adventurous. Venture capitalists are getting into promising startups earlier in their lifecycle. The median early-stage valuation has roughly doubled in the past three years and cracked the $50 million mark in Q3, observed PitchBook. Around 104 mega-deals were completed by Q3, a significant jump from the previous full-year record of 61 in 2020. Late-stage activity also has remained robust throughout the year.

Early-stage biotech startups are commanding the highest proportion of deals compared with other stages through Q3. The top quartile early-stage valuation in the sector also topped $100 million for the first time.

(2) Climate growth. Valuations for early- and late-stage climate tech startups increased in Q3. Climate tech startups raised nearly $13 billion in VC investment globally across 203 deals in Q3 2021, up 38.3% year over year, according to a recent Emerging Tech Research report by PitchBook mentioned in the note.

(3) Enterprising technology. Enterprise tech—i.e., technology that enables the integration of tech resources and data across an organization—commanded nearly half of all deal value through Q3.

Corporate Finance IV: Following PE Money. “A Pre-Thanksgiving Spree Takes Private Equity Deal Value Past $1 Trillion For The First Time In History” was the title of a November 23 Forbes article. That about sums up what is going on in the private equity (PE) markets. But are we at peak private equity? We don’t think so.

“The momentum from late 2020 is expected to continue through 2021 for private equity (PE) firms. The first five months in 2021 saw PE deal volume increase 21.9% compared with the same period last year, resulting in 2,346 deals,” wrote PwC in its midyear 2021 PE deals outlook. It added: “Private equity firms are benefiting from significant market tailwinds triggered by historically low interest rates as well as record fundraising, which is at an all-time high with US PE dry powder at $150.1 billion.”

Here are a few interesting PE trends to follow:

(1) ESG-experts wanted. PwC anticipates that environmental, social, and governance (ESG) considerations will become an integral part of strategic PE valuation from the initial screening phase of deal-making through the exit of an investment. As such, PwC expects PE firms to conduct more thorough analyses of ESG risks across portfolios.

So it’s no wonder that climate science and biodiversity candidates are heavily sought after by PE firms. Top ESG hires have been propelled into the seven-digit annual pay league, as a recent Bloomberg article explored.

(2) SPAC attack. The recent emergence of special purpose acquisition companies (SPACs) has posed a challenge for PE firms: to match or beat SPAC valuations. As we discussed in our April 28 Morning Briefing linked above, recent regulatory scrutiny has tempered the hype around SPAC investments.

Briefly, SPACs were seen as an interesting exit strategy for some PE-held organizations. PwC sees the growing disinterest in SPACs as an opportunity to advance PE as a capital channel into traditional initial public offerings. Low interest rates and “abundant capital” should continue to flow back into PE.

(By the way, PwC thinks that tax law uncertainty could spur more PE exit activity to accelerate timing and avoid potentially unfavorable tax outcomes in the future.)

(3) Teaming upward. PwC indicated that portfolio companies increasingly are viewing PEs as a strategic partner to help them achieve their growth aspirations. That’s important because PEs’ increasing comfort level with their ability to execute on strategic initiatives is driving valuations. Many of the larger recent PE transactions depended upon strategic partnerships. Only a few key players represent the bulk of the PE market, noted a press release from Market Insights Reports.

Corporate Finance V: Following the Deals. Global M&A hit a record high in the first nine months of 2021, according to Dealogic. Venture capitalist Marc Andreessen expressed in 2011 the idea that “software is eating the world.” M&A deals in 2021 fully reflected this expression, observed Dealogic. Technology accounted for 27% of global deal value ($1.2 trillion across 8,797 deals) so far this year, the largest-ever share.

Healthcare came in second place, with 10.5% of total deal value, followed by the real estate (6.7%), finance (6.4), utility & energy (6.0), and telecommunications (5.7) sectors. North America accounted for more than half (51.2) of global deal value during the first nine months, followed by Asia-Pacific (21.6) and Europe (21.3).

By the way, Dealogic emphasized SPACs in its M&A Highlights: First Half 2021. US SPACs issuance collapsed in Q2 (see Dealogic’s chart). SPAC business combinations were a major theme of US M&A early this year, with 155 deals worth $379 billion announced in H1-2021 alone. However, SPAC IPO issuance dropped significantly in April, with the bulk of activity occurring in Q1. On the other hand, SPACs typically have a 24-month window to complete a transaction, so deal-making by SPACs in the US could continue unabated in the coming quarters, says Dealogic.

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Is America Shovel Ready?

November 30 (Tuesday)

Infrastructure I: The Hope. In an hour-long interview with The New York Times on October 12, 2010, President Barack Obama explained why the unemployment rate was still hovering around 10% nearly two years after he signed his economic stimulus package. The President acknowledged that, despite his campaign promises, “there’s no such thing as shovel-ready projects.” Local governments were still facing delays spending the money they were allocated from the stimulus program.

Now President Joe Biden has signed an infrastructure bill for a country that’s even less shovel ready than it was back when he was Obama’s vice president because of today’s severe shortage of construction workers. Let’s have a look at the facts and figures on the ground today:

(1) President Biden signed the $1 trillion Build Back Better infrastructure bill into law on Monday afternoon, November 15. It was a bipartisan victory for the Biden administration. Biden grandly declared: “I truly believe that 50 years from now, historians are going to look back at this moment and say, that’s the moment America began to win the competition of the 21st century.”

The act pours billions into the nation’s roads, ports, and power lines. It budgets $500 billion to highways, $39 billion to urban transit, $65 billion to broadband projects, and $73 billion to electrical grids, among other items. The nation’s busiest passenger rail line, Amtrak’s Boston-to-Washington corridor, gets the biggest slice of a $66 billion rail package.

(2) The November 15 NYT reported: “The infrastructure spending will not jolt the American economy like a traditional economic stimulus plan, nor is it meant to. Officials say the administration will focus as much on ‘shovel-worthy’ projects—meaning those that make the most of federal dollars—as they will on ‘shovel-ready’ ones that would dump money into the economy more quickly.” The administration claims that the package was designed to deliver money over several years, partly to avoid adding to mounting inflationary pressures.

(3) Indeed, the President has claimed that the legislation’s infrastructure spending should help to reduce inflation by boosting productivity as roads and bridges are rebuilt, freight and passenger rail systems upgraded, and environmental pollution cleaned up.

“This is not designed to be stimulus,” said Cecilia Rouse, chair of the White House Council of Economic Advisers. “It’s designed to be the most strategic, effective investments so that we can continue to compete against China and other countries that are making bigger investments in their infrastructure.” She added, “We will see investments starting next year … beginning with our ports, and beginning with other areas where we know we are far behind.”

(4) To be clear, while the infrastructure spending act is billed as a $1 trillion initiative, only about $550 billion of that represents an increase over current spending levels.

(5) On November 14, Biden named Mitch Landrieu, a former mayor of New Orleans and a former lieutenant governor of Louisiana, to oversee the $1 trillion in infrastructure spending. The White House announcement observed: “As Mayor of New Orleans, Landrieu took office at a time when the city’s recovery from the devastation of Hurricane Katrina had stalled. He hit the ground running, fast-tracking over 100 projects and securing billions in federal funding for roads, schools, hospitals, parks and critical infrastructure, turning New Orleans into one of America’s great comeback stories.”

Landrieu was also chair of the US Conference of Mayors, so he knows lots of the local officials around the country who will have to work with him to get his job done.

Infrastructure II: The Challenge. The November 28 NYT featured an article titled “Years of Delays, Billions in Overruns: The Dismal History of Big Infrastructure.” It lays out the challenges, hurdles, and obstacles that Landrieu will have to overcome. The article warns: “As the nation sets out on a national spending spree fueled by the $1.2 trillion infrastructure bill signed by President Biden this month, the job ahead carries enormous risks that the projects will face the same kind of cost, schedule and technical problems that have hobbled ambitious efforts from New York to Seattle, delaying benefits to the public and driving up the price tag that taxpayers ultimately will bear.”

The article points out that the challenges to restoring America’s infrastructure “have grown more potent” in recent years. Among the litany of potential potholes cited: “Agencies have less internal technical talent. Legal challenges have grown stronger under state and federal environmental laws. And spending on infrastructure as a fraction of the economy has shrunk, giving local agencies less experience in modern practices.”

Infrastructure III: The Numbers. There is certainly a pressing need to upgrade the country’s infrastructure. The World Economic Forum ranks the US 13th in terms of overall quality of infrastructure. More than 45,000 US bridges and one in five miles of roads are in poor condition, per the American Society of Civil Engineers.

Here are some of the challenges ahead:

(1) The construction industry is facing sharply growing costs for steel products, up by 101% over the last 12 months, and other key materials (Fig. 1 and Fig. 2).

(2) Shortages of skilled labor are worsening, exacerbated by Covid-induced retirements. Payroll employment in the construction industry recovered to 7.5 million during October, only 150,000 below its pre-pandemic peak of 7.6 million during February 2020 (Fig. 3). The 3.1 million workers in the residential construction sector during October surpassed its pre-pandemic level, while the 3.4 million workers in the nonresidential sector during the month was 182,000 below its pre-pandemic high.

(3) Finding more construction workers to meet the needs of the administration’s infrastructure program will be tough and will drive up labor costs in the construction industry, in which the number of quits has been increasing in recent months (Fig. 4). And construction hires are down in recent months, undoubtedly reflecting a shortage of workers rather than weakening demand for them.

(4) October saw the average hourly earnings of all construction workers rise 4.7% y/y and that of the industry’s production and nonsupervisory workers rise 5.2% (Fig. 5).

(5) During periods of economic expansion, residential and nonresidential construction spending tend to well exceed public construction (Fig. 6 and Fig. 7). During September, spending on residential, nonresidential, and public construction totaled $774 billion, $456 billion, and $344 billion at seasonally adjusted annual rates. It is likely to be tough for contractors chosen to Build Back Better to do so if they can’t attract workers with the necessary skills.

Capital Spending: The Big Boom! Capital spending is shovel ready! Actually, it has been booming in recent months. Debbie and I believe that employers are quickly realizing that labor shortages are here to stay. These shortages are structural; they are chronic. So company managements are scrambling to spend on productivity-enhancing capital equipment, especially those that use state-of-the-art technologies to boost both the manual and mental productivity of workers. Consider the following:

(1) Durable goods orders excluding transportation has soared 34.1% since bottoming last year during April through October of this year (Fig. 8). It has been in record-high territory since December. Nondefense capital goods orders excluding aircraft is up 31.3% over the same period and has been rising in record territory since last November. Shipments data have been closely tracking the orders data, which is impressive given all the angst about supply-chain disruptions.

(2) The following categories of new orders have been leading the charge higher and were at record highs during October: fabricated metals products; machinery; electrical equipment, appliances & components; and all other durable goods (Fig. 9).

In the machinery category, September data showed record orders for industrial, metalworking, and material handling machinery (Fig. 10). Orders for construction, farm, and mining machinery were also strong.

(3) It’s no wonder that the forward earnings of the S&P 500 Industrials sector recently rose to a record high, slightly exceeding its pre-pandemic record high (Fig. 11). The forward earnings of the sector’s Construction Machinery & Heavy Trucks industry has almost fully recovered as well (Fig. 12). At record highs are the forward earnings of the Industrial Machinery, Electrical Components & Equipment, Air Freight & Logistics, and Railroads industries. Lagging behind are Aerospace & Defense and Industrial Conglomerates.

(4) Previously, we observed that high-tech capital spending now accounts for just over 50% of total current-dollar capital spending (Fig. 13). Its share is at a record high. That is probably an underestimate because it includes only spending on IT equipment, software, and R&D. Not included are all the technologies embedded in most machinery.

Also at or near record highs are the industrial production indexes for communications equipment, computer & peripheral equipment, and semiconductors (Fig. 14).

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The Omicron Panic

November 29 (Monday)

YRI Monday Webinar. Join Dr. Ed’s live Q&A webinar on Mondays at 11 a.m. EST. You will receive an email with the link to the webinar one hour before showtime. Replays are available here.

Strategy: The Latest (Viral) Panic Attack. The S&P 500 hit a record closing high of 4704.54 on Thursday, November 18. The next day, investors were unnerved by Austria’s announcement of a full national Covid-19 lockdown starting Monday, November 22. Chancellor Alexander Schallenberg said that the lockdown will last a maximum of 20 days and that a legal requirement to get vaccinated will take effect on February 1, 2022. He was responding to record case numbers and one of the lowest vaccination levels in Western Europe.

Many other European countries are imposing restrictions as cases rise. Neighboring Germany has seen several days of record infections recently (Fig. 1). German Health Minister Jens Spahn warned of “a national emergency that requires a combined national effort.” German leaders already have agreed to introduce restrictions for unvaccinated people in areas with high hospital admissions. And the German parliament has backed requirements for people to show Covid passes on buses and trains and in workplaces.

In the US on Friday, news hit the tape before the open about a new variant of the Covid virus and the S&P 500 plunged 2.3% to 4594.62, putting it 2.4% below its record high (Fig. 2). Here is more on this development:

(1) A new variant of concern. The World Health Organization warned on Friday that a new coronavirus variant discovered in southern Africa, dubbed “Omicron,” is a “variant of concern,” the most serious category the agency uses for such tracking. Such variants are deemed to be dangerous because they may spread quickly, cause severe disease, or decrease the effectiveness of vaccines and treatments. The Delta variant fits these criteria. It took off this past summer and now accounts for virtually all Covid cases in the US.

(2) More than 30 mutations. The concern about Omicron is that researchers in Botswana and South Africa found more than 30 mutations of the spike protein on the surface of the coronavirus. The spike protein is the chief target of antibodies that the immune system produces to fight a Covid-19 infection. With so many mutations, the concern is that Omicron’s spike might be able to evade antibodies produced by either a previous infection or a vaccine.

(3) Banning flights. The November 26 NYT reported: “Countries in Europe as well as the United States and Canada have been among those banning flights arriving from South Africa and several other African nations. But Omicron has already been spotted in Hong Kong and Belgium, and may well be in other countries outside of Africa as well.” Travel lockdowns are a prudent response that could buy governments a little time to make plans for dealing with Omicron if it lives up to the worst predictions. Health leaders could use the delay to put in stronger measures for preventing transmission or boosting vaccinations, for example.

In the US, the latest wave of the (Delta) pandemic has been abating since the late summer, but may be starting to bottom now (Fig. 3). The new variant of Covid-19 could be an unwelcome guest during the holiday season, a traditional time for more social gathering and virus spreading.

(4) Known unknowns. No one knows yet how dangerous the new variant will be. For now, vaccines are expected to provide some protection against it because they stimulate not only antibodies but immune cells that can attack infected cells. Mutations to the spike protein do not blunt that immune-cell response, according to the NYT. And booster shots could potentially broaden the range of antibodies people make, strengthening their ability to fight new variants like Omicron.

(5) Panic Attack #71. Joe and I are adding the latest stock market selloff as Panic Attack #71 on our list of panic attacks since the beginning of the bull market during March 2009. It may be the start of a garden-variety profit-taking correction in reaction to the renewed global health crisis. The arrival of Omicron is a reminder that the pandemic is far from over and that it continues to pose a risk to global travel, trade, supply chains, and economic growth.

Indeed, Friday’s selloff was even more pronounced in the commodity markets. The nearby futures price of a barrel of Brent crude plunged 13.0% to $68.17. It is down 19.5% from a recent high of $84.65 on October 26. On Friday, the nearby futures price of copper fell 4.0%.

As traders quickly concluded that the Fed would be slower to tighten monetary policy if Omicron turned out to be a serious new problem, the 10-year US Treasury bond yield dropped 16bps to 1.48% on Friday and the trade-weighted dollar edged down 0.73% to 96.07.

(6) From Delta to Omicron. Friday’s sell-off was probably a buying opportunity. Let’s remember that the emergence of the Delta variant triggered a selloff, similar in magnitude to what we saw on Friday, of 2.9% in the S&P 500 from July 12 through July 19. The 10-year US Treasury bond yield fell below 1.50% in early June and bottomed at 1.18% in early August. Both stock prices and bond yields headed higher over the rest of the summer through a few days ago, as investors concluded that the available vaccines worked to combat the Delta variant. We should learn in coming weeks whether they’re any match for Omicron.

(7) mRNA to the rescue again. America’s major drug companies announced on Friday that they are prepared to play Whac-A-Mole with the latest Covid variant. Pfizer and BioNTech announced that their joint mRNA vaccine against Covid-19 could be tweaked within 100 days specifically to counter Omicron, while Johnson & Johnson told FOX Business it is already testing its vaccine against the new variant.

Moderna said in a press release that it has already been testing a booster in healthy adults that contains twice the dosage currently authorized. The drug maker has also been “studying two multi-valent booster candidates in the clinic that were designed to anticipate mutations such as those that have emerged in the Omicron variant,” the company said.

US Economy I: Substantial Further Progress. This is the time of year we gather together to give thanks, gifts, and viruses to our family and friends. We thank you for your interest in our research service and wish you lots of health and happiness.

In addition, we all should be thankful that the labor market is continuing to improve, as evidenced by the drop in initial unemployment claims to 199,000 during the week of November 20 (Fig. 4). That’s the first time that claims have been below 200,000 since November 1969.

Before the pandemic, jobless claims were below 300,000 from the week of March 7, 2015 through the week of March 14, 2020. This year, they fell below that level a few weeks after federal supplemental jobless benefits were terminated on Labor Day, September 6. That gave more unemployed workers an incentive to find jobs. Getting a job is relatively easy to do given that the number of job openings has exceeded the number of unemployed workers for the past five months through September, as occurred during the 24 months prior to and including February 2020 (Fig. 5).

This suggests that November’s payroll employment report will be very strong. It will be released on December 3. The next meeting of the FOMC will take place on December 14 and 15. The committee is likely to vote to speed up the pace of tapering the Fed’s purchases of bonds, since by then “substantial further progress” will have been made toward the committee’s “maximum employment and price stability goals.” Indeed, inflation has well surpassed the Fed’s 2.0% target rate so far this year. It first exceeded that target during March, with the PCE deflator rising to 5.0% y/y during October (Fig. 6).

Following the release of October’s higher-than-expected 6.2% y/y jump in the CPI on November 10, the fixed-income markets adjusted to reflect three, rather than two, 25-basis-point hikes in the federal funds rate next year. Melissa and I still expect just two hikes next year, with the FOMC passing on a third hike and raising the inflation target instead from 2.0% to 3.0%. Following Friday’s stock market rout, both the 12-month federal funds rate futures and the 2-year US Treasury note were back in our camp (Fig. 7).

US Economy II: Lots of Liquidity. Notwithstanding the new Covid variant of interest, Joe and I still expect that the S&P 500 will continue to rise to new record highs. Our targets for the index are 4800 by the end of this year, 5200 for next year, and 5500 for 2023. The Fed may decide to taper faster, as discussed below, but it would still be adding liquidity, though at a slower pace, to the economy’s punch bowl—which already has plenty of liquidity from previous rounds of the Fed’s largess. Consider the following:

(1) Bank deposits. Since the last week of February 2020 through the November 17 week this year, total deposits at all commercial banks are up $4.4 trillion (Fig. 8).

(2) Personal saving. Over the past 12 months through September, personal saving totaled $2.4 trillion (Fig. 9). Over the past 19 months through October—i.e., since the pandemic started in March 2020—personal saving totaled $2.9 trillion.

(3) Excess M2 and monetary velocity. A simple eyeball extrapolation of the trend in M2 prior to the pandemic suggests that M2 exceeded that trend by about $2.5 trillion during October (Fig. 10). We know that GDP’s monetary velocity ratio (i.e., nominal GDP divided by M2) is at a record low (Fig. 11). So there’s plenty of cash available to fund more nominal GDP growth.

Less widely followed is the ratio of the market capitalization of the S&P 500 to M2. This measure of the S&P 500’s monetary velocity was 1.8 during October, slightly below its peak before the bear market of the Great Financial Crisis but still well below its peak before the tech bubble’s bear market at the start of the millennium (Fig. 12). There’s plenty of liquidity available to drive stock prices higher.

The Fed: Taper Trot. As inflation has been heating up, more Fed officials have been hot to trot when it comes to speeding up the tapering of the Fed’s bond purchases. Consider the following:

(1) FOMC minutes. In the months leading up to the FOMC’s decision to start tapering, made at its November 2-3 meeting of the Committee, Melissa and I suggested that the Committee should move faster to do so. We figured that with inflation heating up, the Fed might need to raise interest rates sooner than officials were expecting. That’s the conclusion they finally reached as well according to the minutes of their November 2-3 gathering:

“Some participants suggested that reducing the pace of net asset purchases by more than $15 billion each month could be warranted so that the Committee would be in a better position to make adjustments to the target range for the federal funds rate, particularly in light of inflation pressures. Various participants noted that the Committee should be prepared to adjust the pace of asset purchases and raise the target range for the federal funds rate sooner than participants currently anticipated if inflation continued to run higher than levels consistent with the Committee’s objectives.”

(2) Hawkish dove. Last Wednesday, San Francisco Fed President Mary Daly, considered a dove, was the latest Fed official to say that the central bank could speed up the end of its $120 billion monthly bond-buying program.

(3) End may be getting nearer. Fed Governor Christopher Waller and Fed Vice Chairman Richard Clarida both mentioned accelerating the taper process recently. On November 19, Waller said that the Fed should end its purchases by April instead of June.

As noted above, we expect just two 25bps rate hikes next year, with the FOMC passing on a third hike and raising the inflation target instead from 2.0% to 3.0%.

Movie. “The Eyes of Tammy Faye” (+ + +) (link) is a biopic about the rise and fall of Jim and Tammy Faye Bakker, whose praise-the-Lord quirkiness are brilliantly portrayed by Jessica Chastain and Andrew Garfield. They rose from humble faith-based Christian beginnings to create the world’s largest religious broadcasting network and theme park. The televangelist couple was revered for their message of love, acceptance, and prosperity. Their empire came crashing down when it was toppled by financial and personal scandals. Jim Bakker was indicted, convicted, and imprisoned on numerous counts of fraud and conspiracy in 1989. Tammy divorced Jim and remarried in 1992. Chastain deserves an Oscar for her remarkable performance.

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Transportation & Green Ships

November 23 (Tuesday)

Transportation: Peak Shipping? Last week, Target and Macy’s reported strong Q3 results and noted that their holiday merchandise is on hand, ready, and waiting for shoppers. Concurrently, the number of ships bobbing off the coast of Los Angeles decreased last week to 71 from a peak of 86 three days before. And the Freightos Baltic Global Container Index fell 20.7% last week to $9,202, down from its peak of $11,109 on September 10. That’s still far above the $2,375 fetched this time last year, but it indicates movement in the right direction. These pieces of evidence led the WSJ to declare “Supply-chain problems show signs of easing,” in the title of a November 21 article.

Supply-chain problems may not be easing because they’ve been solved, however. They may just be easing because the surge of holiday shipping volume is about to experience its typical seasonal decline. The window to ship goods from Asia to America in time for the holiday shopping season closed in mid-October. Shipping prices reflect the end of the holiday rush, concludes a November 21 Quartz article. Lower shipping prices should be good news for retailers and consumers, as rising shipping prices over the past year have put upward pressure on the prices of the many things we import. Conversely, the development could be bad for the companies doing the shipping.

There are some signs that investors may be getting concerned that the shipping cycle has peaked. The S&P 500 Transportation stock price index has risen 17.3% ytd through Friday’s close. It’s only 3.5% off from its May 7 record high, but it’s trailing the S&P 500’s 25.1% ytd return (Fig. 1). The Transportation index is being bolstered by the S&P 500 Trucking stock price index, which is up 65.7% ytd and only 3.0% off its October 29 high.

The other Transport industries are lagging behind the S&P 500’s ytd performance through Friday’s close: Railroads (18.7%), Air Freight & Logistics (14.4), and Airlines (3.5) (Fig. 2). Compare that to last year, when the S&P 500 Transports and three of its four constituents trounced the S&P 500’s performance: Air Freight & Logistics (47.2%), Trucking (37.5), Railroads (20.1), S&P 500 Transports (18.7), S&P 500 (16.3), Airlines (-31.6).

Here’s a quick look at what may put the brakes on transportation stocks this year:

(1) Imports take a breather. After their sharp, Covid-19-induced drop in the spring of 2020, real merchandise imports surged for the rest of the year as Americans trapped at home filled their hours with online shopping. Imports jumped 30% from their low in May 2020 to their high of $3.04 trillion in March 2021 (Fig. 3). But since their peak and through September, imports have plateaued, albeit at a very high level.

It’s early, but the same pattern may be emerging for West Coast ports’ container traffic. The number of containers reaching the West Coast ports of Long Beach and Los Angeles peaked in June and over the next few months moved sideways, using a 12-month sum. The softening trend appears to have continued in October, when the number of imported containers fell 8% y/y in the Port of Los Angeles and 2.1% in the Port of Long Beach, a November 18 article at gCaptain.com reported.

(2) Rail traffic slowing too. Total railcar loadings have plateaued at a high level, 505,361 as of November 13 using a 26-week average (Fig. 4). However, the number of carloads—which includes coal, chemicals & petroleum products, metal products, and waste & scrap materials—has been rising, while the amount of intermodal loadings, often reflective of import and export activity, has been falling (Fig. 5).

Intermodal railcar loadings, using a 26-weekly average, peaked at 283,120 at the end of January, and it has fallen to 271,271 at its last reading. The year-over-year growth in intermodal shipments has slowed sharply to 0.6% as of November 13, down from a high of 17.6% in mid-June (Fig. 6). Total railcar loadings have been bolstered by an increase in rail transport of coal, pulp and paper products, metals, and waste and scrap (Fig. 7).

Analysts remain optimistic about the S&P 500 Rail industry, forecasting revenue growth of 7.8% and earnings growth of 14.4% in 2022 (Fig. 8 and Fig. 9). Net earnings revisions have been consistently positive this year (Fig. 10). However, the industry’s forward P/E, at 21.6, is close to its record levels reached earlier this year (Fig. 11). (“Forward P/E” is the P/E based on forward earnings per share, or the time-weighted average of consensus estimates for this year and next.)

(3) Trucking stalled too. The amount of cargo hauled by trucks has bounced back from its initial Covid-related drop in 2020; but it subsequently has plateaued, never yet recovering to 2019’s elevated levels (Fig. 12). Despite this, the number of people working in trucking has almost fully recovered to 2019 levels, and the cost of shipping freight by truck soared 16.3% in October (Fig. 13 and Fig. 14).

At J.B. Hunt Transport Services, a trucking company, Q3 intermodal volumes decreased 6% y/y, but higher prices allowed revenue in the segment to increase 17% and operating income to increase 52%. “Demand for intermodal capacity remains strong, however, volumes in the quarter were negatively impacted by a continuation of rail restrictions across the network and elevated detention of trailing equipment at customer facilities. We believe labor shortages across the industry in both rail and truck networks and at customer warehouses are at the core of the supply-chain fluidity challenges limiting our asset utilization and capacity,” the company’s October 15 press release stated.

Analysts remain sanguine about the S&P 500 Trucking industry’s outlook, forecasting a 10.7% jump in revenues and a 17.4% increase in earnings next year (Fig. 15 and Fig. 16). Also at 10.7%, the industry’s forward profit margin is at the highest level of the past 15 years, and its forward P/E of 30.1 is also near the record high (Fig. 17).

(4) Airlines set to fly. Unlike other Transportation industries, the Airline industry’s stocks are not near record highs, and it stands to benefit from pent-up demand. With US Covid-19 cases subdued in most areas, business travel has started to revive, and foreign travelers are expected to return to our shores now that they’re allowed into the US if they’re vaccinated.

The number of travelers passing through TSA checkpoints has risen to 2.21 million on November 21, up from 1.05 million fliers on the same day in 2020 and slightly below the 2.32 million fliers on that day in 2019. United Airlines expects a 50% surge in international inbound passengers, and American Airlines forecasts international capacity for November and December at more than double that of a year ago, according to a November 16 OilPrice.com article.

The airlines will face some headwinds, with the price of fuel surging and workers hard to come by. But the S&P 500 Airline stock price index is still 34% below its July 2019 peak, giving it additional room to fly if Covid-19 cases remain under control and consumers’ and business travelers’ wanderlust returns.

(5) Using a stick. Given the delays at the West Coast ports, the Biden administration has pushed the port operators to operate 24 hours a day, up from 16 hours a day, to clear the system. But there hasn’t been much demand for the extended hours at one terminal in the Port of Long Beach, a November 17 WSJ article reported. The port says truckers don’t want to work overnight. But truckers interviewed for the article said they’ve opted not to pick up additional loads because of the port operator’s onerous equipment-return requirements.

The California ports also announced in October that they would fine ocean carriers $100 a day for any container that overstays its welcome in ports (nine days for those supposed to be moved by truck and three days for those supposed to be moved by rail).

President Biden’s infrastructure act includes $17 billion for infrastructure improvements at coastal and inland ports, waterways, and ports of entry along the US border, a November 9 CNBC article reported. The administration also aims to standardize the data being used by shipping lines, terminal operators, railroads, truckers, warehouses, and cargo owners. The bill includes another $110 billion earmarked to fund the repair of roads and bridges and other transportation projects.

Developing Technologies: A Push To Make Shipping Green. The International Maritime Organization—the UN body that regulates the shipping industry—plans to meet virtually this week to discuss how its constituents can reduce the amount of greenhouse gases ships spew. There’s currently a target for the shipping industry to reduce greenhouse gas emissions 50% by 2050. But there’s a push for the industry to reduce its emissions to zero by 2050, to align it with the 2015 Paris Agreement’s goals, a November 20 Bloomberg article reported.

Fortunately, engineers are hard at work trying to come up with a solution to this giant problem. Here’s a look at some of the new technology floating on the high seas:

(1) Going electric. Norwegian fertilizer producer Yara launched an electric and autonomous container ship last week. The ship can hold 120 TEUs (20-foot equivalent units) of cargo, and the company estimates it will cut 1,000 tonnes of CO2 and replace 40,000 trips by diesel powered trucks a year, a November 19 gCaptain article reported. Yara worked with Kongsberg, a maritime technology company. The ship will hug the coast of Norway as it sails between ports that are 7 to 30 nautical miles apart. Yara is also looking into using green ammonia as an emission-free fuel.

(2) Trying methanol. A.P. Moller-Maersk ordered eight ships that can be propelled by methanol or traditional oil-based fuel for delivery starting in 2024. Each ship costs $175 million and can carry about 16,000 containers. The move is in line with the company’s pledge earlier this year to have all newly built ships use carbon-neutral fuels.

Hyundai Heavy Industries will build the methanol ships, which will replace older ships, saving about one million tons of CO2 a year, an August 24 Bloomberg article reported. Maersk has the option to buy four additional ships, which would cost more both to build and to operate. They’d cost more to build because they would be able to run on either conventional fuel or on methanol, which is twice as expensive.

(3) Adding sails. Cargill would like to hook giant sails to its ships. The sails would be 148 feet high and attached to the decks of cargo ships. Using them could reduce fuel costs and CO2 emissions by as much as 30%, according to an October 31, 2020 gCaptain article. Maersk Tankers has also tried harnessing the wind. It installed wind rotor sales on ships in 2018, which reduced fuel consumption and emissions by 7%-10%.

(4) Going nuclear. The US Department of Energy is spending $8.5 million on research into using small, modular nuclear reactors on commercial ships, a November 19 article in Maritime Executive reported. “Conventional pressurized-water reactors have been in use in military propulsion for decades, and they are in civilian government use in Russia, but they have had few commercial applications in the maritime industry,” the article stated.

One hurdle is the negative perception of nuclear energy after the accidents at Three Mile Island, Chernobyl, and Fukushima. Such perceptions could limit nuclear ships’ port access. New Zealand, for example, bans nuclear vessels in its ports and territorial seas. Angola feels likewise. It once barred a Russian cargo ship from docking in an Angolan port for repairs because the ship was powered by nuclear energy. To get the repairs done, the ship had to sail all the way back to St. Petersburg.

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The Genie Is Out of the Bottle

November 22 (Monday)

YRI Monday Webinar. This week, join Dr. Ed’s pre-recorded webinar here. (Sign in with your Zoom credentials.) Replays are available here.

Inflation I: Persistent & Pesky. This year’s surge in inflation is no longer considered transitory but persistent. During the spring and summer of this year, Fed officials, led by Fed Chair Jerome Powell, promoted the narrative that the higher inflation we’d begun to see was transitory because of the base effect. That’s the phenomenon whereby some prices that had been depressed by last year’s lockdowns and social-distancing restrictions rebounded sharply earlier this year as the economy reopened. Now they are settling down and no longer spiking overall inflation rates. But those rates are still elevated because prices have been heating up recently in other parts of the economy. In addition, wages are rising at a faster pace.

In my book Fed Watching (2020), I titled the chapter on the current Fed chair “Jerome Powell: The Pragmatic Pivoter.” He proved true to form at his November 3 post-FOMC-meeting press conference, pivoting again by acknowledging that inflation was turning out to be more persistent than he had expected.

Powell used the word “transitory” six times during the presser in reference to this year’s surge in the inflation rate, but he undermined its import by saying that the word might not actually help to convey the Fed’s message: “[I]t’s become a word that’s attracted a lot of attention that maybe is distracting from our message, which we want to be as clear as possible.” He used forms of a word that’s the antithesis of “transitory”—i.e., “persistent”—nearly twice as much, 11 times, when discussing the risk that inflation might not be so transitory after all.

Powell attributed this risk to supply-chain disruptions: “We see shortages and bottlenecks persisting into next year, well into next year. We see higher inflation persisting, and we have to be in [a] position to address that risk … should it create a threat of more persistent, longer-term inflation, and that’s what we think our policy is doing now. It’s putting us in a position to be able to address the range of plausible outcomes.” In effect, the Fed chair is telling us that higher inflation will remain persistent as long as supply-chain disruptions persist.

Looking at the causes of supply-chain disruptions provides no assurance that they’ll dissipate anytime soon. With US imports at a record high, a case can be made that the supply side of our economy has been overwhelmed by the demand shock fueled by excessively easy fiscal and monetary policies, particularly in the US (Fig. 1). This puts a large part of the blame for the acceleration of inflation on Washington’s policymakers—back where it belongs. Here’s an update of our thinking on inflation and some of the most recent inflation indicators:

(1) Our inflation outlook. We expect the headline PCED inflation rate to increase 4.5% this year and 3.5% next year. It was 4.4% y/y during September. We expect it will range between 4.0% and 5.0% through mid-2022. Then it should moderate to 3.0%-4.0% during the second half of next year (Fig. 2). As we’ve previously stated, we won’t be surprised if the FOMC decides to raise the Fed’s inflation target from 2.0% to 3.0% next year.

(2) The FOMC’s forecast. The FOMC’s latest Summary of Economic Projections (SAP), dated September 22, shows that the consensus inflation forecast of the committee’s participants for 2021 was 4.2% for the headline PCED. That’s up from 3.4% in June and 2.4% in March. Their significant miss for this year didn’t change their happy inflation outlook for 2022 (2.2%), 2023 (2.2), and 2024 (2.1).

Melissa and I can hardly wait for the December 15 release of the SAP. The latest headline PCED inflation reading for September was 4.4%. October’s headline CPI was up 6.2%. We expect that the next SAP will show a more persistent inflation problem going into next year.

(3) Oh, Deere, COLAs are back! On November 17, the United Auto Workers, said 10,000 members ratified a new six-year contract with Deere & Co., the giant manufacturer of farm and construction equipment, by a vote of 61% to 39%. They had rejected two previous offers.

The contract includes an $8,500 restart bonus, an immediate 10% raise, two 5% raises, and two large bonuses through 2026. Total retirement benefits for an average worker will rise by $270,000. Most important as an economic signal, wages will be adjusted each quarter based on inflation.

A November 18 WSJ editorial rightly warned that such cost-of-living adjustments (COLAs) “were a feature of the 1970s economy but faded as inflation was brought under control. The longer inflation stays high today, the more workers will demand COLAs, putting employers on the hook for long-term costs they can’t control. Once COLAs are embedded into labor contracts, they become hard to wring out. This is how you get a wage-price spiral and durable inflation.”

(4) Regional price indexes remain inflated. The latest pesky news on the inflation front are the prices-paid and prices-received indexes in three of the five regional business surveys available so far for November, conducted by the Federal Reserve Banks (Fig. 3 and Fig 4). The indexes for the New York, Philadelphia, and Kansas City districts all remained near their recent record highs this month. Confirming that supply disruptions are an important source of inflationary pressures, the regional series on unfilled orders and delivery times remained elevated this month (Fig. 5).

(5) Inflationary expectations rising. In a November 8 speech titled “Flexible Average Inflation Targeting and Prospects for U.S. Monetary Policy,” Fed Vice Chair Richard Clarida stated: “Given this economic outlook and so long as inflation expectations remain well anchored at the 2 percent longer-run goal—which, based on the Fed staff's common inflation expectations (CIE) index, I judge at present to be the case—a policy normalization path similar to the median SEP dot plot on page 4 of our September 2021 projections would, under these conditions, be entirely consistent, to me, with our new flexible average inflation targeting framework and the policy rate reaction function.” Translated from the Fed speak, that long sentence means he anticipates one or two rate hikes of 25bps each during the second half of next year.

But we have a problem with Clarida’s reasoning: A CIE showing inflation “well anchored” at 2.0% makes no sense. The CIE is an experimental indicator reflecting seven different surveys and inflationary expectations in the TIPS market. It does not include the monthly survey of inflation expectations conducted by the Federal Reserve Bank of New York, which shows the one-year-ahead expectation at 5.7% during October and the three-years-ahead expectation at 4.2% during the month (Fig. 6). Those expectations make more sense than the CIE and certainly aren’t well anchored anywhere near 2.0%!

Moreover, the 10-year expected inflation proxy implied by the spread between the nominal yield and the TIPS yield was 2.65% on Friday (Fig. 7). We aren’t convinced that it is a useful indicator of market-based inflationary expectations, especially since the Fed is rigging the market by purchasing lots of TIPS for no good reason. The Fed currently owns over 20% of the inflation indexed notes and bonds issued by the US Treasury (Fig. 8 and Fig. 9).

(6) More Bidenflation coming. And by the way, there’s more fiscal stimulus coming from Biden’s Build Back Better spending program on infrastructure. In addition, there could be even more spending on social programs if the social spending bill that passed the House on Friday makes it through the Senate.

Inflation II: Have FAITH? Melissa and I agree with Willem Buiter’s November 14 FT article in which he critiques the Fed’s adoption of “average inflation targeting” (AIT). In August 2020, the Fed committed to overshooting its 2.0% inflation target for the PCED to make up for having undershot it ever since the target was set in January 2012 (Fig. 10 and Fig. 11). The Fed has been doing a great job of overshooting it so far this year!

Buiter concludes: “Why should unintended and mostly unavoidable inflation targeting failures in the past justify future deliberate failures? And the cost of adopting AIT could be serious: future periods of unnecessary, deliberate above-target inflation. It is time to get rid of this potentially costly nonsense.”

In our book The Fed and the Great Virus Crisis (2021), we expanded “AIT” to “FAITH,” or “flexible average inflation targeting hope.” We concluded that the 2020 FAITH statement clearly gives more weight to maximizing employment than to keeping a 2.0% lid on inflation: “Under Fed Chair Powell, the Fed is likely to try to heat up the economy to overcome the GVC-induced hysteresis.”

As noted above, we are forecasting that the Fed will “correct” for overshooting its inflation target this year by raising it from 2.0% to 3.0% next year!

(Willem Buiter is currently a visiting professor at Columbia. He was an external member of the Bank of England’s Monetary Policy Committee from June 1997 to May 2000. In 2010, he joined Citigroup as chief economist. Our paths crossed at Yale University’s graduate school. He completed his PhD in economics in 1975; I earned mine in 1976.)

Movie. “Dopesick” (+ + +) (link) is a sickening docudrama series on Hulu about how Purdue Pharma reformulated OxyContin and, starting in the late 1990s, marketed the opioid as a miracle drug to relieve pain without the risk of addiction. That turned out to be grossly false advertising, as millions of Americans became addicted to it and many died from overdoses. The company attributed the problem to illegal “drug diversion,” which was also grossly false and criminally negligent. However, while prosecutors eventually shut down this homegrown drug lord and imposed a huge fine on the company, no one from Purdue went to jail. The series strongly suggests that a key Federal Drug Administration official turned a blind eye and was rewarded with a cushy job at Purdue. “Regulatory capture” can be a deadly consequence of crony capitalism. The cast of the series, including Michael Keaton and Kaitlyn Dever, is outstanding.

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China, Materials & Green Isn’t Clean

November 18 (Thursday)

China: Chairman-for-Life Xi. At last week’s annual meeting, the Chinese Communist Party’s (CCP) Central Committee rewrote history and described Chinese President Xi Jinping as a core leader who “promoted historic achievements and historic changes.” Doing so put Xi on par with Mao Zedong and Deng Xiaoping. It also set Xi up to be named president for a third term next year, breaking with the recent precedent of Chinese presidents holding office for only two terms. Some believe the CCP has set Xi on the path to becoming Chairman for Life.

Despite Xi’s elevation, not all is well in China. The country is dealing with a meltdown of its real estate market, resurgent Covid-19 hotspots and quarantines, and slowing economic growth. Will these hardships grow large enough to prompt the normally docile citizens of China to protest or even to dethrone Xi? That’s unlikely, but we’ll be watching for any such signs.

Here’s Jackie’s look at some of Xi’s headaches and the recent data showing that China’s economic growth has cooled:

(1) China’s real estate wreckage. The financial woes of China Evergrande Group and other developers have weighed on China’s real estate activity, which represents about a quarter of the country’s GDP. China’s new home sales fell 22.6% y/y in October, following a 15.8% drop in September. New home prices fell 0.3% m/m in October, marking the second consecutive monthly decline. And new construction starts by property developers dropped 7.7% y/y over the January-to-October period. Tales of vacant buildings and apartments are common.

The sector’s woes are traced back to a government policy adopted last year to rein in excessive borrowing and speculation by limiting the amount of debt real estate developers can accumulate. The sector’s recent problems have led policymakers to rethink their approach. They’ve reportedly discussed loosening lending rules to help struggling developers sell assets and avoid default, a November 10 WSJ article reported. Regulators also plan to allow high-quality developers to sell asset-backed securities (ABS) to repay outstanding debt, reopening the ABS market—which hasn’t seen any issuance from developers since August, a November 17 Bloomberg article noted.

Meanwhile, headlines about the country’s real estate giants describe companies scrambling to raise liquidity and struggling to make debt payments. Evergrande missed two bond interest payments, and its grace periods end on December 6 and December 28. It also needs to figure out how to either refund payments or deliver finished apartments to the more than one million buyers of Evergrande apartments.

Evergrande and its leaders have scrambled to raise cash. The developer sold its equity stakes in Shengjing Bank and in an online media company. Evergrande’s billionaire founder and Chairman Hui Ka Yan is believed to have borrowed against two of his luxury residences in Hong Kong, each valued at around HK$800 million, to make the property company’s interest payments, a November 15 Reuters article reported. The company has also sold two of its Gulfstream jets.

Other Chinese developers are struggling as well. At least six real estate developers have either defaulted on their debt or asked investors to wait longer for repayment, a November 10 WSJ article reported. They too are searching for liquidity at a time when the average yield for junk-rated Chinese corporate issuers’ dollar debt hit a record high of 28.5% on Tuesday, a November 15 Reuters article reported.

Kaisa Group Holdings, the country’s second largest developer, ended its interim dividend and is trying to sell property worth an estimated $12.8 billion. The company entered a 30-day grace period after failing to pay some of its bond creditors last week. Yango Group offered to exchange old notes for new notes. Sunac China raised about $653 million by selling shares at a discount and raised another $300 million by selling shares in its property management arm. Sunac also borrowed $450 million from its founder. And China Aoyuan sold its investments in Hong Kong apartments and parking spaces at a loss.

(2) Playing Whac-A-Mole with Covid. China’s zero-tolerance policy regarding Covid-19 continues as it works to snuff out a mini-outbreak that started in mid-October. Recent weeks have seen roughly 100 new cases reported a day, but that fell to 31 on Tuesday and 22 on Monday, Reuters reported.

The pressure is on to keep Covid-19 cases low ahead of the 2022 Winter Olympics, which is poised to kick off in February in Beijing. Anyone entering the city from other parts of the country will be required to show a negative test result from the prior 48 hours, and the number of flights into Beijing from areas in China with moderate to high Covid risk will be reduced.

Cases in Dalian, a northeastern Chinese city, have led to the quarantining of 1,500 students attending a local university, a November 15 AP article reported. There was a huge outcry this week after a home video captured health workers in Shangrao, a central Chinese city, killing a quarantined person’s pet dog. The China Small Animal Protection Association subsequently called for the quarantine system to care for pets whose owners are quarantined.

China’s Covid case counts pale in comparison to the large numbers of cases in the US and Europe. But they’re worth watching because Xi has taken credit for keeping Covid cases low. Any reversal would reflect badly on him.

(3) Economy growing, but slower. Covid-19 lockdowns, supply-chain knots, energy disruptions in October, and a crumbling real estate sector have reduced Chinese economic growth to low-single-digit rates, down from rates in the mid-single digits. Industrial production in October rose 3.5% y/y, faster than September’s 3.1% increase. But in 2019, the country’s industrial production rose 6.9% on a December-over-December basis (Fig. 1).

China’s manufacturing purchasing managers index indicated contraction (levels under 50.0) across the board in October: composite (49.2), new orders (48.8), employment (48.8), and output (48.4) (Fig. 2). Other signs of slowing economic activity are found in the country’s electricity output, which has fallen from 20.4% in March to 4.5% y/y in October, using a three-month moving average (Fig. 3). Likewise, railways freight traffic has been subdued, falling 0.1% in September and rising 0.7% y/y in October (Fig. 4). And the output of cement, corrugated steel bar, and steel—all items used in construction—have fallen sharply, though corrugated steel bar moved higher in October (Fig. 5, Fig. 6, and Fig. 7).

The country’s growth has been supported by strong exports, which rose 24.3% in October y/y, well above 2019 levels in the wake of the Trump tariffs, when exports only grew 0.9% on average per month (Fig. 8). Retail sales grew 4.9% in October y/y and only 3.4% when adjusted for inflation (Fig. 9). Real retail sales’ 24-month growth, at an annual rate, has fallen sharply from north of 10% in the years prior to 2013 and from its peak of 19.4% in February 2010 to almost zero in October (Fig. 10). China’s October jobless rate was unchanged at 4.9%.

The country’s stock market has trailed far behind US stock markets. The China MSCI stock price index is down 13.1% ytd through Tuesday’s close, while the S&P 500 has risen 25.2% (Fig. 11). Analysts are forecasting that companies in the China MSCI index will grow revenue 9.7% and earnings 16.2% in 2022 (Fig. 12 and Fig. 13). The index’s forward P/E (i.e., based on forward earnings, or the time-weighted average of consensus estimates for this year and next) has fallen to 12.9 from 18.3 earlier this year.

Materials: China’s Slowdown Bodes Poorly for Sector. If we asked you which S&P 500 sectors were the top performers since the start of 2001, Consumer Discretionary—home to Amazon—would be a reasonable and correct guess. As would Information Technology, given that it’s home to Systems Software, Semiconductor Equipment, and Semiconductors. Less expected is the S&P 500 Materials stock price index’s appearance near the top of the leader board (Fig. 14).

Here's the performance derby from the start of 2001 through Tuesday’s close for the S&P 500 sectors: Consumer Discretionary (588.5%), Information Technology (522.0), Materials (326.2), S&P 500 (256.1), Health Care (250.9), Consumer Staples (217.7), Industrials (216.5), Energy (82.1), Financials (67.6), Utilities (57.4), and Communication Services (42.1). Real Estate wasn’t an official index until October 2001, but it is up 201.1% since its creation then.

The Materials industries that beat the S&P 500’s performance since the start of 2001 are Specialty Chemicals (1,360.1%), Metal & Glass Containers (1,250.4), Industrial Gases (1,096.4), Steel (483.9), Construction Materials (325.9), and Paper Packaging (279.2).

That said, after surging this year, the S&P 500 Materials sector’s revenue and earnings growth are expected to slow sharply next year. The sector’s revenue is forecast to jump 25.3% this year and only 2.8% in 2022, while its earnings are forecast to soar 84.9% this year and increase 2.1% in 2022 (Fig. 15 and Fig. 16).

The S&P 500 Steel industry is among those that will face tough comparisons next year to 2021 results. The stock price index is near all-time highs, having risen 110% this year (Fig. 17). But after expecting the industry’s earnings to rise nearly 600% this year, analysts are calling for earnings to drop 27.9% in 2022 (Fig. 18). The industry’s forward P/E has also collapsed to 6.4, down from 16.1 at the start of 2021, often a sign that investors believe an industry is experiencing peak earnings (Fig. 19).

The price of steel may be under pressure next year because of the drop in Chinese apartment construction and because the US is moving to ease tariffs on steel produced and imported from the European Union and Japan.

Companies producing materials used in the green economy should dodge the sector’s slowdown, however. As we discuss below, the demand for materials used in electric vehicles, windmills, and solar panels—such as copper and lithium—is expected to continue to grow in upcoming years. The S&P 500 Copper industry’s stock price index, for example, reflects this: It’s near recent highs, and its earnings are expected to grow 10.9% next year.

The S&P 500 Construction Materials industry’s stock price index is also near an all-time high, and its earnings are forecast to grow 21.7% in 2022. Its constituents sell their products primarily in the US, which should benefit from President Biden’s infrastructure bill, and they don’t have exposure to the Chinese market.

Disruptive Technologies: Green Doesn’t Mean Clean. We are big fans of technology, particularly technology that can help address climate change. That said, we were reminded by a thought-provoking article in Der Spiegel that sourcing the metals needed to produce or store green energy—using windmills, solar panels, electric cars, lithium-ion batteries, high voltage power lines, and fuel cells—can cause quite a bit of damage to the Earth and produce a hearty amount of carbon dioxide (CO2).

These metals are most likely being dug out of the ground and processed by CO2-spewing machines, then shipped across an ocean in a CO2-spewing ship, before they’re installed in a green windmill or vehicle. The mining process also requires huge amounts of land, electricity, and water, often in developing regions of the world where water is dear and governments unstable.

Wind turbines, for example, use neodymium, a rare earth metal. The production of one ton of neodymium produces 77 tons of CO2, while the production of a ton of steel emits only 1.9 tons of CO2, the article states.

The amount of metal needed to run our new green world is growing larger every year. The International Energy Agency (IEA) estimates that global demand for critical raw materials will quadruple by 2040, and lithium demand alone could be 42 times greater. Meanwhile, finding new deposits and extracting metals from older mines is getting tougher and more costly, as the easiest targets have already been mined.

The article reports that a medium-sized offshore wind turbine contains 67 tons of copper. There are 11 tons of silver in a solar panel park that’s 1,000 square meters. “An electric car requires six times as many critical raw materials as a combustion engine—mainly copper, graphite, cobalt and nickel for the battery system. An onshore wind turbine contains around nine times as many of these substances as a gas fired power plant of comparable capacity,” it states.

Hopefully, the mining industry will get greener along with the rest of the world, perhaps by employing hydrogen fuel to power its huge excavators and ships. Recycling electronics and batteries could also help reduce the amount of mining of new metals. And despite the dirty business of mining metals, the IEA believes the Earth still benefits when electric vehicles are driven. An internal combustion vehicle produces twice as much CO2 over its life cycle of 200,000 kilometers than is produced by an electric car that requires lithium in its batteries.

But clearly, more needs to be done before we can feel good about going green.

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Updates on Profit Margins & Europe

November 17 (Wednesday)

Earnings: Season’s Greetings. Yes, we know stocks aren’t cheap. So why do they continue to rise to new record highs and to outpace our bullish forecasts? The S&P 500 is only 100 points away from our year-end target of 4800. The simple answer is that earnings continue to exceed analysts’ consensus expectations. That is happening again during the current earnings season for Q3. As Joe observes below: “With 93% of S&P 500 companies finished reporting revenues and earnings for Q3-2021, revenues have beaten the consensus forecast by a well-above-trend 2.9%, and earnings have exceeded estimates by 11.0%.” Here’s more good news on the earnings front:

(1) Quarterly earnings. During the November 11 week, with almost all of the S&P 500 companies having reported their Q3 results, the quarter’s earnings are turning out to be 9.1% better than analysts expected at the start of the earnings season (Fig. 1). The y/y gain is now 38.5% compared to the 26.9% expected at the start of the season.

Many company managements warned that shortages of labor and parts might continue to disrupt their businesses. Yet such negative forward guidance hasn’t weighed on analysts’ consensus earnings estimates for Q4 of this year or for the four quarters of next year (Fig. 2). That’s impressive.

(2) Annual earnings. Just as impressive is that consensus S&P 500 revenues estimates continued to rise to new highs for 2021, 2022, and 2023 through the November 4 week (Fig. 3). The same can be said about consensus earnings-per-share expectations, which rose to $206 for this year, $221 for next year, and $241 for 2023 during the November 11 week (Fig. 4).

(3) Profit margins. Consensus expectations for profit margins (which we derive from analysts’ earnings and revenue estimates) are finally starting to level out, albeit at record highs of 13.1% for this year, 13.2% for next year, and 13.8% for 2023 (Fig. 5). Again, these fearless consensus forecasts are defying all the anecdotal signs of higher costs. So the analysts are either delusional or else they are hearing that managements intend to raise their prices and/or boost their productivity to offset rising costs.

Europe I: Running on Russia’s Fumes. The recent energy crisis in Europe has further disrupted already strained global supply chains. Rising energy costs have threatened to interrupt the operation of many European factories. In an October 24 Bloomberg Opinion article on climate-change policymaking, Stanford University professor Niall Ferguson observed that a series of Europe’s decisions have left the region dangerously dependent on gas imported from Russia.

An October 25 Time article observed: “When the price of natural gas skyrocketed in Europe in early October, [Russia’s President] Putin suggested that the energy crisis was linked to Europe’s shift to renewable energy sources, and that a slower transition that focused on natural gas—Russian, of course—was the better option.”

In the October 18 Morning Briefing, we wrote that the energy crises in Europe “might remain troublesome through the coming winter months.” At the end of October, European gas prices dropped amid a report by Reuters that Putin told the head of Kremlin-controlled energy giant Gazprom PJSC to start pumping natural gas into European gas storage once Russia finishes filling its stocks, which may happen by November 8.

But Moscow chose not to send additional natural gas supplies to Europe during November despite saying it is ready to help. Last week, Amos Hochstein, the US State Department’s senior advisor for global energy security, said that Russia did not cause Europe’s energy crisis, but “took advantage” of it. Putin has rejected claims that his country is weaponizing energy against Europe.

“Russia started pumping less gas to Europe in August, and some analysts suggested that the country was limiting its discretionary supply to support the case for the controversial Nord Stream 2 pipeline, which will bypass Ukraine and Poland to carry gas from Russia to Germany,” CNBC reported. The pipeline is awaiting approval from German regulators but has faced opposition, including concern that it is not aligned with Europe’s climate goals.

Late breaking news from Reuters: “Germany’s energy regulator has suspended the approval process for a major new pipeline bringing Russian gas into Europe, throwing up a new roadblock to the contentious project and driving up regional gas prices. The watchdog said on Tuesday it had temporarily halted the certification process because the Swiss-based consortium behind Nord Stream 2 first needed to form a German subsidiary company under German law to secure an operating licence. European prices jumped almost 11% on news of the hold-up, with the Dutch front-month contract hitting 90.40 euros/MWh in afternoon trade.”

Europe II: Virus Breaking Through. Covid-19 may never go away, but it seems to be transitioning from pandemic to endemic status in many regions around the world. Progress in vaccinations against Covid-19 has been significant, and Covid-related infections, hospitalizations, and deaths have waned.

But cases of the virus among vaccinated people—so-called breakthrough cases such as those mounting now in Europe—could become a bigger problem. The World Health Organization said early this month that Covid cases in Europe have risen steadily in recent weeks. But we need to keep in mind that vaccines are not 100% effective. As millions more people get the vaccine, an increase in the number of breakthrough infections naturally follows.

More important to watch than infections are hospitalizations and deaths. New cases in France, Italy, Germany, and Spain had been on the decline following the Delta outbreak, but now appear to be ticking up again. (See our COVID-19: Cases, Hospitalizations & Deaths.) Infection rates have been harder to squash in the UK given the Delta variant’s ease of transmissibility but seem to be tempering again. Nevertheless, the number of hospitalized patients in Europe has remained low despite the recent rise in Delta cases relative to earlier in the pandemic (Fig. 6).

Europe III: Economic Recovery Waning. Europe’s economic recovery had been accelerating until recently. It may be starting to slow, according to the latest indictors. But the Delta variant of Covid-19 is not what halted the acceleration, notwithstanding the recent rise in breakthrough cases. Supply-chain challenges, including the energy crisis, are the culprit. They pose a greater threat to growth than the virus does as suppliers struggle to keep up with a post-lockdown pickup in orders.

Here’s more to think about:

(1) Flash purchasing managers surveys. The eurozone flash composite and services PMIs hit six-month lows during October, falling to 54.2 and 54.6, respectively, from 60.2 and 59.8 during July as supply-side problems dampened order growth (Fig. 7).

The M-PMI showed factories’ activity expanded at a slower, though still robust, rate in October, with the slowdown linked to supply-chain delays—a major concern hampering production and pushing costs higher. Higher costs have led to near-record increases in average selling prices for goods and services.

(2) Germany Ifo. German business confidence deteriorated in October for the fourth successive month, depressed by concerns about Covid-19 case counts and raw materials supplies (Fig. 8). Both the current situation component and the expectations component turned lower recently, driven by supply-side concerns (Fig. 9).

(3) Industrial production. The Eurozone’s industrial production index was 103.2 during February 2020, just before the pandemic triggered lockdowns (Fig. 10). It plunged to 74.1 during April of last year. As the lockdown restrictions were gradually lifted, it rebounded to 103.0 at the start of this year. It has been hovering around that level since May as a result of supply-chain disruptions.

(4) Retail sales. The volume of retail sales excluding motor vehicles in the Eurozone took a dive last year during the lockdowns (Fig. 11). It then rebounded dramatically. Another round of selective social-distancing restrictions caused sales to swoon late last year and early this year. But by June, sales reached a new record high and remained near there through September.

(5) Economic Sentiment Indicator. On the (mostly) brighter side, the Eurozone’s Economic Sentiment Indicator (ESI) bounced back in October after a brief dip during August (Fig. 12). The overall ESI includes the following subindexes: industrial (40% weight), service (30), consumer (20), construction (5), and retail trade (5). Each of them is up significantly from last year’s lows, with a touch of relative weakness remaining in the consumer indicator (Fig. 13). It is not surprising that the services and retail components led the latest dip given the virus-related concerns, though both did edge higher in October. Among the components of industrial confidence, stocks of finished products and production expectations have deteriorated recently, while order volume has been strong (Fig. 14).

Europe IV: Lots of Easy Money. Now let’s review the latest economic policy developments in Europe:

(1) Monetary policy remains easy. The ECB has pledged to continue its emergency bond-buying program through at least March 2022 and to maintain the monthly pace of purchases under its asset purchase program. ECB’s President Christine Lagarde emphasized during her October 28 press conference the need to be “patient” and “persistent” with interest rates.

Measures of inflation recently have exceeded the ECB’s 2.0% target. However, the ECB does not see the recent rise in inflation as a long-lasting problem. “We foresee inflation rising further in the near term, but then declining in the course of next year,” Lagarde said. She added that over the “medium term” (roughly three years) the bank sees inflation remaining below its 2.0% target rate, so the “conditions” for interest-rate lift-off are “not satisfied.”

Lagarde explained that the global supply shortages and energy prices are behind the ECB’s conviction that recent higher rates of inflation are transitory. “We’re seeing shortages” because “we have this supply-demand disconnection,” Lagarde stated. ECB contacts reported that it will take a “good chunk” of 2022 for the shortages to be sorted out. Lagarde also observed that “both the number of people in the labour force and the hours worked in the economy remain below their pre-pandemic levels.”

Consumer spending in the Eurozone has been robust during the recovery, especially on entertainment, dining, travel, and transportation. But Lagarde is concerned that “higher energy prices may reduce purchasing power in the months to come.” Contributing to high energy prices in Europe is low inventory, with “maintenance in Norway, with demand in China, with the supply by Russia,” Lagarde added.

(2) Fiscal funds on the way. On October 12, the European Commission (EC) issued the first NextGenerationEU (NGEU) green bond, raising €12 billion to be used exclusively for green and sustainable investments across the EU. It represents the world’s largest green bond issuance ever, according to the EC’s website. The issuance represents a start to the NGEU green bond program of up to €250 billion by end-2026. It followed the adoption of the NGEU Green Bond framework earlier in September.

The funds from the NGEU green bond issuances will be used to finance green and sustainable expenditures. Eligible investments from the already approved plans include the creation of a research platform for energy transition in Belgium and the construction of wind power plants on land in Lithuania.

NGEU is a temporary recovery instrument of more than €800 billion in current prices to support Europe’s recovery from the pandemic and help build a “greener, more digital and more resilient” Europe. To finance NGEU, the EC (on behalf of the European Union) will tap the capital markets to raise around €800 billion by year-end 2026, or about €150 billion per year, via a diversified funding strategy that includes the green bonds.

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Is the Meltup a Bubble?

November 16 (Tuesday)

Bulletin Board. You can find replays of this week’s webinar and previous ones here. A complimentary copy of In Praise of Profits! Is available here.

Strategy I: The Not-Everything Bubble. Yes, we know: There are lots of signs of speculative bubbles in the broad stock market led by a few big-cap technology, electric-vehicle, and meme stocks. There are also bubbles in the housing, junk bond, and cryptocurrency markets. It’s been widely described as the “everything bubble.” On the other hand, there aren’t bubbles in biotech stocks or in small- and mid-cap stocks. There’s no bubble in precious metals.

Sentiment in the stock market is not especially euphoric right now. Investors Intelligence’s Bull-Bear ratio was well below 3.00 during the November 9 week, at 2.53 (Fig. 1). Consumers aren’t euphoric either. Debbie and I derive the Consumer Optimism Index by averaging the Consumer Sentiment Index and the Consumer Confidence Index (Fig. 2). During October it was 92.8, which was well below the previous cyclical peak readings that preceded recessions and bear markets.

Bitcoin certainly seems to be in a bubble now that it is back in record territory around $65,000. There is no way to place a value on it. So it could go to a million dollars on its way back to zero (Fig. 3). The 12-month average of the mean existing single-family home price has soared 19.1% over the past two years through September (Fig. 4). This series divided by mean personal income excluding government benefits, on a per-household basis, is the highest since January 2008, at 2.78 (Fig. 5). The record high in this P/E ratio for homes is 3.13, reached during December 2005.

Both the S&P 500 and the Nasdaq have been melting up since they bottomed last year on March 23, with gains of 109.3% and 131.1% since then through yesterday’s close (Fig. 6).

Strategy II: Slicing & Dicing Valuation. Yes, we know: The S&P 500’s forward P/E (i.e., based on forward earnings per share, which is the time-weighted average of consensus estimates for this year and next) is historically high. But this year’s bull market has been led by the meltup in the S&P 500’s forward earnings—suggesting fundamental support underpinning the elevated valuation altitude.

Even stronger have been the forward earnings of the S&P 400/600 (a.k.a. SMidCaps); but until last week, their valuation multiples were falling—suggesting possible opportunity. Joe and I first recommended overweighting the relatively undervalued SMidCaps in the August 9 Morning Briefing.

Let’s have a closer look at the valuation multiples of the S&P 500/400/600 indexes, especially those of the S&P 500, or LargeCaps—which suggest that this index may not be as overvalued as it seems:

(1) The forward P/Es of S&P 500/400/600 rebounded last week from their recent lows to 21.4, 16.9, and 15.8 on Friday (Fig. 7). Our Blue Angels framework compares the stock price indexes to their implied values based on their forward earnings multiplied by forward P/Es of 10.0-22.0 in increments of 2.0 (Fig. 8). It shows that the S&P 500 stock price index has been melting up along with its forward earnings all year while the index’s forward P/E has been ranging between roughly 20.0 and 22.0.

Over the same period, the stock price indexes of the S&P 400/600 have been moving mostly sideways until they broke out to new record highs last week (Fig. 9).

As we’ve previously observed, the forward earnings of the SMidCaps have risen faster than that of the LargeCaps, with their profit margins, rather than their revenues, leading the relative earnings outperformance (Fig. 10, Fig. 11, and Fig. 12). We think all three indexes’ forward earnings will grow at slower and similar paces in coming months, still leaving room for the SMidCaps to outperform on a valuation basis.

(2) S&P 500 Growth valuation remains high, especially relative to the valuation of S&P 500 Value (Fig. 13 and Fig. 14). Here are the forward P/Es for the S&P 500 and its Growth and Value subcomponents on Friday’s close: 21.4, 29.3, and 16.3. Growth’s valuation multiple has been hovering around 28.0 since mid-2020. Value’s forward P/E has been behaving more like those of the SMidCaps.

(3) The Magnificent 8 are the eight stocks in the S&P 500 with the highest market capitalizations. They are Alphabet (Google), Amazon, Apple, Meta (Facebook), Microsoft, Netflix, NVIDIA, and Tesla. They are all in the S&P 500 Growth index. Collectively, their market cap has soared from $1.2 trillion at the start of 2013 to a record $12.0 trillion during the November 5 week (Fig. 15). Over this same period, their market-cap share of the S&P 500 has risen from 8.9% to a record 30.0% (Fig. 16).

Their forward P/E was about 15 in early 2013 (Fig. 17). Since mid-2020, it has been volatile around 40. The forward P/Es of the S&P 500 with and without the Mag-8 currently are around 21 and 18 (Fig. 18). LargeCaps are not overvalued excluding the Mag-8, which may be fairly valued too given their superior ability to grow their earnings.

(4) The Buffett Ratio is off the charts! This ratio is the market capitalization of US equities excluding foreign issues divided by nominal GDP (Fig. 19). Its level usually nearly matches that of another ratio: the market cap of the S&P 500 to S&P 500 revenues. Both ratios are quarterly.

We prefer a similar ratio that tracks these two very closely but is available weekly: the ratio of the S&P 500 stock price index to its weekly forward revenues, i.e., the forward price-to-sales ratio (P/S). This weekly series rose to a record 2.9 during the November 12 week, well exceeding its levels during the two previous bull market peaks.

Why is the forward P/S much more alarmingly elevated than the forward P/E of the S&P 500? For the answer, we need look no further than the forward profit margin of the S&P 500. Its rise to record highs this year reflects a faster rise in forward earnings than forward revenues (Fig. 20 and Fig. 21). That should be comforting, not alarming.

Strategy III: The Fed’s Latest Analysis of Financial Stability. The Fed issued its latest Financial Stability Report last week. There was no mention of the everything bubble. Indeed, the word “bubble” was mentioned only once, referring to “the dot-com bubble” that burst in 2001. Keep walking, nothing to see here.

The November 2019 report issued prior to the pandemic raised a warning flag about risk in the corporate bond market. The problem since has been mostly resolved by record-low corporate bond yields: “Moreover, risky firms will need to roll over only about 3 percent of outstanding speculative-grade bonds within one year, as firms have continued to refinance existing debt with longer-maturity bonds at low interest rates.” What about leverage loans? Their default rates have fallen even though underwriting standards have weakened.

What about the stock market? The report’s finding is “that equity investor risk appetite remained within historical norms.” The report includes an interesting discussion about retail investors, social media, and equity trading. The conclusion is a benign one: “To date, the broad financial stability implications of changes in retail equity investor characteristics and behaviors have been limited, as recent episodes of meme stock volatility did not leave a lasting imprint on broader markets.” In other words, keep walking, nothing to see here.

Fiscal Policy: The President’s Spin. President Joe Biden explained “Bidenflation” in a speech in Baltimore on November 10, 2021. Basically, it’s what happens when government actions boost demand such that demand exceeds supply, so prices go up:

“And the irony is: People have more money now because of the first major piece of legislation I passed. You all got checks for $1,400. You got checks for a whole range of things. If you’re a mom and you have kids under the age of 7, you’re getting 300 bucks a month, and if it’s over—over 7 to 17, you’re getting $360 a month—like wealthy people used to when they’d get back tax returns. It changes people’s lives. But what happens if there’s nothing to buy and you got more money? You compete for getting it there. It creates a real problem. So, on the one hand, we’re facing new disruptions to our supplies. But at the same time, we’re also experiencing higher demand for goods because wages are up, as well as—as well as people have money in the bank. And because of the strength of our economic recovery, American families have been able to buy more products.”

In his speech, Biden observed that because of Covid, people have been staying home and ordering products online: “Well, with more people with money buying product and less product to buy, what happens? ... Prices go up.”

But have no fear, Biden’s Build Back Better infrastructure program will bring inflation down. That’s according to “17 Nobel laureates in economics” who “wrote a letter to me about 10 days ago saying this is going to ... bring inflation down, not up.”

How can even more government spending do that? Infrastructure spending purportedly will end the supply disruptions so that more goods will be available to meet demand. Let’s hope so. But are there enough workers available amid the current labor shortage to Build Back Better without inflating wages, thus feeding a wage-price spiral?

By the way, on October 14, White House Chief of Staff Ron Klain endorsed a tweet that claimed that the inflation and supply-chain issues affecting the country were “high class problems.” Klain made news for appearing to agree with Harvard professor Jason Furman, who served as chair of the Council of Economic Advisers under President Barack Obama. “Most of the economic problems we’re facing (inflation, supply chains, etc.) are high class problems. We wouldn’t have had them if the unemployment rate was still 10 percent. We would instead have had a much worse problem,” Furman wrote in a tweet that Klain shared.

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Inflation: Blast from the Past

November 15 (Monday)

Bulletin Board. Join Dr. Ed’s webinar on Mondays at 11 a.m. EST. You will receive an email with the link to the webinar one hour before showtime. Replays are available here. A complimentary copy of Dr. Ed’s newest book In Praise of Profits! is available here.

Inflation I: Gerald, Jimmy, and Joe. The similarities between the Great Inflation of the 1970s and the current rebound in price inflation are mounting. However, there are important differences as well, which continue to support our Roaring 2020s economic growth scenario.

The biggest difference between then and now is that productivity growth collapsed during the 1970s (Fig. 1). This time, productivity growth has been rebounding since late 2015 and should continue to do so over the rest of the decade. If so, then the prolonged wage-price spiral of the 1970s is unlikely to be repeated during the current decade (Fig. 2). That doesn’t rule out a short-term wage-price spiral, which seems to have started this year and could last through next year. That’s happening because short-term supply-chain disruptions have been impeding productivity, which fell 5.0% (saar) during Q3 (Fig. 3).

In the October 27 Morning Briefing, we wrote: “We are also raising our inflation forecast. We expect the headline PCED to increase 4.5% this year and 3.5% next year. It was 4.4% y/y during September. We expect it will range between 4.0% and 5.0% through mid-2022. Then it should moderate to 3.0%-4.0% during the second half of next year” (Fig. 4). We added that we “won’t be surprised if the FOMC decides to raise the Fed’s inflation target from 2.0% to 3.0% next year.”

Let’s review some of the disturbing parallels between the 1970s and the current situation:

(1) Soaring commodity prices. The CRB raw industrials spot price index soared to new record highs during the 1970s (Fig. 5). Since bottoming on April 21, 2020, the index is up 59% through Friday’s close, holding near last Tuesday’s record high. The price of a barrel of crude oil soared during the 1970s to record highs (Fig. 6). It’s been soaring again over the past year, though it remains well below the 2008 record high. However, both energy and food inflation rates in the CPI have been heating up recently, which is somewhat reminiscent of what happened during the 1970s (Fig. 7).

(2) Rapidly rising wages. As I discussed in my book Fed Watching (2020), during the 1970s, labor unions were still powerful in the private sector. The biggest ones negotiated cost-of-living adjustment (COLA) clauses in their contracts with companies. So the rapid increase in energy and food prices automatically boosted their members’ wages. With productivity growth falling, the result was a rapid increase in unit labor costs, which put upward pressure on prices. (Here is an excerpt from Chapter 3 of Fed Watching, covering The Great Inflation of the 1970s.)

Today, a similarly driven wage-price spiral seems less likely. Unions aren’t as powerful as they were back then, and COLAs are long gone. However, labor actually may have more leverage over wages today than during the 1970s as a result of chronic labor shortages.

Last week in the November 8 Morning Briefing, we wrote: “The labor shortage problem isn’t going away. It is literally in the DNA of the population. The 60-month percent change at an annual rate in the civilian population was down to just 0.4% through December. The working-age civilian population (16 years and older) has been growing a bit more quickly because seniors are living longer, but it was down to 0.6% through October.

“The underlying growth rate in the working-age civilian population determines the underlying growth potential of the civilian labor force … The 60-month percent change at an annual rate of the latter was just 0.2% through October. The Baby Boomers are retiring at a faster pace now that the eldest in this cohort turned 75 years old this year. Young new entrants into the labor force are barely replacing them” (Fig. 8).

Also last week, in the November 9 Morning Briefing, we observed that the wage increases of lower-wage workers are outpacing consumer price inflation, while the wage increases of higher-wage workers are lagging price inflation. That’s because there are more shortages of the former workers than the latter.

In any event, we believe that chronic shortages of labor will be the main driver of the productivity boom of the Roaring 2020s. The current decade, similar to the 1920s, should see a great amount of technological innovation that increases both the manual and mental productivity of workers as well as their standard of living.

(3) OPEC is back in control. During the 1970s, former President Gerald Ford wore a pin with the acronym “WIN,” which stood for “whip inflation now.” Former President Jimmy Carter donned a cardigan sweater to encourage Americans to turn down their thermostats to reduce rising energy costs. Now the specter of inflation is stalking President Joe Biden.

In a November 5 Bloomberg News interview about the administration’s decision not to boost domestic oil production to help lower prices, instead relying on foreign oil production, US Energy Secretary Jennifer Granholm burst out laughing. Bloomberg’s Tom Keene asked her, “What is the Granholm plan to increase oil production in America?” She laughed, saying, “That is hilarious. Would that I had the magic wand on this.” She added, “As you know, of course, oil is a global market. It is controlled by a cartel. That cartel is called ‘OPEC,’ and they made a decision yesterday that they were not going to increase beyond what they were already planning.”

In a Sunday, November 7 interview on CNN, Granholm was asked whether energy costs would go up. She said, “Yes, this is going to happen. It will be more expensive this year than last year.” The Energy Information Agency warns: “We expect that the nearly half of U.S. households that heat primarily with natural gas will spend 30% more than they spent last winter on average if it is a normal winter.” Turn your thermostat down and button your cardigan!

On Monday, November 8, Granholm said that Biden may act soon to address soaring gasoline prices, having pleaded with OPEC to supply more oil without success. She said he might authorize a sale from the US Strategic Petroleum Reserve, which is held in a series of caverns on the Texas and Louisiana coasts. Now that would be hilarious given that US frackers easily could pump up production if they weren’t held back from doing so by the administration’s regulatory hurdles.

(4) Climate change regulations. Despite the 66.5% ytd increase in the price of a barrel of West Texas crude oil, US crude oil field production is up just 4.3% ytd to 11.5 million barrels per day during the November 5 week (Fig. 9). It’s still well below its pre-pandemic high of 13.0 mbd during the October 11 week of 2019.

Oil producers are taking the threat of climate change activism very seriously. Activists are pushing to replace fossil fuels with renewables. As a result, oil producers are slashing their capital spending. What’s the point of finding more oil if it’s likely to be worthless in 30 years? It makes more sense to produce less and sell what you have left at higher prices. This certainly explains why OPEC+ has turned a deaf ear to Biden’s pleas that its member countries produce more oil.

During the 1970s, OPEC cut production to boost the price of oil. It did so because higher oil prices boost its members’ oil revenues. By refusing to produce more now, OPEC again is aiming to boost members’ revenues—by maximizing what oil fetches today given that it may very well be worthless in the not-too-distant future.

One more thought: If the price of oil goes high enough, there could very well be a backlash against climate activism.

(5) Challenges to globalization. The Cold War was still hot during the 1970s. It wasn’t until the Berlin Wall came down in 1989 that globalization got underway. It was accelerated by China’s admission into the World Trade Organization in late 2001. Globalization has been one of the four most powerful deflationary forces since then. (See my “Four Deflationary Forces Keeping a Lid on Inflation.”) Mounting trade tensions between the US and China, the pandemic, and supply-chain disruptions all are challenging globalization.

(6) Déjà vu all over again? On the other hand, there are some very significant differences between now and the 1970s. The dollar remains strong these days, whereas it was very weak back then after former President Richard Nixon closed the gold window on August 15, 1971. Productivity is showing signs of rebounding now, not collapsing as it did during the 1970s. Technological innovations have never been cheaper, more user friendly, or as useful for increasing the efficiency of every business as they are now.

Inflation II: The Supply Side. What about supply-chain disruptions? During the 1970s, they were mostly limited to the availability of oil during the 1973 and 1979 energy crises. Consider the following aspects of the current situation:

(1) Supply disruptions may be less prolonged than widely feared; they’re likely to be mostly resolved by mid-2022, in our opinion. Here is Exhibit A: Inflation-adjusted imports in the US GDP accounts rose to a record high during Q3 (Fig. 10). Granted that without supply-chain disruptions, they might have been higher.

(2) The Biden administration claims that its recently passed infrastructure bill will help to relieve transportation bottlenecks that have disrupted supply chains. We hope so, but we worry about the shortage of labor. Construction is extremely labor intensive and not known for productivity. So the new legislation will make starting and completing projects take longer and could drive up labor costs.

Furthermore, US Transportation Secretary Pete Buttigieg will have a great deal of say in allocating the funds for infrastructure spending. He has very progressive views on the role of infrastructure in our society.

Inflation III: Here and Now. October’s CPI was unsettling, for sure. It confirmed the sea-change in the consensus view of the recent surge in inflation: It is no longer widely perceived to be transitory, but rather persistent. The question is: Will it persist as long as the high inflation of the 1970s did? We don’t think so, for the reasons discussed above.

Let’s mine the latest data for some clues about the likely persistence of inflation:

(1) Headline and core. The headline CPI was up 6.2% y/y through October (Fig. 11). That’s the highest since November 1990. The core rate was 4.6%, the highest since August 1991. The good news is that the comparable three-month annualized inflation rates peaked during the summer and were down to 6.6% and 3.8%, respectively (Fig. 12).

(2) Moderating inflation components. During the spring and summer of this year, inflation was widely viewed as transitory because of the base effect. Some prices that had been depressed by last year’s lockdowns and social-distancing restrictions rebounded sharply earlier this year as the economy reopened. Now they are settling down.

For example, over the past three months through October, at a seasonally adjusted annual rate, the following CPI prices have fallen: airfares (-62.0%), car & truck rentals (-33.6), and lodging away from home (-8.6). The CPI for used cars & trucks is up just 0.9%, after jumping by as much as 121.8% as recently as June.

(3) Accelerating inflation components. The problem is that prices have been heating up recently in other parts of the economy. Over the past three months through October, the CPI for food is up 9.0% (saar). Also rising more rapidly on this basis are new vehicles (15.7%), motor vehicle parts & equipment (16.2), household furniture & bedding (20.2), household appliances (10.0), hospital services (5.7), and energy services (21.7).

Especially troublesome is rent of primary residence (4.8) and owners’ equivalent rent (4.5) (Fig. 13). Granted, these are relatively small increases, but they’ve risen rapidly since the start of the year, and they have large weights in the CPI, i.e., 7.6% and 23.6% respectively. The good news is that their weights are smaller in the PCE deflator at 3.6% and 11.3%.

Inflation IV: Made in China. Finally, we find it interesting that the close correlation between the PPI inflation rates for China’s total industrial products and America’s finished goods has never been closer than over the past year, with the former up 13.5% y/y and the latter up 12.5% y/y (Fig. 14). China’s soaring PPI has been led by a 103.7% increase in coal prices, which has caused a 40.7% increase in China’s CPI for fuel and power (Fig. 15).

Ironically, the “China price” was widely viewed as the source of disinflationary pressures on US prices until recently. Now it may be contributing to some of the inflationary pressures in the US.

The good news for inflation and the bad news for climate activism is that coal prices have been falling sharply recently in China, as the government is doing whatever it takes to produce more coal to generate electricity.

Movie. “Silk Road” (+ +) (link) is a crime thriller docudrama based on the true story of Ross Ulbricht, who developed Silk Road—essentially an “Amazon” for illegal drugs on the Darknet. Ulbricht built his empire from 2011 until his arrest in 2013 after attracting the attention of the FBI and DEA. In February 2015, Ulbricht was convicted of conspiracy to commit money laundering and computer hacking and to traffic fraudulent identity documents and narcotics via the Internet. In some ways, bitcoin steals the show. Ulbricht’s illegal drug trades all were conducted in the cryptocurrency and recorded in the blockchain, a public log that provides anonymity to users who don’t link their identities to their online “wallets.” This raises the question of why so few governments have banned the cryptocurrencies that facilitate criminal activity.

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Health Care & Gates’ Green Investments

November 11 (Thursday)

Health Care: Signaling a Tough 2022? The S&P 500 Health Care sector’s stock price index has posted a double-digit return ytd, which normally would be considered stellar but this year represents underperformance of the S&P 500 by 7ppts (Fig. 1). The sector is up 17.2% ytd versus the S&P 500’s 24.7% ytd gain as of Tuesday’s close. The Health Care sector’s shares may be pricing in the tough year-over-year earnings comparisons that some companies will face in 2022. Many health care companies’ businesses benefitted this year from pent-up demand as Covid threats and lockdowns receded and we all became more comfortable visiting doctors and undergoing medical procedures.

The sector’s stock price performance has also been dragged down by two of its larger industries, Pharmaceuticals and Biotechnology, which is ironic because it is scientific breakthroughs at pharma and biotech companies that brought Covid-19 under control.

Here’s the performance derby for the S&P 500 and its sectors ytd through Tuesday’s close: Energy (56.5%), Financials (35.5), Real Estate (32.6), Information Technology (28.1), Communication Services (25.2), S&P 500 (24.7), Consumer Discretionary (24.3), Materials (23.0), Industrials (20.8), Health Care (17.2), Consumer Staples (8.4), and Utilities (5.9) (Fig. 2).

And here’s how the various S&P 500 Health Care industries have performed ytd through Tuesday’s close: Health Care Facilities (38.5%), Health Care Supplies (34.4), Managed Health Care (29.7), Life Sciences Tools & Services (29.2), Health Care Services (21.7), Health Care Equipment (18.3), Health Care Distributors (17.2), Pharmaceuticals (14.4), Biotechnology (-0.2), and Health Care Technology (-5.5) (Fig. 3 and Fig. 4).

Let’s take a look at what’s been driving some of the good—and bad—price performance in the S&P 500 Health Care sector:

(1) We’re going back to hospitals. The S&P 500 Health Care Facilities stock price index, with a 38.5% ytd gain, is the sector’s top performer. The industry includes HCA and Universal Health Services, which have turned in very different results this year. HCA has risen 49.7% ytd through Tuesday’s close, and Universal Health Services shares have fallen 6.6%. Both operate hospitals, but UHS also operates behavioral healthcare facilities.

The hospital business is enjoying a rebound from 2020, when Covid-19 encouraged patients to postpone all but the most necessary procedures. This year, patient beds filled up despite the resurgence of Covid-19 in the late summer and early fall. UHS’s behavioral health care facilities were hurt by Covid-19 because it meant that beds needed to be spread further apart. A staffing shortage due to the tight labor market and three facilities shut due to Hurricane Ida also hurt results.

UHS’s Q3 earnings dropped to $224.1 million from $246.5 million a year ago. In Q3, the number of patients admitted into the company’s hospitals increased by 12.4% y/y, but those admitted into behavioral facilities dropped 2.7% y/y, its October 25 press release stated.

Unburdened by a behavioral facilities division, HCA reported a 14.8% jump in revenue and a more than doubling of adjusted earnings per share to $4.57 from $1.92 a year ago. The company expects “demand will return to more historical trends with volumes increasing overall by 2% to 3%” in 2022, an October 22 article in Fierce Health Care reported. Covid patients are expected to represent 3%-5% of total admissions, down from 9% this year, the company said.

Tough comparisons and the return to a more normal environment explain why analysts’ financial estimates for the Health Care Facilities industry fall significantly next year. The industry’s revenue is expected to jump 13.1% this year but only 3.8% in 2022 (Fig. 5). Earnings are forecast to surge 41.3% this year but only 5.2% in 2022 (Fig. 6). The industry’s forward P/E (i.e., based on forward earnings, or the time-weighted average of consensus estimates for this year and next) is a below-market 13.0 (Fig. 7).

(2) We’re taking care of our teeth too. The Health Care Supplies industry is the second-best performing industry in the S&P 500 Health Care sector, up 34.4% ytd (Fig. 8). The stock doing the heavy lifting in that industry is West Pharmaceutical Services, which makes vials and needles used in giving vaccines and the like. Its shares have risen 46.2% ytd.

The shares of Align Technology, which designs, manufactures, and markets orthodontics and dentistry products, have also outperformed ytd. Its popular Invisalign system uses a clear retainer-like object to align teeth, replacing the need for unsightly metal braces. Its stock is up 33.1% ytd, and it’s expected to have strong 21.9% earnings growth next year. However, Align’s success isn’t a secret. The shares trade at 52.2 times analysts’ 2022 consensus earnings forecast.

The two other companies in that industry are Cooper Companies, which specializes in contact lenses and surgical items, and Dentsply Sirona, another dental products and technology firm. Both stocks are up ytd—by 19.5% and 6.5%, respectively—and both companies are expected to grow earnings next year, by a respectable 9.8% and 10.4%.

As a whole, the S&P 500 Health Care Supplies industry is expected to grow revenue by 30.0% this year and 11.1% next year. Earnings are forecast to rebound in 2021 by 68.0%, after a tough 2020 when they fell 16.2%, and the bottom line is expected to improve again by 14.8% in 2022 (Fig. 9 and Fig. 10). The P/E based on forward earnings, at 34.7, is well above its historical range (Fig. 11).

(3) Drug stocks drag down the sector. Drug companies that offer Covid-19 remedies or vaccinations are doing well but not those facing pricing pressures or patent expirations. Eli Lilly is the best-performing stock in the S&P 500 Pharmaceuticals industry, up 55.2% ytd. Its drug cocktail to fight Covid-19 is being sold to the government, and its Alzheimer’s treatment has begun the regulatory approval process.

The Pfizer/BioNTech Covid-19 vaccine is being distributed worldwide, and Pfizer has developed a drug that cuts hospitalization and death from Covid-19 by almost 90%. It shares are 28.5% higher ytd. The shares of Zoetis—which makes drugs, nutritional products, and diagnostics for pets and livestock—have risen 19.4% ytd, helped by all the new pets adopted during the pandemic.

Merck shares have been on a rollercoaster ride this month, first rallying on news that it had developed a drug to combat Covid-19. But the gains were cut to only 6.1% ytd after Pfizer announced its Covid-19 drug. Merck’s drug reduces the risk of hospitalization or death from Covid by about 50%, and it has been approved by the UK. The shares of Bristol Meyers and Viatris sit in negative territory ytd, while Johnson & Johnson shares are up only 3.3% ytd.

The S&P 500 Pharmaceuticals industry’s revenue is expected to jump 25.6% this year but increase only 3.2% in 2022 (Fig. 12). Likewise, its earnings are forecast to jump 23.4% this year but rise only 5.8% in 2022 (Fig. 13). At 13.9, the industry’s forward earnings multiple is below where it has been historically, except during the years around the 2008-09 recession (Fig. 14).

In the S&P 500 Biotechnology industry, Moderna and Regeneron Pharmaceuticals have been the two big winners this year. Moderna developed one of the vaccines used to fight Covid-19, and despite a recent pullback, its shares are still up 125.7% ytd. Regeneron’s monoclonal antibody drug has been approved to both treat Covid-19 infection and prevent it among high-risk groups with known exposure. The company soon will apply for approval as a general preventative as well. It has been shown to reduce the risk of contracting Covid-19 by 81.6% compared to a placebo and could serve as a vaccine alternative for the immunocompromised. Regeneron shares have gained 27.6% ytd, far outpacing the 0.2% ytd drop in the S&P 500 Biotechnology index.

The S&P 500 Biotechnology industry’s revenues are expected to jump 26.8% this year but increase only 1.4% in 2022 (Fig. 15). Likewise, earnings are forecast to soar 39.0% this year but dip by 1.6% in 2022 (Fig. 16). One selling point is that the industry’s forward P/E ratio, at only 11.0, is approaching its lowest level since 2011 (Fig. 17).

Disruptive Technologies: Bill Gates’ Climate Change Investments. If you want to feel optimistic that humans can harness technology in time to avoid cataclysmic climate change, take a look at Breakthrough Energy’s website. The organization was established by Bill Gates in 2015 to rally the public and the private sectors to reduce the world’s annual greenhouse gas emissions from 51 billion tons today to zero by 2050.

“Avoiding a climate disaster will be one of the greatest challenges humans have ever taken on,” says Bill Gates in a video on the site. “My basic optimism about climate change comes from my belief in innovation. It is our power to invent that makes me hopeful.”

Breakthrough Energy makes policy recommendations to governments about how to invest in research and development, how to boost innovation, and how to put a price on carbon, among other things. It has received commitments from billionaires around the world to fund more than $2 billion of venture investments that Breakthrough Energy Ventures has and will make. In addition to Gates, the list of investors includes Prince Alwaleed bin Tala, Jeff Bezos, Michael Bloomberg, Ray Dalio, John Doerr, Jack Ma, Julian Robertson, David Rubenstein, and Masayoshi Son.

“The aim of Breakthrough Energy Ventures is to accelerate an energy transition across every sector of the economy. We invest in visionary entrepreneurs, building companies that can have a significant impact on climate change at scale,” the website states. Breakthrough Energy has an “in-house team of scientists and entrepreneurs, with two investment heads— Carmichael Roberts, a chemist and entrepreneur, and Eric Toone, also a chemist—deciding where to place bets and then acting as cheerleaders and mentors,” a February 15 WSJ article on Gates reported.

Breakthrough Energy’s website presents the five grand challenges in reducing the CO2 produced by how we: make things; generate, store, and use electricity; grow things, get around; and live in buildings. The firm’s investments will allow small companies to build out their solutions for reducing CO2 and learn which ones work. This is high-risk, long-term investing—hence the need for billionaires able to absorb losses and wait 10-20 years for returns.

Here are some of the investments Breakthrough Ventures has already made:

(1) Developing new, more efficient clean energy. ClearFlame Engine Technologies has developed an ethanol fuel that can be used in existing heavy-duty truck engines instead of CO2-producing diesel fuel. Commonwealth Fusion Systems is developing fusion systems in smaller and lower-cost facilities that produce net energy. CubicPV has developed solar panels that are 30% more efficient than conventional systems and use silicon and perovskite. H2PRO can produce green hydrogen so efficient that it can heat homes at lower cost than charged today.

C-Zero generates hydrogen by splitting methane into hydrogen and carbon by moving it through a mixture of molten salts. The methane can be sourced from agricultural facilities, thus reducing a source of greenhouse gas from the environment, a July 7 S&P Global article stated. The carbon is solid, not gaseous, facilitating disposal. C-Zero’s system could be used in power generation, heavy industrial heating, and the production of hydrogen and ammonia.

Natel Energy has modernized hydropower using smaller turbines that are less expensive and faster to build to generate energy in projects that are less damaging to the surrounding environment.

(2) Cleaning up the air. 44.01 (named for the molecular mass of CO2) turns CO2 into rock. It partners with companies that use direct air capture technology or other processes to capture CO2. Heirloom uses low-cost minerals to produce oxides that naturally bind to CO2 at ambient conditions to capture CO2 from the air. The minerals are exposed to the air passively and don’t require the energy-intensive systems typically used to push the air through carbon-capture systems. Heirloom injects the captured CO2 underground.

(3) Making buildings greener. 75F has a smart building solution that predicts, monitors, and analyzes a building’s environment and helps building owners save energy and improve air quality. enVerid makes energy-efficient HVAC systems. Dandelion helps homeowners use a geothermal system to replace oil, natural gas, and propane for heating. And Ferbo Energy is harnessing geothermal energy for industrial use.

(4) Cleaning up dirty industries. Boston Metal is making steel using renewable energy and without generating CO2 emissions. Cleaning up the production of concrete is a major focus of the fund. CarbonCure injects recycled CO2 into concrete during mixing. When the CO2 turns into a mineral, it strengthens the concrete and reduces the amount of cement needed in the mix. Ecocem and Solidia are also working to reduce the amount of CO2 generated during the production of cement.

DMC Biotechnologies uses fermentation to produce chemicals like amino acids near their points of use by manufacturers, thereby reducing the CO2 generated by transporting them. Lilac Solutions has developed a method to extract lithium from salt-water brines without the need for huge, environmentally damaging evaporation ponds. Lilac flows brine through tanks filled with ion exchange beads that absorb the lithium.

(5) Making transportation greener. Heart Aerospace plans to deliver 19-seat, electric planes certified for commercial flight by 2026. Initially, they will be able to travel 250 miles, but that’s expected to improve along with improvements in battery energy density. ZeroAvia uses hydrogen to power 10- to 20-seat planes that can travel for up to 500 miles. It plans to have a commercial offering next year. Metro Africa Xpress is bringing electric motorcycles to Africa.

Our Next Energy, or ONE, has developed two lithium-iron-phosphate batteries for use together in a vehicle. The first is used for short trips, and the second kicks in during longer trips. The battery “extender” will allow conventional trucks and SUVs to travel 700 miles on a single charge. Quantum Scape has developed a solid-state lithium battery for electric vehicles that is more energy dense, longer lasting, and safer than conventional lithium batteries. The company, which went public in March, claims its battery increases an EV’s range to 300-400 miles. Redwood Materials, led by the co-founder and former chief technology officer of Tesla, aims to recycle the mountain of EV batteries that will be created in upcoming years.

(6) Making the farm greener. Iron Ox brings the farm indoors. Its facilities grow fruits and vegetables using robotics and artificial intelligence to control the environment, ensuring each plant receives the right amount of sun, water, and nutrients. This “precision farming” uses less water, less energy, emits less CO2, improves plant yields, speeds growing time, and enables the use of smaller greenhouses.

Motif, Nature's Fynd, and Nobell are creating plant-based meats and/or dairy products. Pivot Bio has developed genetically engineered microbes that can produce nitrogen that a farm’s soil requires and eliminate the need to purchase fertilizer.

(7) Developing long-duration energy storage. ESS has developed iron flow, industrial batteries that provide 4-12 hours of energy storage. The batteries are non-flammable, don’t degrade at high temperatures, have a 25-year operating life, and are the greenest on the market, with the lowest CO2 impact. Form Energy has a rechargeable iron-air battery for power grids that’s able to store electricity for 100 hours at a cost that’s competitive with legacy power plants.

Malta’s electro-thermal energy storage system uses steel, air, and salt to store energy from renewable sources. Electricity is turned into thermal energy, which can be stored for six or more hours. It can also be converted back to electricity and sent back to the grid when needed. The plant can be located anywhere, has a lifetime of more than 20 years, and can scale as storage needs grow.

Quidnet Energy stores electricity by pumping water from a pond down a well and into a body of rock, where it’s stored under pressure. When electricity is needed, the water is released, passes through a turbine to generate electricity, and returns to the pond.

The fund has also invested in Reactive Technologies and Sparkmeter, which have technologies to manage the electric grid for better efficiency. Meanwhile, VEIR has developed new utility transmission wires that can move electricity more efficiently—important since renewable energy is often generated far from where it’s used.

All reasons to be optimistic, indeed.

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Are We There Yet?

November 10 (Wednesday)

Central Banks: In No Rush To Raise Rates. The US Federal Reserve, the European Central Bank (ECB), and the Bank of Japan (BOJ) may be winding down their pandemic emergency asset purchases (Fig. 1 and Fig. 2). However, none of the three central banks is in any rush to raise interest rates: The ECB’s and BOJ’s rates remain in negative territory, while the Fed’s is near zero. Each has been claiming that extraordinarily easy monetary policy remains necessary to maintain the momentum of their economic recoveries. Are they being justifiably prudent, Melissa and I wonder, or stuck in autopilot?

The problem is that the list of problems justifying these central bankers’ accommodative approaches is getting shorter and shorter. Most importantly, the pandemic is abating and becoming endemic in many regions, as discussed below. Global economic growth has recovered nicely from last year’s lockdowns. Inflationary pressures are proving to be persistent rather than transitory. Even China’s recent property debt crisis is generally considered by central bankers to be a problem that will be contained in that country.

Yet bankers are fiercely committed to the idea that now is not the right time to raise rates. Here’s what’s keeping global central banks from raising rates despite significant evidence of progress in the health crisis and global economic recovery:

(1) Transitory inflation problem. During his November 3 press conference after the FOMC’s monetary policy meeting, Fed Chair Jerome Powell emphasized that the end of the bond buying would not mean a rush to raise interest rates: “I don’t think that we’re behind the curve. I actually believe that policy is well-positioned to address the range of plausible outcomes, and that’s what we need to do,” Powell said.

Likewise, ECB’s President Christine Lagarde emphasized during her October 28 press conference the need to be “patient” and “persistent” with monetary policy.

Historically, the banks would have raised rates at the first sign of a pickup in inflation closer to their stated goals. Measures of inflation recently have exceeded the ECB’s and the Fed’s 2.0% targets. However, central bankers do not see the recent rise in inflation as a long-lasting problem.

“We foresee inflation rising further in the near term, but then declining in the course of next year,” Lagarde simply stated during her presser. She added that the bank foresees inflation in the “medium term” (or roughly over three years) remaining below the 2.0% target. That means that the “conditions” for interest rate lift-off are “not satisfied.”

Yesterday, we discussed Powell’s fixation on the word “transitory” when discussing inflation. Both Powell and Lagarde feel that inflationary pressures will abate once supply-chain shortages associated with the pandemic are resolved. Recent inflationary pressures in energy markets, too, should be transitory, they believe. Specific to Europe, base-effects from adjustments to the German VAT (value-added tax) will fade from the inflation calculation by January 1.

Despite rising risks of a prolonged acceleration of inflation in the US and Europe, the BOJ’s inflation target has not yet been met. So “there is absolutely no reason to adjust monetary easing,” the BOJ stated in its November 8 Summary of Opinions. Finally, the y/y rate of change in Japan’s CPI is around 0.0%; it is no longer negative! That’s mainly due to rising energy prices, the bank said, indicating that the CPI is likely to increase moderately in positive territory. “In Japan, where underlying inflation is still low, it is important to persistently continue with extremely accommodative monetary policy even when pent-up demand increases,” the bank noted.

(2) Shortage problem. “We’re seeing shortages” because “we have this supply-demand disconnection,” Lagarde stated. ECB contacts reported that it will take a “good chunk” of 2022 for the shortages to be sorted out. The BOJ suggested that “downward pressure on production and exports stemming mainly from supply-side constraints is likely to strengthen in the short run.”

Labor shortages should abate too, central banking officials seem to think, as the labor market has room for improvement. Powell said there is “still ground to cover” in the labor market recovery to reach “maximum employment.” Lagarde observed during her presser that “both the number of people in the labour force and the hours worked in the economy remain below their pre-pandemic levels.” Slack remains in the respect that “you have nearly two million people less employed in the economy today compared with pre-pandemic, where we have three million people who are still on furlough schemes,” she said.

(3) Energy problem. Consumer spending in the Eurozone has been robust during the recovery, especially on entertainment, dining, travel, and transportation. Contributing to high energy prices in Europe is low inventory, with “maintenance in Norway, with demand in China, with the supply by Russia,” Lagarde explained. She is concerned that “higher energy prices may reduce purchasing power in the months to come.” Similarly, the BOJ noted that energy prices were driving up the cost of food, which could have an impact on the strength of pent-up demand.

Pandemic: Is It Abating? Covid-19 may never go away, but it seems to be transitioning from pandemic to endemic status in many regions around the world. Progress in vaccinations against Covid-19, especially in the US, has been significant, and Covid-related infections, hospitalizations, and deaths have waned. However, evidence of breakthrough cases, such as that mounting now in Europe, could become a bigger problem for more vaccinated countries.

Even in parts of the world where vaccinations remain out of reach, the data points are improving. Natural immunity has driven a decline in the prevalence of the virus in these areas. But it remains uncertain for how long natural immunity will work to fend off the virus. In any event, these unvaccinated regions may have been spared the worst of the virus thanks to their youthful demographic profiles.

Perhaps more dangerous to the health and economic well-being of societies than the virus is the response of governments to keep it contained as it continues to pop up. China’s approach, for example, to aim for zero cases of the virus could be especially damaging.

Let’s further explore the status of the virus by region:

(1) US vaxxed and maskless. The Covid-19 pandemic could be over in the US by the time President Joe Biden’s workplace vaccine mandates take effect in early January, Pfizer board member Dr. Scott Gottlieb told CNBC’s “Squawk Box” on November 5. Some 84 million private-sector workers must get either their second Moderna or Pfizer shot or one dose from Johnson & Johnson by January 4 or face regular testing for the virus. “By Jan. 4, this pandemic may well be over, at least as it relates to the United States after we get through this delta wave of infection. And we’ll be in a more endemic phase of this virus,” Gottlieb said.

Nearly 75% of the US population has received two jabs of the Covid-19 vaccine, while nearly 85% has received at least one dose (Fig. 3). As vaccines have proliferated in the US, infection rates and hospitalizations related to the virus have waned significantly, particularly following the wave of Delta variant infections during Q3 (Fig. 4). Deaths recently have risen, but that’s to be expected since they lag cases and hospitalizations; and deaths too seem to have peaked following Delta.

The great news is that, despite the Delta variant, the latest peak in infection rates was well below the previous peak. The other good news is that hospitalizations and deaths should continue to subside relative to cases because the treatments to fight the virus have become quite robust, and more are coming. Data from Pfizer on Friday indicated that its Covid antiviral pill, when paired with an HIV medication, slashed the potential for hospitalization or death by 89% in adults at risk for severe complications.

(2) Europe breaking through. Europe’s breakthrough cases have been all over the news. Those are positive occurrences of the virus in vaccinated people. The World Health Organization said last week that Covid cases in Europe have risen steadily over the past five weeks. But keep in mind that vaccines are not 100% effective. As millions more people get the vaccine, we are going to see an increase in the number of breakthrough infections.

New cases in France, Italy, Germany, and Spain had been on the decline following the Delta outbreak, but now appear to be ticking up again (Fig. 5). Infection rates have been harder to squash in the UK (Fig. 6). Similar patterns are seen in Europe’s hospitalization rates, but hospitalizations are low.

(3) Japan celebrates success. “The bars are packed, the trains are crowded, and the mood is celebratory, despite a general bafflement over what, exactly, is behind the sharp drop,” the Associated Press observed. Japan seems to have effectively squashed the virus for now, with zero new cases appearing since late October (Fig. 7). Some possible explanations include a rapid vaccination campaign and the widespread practice before the pandemic of wearing masks. “Rapid and intensive vaccinations in Japan among those younger than 64 might have created a temporary condition similar to herd-immunity,” said Dr. Kazuhiro Tateda, a Toho University professor of virology.

(4) China going for zero. Most people would agree that the Disney theme parks are fun places to visit. But it probably wouldn’t be much fun to be locked in one with healthcare workers in hazmat suits instead of cast members in costume. Recently, a Halloween Covid scare forced Shanghai Disney into lockdown as China took further steps to eradicate the virus. China’s success story against the virus is tied most closely to its authoritarian approach to contain it. In our April 8 Morning Briefing, we explored China’s harsh intolerance of even one instance of the virus. Indeed, the approach as worked. Since March 2020, China’s cases of the virus have been at or around zero, the Chinese government reports (Fig. 8).

(5) Africa spared. “The pandemic appears to have spared Africa so far. Scientists are struggling to explain why,” was the title of a recent Science.org article. It noted that antibody studies suggest that large numbers of infections have occurred but that the death toll remains low. The article omitted one reason we can think of: demographics.

“Age has been observed as a significant risk factor for severe COVID-19 illness. Most deaths occur in those aged 65 or older. The median age in North and South America, Europe and Asia ranges from 32 to 42.5 years. The age demographic structure of sub-Saharan Africa is much younger—the median age is 18,” according to a piece in The Conversation.

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The Bond Conundrum, Again

November 09 (Tuesday)

Bulletin Board. Replays of the Monday, November 8, webinar with Dr. Ed are available here. For a complimentary e-book version of In Praise of Profits!, go here.

Bonds: The Conundrum Continues. The 10-year US Treasury bond yield recently peaked at 1.68% on October 21 (Fig. 1). On November 3, the FOMC announced that the Fed would start tapering its bond purchases of $120 billion per month by $15 billion per month, thus setting the stage for possible hikes in the federal funds rate during the second half of next year. Yet the bond yield fell to 1.45% on Friday.

In his November 3 press conference, Fed Chair Jerome Powell stressed: “Our decision today to begin tapering our asset purchases does not imply any direct signal regarding our interest rate policy. We continue to articulate a different and more stringent test for the economic conditions that would need to be met before raising the federal funds rate.” He has said the same in previous recent pronouncements on this subject. He has stressed that tapering isn’t the same as tightening nor is it necessarily setting the stage for rate hikes. This helps to explain why there hasn’t been a taper tantrum in the bond or stock markets.

On the other hand, he provided a mixed message at his latest presser, saying: “We see shortages and bottlenecks persisting into next year, well into next year. We see higher inflation persisting, and we have to be in [a] position to address that risk … should it create a threat of more persistent, longer-term inflation, and that’s what we think our policy is doing now. It’s putting us in a position to be able to address the range of plausible outcomes.” In other words, tapering is likely to be followed by tightening if inflation remains persistent, which seems more likely now. Yet the bond market chose to focus on Powell’s most dovish pronouncements.

How can we explain the latest conundrum in the bond market? The Fed has started tapering and might be starting to tighten by mid-2022 (Fig. 2). This year’s rise in inflation has turned out to be persistent rather than transitory (Fig. 3). The Biden administration’s spending programs undoubtedly will increase the federal budget deficit and add to upward inflationary pressures (Fig. 4). Consider the following:

(1) Fed and banks buying bonds. Earlier this year, we attributed the conundrum mostly to the Fed’s bond purchase program. Since the week of March 24, 2020—a day after the Fed announced its QE4Ever program—the Fed had purchased $3.9 trillion in US Treasury and agency securities though the week of November 3, 2021, the same day that the FOMC announced its tapering program (Fig. 5).

Over the same period (through the week of October 27, 2021), commercial banks purchased $1.3 trillion in such securities. They did so because the Fed’s bond purchases boosted commercial bank deposits at the same time that loan demand was weak (Fig. 6).

Remember, tapering means that the Fed will still be filling up the punchbowl with liquidity, but just at a slower pace in coming months.

(2) Retail investors buying bond funds. In the November 2 Morning Briefing titled “What’s Up with TINA?,” we observed that money was pouring into bond mutual funds and ETFs (Fig. 7). Indeed, the 12-month sum of these net inflows rose to a record high of $1.0 trillion during April of this year. This data series remained significant during September at $821.5 billion, with bond mutual funds attracting $617.8 billion and bond ETFs attracting $203.6 billion.

The question is why would retail investors find bonds attractive at historically low yields? The answer might be that not everyone agrees that there is no alternative to stocks. Furthermore, as stock prices have soared, some investors may be rebalancing their portfolios out of stocks and into bonds.

(3) Foreigners buying US bonds. We also observed that foreign investors might very well view US bonds as a good alternative to their domestic bonds. Indeed, the global bond rally at the end of last week seemed to be led by 10-year yields in the UK and Germany (Fig. 8).

The financial markets were expecting a 15bps rate hike by the Bank of England on Thursday. That seemed to trigger a drop in global yields, including in the US, as the dollar also strengthened. In addition, officials of the European Central Bank and the Fed have indicated that they are in no rush to raise their official lending rates.

On Friday, the 10-year US Treasury bond yield (1.45%) remained well above those in the UK (0.76), Sweden (0.23), Japan (0.06), France (0.06), and Germany (-0.28).

China: Cracks in the Foundation. China’s mounting domestic problems also are bullish for US bonds and the dollar. Exports should continue to boost the country’s economy, but not enough to offset the depressing impact of China’s struggling property market. These developments could weigh on commodity prices, bolster the US dollar, and keep a lid on US bond yields. Consider the following:

(1) Exports and imports. On a seasonally adjusted basis, Chinese exports edged down 0.6% during October from September’s record high (Fig. 9). Imports are down 9.8% from their record high during June through October. As a result, China’s trade surplus rose to a record high during October.

By the way, we believe that the 12-month change in the non-gold international reserves held by China less the country’s 12-month trade surplus is a good proxy for capital inflows and outflows (Fig. 10 and Fig. 11). If so, then China’s capital outflows have been increasing in recent months; they’ve totaled $531 billion over the past 12 months through October, little changed from September’s $536 billion, which was the most since July 2017.

(2) Property market. On Friday, BBC News reported that Kaisa Group has become the latest developer to miss a payment to investors. Kaisa said it was facing unprecedented pressure on its finances due to a challenging property market. This comes as rival developer Evergrande Group is still reeling under the weight of more than $300 billion of debt.

Evergrande has been the highest-profile example of China’s debt crisis, but other companies in China’s property sector have similar issues. Their total combined debt is estimated to be more than $5 trillion, according to Japanese banking giant Nomura. That’s almost the size of Japan’s economy. Fantasia, Sinic, and China Properties Group all have defaulted on debts in recent months, while Kaisa is the latest developer to have missed a payment.

Strategy: SMidCaps Outperforming, Finally. About a month ago, we observed that the S&P 400/600 stock price indexes (a.k.a. the SMidCaps) had been moving mostly sideways since early this year, while the S&P 500 stock price index (LargeCaps) was making new highs (Fig. 12). We also noted that the forward earnings (i.e., the time-weighted average of consensus earnings-per-share estimates for this year and next) of the former were rising faster than that of the latter (Fig. 13). As a result, the forward P/Es of the SMIdCaps were falling both in absolute terms and relative to the valuation multiple of the S&P 500 (Fig. 14 and Fig. 15). That might have started to change on Friday, as all three forward multiples rebounded.

Dr. Ed’s New Book: Excerpt. Finally, I have a simple idea for increasing Americans’ appreciation of the importance of corporate profits, which I discuss in my recently released book In Praise of Profits! The federal government likes to give money away. Why not establish an automatic $1,000 savings account for all babies born in 2022 and beyond? That would cost a bit less than $4 billion per year if live births rebound back to the pre-pandemic annual pace of about 3.7 million. The funds would be invested in an S&P 500 exchange-traded fund. Dividends would be automatically reinvested. Beneficiaries would be allowed to have access to the proceeds on a tax-free basis once they turn 65 years old.

Since the end of 1935, the S&P 500 total return index has been rising around 10% per year. Applying this growth rate to a single $1,000 investment starting next year and compounded annually would provide each beneficiary in 2087 with $600,000 in current dollars. That would teach Americans born from 2022 onward the power of profits and compounding dividends on a tax-free basis. Capitalism’s fans would grow along with their “Birth Right Portfolios.”

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Transitory or Persistent?

November 08 (Monday)

Bulletin Board. I discuss my new book In Praise of Profits! in a Barron’s op-ed this week titled “All Americans—Not Just the Wealthy—Are Better Off Than Ever.” You may download a complimentary copy of the book here and see excerpts here. Please review it on Amazon if you have the time and inclination.

Our Monday morning 11 a.m. webinars are a big hit. You will receive the invitation to them an hour before showtime. You can watch reruns here.

The Fed: More Word Games. In his November 3 press conference, following the latest meeting of the FOMC, Fed Chair Jerome Powell used the word “transitory” six times when he discussed this year’s surge in the inflation rate. Nevertheless, he acknowledged that using the word might not actually help to convey the Fed’s message: “[I]t’s become a word that’s attracted a lot of attention that maybe is distracting from our message, which we want to be as clear as possible.”

Powell also attempted, rather laboriously, to explain what the FOMC means by word: “[F]or us, what transitory has meant is that if something is transitory, it will not leave behind it permanently or very persistently higher inflation.” He added, “[W]e’re trying to explain what we mean and also acknowledging more uncertainty about transitory.”

Is that clear? Inflation is transitory, but uncertainly so.

Additionally, Powell used forms of a word that’s the antithesis of “transitory”—i.e., “persistent”—11 times in the presser, when discussing the risk that inflation might not be so transitory after all. He attributed this risk to supply-chain disruptions: “We see shortages and bottlenecks persisting into next year, well into next year. We see higher inflation persisting, and we have to be in [a] position to address that risk … should it create a threat of more persistent, longer-term inflation, and that’s what we think our policy is doing now. It’s putting us in a position to be able to address the range of plausible outcomes.”

Is that clear? Higher inflation is likely to persist, but not for long because the Fed is on it!

The policy referred to is the FOMC’s decision to start tapering its $120 billion in monthly bond purchases by $15 billion per month so that these purchases will end by June of next year. Then the Fed can start raising interest rates if necessary to bring inflation down. In other words, the Fed will continue to fill the punch bowl with liquidity, but at a slower pace through mid-2022 until further notice.

The two-year US Treasury note yield recently peaked at 0.51% on November 1 and fell to 0.39% on Friday, November 5 (Fig. 1). The 12-month federal funds rate futures edged down to 0.36% on Friday. The 10-year US Treasury bond yield recently peaked at 1.70% on October 21 and fell to 1.45% on Friday (Fig. 2). This all suggests that the fixed-income markets are still expecting that the Fed will increase the federal funds rate by 25bps once or maybe twice during the second half of next year.

So despite his strained and often obtuse or conflicting verbiage, Powell is doing a good job of communicating the Fed’s intentions. So far, the fixed-income markets haven’t been betting against him by assuming that the Fed is behind the inflation curve, possibly necessitating raising interest rates sooner than expected and/or by more than Powell currently is signaling.

Nevertheless, Melissa and I still expect that Powell will be transitory, i.e., he probably won’t be reappointed by President Joe Biden. Will his tolerance of higher inflation persist at the Fed if he is gone? Perhaps so, and then some: We expect that he will be replaced by a more progressive Fed chair such as Lael Brainard. We expect that the Fed will be even more “woke” next year than it has been under Powell over the past two years. If so, then we wouldn’t be surprised to see the FOMC lift the Fed’s inflation target from 2% to 3% next year.

US Labor Market I: Employment & Income. Last week brought more good news about the US labor market, which continues to recover. It seems to have been doing so faster after the supplemental federal unemployment benefit was terminated on September 6.

Weekly initial unemployment claims dropped below 300,000 during the October 9 week for the first time since the March 14, 2020 week (Fig. 3). They’ve remained under this pre-pandemic level through the week of October 30, when they were down to 269,000. Payroll employment rose 531,000 during October, after getting revised higher by 118,000 to 312,000 in September and by 117,000 to 483,000 in August. The private sector’s payrolls rose 604,000 to 126.4 million during October, the highest since March 2020 though still 3.3 million below their record high during February 2020 (Fig. 4).

Here are some of the other upbeat developments in Friday’s employment report:

(1) Earned Income Proxy at record high. Our Earned Income Proxy (EIP) for wages and salaries in the private sector jumped 1.5% m/m during September, auguring well for the month’s personal income (Fig. 5). It is up 9.6% y/y through September. The problem is that the PCE deflator is up 4.4% y/y through September. Inflation has been offsetting some of the nominal income gains. As a result, our inflation-adjusted EIP was up a still solid 5.0% y/y through September (Fig. 6).

(2) Full-time employment expanding. Payroll employment measures the number of jobs, while household employment measures the number of workers with either a full-time job or one or more part-time jobs. Over the past 12 months through October, the former is up 5.8 million, while the latter is up 4.4 million. The number of full-time workers increased 4.7 million to 128.3 million, the highest reading since March 2020 but still 3.2 million below the record high during October 2019 (Fig. 7).

(3) Unemployment rate falling. The unemployment rate fell to 4.6% during October, the lowest since March 2020 (Fig. 8). The “short-term” unemployment rate for workers without a job for less than 27 weeks was 3.2%, little changed from September’s 3.1% which was the lowest since February 2020, and down sharply from last year’s peak of 14.1%. Interestingly, the “long-term” unemployment rate for workers without a job for 27 weeks or more peaked at 2.6% during February through April of this year and fell to 1.4% during October. This also lends credibility to the notion that the end of supplemental federal unemployment benefits at the start of September provided an incentive for more workers to find jobs.

(4) Lower-wage workers beating higher-wage ones. Debbie and I have figured out a simple way to calculate the average wage of higher-wage workers. We use the Bureau of Labor Statistics’ data series, provided in its employment report, on both total average hourly earnings (AHE) and the AHE for production and nonsupervisory workers (a proxy for lower-wage workers), who account for about 80% of total private payrolls. The higher-wage series rose 3.1% y/y to $51.70 during October, while the lower-wage series rose 5.8% to $26.30 (Fig. 9 and Fig. 10). The gains of lower-wage workers have been exceeding price inflation in recent months, while price inflation has outpaced the wage gains of higher-wage workers. Upper-income households are in a better position to deal with higher inflation, especially since they’ve accumulated lots of savings since the start of the pandemic.

US Labor Market II: Productivity & Hourly Compensation. Some bad news last week was that economic growth in the nonfarm business sector slowed dramatically during Q3 to 1.7% (saar) as hours worked jumped by 7.0%, resulting in a big 5.0% drop in productivity (Fig. 11). Unit labor costs in the nonfarm business sector increased at an annual rate of 8.3%, reflecting a 2.9% increase in hourly compensation and 5.0% decrease in productivity (Fig. 12). This is the lowest rate of quarterly productivity growth since Q2-1981, when the measure decreased 5.1%.

Is the decade of the “Roaring 2020s” over already? Was it the mouse that roared? Here is why we don’t think so:

(1) Supply and demand disruptions. While hours worked rose significantly during Q3, there were widespread reports of labor shortages. Key parts have also been in short supply. These supply-chain disruptions probably disrupted productivity significantly. On the demand side, these disruptions have stymied consumers from buying certain goods, especially motor vehicles. Debbie, Jackie, and I expect that the productivity growth rebound, which started in late 2015, will turn into a productivity growth boom over the rest of the Roaring 2020s.

(2) Productivity growth trending higher. We continue to monitor the 20-quarter percent change at an annual rate in nonfarm business productivity (Fig. 13). As a result of the setback during Q3, it edged down to 1.6% from a recent peak of 2.0% during Q2. It is still well above the most recent trough reading of 0.5% during Q4-2015.

(3) Population growth slowing. The labor shortage problem isn’t going away. It is literally in the DNA of the population. The 60-month percent change at an annual rate in the civilian population was down to just 0.4% through December (Fig. 14). The working-age civilian population (16 years and older) has been growing a bit more quickly because seniors are living longer, but it was down to 0.6% through October.

(4) Chronic labor force shortages. The underlying growth rate in the working-age civilian population determines the underlying growth potential of the civilian labor force (Fig. 15). The 60-month percent change at an annual rate of the latter was just 0.2% through October. The Baby Boomers are retiring at a faster pace now that the eldest in this cohort turned 75 years old this year. Young new entrants into the labor force are barely replacing them.

So in addition to a significant slowdown in the working-age population in recent years, there has also been a significant drop in the labor force participation rate (Fig. 16).

The labor shortage is not transitory. It’s not even persistent. It’s permanent for the foreseeable future! More and more businesses are realizing this and responding by increasing their capital spending, particularly on technology, to boost the manual and mental productivity of the available labor force. That should allow wages to rise faster than prices, averting a 1970s-style wage-price spiral. As we’ve previously observed, productivity growth collapsed during the 1970s. It is likely to boom during the 2020s. So although higher inflation may be persistent for now, it isn’t likely to be permanent.

Is that clearer than Powell’s take on inflation?

Movie. “Finch” (+) (link) is a post-apocalyptic sci-fi comedy starring Tom Hanks in a movie similar to “Cast Away” (2000), in which Hanks is stranded on a deserted island in the Pacific. His only companion is “Mr. Wilson,” a volleyball that he talks to in order to keep sane. In this movie, Hanks is one of the few survivors of a solar flare that destroys the ozone layer and turns Earth into a wasteland. His companions are a rescue dog named “Goodyear” and two robots, named “Duey” and “Jeff.” The star of the show is Jeff, who looks like a skeletal version of C-3PO in “Star Wars” and is very funny. I am hoping for a sequel starring Jeff and Goodyear in a buddy road-trip movie. Hanks won’t be needed in that film.

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Semis & Quantum Computers

November 04 (Thursday)

Information Technology: Semi Shortage Continues. The scramble for semiconductors continues even as semi manufacturers are operating full tilt and sales are hitting record levels. Worldwide, Q3 semiconductor sales rose 27.6% y/y and 7.4% q/q, the Semiconductor Industry Association reports. Results were broad based geographically, with Q3 sales rising 33.5% y/y in the Americas, 32.4% in Europe, 25.4% in Asia Pacific, and 24.5% in Japan (Fig. 1). Once expected to improve by year-end, semiconductor inventories are now expected to remain tight throughout next year and perhaps even into 2023.

Let’s take a look at some recent developments to see where the market now stands:

(1) CEOs see tightness continuing. Earnings reports this week from ON Semiconductor and NXP Semiconductors indicate that the market remains strong and that semiconductor investors can still be pleasantly surprised.

ON Semiconductor’s Q4 revenue jumped 32% y/y to $1.7 billion, and its non-GAAP earnings per share soared to $0.87, up from $0.27 a year earlier and $0.13 better than analysts expected. The shares have gained 18.9% since the news hit the wires on Monday before the markets opened and have climbed 74.6% ytd. The company, which specializes in auto and industrial chips, told investors the good times would continue, with Q4 revenue forecast to climb 20.0%-26.9%, a range that also was above analysts’ expectations.

ON Semiconductor has been reshuffling its business lines, buying semi businesses with higher margins and growth rates and selling those with lower margins and slower growth. Higher revenue and the portfolio changes helped boost the Q3 non-GAAP operating margin to 24.5%, up from 12% a year ago and 19.6% in Q2. CEO Hassane El-Khoury noted that higher costs have not dragged down margins because the company has been able to pass higher costs on to its customers.

“Looking forward, we expect demand to remain robust and outpace supply through most of 2022,” said CEO El-Khoury in the company’s November 1 conference call. He does not believe chip inventory is building up at customers’ locations or in the inventory chain. “[I]f we don’t ship, the cars don’t ship. That’s a 1 to 1 correlation that I can personally validate given all my conversations with my peers at our customers.” He’s also confident in demand because some customers have been willing to co-fund ON capacity expansions, in a new model for doing business.

NXP Semiconductors, which generates roughly half of its revenue from the auto sector, reported Q3 revenue growth of 26.2% y/y and operating earnings growth of 63.7% y/y. For the current quarter, NXP forecasts revenue that grows 17%-23% y/y, as it anticipates demand once again outstripping available supply. Strong demand has left the company with 85 days of inventory, down three days q/q and below its long-term target of 95 days.

“[W]e think the automotive supply demand equation will continue to be out of balance through 2022. … [O]ur Tier 1 partners explicitly demand that more supply and inventory will be needed in the extended supply chain, which we believe cannot be broadly achieved before 2023,” said NXP CEO Kurt Sievers during the November 2 earnings conference call.

Semiconductor sales have increased as more auto manufacturers have prioritized the production of their high-end vehicles, which use “upwards of twice the semiconductor content from NXP and others.” In addition, EVs and hybrids have doubled from 8% of global auto production in 2019 to about 20% this year, and the average semiconductor content in an electric vehicle is about twice the amount used in a car with an internal combustion engine. As a result, industrywide semiconductor content per vehicle has increased at 10% per year over the last three years, Sievers explained.

The company is seeing longer-term orders and non-cancelable/non-returnable orders, which run through 2022 and give the company greater visibility into their future business, said Sievers. NXP shares are up 2.8% this week through Tuesday’s close and 29.9% ytd (compared with up 0.6% and 23.3% for the S&P 500).

(2) Watching customers become competitors. One notable change in the semiconductor industry is the growing number of giant tech customers that are designing their own semiconductors, though continuing to outsource the chip manufacturing process. Apple, Amazon, Tesla, and Baidu all are designing their own chips and dropping historical suppliers.

“Increasingly, these companies want custom-made chips fitting their applications’ specific requirements rather than use the same generic chips as their competitors,” Syed Alam, global semiconductor lead at Accenture, said in a September 6 CNBC article. “This gives them more control over the integration of software and hardware while differentiating them from their competition.”

Google’s new Pixel smartphone contains a processor developed in house that was specifically designed for artificial intelligence (AI) uses. It replaced Qualcomm’s Snapdragon processor that had been used since the Pixel smartphone was launched in 2016. Google also reportedly is developing chips for its Chromebook laptops.

Almost all of Apple’s Mac computers now use in-house designed processors instead of Intel chips, as Apple historically had used. Apple’s chips allow its Macs to generate less heat, run more quietly, and enjoy longer battery lives relative to Intel’s chips, according to a October 29 review by the WSJ. Apple’s chips also have improved the computer’s performance, graphics, and memory. Now some investors are concerned that Apple might replace the Qualcomm processor in its iPhones with an Apple-designed chip.

Amazon is developing chips for use in its cloud service’s server networks. If successful, it would reduce the company’s use of Broadcom chips, the CNBC article reported. Tesla is working on a chip that would “train artificial intelligence networks in data centers,” and Baidu has launched an AI chip that could be used in autonomous driving.

The next question is how long the supply disruptions in semiconductor manufacturing would need to continue before these tech giants, with billions sitting on their balance sheets, consider manufacturing their own chips as well.

(3) Analysts remain chipper. The strength in the market for semiconductors continues to bolster the industry’s stocks. The S&P 500 Semiconductors industry stock price index has climbed 31.3% ytd through Tuesday’s close, and the S&P 500 Semiconductor Equipment stock price index has gained 40.6%, outstripping the S&P 500’s 23.3% return (Fig. 2 and Fig. 3).

Both industries have forward earnings (i.e., based on the time-weighted average of analysts’ consensus estimates for this year and next) that suggest analysts believe their moonshot trajectories will be continuing. For the S&P 500 Semiconductors industry, analysts’ forecasts imply revenue growth of 20.2% this year and 8.4% in 2022 and earnings growth of 32.5% this year and another 9.7% next year (Fig. 4 and Fig. 5). The strength in the Semiconductor Equipment industry is expected to be even greater, with revenue rising 34.0% this year and 16.6% in 2022 and earnings jumping 57.8% in 2021 and 21.7% in 2022 (Fig. 6 and Fig. 7).

Both industries have forward P/Es (i.e., based on forward earnings) that are at or near the highs of the past decade: The Semiconductors industry has a 20.8 forward P/E, and the Semiconductor Equipment industry has a 17.9 forward P/E (Fig. 8 and Fig. 9).

Disruptive Technologies: Quantum Computing Leaps Ahead. China’s scientists are having a good month. They announced a quantum computer that, if it operates as advertised, trumps US efforts to date. Quantum computers continue to evolve, as do the chips used by these computers and the software being developed to harness their power. Private investors have long made investments in the area, but now two quantum companies have done reverse mergers with SPACs (special purpose acquisition companies) and are trading in the public markets.

Let’s take a look at recent signs that this novel tech area is maturing:

(1) Quantum competition heating up. Chinese physicists have built two quantum computers that they say out-muscle any built in the US. The Zuchongzhi 2 is a 66-qubit programable superconducting quantum computer that’s “10 million times faster than the world’s fastest supercomputer” and can run a calculation one million times more complex than Google’s 55-qubit Sycamore, which launched two years ago, an October 26 South China Morning Post (SCMP) article reported. Chinese scientists also built a quantum computer based on light, the Jiuzhang 2, which they say “can calculate in one millisecond a task that would take the world’s fastest conventional computer 30 trillion years.”

Like other quantum computers, these machines need to operate at very low temperatures in controlled environments and are prone to errors. The Chinese scientists aim to “achieve quantum error correction” in four to five years.

Instead of trying to increase the number of qubits a computer has, scientists at the University of Copenhagen have developed advanced semiconductor qubits, or “spin qubits.” For the physicists in our audience: “Broadly speaking, they consist of electron spins trapped in semiconducting nanostructures called quantum dots, such that individual spin states can be controlled and entangled with each other,” one of the scientists explained in an October 31 SciTechDaily article. The upshot is they make quantum computers less error prone and more powerful.

(2) Quantum computers solving problems. In theory, quantum computers will be used to improve our lives; but as is often the case, reality will be much more complex. While quantum computers may be used in the future to predict stock prices, calculate gene mutations, and discover new materials, they also undoubtedly will be used to steal data protected using current encryption methods and by the military.

First, let’s focus on the positive. Toyota Motor partnered last month with QunaSys, a quantum computing software company, to help find new materials that can be used in solid-state batteries. Employing a quantum computer, the company will use density-functional theory to model the electronic structures of different materials faster than would be possible using a conventional computer, a November 2 Tech Wire Asia article explained. Zapata Computing and the University of Hull in the UK are using quantum computing tools to look for molecules in outer space that could signal signs of life. And Italian scientists are using quantum computers to analyze polymer chains.

Now to the dark side. Quantum technology is being used by military forces hoping to gain an advantage over their enemies. “China’s military is using quantum technology for ultra-secure communication lines, radar that can detect stealth aircraft, and navigation devices for nuclear submarines,” the SCMP reported. At home, IBM and Raytheon Technologies are collaborating to jointly develop advanced AI, cryptographic, and quantum solutions for the aerospace, defense, and intelligence industries and the federal government, an October 11 press release announced.

Quantum computers will also pose a threat to today’s encryption, which secures everything from defense and infrastructure information to our banking accounts. “Bad actors” are supposedly stealing or harvesting encrypted data today with plans to decrypt the information after quantum computing matures and makes unlocking the information possible.

“With the escalation in computing power enabled by quantum technology, the question is not if, but when potentially devastating breaches will occur,” a November 2 article in Professional Security Magazine opined. The article recommends companies today keep their data in separate batches so that it all can’t be accessed at once if security is breached. Regularly changing encryption keys, which would limit the amount of time any intruder might gain access to protected data, is also suggested.

(3) Quantum companies going public. A number of young quantum computing companies have been able to, or plan to, tap the public markets via mergers with special purpose acquisition corporations (SPACs). IonQ, which makes and sells space on its quantum computers, went public on September 30 by merging with a SPAC. After initially stumbling, its shares have rallied almost 50% since the merger.

IonQ’s 22-qubit quantum computer is accessed through the cloud and used by customers like Fidelity and Goldman Sachs. “Fidelity is using IonQ’s hardware to create algorithms that can crunch historical data to determine the likelihood of a borrower defaulting on a loan, while Goldman Sachs uses it to determine how the movement of one company’s stock price is affected by changes in another company’s price,” an October 2 Axios article reported. The company plans to use its new funding to develop a 64-qubit computer by the end of 2023.

Rigetti Computing, which is building an 80-qubit computer, announced in October that it too plans to go public early next year via a SPAC merger, an October 6 FT article reported. The company claims it will build a 1,000-qubit computer in 2024 and another using 4,000 qubits in 2026. In 10 years, the company predicts it will have built a machine “with more computing power than all of today’s cloud computing systems combined.” Rigetti plans to merge with Supernova Partners, a SPAC that’s co-chaired by Alexander Klabin, a hedge fund investor, and Spencer Rascoff, former CEO of Zillow.

“The funding includes a $100 million equity investment from investment groups that include T Rowe Price, Bessemer Venture Partners and Franklin Templeton. Other investors include In-Q-Tel, the CIA’s venture capital arm, and Plantir, the data analytics company that has done extensive work for the national security establishment,” the article states.

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No Shortage of Earnings!

November 03 (Wednesday)

Strategy I: Defining a Meltup. Joe and I have been in the meltup camp for a long time. We are hearing more and more strategists describing the recent action in the stock market as a meltup. However, we associate meltups with a soaring forward P/E for the S&P 500. That’s what we saw happen last year when this valuation multiple soared 79.8% from a low of 12.9 during March 23 to a high of 23.2 during September 2 (Fig. 1). Since then, it has been range bound between roughly 20.0 and 23.0.

The S&P 500’s forward earnings bottomed last year during the May 14 week (Fig. 2). It has soared 54.2% since then to a new record high during the last week of October this year. In other words, this year’s so-called meltup has been led by a “meltup” in earnings rather than in valuation. An earnings-led bull market is much better than a P/E-led bull market. The former is less prone to selloffs and corrections because it is supported by fundamentally strong earnings. That’s especially important now since the forward P/E is high by historical standards.

Our Blue Angels chart shows S&P 500 forward earnings multiplied by forward valuation multiples of 10.0 to 24.0 in increments of two (Fig. 3). These eight series fly in a parallel formation, never colliding. The S&P 500 is the stunt plane that flies in between the vapor trails of these Blue Angels. It shows that last year’s initial rebound in the S&P 500 was led by the P/E, and that since the May 8 week it has been flying higher in between the 20.0 and 22.0 vapor trails.

We are still projecting that forward earnings per share will be end up this year at $220 (up from $217 currently) and rise to $235 at the end of 2022 and $250 at the end of 2023. Our targets for the S&P 500 by the ends of 2021, 2022, and 2023 are 4800, 5200, and 5500. We are assuming that the forward P/E will remain high around its current level. So the meltup should continue to be led by earnings.

Strategy II: Forward Ho! On the old TV series Wagon Train, the wagon master shouted “Forward ho!” when it was time to move on. In the army, officers move their troops by saying “Forward march!” But in a wagon train, people who aren’t riding in or on wagons or horses are walking or running alongside—which is why the wagon master just yells “Forward ho” to let everyone know it’s time to move forward in whichever manner pertains.

It’s been “Forward ho!” for the stock market since March 23, 2020. Forward earnings have been leading the S&P 500/400/600 to new highs since they bottomed during May of last year. Despite shortages of parts and labor, there has been no shortage of earnings to do so. Consider the following:

(1) Q3 earnings reporting season and guidance. We are well into the Q3 earnings reporting season, and it has been going surprisingly well. The latest “earnings hook” shows that Q3’s blend of estimated and reported numbers jumped to $52.38 per share during the October 28 week, up 6.7% since the start of the season and 35.4% y/y (Fig. 4). Even more impressive is that despite lots of reasons to worry about rising costs as well as parts and labor shortages, forward guidance, on balance, boosted consensus earnings expectations for Q4 and for the four quarters of next year (Fig. 5). That’s clearly remarkable under the circumstances!

(2) S&P 500/400/600 forward metrics. The forward revenues of the S&P 500/400/600 stock composites all rose to record highs during the October 21 week (Fig. 6). The forward earnings of all three did so the very next week (Fig. 7). Since they bottomed last year, the forward earnings of the S&P 500/400/600 are up 54.2%, 100.2%, and 160.5% through the end of October. So it’s surprising that the S&P 400/600 indexes (a.k.a. “SMidCaps”) underperformed the S&P 500 (“LargeCaps”) earlier this year and have just been keeping pace with it over the past couple of weeks (Fig. 8).

The forward P/Es of all three indexes have declined since the early summer, with the S&P 400/600 P/Es dropping much more than the S&P 500 P/E as their stock prices stalled while their forward earnings soared (Fig. 9). That pattern may be about to change, as the forward P/Es of all three may be bottoming now, with more upside potential for the SMidCaps than the LargeCaps.

(3) Profit margins. Joe and I calculate forward profit margins simply by dividing forward earnings by forward revenues (Fig. 10). The forward profit margins of the S&P 500/400/600 all have been in record territory since the summer. During the week of October 21, they were 13.2%, 8.5%, and 6.8%. All three may be starting to peak, which wouldn’t surprise us given all the anecdotes about rising costs. Some of those costs can be offset by raising prices and boosting productivity. If so, then margins should stabilize around current levels.

Strategy III: Still Fundamentally Strong. While real GDP rose just 2.0% during Q3, lots of other macroeconomic indicators remain more positive for earnings and the S&P 500. The y/y growth rate of S&P 500 aggregate revenues is highly correlated with the M-PMI (Fig. 11). The latter remained near its recent cyclical high during October, at 60.8. The M-PMI is also highly correlated with the S&P 500’s net earnings revisions index, which has been solidly in positive territory for the past 15 months (Fig. 12). The y/y growth rate in S&P 500 forward earnings is highly correlated with the M-PMI as well (Fig. 13).

The Fed: Target Practice. Recall that the Fed changed its approach to inflation targeting back in August 2020. Before then, the Fed’s stated inflation goal was “symmetric” around 2.0% (as measured by the annual change in the price index for personal consumption expenditures, or PCE)—meaning that undershoots or overshoots would be equally tolerated. Since then, the Fed has adopted a Flexible Average Inflation Targeting, i.e., “FAIT” based approach.

Under FAIT, the Fed still targets stable inflation of around 2.0% but not as a symmetric goal. Persistent overshoots are welcome, to make up for past persistent undershoots. From 2012 until just recently, the PCE rate had been below the 2.0% mark, leaving plenty of make-up room (Fig. 14).

St. Louis Federal Reserve Bank President James Bullard shared his opinion on inflation targeting in a recent interview, informed by 2020 staff research. In a nutshell, he said that the Fed “really is” aiming for 2.0% inflation over a five-year window. (Notably, Bullard is not a voter on the FOMC this year, but he is next year—when the interest-rate discussion is likely to become more pressing.)

Here’s more:

(1) Meat on the bones. After the Fed’s adoption of FAIT last year, Bullard worried that it would not get a good test run—i.e., there’d be no overshoots to tolerate. That would make the Fed’s change of approach “kind of a moot point,” he said. But there was no need for that worry: “Instead, in 2021, beginning in the spring, we’ve had this big inflation shock. So, now we have actual meat on the bones where we can test the new framework, and we can see how it works.” (Editorial: Hooray, and the meat costs more!)

(2) Picking a window. Bullard observed that the test will be how well the Fed can “control that inflationary process.” He suggested looking at core PCE inflation over a five-year window of time. “Now, that window, you could have it be trailing, you could have it be including the current year and trailing years, you could have it be centered, so that you take the current year as the middle of a centered five-year moving average—all of those might be useful in various ways.”

(3) Carving a new path. Bullard referred to FAIT as a “US experiment” that takes “a step toward” price level, or “nominal GDP targeting,” which he has advocated. He noted that a “price level path” can result in “a better equilibrium outcome than inflation targeting” because the latter ignores past misses and just “tries to get it right going forward. Whereas price level targeting makes up for past misses.”

(4) Ready, aim. Bullard said he wants “optionality,” meaning the option to raise rates sooner if inflation gets out of control. To have that option, the Fed first would need to get its bond tapering done soon. Then it could assess “the date of lift-off, which will become the key policy variable at that point,” he said.

(5) Moving target. Bullard didn’t touch on it, but a former Fed official and a Peterson Institute for International Economics contributor recently put forth a case for raising the Fed’s FAIT target from 2.0% to 3.0%, as a September 1 WSJ article discussed. The article noted that in 2010, Olivier Blanchard, then the chief economist of the International Monetary Fund, suggested that the problem of persistently low inflation could be solved with an inflation target of 4.0%.

(6) Top turkey. If that catches on with a more progressive FOMC in 2022, it would certainly keep rates lower for even longer. The FOMC could become more progressive if Biden populates the currently and potentially open Fed governor positions with more progressive folks. In light of the recent insider trading controversy among Fed officials, Melissa and I think that current Fed Chair Jerome Powell could be on the chopping block, to be replaced with a much more progressive head like Fed Governor Lael Brainard.

Brainard has been speaking more about climate change and global inequities these days than FAIT, but she was a big proponent of it when the Fed opted for the approach.

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What’s Up with TINA?

November 02 (Tuesday)

US Stocks & Bonds I: There Are Alternatives. TINA has been around the block a few times during the current bull market, which started in 2009. The acronym stands for “There Is No Alternative.” The simple concept is that stock prices have advanced mostly because there is no alternative asset class worth buying.

Presumably, TINA made more and more sense as bond yields mostly declined since 2009, falling to record lows since the pandemic. The 10-year US Treasury bond yield was 2.82% during March 2009. It has been below 2.00% since August 1, 2019 (Fig. 1). The yield on the high-yield corporate bond composite fell from the low double digits to under 5.00% since November 17, 2020 (Fig. 2).

This might explain why equity ETFs have attracted record net inflows of $658.2 billion over the past 12 months through September (Fig. 3). But that explanation doesn’t jibe with the other relevant flow-of-funds data. Consider the following:

(1) Equities. The record inflow into equity ETFs was offset by a significant net outflow of $387.7 billion from equity mutual funds over the 12 months through September. As a result, the net inflow into equity mutual funds plus ETFs was $270.5 billion over the past 12 months through September. That was the best since February 2018. But this series has been in positive territory during only the past four months through September following 23 months of negative readings. This suggests that retail investors have been mostly late to the party, missing much of the dramatic doubling of the S&P 500 from March 2020 through August 2021.

(2) Liquid assets. Undoubtedly, many retail and institutional investors have quarantined themselves in the money markets since the pandemic started. Since the start of the pandemic during February 2020 through September of this year, M2 is up $5.6 trillion to a record $21.0 trillion (Fig. 4). Eyeballing the chart, we conclude that M2 is currently about $3.0-$4.0 trillion above the pre-pandemic trend line.

The demand deposits component of M2 is up $2.9 trillion to a record $4.5 trillion since February 2020 (Fig. 5). Demand deposits accounted for 21.5% of M2 during September, the highest reading since July 1975 (Fig. 6). Over the past 20 months through September, personal saving has totaled a record $2.8 trillion (Fig. 7).

(3) Bonds. Meanwhile, money has been pouring into bond mutual funds and ETFs (Fig. 8). Indeed, the 12-month sum of these net inflows rose to a record high of $1.0 trillion during April of this year. This series remained significant during September at $821.5 billion, with bond mutual funds attracting $617.8 billion and bond ETFs attracting $203.6 billion.

(4) The Fed. While the demand for bonds remained surprisingly strong since the start of the pandemic, the Fed has been reducing the supply of bonds. Since the last week of February 2020 through the last week of October, the Fed has purchased $4.2 trillion in US Treasuries and agency bonds (Fig. 9).

The Fed’s purchases have boosted demand deposits at commercial banks at the same time as loan demand has been flat (Fig. 10). As a result, commercial banks have purchased $1.4 trillion in US Treasuries and agencies since the last week of February through the October 20 week.

(5) Foreigners. Also reducing the supply of US Treasuries and agencies have been foreign investors. Over the past 12 months through August, they barely purchased any Treasuries, but they did snap up $441.2 billion in agencies (Fig. 11). By the way, foreigners’ net purchases of US equities totaled $243.8 billion over the past 12 months through August.

(6) Bottom line. So there have been alternatives to stocks after all, namely bonds and liquid assets.

US Stocks & Bonds II: The Valuation Questions. Our review of the flow of funds above certainly explains why the 10-year US Treasury bond yield has been fluctuating around 1.50% this year rather than rising over 2.00%—as the jump in inflation from February through August of this year suggests it should (Fig. 12). Similarly bearish for bonds are the copper/gold prices ratio and the ISM’s manufacturing PMI (Fig. 13 and Fig. 14).

The FOMC meets today and tomorrow. The committee is widely expected to announce that the Fed will start tapering its purchases of securities soon, with the aim of ending its QE4ever program by the middle of next year. Both the 12-month futures and the two-year Treasury note yield at their current levels reflect expectations of two 25bps hikes during the second half of next year (Fig. 15).

Presumably, this has all been discounted by both the bond and stock markets. Yet the bond yield continues to fluctuate around 1.50% rather than around 2.00%, and the S&P 500 is at a record high. The forward P/E of the S&P 500 has been remarkably stable in a range between roughly 20.0 and 23.0 since mid-2021 (Fig. 16). It’s been staying so despite the rebound in the bond yield since August 4, 2020, when the yield fell to a record low of 0.52% notwithstanding the upturn in inflation.

Joe and I expect that the S&P 500’s forward P/E will remain elevated. As we have previously observed, much of its stability over the past year has been attributable to the forward P/E of the S&P 500 Growth Index (Fig. 17). It has been fluctuating around 28.0 since mid-2020. It’s also dominated by a handful of large-cap technology stocks. They were formerly known as the “FAAMGs” (for Facebook, Amazon, Apple, Microsoft, and Google/Alphabet). Now they are known as the “GAMMAs,” since Facebook was renamed “Meta” last week.

The GAMMAs currently account for about 25% of the market capitalization of the S&P 500. Their collective forward P/E is currently 37.1. Excluding them, the S&P 500 forward P/E has been hovering around 19.0 since mid-2020 (Fig. 18). We can live with that.

New Book: Excerpts. In Praise of Profits! is the sixth in my series of Predicting the Markets studies. The paperback is available on Amazon. Subscribers are invited to a free download of the Kindle or pdf version of the book here.

My book mostly focuses on what progressives get wrong about entrepreneurial capitalism and profits. Along the way, with all due respect, I take swipes at five of the most famous economists in history. Here are the relevant excerpts:

(1) Adam Smith. Sadly, entrepreneurial capitalism has gotten a bad rap ever since 1776. Perversely, that’s when Adam Smith, the great proponent of capitalism, published The Wealth of Nations. He made a huge mistake when he argued that capitalism is driven by self-interest. Marketing capitalism as a system based on selfishness wasn’t smart. Then again, Smith was a professor, with no actual experience as an entrepreneur.

Smith famously wrote: “It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest. We address ourselves not to their humanity but to their self-love, and never talk to them of our own necessities, but of their advantages.”

This oft-quoted statement is totally wrong, with all due respect to the great professor. The butcher, the brewer, and the baker get up early in the morning and work all day long, trying to give their customers the best meat, ale, and bread at the lowest possible prices. They don’t do so because of their self-love, but rather because of their insecurity. If they don’t rise and shine early each day, their competitors will, and put them out of business. Entrepreneurial capitalism is therefore the most moral, honest, altruistic economic system of them all. Among its mottos are: “The customer is always right,” “Everyday low prices,” and “Satisfaction guaranteed or your money back.”

The problems start when the butchers, brewers, and bakers form trade associations to stifle competition, or join existing ones that do so. The associations support politicians and hire lobbyists who promise to regulate their industry—for example, by requiring government inspection and licensing. In this way, they raise anticompetitive barriers to entry into their businesses. In other words, capitalism starts to morph into corrupt crony capitalism when “special interest groups” try to rig the market through political influence. These groups are totally selfish in promoting the interests of their members rather than their members’ customers. At least Smith got that concept right when he also famously wrote, “People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices.”

(2) Karl Marx. The Communist Manifesto (1848), which Karl Marx wrote with Friedrich Engels, warns that capitalism is prone to recurring crises because “a great part not only of existing production, but also of previously created productive forces, are periodically destroyed.” This happens because capitalism has “epidemics of over-production,” which are resolved through “enforced destruction of a mass of productive forces,” exploitation at home, and imperialism abroad.

Hey, Karl and Friedrich were only 27- and 25-year-old wannabe revolutionaries when they wrote that nonsense. Even as they got older, though, they never figured out that capitalism’s “process of creative construction” improves the standard of living of the consuming class, i.e., all of us. That’s right, Marx and Engels erroneously focused their analysis on class warfare, pitting industrial workers against their capitalist employers, who were caricatured as greedy, exploitive, and imperialist. They failed to understand that the only class that matters in capitalism is the consumer class, which includes everybody. In a capitalist system, producers, workers, merchants all compete to cater to needs of the consumer class.

Capitalism provides the incentive for entrepreneurs to innovate. Driven by the profit motive, the creators of new or better goods and services at affordable prices get rich by selling their products to consumers who benefit from them. They are the true revolutionaries. They destroy the producers who fail to innovate and to provide consumers with the best goods and services at the lowest prices on a regular basis. Capitalism naturally develops technological innovations that benefit all of society on an ongoing basis.

Capitalism eliminates over-production by putting unprofitable companies out of business. Uncompetitive and unprofitable producers are capitalism’s hapless victims.

(3) Joseph Schumpeter. Schumpeter’s process of creative destruction naturally leads to the “paradox of progress.” On balance, society benefits from creative destruction, as this creates new products, better working conditions, and new jobs, thus raising the standard of living. But it also destroys existing jobs, companies, and industries—often permanently. Calling this process “creative destruction,” as Schumpeter did, places the focus on the losers, while calling it “creative construction,” as I do, focuses on the winners—which, by the way, includes all the consumers who benefit from new or better goods and services at lower prices!

(4) John Maynard Keynes. Keynesian macroeconomists tend to focus on the demand side of the economy. Their models are built on a core assumption that economic downturns are caused by insufficient private-sector demand that needs to be offset by government stimulus. Keynesians prefer more government spending over tax cuts, figuring that a portion of people’s tax windfalls is likely to be saved rather than spent. They rarely consider the possibility that demand might be weak because government regulations and policies are depressing profits. All they know for sure is that they can help with stimulative fiscal and monetary policies.

(5) Paul Samuelson. The latest (19th) edition of Economics (2010) by Paul Samuelson and William Nordhaus teaches students that economics “is the study of how societies use scarce resources to produce valuable goods and services and distribute them among different individuals.” This definition hasn’t changed since the first edition of this classic textbook was published in 1948.

I’ve learned that economics isn’t a zero-sum game as that definition implies. Economics is about using technology to increase everyone’s standard of living. Technological innovations are driven by the profits that can be earned by solving the problems posed by scarce resources. Free markets provide the profit incentive to motivate innovators to solve this problem. As they do so, consumers get better products, often at lower prices. The market distributes the resulting benefits to all consumers. From my perspective, economics is about creating and spreading abundance, not about distributing scarcity.

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Greenwashing in Glasgow

November 01 (Monday)

YRI Monday Webinar: ‘Ask Dr. Ed.’ Join Dr. Ed’s webinar on Mondays at 11 a.m. EST. You will receive an email with the link to the webinar one hour before showtime. Replays are available here.

Climate & Energy I: Putin’s Game. The UN’s 26th Conference of Parties (COP26) in the Scottish city of Glasgow has been called humanity’s “last best chance” to get devastating climate change under control. Held between October 31 and November 12, the gathering is the biggest climate conference since landmark talks in Paris in 2015 and is seen as a crucial step in setting worldwide emission targets to slow global warming.

Attending the summit are leaders of more than 120 countries. Not attending the do-or-die summit in person are Russian President Vladimir Putin and Chinese President Xi Jinping, who is expected to attend by video link.

Despite a global push for nations to zero out their greenhouse gas emissions by 2050, Russia has opted for a 2060 target, the same as China. The US has agreed to the 2050 goal. India has not yet made a pledge. Collectively, these four countries account for more than half of CO2 emissions.

Here is more on the two most significant no-shows at COP26:

(1) Xi. Ironically, President Xi may be a germophobe. While he attended the 2015 Paris summit in person, he has missed several high-profile global summits since the Covid-19 outbreak began in late 2019.

Xi is grappling with a crippling energy supply crunch at home, and his government is scrambling to get enough coal to avoid power outages during the coming winter. By not showing up in person, he is signaling that China isn’t ready or willing to make any more commitments than he made late last year. The Chinese government has pledged to slash its carbon intensity—i.e., CO2 emissions per unit of GDP—starting in 2030 to become carbon neutral by 2060, and to halt its construction of coal power plants abroad.

(2) Putin. A Kremlin spokesman told reporters that “unfortunately, Putin will not fly to Glasgow,” while stressing that climate change was “one of our foreign policy’s most important priorities.” Last week, Putin said that Russia, one of the world’s biggest producers of oil and gas, was aiming for carbon neutrality by 2060.

The reason that Putin isn’t in any rush to do something about climate change is obvious: Russia is heavily reliant on producing and selling “dirty” energy, i.e., oil, gas, and coal. It is the world’s largest exporter of natural gas and supplies more than a third of the European Union’s natural gas. Fossil fuel sales account for 36% of the country’s budget, according to the Organization for Economic Co-operation and Development. Profits from fossil fuel sales flow into the country’s sovereign wealth fund and pay for pensions. The revenues also support Russia’s military. So for Russia, a global transition away from fossil fuels is tantamount to an existential threat.

An October 25 Time article observed: “Russia certainly wants to project an engaged partnership to the global community, but it has also spent the past year expanding its petrochemical production facilities, and it has launched a new pipeline project and transport network that will see it double coal and gas exports to China. When the price of natural gas skyrocketed in Europe in early October, Putin suggested that the energy crisis was linked to Europe’s shift to renewable energy sources, and that a slower transition that focused on natural gas—Russian, of course—was the better option.”

The article also observes that Russia is a “cold country.” Keeping 140 million Russians warm during the winter with renewables rather than natural gas isn’t a practical option. Besides, many Russians probably wouldn’t mind a warmer climate in their neighborhood. Russia stands to be a big winner in the Arctic region as the ice melts and makes mining access easier. The region is rich in rare earth minerals, which makes it crucial to countries that are seeking secure sources of these resources. There might even be lots of oil and gas hidden beneath the region’s Artic ice.

Climate & Energy II: Gassy Nations. Worldometer shows CO2 emissions by country for 2016. That year, they totaled 35 billion tons. The four major emitters accounted for more than half of this pollution, as follows: China (29%), US (14), India (7), and Russia (5).

In all four of these countries, power generation accounted for nearly or just over half of their CO2 emissions, as follows: China (41%), US (41), India (52), and Russia (52).

Climate & Energy III: King Coal. In 2020, more than 35% of the world’s power came from coal, according to BP’s Statistical Review of World Energy. Roughly 25% came from natural gas, 16% from hydro dams, 10% from nuclear, and 12% from renewables like solar and wind. Consider the following:

(1) Asia. An October 29 Reuters article is titled “COP26 aims to banish coal. Asia is building hundreds of power plants to burn it.” It observes: “Many industrialised countries have been shutting down coal plants for years to reduce emissions. The United States alone has retired 301 plants since 2000. But in Asia, home to 60% of the world’s population and about half of global manufacturing, coal’s use is growing rather than shrinking as rapidly developing countries seek to meet booming demand for power. More than 90% of the 195 coal plants being built around the world are in Asia, according to data from GEM.”

(2) China. The world’s second-largest economy is its top miner and consumer of coal. China has more than 1,000 coal plants in operation currently and almost 240 planned or under construction. Together, these plants will emit 170 billion tons of carbon in their lifetimes—more than all global CO2 emissions between 2016 and 2020, BP data show.

(3) India. Across India, 281 coal plants are operating, 28 are being built, and another 23 are in pre-construction phases. India’s position—spelled out in a detailed document to be released at COP26—is that developed countries should do more than developing countries to tackle climate change. Accordingly, India will push for developed countries to aim for “net negative” levels of CO2 emissions instead of the proposed “net zero,” providing room for developed countries to emit at “net positive” levels.

India’s top priority is to secure a strong financing deal allowing richer countries to meet their Paris Agreement commitments to provide $100 billion per year to help pay for climate adaptation and transfer clean technology in the developing world.

(4) Greenwashing. All of the above suggests that there will be a great deal of “greenwashing” in Glasgow. The term refers to a PR process whereby an organization markets their goods or services as environmentally friendly when, in fact, they are not. In other words, “greenwashing” is the act of making false or misleading claims about the environmental benefits of a product, service, technology, etc.

(5) Energy commodity prices. The Chinese government’s commitment to find enough coal to avert additional blackouts this winter has sent coal prices into a tailspin. The most traded thermal coal futures contract was down 27.6% last week, the biggest weekly decline since September 2016. It fell as much as 7.7% in Friday’s night session and is down by more than 50% from its record high on October 19. It is still up around 80% this year.

Physical coal prices have not dropped at the same speed, however. The spot prices at the port of Guangzhou slumped by almost 20% last week but are still twice as high as the futures price.

At the end of last week, European gas prices plunged amid a report by Reuters that Russia President Vladimir Putin on Wednesday told the head of Kremlin-controlled energy giant Gazprom PJSC to start pumping natural gas into European gas storage once Russia finishes filling its stocks, which may happen by November 8.

US Inflation: On the Lookout for a Wage-Price Spiral. Tornado chasers chase tornadoes. Most of them do it for the thrill. A few are researching storms. Debbie and I are wage-price spiral chasers as economic researchers rather than as thrill seekers. There is mounting evidence that such a spiral is underway, though it is premature to characterize it as “hyperinflation,” as has been suggested recently by the CEO of Twitter.

We still expect some gradual normalization of global supply chains, which will ease upward pricing pressures. We also expect that the acceleration of productivity growth will allow wages to go up, reflecting chronic labor shortages, without prices rising as greatly as they would absent the productivity factor.

In last Wednesday’s Morning Briefing, we wrote: “We are also raising our inflation forecast. We expect the headline PCED to increase 4.5% this year and 3.5% next year. It was 4.3% y/y during August. We expect it will range between 4.0% and 5.0% through mid-2022. Then it should moderate to 3.0%-4.0% during the second half of next year. We won’t be surprised if the FOMC decides to raise the Fed’s inflation target from 2.0% to 3.0% next year.”

Let’s review the latest relevant inflation data, recognizing that an important piece of the puzzle will come out on Friday in October’s Employment Report, namely average hourly earnings, the monthly measure of wages:

(1) Small business owners feeling the heat. There is a high correlation between the percent of small business owners (SBOs) planning to raise their average selling prices and the percent planning to raise worker compensation within the next three months (Fig. 1). Both series come from the monthly survey conducted by the National Federation of Independent Business. During September, both were at record highs, of 46% and 30%, respectively.

The percent of SBOs planning to raise worker compensation is a good monthly coincident indicator of the y/y growth rate of the quarterly Employment Cost Index, including wages, salaries, and benefits in private industry, which rose to 4.1% during Q3, the highest reading since Q4-2001 (Fig. 2).

The percent of SBOs with positions that they are unable to fill currently rose to a record 50.0% during the three months through September (Fig. 3). This series is a good leading indicator for the Atlanta Fed’s wage growth tracker overall and for job switchers (Fig. 4).

(2) Consumer prices. The bad news is that the percent of SBOs raising their selling prices is a good indicator of the core PCED inflation rate on a y/y basis (Fig. 5). The good news is that the latter was 3.6% during September and during the past four months through September.

More bad news is that the headline PCED increased 4.4% y/y in September, the highest pace since January 1991 (Fig. 6). Food and energy prices rose 4.1% and 24.9% y/y (Fig. 7). More good news is that the three-month annualized percentage changes in both the headline and core PCED inflation rates were 4.3% and 3.3% during September, well below their early summer peaks of 6.7% for both (Fig. 8).

(3) GDP deflators. The headline and core GDP price deflators rose 4.6% and 4.0% y/y during Q3 (Fig. 9). They are the highest readings since Q1-1983 for the former and matching its record high during H1-1989 for the latter. Here are the comparable Q3 inflation readings for the various components of the GDP deflator: headline and core personal consumption expenditures (PCE) (4.3%, 3.6%); PCE durables, nondurables, and services (7.0, 4.8, 3.5); residential investment total, single-family, multi-family (12.0, 12.7, -0.3); nonresidential fixed investment total, equipment, intellectual property, and structures (1.5, 0.4, 0.8, 5.9); exports (17.2); and imports total and ex-petroleum (9.0, 5.5). (See our GDP Deflators chart book.)

GDP: A Whiff of Stagflation. Q3’s real GDP rose just 2.0% (saar), down from 6.7% during Q2. Excluding the boost from less inventory liquidation during the quarter, real final sales of domestic product fell 0.1% (Fig. 10). This weakness was widely attributed to supply-chain disruptions. That’s part of the story. The other part is that those disruptions contributed to the jump in consumer prices that offset personal income growth. The stagnation in real incomes explains why real consumer spending rose just 1.6% during Q3, down from 12.0% during Q2 (Fig. 11). Here are a few other observations about the latest GDP report:

(1) Motor vehicles. Supply disruptions certainly depressed real consumer spending on new motor vehicles, which fell 68.1% (saar) during the quarter (Fig. 12). As a result of parts shortages, retail auto inventories have declined for three quarters in a row. The domestic auto inventory-to-sales ratio plunged to a record-low 0.5 during September. Normally, the ratio tends to fluctuate around 2.5 (Fig. 13). The good news is that once the parts are available again, there will be lots of pent-up demand and plenty of room on the dealer lots for restocking.

(2) Residential investment. Supply-chain disruptions, labor shortages, high materials costs, and soaring home prices weighed on real residential investment during Q3. It fell 7.7% (saar).

(3) Nonresidential investment. Real capital spending edged up 1.8% (saar) during Q3, led by a 12.2% increase in intellectual property products that more than offset declines of 7.3% and 3.2% in structures and equipment (Fig. 14).

Equipment includes information processing (-5.8%, saar), industrial (11.2, to record high), transportation (-18.6), and other equipment (0.4). Intellectual property products include software (15.7, to record high), R&D (9.5), and entertainment/literary/artistic (10.9).

Altogether, spending on IT equipment, software, and R&D in Q3 real GDP rose 10.9% y/y to a record high, accounting for half of current-dollar capital spending (Fig. 15 and Fig. 16).

(4) Trade. On an inflation-adjusted basis, US exports of goods and services has yet to fully recover from last year’s drop, and it has been relatively flat since Q4-2020 (Fig. 17). On the other hand, real imports rose to a new record high during Q1 and continued to do so through Q3. The real trade deficit was a record $1.3 trillion (saar) during Q3 (Fig. 18). In other words, some of the monetary and fiscal stimulus provided by Washington has leaked abroad through the trade deficit, contributing to global supply-chain disruptions.

Movie. “De Gaulle” (+ +) (link) is a docudrama about the life and times of Charles de Gaulle just before and during World War II. He was a French army officer and statesman who led Free France against Nazi Germany in World War II. He chaired the Provisional Government of the French Republic from 1944 to 1946 in order to reestablish democracy in France. He served as the president of France from 1959 to 1969. Objecting to the French government’s armistice with Germany, de Gaulle fled to England. He worked relatively well with Winston Churchill. In regular radio broadcasts over the BBC, he called on his countrymen to resist the Nazi occupation and to support the French resistance.

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Margins, FAANMGs, and Batteries

October 28 (Thursday)

Strategy: The Pressure To Overcome Margin Pressure. Third-quarter earnings results are separating the haves and the have-nots. The haves are companies that are successfully growing their bottom lines despite rising wages, escalating inflation, and disrupted supply chains that are jacking up costs. Some are enjoying sales growth and pricing power, which are offsetting cost increases. Others are employing technology to cut costs and improve productivity. The have-nots are not as lucky.

So far, the haves are outnumbering the have-nots. Since earnings season began, analysts have increased their Q3 earnings estimates by $1.46 per share, bringing the quarterly consensus up to $50.57, a 30.7% y/y increase (Fig. 1). According to Joe, 38% of the S&P 500 companies have reported as of mid-day Wednesday. All 11 of the S&P 500 sectors are beating estimates. Here’s the early read so far on the aggregate earnings-per-share surprise performance derby for the S&P 500 and its 11 sectors: Real Estate (65.5%), Financials (20.2), Consumer Discretionary (16.4), S&P 500 (12.8), Communication Services (11.6), Information Technology (11.6), Health Care (10.2), Industrials (7.4), Consumer Staples (5.1), Energy (4.9), Materials (4.0), and Utilities (2.9).

Fortunately, many S&P 500 companies are entering this difficult period with record-high operating profit margins. Here’s the performance derby for the S&P 500 and its sectors’ operating profit margins based on trailing four-quarter results: Financials (23.2%), Information Technology (21.7), Real Estate (18.0), Communication Services (15.8), Utilities (13.9), S&P 500 (12.0), Materials (11.1), Health Care (8.8), Consumer Staples (7.7), Consumer Discretionary (7.6), Industrials (6.4), and Energy (-0.4) (Fig. 2).

Let’s take a look at how some companies are absorbing the effects of higher costs and inflation and still coming out ahead:

(1) Pricing and sales growth. Like everyone in the food industry, Chipotle has felt the impact of the tight US labor market. The company has increased the minimum wage it pays US employees to $15 an hour, and its labor expense rose 23.9% y/y in Q3. The prices of supplies and shipping have also increased, the Mexican restaurant chain’s executives noted in their October 21 earnings conference call. The company’s expense line for food, beverage, and packaging rose 14.4% y/y in the quarter. Some of that jump occurred because Chipotle opened new stores and increased sales. But the company also experienced “mid-single-digit type inflation” in the quarter, CFO John Hartung said.

Chipotle’s sales surged 21.9% in Q3 y/y, bolstered by 41 new restaurants opened in Q3, the rollout of drive-throughs for digital orders, and new menu items. The company raised prices by about 10% in Q3 and 7.5% in Q4. Before Chipotle raises prices next year, it will be evaluating which cost price increases are permanent and which are temporary, explained CEO Brian Niccol. Wage increases are likely to be permanent, while higher shipping and other costs may be temporary, he said.

(2) Selling more provides a buffer. Tesla surprised investors by delivering 72.9% more vehicles in Q3 than the year-ago quarter. The jump in car sales helped the auto manufacturer report $1.6 billion in Q3 profit, its third consecutive quarterly profit and up from $331 million a year ago. Tesla said that it cut expenses and improved efficiency to more than offset higher commodity and labor costs, a lower average price of vehicles, and parts shortages that meant factories couldn’t run at full capacity, an October 20 WSJ article reported. Recent news that Hertz Global Holdings has put in an order for 100,000 Teslas by the end of 2022 pushed Tesla’s market capitalization above the $1 trillion marker.

(3) Cost-saving technology. With workers in high demand and wages on the rise, companies have a growing incentive to find ways that technology can replace labor and increase productivity. That’s particularly true for labor-intensive businesses like restaurants and retailers. The replacement of labor with technology is one of the reasons that productivity has started to climb, we believe, and may continue to do so for the next few years (Fig. 3).

Buffalo Wild Wings is testing a robotic chicken-wing fryer from Miso Robotics called “Flippy Wings,” which allows kitchen staff to cook more and spend less time attending to the deep fryer, a October 22 Chain Store Age article reported. Flippy’s cousin—which flips burgers and makes fries—was successfully tested in a White Castle last year and is being added in 10 more locations.

Many other robots are looking for restaurant jobs too. Peanut Robotics cleans and sanitizes restrooms; SoftBank Robotics makes Whiz, which vacuums floors; Makr Shakr makes robotic bartenders; and Servi delivers food to customers’ tables, an October 19 NYT article reported. Servi was developed by Bear Robotics and is being brought to market by SoftBank.

Robots increasingly are replacing humans in warehouses too, and soon they’re likely to make deliveries. Amazon has largely automated its warehouses, but still uses humans for the final packing stage. Ocado, a UK online supermarket, also has humans packaging the goods, but a robotic picking arm is “learning the task” so it can eventually replace humans. In addition to using the robots in its own warehouses, Ocado has deals to provide its technology to supermarket companies in eight countries, including the US, Japan, and France, according to an October 25 Reuters article, which includes an amazing video of the robots at work.

Chinese companies appear to be leading the trend. In 2017, JD.com opened a fully automated warehouse in Shanghai, with robots picking, packing, and sending orders off for shipment, according to this YouTube video. It requires just four workers but ships 200,000 packages a day. JD’s next goal: deploying 30 autonomous delivery vehicles in Changshu. The technology was tested during the Covid-19 outbreak, when the robot was used to deliver more than 13,000 packages in Wuhan.

“Eventually, autonomous delivery vehicles will become a part of the city’s infrastructure, ‘like subways,’” said Dr. Qi Kong, chief scientist and head of JD’s autonomous driving technology in a June 15 Traffic Technology Today article.

(4) Not everyone is so lucky. Even as Kimberly-Clark’s Q3 sales rose 7% y/y, its adjusted earnings per share fell to $1.62, down from $1.72 a year ago and below analysts’ consensus forecast of $1.65. The company also lowered its full-year adjusted earnings target to $6.05-$6.25 a share, down from the company’s prior outlook of $6.65-$6.90, an October 25 Barron’s article reported.

The poor showing was due to “significant inflation and supply-chain disruptions that increased our costs beyond what we anticipated,” said CEO Mike Hsu. “We are taking further action, including additional pricing and enhanced cost management, to mitigate these headwinds, as it is becoming clear they are not likely to be resolved quickly.”

Technology: Has FAANMG Stalled? For most of the past decade, the stocks that make up FAANMG—Facebook, Amazon, Apple, Netflix, Microsoft, and Google (Alphabet)—have risen sharply, driven by expanding businesses and earnings growth. But that has changed. Since it peaked at a record high in early September, the group’s collective market cap has dropped 3.5%, while the S&P 500 has risen 1.2% and the S&P 500 excluding FAANMG has gained 3.1% (Fig. 4). Likewise, FAANMG’s market-cap share of the S&P 500 is a lofty 24.7%, but it too has moved sideways since peaking at a record-high 26.7% during August 2020 (Fig. 5).

Here’s a quick look at what’s taking a bite out of the FAANMG stocks’ momentum:

(1) Blame FAA. Looking back over the past three years, each of the FAANMG crowd’s members easily trounced the S&P 500’s performance. The same cannot be said over the past year or the past three months, when Facebook, Apple, and Amazon have sharply underperformed.

Here are the stock price performances of the FAANMG stocks and the S&P 500 over the past three years: Microsoft (203.1%), Google (165.9), Netflix (121.5), Apple (117.7), Facebook (116.3), Amazon (102.9), and S&P 500 (72.2).

The picture isn’t as rosy ytd, with only three of the six FAANMG members outperforming the S&P 500: Google (69.6%), Microsoft (45.9), Netflix (23.4), S&P 500 (21.8), Facebook (15.6), Apple (12.5), and Amazon (4.6).

(2) Why the worry? Amazon’s shares have been under pressure for the past year, perhaps because the company faces very tough comparisons now that Covid-19 cases have diminished and consumers have grown comfortable leaving their homes, an October 27 Barron’s article suggested. Most recently, Q2 revenues rose 27% y/y but missed Wall Street’s expectations. Investors may be in a wait-and-see mode—waiting to see whether supply-chain problems and product shortages hurt the company’s results and watching to see the actions of the company’s first new CEO after founder Jeff Bezos recently stepped down.

Fortunately, Amazon stands to benefit from its market-leading cloud-hosting business. Also, it may gain advertising dollars if advertisers flock to Amazon from other apps now that Apple requires apps to ask users whether they want to be tracked—making it harder for advertisers to target ads and get data. Analysts have been trimming their quarterly and full-year estimates for Amazon, perhaps setting the shares up to rally when earnings are announced today. The consensus earnings forecast for Q3 is $8.90 a share, down from $12.89 three months ago.

Facebook cited Apple’s new advertising rules when explaining why its Q3 revenue was lower than Wall Street analysts expected. The company has also suffered reputational blows recently, as a whistle blower produced internal Facebook documents and testified before legislators that the company knows that its products are harmful to certain populations and has failed to, or can’t, fix the problem.

Investors are also waiting to hear how much supply-chain disruptions are affecting the production of Apple’s products.

The good news is that the forward P/E multiples for Facebook, Amazon, and Apple have declined this year, helping the FAANMG group’s collective forward P/E to drop to a more reasonable 35.8 from 44.7 at its peak in 2020 (Fig. 6 and Fig. 7).

Disruptive Technologies: The Search for a Better Battery. Roughly 30,000 people—government representatives, negotiators, scientists, businesspeople, and activists—are heading to Glasgow to attend COP26 in an effort to get countries around the globe to agree to net zero emissions by 2050. US President Joe Biden will attend. China’s President Xi Jinping won’t. The skeptic in us wonders how many attendees are flying in on private jets and how many plastic cups and cutlery will be used during the two-week event that starts on Sunday.

The world’s ability to replace CO2-producing fuels with renewable energy sources has taken a reputational hit in recent months. Less wind power generation and limited natural gas supplies partially explain why the UK faced a recent spike in electricity prices. It quickly became clear that even industrial batteries that can generate enough power to keep a town’s lights on can only do so for a matter of hours—not days.

Still, improvements in battery technology are important. Stronger batteries might not save the world, but they can extend the range on electric vehicles (EVs) and make consumers more comfortable ditching their gasoline-powered cars. Companies are also working on batteries that can keep a town’s lights on for one to four days. So I asked Jackie to recap some of the recent developments in battery technology:

(1) Tesla brainchild gets developed. On Battery Day in 2020, Tesla introduced the 4680, a new battery that CEO Elon Musk promised would offer six times the power of Tesla’s previous cells and five times the energy capacity. The battery was expected to increase a car’s range by 16% and reduce its fuel cost per kWh by 14%, a September 22, 2020 Electrek article reported at the time of the announcement. The batteries are also expected to charge faster.

Panasonic announced this week that it has mostly solved the technology challenges of manufacturing the 4680 battery and is moving ahead with plans to commercialize it, an October 25 WSJ article reported. Panasonic plans to start test production in Japan by March 2022, and Tesla has said it expects vehicles with the 4680 batteries to be delivered next year.

We’ve always thought that range would be a key determinant of winners and losers in the EV space. Tesla vehicles have offered the longest battery range in their price bracket; but with many new competitors entering the auto market over the next year or two, Tesla’s new battery should help it retain its advantage.

(2) Really big batteries. Honeywell is introducing a utility-scale battery that it says can replace lithium-ion batteries and last for up to 12 hours. While the battery would cost more upfront, it would last more than 20 years, which brings down its overall cost of ownership. And it doesn’t use any rare earth materials, an October 26 article in Energy Storage reported.

While few details are available, Honeywell says its “flow battery” uses a non-flammable electrolyte that converts chemical energy to electricity to store for later use. The technology is being tested by Duke Energy next year. Honeywell claims that when the battery is used in conjunction with renewable energy sources, it can be a cost-effective alternative to coal-fired plants.

Form Energy is also developing an interesting utility-scale, static battery with solid electrolytes. The battery “can store and dispatch energy for up to 100 hours at a cost which is competitive with existing thermal power plants and could be up to 10 times cheaper than lithium-ion.” The battery turns iron into rust as it’s discharged and rust back to iron as it’s charged. All that’s emitted is oxygen, a July 21 article in Energy Storage reported.

Another utility-scale battery alternative that can run from four to 12 hours has been developed by ESS. “The ESS battery technology is a stack of carbon plates that has salt water with iron flowing through each layer. Iron comes out of the salt water solution and sticks to one side of the plates. When the polarity of the plates is changed, the iron dissolves back into the water solution,” an October 11 CNBC article explained. By switching the flow of ions, electricity can be moved onto and off of the grid. Bill Gates’ clean energy investment firm has invested in the company, which went public via merger with a SPAC (special purpose acquisition company) earlier this month.

(3) Batteries on the high seas. The International Maritime Organization set a 2050 deadline for shipping companies to cut their CO2 emissions, but figuring out how to do so has proved difficult. FleetZero believes the answer is batteries. The company, which started in July, has designs to build electric batteries in standard 20-foot shipping containers. When a ship comes into port, the container holding the drained batteries would be swapped out for a new container with fully charged batteries, the company’s website explains.

FleetZero plans to use smaller cargo ships that carry 2,000 containers instead of using the giant cargo ships that can hold 20,000 containers. Smaller ships would require fewer batteries. They would be able to access a larger number of ports than the large cargo ships that require deep ports. Smaller ships are also less expensive to manufacture and would generate cash flow and profit faster. FleetZero is building its first battery prototype in Alabama and plans to convert a small diesel ship to use it by the end of next year, an October 26 CNBC article reported.

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Kinks in the Chain

October 27 (Wednesday)

Global Supply Chains I: From JIT to JIC. Melissa and I have been researching the causes of the global supply-chain disruptions. Below, we consider lots of the common explanations. They all make sense and have been contributing to the mess.

When all is said and done, the basic problem is that just-in-time (JIT) inventory management doesn’t work in a global pandemic. As a result, businesses are now scrambling to adopt just-in-case (JIC) inventory management. That’s easier said than done because everyone is trying to do so at the same time. Undoubtedly, the resultant hoarding has compounded the transition problem.

Also exacerbating the problem is that fiscal and monetary policymakers responded to the pandemic by first slamming on the economic brakes, with lockdowns and social-distancing restrictions, then slamming on the accelerator, reversing course with overly stimulative policies. The resulting demand shock triggered the supply shock. It has all been very shocking, indeed.

JIT was first implemented in the 1970s by the Japanese automaker Toyota Motor Corporation. The company’s executives decided that Toyota could adapt more quickly and efficiently to changes in demand if it did not keep any more inventory in stock than was immediately needed.

Investopedia wisely observes: “A chief benefit of a JIT system is that it minimizes the need for a company to store large quantities of inventory, which improves efficiency and provides substantial cost savings. However, if there is a supply or demand shock, it can bring everything to a halt.”

Not surprisingly, the industry for which JIT was invented has been the hardest hit by supply-chain disruptions. Automakers have been crippled by a shortage of computer chips—vital car components produced mostly in Asia. Without enough chips on hand, auto factories from India to the US to Brazil have been forced to halt assembly lines.

The pandemic clearly triggered the supply disruptions, as the transportation of parts and finished goods was impeded by sidelined Covid-stricken port workers and truck drivers. JIT depends on reliable shipping, which has been anything but that lately.

Global Supply Chains II: A Woeful Dashboard. The widespread consensus these days seems to be that the supply disruptions will last through mid-2022. Then all should be well again. That makes sense to us, but it might be wishful thinking. No one really knows how long it will take to remove all the kinks from the supply chains.

In line with the consensus view, Debbie and I are slashing our Q3 real GDP forecast to zero (from 4.0%) and cutting our Q4 estimate to 2.0% (from 3.0% saar). We are leaving the first two quarters of 2022 at 2.5% but raising Q3 and Q4 to 3.0% (from 2.5%) (Fig. 1).

We are also raising our inflation forecast. We expect the headline PCED to increase 4.5% this year and 3.5% next year. It was 4.3% y/y during August (Fig. 2). We expect it will range between 4.0% and 5.0% through mid-2022. Then it should moderate to 3.0%-4.0% during the second half of next year. We won’t be surprised if the FOMC decides to raise the Fed’s inflation target from 2.0% to 3.0% next year.

In addition to watching inflation for signs that the supply disruptions are worsening or improving, here are a few of the other key indicators we will be monitoring:

(1) Purchasing managers. September’s survey of manufacturing purchasing managers showed that in recent months there has been an unusual widening gap between the M-PMI new orders index, which is rising, and the production index, which is falling (Fig. 3). The M-PMI supplier deliveries and backlog of orders remain elevated but are down from their record highs during the early summer (Fig. 4). The M-PMI customer inventories index remains near recent record lows (Fig. 5).

(2) Regional business surveys. Like the M-PMI, indexes of unfilled orders or delivery times in the five regional business surveys conducted by Federal Reserve Banks also remain elevated during October but down from recent highs (Fig. 6). The same can be said of the prices-paid and prices-received indexes for the regions (Fig. 7).

Global Supply Chains III: A Sea of Troubles. It’s not even November yet, but already lots of parents are rushing to buy holiday gifts—because how do you explain to a kid that the L.O.L. doll they requested from Santa are stuck in Chinese warehouses? Under pressure from tight labor markets, lean inventories, and traffic jams from the points of manufacture to delivery, supply chains are clogged as never before.

The problem is touching just about everyone in the market for a new something, big or small. Kitchen cabinet deliveries are delayed. New car purchases seem to take forever. Melissa recently noticed a stark lack of shampoo options at her local Walgreens.

The solutions aren’t simple because there is not just one kink in the chain but many. Here’s a list:

(1) Global factories shutdown. When the virus outbreak occurred, mass quarantines forced factories to shut down around the globe. Since reopening, they’ve struggled to keep up with new orders. China’s manufacturing activity collapsed during February 2020 (Fig. 8). It quickly recovered since then but is stalling again now. German industrial production is lagging new orders in recent months more than ever before (Fig. 9).

(2) Lopsided demand. Consumers on lockdown in early 2020 quickly shifted their demand from services to goods. Stuck at home, many consumers renovated them or moved to bigger ones in the suburbs. Consumers also upgraded their stay-at-home entertainment and workout routines with the purchase of electronics like computers and flat-screen TVs as well as gym equipment. (See our Personal Consumption Expenditures.)

(3) Containers stuck. Finished products are piling up in manufacturing warehouses waiting to be shipped to their destined port. But shipping containers have been hard to come by. Many have been stuck in parts of the world where they are usually not found. Initially in the pandemic, during spring 2020, consumer demand slumped, and shipping lines canceled many of their routes between Asia and North America. As consumer demand returned with a vengeance during summer 2020, thousands of empty containers were stuck in the US, and exporters in China faced long waits for boxes in which to ship their goods, observed the August 4 WSJ.

Shippers “are refusing to send boxes inland to pick up their cargo because they are trying to get empty containers back to factories in Asia as quickly as possible to take advantage of historically high shipping prices for exports from the continent.” For loaded inland-bound containers, congestion on rail networks and a shortage of truck chassis, drivers and warehouse workers has led to big backups at cargo facilities.”

(4) Congested docks. Dozens of loaded container ships are floating in the waters near Los Angeles and Savannah waiting for up to two weeks to be unloaded. Early in the pandemic, Covid outbreaks among dockworkers forced shutdowns of ports. Events like the container ship blockage of the Suez Canal in March and China’s shutdown of the third-busiest container port in August after a dockworker tested positive for Covid further slowed shipping momentum.

(5) Chain gangs wanted. Retirees, quitters, and labor unions are tightening the labor market for essential logistics workers from longshoremen to truckers and rail workers alike. “Once a berth becomes available, longshoremen operating massive blue cranes lift the metal containers and position them to head inland via truck or train. Ideally, a truck driver who has been alerted to the presence of a customer’s goods arrives at a terminal to find a chassis waiting. The container is then hoisted aboard and the driver pulls the chassis to the customer’s warehouse,” explained an October 2 Washington Post article.

Some trucks bring the “containers to various hubs where the containers are loaded on trains and taken inland. When the system works properly, containers are lifted from arriving trains and placed directly onto a wheeled chassis, which is then hauled away by a local driver. The chassis is supposed to be quickly unloaded by the final customer and returned by truck to the rail yard,” said a September 3 Forbes article. But there are bottlenecks in rail freight too, largely related to a shortage of rail workers.

(6) Component problem. The imbalance between booming consumer demand for goods and strained manufacturing capacity inevitably has generated supply shortages for key raw materials and parts. For example, shortages for chemicals like resin and polymers have reduced production by paint suppliers. (August’s Hurricane Ida in Texas added to paint supplier capacity troubles). Lumber and labor shortages have slowed housing starts (Fig. 10).

Semiconductor shortages have severely impacted inventories from cars and computers to appliances and toothbrushes. German auto production staged a brief recovery earlier this year but has also been slipping again recently (Fig. 11).

(7) Hoarding for the holidays. Manufacturers and retailers are panic-ordering extra inventory just in time for the Christmas and holiday season—which has worsened the situation, noted an October 20 CNBC article. “Because the problems are well known, orders for raw materials, component parts, and finished goods are now being placed earlier than normal, which is lengthening the queue, creating a vicious cycle,” an RBC analyst quoted in the article observed. Extra inventory also means extra strain on warehouse capacity.

(8) Factories gone cold. The latest energy crises in mainland China and Europe are further disrupting global supply chains. China’s power supply shortages have interrupted the operation of many factories. Europe is in the same boat.

Santa’s sleigh may be short on gas this year.

Global Supply Chains IV: Blaming California Regs. Social media is full of stories and tweets blaming regulations in California for the supply-chain problems in the US. However, USA Today fact checked whether this is true and found the thesis to be wanting. The USA Today piece was responding to an October 13 Facebook “news” post that debunked the idea that the California port situation is caused by a driver shortage: “Not so fast: It is in part caused by a California Truck Ban which says all trucks must be 2011 or newer and a law called AB 5 which prohibits Owner Operators.”

While those regulations cited are real, USA Today found, they aren’t contributing to the supply-chain delays in California because about 96% of trucks serving California ports already are compliant. A representative for the California Air Resources Board quoted in the article said, “[A]ny truck with a 2007 or newer engine is currently in compliance.”

Another viral post on social media mentions the California Assembly Bill, a January 2020 law that required companies that hired independent contractors to reclassify them as employees. But whether this “gig worker” law applies to independent truck drivers remains in question all the way up to the Supreme Court. It is not in effect now, a CEO of a West Coast port company told USA Today.

Likewise not now in effect is a California ban on new gas-powered cars and light trucks by 2035 announced last year. Fourteen years off, that can’t be the cause of California port delays either.

While Melissa and I would have liked to have learned that California regulations were to blame, as rolling them back seems to us an easier fix than coming up with more truck drivers, our digging suggests they’re not.

Global Supply Chains V: Amazon’s Fixes. You would think that pivoting the logistics operations for a retail behemoth like Amazon during a pandemic and amid a supply-chain crisis would be as difficult as unlodging the Ever Given ship from the Suez Canal. But Amazon promises “to get customers what they want, when they want it, wherever they are this holiday season,” according to the company. Last-minute shoppers will have access to millions of items within as fast as five hours from click to doorstep in 15 metro areas.

How will the company possibly swing that at a time like this? Here’s the short list of what Amazon is doing to make good on its motto, “safety, speed, and efficiency”:

(1) Putting people and safety first. Initially during the pandemic, the slowdowns in demand for goods and factory production hit Amazon’s supply chains hard, resulting in delivery delays and out-of-stock notices, reported CNBC on September 29. But the ecommerce giant overcame the challenge as a surge in sales led to record profits in July. Turning attention away from exploratory projects and toward the supply-chain challenges at hand, senior leaders met daily “to tackle inventory issues and discuss the latest coronavirus updates,” wrote CNBC.

Amazon also picked up its hiring, bringing on thousands of new warehouse and delivery workers between March and mid-April to keep up with order fulfillment. Through June 30, Amazon’s y/y headcount grew 34%, reported CNBC.

Amazon also spent billions on coronavirus-related investments, like safety gear for workers, an internal Covid-19 testing initiative, and new processes to stem virus transmission in its warehouses.

(2) Focusing on the essentials. Amazon’s ability to flexibly manage inventory utilizing technology was a strength going into the pandemic that has proved invaluable during it. Struggling early in the pandemic to meet its promised two-day delivery window for Prime subscribers, Amazon pivoted to a pandemic-friendly logistics strategy. That included giving precedence in warehouses to high-demand items like hand sanitizer and paper towels and capping how much inventory third-party sellers may store in its warehouses, CNBC observed.

(3) Expanding internal infrastructure. Amazon’s in-house fulfillment system was robust before the pandemic, but the company has made additional investments to expand its fulfillment capabilities.

To meet new holiday season demand, “Amazon said it has increased ports of entry across its network by 50%, doubled its container processing capacity, and expanded its ocean freight carrier network partnerships to secure committed capacity into critical ports within its network. Later in the holiday season, Amazon expects to have more than 85 aircraft in its fleet to help ensure ample capacity to transport customer packages across longer distances in shorter timeframes,” according to an October 25 post in a retail supply-chain publication.

Furthermore, “Amazon has opened more than 250 new fulfillment centers, sortation centers, regional air hubs, and delivery stations in the U.S during 2021, including over 100 new buildings in September alone.”

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Less Worrisome Worry List, For Now

October 26 (Tuesday)

YRI Monday Webinar. Instead of my regular Sunday video podcast, I’ve started doing webinars on Mondays at 11 a.m. EST as a better way to interact with you. You will receive an email with the link to the webinar one hour before showtime. I aim to keep them relatively short, say about half an hour. Replays are available here. As always, we welcome your feedback.

Dr. Ed’s New Book. In Praise of Profits! is available on Amazon. Subscribers are invited to a free download of the Kindle or pdf version of my new book here. You can see key excerpts here as well.

Strategy: Be Happy. The first paragraph of my 2018 book Predicting the Markets observes: “Books don’t usually come with theme songs. But if I had to pick one for my professional autobiography, it would be “Don’t Worry, Be Happy” (1988), written and sung by Bobby McFerrin. During the 40 years that I have spent on Wall Street as an economist and investment strategist, investors benefited from great bull markets in both stocks and bonds. Yet instead of being happy, it seemed to me that most investors were worried for most of that time.”

There were lots of worried investors during September. In our September 13 Morning Briefing, we observed that a “long worry list is traditional this time of year.” The S&P 500 fell 5.2% from its record high of 4536.95 on September 2 to 4300.46 on October 4 (Fig. 1). By last Thursday, October 21, it was back up by 5.8% to a new record high of 4549.78. Joe and I are still shooting for the index to hit 4800 by the end of this year and 5200 sometime next year.

Investors may still be worried, but the stock market is happy. Let’s review why the worry list might have lightened up recently:

(1) Sectors. During September’s swoon, S&P 500 Energy and Financials outperformed the other nine S&P 500 sectors and the broader index as follows: Energy (13.6%), Financials (-0.8), Consumer Discretionary (-3.0), S&P 500 (-5.2), Consumer Staples (-5.4), Industrials (-6.0), Materials (-6.7), Information Technology (-6.7), Communication Services (-6.8), Utilities (-7.1), Real Estate (-7.6), and Health Care (-8.0). (See Table 1.)

The rebound from October 4 through October 21 was led by the Consumer Discretionary and Information Technology sectors: Consumer Discretionary (7.9), Information Technology (7.4), Materials (6.2), Industrials (5.9), S&P 500 (5.8), Financials (5.8), Real Estate (5.2), Energy (4.8), Health Care (4.5), Utilities (3.4), Communication Services (3.3), and Consumer Staples (3.0). (See Table 2.)

(2) Technicals. The percent of S&P 500 companies showing positive y/y price comparisons on October 22 was 89.5%, solidly in bullish territory (Fig. 2). Likewise bullish was the percent of S&P 500 companies trading above their 200-day moving averages (dma) that day, which was 73.3% (Fig. 3).

During September’s selloff, the S&P 500 remained above its 200-dma (Fig. 4). The S&P 500 Transportation Index briefly dipped below its 200-dma but is back above that indicator of past momentum now (Fig. 5). The Nasdaq rebounded off its 200-dma in early October (Fig. 6).

(3) Sentiment. The Investors Intelligence Bull/Bear Ratio dropped below 2.00 to around 1.85 during the first three weeks of October as the percentage of bears rose to nearly a quarter of respondents to the sentiment survey, and the correction camp rose to about a third (Fig. 7). For contrarians, these relatively high readings of investor caution are bullish. The S&P 500 VIX, a measure of stock market volatility that tends to confirm extreme readings in the Investors Intelligence bearish percentage, was relatively calm at 15.4 on Friday (Fig. 8).

(4) Valuation. The S&P 500’s forward P/E (i.e., based on the weighted average of this year’s and next year’s consensus earnings-per-share estimates) remained relatively high at 20.9 on Friday (Fig. 9). The forward P/E of S&P 500 Value was relatively cheap at 16.5 compared to Growth’s 28.1. Growth’s valuation multiple has been mostly boosted by the forward P/E of the Magnificent Five FAAMG (i.e., Facebook, Amazon, Apple, Microsoft and Alphabet/Google) stocks collectively, which was 35.4 on Friday (Fig. 10). The forward P/E of the S&P 500 excluding them was 17.8 on October 15.

(5) Earnings. During the current Q3 earnings reporting season, company managements have been saying that their costs are rising and that they are experiencing shortages of parts and labor. But despite managements’ cautious guidance, analysts’ consensus earnings estimates have remained stable for Q4 and have continued to rise for the four quarters of 2022 (Fig. 11). As a result, S&P 500 forward earnings rose to yet another record high of $217.03 per share during the week of October 21 (Fig. 12).

The S&P 500 Net Earnings Revisions Index has remained solidly in positive territory—at around 15.0 during October so far—as it has for the previous 10 months (Fig. 13).

(6) Liquidity. It is widely expected that the Fed will start tapering its purchases of bonds following the November 2-3 meeting of the FOMC and stop doing so by mid-2022. Melissa and I agree with that assessment. The 10-year bond yield has reflected this outlook, rising from a recent low of 1.19% on August 4 to 1.63% on Monday.

Nevertheless, there is ample liquidity in the Fed’s punch bowl to keep the party going in the stock market. The ratio of M2 to nominal GDP has been hovering around a record 90% in recent quarters through Q2 (Fig. 14). Demand deposits in M2 have soared by $2.9 trillion to a record $4.5 trillion during the 19 months of the pandemic through August (Fig. 15).

(7) Fiscal policy. The Democrats in Congress are likely to cut back on their fiscal spending plans to get the votes needed to enact them through the reconciliation process. The plans will still be huge and stimulative. The debt ceiling is likely to be raised with the reconciliation process. On Sunday, House Speaker Nancy Pelosi (D-CA) was asked about using reconciliation to do so on CNN’s State of the Union. She responded, “That’s one path, but we’re still hoping to get bipartisanship.”

(8) Energy crisis in China. China is the world’s top coal miner and consumer, and top emitter of CO2. The Chinese government has pledged to slash its carbon intensity—i.e., CO2 emissions per unit of GDP—by 2030, to become carbon neutral by 2060, and to halt its construction of coal power plants abroad.

For now, however, the country has more immediate energy concerns. Winter is coming, and China is already having a below-average cold snap. Its winter heating needs are about to soar. The government is desperately scrambling to get more coal to generate more electricity after the country’s recent power crisis, which sparked energy rationing and an economic growth slowdown. Coal-fired power accounts for roughly 60% of China’s total electricity generation.

On Friday, President Xi Jinping said China will make efforts to ensure the stable supply of coal and electricity for economic and social use. He also called for more exploration and development of oil and gas, state media reported. China’s thermal coal futures plunged on Friday following Beijing’s strongest intervention in years to boost supply of the commodity—and thereby slow runaway prices for it—amid a widespread power crunch.

The most actively traded futures price for thermal coal in China plunged 30% below a record high hit on Tuesday. That brought it down nearly 15% for the week, the biggest weekly drop since May, reported Reuters.

(9) Energy crisis in Europe. In an excellent October 24 Bloomberg Opinion article on the climate-change policymaking, Stanford University professor Niall Ferguson observes that the European and British decisions not to invest in hydraulic fracturing (“fracking”) and the German decision to renounce nuclear power after the 2011 disaster in Fukushima, Japan, have left Europe dangerously dependent on gas imported from Russia.

The Nord Stream 2 pipeline is completed and ready to pump Russian gas to Europe, but nothing is flowing yet because the project is still awaiting clearance from Germany’s energy regulator. On Friday, the regulator suggested clearance will be coming soon.

(10) Property bubble in China. Evergrande is still in business. The Chinese property developer surprised international investors and dodged a default by making $83.5 million in overdue interest payments on around $2 billion of outstanding dollar bonds, the WSJ reported yesterday. It also said construction is progressing at some of its residential projects in southern China.

(11) Pandemic. Of course, the pandemic isn’t over. However, the latest wave of the pandemic in the US peaked on September 8 based on the 10-day moving average of hospitalizations, which since has fallen by 46% through October 22 (Fig. 16). The percent of Americans who have received at least one dose of the vaccine is up to 84%.

(12) Inflation and supply disruptions. Inflation is the one item on the worry list that has gotten worse lately. No one views it as a transitory problem related to the base effect any longer. Instead, the consensus view is that it’s a more persistent problem owing to global supply-chain disruptions and ongoing shortages of labor.

An argument can be made that inflation will prove to be a long-lived problem if a wage-price spiral unfolds. Workers have been getting bigger wage increases recently, but they are also seeing the prices they pay go up just as fast.

September data show that the percentage of small business owners planning to increase workers compensation in the next three months rose to a record high 30.0% (Fig. 17). This series is highly correlated with the y/y growth rate of wages and salaries in the Employment Cost Index. The same survey found that 46.0% of them are both raising average selling prices and planning to do so (Fig. 18).

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Phillips Curve Making a Comeback?

October 25 (Monday)

YRI Monday Webinar: ‘Ask Dr. Ed.’ It’s time for something new and slightly different: Instead of the Sunday video podcast, I’m going to try a webinar on Mondays at 11 a.m. EST as a better way to interact with you. You will receive an email with the link to the webinar one hour before showtime. I will aim to keep them relatively short, say about half an hour. Replays will be available here. As always, we welcome your feedback.

Dr. Ed’s New Book. In Praise of Profits! is already the #1 New Release in Stock Market Investing on Amazon. The main theme is that “profits” isn’t a four-letter word but rather the ultimate source of economic prosperity. Subscribers are invited to a free download of the Kindle or pdf version of the book here. You can see key excerpts here as well.

US Labor Market I: The Great Resignation. More and more American workers are singing Johnny Paycheck’s song “You Can Take This Job and Shove It!” During August, a record 4.3 million workers quit their jobs (Fig. 1). Over the past 12 months through August, quits totaled a record 43.4 million (Fig. 2).

Here’s a comparison of the number of quits during August in selected industries on a seasonally adjusted basis, in thousands: total (4.3 million), accommodation & food services (892), retail trade (721), professional & business services (706), health care & social assistance (534), manufacturing (306), construction (199), and state & local education (70) (Fig. 3).

How can we explain the Great Resignation? Actually, it isn’t much greater than the previous record wave of 42.2 million quits over the 12 months through January 2020. The labor market was hot back then. It is even hotter now, as evidenced by the 10.4 million job openings during August, well above the pre-pandemic record high of 7.6 million during November 2018 (Fig. 4).

Obviously, some of the quitters switched less-than-ideal jobs for better ones; other quitters are officially unemployed (counted as such if they are seeking another job); and still others dropped out of the labor force entirely.

Here’s a list of the main reasons that people are quitting their jobs:

(1) Better pay. Many of the job switchers must be doing so to get better pay. The Atlanta Fed’s Median Wage Growth Tracker showed that during September job switchers saw their wages grow by 5.4% y/y, while job stayers received increases of 3.5% y/y (Fig. 5). The 190bps spread between these two measures was the highest since the late 1990s, when the labor market was also as hot as it is today (Fig. 6).

(2) Stay-at-home caregivers. Daycare centers are short of workers. It’s becoming harder to find quality affordable daycare, giving some parents added reason to stay home with young children rather than return to work. Some people may also have quit their jobs to provide elder care to family members rather than exposing them to the risk of catching Covid in assisted-living facilities.

(3) Jobs are more stressful. Employees have to work harder and longer hours because their employers are understaffed. Pandemic border closures have reduced the availability of legal immigrant workers. Jobs that entail dealing with the public, particularly in retailing and food services, have become especially stressful owing to cranky patrons amid the staffing shortages.

(4) Retirements. The Baby Boomers are retiring. The oldest of them turned 65 during 2011 and 75 during 2021 (Fig. 7). The pandemic probably caused many Baby Boomers who had been working past the traditional retirement age of 65 to stop working. Over the past 19 months through September, the number of seniors in the labor market fell by 366,000 compared to the 132,000 increase during the previous 19 months. The number of seniors not in the labor force increased by 3.0 million over the past 19 months through September compared to 2.7 million during the previous 19 months.

(5) Self-employed. Some workers who quit have become self-employed. The number of them peaked at a record 16.6 million this July (Fig. 8). It since has edged down to 16.4 million during September.

(6) Unemployment benefits. Federal pandemic relief dollars that many unemployed workers collected until September may have made a lot of them less eager to return to work. Initial unemployment claims have been below 300,000 per week since the week of October 9.

(7) Pandemic-related. Some workers have quit because they are sick with Covid or are caring for someone who contracted the virus.

US Labor Market II: Chronic Labor Shortages. As discussed above, there are lots of good explanations for why people are quitting their jobs and why employers have so many jobs openings that are hard to fill. However, the most compelling structural reason for widespread labor shortages is a demographic one, as Melissa and I often discuss. Consider the following:

(1) Working-age population. The working-age civilian population 16 years old and older is growing at a slower pace, mostly because Baby Boom seniors are retiring at a faster pace while the rest of the working-age population (i.e., excluding seniors) stopped growing in recent years (Fig. 9). The average annualized growth rate over the past 60 months (i.e., the five years through September) of the total working-age population was only 0.6%, while the same excluding seniors was -0.1% (Fig. 10).

(2) Labor force. The civilian noninstitutional labor force reflects the underlying population trends, with the five-year average growth rate at 0.2% through September (Fig. 11). Excluding the seniors, who undoubtedly will continue to retire at a faster pace, the comparable growth rate is zero.

US Labor Market III: Productivity to the Rescue? Labor shortages are likely to be long term rather than short term in nature. So recent upward pressures on wages are likely to persist.

Prior to the pandemic, Fed officials were surprised that their easy monetary policies, which succeeded in lowering the unemployment rate to 3.5% during the first two months of 2020, failed to boost wage and price inflation as they had hoped. They concluded that the Phillips Curve, which posits an inverse relationship between the jobless rate and inflation, had flattened.

Since the pandemic, the Phillips Curve has risen from the dead, as the unemployment rate fell and both wage and price inflation have accelerated. Given that labor shortages are chronic, won’t that mean that we’re in for a long-lasting wage-price spiral like the one during the 1970s (Fig. 12)?

Not necessarily, because the simplistic Phillips Curve model is missing an important determinant of inflation, i.e., productivity. A tighter labor market can boost wage inflation, but it also can stimulate productivity. In this scenario, nominal wages will rise without putting as much upward pressure on consumer prices.

An alternative model that adjusts for this is my Real Phillips Curve Model, which compares the unemployment rate to the growth rates of both productivity and inflation-adjusted hourly compensation. Here’s what it tells us:

(1) With few exceptions, there has been an inverse correlation between the unemployment rate and the growth rate of productivity (using the 20-quarter percent change at an annual rate) (Fig. 13). Productivity growth tends to be best (worst) when the jobless rate is low (high). That makes sense: Unemployment tends to be high during recessions, when weak demand depresses productivity because output falls faster than hours worked.

(2) The 1970s was a decade of relatively high unemployment, resulting in a sharp drop in productivity growth, which contributed to the decade’s wage-price spiral. During the 2020s, I believe that labor will continue to be relatively scarce, which is why I expect a productivity boom over the remainder of the decade, which should help to subdue price inflation.

(3) Interestingly, there is also an inverse correlation between the unemployment rate and inflation-adjusted hourly compensation (Fig. 14). High unemployment depresses real pay because it depresses productivity. Low unemployment boosts productivity, which boosts real pay without boosting consumer price inflation.

(4) I conclude that labor shortages are likely to depress the unemployment rate while boosting productivity growth. If so, then a 1970s-style wage-price spiral isn’t likely to occur.

Movie. “Dune” (+) (link) is a sci-fi flick based on the 1965 book with the same title. My wife enjoyed the movie more than I did. That’s probably because I didn’t read the book, but she did and told me that the movie’s script is true to the original. She is also a Trekkie, while I am not even though I did quote Mr. Spock in my new book, saying “Live long and prosper.” The movie is visually impressive, especially since we saw it on an IMAX screen. It’s also very dusty, as it was filmed mostly in the deserts of Jordan and Abu Dhabi. It’s reminiscent of the “Star Wars” movies and “Lawrence of Arabia.” I would love to fly in one of the film’s dragonfly-like helicopters. I just don’t understand why the battle scenes included old-fashioned hand-to-hand sword fights instead of fights using laser swords or guns. Climate-change activists undoubtedly would see this film as prophetic.

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Radioactive Briefing

October 21 (Thursday)

Dr. Ed’s New Book. In 2018, I published Predicting the Markets: A Professional Autobiography. I’ve followed that up with a series of Topical Studies examining the issues that I discussed in my book but in greater detail and on a more current basis. The latest one is In Praise of Profits! The main theme is that “profits” isn’t a four-letter word but rather the ultimate source of economic prosperity. The paperback is available on Amazon. Subscribers are invited to a free download of the Kindle or pdf version of the book here. You can see key excerpts here as well.

Energy, Shipping & Labor I: The Fallout Continues. With the number of container ships bobbing off the coast of Los Angeles rising to 100, the US supply chain hasn’t improved over the week since President Joe Biden pushed the docks to operate 24/7. Retailers’ shelves continue to look sparse in some locations. And we can’t believe it, but toilet paper availability has once again become a hot topic. Last week, our local Costco lacked toilet paper entirely, while Target had only a private-label brand available on an otherwise empty shelf.

In addition to logistical issues, transportation companies are facing higher fuel costs, with crude oil futures almost triple the price they fetched during the start of the Covid crisis. Labor pressures are bubbling up too, and a number of unions are pouncing on an opportunity to advocate for higher wages and better benefits. The resulting higher expenses are being called out by an increasing number of companies as they report Q3 earnings. Let’s look at what some had to say:

(1) Rising costs bite P&G. Consumer products company Procter & Gamble increased its fiscal 2022 (ending June 30) estimates for commodity and freight expenses by $400 million since its last update three months ago. It’s now forecasting higher commodity costs of $2.1 billion after tax and higher freight costs of $200 million. Those estimates totaled just $1.9 billion three months ago, an October 18 FT article reported.

P&G has been paying more for resin, pulp, packaging, and other raw materials, reported CFO Andre Schulten on the recent September-quarter conference call. The company also has been experiencing truck driver shortages and rising costs for diesel fuel. With plans to increase prices, P&G maintained its core earnings growth outlook for the current fiscal year at 3%-6%.

“Supply chains are under pressure from tight labor markets, tight transportation markets, and overall capacity constraints,” said Schulten “Inflationary pressures are broad-based and sustained.”

(2) Higher fuel prices hurt Delta. Delta Air Lines reported a profit in Q3 but warned that higher fuel prices would result in a “modest” loss in Q4 despite an expected pickup in traffic.

The airline expects traffic will rise in Q4 and is boosting its capacity estimate to 80% of 2019 levels from 71% in Q3. However, Delta is forecasting the average price of fuel per gallon will rise to $2.25-$2.40 per gallon in Q4, up from an average of $1.97 in Q3, which will mean the airline will report a loss again in the last quarter of the year.

(3) Labor gaining confidence. The rising cost of labor as well as the inability to hire enough workers is noticeably impacting companies’ bottom lines. Well aware of this trend, workers and the unions appear to have realized that their negotiating leverage has increased, and a number of companies are facing strikes or the threat thereof.

“With companies nationwide struggling to fill jobs and grappling with supply chain tie-ups, union officials say they are seizing the moment to regain benefits they lost in the late 1990s, when an era of assembly-line layoffs and outsourcing diminished unions’ leverage,” an October 14 Washington Post article reported.

This week, real estate firm Zillow grabbed headlines when it said its home-flipping unit, Zillow Offers, wouldn’t buy any homes for the remainder of the year. In a press release, Zillow blamed a lack of labor and materials for the backlog it was experiencing in renovations and operational capacity.

Restaurant company Brinker International, owner of Chili’s and Maggiano’s Little Italy, reported sales and traffic for its fiscal Q1 (ended September) that hit analysts’ targets. However, at 34 cents a share, earnings were almost half of the 69 cents analysts expected. Brinker blamed labor and commodity “challenges” that affected the company’s margins and bottom line more than management had expected, an October 19 press release stated.

At four Kellogg food manufacturing plants, 1,400 union workers have been on strike since October 5 “in an attempt to force the company to end forced overtime work and stop it from redrawing the workers’ benefits scheme after its previous contract expired on October 5,” an October 12 FT article reported. Employees are looking for guarantees that they’ll continue to receive cost-of-living wage increases that match inflation and high-quality health insurance benefits.

The Kellogg strikers were followed by more than 10,000 John Deere workers at 14 plants who have been striking since October 14. The farm equipment maker’s workers rejected the company’s offer to increase wages by 5%-6%, noting that the company can’t hire enough employees with the wages they’re currently offering, the above Washington Post article noted.

Workers at Starbucks coffee houses in the Buffalo, NY area announced in August that they are forming a union and have asked the National Labor Relations Board to hold elections on union representation. There have been other attempts to unionize Starbucks employees in the US, but so far none have been successful.

And in Hollywood, a union representing production crew workers negotiated a three-year contract with film and TV studios after threatening to strike. The workers will receive a minimum number of hours of rest between shoots, pay increases, and a commitment by companies to fund a $400 million deficit in the IATSE pension and health plan without imposing higher premiums or increasing the cost of coverage, an October 16 NYT article reported. Studios will also give a day off to crews on Martin Luther King’s birthday.

Energy, Shipping & Labor II: The Fed Is Aware. The Federal Reserve’s October Beige Book, a summary of economic conditions across the 12 Fed districts, released yesterday, makes clear that the Fed understands the challenges companies are facing. Economic activity, which grew at a modest to moderate rate, was “constrained by supply chain disruptions, labor shortages, and uncertainty around the Delta variant of COVID-19,” the report stated. Rising wages and input costs were frequently noted in the report, as were the price increases companies were able to pass along to their customers.

Here’s a look at some of the report’s details:

(1) Workers needed. A lack of employees is holding back economic growth. “Employment increased at a modest to moderate rate in recent weeks, as demand for workers was high, but labor growth was dampened by a low supply of workers,” the Beige Book stated. Labor supply was “particularly low” in technology and transportation firms. And many retail, hospitality, and manufacturing firms cut hours or production due to lack of workers. High turnover, childcare issues, and vaccine mandates contributed to the problem.

Companies are responding to the tight labor market by increasing training to expand the candidate pool and increasing automation. The report also cited “robust wage growth” employed by companies to attract and retain workers. “Many also offered signing and retention bonuses, flexible work schedules, or increased vacation time to incentivize workers to remain in their positions.”

(2) Prices significantly elevated. The Beige Book reported “significantly elevated” prices in most districts. Prices were being pushed up by the rising demand for goods and raw materials, supply chain bottlenecks, transportation and labor constraints, and commodity shortages. The report highlighted the rising prices of steel, electronic components, and freight costs.

Many companies have been able to raise selling prices to customers thanks to strong demand. Auto sales were “widely reported as declining due to low inventory levels and rising prices.” Some Fed districts expected prices to remain high or increase further, while others forecast a moderation in the rate of price increase over the next 12 months.

Disruptive Technologies: The Nuclear Option. The spike in energy prices has made it clear that the transition to “green” energy is going to be trickier than many expected. The price of Brent crude oil futures is up 64% ytd, the price of natural gas futures has risen 100% over the same period, and there has even been a 114% ytd jump in the price of coal through October 8 (Fig. 1 , Fig. 2, and Fig. 3). Prepare to wear sweaters this winter.

The energy conundrum has countries and investors taking a second look at nuclear energy despite concerns about safety and nuclear waste. England and France are making nuclear energy a pillar of their energy strategies. And investors are sending the price of uranium into orbit. Here’s our look at some of these latest developments in the nuclear industry:

(1) Getting some respect. France and the UK are embracing nuclear energy as a carbon-free option for producing energy. Nuclear power provided about 16.8% of Britain’s electricity generation in 2019 but more than 70% of France’s. Nuclear provides France with some of the lowest-cost electricity in the EU.

The UK’s plan to reach net zero carbon emissions by 2050 is expected to rely on building more nuclear power plants, which is necessary because almost all of the country’s existing nuclear plants, some of which date back to the 1950s, are scheduled to be retired by 2035.

One large nuclear plant is under construction in the UK, with two more on the drawing board: a 3.2 gigawatt (GW) plant in Sizewell, England to be built by French utility EDF and a 3.0 GW plant in Wylfa to be built by Westinghouse, according to an October 15 FT article.

In addition to supporting the construction of those large plants, the UK government is expected to support the less expensive and less risky buildout of small modular reactors (SMRs). We discussed SMRs in the February 18 Morning Briefing, which looked at some of the new technological developments in the nuclear industry. SMRs could be used to help electrify communities or provide the energy to an industrial plant.

Earlier this month, French President Emmanuel Macron signaled his commitment to nuclear energy by pledging to invest €1 billion in nuclear power by 2030, including an intention to roll out SMRs, an October 12 FT article reported. This is a turnabout from Macron’s stance on nuclear energy earlier in his presidency: In 2012, in the wake of the explosion at Japan’s Fukushima plant, he announced plans to shut 14 reactors and reduce nuclear energy to 50% of France’s electricity mix.

(2) Investors sniff out a nuclear revival. The prices of uranium and uranium-related stocks have jumped recently. The spot price of uranium hit $47 a pound, up from $32 at the start of August but still well below the 2007 peak of $137, an October 19 WSJ article reported.

Part of the rise in prices may reflect growing expectations that we will need to depend on nuclear energy as a steady source of power in a world filled with renewable energy sources. The price action represents a major reversal from the years after the Fukushima explosion, which led Germany to accelerate the closure of its nuclear plants and miners to reduce production. Hedge funds betting on uranium have been winners.

Prices also may have benefited from the creation of Sprott Physical Uranium Trust by Sprott Asset Management in July. The new exchange-traded trust purchases large stockpiles of uranium. Its share price, while down from September’s peak of C$18.45, has risen almost 40% since it began trading on July 19 to C$15.21 as of Tuesday’s close.

Another trust was formed this week by Astana International Financial Centre. The $50 million ANU Energy OEIC will hold physical uranium sourced from Kazatomprom, the world’s largest producer of uranium, which will also own an equity stake in the trust, according to a press release.

There’s also speculation that uranium and uranium-related securities jumped because they are part of a momentum trade favored by retail investors. The NorthShore Global Uranium Mining ETF has soared 123.6% ytd through Tuesday’s close, and the Global X Uranium ETF is up 89.2% over the same period. Likewise, shares of Canadian uranium company Cameco have risen almost 100% ytd through Tuesday’s close.

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Recession Assessment

October 20 (Wednesday)

Dr. Ed’s New Book. In 2018, I published Predicting the Markets: A Professional Autobiography. I’ve followed that up with a series of Topical Studies examining the issues that I discussed in my book but in greater detail and on a more current basis. The latest one is In Praise of Profits! The main theme is that “profits” isn’t a four-letter word but rather the ultimate source of economic prosperity. The paperback is available on Amazon. Subscribers are invited to a free download of the Kindle or pdf version of the book here. You can also see key excerpts here.

US Economy: Hypersonic Business Cycle? Debbie and I have observed that the current business cycle has been on a cocktail of steroid and speed. Last year’s economic downturn was extremely severe, but the recession lasted only two months. A recession that short had never happened before. Real GDP bottomed during Q2-2020 and fully recovered to its Q4-2019 pre-pandemic record high by Q2-2021. That was a remarkably fast recovery.

The economic expansion phase started with a boom, as real GDP rose 6.3% and 6.7% (saar) during the first two quarters of this year (Fig. 1). The consumer-led demand boom quickly triggered widespread supply disruptions, which have caused inflation to soar in recent months.

The supply bottlenecks are already depressing real GDP growth. The Atlanta Federal Reserve Bank’s GDPNow tracking model showed real GDP growing at just 0.5% during Q3 as of October 19, down from 1.2% on October 15. What’s next—another recession? We don’t think so. We expect that global supply-chain problems will clear up by the spring of next year, resulting in stronger economic growth as pent-up demand is met by ample supplies again.

Nevertheless, the hands-down winners for calling the next recession are David G. Blanchflower, a professor of economics at Dartmouth College and a former member of the rate-setting committee of the Bank of England, and Alex Bryson of University College London. In an October 7 paper titled “The Economics of Walking About and Predicting US Downturns,” they point to declining consumer confidence as a bellwether for recession. Their research indicates that a recession could occur within the next year and a half: “We show consumer expectations indices from both the Conference Board and the University of Michigan predict economic downturns up to 18 months in advance in the United States.”

It’s true that the average of the expectations indexes from the Consumer Confidence Index and the Consumer Sentiment Index is one of the 10 components of the Index of Leading Economic Indicators (LEI). It did drop sharply during September (Fig. 2). However, the overall LEI rose sharply during August, the sixth consecutive increase to new record highs (Fig. 3). A rule of thumb is that the LEI tends to fall for three consecutive months before the onset of recession. Odds are that the LEI will show another gain during September when it is reported on Thursday.

Fed: Eight Big ‘Buts.’ “Hedging their bets” is the best way to describe comments from participants in the September 22 Federal Open Market Committee (FOMC) meeting. The Minutes released last week discussed promising data on growth and unemployment. But several big factors were cited as weighing on the outlook.

“Most” Fed governors and regional presidents—i.e., “participants” in the meeting—remarked that the standard of “substantial further progress” toward the Fed’s price stability goal had been met, the Minutes said, and “many” participants felt that the labor market had “continued to show improvement.”

Nevertheless, these participants qualified that progress with several big “buts.” The good news is that aggregate demand is strong. But the bad news is that the growth is constrained by supply-side factors, causing higher-than-expected inflation. More bad news is that the bottlenecks are not expected “to be fully resolved until sometime next year or even later.”

Improvements on the employment front were caveated with the slow progress on labor force participation, which is causing labor shortages. That’s despite the reopening of schools and the expiration of the federal boost to unemployment benefits, the FOMC said. This “likely reflected in part concerns about the resurgence of the virus” and “childcare challenges.” Last, but not least, economic-related risks from the Covid-19 health crisis remain, said the FOMC.

Normally if the Fed hedges a positive outlook, that implies accommodative monetary policy should continue, but maybe not in this case. They can’t solve for these downside risks to the economic outlook, the FOMC officials fully admit, and could make things worse if they tried. Participants “noted that adding monetary policy accommodation at this time would not address [supply or labor] constraints or that the costs of continuing asset purchase might be beginning to exceed their benefits.” In other words, the Fed will start tapering its bond purchases soon, most likely right after the next FOMC meeting, on November 2-3.

Here’s a bigger list of upbeat developments noted by participants along with their associated “buts”:

(1) Business sector demand strong, but supply constrained. “[P]articipants observed that firms in a number of industries were facing challenges keeping up with strong demand due to widespread supply chain bottlenecks as well as labor shortages.” They noted: “The supply chain bottlenecks were creating challenges for a number of manufacturers,” including chip shortages for automakers and port congestion and ground transportation delays for retailers.

(2) Employment stronger, but has slowed. “After a rapid pace of almost 1 million per month in June and July, job gains slowed to 235,000 in August as the resurgence of COVID-19 cases weighed on employment in high-contact service sectors, particularly in the leisure and hospitality sector,” participants stated.

(3) Labor force participation low, but could improve. “Meanwhile, the labor force participation rate was little changed, remaining at a lower level than its pre-pandemic values … Various participants suggested that a complete return to pre-pandemic conditions was unlikely, as the pandemic had prompted reductions in the workforce that were likely to persist, including [many] retirements and other departures from the labor force.”

(4) Inflation elevated, but that’s transitory (maybe). “Inflation was elevated, largely reflecting transitory factors.” Nevertheless, participants “marked up their inflation projections, as they assessed that supply constraints in product and labor markets were larger and likely to be longer lasting than previously anticipated.” Furthermore, wage inflation is persisting, with labor shortages “causing firms to reduce hours and scale back production while also leading employers to provide incentives to attract and retain workers.”

(5) Consumer spending promising, but constrained. “The spread of the Delta variant was weighing on spending for some consumer services, and low inventories and high prices due to supply constraints were restraining spending on many goods, most notably motor vehicles. Nonetheless, participants expected the accumulated stock of savings, the release of pent-up demand, and progress on vaccinations to continue to support household spending in coming months.”

(6) GDP strong, but not as much as expected. Participants “marked down their projections of real GDP growth for the year, pointing to a reassessment of the severity and likely duration of supply constraints or of the effects of the spread of the Delta variant on the economy. Still, participants foresaw rapid growth this year.”

(7) Business investment looking up, but inventory still low. “A couple of participants noted that inventories-to-sales ratios were at or near record-low levels in many industries, and the need to rebuild them would boost business investment going forward.”

(8) Vaccinations have progressed, but risks remain. Participants noted that “the path of the economy continued to depend on the course of the virus. Progress on vaccinations would likely continue to reduce the effects of the public health crisis on the economy, but risks to the economic outlook remained.” The pace of hospitalizations has been falling quickly in recent weeks (Fig. 4).

Climate Central Planners: Good Friends Fighting the Good Fight. “Good friends” is how European Central Bank (ECB) President Christine Lagarde has characterized her relationship with US Treasury Secretary Janet Yellen. She is also good friends with Fed Governor Lael Brainard. Lately, it seems that Lagarde and Brainard have been spending quality time together.

Together, they are working on climate policy through the Network of Central Banks and Supervisors for Greening the Financial System. Both are passionate about doing what they can as central bankers about the climate change crisis discussed in the Sixth Assessment Report by the Intergovernmental Panel on Climate Change. The report, which both have discussed at recent speaking engagements, noted that “if global warming increases, some compound extreme events with low likelihood in [the] past and current climate will become more frequent, and there will be a higher likelihood that events with increased intensities, durations and/or spatial extents unprecedented in the observational record will occur.”

But what role do central bankers have to play in climate change? Lagarde and Brainard seem to think it goes without question that monetary policy leaders should have a hand in setting global climate policy—indeed that they have a responsibility to vulnerable communities around the world to do so.

If these two have their way, corporations had better prepare to comply to lots more environmental, social, and governmental (ESG) reporting requirements. They may have to be stress-tested for climate-change scenarios, like rising temperatures and sea levels. Consider the following:

(1) Lagarde. Klaus Schwab, the executive chairman of the World Economic Forum, recently discussed the Covid-19 recovery, climate change, inequality and more with Lagarde. During the discussion, Schwab asked Lagarde: “[W]hat can institutions like the ECB and also central banks do to make monetary policy really contribute to a healthier life and wholesome planet?”

She answered: “The fight against climate change should be one of the considerations that we take when we determine monetary policy … Because obviously, climate change has an impact on price stability.” She noted that climate change outcomes like droughts and rising sea levels affect agricultural production, where people live, the cost of living, and even asset valuation because they involve underappreciated risks. She submitted that such risks should be “better identified, together with the risks that they carry.”

Concluding her answer, Lagarde said: “[T]o be firm … to have a way of life, we need life. And in the medium term, … major threats on the horizon …could cause the death of hundreds of thousands of people.” She added that “hard decisions” have to be made, “such as pricing carbon emissions” and new regulations that will make things more expensive. She thinks that “the trade-off that we reach will probably require some redistribution” because “less privileged people” are more exposed to climate change.

(2) Brainard. The Fed “is carefully considering the potential implications of climate-related risks for financial institutions and the financial system,” Brainard said during an October 7 speech titled “Building Climate Scenario Analysis on the Foundations of Economic Research.” “The future financial and economic consequences of climate change will depend on the severity of the physical effects and the nature and speed of the transition to a sustainable economy,” she said, pointing to the “growing costs associated with the increasing frequency and severity of climate-related events.”

Financial instability could even result from extreme weather events, she noted, if they cause sudden asset price changes: “The cumulative effects associated with climate change could lead to irreversible ‘tipping points’ that introduce new climate shocks and change the relationships between climate-related shocks and economic variables. Tipping points, such as melting ice sheets and loss of permafrost or forests, have the potential to create large disruptions in weather systems, regional water supplies, and the habitability of large land masses,” she stated.

To get ahead of the instability, Brainard proposed looking at climate scenario analysis to “help with risk identification and suggest useful lessons to inform subsequent improvements in modeling, data, and financial disclosures.”

We are all climatologists now, and our monetary central planners now double as climate central planners.

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The Fed’s Squid Game

October 19 (Tuesday)

US Economy: Green Light, Red Light. The Fed’s ultra-easy monetary response to the pandemic has provided a very bright green light for the demand side of the economy. It has allowed fiscal policy to provide lots of relief checks that caused the federal budget deficit to balloon. But the checks also fueled a V-shaped economic recovery without pushing up interest rates, so far, even though inflation has certainly rebounded.

The Fed’s pandemic response has also given a very bullish green light to the stock and commodity markets, by lowering the federal funds rate down to zero on March 15, 2020 and following that up just one week later with QE4ever on March 23.

When inflation started to soar earlier this year, Fed officials didn’t waver but kept the bright green light steadily shining. They did so by claiming that y/y price comparisons were boosted mostly by the “base effect,” causing a transitory increase in inflation. But now, they’ve replaced the steady green light with a flashing orange one.

In other words, Fed officials have acknowledged just recently that inflation is turning out to be more persistent and that the base effect no longer applies as it did from March through August. Their explanation now is that supply bottlenecks are lifting inflation. The bottlenecks too should be transitory, they say. But just in case, they are hedging their bets: Fed officials now are signaling that tapering will start soon and end around mid-2022, just in case the bottlenecks persist and they have to start raising interest rates to battle a far more persistent wage-price spiral than expected. In other words, we should all be ready for the Fed to turn on at least a flashing red light during the second half of next year.

Consider the following:

(1) Powell is frustrated. In our October 4 Morning Briefing titled “A Spell of Stagflation,” Melissa and I wrote: “[T]he recent heightened levels of inflation have proven to be more persistent and less transitory than Fed officials had predicted. Last Wednesday [September 29], Fed Chair Jerome Powell said, ‘It’s also frustrating to see the bottlenecks and supply chain problems not getting better—in fact at the margins apparently getting a little bit worse. We see that continuing into next year probably, and holding up inflation longer than we had thought.’’ He said so during a panel discussion hosted by the European Central Bank.

He was no longer talking about the temporary base effect but about a more persistent problem with global supply chains. He didn’t mention that ultra-easy monetary and fiscal policies have been overheating demand, thus contributing to the supply bottlenecks and resulting in higher inflation.

(2) Word count. The Minutes of the September 21-22 meeting of the FOMC, released on October 13, mentioned the words “bottlenecks” and “shortages” nine times each. The word “taper” was mentioned eight times. For example, the Minutes noted: “With respect to the business sector, participants observed that firms in a number of industries were facing challenges keeping up with strong demand due to wide-spread supply chain bottlenecks as well as labor shortages.”

(3) Lots of liquidity. Since the week of March 18, 2020 through the October 6 week of this year, the Fed’s holdings of US Treasury and agency securities increased by $4.0 trillion (Fig. 1). All those purchases boosted commercial bank deposits and caused the banks to increase their holdings of the same type of securities by $1.3 trillion over the same period because loan demand has been weak.

Demand deposits in M2 soared by $2.9 trillion from February 2020 to a record $4.5 trillion through August of this year (Fig. 2). They are up 100% on a y/y basis (Fig. 3). The ratio of M2 to nominal GDP has been hovering around a record 90% for the past five quarters through Q2 (Fig. 4). In other words, M2 is equivalent to almost a year’s worth of nominal GDP. The Fed’s punch bowl remains full, brimming with rum punch.

(4) Bottlenecks and shortages. The demand shock resulting from the end of last year’s lockdowns and the massive fiscal and monetary stimulus triggered a supply shock resulting in bottlenecks, shortages, and rapidly rising prices. Industrial production in the US declined 1.3% m/m in September, as supply-chain disruptions and lingering effects of Hurricane Ida weighed on manufacturing and mining output during the month. This decline is the sharpest since February, when severe winter weather in the South and central region of the country disrupted factory activity. In August, industrial output fell by a revised 0.1% versus a 0.4% rise previously estimated.

Manufacturing output—the biggest component of industrial production—fell by 0.7% m/m in September. Motor vehicle and parts production decreased by 7.2% amid the shortage of semiconductors (Fig. 5). The good news was that output of industrial equipment and information processing equipment rose 1.2% m/m and 0.1% m/m—with the latter at a new record high (Fig. 6).

The supply-chain problems are global. Industrial production fell 1.6% m/m during August in the Eurozone. One of the steepest declines was in Germany, where manufacturing output dropped 4.1% (Fig. 7). However, industrial output rose 1.0% in France and 0.1% in Spain.

In Germany, factory orders remain on a rising trend, despite August’s dip, while production has been declining in recent months (Fig. 8). Germany’s large auto industry has been forced to idle production and put thousands of workers back on furlough due to shortages of materials, particularly semiconductors (Fig. 9).

In the US, survey readings on regional business conditions in October are available only from the New York Federal Reserve Bank so far. Unfilled orders and slow delivery times remained elevated, and so did prices-paid and prices-received indexes.

(5) Inflation. So in recent weeks, the consensus outlook for inflation has evolved in the same way as the Fed’s outlook has. Instead of transitory, inflation is looking more persistent as a result of the supply bottlenecks that are widely expected to persist through the first half of next year. If so, then economic growth should get a boost in the second half of 2022 and inflationary pressures should abate at the same time.

Meanwhile, Debbie and I should note that both the headline and core CPI inflation rates, on a three-month annualized basis, have diminished, to 4.7% through September from a recent peak of 9.3% during June and to 2.7% during September from a recent peak of 10.2%, respectively (Fig. 10).

Most of this improvement in fact is attributable to the moderation of prices most affected by the base effect: used cars and trucks (-8.1% down from a recent high of 121.8%), gasoline (26.4, 98.8), apparel (-2.8, 9.0), lodging away from home (9.3, 62.4), airfares (-60.3, 84.3), and truck & car rental (-61.1, 182.2).

On the other hand, here are some September CPI readings that remain disturbingly high or have been moving higher: new vehicles (17.2%), motor vehicle parts & equipment (14.6), household furniture & bedding (16.4), household appliances (12.3), food (8.2), rent of primary residence (3.7), and owners’ equivalent rent (3.9). (See our CPI Inflation Components (3-month basis).

Strategy I: Red Light for Stock Bulls? The Fed’s flashing orange light isn’t going to stop the stock markets bulls from charging higher through at least mid-2022, when the Fed might finally start raising the federal funds rate. Both the 12-month forward futures for the federal funds rate and the two-year Treasury yield suggest that the markets expect one or two rate hikes during the second half of 2022 (Fig. 11). For now, there’s plenty of cash on the sidelines to buy stocks, as noted above. Consider the following:

(1) Revenues, earnings, and profit margins. The outlook for S&P 500 revenues growth remains positive. S&P 500 aggregate revenues is highly correlated with business sales, which rose 15.3% y/y through August (Fig. 12).

The forward revenues of the S&P 500/400/600 (i.e., the time-weighted average of consensus revenues estimates for this year and next for the three indexes) are still rising in record-high territory (Fig. 13). The forward earnings of the S&P 500/400/600 are doing the same (Fig. 14). Forward profit margins remain in record-high territory as well.

(2) Blue Angels. Our Blue Angels framework shows that the forward earnings of the S&P 500/400/600 continue to fly into the wild blue yonder (Fig. 15). The forward P/E of the S&P 500 has been hovering north of 20.0 recently, while the forward P/Es of the S&P 400/600 have been closer to 16.0.

Strategy II: Green Light for Banks? Among the best-performing S&P 500 industry groups this year to date are Diversified Banks and Regional Banks. The big banks provided lots of good news last week about their Q3 earnings results even though loan demand has been weak (Fig. 16).

Many of the banks set aside billions of dollars last year to prepare for the likelihood that consumer and business loans would go bad as a result of the pandemic-driven recession (Fig. 17). But that didn’t happen thanks to the massive intervention by the Fed. So this year, banks are reducing their reserves for loan losses, which has boosted their earnings. They are likely to continue doing so over the next couple of quarters.

Wall Street firms are also benefiting from the Fed’s ultra-easy monetary policy, which has fueled a boom in M&A activity and a surge in investment banking fees (Fig. 18). In other words, Fed policy has benefitted the banks a great deal. By the way, the widespread notion that banks do best when bond yields are rising may not apply to investment banks. Low bond yields fuel M&A deal-making and fees.

China: Running Out of Juice. Last Wednesday, Jackie and I observed that China is in the midst of a serious energy crisis. The country’s utilities are having a tough time keeping up with the demand for electricity, which has been booming as producers have been scrambling to fill export orders, especially from the US. Chinese exports rose 20% y/y during September to a new record high. There has been a remarkably close correlation between Chinese exports and electricity demand (Fig. 19). The shortage of electricity depressed China’s Q3 real GDP growth rate to 4.9% y/y and only 1.6% q/q (saar).

Movie. “Squid Game” (+) (link) is a dystopian television series produced in South Korea and distributed worldwide by Netflix. I’ve watched only the first two episodes, but I thought that the show might be a cautionary tale about the Fed. While the Fed hasn’t forced investors to buy stocks and bonds, lots of them have felt compelled to play the game because the alternative yields available in the money markets are close to zero thanks to the Fed’s zero-interest-rate policy. Meanwhile, the gains in stocks and bonds since last March have been spectacular—all the more reason to keep playing. The Fed has provided a bright green light for investors. So the bulls continue to charge ahead, especially in the stock market, knowing that at some point the Fed will say “Red light!” Nevertheless, a lot of investors could get killed when that happens.

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Climate Central Planners

October 18 (Monday)

Strategy I: Changing the Climate. The evidence is rapidly mounting that our global Climate Central Planners (CCPs) are just as incompetent as most central planners have been in the past. They are rushing the transition from fossil fuels to renewable sources of energy. One problem is that renewable sources aren’t reliable, whereas fossil fuels have been a very reliable source of energy (except when OPEC’s central planners meddled in the oil market during the 1970s). Another problem is that renewable sources aren’t expanding fast enough to offset the restrictive impact that the CCPs’ policies are having on fossil fuel supplies.

Yale Professor Bill Nordhaus won the Nobel Prize in economics in 2018 for a very simple idea: The best way to get rid of fossil fuels is to raise their prices. The burning of fossil fuels and release of CO2 and other greenhouse gas emissions create significant externalities. On their own, markets are not yet capable of correcting these externalities, according to the professor. The solution is to increase the cost of fossil fuels to reflect the cost of the CO2 pollution they produce. But since markets don’t put a price on externalities, CCPs must do everything they can to drive up the cost of fossil fuels, forcing us all to use renewable sources of energy.

Sounds good in theory. But in reality, renewables aren’t ready for prime time. So instead of a smooth transition, the rush to eliminate fossil fuels is causing their prices to soar and disrupting the overall supply of energy.

But wait: The inflationary consequences of incompetent climate central planning aren’t limited to fossil fuels. According to an October 14 WSJ article titled “Metals Prices Surge After Gas Crunch Crimps Output,” higher energy prices are pushing up other commodity prices: “Metals prices surged to multiyear highs after smelters, facing soaring energy bills and pressure to cut their carbon emissions, curtailed production.”

In other words, inflationary pressures are mounting thanks to the CCPs’ poorly conceived and executed transition from dirty to clean energy. The CCPs never prepared their citizens for how expensive and disruptive to people’s lives their disruptive plans might be. The result may very well be a big populist backlash against what CCPs seek to accomplish.

Consider the following related developments:

(1) Energy prices soaring. The nearby futures price of a barrel of Brent crude oil rose to $84.86 at the end of last week. It is up 64% ytd (Fig. 1). The nearby futures price of natural gas in the US is up 113.0% over the same period. Also at the end of last week, the nearby futures price of a gallon of gasoline rose to $2.49, the highest since September 29, 2014 (Fig. 2).

During the October 8 week, US crude oilfield production remained 1.4mbd below its pre-pandemic record high of 13.0mbd notwithstanding the surge in energy prices (Fig. 3). During the October 15 week, the total oil and gas rig count was 31% below its pre-pandemic reading of 790 rigs (Fig. 4).

(2) Metals prices soaring. The metals component of the CRB raw industrials spot price index jumped to a record high at the end of last week (Fig. 5). It includes scrap copper, lead scrap, steel scrap, tin, and zinc. Leading the charge were the prices of zinc and tin (Fig. 6 and Fig. 7). As a result, the broader CRB raw industrials spot price index also rose to a record high.

(3) Dollar remaining firm. In the past, there has been a strong inverse correlation between the broad-based S&P Goldman Sachs commodity index and the trade-weighted US dollar (Fig. 8). So far, it’s different this time. The dollar remains firm despite the recent jump in the commodity index, led by energy and metals prices.

(4) The big surprise. Debbie and I aren’t surprised by the strength of the dollar because we’ve expected that China’s mounting problems in the property market would benefit the greenback. But we also expected that these problems would weigh on China’s economic growth and be bearish for commodity prices. The outlook for China’s economic growth looks grimmer now as a result of the country’s energy crisis.

Now here is the BIG SURPRISE: In just the past couple of weeks, we all learned that commodity prices can continue to move higher even if China’s economy slows. All it takes is for the disruptive energy policies of the global CCPs to cause shortages of fossil fuels, sending their prices to the moon. The resulting sky-high electricity costs and blackouts are depressing the production of other energy-intensive commodities and causing their prices to soar. We can blame Al, Klaus, Angela, Greta, Larry, George, Joe, and Jinping for this mess.

Strategy II: Braking China. China’s central planners have a problem. The country is in the midst of a serious energy crisis. The demand for electricity has been booming as producers have been scrambling to fill export orders, especially from the US. Chinese exports rose 20% y/y during September to a new record high (Fig. 9).

China is the world’s largest coal consumer, with 60% of the country’s electricity generated by burning coal. Shortages of coal are disrupting electricity production.
Consider the following chronology:

(1) Trade tensions with Australia. Australia’s ties with top trade partner China soured in 2018 when it became the first country to publicly ban China’s Huawei from its 5G network and worsened after Canberra called for an inquiry into the origins of the coronavirus. During November 2020, China found coal imports from Australia failed to meet environmental standards. China’s Foreign Ministry said reduced imports of Australian products like wine, coal, and sugar were the result of buyers’ own decisions, after media reports stated that Beijing had warned importers to stop buying a range of Australian goods (source).

(2) Xi makes a promise at UN. China’s President Xi Jinping announced in late 2020 at a UN summit on climate change that the country would cut its CO2 emissions per unit of GDP, or carbon intensity, by more than 65% from 2005 levels by 2030. Xi also pledged sharp increases in renewable energy capacity at the summit. However, his carbon intensity targets have been the most closely followed guidelines for emissions reduction at the provincial government level. Local authorities have the responsibility of making sure the targets are reached (source).

(3) Problems started in March in Inner Mongolia. China’s massive industrial base started experiencing intermittent jumps in power prices and usage curbs since at least March 2021. That’s when provincial authorities in Inner Mongolia ordered some heavy industries, including an aluminium smelter, to curb use so that the province could meet its energy-use target for Q1 (source).

(4) Problems spread in May to Guangdong. In May 2021, manufacturers in Guangdong province, a major exporting powerhouse, encountered similar requests to curb consumption as a combination of hot weather and lower-than-usual hydropower generation strained the grid (source).

(5) Power to the people, whatever it takes. In late September, the China Electricity Council, which represents power suppliers, said that coal-fired power companies were now “expanding their procurement channels at any cost” in order to guarantee winter heat and electricity supplies (source). (On the other hand, the Chinese government announced earlier this month that it will introduce tougher punishments for regions that fail to meet targets aimed at cutting energy intensity and CO2 emissions.)

(6) Flooded coal mines. During October, flooding in a key coal-producing province worsened the supply outlook. Some 17 regions managed by State Grid in China have enforced power consumption cuts since September (source).

(7) Coal prices still soaring. The country’s September PPI report, released last week, showed that coal prices rose 75% y/y (Fig. 10). Analysts are expecting electricity shortages and rationing to continue into early next year.

The energy crisis in China highlights the difficulty in cutting the global economy’s dependency on fossil fuels as world leaders seek to boost efforts to tackle climate change at talks next month in Glasgow.

Strategy III: Roaring 2020s vs That ’70s Show. So how do all these recent developments affect our outlook for the rest of the decade? We have previously discussed two alternative scenarios: the Roaring 2020s and the Great Inflation 2.0 (a.k.a. “That ’70s Show.”) In the October 6 Morning Briefing, we wrote: “We don’t mean to suggest that this two-scenario paradigm means that only one scenario will get the entire decade right. The outcome may very well be some mix of the two. Or one might prevail through, let’s say, the first half of the decade, while the other does so over the rest of the decade.”

We also reiterated our subjective probabilities for the two scenarios. We assigned 65% to the Roaring 2020s and 35% to the Great Inflation 2.0. Consider the following:

(1) Brief history of the 1970s. The Great Inflation 1.0 of the 1970s offers the most relevant cautionary tale for current times, as inflationary pressures have been building during 2021. Just about everything that could go wrong on the inflation front did so in the 1970s. President Richard Nixon closed the gold window on August 15, 1971. During the decade, the foreign-exchange value of the dollar plunged by 53% relative to the Deutsche mark, and the price of gold soared 1,402%. The CRB raw industrials spot price index, which was relatively flat during the 1950s and 1960s, jumped 165% during the decade because of the weaker dollar. A supply shock in late 1972 through early 1973 sent soybean prices soaring. As a result of the oil crises of 1973 and 1979, the price of a barrel of West Texas Intermediate crude oil rose 870% from $3.35 at the start of the decade to $32.50 by the end of the decade.

Cost-of-living adjustment clauses in labor union contracts caused these price shocks to be passed through into wages, resulting in an inflationary wage-price spiral. Nominal hourly compensation—which includes wages, salaries, and benefits—soared from a low of 3.5%, at an annual rate for the 20 quarters through Q2-1965, to a high of 11.4%, for the 20 quarters through Q1-1982.

Meanwhile, productivity growth, measured on a comparable basis, dropped from a peak of 4.6% through Q1-1966 to zero through Q3-1982 (Fig. 11). The 20-quarter annualized growth rate in unit labor costs (ULC), which is the ratio of nominal hourly compensation to productivity, soared from about zero per year during the first five years of the 1960s to over 10.0% during the late 1970s and early 1980s (Fig. 12). Since ULC is the key determinant of consumer price inflation as measured by the 20-quarter annualized percent change in the core PCE deflator, price inflation also soared from the mid-1960s through the early 1980s. (For more on the Great Inflation of the 1970s, see this excerpt from my 2018 book.)

(2) Brief history of the 2020s. Events of the past few weeks certainly are reminiscent of the 1970s, especially the mounting energy crises not only in China but also in Europe. Last week’s PPI and CPI reports for September in the US show that inflation is proving to be less transitory and more persistent than had widely been expected. Fed officials have acknowledged that in their recent remarks about inflation, which have been focused less on the temporary “base effect” and more on the persistent and widespread supply-chain bottlenecks.

Nevertheless, while the energy crises in China and Europe might remain troublesome through the coming winter months, we expect the recent surge in fossil fuel prices will stimulate more supplies of coal, gas, and petroleum products. We don’t see a repeat of the recessions induced by the two energy crises of the 1970s.

We also don’t expect another wage-price spiral similar to the one that fueled the Great Inflation of the 1970s. The main reason we believe that the 2020s will be different than the 1970s in that respect is our expectation that productivity growth will increase from 2.0% a year currently to 4.0% over the next few years, unlike during the 1970s when it dropped to zero.

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JP Morgan, China & Methane

October 14 (Thursday)

Financials: JPM Is Out of the Gate. Improving credit quality and a rising equity market helped JPMorgan turn in Q3 earnings that largely met expectations. The bank’s revenue rose 1% y/y to $29.7 billion, and its net income jumped 24% y/y to $11.7 billion due to a reserve release. Excluding a reserve release and a tax benefit, the bank’s profit was $9.6 billion, up from $9.4 billion a year ago. Going forward, the bank’s fortunes may be decided by whether higher interest rates on loans will be large enough to offset the rising costs that the bank expects to incur.

JPM shares are up 30.1% ytd through Tuesday’s close and sold off by 2.6% in trading Tuesday. They have performed in line with the S&P 500 Financials sector this year so far, which has turned in the second-best ytd performance among the 11 S&P 500 sectors.

Here’s the performance derby for the S&P 500 and its sectors ytd through Tuesday’s close: Energy (49.4%), Financials (30.6), Real Estate (24.2), Communication Services (19.7), Information Technology (15.3), S&P 500 (15.8), Industrials (12.6), Materials (12.0), Consumer Discretionary (11.6), Health Care (10.4), Consumer Staples (4.3), and Utilities (2.4) (Fig. 1).

Let’s look at the details of JP Morgan’s earnings release and some of the important financial metrics affecting the banking industry:

(1) Equity & M&A provide a tailwind. The S&P 500 is up 15.8% ytd though Tuesday’s close, bringing its three-year gain to 57.2% (Fig. 2). The strong US stock market in recent years has helped JP Morgan’s equity and M&A advisory business lines. During Q3, the bank’s gross investment banking revenue jumped 60% y/y to $1.3 billion. Revenue in equity-market-related activities increased 30% y/y to $2.6 billion. The fixed income markets weren’t as helpful, with related revenue down 20% y/y due to lower results in commodities, rates, and spread products versus a strong year in 2020.

A strong stock market benefitted the bank’s asset and wealth management division as well. Assets under management climbed 17% during Q3 to $3.0 trillion thanks to higher asset prices and net inlows, the bank reported. It’s notable that loans in the asset & wealth management unit rose 20% y/y and 3% q/q, primarily driven by securities-based lending.

A rising equity market should also have benefitted other banks with capital markets exposure. The value of US initial public offerings and secondary equity issuance has fallen 12.9% in Q3 y/y, but is up 24.0% ytd, according to Dealogic data in the WSJ (Fig. 3). The value of US M&A deals was up 35.2% in Q3 for the whole industry.

(2) Companies don’t need loans. With the capital markets wide open and balance sheets flush, companies’ need for loans has dropped. In JPMorgan’s Commercial Banking unit, commercial and industrial loans dropped 9% y/y and rose 1% q/q after excluding government-backed PPP loans. The segment’s net interest income was up 1% y/y and flat q/q.

Drumming up loan business is an issue across the banking industry. Commercial & industrial (C&I) loans across all US commercial banks jumped in early 2020 when companies borrowed money as a safeguard against the uncertain economic impact of Covid-19. Since peaking in at $3.1 trillion the week of May 13, 2020, C&I loans have fallen 23% to $2.4 trillion (Fig. 4). JP Morgan CEO Jamie Dimon said in the company’s Q3 press release that the bank is “seeing early signs of commercial real estate loan growth on modestly higher new loan originations in commercial term lending.”

The potential improvement in net interest margins could help banks’ bottom lines in the future. Through Q2, banks’ net interest margins fell to 2.5%, lower than at any time over the past 37 years (Fig. 5). But in recent months as the economy has recovered, the US yield curve spread has steepened sharply to 144 bps, up from its 2019 low of -66 bps (Fig. 6). Higher-than-expected inflation data and rising energy prices have pushed up 10-year Treasury yields to 1.56%, while the Fed funds target rate remains close to zero and is only expected to rise slowly over the next year (Fig. 7).

China: Getting Dicey. China continues to face numerous problems simultaneously. The country’s property market remains under stress, as home sales are falling and some weaker property developers are defaulting or postponing debt payments. An energy crisis is pushing up the price of coal and electricity, forcing companies to pay more and intermittently turn off their production. But China’s President Xi Jinping is focused instead on China’s reunification with Taiwan.

Xi has just over a year to clean up this mess before the 20th National Party Congress meets in November 2022. There, party leaders decide whether Xi remains in his role for an unprecedented third term, now that term limits have been revoked. While there are no alternative contenders right now, Xi no doubt would like to enter the meeting in a position of strength. Let’s take a look at some of the problems he’d probably like to resolve sooner rather than later:

(1) The Evergrande fallout continues. China Evergrande Group hasn’t officially defaulted, but it hasn’t paid the interest on its dollar-denominated bonds, and the clock is ticking. Meanwhile, some developers are reporting that September home sales fell by more than 20%-30% y/y. A handful of property developers have defaulted on or deferred debt payments. And yields on junk-rated dollar-denominated Chinese bonds have jumped north of 17%.

Sinic Holdings Group said it doesn’t expect to repay a $250 million bond due October 18, and that not doing so may trigger cross-defaults on two other notes, an October 12 Bloomberg article reported. Modern Land (China) asked bond investors to defer by three months a $250 million bond payment due October 25. Fantasia Holdings Group didn’t pay $206 million of principal due on a dollar-denominated bond. And Xinyuan Real Estate offered to pay only 5% of the principal on a note due October 15 and swap the remaining debt for bonds due 2023.

Local governments are acting to bolster the market. Harbin, a city in the northeast, is offering to provide subsidies of up to 100,000 yuan ($15,497) for homebuyers under 35, an October 13 South China Morning Post article reported. The city is also allowing developers to presell homes earlier than previously allowed. Eight other cities are barring developers from cutting home prices too deeply and in some cases instituted minimum prices, an October 12 WSJ article reported, citing Chinese state media.

Despite the doom and gloom, a Morgan Stanley analyst upgraded China’s property sector to “attractive,” believing that default risks and property market weakness are priced into property stocks. In addition, she believes that policy easing looks “more likely now” and that easing would support property stocks, an October 12 CNBC article reported.

(2) Energy crisis continues too. Coal prices hit new highs on Monday in China, as floods have hurt coal production in northern China—the latest in a string of problems that have weighed on electricity production. The country went so far as to allow power companies to charge market prices for electricity sold to industrial users, while consumers, agricultural users, and public welfare initiatives continue to be charged fixed prices.

Power shortages, which are expected to continue through year-end, are hamstringing a wide range of industries. Manufacturers of everything from semiconductors to cement, steel, and aluminum have been forced to suspend operations intermittently. Analysts and traders are forecasting a 12% drop in industrial power consumption in Q4 because of short coal supplies, an October 11 Reuters article reported. The price of coal futures hit ¥1,714 per unit on September 30, up 90% ytd (Fig. 8).

(3) And while Rome burns . . . China’s President Xi continues to rattle sabers in Taiwan’s direction. In a speech last weekend, he said: “To achieve the reunification of the motherland by peaceful means is most in line with the overall interests of the Chinese nation, including our compatriots in Taiwan.” Lest anyone didn’t get his gist, he continued: “No one should underestimate the Chinese people’s determination, and strong ability to defend national sovereignty and territorial integrity. The historical task of the complete reunification of the motherland must be fulfilled, and it will definitely be fulfilled.”

China’s military backed Xi’s threat by saying on Monday that it had conducted drills on China’s beaches located across the sea from Taiwan. China has also been regularly flying military aircraft into Taiwan’s air defense zone. Fifty-two Chinese aircraft flew into the space on Monday during the day, and four followed at night.

Disruptive Technologies: Focus on Reducing Methane. With the COP26 climate conference slated for October 31 in Glasgow, headlines are full of items about how to slow or reverse climate change. In addition to reducing CO2, scientists are focused on reducing methane because it has a warming effect that’s more than 30 times greater than CO2.

The US and EU launched in September a Global Methane Pledge, the supporters of which promise to cut methane emissions by at least 30% from 2020 levels by 2030. Thirty-four countries—including Argentina, Canada, Germany, Ghana, Indonesia, Iraq, Italy, Japan, Mexico, and the UK—have indicated their support for the pledge, which will be formally launched at COP26. However, the agreement doesn’t have the support of four of the top five emitters of methane, China, Russia, Brazil, and India.

Here are the major sources of methane, according to a September 23 McKinsey report: livestock (25%-30%), coal mining (10-15), gas (10-15), oil (10), rice cultivation (7-10), biomass burning (8-10), wastewater (7-10), solid waste (7-10), and other (2).

Fortunately, scientists in companies and academia have come up with a host of new technologies to reduce methane emissions:

(1) Blame the cows. Environmentalists aim to reduce the methane produced by cows and sheep burping and defecating. Fortunately, there may be some easy, relatively inexpensive solutions to the gassy problem.

A cow feed, Bovaer, contains an organic compound that inhibits cows’ methane production by up to 80%, a September 30 article in The Guardian reported, without affecting the taste or production of the cows’ milk or meat. Bovar, which was approved for use in Brazil and Chile, is produced by DSM, a Netherlands-based provider of nutritional and pharmaceutical ingredients and chemicals.

Another feed additive, Kowbucha, is being developed by the New Zealand Agricultural Greenhouse Gas Research Centre, which is also evaluating which cows produce the most and least methane.

Meanwhile, scientists at the University of New Hampshire have found that feeding cows seaweed reduces methane production by up to 20%, an October 12 CNBC article reported. At the University of California, Davis, researchers have determined that three ounces of seaweed a day can reduce methane emissions by more than 80%, The Guardian article noted. Scientists also are determining which seaweed is most effective and developing inland sources, so it can be grown near where it would be used.

As much as 95% of an animal’s methane emissions come from its mouth and nose. A UK company, ZELP, created a mask for cows that it claims neutralizes about 50% of the methane cows emit. The mask sits just above a cow’s nostrils and captures the methane expelled. When the methane level gets high, the mask sends the gas to a mechanism that converts the methane into CO2 and water, which is expelled from the mask. The process reduces methane’s global warming potential to less than 1.2% of its original value, a January 1 Wired article reported. Cargill plans to distribute the mask to dairy farmers next year.

(2) Targeting energy. Vast amounts of methane are released during the production and combustion of oil, gas, and coal. Methane is emitted from the production of coal, and the solution—until the recent gas shortage—has been to stop using coal and switch to natural gas or renewables.

However, the production of natural gas—the “clean” fuel that we’ve come to depend on—can also release methane. It leaks from natural gas wells and pipelines. Satellite images show large amounts of methane pouring out of Texas’ Permian Basin, Russia, and Central Asia. The technology exists to reduce the methane emitted; the question is how to incentivize companies to pay for and use the technology. If known technology were to be deployed across the oil and gas value chain, the International Energy Agency (IEA) estimates that about 75% of total oil and gas methane emissions could be avoided, a 2020 IEA report stated.

(3) Impressive field work. Bloomberg produced a damning article on October 12 about the methane that’s leaking from old, decrepit gas wells scattered around the US. It explains that large, well funded energy companies often find and drill wells. As production declines, wells are sold to a smaller company—which often happens more than once. However, the smaller companies often lack the financial means or desire to maintain wells or plug them at the end of their life to prevent gas leaks.

Regulators don’t collect the money upfront to plug wells. The Interstate Oil & Gas Compact Commission estimates that there may be up to 800,000 orphaned wells around the country.

In mid-September, the Environmental Protection Agency (EPA) proposed tightening requirements that oil and gas operators find and fix leaks and do more to prevent them in the first place, reported a September 20 Scientific American article. The proposals, under review by the White House, are expected to be finalized next year.

One environmental organization, the Clean Air Task Force, suggests that the EPA more frequently inspect oil and gas infrastructure and that the industry reduce venting and flaring at wellheads and improve storage.

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Lots of Moving Parts in US Labor & Housing Markets

October 13 (Wednesday)

US Labor Market: Quitters. The US labor market has probably never been so dynamic or so confusing. We all know that there have been about 10 million job openings for about 8 million unemployed workers over the past few months (Fig. 1). The unemployed want to go back to work or else they would be counted as “not in the labor force.” Employers are offering them more than enough jobs, as there are 1.25 open positions for each of the unemployed (Fig. 2).

What’s going on? Part of the problem is that the labor market is so tight that a record 4.3 million workers quit their jobs during August (Fig. 3). That contributed to the 10.4 million job openings that are taking longer and longer to fill as workers have become pickier about the type of jobs and the amount of pay that they are willing to accept. And of course, not all of the quitters are looking for a new job. Some are simply dropping out of the labor force for other reasons, including retirement of course.

The hirings rate, which is the number of hirings divided by total payroll employment, has exceeded the comparable quits rate since the start of the data in 2001 (Fig. 4). This year, the quits rate has soared to record highs. The hirings are up too, but many employers are hard pressed to fill their job openings as rapidly as workers are quitting.

Here is the performance derby showing the number of job openings in the major industries during August from highest to lowest (in thousands): professional & business services (1,810), leisure & hospitality (1,709), health care & social assistance (1,538), retail trade (1,186), manufacturing (870), transportation, warehousing & utilities (537), financial activities (479), construction (344), wholesale trade (272), information services (154), and mining & logging (36).

US Housing Market I: Home Price Appreciation Peaking. Temperatures are dropping nationwide now that we are well into the fall season. The housing market may be cooling nationwide too. That’s partly because the best cure for sky-high home prices and a shortage of housing inventory may be sky-high home prices.

There are several reasons for this. Recent home price appreciation has incentivized some homeowners to list their homes to capitalize on their home equity gains, increasing the supply of available homes, which could put a lid on further price gains. Aggressive competition for homes and rising prices have discouraged would-be home buyers in search of affordable homes, weakening the intense pandemic-led demand for homes that drove prices up. Home sale closings increasingly are being derailed by buyer-commissioned appraisals listing home values at far lower than agreed-upon sale prices, the October 10 WSJ reported.

As prices cool off, discouraged would-be home buyers are returning: “Rising inventory and moderating price conditions are bringing buyers back to the market,” said Lawrence Yun, National Association of Realtors’ (NAR) chief economist.

Consider the following:

(1) Home sales. The number of new US homes for sale ticked up during August to 378,000 units. That partly reversed an unexpected drop in new home sales during June, which continued into July (Fig. 5). New home sales currently remain well below the post-pandemic-onset peak of 993,000 units (saar) at the start of this year.

Total existing home sales and sales of existing single-family homes also ticked up in August, to 5.9 million and 5.2 million units (saar), respectively, but remained below their recent post-pandemic-onset peaks of 6.7 million and 6.0 million, respectively, during October 2020 (Fig. 6).

(2) New and existing home prices. The median single-family existing home price dropped from its record-high 24.5% y/y rate during May to 15.6% during August (Fig. 7). Both new and existing home prices, on a 12-month moving-average basis, rose to new record highs during August (Fig. 8 and Fig. 9).

(3) Housing inventories. Housing inventories have been extremely tight in both the new and existing markets. However, this might be changing. New homes for sale rose to 378,000 units (sa) during August, the ninth gain in 10 months and highest level since the end of 2008 (Fig. 10). And the ratio of new homes for sale to new homes sold, an indicator of months’ supply, rose to 6.1 in August from the record low of 3.5 in October 2020 (Fig. 11). A similar dynamic is showing up in existing home inventories (Fig. 12 and Fig. 13).

(4) Traffic & contracts signed. Meanwhile, traffic of prospective new home buyers declined from last November’s record high through August (Fig. 14). Traffic edged up in September but remains well below the record pandemic-induced high. Some prospective home buyers were finally able to tap into available inventory as pending home sales recovered in August, realizing significant gains after two prior months of declines (Fig. 15).

US Housing Market II: Rents Stabilizing. As a part of the Q3-2021 Zillow Home Price Expectations Survey, more than 100 real estate experts guessed that rents likely would stabilize where they are now despite a potential rise in vacancies. Despite the expiration of the federal eviction moratorium on July 31, the widely feared eviction cliff has not occurred, reported the Washington Post. Consider the following:

(1) Vacancies. During Q2, renter vacancy rates had fallen to just 6.2%, the lowest since Q2-2020 and a near record low (Fig. 16). The percent of households renting rather than owning a home rebounded sharply during the first half of this year (Fig. 17).

In light of the expiration of the federal eviction moratorium on July 31, vacancies are anticipated to rise in the coming months—but not enough to significantly affect prices, according to Zillow’s expert survey. The Supreme Court blocked the Centers for Disease Control and Prevention’s attempt to prevent evictions in areas with high Covid-19 infection rates, leaving lots of renters at risk of eviction. Following the ruling, Zillow estimated more than 485,000 eviction filings in September and October, with more than half of those likely to result in actual evictions—representing just 0.6% of the 43.9 million renters in the US.

(2) Rental prices. Nationally, the median monthly rent for vacant units during Q2 held at Q1’s record high of over $1,200 (Fig. 18). Tenant rent inflation in the Consumer Price Index partly recovered through August after bottoming early this year (Fig. 19).

(3) Federal relief. States and localities have been slow to distribute federal aid to renters in need. From January through July 31, state and local programs spent just $5.1 billion to support the housing stability of vulnerable renters out of the $25 billion allocated under the first round of Emergency Rental Assistance, according to the US Department of the Treasury. The pace of support quickened in August to a total of $7.7 billion, according to a Treasury update. How many renters will be at risk of eviction in the near future could depend on how quickly the aid is distributed.

US Housing Market III: Even More Upside for Homebuilders? Construction and housing stocks have had a good year. The iShares US Home Construction ETF has risen 20.2% ytd as of Monday’s close, compared to a 16.1% rise in the S&P 500. Investors slightly pulled back early this summer on concerns about rising costs, then regained confidence in July. The ETF has settled again some, remaining on higher ground for this year.

The S&P 500 Homebuilding stock price index has also performed well, with a ytd gain of 19.0%, and is at a record high for the first time since 2005. However, the price index is now below its 200-day moving average (200-dma) for the first time since May 2020 (Fig. 20). The industry’s forward operating earnings per share recently hit another new high, furthering its vertical ascent (Fig. 21). But while analysts’ earnings growth forecasts for 2021 have risen to 66.0% as of the September 30 week, forecasts for 2022 have moderated since earlier this year to 12.7%. The industry’s forward P/E (i.e., based on the time-weighted average of consensus earnings estimates for this year and next) of 7.1 remains near the bottom of its trading range over the past five years (Fig. 22).

If demand for homes is dwindling at current price levels while labor costs are elevated, what positives are investors hanging onto? Prices for key building commodities have declined, which could bring home prices down further and thereby boost demand. In addition, it’s possible that remaining supply shortages may soon end as the pandemic (hopefully) abates. Over the medium term, Melissa and I have been watching for any lasting negative outcomes for the rental market stemming from continued rising rents and/or the looming eviction cliff, but none seem to be materializing.

Dragging down the pace of residential construction overall is the slow pace of housing starts in the single-family market. But the multi-family market seems to be booming, both in terms of starts and permits (Fig. 23). That trend could escalate if more states follow California’s recent ruling to overturn 100-year-old single-family zoning laws, thereby legalizing duplexes and quadplexes and making it easier to build small apartment buildings. By the way, that’s all part of Biden’s agenda for more affordable housing.

Over the longer term, current housing market dynamics and generational trends that we’ve previously discussed suggest to us that the most bullish opportunities can be found in the shares of apartment developers. Surely, they’ll be building assisted living facilities for aging seniors and affordable complexes for debt-laden millennials. Let the multifamily-unit building continue!

US Housing Market IV: Institutional Investors Buying the American Dream. Have you seen the barrage of new Zillow commercials advertising that they’ll buy your home instantly for cash? Maybe not if you live up North. But down South—where both of my Millennial daughters live—iBuyers, or “instant buyers,” and other large institutional buyers are gobbling up residential real estate. That seems to be especially true in my daughter Sarah’s neighborhood in suburban Raleigh, NC.

While large institutional investors such as iBuyers are cropping up in certain regions, however, they’re still relatively small players in the nationwide residential real estate market. But that doesn’t mean that they’re not growing as a share of it. Consider the following:

(1) Zillow. During Q2, Zillow purchased a record 3,805 homes, more than double its Q1 total, and sold 2,086 homes, according to Vice.com. Zillow Research reported that homeowners used an iBuying service to sell more than 15,000 homes during Q2, pushing the iBuyers’ overall market share to a record 1% of all US home purchases.

(2) BlackRock. Back in June, we explored the flak that BlackRock had taken for reportedly forcing families out of residential markets by snapping up homes and propping up prices. But the singling out of BlackRock was unwarranted, we observed, given how small a portion of the US rental housing market BlackRock represents. Specifically, BlackRock’s asset funds that invest in real estate or infrastructure had a fair market value of just $75 million in 2020—with just a piece of that invested in rental properties—compared with the $4.5 trillion size of the US rental market. That was according to an analysis in The American Prospect, an independent political journal with a self-proclaimed progressive tilt.

(3) Getting bigger. But counting all institutional real estate investors broadly defined, their combined market share is significant and growing as a share of the national residential housing market. In a recent study, Redfin found that Q2, 68,000 homes were purchased by investors compared to around 60,000 during 2019 before the pandemic triggered a downturn. That was up from the series low (going back to 2000) of 10,000 during 2009. (See the second chart in the study for a demonstration of the rising market share.)

“Investors see soaring home prices as an opportunity,” said Redfin Senior Economist Sheharyar Bokhari. “With housing values consistently on the rise, solid returns are pretty much guaranteed—especially when you’re an investor who has access to extremely cheap debt.” Bokhari continued: “Investors are also taking advantage of surging demand in the rental market. With so many Americans priced out of homeownership, investors can turn an easy profit by buying up properties and renting them out.”

Redfin broadly defined an investor “as any buyer whose name includes at least one of the following keywords: LLC, Inc, Trust, Corp, Homes” as well as any “buyer whose ownership code on a purchasing deed includes at least one of the following keywords: association, corporate trustee, company, joint venture, corporate trust.” It noted: “This data may include purchases made through family trusts for personal use.”

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Profit Margin Winners & Losers

October 12 (Tuesday)

Strategy I: Climate Change & Energy Stocks. Climate change activists are working hard to save humankind from natural disasters, which they believe are getting unnaturally worse as a result of all the CO2 that humans are spewing into the atmosphere. Whether the activists are right or wrong, they are making progress in weaning us off fossil fuels. The problem is that demand for energy is increasing faster than renewable sources of energy can replace the looming shortage of fossil fuels as energy companies slash their spending on developing these traditional sources.

In addition, renewable energy sources are much less reliable than oil, gas, and coal. Wind turbines don’t work when the wind isn’t blowing. Hydroelectric power can’t be generated during droughts. Solar cells generate electricity when the sun is shining, but battery technologies aren’t ready to store enough of it when the sun isn’t shining, like at night.

Ironically, climate change may be making renewable sources of energy even less reliable if it is changing wind and precipitation patterns. As a result, we will continue to need fossil fuels at least as backup sources of energy when the renewable sources are down. But there may not be enough fossil fuels to back us up if energy companies stop investing in obtaining them.

The paradox of our human condition is that we may be at risk from more frequent and more catastrophic natural disasters if we don’t address climate change more quickly, but we could also freeze in the dark if renewable energy sources fail while the traditional fossil sources are becoming scarcer and extremely costly just when we most need them. Governments pushing for a rapid transition are likely to get lots of pushback from their citizens if the lights go out too often and utility bills soar.

Between 1980 and 2021, 19 wildfire, 29 drought, 56 tropical cyclone, 141 severe storm, 35 flooding, 19 winter storm, and 9 freeze billion-dollar disaster events affected the US, according to the National Oceanic and Atmospheric Administration (NOAA). This NOAA chart shows that they have become increasingly costly. This supports the climate change activists’ anxiety and rush to replace fossil fuels with renewable energy sources. However, keep in mind that our population has been growing, with more Americans choosing to live in harm’s way, i.e., exposing themselves to more risks of being hit by natural disasters.

For investors, the dilemma is that the more they invest in clean energy, the less capital will be available for fossil fuels. The result could be higher fossil fuel prices, with the stock prices of fossil fuel producers (with the lowest ESG—or environmental, social, and corporate governance—scores) rising faster than those of companies with low carbon footprints (with high ESG scores).

The bottom line is that investors who aren’t constrained by ESG mandates are likely to overweight energy stocks in their portfolios, and those stocks are likely to outperform the S&P 500 for the foreseeable future. That’s assuming that the fossil fuel industry continues to experience the same dynamics, i.e., a dearth of capital spending on the production of fossil fuels and high or rising fossil fuel prices. Fossil fuel producers will see higher margins as a result of higher prices and less capital spending. Consider the following:

(1) Energy’s market-cap and earnings shares are low. In this scenario, it won’t take much of an overweight in the S&P 500 Energy sector to beat the S&P 500. The sector currently accounts for only 2.8% of the index’s market cap and 4.2% of the index’s earnings share (Fig. 1). The comparable stats for the S&P 400 and S&P 600 are comparably tiny (Fig. 2 and Fig. 3). During 2008, when the price of oil soared, the market-cap shares of the S&P 500/400/600 ranged about 10%-15%.

(2) Energy fundamental metrics and the oil price. The forward revenues, forward earnings, and forward profit margin of the S&P 500 Energy sector all are highly correlated with the price of a barrel of Brent crude oil (Fig. 4, Fig. 5, and Fig. 6). Not surprisingly, the same can be said about the S&P 500 Energy sector’s stock price index (Fig. 7).

(3) Energy’s profit margin. The prices of all fossil fuels are soaring, including oil, natural gas, and coal (Fig. 8). In the past, fossil fuel companies would have responded to such price signals by ramping up their capital spending to increase their capacity to produce more. This time is likely to be different because they are facing mounting pressure from climate change activists both in and out of governments to spend more on developing renewable sources of energy and less on fossil fuel sources. In the short term, overall energy capital spending is likely to remain depressed, especially on fossil fuels.

The result should be higher margins for the fossil fuel industry. The weekly forward profit margin of the S&P 500 Energy sector is a good leading indicator for that industry’s actual quarterly profit margin (Fig. 9). The weekly series has rebounded from last year’s low of 0.2% during the April 30, 2020 week to 7.7% during the September 29 week, the highest reading since December 6, 2018. Joe and I will be watching it.

Strategy II: Q3’s Earnings Season. During the previous earnings reporting season, for Q2-2021, companies handily beat expectations for both revenues and earnings. The y/y growth rates in both marked this cycle’s peaks for them. Both growth rates will be lower for the Q3 earnings reporting season, starting this week. In addition, managements’ guidance will likely be far more cautious as more company managements raise caution flags about higher labor and materials costs as well as shortages of workers and parts. Rapidly rising energy input costs undoubtedly will also be mentioned in most of the conference calls with company managements.

Analysts are likely to ask managements about the expected impact of a corporate tax hike on earnings. Managements are likely to say that they can’t say until they know what the tax rate will be. They might be asked about the impact of the global 15% minimum corporate tax rate that 130 countries just agreed to.

Managements no doubt will discuss how all the above is likely to impact their profit margins. Many of them are likely to say that they are raising prices and scrambling to use technology to offset at least some of the pressures on their margins. Now consider the following:

(1) Analysts’ consensus estimates for Q3. As of the October 7 week, industry analysts estimated that S&P 500 earnings increased 26.5% y/y during Q3 compared to 88.6% during Q2 (Fig. 10). Their estimate for Q4 growth is currently 20.3%.

Here are the Q3 earnings growth rates currently expected for the S&P 500 and its sectors: S&P 500 (26.5%), Communication Services (23.8), Consumer Discretionary (7.7), Consumer Staples (3.5), Energy (1,487.8), Financials (18.1), Health Care (15.3), Industrials (75.9), Information Technology (28.8), Materials (92.4), Real Estate (17.2), and Utilities (0.3). (See our Earnings Season Monitor: S&P 500 Sectors.)

(2) Forward metrics remain strong for S&P 500. The forward revenues of the S&P 500 rose to yet another record high during the final week of September, while the index’s forward earnings did the same during the first week of October (Fig. 11).

The S&P 500’s forward profit margin was flat at a record 13.1% during the last week of September. This implies that, so far, companies have been able to offset rising costs by raising their prices and/or increasing their productivity. We continue to believe that productivity could increase fast enough over the next few years to avert a 1970s-style wage-price spiral.

Strategy III: Investment Style Guide. In recent weeks, Joe and I have observed that while the S&P 500 stock price index was climbing to new record highs, at least until its recent peak on September 2, the S&P 400/600 SMidCap indexes were moving sideways. That was the case since around mid-March (Fig. 12). In recent days, the SMidCaps have started to outperform (Fig. 13).

That makes more sense to us since the forward earnings of the S&P 400/600 have rebounded faster from their 2020 lows significantly faster than the forward earnings of the S&P 500 has done (Fig. 14). As a result, the forward P/Es of the S&P 400/600 dropped sharply in recent weeks to close at 16.3 and 15.6 at the end of last week, while the forward P/E of the S&P 500 fell to 20.2, remaining in the 20.0-23.0 range it has been in since the second half of last year (Fig. 15).

Joe and I had a look at the stock price charts for the S&P 500/400/600 sectors (Fig. 16, Fig. 17, and Fig. 18). We are seeing bullish patterns in the Energy and Financials sectors of the three indexes and mostly sideways patterns in the other sectors.

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Lots of Good News About Jobs

October 11 (Monday)

YRI Podcast. In our latest video podcast, Dr. Ed discusses the main points of today’s Morning Briefing.

US Labor Market I: EIP at Record High. The bad news in Friday’s employment report was that payrolls rose only 194,000 during September. However, that disappointment was mostly attributable to a 160,800 drop in state and local education employment. This category is included in government payrolls, which fell 123,000 last month. The news from the private sector of the labor market was good:

(1) Earned Income Proxy at a record high, again. Private-sector payrolls rose 317,000. In addition, average weekly hours in private industry rose 0.6% (Fig. 1). As a result, aggregate weekly hours rose 0.8% m/m and 4.6% y/y to 4.4 billion hours during September, the highest reading since March 2020. Here’s more good news: Average hourly earnings for all private-sector workers rose 0.6% m/m and 4.6% y/y. The bottom line is that our Earned Income Proxy (EIP) for private-sector wages and salaries in personal income rose 1.4% m/m and 9.4% y/y to yet another record high (Fig. 2)!

(2) Inflation is eroding consumers’ purchasing power. Now for a bit of bad news: Inflation has been eroding the gains in our EIP. On an inflation-adjusted basis, using the headline PCE deflator, our EIP was down 0.1% m/m and up 4.7% y/y (Fig. 3).

(3) Teachers quitting and retiring? Why did state and local education payrolls fall so much in September? The drop was probably Covid related. Some schoolteachers likely have retired or quit rather than risk exposure to the Delta variant of the virus. Others likely were discharged for refusing to go along with vaccination requirements.

(4) Pandemic-challenged industries still rebounding. Debbie and I have been tracking payroll employment in the industries that are most at risk of layoffs resulting from social-distancing restrictions (Fig. 4). They include retail trade, hotels & motels, air transportation, restaurants & other eating places, arts, entertainment & recreation (which includes amusements and gambling industries), and offices of real estate agents & brokers. They were particularly hard hit during last year’s lockdowns.

Altogether, they plunged from a record high of 31.8 million during February 2020 to 22.0 million during April 2020. They rebounded to 30.2 million by this August. We estimate that they rose by 250,000 during September. All in all, they are still down about 1.3 million from their record high. The problem seems to be the availability of workers rather than the demand for them.

US Labor Market II: More Full-Time Jobs. The really good news is in the household measure of employment, which rose 526,000 during September. It counts the number of workers with one or more jobs, whereas the payroll measure counts the number of jobs. Another difference is that the household measure includes self-employed workers; as a result, it has always exceeded the payroll measure (Fig. 5). Consider the following related developments:

(1) More full-time jobs. Full-time household employment rose 591,000 during September, while part-time household employment fell 36,000 during the month (Fig. 6).

(2) Fewer part-time jobs for economic reasons. We can mix and match the part-time household series to compare it to the payroll survey’s “part-time employment for economic reasons” measurement (Fig. 7). The percent of part-time employment that is attributable to economic reasons was down to 17.4% in September from a peak of 57.0% during April 2020. The latest reading was little changed from the August level, which was the lowest since February 2020.

(3) Bottom line. The demand for labor is so strong relative to the availability of workers that employers seem to be offering more full-time employment to their workers who previously had part-time jobs but wanted to work full time.

US Labor Market III: Bigger Gains for Lower-Wage Workers. Over the past 12 months through September, the wages of lower-wage workers have risen faster than those of higher-wage workers. Debbie and I have devised a simple way to compare the average hourly earnings (AHE) of lower-wage and higher-wage workers. The Bureau of Labor Statistics provides a data series for the AHE of all workers and of production and nonsupervisory (P&NS, lower-wage) workers, who currently account for 81% of total private nonfarm payroll employment (Fig. 8). We can use these two series and the payroll data to calculate a data series for higher-wage workers. Consider the following:

(1) Lower vs higher wages. During September, total AHE was $30.90 per hour, up 4.6% y/y, with lower-wage AHE at $26.20 per hour (up 5.5%) and higher-wage AHE at $51.40 per hour (up 2.6%) (Fig. 9). Over the three months through September, the AHEs of lower-wage workers rose 6.7% (saar), and those of higher-wage workers rose 3.2% (Fig. 10). However, on an inflation-adjusted y/y basis through August, the real wage for lower-wage workers was up 0.6%, while the one for higher-wage workers was down 1.6% (Fig. 11).

(2) Wages by industry. Here is the performance derby of the percent change in the total versus P&NS AHEs for the major industries on a y/y basis and in current dollars through September: information (0.8%, 0.9%), utilities (2.2, 2.6), natural resources (2.1, 4.5), wholesale trade (3.8, 4.0), retail trade (3.9, 5.1), manufacturing (3.9, 5.1), construction (4.5, 5.8), all workers (4.6, 5.5) professional & business services (4.7, 4.9), financial activities (5.3, 4.0), education & health (5.8, 7.3), transportation & warehousing (6.0, 8.6), and leisure & hospitality (10.8, 12.9).

Lower-wage workers have received bigger-percentage wage gains than higher-wage workers in all of the major industries except financial services. Among the biggest wage increases occurred in the education & health, transportation & warehousing, and leisure & hospitality industries (Fig. 12). They are among the industries with the highest job openings rates based on July’s JOLTS report (Fig. 13).

US Labor Market IV: Not in Labor Force. The labor force includes all employed and unemployed workers who are 16 years and older. During September, it totaled 161.4 million, which was still 3.2 million below the record high during December 2019 (Fig. 14). The flip side of this fact is that the number of people not in the labor (NILFs) rose 4.8 million over this same 21-month period. The mystery that macroeconomists are trying to solve is: Where did they go, and will they come back? The short answer is: Probably not. Consider the following:

(1) More senior NILFs. Seniors, who are 65 years old or older, have been retiring at a faster pace (Fig. 15). The pandemic may have convinced some of them to retire sooner than they had planned. The oldest Baby Boomers turned 65 during 2011 and 75 this year. The number of senior NILFs rose 2.9 million over the past 20 months through September.

(2) More prime-age NILFs. The number of prime-age NILFs, aged 25-64, is up 1.6 million over the 20 months through September. Some may have dropped out of the labor force to provide child or elder care to family members during the pandemic. Some of them might reenter the labor force now that schools have reopened for in-class sessions.

(3) The grim reaper. Widely ignored is the likelihood that the labor force has been depressed by the number of deaths since the pandemic started in February 2020 through June of this year (Fig. 16). Over this 17-month period, the number of deaths totaled 569,000, up from 231,000 during the previous 17 months. In addition, Covid survivors who were hospitalized dropped out of the labor force for some period of time.

(4) Fewer foreign workers. The Bureau of Labor Statistics’ annual 2020 Foreign Born Workers Summary report stated: “From 2019 to 2020, the overall labor force declined by 2.8 million; the foreign born accounted for 1.1 million of this decline,” or 38.4%. It added: “The foreign born include legally-admitted immigrants, refugees, temporary residents such as students and temporary workers, and undocumented immigrants.”

The leisure and hospitality industry is highly dependent on temporary immigrant workers. Nearly a quarter of leisure and hospitality workers were immigrants leading up to the pandemic, observed New American Economy. The high turnover rates common in the industry mean that a fresh pool of candidates recurringly is needed to replenish staffing.

Last year, then President Trump had banned nearly all incoming foreign workers to protect American workers from foreign competition during the pandemic. “The seven most popular categories of student and work-related visas were down 89% to 408,046 in June through December last year from 3.66 million over the same period in 2019, according to State Department data,” reported the February 15 WSJ.

Biden’s administration reversed the bans during February of this year, but it could take years to tackle the growing immigration visa backlog, observed a law group blog. Pandemic-related travel restrictions may continue to block foreign-born workers from entering the US as well. Researchers for the Dallas Federal Reserve Bank wrote back in 2005 that the US needs to utilize immigration policy to offset the impact on the labor force as the Baby Boomers age out of it.

Movie. “No Time To Die” (-) (link) was very disappointing. The highlights were the usual thrill-packed opening of the James Bond films and a shootout in Cuba. The other car chases and shootouts weren’t thrilling at all. Daniel Craig looks totally bored once again, as he did during the previous four films in which he played Bond. This will be his last time playing 007. So far, 12 male actors have had the role in 27 movies over the past 59 years. The next 007 might be a female. Rami Malek, who was great in “Bohemian Rhapsody,” was awful as the villain in this film. He mumbled a lot. Most of the scenes could have used more lighting—unless the filmmakers were trying to hide the movie’s lame plot and dialogue? “Goldfinger” is still the best of the franchise, and Sean Connery was the best “Bond, James Bond,” of them all. (Here is a complete list of the Bond flicks.)

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Facebook, Russian Gas & Green Shell

October 07 (Thursday)

Technology: A Look at the ‘F’ in ‘FAANGM.’ As former President Richard Nixon learned, television is a powerful medium. Frances Haugen, a former Facebook employee, came across very authoritative both on 60 Minutes and during her testimony before a Senate subcommittee. She appears to understand the complicated technology behind artificial intelligence (AI) and algorithms. She is articulate and explains the technology in concise, plain English. And she has the ear of Congress and damning research on Facebook.

On Tuesday, the day of Haugen’s congressional testimony, Facebook shares rose $6.73, or 2.1%. Perhaps the shares rallied because many of Haugen’s comments were already contained in a package of stories about Facebook that WSJ ran beginning on September 13. Facebook’s shares are down 12.1% since the day before the series began through Tuesday’s close versus the S&P 500’s 2.5% drop.

But we wouldn’t underestimate the power of what Haugen said to Congress. Our takeaways for investors:

(1) AI isn’t doing the job. Haugen believes that Facebook has focused on scale over safety. The need for scale is part of the reason Facebook uses AI to police its platforms, she said.

The problem: Facebook’s AI fails to catch all but 10%-20% of hate speech. AI has an even tougher time monitoring content in countries where the company doesn’t “speak” the language or isn’t familiar with a dialect. The implication is that far more humans are needed to monitor the commentary on Facebook. Employing them would be expensive.

A senator presented with Haugen three very inappropriate ads that were approved by Facebook for viewing by children. He asked how they could have been approved. Probably because no human saw them and AI didn’t flag them as inappropriate, she replied.

(2) Rein in the algos. Facebook designs algorithms to maximize usage and profits and has disregarded some of the associated risks, Haugen claims. Its engagement-based rankings amplify preferences; in so doing, they can fan hate speech, ethnic violence, and harmful information such as images that encourage anorexia among teenage girls.

The algorithms can be tweaked to make the system safer. During last year’s presidential election, Haugen explained, Facebook implemented safeguards to reduce its spread of misinformation. After the election, the safeguards were eliminated. The company’s ostensible reason for eliminating them was to protect free speech. Haugen alleges that the underlying reason was to increase usage of the platform, and therefore profits.

Haugen suggests that Congress establish a regulatory agency and regulations that force Facebook to turn over data about its algorithms. She also recommends changing Section 230 of the Communications Decency Act, which currently shields Facebook and other Internet companies from lawsuits regarding the content on their platforms. She suggests the law be changed to hold the platforms responsible for decisions related to their algorithms. She would also raise the age required to join Facebook and Instagram to 16 or 18 years old up from 13 today. None of these measures would help Facebook’s profitability.

(3) Zuck responds. After Haugen’s congressional testimony, Facebook CEO Mark Zuckerberg took to Facebook to share his take on the day. “We care deeply about issues like safety, well-being and mental health. It’s difficult to see coverage that misrepresents our work and our motives. At the most basic level, I think most of us just don’t recognize the false picture of the company that is being painted,” he wrote in the post.

The company doesn’t ignore its own research, Zuckerberg said. It cares about and takes action to fight harmful content. And Facebook isn’t causing polarization in other countries where its service is used just as heavily as it is in the US. It does not prioritize profit over safety and well-being. Facebook introduced Meaningful Social Interactions to the News Feed to show fewer viral videos and more content from friends and family even though they knew it would reduce the time people spent on Facebook.

Facebook is disincentivized to publish harmful or angry content because advertisers don’t want their ads appearing next to harmful or angry content. And the company continually works on keeping children safe on its site.

Zuckerberg concluded by throwing the problems into Congress’ lap. He wrote that he has asked Congress many times to update its Internet regulations on issues that include the proper age children should be allowed to use Internet services, how to verify ages, and how to balance teen privacy and parents’ need to know.

(4) Is FAANGM long in the tooth? The total market capitalization of FAANGM (Facebook, Amazon, Apple, Netflix, Google/Alphabet, and Microsoft) has increased 19.0% this year and it isn’t far from its most recent peak hit on September 3 (Fig. 1). The market capitalization of the FAANGM stocks as a percent of the S&P 500 has gone sideways for much of the past year. The market capitalization of FAANGM is 25.0% of the S&P 500, the same as it was in the second half of 2020 (Fig. 2).

One thing the FAANGM stocks have in their corner is amazing revenue and earnings growth prospects. Their forward revenue and forward earnings performances (i.e., based on the time-weighted average of consensus estimates for this year and next) far outpace those of the S&P 500 (Fig. 3 and Fig. 4).

Flattish stock performance and continued earnings growth over the past year have helped deflate the forward P/E of the FAANGM stocks from 44.7 on August 28, 2020 to a recent 34.8 last Friday (Fig. 5). Without the FAANGM stocks, the S&P 500 forward P/E falls to 18.1 compared to 20.6 with them (Fig. 6). During that time period, the forward P/Es of Amazon and Netflix have deflated the most. Here are the forward P/Es of the FAANGM constituents today and back on August 28, 2020: Amazon (51.1, 85.1), Netflix (49.2, 66.1), Microsoft (31.3, 35.2), Google (25.9, 31.2), Apple (25.0, 31.3), and Facebook (21.8, 29.5) (Fig. 7). Facebook’s forward P/E is higher than it was in 2019, but lower than it was in most other years (Fig. 8).

Energy: Gas Prices Take a Breather. Russian President Vladimir Putin gave us a reminder yesterday of just how much control he has over European energy prices. Just a hint from him that Russian-backed Gazprom might increase supplies sent natural gas prices tumbling on Wednesday from more than £4 per therm to £2.87, according to an October 6 FT article. Putin is wise enough to know that nothing kills a commodity market rally faster than high prices.

Putin said the current surge in the price of natural gas is a sign that Europeans are making a mistake by moving away from Russian natural gas. Actually, the opposite appears to be true: The EU erred by not incentivizing European producers of natural gas to keep producing and using any uptick in renewable energy production to decrease the amount of Russian natural gas it purchased.

In the US, the price of natural gas fell Wednesday by almost 10% to $5.71, though that’s still more than double the lowest prices fetched earlier this year (Fig. 9). The price of West Texas intermediate crude oil is $76.94 per barrel, down by 2.5% Wednesday but still up 59.6% ytd (Fig. 10). And something to keep an eye on is the price of gasoline, which has jumped to $3.29 per gallon, up 41% ytd. Higher gasoline prices could dampen consumer spending just in time for the holidays (Fig. 11).

Disruptive Technologies: Oil Giant Going Green. There are many reasons why the world is seeing rising energy prices. For one, many large oil companies are going green and pledging to reduce carbon dioxide (CO2) emissions. They’re increasing their investments in renewable energy sources and often decreasing their spending on oil and gas development.

Royal Dutch Shell was moving in that direction when it got a shove to accelerate the change. The District Court in the Hague, Netherlands, ruled the company must dramatically reduce its CO2 emissions: 45% by 2030, 72% by 2040, and 100% by 2050 compared with 2010 levels (see our June 3 Morning Briefing).

While Shell is appealing the Hague’s decision, the company has announced a plan to reduce the carbon intensity of its products by 100% by 2050, and it sees its oil production declining by 1%-2% a year but continuing to help the company fund its transition.

Shell’s capital spending is adjusting to reflect the company’s green goals. Shell announced in October 2020 that it would increase its spending on low-carbon energy to 25% of its overall capital expenditures by 2025. That translates into more than $5 billion a year, up from $1.5-$2.0 billion now, a January 31 Reuters article reported.

I asked Jackie to look into the many green energy investments Shell has made in just the past few months. Here’s her report:

(1) Buying and selling. Last month, Shell agreed to sell all of its operations in the US Permian Basin to ConocoPhillips for about $9.5 billion. The company said it decided selling was more attractive than acquiring additional assets to grow its Permian presence. “We found the cost of acquisitions in the last few years was above what we felt was going to be value-accretive for our shareholders,” Wael Sawan, Shell’s upstream director, said in a September 20 WSJ article. About $7 billion will be returned to shareholders, and the remainder will be used to strengthen its balance sheet.

Conversely, Shell purchased in July Next Kraftwerke, a virtual power plant operator that remotely connects and manages the wholesale electricity produced by more than 10,000 decentralized energy sources that include photovoltaics, bioenergy, and hydropower located in eight European countries. The deal helps Shell achieve its goal of selling about 560 terawatt hours of electricity a year by 2030, roughly twice as much as it sold at the start of 2021.

In February, Shell bought ubitricity, which installs electric vehicle (EV) chargers in lampposts and other structures. Shell aims to install 50,000 on-street EV chargers across the UK by the end of 2025, dramatically expanding the UK’s existing network of 3,600 ubitricity chargers. The system is needed because more than 60% of households in English cities and urban areas do not have off-street parking. Globally, Shell aims to grow its EV network from 60,000 today to 500,000 by 2023.

Two years ago, Shell acquired Limejump, which manages a huge battery storage device in the UK. It buys electricity from 675 wind farms, solar installations, and other renewable generators across Britain and sells the electricity to businesses that want green energy.

(2) Developing green energy. Earlier this month, Shell announced plans to build two large solar projects in England able to generate a total of 800 megawatts of energy and store that energy in batteries.

The company is also developing wind farms. It plans to develop and operate a 1.4 gigawatt floating offshore wind farm in South Korea through a joint venture with CoensHexicon. The project is expected to generate up to 4.7 terawatt hours of electricity. Shell and ScottishPower are developing another floating offshore wind farm in the waters northeast of Scotland.

Shell has developed its first US biomethane facility, in Junction City, Oregon. It uses “locally sourced” cow manure and excess agricultural residues to produce “renewable” natural gas. The facility began production in September, a company press release states. Shell is developing two additional biomethane facilities within operating dairies in Kansas and in Idaho. The three facilities are expected to produce 1,636,000 MMBtu a year of natural gas.

Shell announced in September plans to transform one of its major refineries in Rotterdam, Netherlands into a 820,000-tonnes-a-year biofuels facility. The facility is expected to produce aviation fuel and diesel made from waste by 2024. The waste may include used cooking oil, animal fat, other industrial and agricultural residual products, and vegetable oils.

Shell is rolling out hydrogen refilling locations too. One being built at the Qbuzz bus depot in Peizerweg, Netherlands will be able to serve up to 20 hydrogen buses. Shell will provide the green “certified” hydrogen. After 10 minutes of refueling, a bus will be able to travel 400 kilometers on a full tank of 25 kilos of hydrogen.

Shell is also rolling out 51 hydrogen refueling stations in California at existing Shell stations. In Europe, Shell has committed to building hydrogen refueling stations in 2024 for Daimler Truck’s customers. Daimler plans to deliver its hydrogen-burning heavy duty trucks in 2025. The stations will be in the Port of Rotterdam in the Netherlands and in Cologne and Hamburg, Germany.

(3) Burying CO2. Shell is working with TotalEnergies, Energie Beheer Nederland, and Gasunie to develop a project dubbed “Aramis.” Industrial companies (e.g., in the steel, chemicals, cement, refinery, and incinerator industries) would ship their CO2 waste to the onshore collection hub. The CO2 will be transported via pipeline to offshore platforms, where it will be injected in depleted offshore gas fields 3-4 km below the seabed, the project’s website explains. A final investment decision on the project is expected by 2023, and it should be operational by 2026.

Athos and Porthos are two other facilities under development by other companies that plan on capturing carbon and storing it the under the seabed.

Among Shell’s other projects, it has hired Penguin International Ltd to design, build, and operate at least three electric ferries to shuttle Shell employees between the company’s facilities on the islands of Bukom and Singapore. The 200-seat ferries will use lithium-ion batteries and replace in 2023 the diesel-powered ferries currently in use on the 5.5-kilometer trip.

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That ’70s Show?

October 06 (Wednesday)

Strategy I: Panic Attack #70. The S&P 500 peaked at a record 4536.95 on September 2 (Fig. 1). It is down 4.2% through yesterday’s close. The Nasdaq is down 6.1% from its record high on September 7 (Fig. 2). In our opinion, the recent selloff merits inclusion as Panic Attack #70 in our list of panic attacks since 2009. (See our Table of S&P 500 Panic Attacks Since 2009.)

However, Joe and I could identify one main cause for each of the previous 69 panic attacks. This one comes with a long list of worries. In fact, we came up with a list of nine worries in our September 20 Morning Briefing. At the top of the list was Evergrande. We didn’t even include a global energy crisis on our worry list; it just came to our attention last week. Now it is at the top of our list:

(i) Global energy crisis.
(ii) Evergrande could be China’s Lehman or LTCM.
(iii) Inflation has yet to show signs of peaking.
(iv) The Fed is expected to start tapering before the end of this year.
(v) The debt ceiling has to be raised so that the Treasury can pay the bills.
(vi) Congressional Dems are pushing through huge spending and tax proposals.
(vii) Parts shortages are forcing companies to scale back their production.
(viii) Valuation remains elevated.
(ix) There are plenty of geopolitical risks.
(x) And oh yeah, the pandemic is still out there.

Last year’s pandemic-related lockdowns around the world caused oil, gas, and coal prices to plunge. Producers of these fossil fuels slashed their capital spending. As economies reopened and governments provided massive fiscal and monetary stimulus, demand for energy soared. So did energy prices because of shortages of fossil fuels, especially coal and gas.

These shortages were exacerbated by government missteps and intrigue. Consider the following:

(1) Europe. Russia has been delivering gas to Europe under its contractual obligations. Europe needs more supplies of gas to make up for setbacks in renewable sources of energy, especially electricity generated by wind turbines and hydroelectric power. The Russians refuse to provide more gas through Ukrainian pipelines, which have ample capacity. They obviously are attempting to blackmail their European customers into providing Nord Stream 2 with an operating license as soon as possible. This new pipeline runs on the bed of the Baltic Sea from Russia to Germany and has just started to be tested. The price of natural gas in the US has soared 127% ytd through Monday (Fig. 3).

(2) China. Meanwhile, the Chinese government slashed its purchases of coal from Australia because the government there has been calling for an independent investigation of the origin of Covid-19 in China. As a result, the Chinese government has been forced to order blackouts that are depressing production and exacerbating global supply-chain disruptions. China’s PPI for coal was up 57.1% y/y through August (Fig. 4).

(3) OPEC+. On Monday, OPEC+ announced that it would stick to an existing pact for a gradual increase in oil output, sending crude prices to three-year highs and adding to inflationary pressures that consuming nations fear will derail an economic recovery from the pandemic. OPEC+ chose to ignore calls from big consumers, such as the US and India, for extra supplies after oil prices surged more than 50% this year. OPEC+ “reconfirmed the production adjustment plan,” the group said in a statement issued after online ministerial talks, referring to a previously agreed deal under which 400,000 barrels per day (bpd) would be added in November. The price of a barrel of Brent crude oil is up from last year’s low of $19.33 on April 21 to over $80 yesterday (Fig. 5).

(4) US. Notwithstanding soaring oil and gas prices, the numbers of oil and gas rigs remain considerably below their prior peaks (Fig. 6). US crude oil field production is almost 2.0 million barrels below its record high during 2019 (Fig. 7). Fossil fuel energy companies slashed their capital spending last year as the prices of oil, gas, and coal dropped. They aren’t responding to the rebound in energy prices by expanding their capacity because climate change activists in both the private and public sectors are forcing them to spend more on developing renewable sources of energy. However, these alternative sources are not as reliable as fossil fuels.

Strategy II: Updating the Worry List. Meanwhile, some of the other worries on our worry list have become more worrisome:

(1) Supply bottlenecks. The shortage of chips is significantly depressing auto production and sales. Last week, we reported that Ford was parking thousands of new trucks at the Kentucky Speedway owing to lack of key semiconductor parts. Motor vehicle sales plunged 6.2 million units (saar) from a recent high of 18.5 million units during April to 12.3 million units during September, led by a 4.6 million unit drop in light truck sales over this period (Fig. 8).

September’s PMI survey for manufacturing showed that the new orders index has exceeded the production index for all but two months since June 2020 (Fig. 9).

The supply-chain disruptions are depressing real GDP. The Atlanta Fed’s GDPNow tracking model showed Q3’s real GDP growth at 1.3% as of October 5, down from 2.3% on October 1.

(2) Inflation and bond yields. The prices-paid indexes in the M-PMI and NM-PMI remained elevated at 81.2 and 77.5, respectively, during September (Fig. 10). They were even higher early in the summer. However, both upticked during September and will likely move higher during October reflecting the jump in energy prices.

(3) China’s property bubble. Evergrande is turning out to be the tip of the iceberg in China’s property market. Mid-sized developer Fantasia Holdings missed a bond payment on Monday. Fantasia had issued a statement last month that it had sufficient working capital and no liquidity issues. Kaisa Group, Central China Real Estate, and Greenland became the latest property companies to see their bonds clobbered by uncertainty surrounding debt troubles at China Evergrande. Since China stepped up its scrutiny of developers with its “three red lines” leverage targets in August last year, the taps have dried up for the industry.

(4) Taiwan. The BBC reported that Taiwan has urged Beijing to stop “irresponsible provocative actions” after a record number of Chinese warplanes entered its air defense zone on Monday. The incursion marks the fourth straight day of such flights by Chinese aircraft, with almost 150 aircraft sent into Taiwan’s defense zone in total.

The BBC noted: “In an essay for Foreign Affairs magazine on Tuesday, Taiwan’s President Tsai Ing-wen warned there would be ‘catastrophic’ consequences for peace and democracy in Asia if the island were to fall to China. … Beijing is becoming increasingly concerned that Taiwan’s government is moving the island towards a formal declaration of independence and wanted to warn President Tsai against taking steps in that direction.”

(5) The pandemic. And let’s not forget that the pandemic isn’t over. New Zealand is giving up on its “Covid Zero” policy. That’s because notwithstanding closing its borders and enforcing strict lockdowns, the Delta variant continues to spread. Instead of zero tolerance, the government is moving on measures to help it coexist with the virus, as have other Asia-Pacific countries.

Strategy III: Tale of Two Scenarios. “What Are the Odds?” That was the title of our September 27 Morning Briefing. Debbie and I discussed the odds of the current decade playing out like either the Roaring ’20s (TRT-2.0) or the Great Inflation of the ’70s (TGI-2.0). We reiterated our subjective probabilities for the two scenarios and are doing so again now. We assign a 65% subjective probability to TRT-2.0 and 35% to TGI-2.0.

We don’t mean to suggest that this two-scenario paradigm means that only one scenario will get the entire decade right. The outcome may very well be some mix of the two. Or one might prevail through, let’s say, the first half of the decade, while the other does so over the rest of the decade.

For example, the events of last week suggested a replay of the Great Inflation scenario. There were lots of inflationary happenings during the 1970s, but the two major events were the oil crises of 1973 and 1979. The results were long lines to fill cars with gasoline, a wage-price spiral, stagflation, and two recessions. This time, we might be experiencing another energy crisis that has the potential to boost inflation and eventually cause a recession. We will keep you posted on the tale of the two scenarios through the end of the decade.

Strategy IV: Fundamentals Remain Strong. The good news is that the underlying fundamentals for the stock market remain solid. S&P 500 forward revenues rose to yet another record high during the September 23 week (Fig. 11). Forward earnings also rose to a new record high during the September 30 week.

At the end of September, industry analysts estimated that S&P 500 operating earnings rose 26.9% y/y during Q3 following Q2’s 88.6% gain (Fig. 12 and Fig. 13). Joe and I expect yet another earnings hook during the current earnings season (for Q3) as results once again beat expectations. However, this time we expect to hear lots of unsettling guidance about rising labor costs and widespread labor shortages. We also expect to hear more bad news about supply-chain disruptions.

Joe and I still expect to see 4500-4800 on the S&P 500 by the end of this year. However, October could see more sideways volatility, with the S&P 500 Energy and Financial sectors’ stocks outperforming Technology. The result may be a buying opportunity in tech stocks, which could lead a year-end Santa Claus rally.

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People’s Bank of Amerika (FKA ‘the Fed’)

October 05 (Tuesday)

The Fed I: Central Bank for Progressives. Melissa and I predict that the FOMC will be even more progressive in 2022. We expect that Fed Chair Jerome Powell won’t be reappointed by President Joe Biden but replaced by Fed Governor Lael Brainard or former Fed Governor Sarah Bloom Raskin.

Both prospective chairs have worked closely with US Treasury Secretary Janet Yellen in the past for many years. Both have longer and more consistent track records as Democratic liberals than Powell, who is a Republican but pivoted the Fed toward a progressive monetary stance in response to the pandemic, as we discussed in last Wednesday’s Morning Briefing.

Two more Fed governor positions may open up soon and also be filled with progressives. There are currently two open president positions among the 12 regional Federal Reserve Banks (FRBs). Powell pledged on Thursday to redouble efforts to find “diverse candidates” to replace the two presidents who resigned last week after criticism of their securities trading.

What would that mean for monetary policy? It might be hard to imagine a more progressive monetary policy than the one embraced by Powell since last March. But a more persistent inflation problem than the FOMC currently anticipates—which wouldn’t surprise us—could alter the FOMC’s expected policy course.

The committee is widely expected to vote to start tapering the Fed’s bond purchases at the November 2-3 FOMC meeting, with the goal of finishing doing so by mid-2022, and then proceed to raise the federal funds rate during the second half of next year. But if inflation remains persistently elevated into early next year, we think they might proceed with tapering at a faster pace but raise the inflation target from 2.0% to 3.0% in an effort to either delay raising the federal funds rate for as long as possible or normalize it gradually. Now consider the following related developments:

(1) Fed governor vacancies. Biden could have the opportunity to fill two more Fed governor seats. Randal Quarles’ four-year term as vice chair for supervision ends next week, on October 13, though he can stay as a governor. Our guess is that Fed Vice Chair Richard Clarida will soon resign. Bloomberg reported on Friday that Clarida traded between $1 million and $5 million out of a bond fund into stock funds one day before Chair Jerome Powell issued a statement flagging possible policy action as the pandemic worsened.

(2) Regional Fed president vacancies. Two presidents of regional FRBs recently decided to retire early amid revelations of similar trading activities. FRB-Boston President Eric Rosengren and FRB-Dallas President Robert Kaplan both announced their decisions to resign on the same day, Monday, September 27. Kaplan cited financial disclosure distraction as the reason for his early retirement, whereas Rosengren cited health reasons.

Both reportedly traded assets during 2020 that benefited from the Fed’s buying spree, according to CNBC. Moreover, Powell and FRB-Richmond President Thomas Barkin held onto assets in classes that the Fed purchased too. Supposedly, however, none of the officials broke any laws or official ethics rules.

The main point of contention is that the Fed neglected to do its housekeeping on conflict-of-interest guidelines following the previous recession. During his September 22 press conference, Powell defensively stated that this sort of activity is “now clearly seen as not adequate” in “sustaining the public’s trust.” He added: “We need to make changes, and we’re going to do that as a consequence of this.”

(3) The dot plot thickens. In March, June, September, and December of each year, the Federal Reserve Board members and regional bank presidents submit their economic projections for the current and next couple of years. These include their latest forecasts for the federal funds rate, which are plotted on a chart that has come to be known as the Fed’s “dot plot.”

Both June’s and September’s dot plots showed the Fed’s 18 anonymous dots all in a row near a zero percent rate for 2021. For 2022, June’s plot showed seven dots suggesting a rate rise would be appropriate. In September, two dots crept up, as nine dots showed rate increases in 2022. But the December 2021 and March 2022 dots could be affected by the turnover on the FOMC. If the group represented by the dots migrates toward more progressive individuals, rates could be held lower for much longer.

Additionally, a former Fed official and a Peterson Institute for International Economics contributor recently put forth a case for raising the Fed’s flexible average inflation target from 2.0% to 3.0%. If that catches on with a more progressive FOMC, it could also keep the dots lower for longer.

The Fed II: Brainard as Powell’s Successor? Fed Governor Lael Brainard was on the short list of two leading candidates for the Biden administration’s US Treasury secretary spot. Ultimately, Brainard’s former colleague, former Fed Chair Yellen, won the position. Brainard has a long tenure at the Fed, and both Biden and Yellen evidently appreciate her work. So we could see Brainard being offered the Fed chair position if Powell is not reappointed. Brainard is a highly active board member, serving on seven of the eight Fed board member committees.

Brainard’s work history is certainly more progressive than Powell’s. She served in the Obama administration as undersecretary of the US Department of the Treasury from 2010 to 2013 and counselor to the secretary of the Treasury in 2009. Brainard has close ties to Bill and Hillary Clinton. She served as former President Clinton’s deputy national economic adviser, deputy assistant, and personal representative to the G-7/G-8, and Hillary Clinton’s 2016 presidential campaign reportedly considered her for the top US Treasury seat.

Since becoming a Fed governor on June 16, 2014, Brainard has been vocal about the Fed addressing climate change issues that might affect financial stability, achieving greater inclusiveness in US employment, maintaining stringent bank regulations, and establishing more urgency around the regulation and centralization of digital currencies. The current Fed chair and Brainard have disagreed openly on the last two issues.

The Fed III: Behind the Curve. The Fed is clearly behind the inflation curve. An even more progressive Fed in 2022 might remain behind the curve. Powell has often stated that the Fed has “tools” to deal with inflation. Just last week on September 28, in congressional testimony, he said, “If sustained higher inflation were to become a serious concern, we would certainly respond and use our tools to ensure that inflation runs at levels that are consistent with our goal.”

The only tool that we can think of is raising interest rates until they slow the economy or cause a recession. A more progressive Fed is likely to resist using this tool for as long as possible.

I asked Mali to run some charts showing the federal funds rate, which is currently close to zero, versus the headline and core PCED inflation rates on a y/y basis, which were 4.3% and 3.6%, respectively, during August (Fig. 1 and Fig. 2). We also compared the federal funds rate to the CRB all commodities and raw industrials spot price indexes (Fig. 3 and Fig. 4).

In all these charts, the federal funds rate—which has been pegged at 0.00%-0.25%—should have been raised by now based on its relationship to inflation and commodity prices prior to the Great Financial Crisis (GFC) of 2008. However, the central bankers at the Fed felt compelled to provide unconventional ultra-easy monetary policy in response to the GFC. They claimed they would be temporary. Instead, they upped the ultra-easy ante in response to the Great Virus Crisis.

The Fed IV: From Russia with Love. President Biden would like to add yet another progressive to his administration. The WSJ subtitled an editorial about Biden’s nominee to head the Office of the Comptroller of the Currency (OCC) as follows: “Biden’s nominee to regulate banks really, really hates ... banks.” In that role, Biden’s pick, Saule Omarova, would supervise roughly 1,200 financial institutions with a combined asset value of $14.9 trillion and manage a fiscal 2021 budget of $1.1 billion. Yet she reportedly wants to eliminate the big banks she’d be appointed to regulate.

Omarova, a native of Kazakhstan, teaches law at Cornell University and graduated from Moscow State University in 1989 on the Lenin Personal Academic Scholarship. If that doesn’t sound leftist enough, have a look at Omarova’s Twitter account. She continues to believe that the Soviet economic system was superior: “Market doesn’t always ‘know best,’” she tweeted in 2019.

Her academic writings are unabashedly progressive. She advocates policies that would jeopardize the continuation of the financial sector as we know it if put into action. But provocative ideas are the ticket to moving ahead in the academic arena, Todd Baker, a senior fellow at Columbia University and managing principal of Broadmoor Consulting, told American Banker. In his opinion, Omarova would be less provocative and more administrative “within the context of existing laws” in the OCC office.

Melissa and I think that Omarova’s chance of getting through the 50-50 Senate is probably less than 50-50, but it’s possible. It also seems that she would not have the power to implement her policies without congressional action. Some political analysts suggest that Omarova’s nomination may be an attempt to persuade liberals not to fight a potential reappointment of Fed Chair Jerome Powell.

Here’s a closer introduction to her views and her chances of taking the OCC seat:

(1) She is pro-centralization. Omarova believes the tight financial and fintech regulations of China’s central bank offer valuable lessons for the US. She has gone so far as to propose that the Fed take over consumer bank deposits and create a central bank digital currency to turn the Fed’s balance sheet into a true “People’s Ledger,” as an October 2020 paper of hers was titled. She also has advocated for adding workers’ wages and the price levels of financial assets to the Fed’s list of mandates, reported the WSJ.

(2) She is pro-green policy. Omarova views climate change as a systemic risk to the financial system. She’s all for the National Investment Authority bill in the House to expand affordable green housing, according to her Twitter feed.

(3) US Chamber of Commerce is anti-Omarova. On the one hand, her extremely progressive writings are a turnoff to moderate mainstream Democrats. And on Tuesday, the US Chamber of Commerce wrote to the leadership on the Senate Banking Committee that the group “strongly opposes” Omarova’s nomination. On the other hand, her prior government experience could attract bipartisan support to offset that opposition. She did work as a special adviser for regulatory policy at the Treasury Department under President George W. Bush.

Back to the Future? Amerika was a television miniseries broadcast on ABC in 1987. It starred Kris Kristofferson, Mariel Hemingway, Sam Neill, and Robert Urich. It was about life in the US after a bloodless takeover by the Soviet Union. American apathy and an unwillingness to defend freedom on the part of many citizens made the Soviet takeover rather easy. In February 1987, the miniseries was parodied on the NBC show Saturday Night Live as “Amerida,” in which a debt-ridden US is mortgaged to Canada and subsequently repossessed. (Source: Wikipedia.)

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A Spell of Stagflation

October 04 (Monday)

YRI Podcast. In our latest video podcast, Dr. Ed discusses the main points of today’s Morning Briefing.

US Economy: Less Growth, More Inflation. Consumers led the V-shaped economic recovery last year. That’s not the case this year because they satisfied much of their pent-up demand last year, especially for goods, as government relief checks bolstered their income and spending. In addition, rapidly rising prices are depressing consumer demand this year. Inventory restocking and strength in capital spending are offsetting some of the weakness in consumer spending. Consider the following:

(1) Purchasing power. The rebound in inflation this year is weighing on the purchasing power of personal income. Over the first eight months of this year, personal income less government social benefits rose 4.0% in current dollars but only 0.4% in real dollars (Fig. 1). The PCE deflator is up 3.6% since the end of last year through August.

(2) Consumer spending. Over this same eight-month period, personal consumption expenditures rose 10.7% in current dollars but 6.8% on an inflation-adjusted basis (Fig. 2). Inflation-adjusted spending on consumer services was up 5.8% since the end of last year through August, but inflation-adjusted spending on goods was down 4.6% during the five months through August after rising 14.0% during the first three months of the year (Fig. 3). Rapidly rising prices have weighed on demand. In addition, shortages of new and used cars have depressed auto sales (Fig. 4).

(3) Consumer optimism. Debbie and I track the comparable averages of the Consumer Sentiment Index and the Consumer Confidence Index (Fig. 5). The resulting Consumer Optimism Index fell sharply in September to 91.1 from a recent peak of 107.2 during June. The current conditions component of our index fell 2.0 points, while the expectations component fell 1.6 points last month; since June, they are down 12.4 points and 18.7 points, respectively.

The weakness was widely attributed to the spread of the Delta variant of the Covid-19 virus, which caused hospitalizations to surge in some parts of the country during the late summer (Fig. 6). Consumer spending must also be depressed by rapidly rising prices, including the $1.00 surge in the retail price of a gallon of gasoline to $3.27 from the December 14, 2020 week to the September 27 week.

(4) Costco and Bed Bath & Beyond. Also depressing consumer spending are shortages of common household products, again. Last Thursday, retail giant Costco began limiting customer purchases of toilet paper, bottled water, and cleaning supplies to forestall bare shelves reminiscent of the initial phases of the pandemic. This time, the problem is a serious lack of everything from cargo ships to tractor trailers in the supply chains that bring everything to local stores. The labor shortage caused by the pandemic hit everywhere, and that includes the workplaces of truckers, ship crews, dock workers, and freight handlers.

Also last Thursday, Bed Bath & Beyond’s stock price dropped more than 20% when the company announced its latest results. The press release stated, “As COVID-19 fears re-emerged amid the on-going Delta variant, we experienced a challenging environment. This was particularly evident in large, key states such as Florida, Texas and California, which represent a substantial portion of our sales. Furthermore, unprecedented supply chain challenges have been impacting the industry pervasively, and we saw steeper cost inflation escalating by month, especially later in the quarter, beyond the significant increases that we had already anticipated. This outpaced our plans to offset these headwinds. These factors impacted sales and gross margin.”

(5) Inventories and capital spending. The good news in all this is that a slowdown in consumer spending should give businesses some time to rebuild their depleted inventories. Supply-chain disruptions may slow that process down, but less so than they would have if consumer spending were continuing to boom. These disruptions should also continue to bolster capital spending as supply chains are reshored during the global transition from just-in-time to just-in-case inventory management. If so, we should see this in rising inventory-to-sales ratios in the not-too-distant future (Fig. 7).

For the here and now, September’s M-PMI report showed a big increase in the manufacturing inventories component (Fig. 8). However, the survey also found that the customer inventory index remained near recent record lows. That’s because the backlogs represented by the survey’s orders and supplier deliveries indexes remained near recent record highs during September (Fig. 9).

Inflation I: Chaos Theory. The policies—lockdown- and climate-related, monetary and fiscal—of our enlightened government officials around the world (particularly those in the US, Europe, and China) have created a perfect storm in global supply chains. The lockdowns boosted pent-up demand. Ultra-easy monetary and fiscal policies also have boosted demand. Rolling lockdowns around the world, especially at major shipping ports, have caused major backups in unloading container ships.

Energy demand has recovered globally from the initial round of lockdowns. However, climate change activists have succeeded in restricting the supplies of fossil fuels faster than such fuels can be replaced by renewable sources of energy. Energy companies have cut both their drilling for and capital spending on fossil fuels under pressure from the activists. Meanwhile, wind turbines have proven unreliable when the wind stops blowing. Hydroelectric output has been disrupted by droughts. Consider the following:

(1) China. Last week, local officials forced factories in China’s Guangdong and Jiangsu provinces to curtail operating hours or shut down temporarily as officials try to reduce energy usage. Factories are cutting production because coal prices are soaring as a result of reduced imports from Australia since last year after a diplomatic tiff over Canberra’s call for an independent global inquiry into the origins of Covid-19. The PPI for coals was up 57.1% y/y during August (Fig. 10).

More than 10 Taiwan-based semiconductor-related companies filed announcements with the Taiwan Stock Exchange last week saying they are temporarily closing facilities in China. It’s too early to assess the impact on supply chains, but it could be yet another significant blow to trade globalization.

Part of the power problem is that renewable energy sources aren’t reliable. The southwestern province of Yunnan, which produces hydropower, has been struggling with droughts throughout the year. In China’s Northeast, output from wind farms was extremely low for a few days recently due to the weather.

On Friday, China ordered state-owned energy companies “to do whatever it takes” to secure fuel supplies.

(2) Europe. A shortage of natural gas, which accounts for a fifth of Europe’s electricity, is causing electricity bills to soar. About a third of European gas supply comes from Russia; another fifth comes from Norway. Both countries have been hit with disruptions, such as a fire at a processing plant in Siberia, causing lower-than-expected supply. The French government said last week it would block any increase in household gas and electricity bills until the spring.

The September 15 issue of The Economist reported that about a tenth of Europe’s power is generated by the wind. In some countries, including Germany and Britain, the share is twice that. Recently, however, the air has been unusually still. In Germany, for example, during the first two weeks of September, wind-power generation was 50% below its five-year average.

By the way, more than 40 members of the European Parliament from all political groups are urging the European Commission to launch an investigation into Russian gas giant Gazprom over alleged market manipulation that could have contributed to the record-high natural gas prices in Europe.

Sergiy Makogon, the CEO of Ukraine’s transmission system operator GTSOU, claims that Russia is causing the crisis in Europe by refusing to use Ukraine’s empty pipelines to send more gas. He accuses President Vladimir Putin of blackmailing Europe to commission the Nord Stream 2 pipeline.

(3) UK. The October 1 WSJ reported that the UK government recently stepped in with subsidies to reopen a fertilizer plant closed by rising energy costs; the plant supplies a significant share of the country’s carbon dioxide, a byproduct needed in food processing.

Inflation II: Frustrating Bottlenecks. As a result of all of the above, the recent heightened levels of inflation have proven to be more persistent and less transitory than Fed officials had predicted. Last Wednesday, Fed Chair Jerome Powell said, “It’s also frustrating to see the bottlenecks and supply chain problems not getting better—in fact at the margins apparently getting a little bit worse. We see that continuing into next year probably, and holding up inflation longer than we had thought.”

He is no longer talking about the temporary “base effect” but about a more persistent problem with global supply chains. He didn't mention that ultra-easy monetary and fiscal policies have been overheating demand, thus contributing to the supply bottlenecks and resulting in higher inflation. Consider the following recent developments on the inflation front:

(1) Discount stores. Dollar Tree announced on Friday that it will begin selling items at $1.25 and $1.50—instead of the usual $1.00 for all items—at some locations for the first time. (Will the company change its name to “A Dollar Fifty Tree?”)

(2) Consumer prices. During August, on a y/y basis, consumer prices as measured by the PPI (which excludes rent), the CPI, and PCED rose 7.4%, 5.3%, and 4.3% (Fig. 11). The so-called base effect must be diminishing, suggesting that elevated inflation is likely to persist over the rest of this year and probably the first half of next.

(3) Prices paid. The prices-paid index in September’s M-PMI survey was 81.2, down from a recent record high of 92.1 during June—which was the highest since summer 1979. However, the average of the prices-paid indexes of the five regional Fed surveys jumped to a new record high during September (Fig. 12).

(4) Commodity prices & the dollar. The GSCI commodity price index moved higher again at the end of last week, led by energy prices (Fig. 13). Debbie and I expect that OPEC will respond to the rise in oil prices by increasing production to stabilize the price. The CRB raw industrials spot price index, which does not include any energy commodities, is looking toppy (Fig. 14). We believe that the recent strength in the dollar will continue, which will cause commodity prices to move lower. But first, let’s not forget: Winter is coming.

In Praise of Profits! My latest book is titled In Praise of Profits! The paperback should be on Amazon by mid-October, and the Kindle version should be available before the end of the month.

The main theme is that profits isn’t a four-letter word. Progressives claim that free-market capitalism, driven by the profit motive, causes wage stagnation and results in both income and wealth inequality. They want the government to redistribute income and wealth by increasing taxes on the rich and on corporations. They refuse to acknowledge that profit-driven capitalism is the source of our nation’s widespread prosperity. They say that the relevant data support their claims; that’s not so, as I demonstrate in my book. I conclude that the entrepreneurial variety of capitalism—as opposed to crony capitalism, the other kind—should be allowed to flourish. If it does so, so will we all.

In my study, I show that the progressives’ narrative about the relationship between profits and prosperity is wrong and misleadingly pessimistic. In short, it’s backward: Market driven profit is the source of prosperity, not its nemesis. Ironically, profit is what drives the progress in standards of living that progressives champion and try to bring about with their policy approaches. But progressives seem blind to the progress that has been achieved and perpetually want to do more. In my opinion, progress has been made despite their persistent policy interventions thanks to the power of the profit motive to deliver profits and widespread prosperity in a free-market economic system.

My study is especially relevant today as progressives are pushing to raise income and wealth taxes on upper-income households and to raise the corporate tax rate. The unintended and unwelcome consequence is that many of those households own pass-through businesses that collectively account for many jobs and are major drivers of jobs growth.

Perhaps I’ve been biased by my Wall Street background to focus on profits as the main driver of the business cycle. However, in my career I have seen profitable companies consistently respond to their success by hiring more workers, building more plants, and spending more on equipment as well as on R&D. I’ve seen plenty of unprofitable companies batten down the hatches. They freeze hiring and fire whomever they can, ideally without jeopardizing their business. They restructure their operations to reduce their costs, including divesting or shuttering divisions that are particularly unprofitable. They freeze or slash capital budgets.

Notwithstanding politicians’ claims, it is profitable businesses that create jobs, not US presidents or Washington’s policymakers and their economic advisers. Most of the jobs in our economy are created by small businesses, started and run by entrepreneurs, that grow into bigger companies. The result of burdening companies with more taxes is less prosperity.

The pass-throughs employ lots of workers. Consider the following statistics, all based on the Bureau of Economic Analysis’ latest available data:

(1) In 2018, the US had 2.1 million C corporations and 36.2 million pass-through business entities, including 5.1 million S corporations, 27.1 sole proprietorships, and 4.0 million partnerships (Fig. 15).

(2) In 2017, C corporations employed 55.9 million workers. S corporations employed 34.6 million workers. Assuming very conservatively that sole proprietorships employed only the owner and that partnerships employed only two partners on average, the total employment attributable to pass-throughs would be around 70 million workers.

(3) In 2017, the total household measure of employment, which measures the number of workers rather than the number of jobs, was about 153 million. Back then, the payroll measure of employment showed about 22 million federal, state, and local government jobs.

In other words, pass-throughs accounted for more than half of the private sector’s 130 million workers!

(4) Another way to corroborate this startling finding is to subtract the 56 million workers at C corporations from the 130 million private-sector workers. The result remains startling: 74 million workers presumably working at pass-throughs!

Raising the income tax rate on upper-income households would hit lots of those that own pass-through businesses. S corporations don’t pay the corporate tax rate. Rather, most of the income of S corporations is paid as dividends that are taxed as personal income. Sole proprietorship and partnership incomes are also taxed as personal income. Historically, sole proprietorship income has equaled around 80% of corporate profits, which includes the profits of both C and S corporations.

Taxing the rich by raising the top income tax rate would reduce the profits of pass-throughs. Increasing the corporate tax rate would reduce the profits of C corporations. Neither can be good for creating more jobs that buoy standards of living.

Movie. “The Many Saints of Newark” (- -) (link) is a fictional history of Tony Soprano, recounting the events of his childhood that would shape him into the troubled mafioso. The movie is a prequel to the long-running HBO series “The Sopranos.” It’s fun to get a little background on Tony’s wonder years. However, the movie is slow paced and mostly boring--a big disappointment. More time should have been spent on the events and people in Tony’s life that would explain why he needed to see a psychologist during his adult life.

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September, Energy, & Crypto

September 30 (Thursday)

Strategy: October Is Coming. September lived up to its reputation and dented stock portfolio returns, but not too badly. The S&P 500 fell 3.8% mtd through Tuesday’s close, but the index remains solidly in positive territory, up 15.9% ytd through Tuesday’s close. Surging interest rates and higher oil and gas prices in September helped insulate the Energy and Financial sectors while hurting the Real Estate and Utilities sectors.

Here’s the performance derby for the S&P 500 and its sectors for the month of September through Tuesday’s close: Energy (10.9%), Financials (-0.4), Consumer Discretionary (-1.2), Consumer Staples (-3.5), S&P 500 (-3.8), Industrials (-4.3), Information Technology (-5.1), Health Care (-5.2), and Materials (-5.6), Real Estate (-5.8), Communication Services (-6.0), and Utilities (-6.9) (Fig. 1).

The ytd performance derby for the S&P 500 and its sectors is a much happier picture: Energy (40.4%), Financials (29.4), Real Estate (23.2), Communication Services (21.6), S&P 500 (15.9), Information Technology (15.4), Health Care (12.7), Industrials (12.6), Consumer Discretionary (11.3), Materials (11.2), Consumer Staples (3.7), and Utilities (1.3) (Fig. 2).

There has been a lot of concern that higher wages, higher energy prices, and higher transportation costs will weigh on earnings for the remainder of this year and into 2022. It’s certainly something we’ll be tracking. But so far, analysts remain relatively sanguine, forecasting that S&P 500 earnings will rise 9.2% next year on top of a 46.3% expected jump in earnings growth this year (Table 1). Here’s a quick look at what some companies have been saying about the price pressures they’re facing:

(1) Raw materials prices and supplies color Sherwin Williams earnings. The lack of availability and rising prices of raw materials prompted Sherwin Williams to lower its Q3 and 2021 forecasts. The change was blamed on Hurricane Ida, which hit Gulf Coast suppliers harder than expected. To diversify its supply chain, Sherwin Williams announced that it purchased a resin manufacturer with locations in Oregon and South Carolina.

Paint company executives on a conference call emphasized that demand was not the problem and should remain strong well into 2022. However, tight supplies are expected to dent Q3 sales, which are now forecast to be flat or down slightly instead of the company’s September 8 expectation of up or down slightly. Raw materials costs are expected to rise by a percentage in the high teens for the full-year 2021 versus the previously expected mid-teens. And adjusted diluted net income is forecast to be $8.35-$8.55 per share this year, down from the September 8 forecast of $9.15-$9.45, a September 28 company press release stated.

(2) Food prices on the rise. US food companies—including Campbell Soup, Conagra Brands, General Mills, and J.M. Smucker—are also facing higher costs and passing some of that cost on to consumers, a September 22 WSJ article reported. Companies noted that they’re paying higher prices on everything from raw ingredients, cooking oil, steel, fuel, and shipping while also juggling labor shortages and wage increases. Smucker reported that the frost in Brazil and heatwave in the US Pacific Northwest hurt harvests of coffee and fruit, while the February frost in Texas that closed chemical plants kept packaging prices high.

Higher food prices and labor shortages are also pressuring restaurants. Darden Restaurants—which owns Olive Garden and LongHorn Steakhouse, among other chains—sees inflation of about 4% during fiscal 2022 (ending May) as commodity and labor costs rise, a September 23 WSJ article reported. The company said it has one or two sections with six to eight tables “closed at most restaurants on most nights due to staffing limits.” And it can’t pass all of its cost increases on to customers for fear of pricing the average customer out of the casual dining experience.

(3) Higher clothing prices coming? Last week, Nike cut its sales forecast due to disruptions in transportation and the closure of factories in Vietnam due to Covid-19. More than half of Nike’s footwear is produced in Vietnam, where nearly all factories are closed. As a result, the company warned that its fiscal Q2 (ended August) sales would be flat to down and that fiscal 2022 sales (ending May) would grow by a mid-single-digit percentage, down from previous expectations for low-teens growth.

Nike isn’t alone. Vietnam is the second largest supplier of apparel and footwear to the US after China, a September 29 NYT article reports. So retailers in developed countries have vaccinated customers looking to shop, but their inventories are thin because their suppliers’ factories are in sparsely vaccinated, Covid-ravaged places like Vietnam, where only 15.4% of the population had received one vaccination as of the beginning of September.

This could mean retailers will have less inventory during the holiday season, giving them the ability to raise prices and to avoid the holiday sales usually used to clear out remaining year-end inventory.

Energy: Costly Transition. For various reasons, the price of energy—electricity, natural gas, oil, and coal—is going through the roof around the world. Renewable energy advocates are about to find out how much the world is willing to pay to wean itself off fossil fuels.

True believers may view today’s high energy prices as the latest signal that we should double down on producing renewable energy so that we’re not dependent on natural gas or coal in the future. But we have a feeling that politicians may not be that resolute. High electricity prices and blackouts have a way of sharpening politicians’ focus on securing reasonably priced energy for their constituents to avoid being shown the door on election day. Here’s a quick look at the intertwined fates of the energy and carbon markets:

(1) All prices heading up. Break out your sweaters: It may be very expensive to heat our homes this winter. The Brent crude oil futures price has risen to $79.09 per barrel as of Tuesday’s close, up from $51.09 at the start of 2021 and $19.33 at its pandemic low in 2020 (Fig. 3). The prices of gasoline and heating oil futures price have also surged, by 56% and 54% ytd (Fig. 4). Following the same trajectory, the price of natural gas futures hit a recent high of $5.84, up from $2.54 at the start of this year and the highest level since February 21, 2014 (Fig. 5). Even the dreaded coal is undergoing a revival of sorts as coal-fired electric plants, the dirty villains of the energy industry, are being switched on to meet electricity demand.

As we mentioned in last Thursday’s Morning Briefing, capital expenditures for upstream oil and gas projects worldwide fell more than 25% in 2020 to about $305 billion, down from $420 billion a year earlier, according to data from Statista. This year, capex is expected to increase by only 2% to $310 billion, which won’t likely keep pace with increasing demand.

And just as energy prices have climbed, so too has the price for carbon credits in Europe’s Emission Trading System—almost doubling to roughly €65 from €35 at the start of this year. As utilities have upped their power generation, they’ve needed to buy carbon credits to offset the amount of carbon dioxide they’re producing. Also boosting the price: Investors have reportedly jumped into the market. The higher price of carbon credits is increasing the costs for utilities in Europe, a cost likely to be passed down to consumers and industrial customers.

One might think the rising prices of energy and carbon credits in Europe would push production offshore to cheaper pastures. However, the EU plans to pass a carbon tax on imports of items like steel to level the playing field for its domestic producers.

(2) China facing blackouts too. China’s energy shortages may have different roots, but they are painful to individuals and businesses. In attempts to reduce energy consumption and carbon emissions, “local officials have forced factories in China’s Guangdong and Jiangsu provinces to curtail operation hours or shut down temporarily,” a September 27 WSJ article reports. A Guangzhou handbag accessories factory was ordered by the local government to cut production and operate only two days a week, according to the WSJ article.

Officials may be trying especially hard to reduce emissions in the weeks prior to a UN environmental conference on October 12-13 hosted by China’s southwestern city of Kunming. That’s followed by the 2022 Winter Olympics opening on February 4 in Beijing. The government has said it will cut energy intensity per unit of GDP by about 3% from last year in an effort to reach peak carbon emissions before 2030. The country also has promised to end funding for coal electric plants overseas.

Surging coal prices are forcing factories to cut production. Coal supply was hurt when China banned the import of coal from Australia after the Aussies angered the Chinese by calling for an independent global inquiry into the origins of Covid-19. In addition, some of China’s highest-quality, easiest-to-mine coal mines have been depleted. A September 29 South China Morning Post article reported that China’s six major power generation groups have stockpiles to meet demand for only 15 days, a near record low; in theory, inventory should equal no less than 20 days’ worth of consumption.

The combination of government dictates to reduce energy consumption and the shortage of coal have affected electricity availability. A September 28 Bloomberg article estimates that “at least 20 Chinese provinces and regions, making up more than 66% of the country’s gross domestic product, have announced some form of power cuts, mostly targeted at heavy industrial users.” There are also reports of blackouts in some areas.

The more that Chinese factories shut down, the more likely the US will feel the impact. A Toyota spokesperson said its operations were being affected, as were areas of China that produce steel, nickel, and materials used in semiconductors. Ten Taiwanese semiconductor-related companies temporarily closed facilities in Kushan (near Shanghai), the WSJ reported. Apple’s suppliers are affected, as are companies that supply semiconductor chip packaging materials to auto chip manufacturers.

The energy supply woes combined with the Evergrande debacle have analysts slashing their estimates for Chinese economic growth for the remainder of this year.

(3) Everyone wants LNG. Demand for liquified natural gas (LNG) has surged from China, Europe, and Brazil, where a drought has reduced hydropower—on top of high preexisting demand from Japan. Natural gas in Asia and Europe trades at a sharp premium to the US commodity.

“With [natural] gas prices at record highs near $29 per mmBtu in Europe and Asia versus just around $6 in the United States, traders said buyers around the world would keep purchasing all the LNG the United States could produce. The United States exports about 10% of the gas it produces as LNG,” a September 28 Reuters article explained.

US natural gas exports surged to a record high of 6.0 trillion cubic feet in March and held near that level in June, limited only by LNG facilities’ capacity (Fig. 6). US stocks of crude oil and petroleum products are well below levels at this point of 2019 and 2020 (Fig. 7). US natural gas in storage is 6.9% below the five-year average at this time of year (Fig. 8).

Disruptive Technologies: Crypto Critics. Cryptocurrencies have had a tough few weeks. They’ve been denounced by none other than Securities & Exchange Commission (SEC) head Gary Gensler, JPMorgan CEO Jamie Dimon, and China. This helps to explain the 18.6% drop in the price of bitcoin since September 6, which is sharp but not enough to wipe out the currency’s 44.2% ytd gain through Tuesday’s close (Fig. 9). Let’s take a look at what this trio of naysayers is saying:

(1) China says “no go.” All cryptocurrency transactions and mining were banned by China last Friday. The country previously had raised concerns that crypto speculation could hurt the country’s economy. Chinese officials also worried that crypto mining’s high energy requirements would hurt progress toward the country’s environmental goals. A September 24 Reuters article estimated that prior to the ban, virtual currency mining in China accounted for more than half of the world’s crypto supply.

It’s also likely that Chinese officials didn’t like the lack of control they had over cryptocurrencies. They couldn’t prevent the flow of funds out of the country through cryptocurrencies. Instead, the country has introduced the digital yuan, which it created and will control entirely.

The world’s biggest crypto exchange, Binance, has been blocked from China since 2017. But other crypto exchanges have begun cutting relationships with Chinese customers since the announcement last week. Crypto exchange Huobi has stopped accepting new Chinese customers, and it will remove existing Chinese customers from its crypto exchanges by year-end, a September 27 FT article reported. Alibaba said it won’t allow merchants to sell crypto mining rigs. And FTX, Hong Kong’s biggest crypto exchange, has upped and moved its headquarters to the Bahamas.

(2) JP Morgan’s Dimon doesn’t waver. JP Morgan CEO Jamie Dimon has been a vocal critic of cryptos in the past. And he doubled down in a September 22 interview with The Times of India last week. “I am not a buyer of bitcoin. I think if you borrow money to buy bitcoin, you’re a fool.” He does, however, believe the government will step in and regulate cryptocurrencies.

(3) Here comes Gary. SEC Chairman Gary Gensler is calling cryptocurrencies a duck. If cryptos look like securities and act like securities, he’s saying, then they should be regulated like securities, something that seems far overdue.

Gensler wants crypto exchanges to register with the SEC, warning that if they fail to do so they’ll be hit with enforcement actions. He also has asked Congress to work with regulators to regulate stable coins. And he raised his concern about the public getting involved with “Wild West” crypto market. “I do really fear … there’s going to be a problem with lending platforms or trading platforms, and frankly when that happens a lot of people are going to get hurt,” he said according to a September 21 MarketWatch article.

Anyone who thinks Gensler is overstepping might consider reading this September 27 CNN article about a German hamster, Mr. Goxx. He runs on an “intention wheel” before picking a cryptocurrency and then runs through a buy or a sell tunnel to let its owner know how to trade the currency. These trading sessions are, of course, live-streamed on Twitch, and Mr. Goxx’s portfolio is up 16%.

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Is Powell Transitory?

September 29 (Wednesday)

Strategy I: Making Sense of Bond Yields. The action of the 10-year US Treasury bond yield is finally making sense. It made sense earlier this year when the yield rose from 0.93% at the start of the year to peak at 1.74% on March 31. It didn’t make much sense that the yield subsequently fell to a recent low of 1.19% on August 3-4 as inflation was heating up (Fig. 1). That decline suggested that bond investors agreed with Fed Chair Jerome Powell’s assertion that the rise in inflation was “transitory.”

Melissa and I argued that the unexpected drop in the yield could be explained by the Fed’s buying $120 billion per month in Treasury and agency bonds since the start of this year (Fig. 2). We also observed that those purchases boosted commercial bank deposits at a time of weak loan demand (Fig. 3). As a result, commercial banks have also been loading up on Treasury and agency securities. Since the end of last year through the September 15 week, the Fed purchased $1,090 billion of these securities, while the commercial banks purchased $534 billion of them.

This explanation has been confirmed by the recent increase in the bond yield, which followed the FOMC’s recent signals that the bond purchase program will be tapered starting after the November 2-3 meeting of the committee (Fig. 4). Powell confirmed that at his press conference following the September 21-22 meeting. In addition, yesterday he conceded that inflation may not be as transitory as he thought. Consider the following:

(1) FOMC statement. The FOMC statement dated September 22 noted: “Last December, the Committee indicated that it would continue to increase its holdings of Treasury securities by at least $80 billion per month and of agency mortgage‑backed securities by at least $40 billion per month until substantial further progress has been made toward its maximum employment and price stability goals. Since then, the economy has made progress toward these goals. If progress continues broadly as expected, the Committee judges that a moderation in the pace of asset purchases may soon be warranted.”

Similar language appeared in the July 28 statement, but the conclusion about when tapering might begin was much more ambiguous: “Since then, the economy has made progress toward these goals, and the Committee will continue to assess progress in coming meetings.”

(2) Powell’s press conference. In his post-meeting press conference on September 22, Powell said that “for inflation we appear to have achieved more than significant progress.” Then he added, “Many on the Committee feel that the substantial further progress test for employment has been met. Others feel that it’s close, but they want to see a little more progress. There’s a range of perspectives. I guess my own view would be that the test, the substantial further progress test for employment, is all but met.”

(3) Brainard’s remarks. Fed Governor Lael Brainard, who might be the next Fed chair, reiterated Powell’s assessment in the text of her remarks prepared for the annual meeting of the National Association for Business Economics on Monday. She said, “Employment is still a bit short of the mark on what I consider to be substantial further progress. But if progress continues as I hope, it may soon meet the mark.”

(4) Nominal versus real yield. The backup in the nominal bond yield has been attributable mostly to the increase in the 10-year TIPS yield, while the widely used proxy for 10-year expected inflation at an annual rate has remained relatively flat around 2.35% (Fig. 5 and Fig. 6).

(5) Copper/gold price ratio. The copper/gold price ratio has tracked the bond yield closely since 2004 (Fig. 7). They’ve diverged briefly from time to time, especially since early 2020. Currently, the ratio suggests that the yield should be closer to 2.50% rather than 1.50%. Then again, the ratio might converge to the bond yield if China’s economic troubles depress the price of copper relative to the price of gold.

(6) Powell’s latest assessment. Powell testified before a congressional committee yesterday on the Fed’s response to the pandemic. He conceded that inflation has been less transitory and more persistent than he expected. He is no longer talking about the temporary “base effect” on inflation. Instead, he is blaming the problem on supply bottlenecks. Here is what he said:

“Inflation is elevated and will likely remain so in coming months before moderating. As the economy continues to reopen and spending rebounds, we are seeing upward pressure on prices, particularly due to supply bottlenecks in some sectors. These effects have been larger and longer lasting than anticipated, but they will abate, and as they do, inflation is expected to drop back toward our longer-run 2 percent goal.”

He added, “The process of reopening the economy is unprecedented, as was the shutdown. As reopening continues, bottlenecks, hiring difficulties, and other constraints could again prove to be greater and more enduring than anticipated, posing upside risks to inflation. If sustained higher inflation were to become a serious concern, we would certainly respond and use our tools to ensure that inflation runs at levels that are consistent with our goal.”

Powell has often stated that the Fed has “tools” to deal with inflation. The only tool that we can think of is raising interest rates until they slow the economy or cause a recession.

(7) Taper tantrum. The bond yield was 1.33% on September 21, the day before the latest FOMC meeting. Our conclusion is that the recent backup in the bond yield reflects the widespread perception that the Fed will start tapering soon and that inflation may be more persistent than had been widely expected. We believe that the bond yield is back on track to hit our year-end target of 2.00%.

Strategy II: Staying Bullish But Diversified. The S&P 500 peaked at a record 4536.95 on September 2. It is now down 4.1% through yesterday’s close. That’s consistent with September’s historical track record of being the toughest month of the year to own stocks. It was particularly hard on Growth stocks over the past two days as rising bond yields and rising oil and gas prices boosted S&P 500 Financials and Energy at the expense of Technology. Prior to this development, the month saw Growth outperform Value (Fig. 8).

Joe and I aren’t big fans of the Growth-vs-Value paradigm. We prefer to focus on sectors and industries. In any event, we’ve favored a diversified approach to the bull market. We’ve observed on a regular basis that the market has a tendency to regularly let outperforming sectors underperform for a while as underperforming ones get a turn to outperform.

We expect that rising bond yields and energy prices will continue to favor Energy and Financials at the expense of Technology. But that should create buying opportunities in the Technology sector. Consider the following:

(1) Market-cap shares. If we view the S&P 500 as a managed portfolio, then its managers are heavily overweighting Technology, which currently has a market-capitalization share of 28.1% (Fig. 9). That share increases to 39.5% if we include the market-cap share of the Communication Services sector.

Among the most underweighted sectors by market-cap shares are Energy (2.5%), Materials (2.5), and Utilities (2.5). That’s because their earnings shares are about the same as their market-cap shares.

Financials still look relatively attractive on this basis with a market-cap share of 11.1% and an earnings share of 16.5%. The same can be said for Health Care with a market-cap share of 13.3% and an earnings share of 16.2%.

(2) Market-cap correlations. The market-cap share of Financials has been somewhat correlated with the 10-year bond yield (Fig. 10). Likewise, the market-cap share of Energy has shown some correlation with the oil price (Fig. 11).

Strategy III: Watching DC’s Sausage Factory. By most accounts, this is the week that will make or break the Biden administration’s Build Back Better fiscal extravaganza. It’s mostly up to House Speaker Nancy Pelosi (D-CA) to get it through the House and Senate Majority Leader Chuck Schumer (D-NY) to get it through the Senate.

“Laws are like sausages,” German statesman Otto von Bismarck reputedly said, “it is better not to see them being made.” That’s why we prefer to wait to analyze fiscal measures until they are actually enacted. However, in this case, the most likely scenario, in our opinion, is that the bipartisan physical infrastructure bill will be enacted before the giant $3.5 trillion “human infrastructure” package using the reconciliation process, which will also keep the government open and raise the debt limit. Pelosi indicated that the size of the second bill will have to be scaled back to get enough Democrats to vote for it under the reconciliation process, since no Republicans will do so.

Fed: Is Powell a Lame Duck? Fed Chair Powell has often said that this year’s surge in inflation is likely to be “transitory.” We noted above that he is starting to acknowledge that it might be more persistent. The word “transitory” may soon apply to Powell’s tenure at the Fed.

The question of the day is whether President Joe Biden will reappoint Powell when his term expires in February 2022. Melissa and I suspect that our progressive President may prefer to replace Powell, who has pivoted to the left over the past couple of years, with someone more consistently progressive like Fed Governor Lael Brainard.

Indeed, the Fed is likely to become even more progressive if more Fed seats open up and are filled with more progressives. Consider the following:

(1) Six months and counting. Powell’s four-year term as Fed chair began on February 5, 2018 and ends in February 2022. Technically, Powell’s term as a Fed governor does not end until 14 years after his term as a board member began on May 25, 2012. Traditionally, however, the Fed chair resigns as a board member once his or her term as chairperson expires.

(2) Unprecedented mission creep. Powell has pivoted his monetary policy stance a few times during his tenure. When the pandemic hit, Powell adopted the most progressive-leaning policy ever when the Fed and the US Treasury partnered to deliver unprecedented monetary and fiscal policy stimulus. The Fed slashed interest rates to near zero for the first time since the 2008 recession in an emergency action on March 15, 2020 and implemented QE4ever on March 23. Since then, the Fed has maintained its ultra-easy policy despite recent evidence of rising inflation and progress in the labor market.

Recent months have seen further escalation of the Fed’s mission creep into issues once considered to be the exclusive domain of fiscal policymakers, such as climate change and economic inclusiveness. Such progression toward the progressive is particularly remarkable given the chair’s conservative background as a lawyer, investment banker, and two US Treasury posts (assistant secretary and undersecretary) in the Republican administration of President George H.W. Bush.

(3) Break with the past. In the past, the Fed has acted in anticipation of inflation heating up. But under Powell’s leadership, the Fed prioritized “inclusive” maximum employment over its stated 2.0% inflation target in its August 2020 Statement on Longer-Run Goals. In that statement, the Fed also embraced flexible average inflation targeting to indicate its tolerance for inflation overshoots to compensate for prior inflation shortfalls.

(4) What’s ahead? Powell’s final pivot could be when the Fed finally begins to reverse its pandemic policy by first tapering its asset purchases, as was telegraphed at the September 21-22 FOMC meeting. Fed officials have indicated that interest-rate increases will come after asset purchases are tapered. The Fed’s September 22 Summary of Economic Projections suggests rate increases could occur in 2022 and 2023. But those projections could shift if some of the officials making them are replaced.

(5) Senator Warren objects. If Powell is renominated, he will be opposed by Senator Elizabeth Warren (D-MA). She thinks he has been too easy on the banks. In yesterday’s congressional hearing, she told him directly, “[T]hat makes you a dangerous man to head up the Fed.”

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Some Good News, Some Bad News

September 28 (Tuesday)

Good News I: Pandemic Wave Cresting. In the US, the third wave of the pandemic seems to be cresting (Fig. 1). The 10-day moving average of new positive Covid results is down 35% from its recent peak on September 3 through September 24. The number of Covid hospital patients is looking toppy as well. However, Covid-related deaths are still rising, though remain well below the record high earlier this year (Fig. 2). As of September 24, 81% of Americans 16 years old and older had at least one dose of a Covid vaccine (Fig. 3).

Good News II: Economy Growing. The US economy continues to perform well even though the pandemic clearly isn’t over. The TSA checkpoint travel numbers at US airports are back near pre-pandemic readings (Fig. 4). Railcar loadings excluding coal are back at pre-pandemic levels as well, and so are intermodal loadings (Fig. 5).

On the other hand, loadings of motor vehicles are down in recent weeks because auto manufacturers are experiencing parts shortages (Fig. 6). Ford is still making trucks; it’s just making them without the necessary parts, holding them until the chips finally come in, and then shipping them out to dealers. Ford is doing this with what looks like thousands of vehicles. The Drive obtained satellite images of Kentucky Speedway, which show thousands of trucks at the facility awaiting chips.

Yesterday’s durable goods orders release for August was strong again, as Debbie discusses below. Nondefense capital goods orders excluding aircraft rose 0.5% m/m and 13.7% y/y to yet another record high (Fig. 7). Shipments are lagging orders as they typically do. In other words, it’s hard to see the disruption caused by parts shortages in the relationship between orders and shipments.

During Q2, real GDP exceeded its pre-pandemic level (Fig. 8). After rising by over 6.0% (saar) during Q1 and Q2, it is likely to settle down to between 3.0% and 4.0% growth during the second half of this year, more in line with its underlying long-term trend. The Atlanta Fed’s GDPNow model estimate for real GDP growth during Q3-2021 was 3.2% on September 27.

Bad News I: Winter Is Coming. Be warned: As the character Eddard Stark said in the HBO’s Game of Thrones, “Winter is coming.” The mad rush to stop climate change by going cold turkey on fossil fuels could leave lots of people out in the cold this winter. Greta Thunberg and other climate change activists are succeeding in pushing their agenda to get us off our addiction to fossil fuels. This is causing major withdrawal pains since alternative sources of energy are turning out to have some significant disadvantages. Consider the following:

(1) Wind turbines don’t work when the wind stops blowing. Last Thursday, Jackie and I wrote: “The UK has noble intentions of cutting its carbon footprint by turning to electricity generated by windmills and by closing all coal plants by late 2024. Wind power represented about a quarter of the power used by Great Britain last year. But the wind in the North Sea unexpectedly dropped dramatically in September, reducing related electricity production, a September 13 WSJ article reported. The shortfall of wind-generated electricity has forced a return to gas- and coal-fired electricity plants.”

(2) Gas prices are soaring in Europe, boosting inflation and depressing economic growth. European gas prices are up almost 500% in the year. At their peak, UK electricity prices more than doubled in September and were almost seven times as high as at the same point in 2020. Power prices also have jumped in France, the Netherlands, and Germany (Fig. 9). The price surge shows the need to have backup power supplies for when the wind doesn’t blow and the sun doesn’t shine.

(3) The biggest industrial energy users of electricity are particularly hard hit by the price spike. Zinc producer Nyrstar NV said on Thursday it is cutting output at a major Dutch plant during peak times of day. A major fertilizer maker was forced to shut down two UK plants as a result of the soaring natural gas price. A shortage of fertilizer could boost food prices. High energy prices could put inflationary pressures on other costs, which will end up being passed on to customers.

(4) A September 27 Bloomberg article concluded: “The crisis in Europe presages trouble for the rest of the planet as the continent’s energy shortage has governments warning of blackouts and factories being forced to shut.”

(5) Under pressure from the activists, the major oil companies are limiting their spending on new oil and gas supplies. On September 15, in an interview with Bloomberg News, Chevron’s Chief Executive Officer Mike Wirth predicted that energy prices will remain high for the foreseeable future because oil and gas producers are hesitant to drill for more oil and gas. He didn’t say it explicitly, but his remarks implied that climate change activists are “interfering with market signals.”

The oil and gas industry obviously has been affected by two of this year’s major events: A Dutch court earlier this year ordered Royal Dutch Shell to reduce carbon emissions by 45% by 2030. And Exxon Mobil was forced to backtrack on an aggressive expansion plan as climate change activists succeeded in adding two board members.

Wirth concluded with a question that sounded rhetorical to me: “Looking out for a few years if the global economy continues to grow and recover post Covid, is there sufficient reinvestment in the energy that runs the world today? Or are we turning so quickly to the energy that runs tomorrow that we created an issue in the short term?”

(6) Alternative renewable sources of energy aren’t coming on stream fast enough to replace the deficit between demand and supply, and they aren’t reliable, especially when we need them like during the winter. And don’t forget: Winter is coming.

Bad News II: Credit Crunch & Energy Crises in China. In the US, most recessions have been caused either by credit crunches, energy crises, or both. Jackie and I are seeing more signs of both crises unfolding in China. President Xi Jinping soon may have to borrow a phrase from Hamlet: “When sorrows come, they come not single spies but in battalions.” In addition to a debt crisis in the real estate sector, China is developing an energy crisis. Consider the following:

(1) A September 25 Bloomberg article is provocatively titled “Why China's Evergrande Crisis Could Be Worse Than the U.S. Crash.” It notes that “[r]eal estate and related industries account for almost 30% of China’s GDP—a far higher share than the U.S. at the height of its boom.” It also reports that the homeownership rate is 90%, and it’s estimated that urban Chinese people have more than 70% of their net worth in property. If Xi is really set on taking air out of China’s property bubble by reducing the availability of credit to developers and making housing more affordable, lots of his citizens will be very unhappy.

(2) A September 20 Bloomberg article reported, “China is planning to expand air pollution curbs in Beijing and nearby provinces to more cities that are crucial for the production of coal, steel and transport fuel. The move comes as President Xi Jinping tries to ensure blue skies for the Winter Olympics to be held in and around the Chinese capital in February, and are on top of national efforts to reduce carbon emissions and control power usage to improve efficiency and avoid crunches.”

(3) Some northern provinces have ordered industrial cuts in order to meet emissions and energy intensity goals, while others are facing an actual lack of electricity amid high demand. Residents in several of these provinces have been experiencing blackouts. The September 26 Bloomberg reported, “Power rationing has spread across many of China’s economic powerhouse provinces as local governments risk missing targets for reducing the emissions intensity of their economies, with smelters in Yunnan, textile plants in Zhejiang and soybean crushers in Tianjin all reported to have halted to prevent power cuts to non-industrial users.”

(4) During August, China’s PPI inflation rate was 9.5% y/y, the highest since September 2008 (Fig. 10). The PPI for coal is up 57.1% (Fig. 11). The CPI was up only 0.8% over the same period. It was held down by meat prices, which fell 27.1% (Fig. 12). However, the CPI for fuel and power was up 26.2% (Fig. 13).

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What Are the Odds?

September 27 (Monday)

YRI Podcast. In our latest video podcast, Dr. Ed discusses the main points of today’s Morning Briefing.

On the Road Again: Cincinnati. At the end of last week, I visited our accounts in Cincinnati. It was my first business trip since the start of the pandemic. I really enjoyed meeting with these folks again in person. Everyone I met seems to be Zoomed out and happy to be in their offices at least part time.

The hotel I stayed at was comfortable but short staffed. At breakfast, the waitress asked me if I would like coffee. I said “yes.” She brought it. Then I had to ask her for milk, sugar, and a spoon. She brought them all in three separate trips. My experience confirms the macro data showing that it is hard to get skilled help. On the taxi ride back to the airport, the driver, a retired undertaker, shared some strange stories about dead people with me. As I said, it’s nice to be on the road again.

In my meetings, there was no shortage of subjects to discuss, including Evergrande, Xi, Mao, China, Taiwan, demography, supply chains, transitory inflation, persistent inflation, wage-price spirals, stagflation, debt ceiling, fiscal cliff, tapering, bond yields, Powell, productivity, technology, labor force, unemployment, pandemic, earnings, profit margins, labor costs, commodity prices, West Coast ports, natural gas, Growth vs Value, and the dollar.

We also discussed the odds of the current decade playing out like either the Roaring ‘20s (TRT-2.0) or the Great Inflation of the ‘70s (TGI-2.0). In addition, we talked about a related topic: Will inflation be transitory or persistent? In the June 1 Morning Briefing, I assigned a 65% subjective probability to TRT-2.0 and 35% to TGI-2.0. I also wrote: “I may be spending much of the rest of this decade tweaking these probabilities.” For now, I’m staying with 65/35. The following two sections update my views on these two alternative scenarios.

US Economy I: TRT-2.0 (65% probability). In the Roaring 2020s scenario, companies use technological innovations to augment the physical and mental productivity of their workers in response to the chronic shortage of labor. Demographic factors explain why the labor force currently is growing by only 0.2% annually, though immigration might boost this growth rate a bit (Fig. 1). Nonfarm business (NFB) productivity, based on the five-year growth rate at an annual rate, has already rebounded from 0.5% at the end of 2015 to 2.0% during Q2-2021. In the Roaring 2020s scenario, it rises to 4.0% by the second half of the current decade, matching peaks in previous productivity booms (Fig. 2). Consider the following related developments:

(1) More on productivity. This may be hard to believe, but the productivity data compiled by the Bureau of Labor Statistics show that the drop in the growth rate of productivity over the past two decades was largely attributable to manufacturing rather than services (Fig. 3). I believe that’s because manufacturing capacity stopped growing in the US after China joined the World Trade Organization (WTO) at the end of 2001 (Fig. 4).

In the Roaring 2020s, manufacturing is reshored to the US in response to labor shortages in China and the worsening Cold War between China and the US. That may take some time and be expensive, but the supply chains brought back home should be very productive and save on transportation costs. Debbie and I are able to track manufacturing productivity on a monthly basis with our manufacturing productivity proxy, which is simply manufacturing industrial production divided by payroll employment in manufacturing (Fig. 5). Its 20-quarter annualized growth rate actually had been negative since mid-2015 until just recently turning flat in August!

(2) Good for labor. In TRT-2.0, the labor market remains tight, especially as supply chains are reshored. Wages increase at a faster pace, but that’s not inflationary because of the rebound in productivity growth. We have previously observed that the growth rate of inflation-adjusted NFB hourly compensation is highly correlated with the growth rate of productivity (Fig. 6). Faster growth in the latter will allow real pay to grow faster as well, thus boosting the growth in consumers’ purchasing power and standards of living.

(3) Great for profit margins. Faster growth in productivity boosts not only real wages but also corporate profit margins. The pandemic seems to have accelerated the pace of productivity growth, as companies have embraced technology as the best and fastest way to boost productivity. We can see this in the S&P 500 profit margin, which rose to a record high of 13.5% during Q2-2021 (Fig. 7).

Of course, this series can be misleading if rising commodity prices boost the margins of commodity producers in the S&P 500. I asked Joe to calculate this margin excluding the Energy and Materials sectors of the S&P 500. This measure rose to an even higher record high of 14.1%!

We are able to monitor the S&P 500 forward profit margin on a weekly basis with and without Energy and Materials (Fig. 8). Both rose to record highs during the September 16 week.

(4) Good for business. July’s business sales of goods was released along with August’s retail sales on September 16. This series, which is highly correlated with aggregate S&P 500 revenues, rose 16.3% y/y to a record high during July, while S&P 500 aggregate revenues jumped 24.4% y/y through Q2 (Fig. 9 and Fig. 10). While nominal retail sales has been in a downward trend since it hit a record high during April, both manufacturing shipments and wholesale sales rose to record highs during July (Fig. 11).

The slowdown in retail sales reflects the very strong 48% recovery in this series, from its bottom during April 2020 through its recent peak, that obviously must have satisfied lots of pent-up demand—so much so that business inventories have yet to fully recover, particularly in the retail sector (Fig. 12 and Fig. 13). In other words, inventory restocking should boost economic activity during the second half of this year, offsetting the slowdown in consumer spending.

Below, Debbie discusses the Index of Leading Economic Indicators. It rose 0.9% m/m in August and 21.0% during the past 16 months—averaging monthly gains of 1.0% over the past six months. It’s been rising in record-high territory since April.

(5) Expanding capacity. As noted above, US manufacturing capacity has been basically flat since China joined the WTO. It has remained flat so far this year through August. However, a strong economic recovery so far, lean inventories, tight labor markets, parts shortages, and reshoring should stimulate capacity expansion in the US. Debbie and I are watching manufacturing capacity as well as capital spending indicators.

We like what we are seeing in the monthly data on industrial production of business equipment (Fig. 14 and Fig. 15). Output of high-tech equipment continues to rise in record territory. Industrial equipment output has fully recovered to its pre-pandemic level. New orders for industrial equipment is up 84% y/y through July to a record high (Fig. 16). The Biden administration’s proposed infrastructure spending program should boost orders and output of construction equipment.

US Economy II: TGI-2.0 (35% probability). There are still eight years and three months ahead for the current decade. So it could take some time before we can determine which of the two scenarios best describes the 2020s. We believe that the most important variable in deciding the winner will be productivity.

Productivity growth collapsed during the 1970s. Based on the 20-quarter percent change at an annual rate, it peaked at a record 4.6% during Q1-1966, falling to 0.2% during Q3-1982. As noted above, we will also be monitoring real wages and profit margins.

Also during the 1970s, the dollar was weak and commodity prices soared. Labor unions had cost-of-living clauses. So the jump in food and oil prices spread rapidly to wages, resulting in a wage-price spiral.

This time, the dollar was weak earlier this year, but has stabilized since the spring. Commodity prices have soared over the past year, but China’s economy is slowing. So commodity prices may be peaking already. Unlike the 1970s, we are expecting a technology-led productivity boom during the 2020s.

US Economy III: Inflation Odds. Most important for determining whether the current decade will be TRT-2.0 or TGI-2.0 will be inflation. In the TRT-2.0 scenario, the jump in inflation in recent months is either transitory, lasting through the end of this year, or a bit more persistent, lasting through mid-2022. In the TGI-2.0 scenario, inflation remains troublesome over the rest of the decade. Here are the three inflation scenarios with our subjective probabilities:

(1) Transitory and short lived (40%). Debbie and I believe that China’s domestic woes are making a top in commodity prices (Fig. 17). A drop in commodity prices would be an early sign that inflationary pressures are dissipating.

We are also monitoring the averages of the prices-paid and prices-received indexes of the five regional Fed districts. We have New York, Philly, and Kansas City so far for September. Their averages are also looking toppy (Fig. 18).

Fed Chair Jerome Powell has been the most vocal proponent of the notion that the recent surge in inflation reflected the “base effect” of the pandemic, with prices depressed during the lockdowns last year and rebounding this year. The inflation readings in coming months will either confirm or refute this notion.

(2) Transitory but longer lasting (25%). Joe and I expect that during the Q3 earnings reporting season starting in early October, company managements will talk about rising labor costs and ongoing shortages of workers. Some may say that they are either raising prices, boosting productivity, or taking a hit in profit margins.

The word “shortage” appears 77 times in the Fed’s Beige Book dated September 8. That’s up from 61 mentions in the July 14 report and just 19 in the January 13 report. We expect that labor shortages will be offset by productivity gains and that shortages of parts will diminish as global economic growth slows and as broken supply chains are repaired.

We agree with Powell’s base-effect case for transitory inflation. However, we think inflation could prove to be more persistent than Powell seems to. In the PPI, parts shortages may continue to boost prices. In the CPI and PCED, rent inflation is already showing signs of making a comeback.

(3) Persistent (35%). In the TGI-2.0 scenario, inflation is persistent and could get worse. It has turned out to be more troublesome than Fed officials expected. The FOMC’s Summary of Economic Projections shows the following median forecasts for PCE inflation in 2021: December 2020 (1.8%), March 2021 (2.4), June (3.4), and September (4.2).

If productivity growth doesn’t improve as we expect, then upward wage pressures would cause a wage-price spiral similar to what happened during the 1970s.

Another recent concern of ours is that climate change activists are succeeding in pushing their agenda to get us off our addiction to fossil fuels. This is causing major withdrawal pains since alternative sources of energy are turning out to have some significant disadvantages. For example, wind turbines don’t work when the wind stops blowing. Under pressure from the activists, the major oil companies are limiting their spending on new oil and gas supplies. Alternative renewable sources of energy aren’t coming on stream fast enough to replace the deficit between demand and supply, and they aren’t reliable when we especially need them such as during the winter.

Natural gas prices are soaring. Rapidly rising energy prices boost inflation and depress economic growth. The result could be stagflation. (See our story “Running Low on Gas” in the September 23 Morning Briefing.)

Movie. “Nine Perfect Strangers” (+) (link) is an eight-episode mini-series on Hulu about nine very different people who are hoping to find peace from their demons at Tranquillum House, a secluded retreat run by a mysterious wellness guru, Masha, played by Nicole Kidman. Masha’s treatments include the usual Zen rituals such as meditation. But she also spikes her guests’ breakfast smoothies. The acting is good, especially by Melissa McCarthy, Michael Shannon, and Bobby Cannavale. The series is entertaining but not a must-see.

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Natural Gas & Unnatural Exosuits

September 23 (Thursday)

China: More on Evergrande. As the drama around Evergrande continues to unfold, the company reported Wednesday that it had “reached an agreement” with yuan bondholders, which isn’t the same as saying, “We’ve made our interest payment.” But that statement plus a large liquidity injection by the Chinese central bank was enough to stabilize the situation for the moment.

Foreign investors in the company’s dollar-denominated bonds will get a better idea today of how they’ll be treated when a dollar-denominated bond interest payment is due. Our guess: They won’t be treated as well as yuan bondholders.

The importance of the real estate market to the Chinese economy is unquestionable. One analyst on Twitter listed no fewer than 31 Chinese real estate companies, which had leverage ranging from 20% to 123%. At least eight Chinese cities have come up with measures to prevent developers from selling homes at sharp discounts, thereby harming the broader market, a September 22 article in the South China Morning Post reported.

Some analysts are speculating that Chinese President Xi Jinping is okay with the demise of Evergrande and some pain in the real estate market if it washes out the sector’s speculation and means that apartment prices fall to levels more affordable for the average Joe. But sometimes, you have to be careful what you wish for. Those real estate companies have workforces. They employ tradespeople. They buy materials and furniture. So any slowdown in the real estate business would have ripple effects that extend far beyond the real estate companies at the center of the problem. Put differently, the Chinese Central Bank might not have felt the need to make such a large liquidity injection if all were well.

US companies that generate revenue from China should be concerned, particularly if they sell products to real estate developers or to Chinese consumers. Names mentioned in this 2020 CNBC article as having large Chinese exposure include Wynn Resorts and Las Vegas Sands, which have large chunks of revenue coming from Macau. Other standouts with large revenue generated in China include: Apple (17%), Nike (17), Estee Lauder (17), Tapestry (15), and Starbucks (10). Meanwhile, 7%-10% of fees at Marriott and Hyatt are sourced from their Chinese operations. And we haven’t touched upon the companies that produce commodities used in apartment building construction.

So while financial markets rallied on Wednesday, we wouldn’t take it as a sign that the Evergrande crisis is over.

Energy: Running Low on Gas. Corporate margins, while still at record highs, are facing a trifecta of pressures. US wages are on the rise as employers are having difficulties filling open jobs. Transportation costs are soaring, as more than 70 container ships bob outside of the Port of Los Angeles. And then there’s the latest problem: the soaring price of natural gas.

The price of natural gas futures has risen 89% ytd, from $2.54 as the year began to $4.81 as of Tuesday’s close, off a bit from this year’s high of $5.46 last Wednesday (Fig. 1). The price hasn’t been this high since a brief spike in 2013. The surge in the price of natural gas is particularly notable because it comes in advance of the winter heating season, when a price pop normally occurs. The natural gas price jump has caused the price of electric power and carbon credits in Europe to jump as well (Fig. 2).

The potential problem is rooted in Europe, where we may be witnessing the unexpected consequences of the European Union’s push to cut greenhouse emissions. Less natural gas is being produced in Europe, and a greater dependency on wind power and imports is proving unreliable. The skyrocketing price of natural gas is affecting business operations in Europe and raising questions about the wisdom of the US exporting our natural gas supplies. Here’s a quick look at the situation:

(1) No wind in the sails. The UK has noble intentions of cutting its carbon footprint by turning to electricity generated by windmills and by closing all coal plants by late 2024. Wind power represented about a quarter of the power used by Great Britain last year. But the wind in the North Sea unexpectedly dropped dramatically in September, reducing related electricity production, a September 13 WSJ article reported. The shortfall of wind-generated electricity has forced a return to gas- and coal-fired electricity plants.

(2) Low gas inventories. The need for natural gas-generated electricity comes at an inauspicious time. Natural gas inventories are extremely low in Europe, which is unusual for this time of year because the heating season hasn’t begun. There has been lower production of natural gas in Europe due in part to EU taxes on carbon emissions meant to discourage the use of fossil fuels. Denmark committed to stop pumping oil and gas by 2050. And a Dutch gas company decided to close a huge gas field near Groningen due to public pressure after earthquakes hit nearby, a September 22 WSJ article reported.

Capital expenditures for upstream oil and gas projects worldwide fell more than 25% in 2020 to about $305 billion, down from $420 billion a year earlier, according to data from Statista. This year, capex is expected to increase by only 2% to $310 billion. That likely won’t be large enough to keep up with increasing demand for energy as the global economy rebounds from Covid.

As natural gas production has slowed, Europe has grown increasingly reliant on imports from the US and Russia. Russia supplies about 40% of Europe’s natural gas. While Kremlin-controlled Gazprom has fulfilled its long-term contracts, it has restricted additional sales and allowed its storage facilities in Europe to fall to low levels, a September 22 FT article noted.

A September 19 Bloomberg article attributed Russia’s lack of additional sales to Europe to an energy crunch that Russia is facing. However, the International Energy Agency has called on Russia to increase natural gas supplies to Europe, while the European parliament has launched an investigation into Gazprom’s actions, the FT article stated. The unanswered question is whether Russia is cutting off supplies in retaliation for the US opposition to the Nord Stream 2 pipeline, which would carry gas from Russia to Europe and, from the US perspective, make Europe even more dependent on Russia’s natural gas supplies.

Adding to the difficult situation, European buyers are competing against Brazilian and Asian buyers for liquid natural gas (LNG) supplies. “[C]ountries from Japan to India are panic-buying before the winter, heightening competition for the small fraction of the supply that trades freely in the spot market and isn’t tied to long-term contracts,” a September 20 Bloomberg article reported. Demand for LNG is also coming from Brazil, which has turned to the energy source because it is suffering from a drought that has reduced the hydropower that’s normally generated by dams.

(3) Ripple effects. European governments have started to plan how to provide emergency aid to households and utilities hurt by the high costs of natural gas and electricity. UK energy retailers are distressed because of the spike in gas and electric prices. PFP Energy and MoneyPlus Energy went out of business when electricity prices spiked earlier this month. Green Energy and Avro—a small energy retailer and a medium-sized energy retailer covering 1.5 million UK households—declared bankruptcy this week. More bankruptcies are expected.

Natural gas is used to make ammonia, which is used in the production of ammonium nitrate, a fertilizer. Two fertilizer factories in the UK owned by CF Industries Holdings shut down because of high gas prices, as did a Norwegian fertilizer manufacturer Yara International. The British government struck a deal with CF Industries to restart and run one of its plants.

If farmers don’t have access to fertilizer, food production could fall and prices could spike. Or farmers could pass on the higher cost of fertilizer and charge more for their crops. In addition, carbon dioxide is a byproduct of fertilizer production and is used by numerous industrial processes including the slaughter of animals and manufacture of vacuum packs, dry ice, and beer, a September 20 WSJ article reported.

(4) Impact at home. US and Russian gas exporters are making hay. US LNG exports have grown to record highs in the first half of 2021, and natural gas sales to Mexico through a pipeline increased 25% y/y in June, noted a September 20 article in Oilprice.com. In total, US natural gas exports rose to 5.4 trillion cubic feet in June, up from 3.4 trillion a year ago and 1.8 trillion five years ago (Fig. 3). The shares of Cheniere Energy, a US LNG exporter, have climbed almost 50% ytd.

As a result, 16% of US natural gas production is now being exported, and US inventories are about 8% below their five-year average. A trade group representing chemical, food, and materials manufacturers, the Industrial Energy Consumers of America, has urged the Department of Energy (DOE) to order LNG producers to reduce exports due to the risk of price increases and shortages of natural gas in the US this winter, a September 17 Reuters article reported.

ICEA also has asked the DOE to freeze permitting for new LNG export plants and to order producers to reduce shipments until US inventories increase, the Reuters article stated. “Buyers of LNG who compete for natural gas with U.S. consumers are state-owned enterprises and foreign government-controlled utilities with automatic cost pass through,” said Paul Cicio, president of IECA. “U.S. manufacturers cannot compete with them on prices.”

The world needs a warm winter.

Disruptive Technologies: Sensitive Robots. We may be hopelessly old-fashioned, but when we think “robot,” what comes to mind is Rosie the Robot in The Jetson’s 1960s cartoon. Rosie had a heart of gold, though her body was made of steel. Some of today’s newest robots are made of much softer materials, allowing them to be worn comfortably and pick things up delicately. Here’s a look at some of the new tricks these soft robots have learned:

(1) Spiderman’s suit comes alive. Muscle and joint injury is one of the top reasons a soldier is removed from combat. Early R&D had focused on exoskeletons, robotic limbs that a soldier could strap on to increase the body’s strength. But exoskeletons tend to be bulky and uncomfortable for long-term use.

In 2011, the Defense Advanced Research Projects Agency (a.k.a. DARPA) started the Warrior Web program to spur development of a lightweight “exosuit” for soldiers to wear under their uniforms to augment the work of muscles and reduce injuries, a June 3 SRI International blog post explained. SRI answered the call by developing the SuperFlex, a soft, flexible body suit with “artificial muscle actuators.” The actuators use “twisted pair transmissions” that can duplicate the “forces and motions of natural muscles with very little added bulk or weight.”

Basically, the fabric contains devices that help the muscles move. The suit is also made of a fabric that distributes loads across the skin. In addition, it contains motion trackers that can predict the user’s action to know when to complement the motion of the user and not fight against it.

SRI’s technology was spun off into another company, Seismic, and Seismic Powered Clothing was developed. It aims to help workers avoid injury and to give the elderly and disabled additional core support, strength, power, and mobility.

(2) Picking Peeps. Soft Robotics has developed claw-like devices made of flexible materials that have the dexterity to pick up and move soft, irregular items like fruits and vegetables, rolls, chicken wings, and Peeps without damaging them. The company has combined its soft pickers with 3D machine perception and artificial intelligence to make even smarter pickers that have hand-eye coordination. The privately held company counts ABB Technology Ventures, FANUC, Honeywell Ventures, and Yamaha Motor as investors.

RightHand Robotics’ picking system can delicately pick up irregularly shaped products of various weights. The company’s robots were chosen by Apologistics, an online pharmacy in Europe, to pick up products in its new fulfillment center. A facility that sends out 25,000-30,000 parcels per day requires no more than 20 employees working in automation. “Competitors our size have 250 to 300 people in fulfillment working around the clock for the same output,” said Michael Fritsch, founder of Apologistics, in a RightHand presentation.

(3) Electrifying invention. Grabit uses electrohesion—the static cling that makes a balloon stick to your hair—to automate the lifting and moving of items. It’s a technology invented at the above-mentioned SRI International by a group led by Harsha Prahlad. The technology was licensed to Grabit, where Prahlad is a co-founder and chief technology and products officer.

Grabit says its machines can pick up items as delicate and light as an egg or as large as a 50-pound box. One machine stacks products like leathers, meshes, and composite fibers; another keeps packages from bunching up on conveyor belts. Grabit even offers a conveyor belt that sorts items as they move.

Nike uses Grabit machines to stack the 40 pieces of material used in the upper part of a sneaker; the task, which takes a human 20 minutes, is completed by a Grabit machine in just 50 seconds, according to a case study by TM Robotics that appeared in Robotics Tomorrow on April 15.

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Animal Farm

September 22 (Wednesday)

China I: Gray Rhinos and Black Swans. Michele Wucker’s book The Gray Rhino: How to Recognize and Act on the Obvious Dangers We Ignore was published in 2016. It is especially relevant to 2021. She defines a “gray rhino” as “a highly probable, high impact yet neglected threat: kin to both the elephant in the room and the improbable and unforeseeable black swan. Gray rhinos are not random surprises, but occur after a series of warnings and visible evidence. The bursting of the housing bubble in 2008, the devastating aftermath of Hurricane Katrina and other natural disasters, the new digital technologies that upended the media world, the fall of the Soviet Union … all were evident well in advance.”

More recently, the pandemic started as a black swan event early last year. This year’s white rhino is Evergrande. Consider the following:

(1) The rhino’s first appearance. Evergrande is the second-largest property developer in China. It is also the world’s most indebted developer. According to an article on Bloomberg yesterday, it had a liquidity scare in August 2020 when it reportedly sent a letter to the provincial government of Guangdong, warning officials that it might default on payments due in January 2021 with dire consequences for the entire financial sector. The article observed:

“Reports of the plea for help emerged on September 24 [in 2020], sending Evergrande’s stock and bonds tumbling even as the company dismissed the concerns. The letter, which was widely circulated on social media, was verified to Bloomberg at the time by people familiar with it, but Evergrande later disputed its authenticity. Crisis was averted soon … when a group of investors waived their right to force a $13 billion repayment.”

Bloomberg also reported that “Beijing was said to have instructed authorities in Guangdong to map out a plan to manage the firm’s debt problems, including coordinating with potential buyers of its assets. Regulators in September last year signed off on a proposal to let Evergrande renegotiate payment deadlines with banks and other creditors, paving the way for another temporary reprieve.”

(2) Reining in the rhinos. This year, the September 15 WSJ reported: “Worried about a housing bubble, China’s government has repeated the mantra that ‘homes are for living in, not for speculation,’ for almost half a decade, but pressure on real-estate developers has intensified in roughly the last year. Regulators have capped banks’ exposure to real estate, both in loans to developers and mortgages; introduced a system of ‘three red lines’ that restricts more indebted developers from taking on new debts; and overhauled land auctions. Local governments have also introduced their own curbs to help rein in the market.”

(3) Wounded rhinos. Those credit-tightening measures have hit property developers hard. As of mid-August, developers had defaulted on $6.2 billion of high-yield debt this year, a higher total than the previous 12 years combined. Bad property loans at commercial banks are the highest in more than a decade. National home sales by value tumbled 19.7% y/y in August, the largest drop since April 2020. Growth in home prices and real-estate investment has slowed, while construction starts fell 3.2% in January-August, compared to a year earlier.

Monday’s South China Morning Post reported that more cracks are starting to show among other Chinese developers. The yields on Chinese junk-rated companies are soaring. By one measure, they are up from 10.5% on June 30 to 15.8% last week. It’s starting to play out as an old-fashioned credit crunch that could burst China’s housing bubble.

(4) Bad assumption. In recent days, we’ve suggested that the Chinese government will have no choice but to intervene by selling pieces of Evergrande to other property companies in China. The problem with that notion is that its competitors may be turning into wounded rhinos as well. If so, then the Chinese government will be forced to reconsider the size and scope of the measures that will be necessary to avert the Great Fall of China, or at least a crash in its real estate sector.

By the way, the publicist for Wucker’s book stated that it was the #1 best-selling English language book in China in 2016.

China II: George Orwell’s Playbook. George Orwell published Animal Farm: A Fairy Tale in 1945. Wikipedia describes the book as follows: “The book tells the story of a group of farm animals who rebel against their human farmer, hoping to create a society where the animals can be equal, free, and happy. Ultimately, the rebellion is betrayed, and the farm ends up in a state as bad as it was before, under the dictatorship of a pig named Napoleon.”

The US publishers dropped the subtitle when it was published in 1946. Orwell suggested the subtitle used for the French translation of the book, “Union des Républiques Socialistes Animales,” which abbreviates to “URSA,” the Latin word for “bear,” a symbol of Russia.

A modern-day version of Orwell’s playbook for dictators is now playing out in China. An excellent summary is provided in a September 20 WSJ article titled “Xi Jinping Aims to Rein In Chinese Capitalism, Hew to Mao’s Socialist Vision.” Chinese President Xi Jinping is a fan of Mao Zedong, whose autocratic rule of China from 1943 to 1976 was marked by policy disasters and bloody power struggles. In March 2018, the Chinese Communist Party (CCP) unveiled plans to let Xi remain president indefinitely. He is also party chief and military-commission chairman. These two additional powerful positions aren’t subject to formal term limits.

On July 1, 2021, when the CCP celebrated its centenary, Xi wore a Mao suit and stood behind a podium adorned with a hammer and sickle, pledging to stand for the people. After the speech, he sang along with “The Internationale” broadcast across Tiananmen Square. In China, the song long has symbolized a declaration of war by the working class on capitalism.

This year, Xi has launched a multi-front campaign against private enterprise. An August 1, 2021 Bloomberg article called the government’s recent assault on capitalism “progressive authoritarianism.” In the August 23 Morning Briefing, we concluded:

“President-for-life Xi and his CCP seem to have decided that the state must do everything in its power to increase the birth rate in China. That means that the cost of having children has to be lowered at the same time as incomes are boosted for more families. That requires reducing income inequality so that the rich don’t drive up the prices of goods and services that are necessary for childrearing. The result has been a barrage of regulations on business. They are seemingly unrelated. The common theme though is to change China’s destiny by changing its demographic profile with more babies.”

Strategy I: More Gray Rhinos. In Monday’s Morning Briefing, Joe and I compiled a list of nine potential gray rhinos that could unsettle the stock market. At the top of the list is Evergrande:

(1) Evergrande could be China’s Lehman or LTCM.
(2) Inflation has yet to show signs of peaking.
(3) The Fed is expected to start tapering before the end of this year.
(4) The debt ceiling has to be raised so that the Treasury can pay the bills.
(5) The Dems are pushing trillion-dollar spending and tax proposals through Congress.
(6) Parts shortages are forcing companies to scale back their production.
(7) Valuation remains elevated.
(8) There are plenty of geopolitical risks.
(9) And oh yeah, the pandemic is still out there.

Nevertheless, we concluded: “We acknowledge that there are both technical and fundamental issues weighing on the market over the near term. We expect that most of them will be cleared up by the end of October, setting the stage for the traditional year-end Santa Claus rally.”

So we don’t expect that these gray rhinos will kill the bull that’s been charging in the stock market since March 2009. Indeed, we recently raised our 2022 year-end target for the S&P 500 to 5200. Then again, we don’t have a list of black swans since they are unforecastable by definition.

Strategy II: Blue Angels. We’ve discussed gray rhinos and black swans; now let’s talk about blue angels. That is, let’s turn to our Blue Angels analysis, which tracks the S&P 500 price index relative to the S&P 500’s forward earnings per share (i.e., the time-weighted average of consensus estimates for this year and next) multiplied by forward P/Es of 10 to 24 in increments of 2 (Fig. 1). It shows that forward earnings continued to rise to yet another record high through the September 20 week. Earlier this year, the S&P 500 was following the Blue Angel flight pattern represented by a 22.0 forward P/E; with Monday’s selloff, the forward P/E fell to 20.3 (Fig. 2).

A closer look at the fundamentals of the S&P 500 shows that forward revenues remained on a steep uptrend in record-high territory through the September 16 week (Fig. 3). The same can be said about forward earnings, which is now up to a record-high $214.80 per share. The forward operating profit margin was unchanged at 13.2% during the September 16 week, which was unchanged from the week before—and also at a record high. These metrics all augur well for Q3’s earnings season next month.

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Too Grande To Fail?

September 21 (Tuesday)

China I: Buy on the Drop? Joe and I might have to start a panic attack list for the China MSCI stock price index like the one we’ve been keeping for the S&P 500 stock price index since 2009. We are up to 69 panic attacks in the S&P 500. (See our S&P 500 Panic Attacks Since 2009.)

Since 2009, there have been several selloffs in the China MSCI stock price index (Fig. 1). They tended to coincide with the selloffs in the S&P 500, suggesting that most of them weren’t homegrown and were caused by the jitters in the US stock market (Fig. 2).

However, the selloff in China’s MSCI during 2018 was attributable to mounting trade tensions between the US and China. The selloff in early 2020 was triggered by the pandemic lockdowns that the Chinese government imposed during January and February of that year. The selloff in recent weeks has been caused by numerous regulations imposed on high-tech companies in China by the government. The drop in China’s MSCI in recent days has been caused by the looming collapse of Evergrande. This index peaked at a record high on February 17 and is down 29.4% since then through Friday’s close. China’s stock markets are closed for their mid-Autumn festival, so the China MSCI index will likely fall even further when trading begins on Wednesday.

As we all have learned very quickly in recent days, Evergrande is a huge property developer in China. Here are the gory details of Evergrande’s rise and fall, some of which Jackie and I reviewed last Thursday:

(1) Massive scale. Evergrande until recently was China’s second-largest property developer, with $110 billion in sales last year. It has $355 billion of assets across 1,300 developments, many located in China’s lower-tier cities. Evergrande has 200,000 employees and hires 3.8 million workers every year for project developments. Evergrande has 800 residential buildings across China that are unfinished, leaving as many as 1.2 million people not knowing when or if they will be able to move into their new homes.

(2) Massive debt. The company’s liabilities exceed $300 billion and are owed to more than 128 banks and more than 121 non-bank institutions. Evergrande is one of the largest bond issuers in the emerging markets, with $20 billion of debt outstanding.

Evergrande raised funds in the shadow banking market via trusts, wealth management products, and commercial paper. About 40 billion yuan, or roughly $6 billion, of the wealth management products have matured, and the company has not paid investors. An Evergrande executive said that more than 70,000 people across China have bought the company’s wealth management products. Many of the investors are Evergrande workers because the company encouraged staff to purchase the investments.

Yesterday, The New York Times reported: “When the troubled Chinese property giant Evergrande was starved for cash earlier this year, it turned to its own employees with a strong-arm pitch: Those who wanted to keep their bonuses would have to give Evergrande a short-term loan.”

(3) Massive crisis. Evergrande is facing a liquidity crisis. In what’s never a good sign, the firm hired two restructuring shops—Houlihan Lokey (China) and Admiralty Harbour Capital—and retail investors in Evergrande’s wealth management products showed up at headquarters to demand their money back. On Friday, Chinese junk-bond yields jumped to an 18-month high, and shares of real estate companies plunged after Evergrande had its credit rating downgraded and requested a trading halt in its onshore bonds. Evergrande’s main banks were told by China’s housing ministry last week that the developer won’t be able to make interest payments due September 20, which was yesterday.

(4) Massive save? We believe that Evergrande is too big to fail. Yesterday, we observed: “The financial press has been suggesting that the collapse of China’s second-largest property developer could cause shock waves similar to Lehman’s bankruptcy in 2008. We think the collapse of Long-Term Capital Management (LTCM) in 1998 is a better analogy. We expect that the Chinese government will restructure Evergrande, probably by splitting up its businesses among other property developers.”

Lehman was allowed to fail by the US Treasury and the Fed. (See Appendix 4 of my book Fed Watching For Fun and Profit.) They could have chosen to bail it out but didn’t. US government officials should have known better but didn’t. Lehman had sold lots of credit derivative products around the world. The resulting financial crisis confirmed that Lehman was too big to fail. LTCM was restructured by the Fed with the help of the major banks in the US. Lehman turned a garden-variety bear market in the stock market into a ferocious bear market. LTCM triggered a garden-variety correction.

Chinese government officials are well aware of the headlines comparing Evergrande to Lehman. They are well aware of the consequences of letting the firm fail. So they’ll intervene to restructure it. When, they do, stock markets around the world should enjoy relief rallies.

China II: Structural Problems. China’s property developers have been a very important source of economic growth and employment in China. The Chinese government needs all the growth it can get out of the property sector and export markets because China’s consumer spending has been slowing dramatically as a result of its rapidly aging demographic profile.

Inflation-adjusted retail sales in China may be the most important variable for tracking the increasingly dismal economic impacts of China’s aging demographics. Every month, the Chinese report nominal retail sales and the CPI, which we use to calculate real retail sales. We’ve been monitoring the yearly percent change in this series for the past few years (Fig. 3). To smooth out the impact of the pandemic on this series, Mali and I calculate the 24-month growth rate in the 24-month average of the series (Fig. 4). The result must be downright alarming for the Chinese government. At an annual rate, this growth rate peaked at a record high of 18.7% during May 2011. It has been trending down since then, falling to almost zero during August of this year!

We’ve been monitoring this series for some time as an indicator of how China’s rapidly aging population might weigh on the country’s economic growth. The legacy of China’s disastrous one-child policy, which was imposed from 1979 through 2015, has frustrated the government’s efforts to transform the Chinese economy from export-led growth to consumer-led growth. The ongoing strength in China’s exports explains why industrial production growth, calculated on the same basis as real retail sales, remains relatively strong around 5%—though that too is down significantly from a peak of 15.0% during March 2012 (Fig. 5).

Perhaps China needs to be building more nursing homes and fewer apartment buildings.

China III: Credit Crunch Unlikely. From what we can gather, we don’t expect Evergrande’s troubles to cause either a domestic or global credit crunch. To put its $300 billion debt into perspective, consider that Chinese bank loans have increased from about $5 trillion during 2008 to about $30 trillion now (Fig. 6). Chinese social financing totaled $4.7 trillion over the past 12 months through August (Fig. 7). That sum includes $3.1 trillion in bank loans (Fig. 8).

Chinese banks have been able to finance all of their lending with their deposits. M2 increased from around $6 trillion during 2008 to $36 trillion currently. Bank loans are currently 81.2% of M2, a record high, but have never come close to 100% of M2 (Fig. 9).

So we don’t expect a credit crunch in China. We do expect that the People’s Bank of China (PBOC) will inject more liquidity into the financial system. While the Fed, ECB, and BOJ all are talking about talking about tapering, the PBOC is expected to ease credit conditions in response to the slowing of China’s economy as a result of high raw material costs, new Covid-19 outbreaks, floods, and now Evergrande.

The PBOC delivered a surprise cut in bank reserve requirements in July (Fig. 10). Another one is likely before the end of this year. In mid-August, the PBOC also injected billions of yuan through medium-term lending facility (a.k.a. MLF) loans into the financial system.

China IV: Global Repercussions. At this time, the major global impact of the Evergrande crisis is likely to be on foreign exchange and commodity markets. The trade-weighted dollar bottomed this year on June 1 and rose 2.6% through Friday’s close and is likely to move higher now (Fig. 11). The trade-weighted dollar tends to be highly inversely correlated with the Goldman-Sachs commodity index (S&P GSCI). This index has been looking toppy in recent weeks.

Among the commodity prices that are most sensitive to economic activity in China is the price of copper. More often than not, the China MSCI stock price index (in yuan) closely tracks the price of copper (Fig. 12). As noted above, the China MSCI is down 29.4% from its record high on February 17 through Friday’s close. Copper has been looking toppy in recent weeks, and now is likely to move lower.

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What’s the Matter?

September 20 (Monday)

YRI Podcast. In our latest video podcast, Dr. Ed discusses the main points of today’s Morning Briefing.

Strategy I: Sloppy Looking Technicals. The S&P 500 peaked at a record 4536.95 on September 2. By Friday’s close, it was down 2.3% to 4432.99. It declined for a second week in a row (Fig. 1). Could this be the start of Panic Attack #70? Joe and I don’t think so, but we may be overdue for a fright, especially now that Halloween costumes are already on sale.

Panic Attack #69 occurred in late February, when the brief return of the Bond Vigilantes spooked stock investors. It was more of a panic in the Nasdaq than in the S&P 500 (Fig. 2). The former fell 10.5% from February 12 through March 8. Because Value stocks outperformed Growth stocks back then, there really wasn’t a panic attack in the broader S&P 500. (See our Table of S&P 500 Panic Attacks Since 2009.)

Let’s keep in mind that the S&P 500 doubled from March 23, 2020 through August 16 of this year. It was the fastest doubling of this stock price index since WWII. Joe and I are certain that it won’t double again over the next 12-18 months.

In last Monday’s Morning Briefing, we updated our earnings outlook and targets for the S&P 500. We are now forecasting earnings per share of $210 this year, $220 next year, and $235 in 2023. To forecast the S&P 500, we need to forecast forward earnings per share, i.e., the time-weighted average of consensus estimates for this year and next year. We are predicting $220 at the end of this year, $235 at the end of next year, and $250 at the end of 2023. Assuming a 22.0 forward P/E, our targets for the S&P 500 are now 4800 by the end of this year, 5200 by the end of next year, and 5500 by the end of 2023.

We acknowledge that there are both technical and fundamental issues weighing on the market over the near term. We expect that most of them will be cleared up by the end of October, setting the stage for the traditional year-end Santa Claus rally. Consider the following:

(1) 200-dma. The S&P 500 has exceeded its 200-day moving average (200-dma) for 320 trading days (Fig. 3 and Fig. 4). That’s the longest such stretch since the start of the bull market in 2009. The S&P 500 is overdue for at least a retest of its 200-dma.

(2) Breadth. Earlier this year on April 16, 96.2% of the S&P 500 companies were trading above their 200-dmas. By Friday of last week, this percentage had dropped to 68.1% (Fig. 5). On the other hand, over 90% of the S&P 500 stocks still showed positive y/y price changes last week (Fig. 6).

(3) Dow Theory. Also raising a caution flag is the Dow Theory. The Dow Jones Transportation Index is down 10.5% since it peaked at a record high on May 7. The S&P 500 Transportation Index is down 12.5% since it peaked on May 7 (Fig. 7). It fell to 2.6% below its 200-dma on Friday. That could be a bearish signal for the S&P 500 stock price index (Fig. 8).

(4) Seasonals. September tends to be the worst month of the year for stocks. From 1928 through 2020, it had more down months (50 of them) than did any of the other months. The average price change for the S&P 500 was -1.0% over that period (Fig. 9). October has also been prone to some significant selloffs in the past. However, more often than not, weakness in September and October has created significant buying opportunities.

(5) Sentiment. The Investors Intelligence Bull-Bear Ratio was over 3.00 in recent weeks (Fig. 10). It dropped below that relatively bullish level during the August 17 week, falling to 2.26 during the September 14 week. We expect that it will soon show readings below 2.00. From a contrarian standpoint, the rapid decline in bullish sentiment is bullish.

Strategy II: A Long Worry List. The stock market’s technicals have turned less constructive, mostly because investors have been adding worries to their list of worrisome fundamentals. Since 2009, almost all of the selloffs that we included in our table of panic attacks have been attributable to just one major potentially bearish event. This time, we can identify the following nine worries:

(1) Evergrande could be China’s Lehman or LTCM. Jackie and I wrote about Evergrande in last Thursday’s Morning Briefing. That very same day, Chinese junk-bond yields jumped to an 18-month high, and shares of real estate companies plunged after Evergrande had its credit rating downgraded and requested a trading halt in its onshore bonds. Evergrande’s main banks were told by China’s housing ministry last week that the developer won’t be able to make interest payments due September 20, according to a September 16 Bloomberg story titled “China’s Nightmare Evergrande Scenario Is an Uncontrolled Crash.” As a systemically important developer, an Evergrande bankruptcy would cause problems for the entire property sector, which has been an important source of economic growth and jobs in China.

Evergrande has more than 70,000 investors. It has construction of unfinished properties with enough floor space to cover three-fourths of Manhattan. If that all grinds to a halt, it will leave more than a million homebuyers in limbo. The financial press has been suggesting that the collapse of China’s second-largest property developer could cause shock waves similar to Lehman’s bankruptcy in 2008. We think the collapse of Long-Term Capital Management (LTCM) in 1998 is a better analogy. We expect that the Chinese government will restructure Evergrande, probably by splitting up its businesses among other property developers.

(2) Inflation has yet to show signs of peaking. Last week, the Bureau of Labor Statistics released August’s CPI. It was up 5.3% y/y, which was a downtick from July’s reading of 5.4% (Fig. 11). The core CPI was up 4.0% y/y in August, which was a few downticks from the recent peak of 4.5% during June. That’s just about the only sign that inflation is peaking and the only one confirming Fed Chair Jerome Powell’s “transitory” narrative on inflation. The three-month annualized gains in the headline and core CPI through August were hotter, at 6.6% and 5.3%, though those were somewhat lower readings than two months ago (Fig. 12).

On the other hand, surveys of inflation expectations continued to get hotter in July. (See our Inflation Expectations chart book.) That’s because most people probably give more weight to the more noticeable price increases of items they consume every day such as food and gasoline, which rose 3.7% and 42.7% y/y through August (Fig. 13). Rent inflation is also rising. In recent days, the price of natural gas has doubled (Fig. 14).

(3) The Fed is expected to start tapering before the end of this year. As we wrote in last Tuesday’s Morning Briefing, the WSJ assigns one of its top reporters to watch the Fed. Currently, it’s Nick Timiraos. Fed officials often have set the stage for their next policy move by “planting” the story with the WSJ. On Friday, September 10, Nick wrote an article titled “Fed Officials Prepare for November Reduction in Bond Buying.”

Fed officials clearly are doing everything they can to avoid a tapering tantrum. We think that they will succeed. The WSJ article reported that the FOMC is likely to discuss tapering at its September 21-22 meeting and vote to do so at the November 2-3 meeting. “Under the plans taking shape, officials could reduce those purchases at a pace that allows them to conclude asset buying by the middle of next year.” That certainly sounds like an off-the-record comment by somebody high up at the Fed.

(4) The debt ceiling has to be raised so that the Treasury can pay the bills. Mitch McConnell (R-KY), the Senate’s top Republican, has told Treasury Secretary Janet Yellen that congressional Democrats will have to raise the US debt ceiling on their own, even as she warns of a default and new financial crisis if lawmakers do not raise the federal borrowing limit.

“Let me be crystal clear about this: Republicans are united in opposition to raising the debt ceiling,” McConnell told reporters after a Senate GOP caucus meeting last Tuesday. He said Republicans previously favored lifting the debt ceiling on a bipartisan basis but oppose that now because Democrats are pushing a multitrillion-dollar spending and tax bill the GOP rejects. He has said Democrats should extend the debt limit on a party-line basis in the budget bill. “So if they want to do all of this on a partisan basis, they have the ability and the responsibility to ensure that the federal government does not default,” he said.

Democrats control the House and the Senate, but a debt-ceiling extension is subject to a filibuster, meaning it would require 60 votes to advance. That means winning the support of at least 10 of the 50 Republican senators, which isn’t going to happen. That will force the Democrats to include it in their reconciliation spend-and-tax bill.

(5) The Dems are pushing trillion-dollar spending and tax proposals through Congress. Read his lips. On February 20, 2020 before a national audience during a Democratic debate hosted by MSNBC, President Joe Biden promised: “Taxes on small businesses won’t go up.”

To pay for their $3.5 trillion social welfare agenda, congressional Democrats have proposed $2.9 trillion in new taxes. Their revenue proposal suggests raising the income tax, the corporate tax, and the investment tax, as well as creating an additional surtax on wealthy Americans. It would also introduce forced retirement account distributions, taxes on tobacco and nicotine products, subsidies for journalists, and nearly $80 billion for the Internal Revenue Service to enforce federal tax laws.

According to an analysis by the Americans for Tax Reform, “Despite Biden’s pledge, Democrats have proposed several tax increases that will hit small businesses.” The analysis observes that raising the top income tax rate to 39.6% will increase taxes on businesses organized as pass-through entities like sole proprietorships, LLCs, partnerships, and S-corporations. Raising the corporate tax rate to 26.5% will raise taxes on many small businesses that are structured as corporations.

The analysis concludes: “The Democrat tax-and-spend plan will see small businesses hit with hundreds of billions of dollars in higher taxes, despite Biden’s earlier pledge.”

(6) Parts shortages are forcing companies to scale back their production. The August 30 NYT included an article titled “The World Is Still Short of Everything. Get Used to It.” The “Great Supply Chain Disruption” shows no sign of ending anytime soon. The longer it lasts, the more it is likely to weigh on global economic growth and to boost inflation.

Shipping problems have plagued global supply chains. The boom in post-lockdown demand last year boosted the demand for imports in the US. That caused a shortage of shipping containers, which was exacerbated by pandemic-related shortages of dock workers to load them at major Chinese ports and unload them at West Coast ports in the US. Companies around the world can no longer count on cheap and reliable sea transport of their goods.

(7) Valuation remains elevated. The forward P/E of the S&P 500 has been fluctuating in a flat range roughly between 20.0 and 23.0 since the end of April 2020 (Fig. 15). That’s almost as high as the valuation multiple prior to the bursting of the tech bubble in 2000. Meanwhile, the forward P/Es of the S&P 400 and S&P 600 continued to fall on Friday, to 16.3 and 15.3. Both are below their pre-pandemic highs even though their forward operating earnings per share continued to soar to new highs during the September 9 week (Fig. 16).

(8) There are plenty of geopolitical risks. On Friday, China flew 10 aircraft including fighter jets into Taiwan’s air space just a day after the UK, US, and Australia signed a defense pact to push back against Beijing. Taipei said two J-11 fighters, six J-16 fighters, one Y-8 anti-submarine plane, and one Y-8 spy aircraft entered its air defense identification zone near Pratas Island today.

Meanwhile, all is not quiet on NATO’s eastern front. Russia is conducting one of its largest military exercises since the Cold War in Belarus, which shares a border with Poland. The Russian Defense Ministry, which described the exercise as “strategic,” stated that more than 200,000 troops from both countries are taking part in the drill, conducted on Russian and Belarusian territories. The ministry also said that 80 military jets and helicopters and more than 760 units of various military equipment are part of the drill.

(9) And oh yeah, the pandemic is still out there. Many people are behaving as though we are done with the virus. However, the virus is not done with us just yet.

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Travel, Evergrande & Hydrogen

September 16 (Thursday)

Consumer Discretionary: Travel Industry Fights Covid. The dog days of summer weren’t kind to travel-related industries notwithstanding the continued US economic recovery. After rallying in early spring, the stocks of many travel companies were deflated over the ensuing months by Covid-19’s Delta variant. While US consumers continued to travel, the anticipated return of the business traveler was pushed out—presumably by a quarter or two—as companies postponed a fall return to the office because of the spike in Covid cases. A number of airlines lowered their earnings forecasts, but analysts seem to be looking past Q3 and raising their estimates, especially now that US Covid cases appear to have topped out.

At its peak on April 6, the S&P 500 Airline industry stock price index was up 36.7% ytd, but most of those gains have disappeared, leaving the index up only 3.7% ytd through Tuesday’s close (Fig. 1). Likewise, the S&P 500 Hotels, Resorts, & Cruise Lines stock price index was up 21.8% ytd at its peak on April 28, but that ytd gain has shrunk to 12.6% (Fig. 2). The S&P 500 Casinos & Gaming index was up 20.1% at its March 17 peak, and today it’s in negative territory, down 4.5%, as of Tuesday’s close (Fig. 3).

In recent days, the number of US Covid-19 cases appears to have peaked. The number of new positive Covid-19 cases, using a 10-day moving average, has fallen to 138,000, down from the recent peak of 164,000 on September 2 (Fig. 4). If US cases continue to recede, domestic players in the travel business should continue to benefit.

However, China quickly has become a problem for international travel players. The country’s Covid outbreak is continuing to spread, and the country has warned that it’s cracking down on gambling in Macau. Let’s take a look at the divergent trends in US and Chinese travel:

(1) US hotels booking up. Retail demand for US hotel rooms has rebounded despite the onset of the Delta variant. Over Labor Day weekend, US hotel occupancy was nearly as high as during the comparable days of 2019, while room rates adjusted for inflation were 9% higher, according to STR data highlighted in a September 10 report by Calculated RISK.

While retail consumers appear comfortable staying at a hotel, business travel has yet to return to anywhere near pre-Covid levels. Marriott International’s business from business travelers was down 40% over the summer compared to 2019 levels, and that’s an improvement over down 60% in March, noted CFO Leeny Oberg at September 14 JPMorgan conference. Right direction, but still sharply negative.

(2) Reading the Covid tea leaves. The onset of new Covid cases in China should be keeping CEOs of travel-related companies awake at night. China was the first region to recover from the Covid outbreak in 2020, and its travel business had almost entirely recovered until this July, when Covid sickened airport staff in the eastern city of Nanjing. Covid proceeded to spread to more than half of the country’s 31 provinces and to infect more than 1,200 people. Tens of millions of residents were placed under lockdown, and massive testing and tracing ensued.

On August 23, China reported no new locally transmitted symptomatic cases, and it was hoped that the outbreak was over—until cases started to pop up in Fujian earlier this month. New Covid-19 cases in the southeastern province have risen to 186 over the past week, with 51 recorded on Tuesday, a September 15 South China Morning Post article reported. Areas in affected cities are being locked down again.

(3) Covid side effects in China. China’s small numbers of new Covid cases are having an outsized impact because the country’s zero-tolerance policy often leads to localized lockdowns. Yum China Holdings—which operates KFC, Taco Bell, and Pizza Hut restaurants in China—warned investors that its Q3 adjusted operating profit would fall 50%-60% because of Covid-related restaurant closures. “At the peak of the outbreak in August 2021, more than 500 of our stores in 17 provinces were closed or offered only takeaway and deliver services,” a September 14 Yum China press release stated. It continued: “[O]ur business recovery remains to be uneven and nonlinear, as regional outbreaks occur and corresponding public health measures are implemented. The company expects a recovery of same-store sales to take time.”

China’s air passenger traffic tumbled 51.5% in August y/y, a September 14 Reuters article stated. At Marriott International, July business in China surpassed July 2019 levels by about 9%. But in August, revenue per available room in mainland China declined about 50% compared to 2019 levels because of Covid, Marriott CEO Anthony Capuano said at a September 9 Bank of America conference.

“You saw a pretty stringent lockdown put in place really in over 150 markets across China, and that obviously impeded the pace of recovery,” said Capuano.

(4) Analysts inch toward positivity. We track analysts’ net earnings revisions, i.e., the three-month moving average of the number of upward revisions in forward earnings less the number of downward ones, expressed as a percentage of total forward earnings estimates. (Forward earnings is the time-weighted average of analysts’ earnings-per-share consensus estimates for this year and next.) After more than a year of negative net earnings revisions, they turned positive for the S&P 500 Hotels, Resort, & Cruise Lines industry in June. Net revisions were positive by 0.8% in June, 1.5% in July, and 9.9% in August (Fig. 5). Analysts’ forward earnings per share estimate for the industry turned positive at the end of May and has soared 120.3% since the end of Q2. (Fig. 6).

The same pattern appears in the S&P 500 Airline industry, where analysts’ net earnings revisions were negative for more than a year until July, when they turned positive at 1.8%, and August, 17.3% (Fig. 7). Analysts’ consensus estimate for forward earnings turned positive at the beginning of August and is also on steep upward path (Fig. 8).

The pattern repeats yet again in the S&P 500 Casinos & Gaming industry; but here, it may reverse because of recent news out of Macau. Analysts’ net earnings revisions had been negative for more than a year when they turned positive in June, at 3.2%, and remained so in July, 7.5%, and August, 0.2% (Fig. 9). Analysts’ forward earnings per share for the industry turned positive in mid-May and has risen 61.4% since the end of Q2 (Fig. 10).

Recent news may reverse this positive trend. On Tuesday, Macau’s government announced that it would start a 45-day public gaming consultation. Under review are “the number of licenses to be given, increased regulation and protecting employee welfare, as well as introducing government representatives to supervise day to day operations at the casinos,” a September 15 Reuters article reported. Macau has tightened security of casinos recently, in part to reduce illicit capital flows from mainland China.

Macau’s casino operators are required to rebid for their casino licenses when they expire in June 2022. Shares of Las Vegas Sands and Wynn Resorts, which have large Macau operations, both fell more than 12% Tuesday on the news.

China: An Eye on Evergrande. Evergrande is a huge property developer in China, with more than $300 billion of debt outstanding, and it’s facing a liquidity crisis. In what’s never a good sign, the firm hired two restructuring shops—Houlihan Lokey (China) and Admiralty Harbour Capital—and retail investors in Evergrande’s wealth management products showed up at headquarters to demand their money back.

Some fear a Evergrande meltdown will have systemic risks on par with the impact Lehman Brothers’ demise had on the US stock market. While we don’t see the Chinese government saving Evergrande, we’d expect it will provide enough liquidity to make the company’s retail creditors whole. Or at least we hope so.

Here are some Evergrande basics, which will show why we keep writing about a property company on the other side of the world:

(1) It’s huge. Evergrande was until recently China’s second-largest property developer, with $110 billion in sales last year. It has $355 billion of assets across 1,300 developments, many located in China’s lower-tier cities, a July 27 Reuters article explained. In recent years, the company has branched into unrelated businesses including electric cars, football, insurance, and bottled water. And recently, the company has been trying to sell its businesses, apartments, and properties at deep discounts to avoid a cash crunch.

Evergrande has 200,000 employees and hires 3.8 million workers every year for project developments. Its shares have fallen more than 80% over the past year to 2.97 Hong Kong dollars on Tuesday, and some of its bonds trade at under 30 cents on the dollar.

(2) It owes lots of money. Evergrande is believed to have more than $300 billion of debt outstanding. Some is owed to bond investors and banks, some is owed to suppliers and individuals who put deposits down on unfinished apartments. And yet more debt is owed to retail investors who bought wealth management products from the developer.

The company’s liabilities are owed to more than 128 banks and more than 121 non-bank institutions. Evergrande is one of the largest bond issuers in emerging markets, with $20 billion of debt outstanding.

Evergrande has 800 residential buildings across China that are unfinished, leaving as many as 1.2 million people not knowing when or if they will be able to move into their new homes, a September 10 NYT article reported. According to an August 10 NYT article, one Evergrande homebuyer has been waiting four years for the apartment he has sunk well over $100,000 into—via downpayment and monthly mortgage payments—without signs of progress or communication from Evergrande; his only recourse is to sue the company.

Evergrande raised funds in the shadow banking market via trusts, wealth management products, and commercial paper. About 40 billion yuan, or roughly $6 billion, of the wealth management products have matured, and the company has not paid investors, a September 14 Bloomberg article reported. Last week, the company offered to return investors’ money in instalments over a number of years or swap what was owed for Evergrande property or use the owed funds to reduce mortgage loans.

An Evergrande executive said that more than 70,000 people across China have bought the company’s wealth management products. Many of the investors are Evergrande workers, because the company encouraged staff to purchase the investments, the Bloomberg article stated.

Several hundred of the people who are owed money marched on Evergrande’s headquarters in Shenzhen on Sunday. One 31-year-old factory worker, who traveled more than 20 hours to join the protest, had purchased 800,000 yuan of Evergrande’s wealth management product that mature in December, financing some of it with a loan. He was told the investment was “very safe because this is a Global 500 company.”

(3) Evergrande’s woes gives other property companies’ headaches. S&P Global Ratings said that the bond market volatility resulting from Evergrande’s troubles could hurt other developers’ efforts to refinance their own debt. Rated developers were due to repay 480 billion yuan of onshore and offshore debt over the next 12 months.

“Privately-owned developers Guangzhou R&F Properties Co. and Xinyuan Real Estate Co., downgraded this month over concerns they will struggle to repay debts, have seen yields on their bonds surge above 30% in a sign of weakening access to market funding,” a September 13 Reuters article reported.

Disruptive Technologies: Debating Batteries vs Hydrogen. Perhaps the most successful electric vehicle (EV) manufacturer to date, Elon Musk notoriously has said that hydrogen cars are “mind-bogglingly stupid.” Yet there are some very smart, very rich people betting that hydrogen will power our future. Andrew Forrest, founder of Australian mining company Fortescue Metals Group and Australia’s second-wealthiest man, is on the other side of the debate.

Forrest calls green hydrogen the answer to the climate crisis. His goal is to make 15 million tonnes of renewable green hydrogen by 2030, though skeptics note that hitting that goal would take two to three times as much electricity as Australia consumes today, noted an August 18 article in PV Magazine. It’s an outrageous pledge that frankly reminds us of something Musk might say. Here’s a quick look at the pros and cons of electric versus hydrogen and how companies are betting on the future:

(1) Pros and cons. One of the benefits of hydrogen fuel cells is the ready availability of hydrogen; most EV batteries require the mining of lithium and recycling of batteries.

Hydrogen powered vehicles can be refueled at a pump in 10 to 15 minutes, almost as fast as a gasoline powered vehicle. Fully recharging an EV can take an hour or more. And hydrogen vehicles can go further than EVs before refueling—500-600 miles per tank versus 300-500 miles per charge.

That said, battery powered EVs have advantages too. A hydrogen powered vehicle is more expensive to produce than an EV right now, though the cost should drop as the technology evolves and more vehicles are produced. Also, there are a growing number of electric-refueling stations and almost no hydrogen refueling stations. But then again, electric charging stations have proliferated rapidly, showing how quickly that problem might be resolved.

(2) Some truck companies hedge their bets. Because of the power and long range it offers, hydrogen is often considered a good alternative for powering for trucks, buses, and ships. That said, the technology is in its early stages of development, and most companies seem to be developing both battery and hydrogen fuel cell powered vehicles.

Hyundai Motor Group recently announced plans to develop hydrogen fuel cell versions of all its commercial vehicles by 2028, a September 7 CNBC article reported. The company plans to offer trucks powered by electric batteries and hydrogen fuel cells, believing that they will both have a similar price point by 2030.

Toyota plans to make fuel cells for heavy trucks in Kentucky by 2023, a September 13 Automotive News article reported. It’s also working with Israeli startup REE Automotive to produce EVs. Likewise, GM plans to supply Navistar trucks with fuel cell systems next year, and it has a line of battery powered trucks.

BMW Group is developing hydrogen fuel cell cars and expanding its current EV offerings. The BMW iX5 Hydrogen will be available for demonstration and testing purposes at the end of next year. Jaguar Land Rover also has a foot in both camps, developing a hydrogen car and planning to sell only hydrogen and electric vehicles by 2025.

(3) Not everyone’s convinced. MAN Truck and Bus, a subsidiary of Volkswagen Group, is planning to shift from building diesel trucks and busses to building EVs starting next year. The company opted to build electric powered trucks over hydrogen powered trucks because “cost parity with diesel can be achieved more quickly,” MAN’s CEO Dr. Andreas Tostmann said in an August 31 Electrek article.

And of course, Tesla remains wedded to the EV. Development of its Tesla Semi, which uses a battery, was announced in 2017, but production has been stymied by the limited availability of battery cells and supply-chain challenges, a July 26 Electrek article reported.

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Inflation & Labor

September 15 (Wednesday)

US Inflation: Transitory vs Persistent. August’s headline and core CPI were up less than expected: 0.3% m/m and 0.1% m/m. On a y/y basis, they also eased off but remained elevated at 5.3% and 4.0%.

The CPI results are consistent with Fed Chair Jerome Powell’s narrative that the surge in inflation is likely to be transitory rather than persistent. The FOMC is now likely to wait until the committee meets in early November rather than next week to start tapering the pace of its asset purchases.

Some of the moderation in inflation may very well reflect the diminishing impact of the base effect, i.e., comparison against pandemic-depressed year-ago prices, as Powell has been predicting. Some of the moderation might also be attributable to the Delta variant of the Covid virus, which got a good chance to spread more rapidly as a result of July 4th and Labor Day get-togethers. Another moderating factor at play is productivity, which seems to have been boosted by the pandemic.

The spectrum of inflation forecasts covers three possible scenarios currently. On one end is that it is transitory and will prove to be short-lived. In the middle is that it is persistent (but ultimately transitory). At the other end is that it is permanent (or at least long lasting). Debbie and I are somewhere in the middle between transitory and persistent (but transitory). We aren’t convinced that the CPI inflation rate will fall back to the Fed’s 2.0% target in coming months. But it could do so later next year.

More broadly, for the remainder of the decade, we remain in the Roaring 2020s camp, with productivity-led growth keeping a lid on inflation. However, we are mindful of some of the similarities between the Great Inflation of the 1970s and the current situation. Now consider the following:

(1) Inflation expectations remain elevated. Let’s dispense with the bad news on the inflation front. The Federal Reserve Bank of New York compiles a monthly survey of inflation expectations. The data are available since mid-2013. The one-year- and three-year-ahead expectations rose to their series’ highs of 5.2% and 4.0% during August (Fig. 1).

Here are the one-year inflation expectations by age: under 40 (4.5%), 40-60 (4.8), 60 & over (6.0). Here are the same by education: high school (6.0), some college (5.9), BA degree or higher (4.0). And here are the same by annual income: under $50,000 (5.2), $50,000-$100,000 (5.5), over $100,000 (4.9). (See our Inflation Expectations chart book.)

(2) Small business owners raising prices. There was also bad news on the inflation front in the August survey of small business owners conducted by the National Federation of Independent Business (NFIB), released yesterday. It showed that 49% of them are raising their prices, while 44% are planning to raise their prices (Fig. 2). Price hikes were the most frequent in wholesale (68% higher, 0% lower), manufacturing (60% higher, 2% lower), and retail (52% higher, 4% lower).

(3) PPI for personal consumption. On Monday, we observed that the PPI for personal consumption (C-PPI) rose to 7.4% y/y during August, auguring for higher inflation rates for the CPI and PCED during the month (Fig. 3). However, as we noted, the C-PPI excludes rents and import prices. Nevertheless, we would be more relieved about inflation had the C-PPI confirmed the easing of inflationary pressures suggested by the CPI.

(4) Diminishing base effect. Okay, now we can proceed with the good news in the CPI based on the three-month percentage changes through August at annual rates. Here are the latest three-month inflation rates versus their most recent peaks for the headline CPI (6.6%, 9.3%) and core CPI (5.3, 10.2) (Fig. 4). These three-month comparisons help us to reduce the impact of the base effect in the y/y comparisons. It is encouraging to see them moderating.

Among the biggest outliers on the inflation front recently were CPI items that had significant base effects: gasoline (31.7%, down from 98.8%), lodging away from home (40.2, 62.4), airfares (-27.0, 84.3), car & truck rental (-32.8, 182.2), and used cars & trucks (36.1, 121.8) (Fig. 5).

On the other hand, a few items continue to be more inflation prone: new vehicles (20.0%), motor vehicles & parts (14.1), food (7.6), and nonalcoholic beverages (10.6) (Fig. 6).

(5) The rent is due. Rent is one of the CPI categories with the largest weight in the index. It could be troublesome in coming months as employment and wages increase. Rent of primary residence over the latest three months bottomed at 1.2% (saar) during January. It was up to 2.8% during August (Fig. 7). Owner’s equivalent rent is up from 1.4% during January to 3.5% in August.

US Labor Market I: Mismatches. Last year’s pandemic lockdowns resulted in lots of layoffs. The federal government stepped in to help with enhanced federal unemployment benefits. Americans are slowly learning to live with the virus, aided by vaccines and treatments. Businesses are looking for workers again. But they’re not having an easy time finding and hiring them. That’s mainly attributable to the following three factors:

(1) Federal unemployment benefits may have incentivized lots of workers not to bother looking for a job.

(2) School closures forced many parents to stay at home to care for their kids.

(3) Many seniors in the workforce decided to retire.

It’s possible that the worker shortage is about to reverse, at least in part, given that the enhanced benefits expired on Labor Day and many kids returned to in-person learning the day after. Workers who retired as a result of the pandemic are unlikely to return to the labor force.

A more structural problem may be skills and geographic mismatches between available jobs and workers seeking employment. This would certainly explain why there are so many job openings when unemployment remains relatively high. A new complication is that the Biden administration has asked companies to fire workers who refuse to be vaccinated or to be tested on a weekly basis.

US Labor Market II: Lots of Help Wanted. The employment reports for September and October should provide insights into how these developments are impacting the labor market. For now, let’s see what the recent employment reports tell us:

(1) Record job openings. The number of unemployed workers fell to 8.4 million during August (Fig. 8). That’s only 2.7 million above the level during February 2020 before the lockdowns. Meanwhile, the number of job openings totaled a record 10.9 million during July. That’s 3.9 million more than during February 2020.

Job openings have soared to a record high of 7.4% of payroll employment (Fig. 9). Of the total job openings, nearly 5.5 million are in leisure and hospitality, professional and business services, and health care and social assistance—at about 1.8 million openings for each of these industries.

(2) Small businesses seeking help. August’s NFIB survey of small business owners found that they have lots of job openings. A record 50% of them reported having job openings, and 60% (91% of those hiring or trying to hire!) said they’re finding few or no qualified applicants for the open positions (Fig. 10). Specifically, 31% of owners reported few qualified applicants for their open positions (unchanged from the July percentage), and 29% reported none (up 3 points), a 48-year record high!

(3) Labor shortages in Richmond district. The Federal Reserve Bank of Richmond is one of the five Fed district banks that conducts a regional business survey every month. It’s the only one that asks about wages and the availability of skills needed (Fig. 11 and Fig. 12) . The following is the woeful tale told by the Richmond Fed about the district’s labor market:

“Throughout the pandemic, many manufacturers have reported increased absenteeism, often resulting from employees quarantining after contracting or being exposed to the virus. In addition, manufacturers have seen employees leave their jobs and have struggled to replace them. In our April survey, 43 percent of manufacturing firms cited difficulty finding workers as their top challenge to increasing supply. In August, 75 percent of manufacturing survey respondents reported having difficulty hiring workers since the spring. Without sufficient labor, employers have in some cases needed to change their policies to retain employees. For example, one firm in our manufacturing panel reported having to relax the company’s attendance policy to avoid terminating a large portion of its workforce. Another firm instituted an attendance incentive program.

“Survey respondents have also reported that employees, on average, are working longer hours. In April, the diffusion index for hours in the average workweek reached its highest level since 2004. Firms have also been raising wages to attract workers. In August, the wage index on our manufacturing survey hit a record high. However, firms still reported that it was increasingly difficult to find workers.”

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Global Tapering Ahead?

September 14 (Tuesday)

Central Banks I: The Wild Credit Bunch. The Great Virus Crisis (GVC) started on March 11, when the World Health Organization declared that Covid-19 had turned into a pandemic. Credit markets froze around the world. A worldwide credit crunch spread faster than the pandemic. It was feared that the GVC would quickly eclipse the calamity that was the Great Financial Crisis (GFC). There was a mad dash for cash in late February and the first two weeks of March.

The major central banks had learned some emergency responses for dealing with a calamity during the GFC. They quickly responded to the GVC by flooding the global financial system with liquidity. The Fed did so with QE4ever on March 23. The European Central Bank (ECB) announced its Pandemic Emergency Purchase Programme (PEPP) on March 18. The Bank of Japan (BOJ) announced its measures to maintain order in the financial system in light of Covid-19 on March 26.

The result has been a flood of liquidity, as evidenced by the surging of the three central banks’ total assets, which jumped $8.3 trillion from $16.2 trillion during the week of March 23, 2020 to a record-high $24.5 trillion at the end of August (Fig. 1). Over this period, the assets of the three central banks increased as follows: Fed ($3.1 trillion to $8.3 trillion), ECB ($4.1 trillion to $9.6 trillion), and BOJ ($1.1 trillion to $6.6 trillion) (Fig. 2).

If you want to add to your worry list for the stock market, then look at the yearly growth rate in the total assets of the three central banks (Fig. 3). It has fallen abruptly from a peak of 58.2% during the February 19 week of this year to 16.8% at the end of August, which is still relatively high. Further declines are likely if the Fed joins the ECB in tapering asset purchases; the ECB announced last week it’s time to start tapering.

However, the growth rate in the combined balance sheets of the three central banks doesn’t seem to work very well as a market-timing tool. On the other hand, the level of this combination has shown a tendency to correlate well with the level of the S&P 500 (Fig. 4). While the sum of the assets of the central banks may grow more slowly up ahead, it isn’t likely to fall anytime soon.

The S&P 500 has experienced two “tapering tantrums,” or declines in the price index resulting from investor panic over prospects of the Fed’s tapering the pace of its asset purchases. One was during the spring of 2013, when the index fell 5.8%, and the other was during the fall of 2018, when it fell 19.8% (Fig. 5). The S&P 500 has exceeded its 200-day moving average by at least 10% since early this year (Fig. 6). So it may be overdue for a brief tantrum that could be triggered on September 22.

As Melissa and I noted yesterday, “Mark September 22 on your calendar. That’s the day when the FOMC will release its latest ‘Summary of Economic Projections’ (SEP). We expect that at least 10 of the participants will project a rate increase next year, up from seven in June’s dot plot. We also expect that the median inflation forecast will be raised for 2021. It was 3.4% in June’s SEP, up from 2.4% in March.” (See our FOMC Economic Projections.)

In addition, we expect that the FOMC will vote to start tapering at that meeting if today’s CPI for August blows a hole in Fed Chair Jerome Powell’s thesis that the recent surge in inflation is transitory. As we also noted yesterday, August’s PPI for personal consumption doesn’t augur well for that month’s CPI and PCED. If today’s CPI news is relatively benign, then the FOMC might signal that they’ll wait until their November 2-3 meeting to start tapering. By then, they will have September’s employment report and September’s inflation readings in hand.

Central Banks II: ECB Is Recalibrating. The latest meeting of the ECB’s Governing Council was held last week on Thursday. The group voted to maintain the interest rate on the ECB’s main refinancing operations at 0.00%, on the marginal lending facility at 0.25%, and on the deposit facility at -0.50%. “Based on a joint assessment of financing conditions and the inflation outlook, the Governing Council judges that favourable financing conditions can be maintained with a moderately lower pace of net asset purchases under the [PEPP] than in the previous two quarters,” the ECB said in a statement.

The PEPP was implemented in March 2020 to counter the negative impact of the pandemic on the Eurozone economy and financial system. It is due to end in March 2022 at a value of around €1.85 trillion. Here’s more on the ECB and developments in the Eurozone:

(1) ECB’s version of QE4ever. In a press conference on Thursday after the meeting, ECB President Christine Lagarde said the verdict was a “unanimous decision in all respects.” She said that the ECB wasn’t tapering, but rather “recalibrating.” Meanwhile, the asset purchase program (APP)—which is being used in combination with PEPP to support the 19 member countries’ economy—will continue at a monthly pace of €20 billion: “The Governing Council continues to expect monthly net asset purchases under the APP to run for as long as necessary to reinforce the accommodative impact of its policy rates, and to end shortly before it starts raising the key ECB interest rates,” the statement said.

In addition to buying bonds, the ECB has also pumped up lending to Eurozone credit institutions with long-term refinancing operations (LTROs). LTROs provide low-interest-rate funding to Eurozone banks, with sovereign debt as collateral on the loans. The loans are offered monthly by the ECB and are typically repaid in three months, six months, or one year. They’ve soared by €1.4 trillion since the end of March 2020 to €2.2 trillion at the start of September (Fig. 7 and Fig. 8).

(2) ECB’s inflation debate. The Eurozone’s CPI increased by 3.0% y/y during August, according to preliminary estimates published last Tuesday, after rising by 2.2% in July (Fig. 9). If the August figure is confirmed in a few weeks’ time, it would represent the highest inflation reading for 10 years. This comes after Germany reported on Monday of last week its highest consumer prices since 2008, with a headline inflation rate of 3.4% in August. France also reported its highest inflation rate in nearly three years on Tuesday (Fig. 10).

On the ECB’s Governing Council, as on the Fed’s FOMC, there are doves who believe that the rebound in inflation is transitory and hawks who worry that it might be more persistent. Yannis Stournaras is a member of the Council and the Governor of the Bank of Greece. He is a dove. In a Bloomberg interview on September 1, he said, “According to most estimates, the recent jump in inflation is due to temporary factors related to various supply-side bottlenecks caused by the pandemic.” Klaas Knot and Robert Holzmann are two hawks on the Council who want the ECB to slow the pace of bond buying in Q4, reflecting the region’s improving economy.

(3) Consumer-led recovery in the Eurozone. The Eurozone’s real GDP grew more than initially estimated for Q2—by 2.2% q/q and 14.3% y/y (Fig. 11). That’s in line with the 12.2% y/y rebound in US real GDP during Q2. The August 30 FT reported: “This summer’s resurgence of coronavirus cases across the eurozone has had little impact on the bloc’s economic recovery, according to unofficial data which suggest that European consumers are driving the rebound.” Apparently, the Delta variant hasn’t been as painful as feared in Europe, economically at least. Europeans, like Americans and other people around the world, are going about their lives and business despite the pandemic. August’s PMIs remained elevated, with the C-PMI at 59.0, the M-PMI at 61.4, and the NM-PMI at 59.0 (Fig. 12).

Central Banks III: BOJ Starts Retreating. The BOJ may be on course to unwind its ultra-easy monetary policies over the next couple of years. That’s according to a September 13 Reuters article titled “After the ‘bazooka’, Bank of Japan dismantles the work of its radical chief.” Here is the gist of the story:

“After years of shock-and-awe stimulus, the Bank of Japan is quietly rolling back radical policies introduced by its bold chief Haruhiko Kuroda and pioneering controversial new measures that blur the lines between central banking and politics. The unwinding of Japan’s complex policy is driven by Deputy Governor Masayoshi Amamiya, insiders say, a career central banker considered the top contender to replace Governor Kuroda whose term ends in 2023.”

The BOJ took a very tiny first step toward normalizing monetary policy when its Policy Board met on March 19 and voted to allow long-term interest rates to move up and down by 0.25% around its 0% target, instead of by the implicit band of plus or minus 0.2%. The committee also decided to remove explicit guidance about the BOJ’s purchases of exchange-traded funds (ETFs). Instead, such purchases would be more “flexible and nimble.” On the other hand, the BOJ adopted a new scheme similar to that of the ECB’s LTRO program, under which it pays interest of up to 0.2% to financial institutions that tap its loan programs.

Based on interviews with various insiders, the Reuters article reported that these measures pave the way for an eventual retreat from Kuroda’s policies. “While that intention was hidden from markets, it would mark a symbolic end to Kuroda’s bold experiment based on the text-book theory that forceful monetary action and communication can influence public price expectations and drive inflation higher.” The textbook theory hasn’t worked in Japan.

Data through the week of August 27 show that the BOJ’s assets and holdings of long-term government bonds (both in yen) are still rising to record highs, but the pace of increase has slowed sharply since the week of December 18 (Fig. 13).

Central Banks IV: PBOC Expected To Ease. While the Fed, ECB, and BOJ all are talking about talking about tapering, the People’s Bank of China (PBOC) is expected to ease credit conditions in response to the slowing of China’s economy as a result of high raw material costs, new Covid-19 outbreaks, and floods.

The PBOC delivered a surprise cut in bank reserve requirements during July (Fig. 14). Another one is likely before the end of this year. In mid-August, the PBOC also injected billions of yuan through medium-term lending facility (MLF) loans into the financial system. The PBOC isn’t expected to reduce interest rates because inflationary pressures are rising in the property market and in producer prices.

Over the past 12 months through August, Chinese bank loans are up $3.1 trillion to a record-high $29.0 trillion (Fig. 15 and Fig. 16).

Central Banks V: In the Fed We Trust. The WSJ assigns one of its top reporters to watch the Fed. A few years ago, Jon Hilsenrath was the guy. Now its Nick Timiraos. Fed officials often have set the stage for their next policy move by “planting” the story with the WSJ. On Friday, September 10, Nick wrote an article titled “Fed Officials Prepare for November Reduction in Bond Buying.”

Fed officials clearly are doing everything they can to avoid a tapering tantrum. We think that they will succeed. The WSJ article reported that the FOMC is likely to discuss tapering at its September 21-22 meeting and vote to do so at the November 2-3 meeting. “Under the plans taking shape, officials could reduce those purchases at a pace that allows them to conclude asset buying by the middle of next year.” That certainly sounds like an off-the-record comment by somebody high up at the Fed.

Melissa and I have opined in recent weeks that the FOMC should get started with tapering so that they can end doing so before interest rates might have to be raised in the event that inflation is less transitory and more persistent than Fed officials expected. The Journal article observed: “Fed officials have indicated they don’t want to be in a position where they are still increasing their $8.4 trillion asset portfolio when an interest-rate increase might be needed to keep inflation in check.”

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Not So Transitory After All?

September 13 (Monday)

YRI Podcast. In our latest video podcast, Dr. Ed discusses the main points of today’s Morning Briefing.

Strategy I: Raising Our Earnings Forecasts. Industry analysts continue to raise their earnings estimates for 2021, 2022, and 2023. Joe and I are doing the same. The difference is that their consensus estimates change on a weekly basis, while ours do quarterly, as Joe and I usually adjust them after earnings-reporting seasons. We are raising our S&P 500 earnings-per-share estimates for this year, next year, and the following year by $5 each and sticking with our estimates for S&P 500 revenues.

Here are our latest estimates for S&P 500 revenues, earnings, and profit margins:

(1) Revenues: 2021 ($1,600), 2022 (1,650), and 2023 (1,700) (Fig. 1).

(2) Earnings: 2021 ($210), 2022 (220), and 2023 (235) (Fig. 2).

(3) Margins: 2021 (13.1%), 2022 (13.3), and 2023 (13.8) (Fig. 3).

Now all we have left to do before we take the rest of the day off is to forecast forward earnings and the forward P/E to calculate our S&P 500 targets:

(4) Forward Earnings: 2021 ($220), 2022 (235), and 2023 (250) (Fig. 4).

(5) Forward P/E: 2021 (22.0), 2022 (22.0), and 2023 (22.0) (Fig. 5).

(6) S&P 500 Target: 2021 (4800), 2022 (5200), and 2023 (5500) (Fig. 6).

The Q2 earnings season was the fifth in a row in which results were much better than consensus forecasts (Fig. 7). As a result, industry analysts have been raising their estimates for the remaining two quarters of this year and all four of next year (Fig. 8). As of the week of September 2, they were projecting earnings to be $201.04 this year and $220.35 next year (Fig. 9).

Forward earnings, the time-weighted average of the consensus estimates for this year and next year, rose to a record high of $214.04 per share during the September 2 week. (See YRI S&P 500 Earnings Forecast. For a thorough primer on forward earnings, see S&P 500 Earnings, Valuation & the Pandemic.)

Strategy II: Inflation vs Bond Yields. At the end of last week, the S&P 500 was down just 1.7% from its record high of 4536.95 on September 2. That’s impressive considering the long list of current worries: Inflation has yet to show signs of peaking. The Fed is expected to start tapering before the end of this year. The ECB has already started to taper. The Democrats are pushing trillion-dollar spending programs along with trillion-dollar tax proposals through Congress. The debt ceiling has to be raised so that the Treasury can pay the bills. Parts shortages are forcing companies to scale back their production. There are geopolitical risks. September and October tend to be bad months for stocks. And oh yeah, the pandemic is still out there.

Inflation should be a major concern, yet the bond yield remains subdued around 1.30%. Friday’s PPI should have unsettled the bond market, but it didn’t do so. Also subdued has been the forward P/E of the S&P 500. It has remained elevated around 22.0 since the second half of 2020. Equity and bond markets remain unperturbed by the latest signs that inflation is still heating up rather than cooling off. Consider the following:

(1) PPI might be a warm-up act for CPI. The PPI bottomed last year at -1.5% y/y during April (Fig. 10). So the base effect on inflation should be diminishing in the August data. Yet there was no sign of a peak in this series during August, when it rose to 8.3%, with the goods component up 12.6% and the services component up 6.4%.

The CPI and PCED inflation rates track the PPI for personal consumption closely (Fig. 11). The bad news is that the latter was up 7.4% during August, suggesting that July’s 5.4% and 4.2% increases in the CPI and PCED rose even more last month.

The only good news we can find on the inflation front is that the prices-paid indexes of the national M-PMI and NM-PMI seem to have peaked during June and July, respectively (Fig. 12). The average of the two is down from 85.8 during June to 77.4 during August.

(2) The Fed is still replenishing the punch bowl. So why doesn’t the bond market care? Where oh where are the Bond Vigilantes? They’ve been drowned by all the liquidity provided by the Fed. Tapering, if and when it happens, initially will only slow the pace at which the Fed is filling the punchbowl, not stop their pouring. For now, it continues to overflow.

We can see that in the widening divergence between commercial bank deposits, which rose to a record high at the end of August, and bank loans, which are no higher now than they were before the pandemic (Fig. 13). The Fed’s bond purchases have boosted bank deposits, while the Fed’s zero-interest-rate policy has allowed companies to borrow at record-low yields in the bond market. Banks have put the surplus cash mostly into Treasury and agency securities. The banks along with other financial intermediaries have also been pouring their cash into reverse repos at the Fed, which totaled a record $1.40 trillion during the week of September 1 (Fig. 14).

(3) Fund inflows are a plus. Meanwhile, the 12-month sum of net inflows into equity mutual funds and ETFs turned positive during June and July for the first time since early 2019 (Fig. 15). Over the 12 months through July, equity ETFs had net inflows totaling $594 billion, while equity mutual funds had net outflows of $468 billion.

By the way, there is actually a very simple explanation for why the 10-year Treasury bond yield peaked at 1.74% on March 31 of this year and fell to a recent low of 1.19% on August 4, closing at 1.35% on Friday. On a 12-month basis, net inflows into bond mutual funds and ETFs soared from $572 billion during January to peak at a record $1.01 trillion during April (Fig. 16). It remained substantial at $861 billion through July. Contrary to TINA (“there is no alternative” to equities), bonds are still viewed by some investors as an alternative to stocks!

That’s on top of the $1.6 trillion of US Treasury and agency bonds purchased by the Fed and the commercial banks from the start of this year through late August (Fig. 17).

(4) Blue Angels and valuation. All this liquidity certainly helps to explain why the forward P/E of the S&P 500 has been remarkably stable over the past year at a relatively high level. That stability has allowed the S&P 500 to melt up along with forward earnings since last summer, as we can see in our Blue Angels framework (Fig. 18).

Inflation I: More of It. Debbie and I are starting to worry that inflation may not be as transitory as Fed Chair Jerome Powell has been claiming it will be. As she discusses below, the PPI for final demand of both goods and services rose 0.7% m/m and 8.3% y/y during August, the most since 12-month data were first calculated in November 2010. The three-month annualized increase was 10.6% (Fig. 19). Here are some details on the PPI for final demand for goods (PPI-FD-G) and services (PPI-FD-S):

(1) Goods. The PPI-FD-G rose 1.0% m/m. Half of the broad-based advance in August can be attributed to a 2.9% rise in prices for final demand foods, with about a quarter of the August advance attributable to an 8.5% rise in the index for meats. Prices for residential natural gas, industrial chemicals, processed young chickens, motor vehicles, and steel mill products also moved higher.

(2) Services. The PPI-FD-S moved up 0.7% in August. Two-thirds of the broad-based increase in August can be traced to the 1.5% increase in the index for final demand trade services, which measures changes in the margins received by wholesalers and retailers. Prices for final demand transportation and warehousing services climbed 2.8% m/m and 15.8% y/y (Fig. 20). Excluding these items, the overall services PPI was up just 0.1% m/m, but still up 4.6% y/y.

(3) Bottom line. There really is no sign yet that inflation is transitory. This will put more pressure on Fed officials to start tapering soon just in case they have to raise interest rates sooner than they expected.

Mark September 22 on your calendar. That’s the day when the FOMC will release its latest “Summary of Economic Projections” (SEP). We expect that at least 10 of the participants will project a rate increase next year, up from seven in June’s dot plot. We also expect that the median inflation forecast will be raised for 2021. It was 3.4% in June’s SEP, up from 2.4% in March.

Inflation II: More on It. The Bureau of Labor Statistics (BLS) has been compiling the Producer Price Index (PPI) since 1947. Prior to January 2014, the PPI was based on stage-of-processing (SOP) and limited to finished, intermediate, and crude goods. Since then, the BLS has expanded coverage beyond that of the SOP system through the addition of services, construction, exports, and government purchases. BLS refers to this as the Final Demand–Intermediate Demand (FD–ID) system.

As a result of FD–ID, the PPI now includes indexes for personal consumption, which reflect the prices of marketable output sold by producers to consumers. The CPI includes prices paid by consumers. So the “C-PPI” excludes rent and prices of imports. The C-PPI excludes taxes, while the CPI includes sales taxes paid by consumers.

Since July 2009, the PPI has also included commodity indexes for services and construction in addition to raw materials.

For more information, see the article titled “Comparing new final demand producer price indexes with other Government price indexes” in the BLS’s Monthly Labor Review, dated January 2014.

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Transportation, Supply Chains & Carbon Trading

September 09 (Thursday)

Transportation: Tangled Supply Chains. One of the things we’ve enjoyed since getting vaccinated is shopping in stores. Over the last few months, whether we’re shopping for food or clothes or home goods, it’s been apparent that store shelves are sparsely stocked. A September 3 New York Post article noted that New York area amateur tennis players were causing a racket because they couldn’t find new tennis balls to buy while inspired by the US Open.

These casual observations are confirmed by inventories-to-sales data. The real business inventories-to-sales ratio tumbled to 1.4 in June, down from the Covid-related spike to 1.8 last year (Fig. 1). The drop in the real inventories-to-sales ratio among retailers is even more dramatic, as it fell to 1.1 in June near a record low over the last two decades (Fig. 2). Excluding motor vehicles & parts dealers, the adjusted real inventory-to-sales ratio for retailers sank even further to 0.9, which means that retailers are selling goods faster than they can restock their shelves (Fig. 3). The ratio is lower than at any point since 1980.

Much of the blame for thin inventories rests on surging US demand and troubled global supply chains. Covid-19 has shut down Chinese ports from time to time, resulting in delays. Ships are lined up in the ocean waiting to dock at backed up US ports. Once unloaded, containers face more delays in overburdened rail yards and understaffed trucking companies. It has all led to skyrocketing shipping prices that few see abating anytime this year. Here’s a look at the pickle logistics pros are in:

(1) US imports booming. US merchandise imports may have tumbled in early 2020, but they’ve more than recovered since then. In July, real US imports jumped 9.5% y/y, near an all-time high (Fig. 4 and Fig. 5). Some of the surge may reflect retailers restocking their shelves and/or shipping product to the US early for the holidays. Imports may also be jumping as companies rebuild inventories and edge away from just-in-time inventory management, which has proved problematic over the past year.

The surge in trade is also evident in Chinese export data. Chinese exports rose by 6.3% m/m in August despite a jump in Covid-19 cases in August (Fig. 6).

(2) Traffic in shipping lanes. The import data are confirmed by West Coast ports’ container traffic, which also stands near record-high levels. The 12-month sum of 20-foot equivalent containers entering the Los Angeles and Long Beach ports hit 10.4 million in July, a record high. The problems are that the ports can’t unload the goliath container ships fast enough and, once unloaded, the rail and trucking capacity isn’t great enough to take the containers to their destination in a timely manner.

On September 7, 43 container ships sat in the waters outside of the Los Angeles and Long Beach ports waiting to be unloaded, down from a record peak of 47 on August 29, according to the Marine Exchange of Southern California’s Twitter account. There are more ships at anchor than the 31 container ships at berth.

China’s ports have also had their share of problems, entangled by a number of Covid-19 shutdowns this year. The export port Ningbo-Zhoushan was closed for two weeks last month after one person came down with Covid-19. The closure of the third-largest Chinese port caused a ripple effect of disruptions at other Chinese ports, like Shanghai and Hong Kong, as ship operators looked for alternatives to the Ningbo-Zhoushan port, a September 7 WSJ article reported. The closure followed the three-week closure of the Yantian port in Shenzhen in May after another Covid-19 outbreak occurred.

(3) Shipping containers wanted. The lowly shipping container is in hot demand. With imports flowing from China to the US, there are too many containers in the US and not enough in China. Additionally, a lack of workers is causing delays at ports, rail terminals, on truck routes, and at company warehouses, leaving full containers stacked up and waiting to be moved and unloaded.

The sheer volume of shipping containers due to rising trade volumes is only exacerbating bottlenecks. “Major U.S. ports were forecast to handle the equivalent of some 2.37 million imported containers in August, according to the Global Port Tracker report produced by Hackett Associates for the National Retail Federation. The figure is the most for any month in records dating to 2002, and NRF projects overall inbound volumes for the year will reach 25.9 million containers, measured in 20-foot equivalent units. That would break the record of 22 million boxes in 2020,” a September 5 WSJ article reported.

(4) Workers wanted too. Bob Biesterfield, chief executive of freight broker C.H. Robinson Worldwide, said “shortages of truck drivers and warehouse workers are making shipping delays worse as the need to replenish inventories is at an all-time high,” the WSJ reported.

The number of US truckers moving general freight has dropped to 430,000, down from 465,000 at the start of 2020. The scarcity of drivers has Walmart offering an $8,000 signing bonus for some drivers, an August 30 FT article reported.

(5) Prices on the rise. Prices throughout international supply chains have risen. Spot container shipping rates from Asia to the US West Coast are up 462% y/y, according to the Freightos Baltic Index, quoted in an August 26 WSJ article. The price of shipping a 40-foot container of games from Shanghai to Michigan cost $6,000-$7,000 before the pandemic. Now it could cost $26,000-$35,000, a board game inventor said in an August 30 NYT article.

A.P. Moller-Maersk CFO Patrick Jany noted on the company’s August 8 earnings conference call that the shipping company’s average freight rate increased by 59% in Q2, driven by demand across all regions and higher long- and short-term rates. In addition, total volumes for the quarter increased by 15%. The strong market should continue until at least the end of the year, as there’s unmet shipping demand. But executives did warn that when disruptions end, prices could correct quickly.

The price of transporting freight by truck rose by 13.8 y/y in July, according to the Producer Price Index report (Fig. 7). This pricing strength is occurring even as the Truck Tonnage index appears to be rolling over from its recent March high (Fig. 8).

(6) A look at transport sector stocks. The S&P Transportation composite has risen 9.7% ytd through Tuesday’s close, lagging the S&P 500’s 20.3% return (Fig. 9). The index has been sliding since it peaked on May 7, when it was up 21.5% ytd. Its performance has been dragged down by Airlines, which have suffered from the resurgence of Covid-19, and by Railroads. Here’s how the various industries in the S&P Transportation index have performed ytd: Trucking (45.8%), Air Freight & Logistics (11.5), Airlines (6.2), and Railroads (5.7).

There’s a lot of optimism priced into the S&P 500 Trucking and Railroad industry indexes. The Trucking industry’s forward earnings (i.e., the time-weighted average of consensus estimates for this year and next) represents expected growth of 20.2%, and its shares trade at 28.4 times forward earnings (Fig. 10 and Fig. 11). While the S&P 500 Railroads index hasn’t risen as sharply as its Trucking counterpart, it is near an all-time high. Its forward earnings suggest expected growth of 15.3%, and the index trades at a forward earnings multiple of 20.2 (Fig. 12 and Fig. 13). When smooth sailing returns to the shipping industry—and shipping supply catches up with demand—the earnings multiples for both industries, which are near record highs, could find themselves under pressure.

Disruptive Technologies: Welcome to Carbon Trading. Recent storms and fires plaguing the US reinforce the changes to the US climate that many attribute to an increase of carbon dioxide (CO2) in the atmosphere. In recent weeks, we’ve looked at the technology being developed to literally suck CO2 out of the air or prevent it from entering the air in the first place (see our Morning Briefings from September 2 and August 19). With the price of carbon credits in Europe reaching a record high this week, I asked Jackie to take a look at the emerging markets for carbon credit trading and the many small companies sprouting up to pounce on the resulting opportunities. Here’s her report.

(1) Profitable and environmental. The European Union (EU) is the furthest along in developing a market for carbon credits, having created the European Union Emissions Trading System (ETS) in 2005. The ETS covers CO2 released during a variety of industrial processes in a variety of industries in the EU, including oil refineries producing fuel for electricity and heat; producers of steel, iron, aluminum, cement, lime, glass, ceramics, pulp, paper, cardboard, acids, and bulk organic chemicals; and commercial planes.

In general, the ETS caps the amount of greenhouse gas participants can emit. If the participants don’t use their allotted greenhouse credits, they can auction off what remains in the market. If they spew more greenhouse gas than is allotted, then they need to enter the market and buy offsetting credits.

The price of EU carbon credits has more than doubled since the start of this year to a record €61 on Monday. The move in recent days was attributed to the anticipation of tighter regulations and a tight natural gas market in Europe, which may mean more coal will need to be burned to generate electricity this winter, an August 30 FT article explained.

(2) More restrictions lie ahead. The EU aims to reduce the average greenhouse gas emissions by 55% in 2030 and be net zero by 2050 compared to 1990 levels. To get there, the ETS will be expanded to cover emissions from the car industry and emissions from heating buildings. The EU is also considering a proposal for a carbon border adjustment mechanism, which is basically a tax on importers of steel, cement, aluminum, and fertilizer into the EU, to level the playing field with their EU-based competitors who must pay for carbon credits.

Other countries may enter the fray as well. China launched a carbon market this summer, but the caps currently cover only its energy industry’s 2,225 sites, which account for 40% of the country’s CO2 emissions and about 15% of the world’s emissions. China’s other industries are expected to be added at a later date. There’s a key difference between the Chinese and EU systems: China’s focuses on carbon intensity, while the EU market focuses on total emissions.

“Analysts warned that an oversupply, a limited scope, and no cap on total emissions meant China’s scheme was unlikely to assume immediately its intended ‘central role’ towards achieving the country’s goal of reaching peak carbon emissions by 2030 and reaching net zero emissions by 2060,” a July 16 FT article stated. In other words, this was a first step by China, and it’s hoped that after a trial phase the Chinese system will be tightened up, just as the European system was. The price of carbon on the Chinese market fell to a record low in late August.

California has a cap-and-trade market that covers 450 entities responsible for 86% of the state’s greenhouse gas emissions, including electricity generators, fuel distributors, and large industrial facilities. The Biden administration has appointed a working group to assign a US carbon price, but a recommendation from the group isn’t expected this year.

(3) Carbon trading becomes big business. A carbon-offset credit is a transferable instrument certified by an independent entity or government. Each credit represents a reduction of one metric ton of CO2 or the equivalent amount of greenhouse gas, states an August 16 primer by Institutional Investor sponsored by the CME Group. There is a growing group of folks who trade carbon credits and another group of companies that verify environmental projects that create carbon credits.

Companies including Verra, The Gold Standard, The American Carbon Registry, and Climate Action Reserve will audit projects that reduce CO2, like reforestation projects, and new solar or wind projects that replace fossil fuel. They’ll operate registries to keep track of the project and credits.

There are critics who don’t believe that old projects or projects that would have proceeded anyway should be eligible for certification because they’re not “additive” in helping to reduce the world’s greenhouse gasses. Instead, critics argue these unworthy or preexisting projects give deep-pocketed polluters an easy way to buy carbon credits while they continue polluting.

There are also companies that put together carbon-offset programs. Investopedia ranked Native Energy the best overall carbon-offset program for 2021 in a May 25 article. Founded in 2000, Native Energy offers projects verified by third parties, carbon credits for purchase by companies and individuals, and project design services.

The size of the global carbon-trading market remains small, at €238 billion; but it grew 23% last year, and Wood Mackenzie estimates that it could grow to $22 trillion by 2050, a September 1 WSJ article reported. Traditional oil and gas traders like Vitol Group, Glencore, BP, and Royal Dutch Shell are increasing their ranks of traders to focus on this market.

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Around the World

September 08 (Wednesday)

Pandemic: Learning To Live with Covid. The Covid virus loves American holidays (Fig. 1). That’s when Americans love to get together, providing the virus with a great opportunity to spread. Last year, the first wave of the pandemic got a big boost from Memorial Day and Independence Day. The second wave coincided with 2020’s year-end holidays. The third and current wave seems to have started on July 4 and might have just gotten a boost from Labor Day.

The good news is that nearly 80% of the adult population has been vaccinated at least once (Fig. 2). The bad news is that hospitals in the hot spots are running out of beds for the unvaccinated who get infected and must be hospitalized. However, so far, the number of deaths is well below those of the previous two waves (Fig. 3). Let’s take a quick world tour of the pandemic:

(1) Europe and Japan. So far, the hospitalization data for France, Italy, and the UK show that their second waves of the pandemic are bottoming (Fig. 4). Their second waves started at about the same time as those in the US but lasted longer this year, into the spring and early summer months. Germany’s data on new cases show three waves so far, with the latest one currently bottoming (Fig. 5). Japan’s latest wave is its worst one so far.

(2) India and Brazil. India’s first wave occurred last summer (Fig. 6). The country’s second wave was a nightmare earlier this year. The number of new cases crested at 382,588 on May 10, based on the 10-day moving average. But then it plunged to around 40,000 currently. Brazil seems finally to be coming out of one long wave of pandemic misery.

(3) Israel. Israel has been the poster child for how to deal with the pandemic most effectively, by rapidly vaccinating most of the adult population. However, a third wave started this summer, with new cases exceeding the previous two peaks (Fig. 7).

Bloomberg reported yesterday, “The nation of 9 million became the test case for reopening society and the economy in April when much of Europe and the U.S. were still in some form of lockdown. Yet Israel now shows how the calculus is changing in places where progress was fastest. …

“Following the spread of the Delta variant over the summer, Israel has seen cases climb, reaching an all-time high of 11,316 daily cases on Sept. 2. The number of people falling seriously sick and being hospitalized, though, has risen less than it did during the last coronavirus wave, peaking at 751 in late August, compared with 1,183 in mid-January. The trend is now downward.”

(4) Living with Covid. The article quoted an Israeli professor of infectious diseases with the bottom line on the pandemic: “If you are able to maintain life without lockdown, and to avoid very high numbers of hospitalizations and death, then this is what life with Covid looks like.”

World Economy I: Slowing but Growing. Policymakers in the US responded to the pandemic with much more monetary and fiscal stimulus than did policymakers elsewhere in the world. A significant portion of that stimulus “leaked” abroad through the US trade deficit. That boosted the global economic recovery from the pandemic lockdowns. Of course, other countries also responded with their own stimulative policies. Consider the following:

(1) US trade. During Q2, US current-dollar imports of goods rose to a record $2.8 trillion (saar) (Fig. 8). The trade deficit in goods widened to a record $1.1 trillion during Q2 (Fig. 9).

(2) Commodity prices. Debbie and I view broad commodity indexes as very good indicators of global economic growth. Both the CRB all commodities index and the CRB raw industrials spot price index have rebounded from their pandemic lockdown lows of last year back to their previous record highs during 2011 (Fig. 10). Their ascents during the Great Virus Crisis have been very similar to their ascents following the Great Financial Crisis.

Both of these indexes may be peaking now. If so, then the slowdown in US economic growth we discussed in yesterday’s Morning Briefing may be contributing to a global growth slowdown. China’s economy has also gotten a boost from an export boom to the US, but real US consumer spending on goods has dropped for the fourth month in a row, as we also discussed yesterday. In the August 23 Morning Briefing, we observed that China’s retail sales have stopped growing as a result of the country’s rapidly aging demographic profile. Furthermore, the global auto industry has been forced to tap on the production brakes as a result of semiconductor shortages.

(3) Global PMIs. The global composite purchasing managers index (C-PMI), which includes the global manufacturing (M-PMI) and nonmanufacturing (NM-PMI) indexes, peaked at 58.5 in May then fell for the next few months to 52.6 in August (Fig. 11). Leading the decline have been the PMIs for emerging economies. The M-PMI for advanced economies has been holding up better than that for emerging ones (Fig. 12). The NM-PMIs have been weakening across the board.

Here are August readings for selected advanced economies’ M-PMIs and NM-PMIs: Eurozone (61.4, 59.0), UK (60.3, 55.0), US (59.9, 61.7), and Japan (52.7, 42.9).

Here is what we have for selected emerging market economies’ M-PMIs and NM-PMIs during August: Brazil (53.6, 55.1), India (52.3, 56.7), China (50.1, 46.7), and Russia (46.5, 49.3).

(4) Global real GDP. On a y/y basis, global real GDP growth set a record for sure during Q2, since most economies were hit by pandemic lockdowns a year ago and have staged V-shaped recoveries since then through this year’s Q2. However, all Vs come to an end. We aren’t likely to see y/y growth rates in real GDP like these again in our lifetimes: UK (22.2%), Mexico (19.6), Singapore (14.6), Eurozone (14.3), Canada (12.7), Brazil (12.4), Australia (9.6), Taiwan (8.4), China (7.9, down from a peak of 18.3% during Q1), Japan (7.6), Indonesia (7.1), and South Korea (6.0). (See our Comparative Global GDP Growth Rates chart book.)

(5) Global parts shortage. The parts shortages, especially in the auto industry, may weigh on global economic growth more than widely anticipated. We can see this happening in Germany, where it appears that manufacturing orders can’t be filled fast enough: German manufacturing orders—up 3.4% m/m during July to a record high—have been strong yet industrial production has been relatively weak, falling during the three months through June before July’s 1.0% blip up (Fig. 13).

German auto production staged a brief recovery earlier this year but has also been slipping recently (Fig. 14). German technology and engineering group Bosch, which is the world’s largest car-parts supplier, reports that semiconductor supply can’t keep up with demand for chips in everything from cars to PlayStation 5s and electric toothbrushes.

The move to electric vehicles is exacerbating the problem. For example, a Ford Focus typically uses roughly 300 chips, whereas one of Ford’s new electric vehicles can have up to 3,000 chips, according to CNBC. Ford also reported that lithium, plastics, and steel are all in relatively short supply. Malaysia, where many of Volkswagen’s suppliers are based, has been hit hard by the coronavirus in recent weeks, leading to several factory shutdowns.

 World Economy II: Forward Revenues, Earnings, and Margins. Joe and I also like to get a read on the global economy by tracking the forward revenues (FR) of the major MSCI stock price composites (Fig. 15). Through the week of August 26, they are showing that the All Country World FR fully recovered what it lost last year. That was all because the FR for the US has been rising in record territory since earlier this year. The FRs of Emerging Markets, EMU, Japan, and the UK bottomed last year and have recovered but remain below their pre-pandemic levels.

In other words, the forward revenues data confirm that the US economic recovery has been stronger than elsewhere around the world and that the US has “shared” some of this growth with the rest of the world through the widening US trade deficit.

A similar story is told by the forward earnings (FE) of the major MSCI composites (Fig. 16). The FE recoveries have been stronger than the FR recoveries because forward profit margins (FPMs) have snapped back from last year’s lows around the world (Fig. 17). In fact, all of the major MSCI composites have FPMs above their pre-pandemic levels. Here they are for the week of August 26: US (13.0%), All Country World (10.7), UK (10.5), EMU (8.3), Emerging Markets (8.2), and Japan (7.1).

Around the world, companies are boosting productivity to offset labor shortages that are attributable to the increasingly geriatric demographic profile of the world’s population and labor force. We discussed this development in the August 10 Morning Briefing titled “Voluntary Self-Extinction of the Human Race.” The pandemic has exacerbated the labor shortages around the world. The result has been V-shaped recoveries in profit margins over the past year.

World Strategy: Stay Home or Go Global? The aforementioned metrics show that the US is outperforming the rest of the world. That’s showing up in the extreme divergence between the forward P/Es of the US MSCI, which was 22.0 at the end of August, and the All Country World ex-US MSCI, which was 14.7 at the end of last month (Fig. 18).

However, as we have noted in the past, it makes more sense to compare the valuation multiple of the rest of the world to the forward P/E of the S&P 500 Value index (Fig. 19). It was 16.5 in early September. The rest of the world is still relatively cheap even on this basis. Nevertheless, the uptrends in the Stay Home vs Go Global ratios remain solidly intact, and we continue to recommend overweighting the US (Fig. 20).

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Let’s Get Real

September 07 (Tuesday)

YRI Podcast. In our latest video podcast, Dr. Ed discusses the main points of today’s Morning Briefing.

US Economy: Real GDP Slowing. Debbie and I have been expecting that real GDP growth will slow to 3%-4% (saar) during the second half of this year from 6.3% and 6.6% during Q1 and Q2 (Fig. 1). Next year, we are predicting around 2.5% growth. Consider the following:

(1) Less pent-up demand left. We figure that consumers have satisfied lots of their pent-up demand for goods and then some. There may be more fiscal stimulus coming, but that will most likely be for $550 billion of infrastructure spending (above the current base line) spread out over the next five to eight years. We are assuming that there won’t be a fourth round of government relief checks to consumers. We aren’t concerned about a “fiscal cliff” since the end of relief checks should continue to be offset by gains in employment and wages (Fig. 2).

Indeed, while August’s 235,000 increase in payroll employment was disappointing, average hourly earnings (AHE) for all workers rose 0.6% m/m. That led our Earned Income Proxy for private-sector wages and salaries to increase 0.8% m/m to yet another record high (Fig. 3). The problem is that the recent surge in inflation has reduced the purchasing power of consumers’ incomes (Fig. 4). Since the end of 2020 through July of this year, private wages and salaries are up 3.8% in current dollars and 0.7% in real dollars.

On an inflation-adjusted basis, consumer spending on goods rose well above trend last spring through March of this year (Fig. 5). It has dropped 4.3% over the past four months through July. Inflation-adjusted spending on services remains below its pre-pandemic peak and is still trending higher. There’s potential pent-up demand for services. But total real consumer spending has been flat for the past four months through July, though at a record high.

(2) Missing parts for autos. We are concerned about the shortage of parts, which has forced the auto industry to reduce production, resulting in depleted inventories and depressed sales (Fig. 6, Fig. 7, and Fig. 8). Indeed, motor vehicle sales dropped from a recent high of 18.5 million units (saar) during April to 13.1 million units during August, led by a big drop in domestic light truck sales. Also depressing auto sales are soaring new and used auto prices, up 6.5% y/y and 36.5% y/y during July, based on the PCED. The good news is that when the parts become available again, auto sales should give consumer spending a lift.

(3) Inflating houses are depressing buyers. Following the end of the lockdown recession last year, housing sales soared. However, the sales boom was tempered by record-low inventories of new and existing homes for sale. As a result, home prices soared to levels that have caused would-be first-time homebuyers to continue to rent.

If you own a home, the good news is that the median price of an existing single-family home rose 18.6% y/y during July to a record $367,000 (Fig. 9). That’s the bad news if you are a first-time homebuyer. The shortage of housing inventory and soaring prices have depressed not only housing sales but also housing-related retail sales (Fig. 10).

(4) Capital spending booming. Debbie and I expect that capital spending will remain robust at least through next year as companies scramble to deal with labor shortages by spending on capital goods that can augment the physical and mental productivity of their workforce. We are not surprised to see nondefense capital goods orders excluding aircraft continuing to soar in record-high territory (Fig. 11). During July, this series was 18.0% above its pre-pandemic reading during January 2020. Leading the way has been industrial machinery (Fig. 12). More spending on infrastructure should boost construction equipment orders. The reshoring of supply chains should continue to boost capital spending across the board.

(5) Restocking depleted inventories. Inventory investment was a major drag on real GDP growth during the first and second quarters of this year. Most of the decline in inventories occurred in manufacturing and retail autos (Fig. 13). The slowdown in consumer spending may actually be a welcome development, providing some slack for businesses to rebuild their inventories. Many of their managers must be moving away from just-in-time inventory systems to just-in-case management until supply chains are brought closer to home.

(6) Government spending. Spending on goods and services by the federal, state, and local governments hasn’t contributed much to real GDP growth since roughly 2010 (Fig. 14). Similarly, public construction put in place, in current dollars, has been relatively flat around $300 billion (saar) since 2008 (Fig. 15). It has remained well below residential and nonresidential construction spending since 2013. It should get a significant lift if Congress enacts the $550 billion infrastructure spending bill.

US Labor Market: Mixed Signals. August’s employment report, released on Friday by the Bureau of Labor Statistics (BLS), was mostly on the disappointing side following better-than-expected reports for June and July. August’s weakness was largely blamed on the Delta variant of the Covid-19 virus.

Indeed, the BLS reported that the number of persons “unable to work because their employer closed or lost business due to the pandemic” rose 400,000 m/m during August to 5.6 million. This would certainly explain why the number of unemployed workers remained high at 8.4 million last month. Debbie and I also suspect that seasonal factors have been distorted by the pandemic.

As noted above, there was some good news for workers on the wage side, which boosted our Earned Income Proxy. Consider the following:

(1) Employment and unemployment. While August’s payroll employment gain was much weaker than expected, the household measure of employment rose 509,000, outpacing the 190,000 increase in the labor force. The result was a drop in the unemployment rate from 5.4% during July to 5.2% during August. The former measures the total number of full-time and part-time jobs, while the latter measures the number of people employed no matter how many jobs they have.

(2) Wages. The good news for workers was that their wages as measured by AHE rose 0.6% m/m and 4.3% y/y. AHE for production and nonsupervisory (P&NS) workers—who accounted for 81% of payrolls, excluding government jobs, during August—rose 0.5% m/m and 4.8% y/y. The bad news was that workers’ real pay was eroded by a 4.2% y/y increase in the PCED inflation rate through July.

(3) High and low wages. Debbie and I can calculate AHE for higher-wage workers ($51.50 per hour in August) using the BLS data for the AHE of all workers ($30.70) and for P&NS workers ($26.00) (Fig. 16). On a y/y basis, they were up 3.5%, 4.3%, and 4.8%. Again, keep in mind that the PCED inflation measure was up 4.2% y/y in July.

A sign of the times: On Thursday, Walmart raised the pay for more than 565,000 store employees for the third time in the past year, putting the company’s US average hourly wage at $16.40.

(4) Three-month inflation. In an effort to reduce the pandemic lockdown’s “base-effect” on inflation readings this year, we have been focusing on the latest three-month percent changes at seasonally adjusted annual rates (saar) rather than the y/y comparisons. So, through July, the PCED is up 5.9% over the past three months (saar) vs 4.2% y/y.

Now let’s do the same for the AHEs of the major industries through August on a three-month basis: leisure & hospitality (16.8%), transportation & warehousing (12.5), professional & business services (6.3), natural resources (6.2), education & health services (5.8), retail trade (4.9), financial activities (4.2), manufacturing (4.2), utilities (4.2), wholesale trade (4.1), other services (4.0), construction (3.9), and information services (2.7).

And here are the similar comparisons for the AHEs of higher-wage workers (4.8%), all workers (5.5), and lower-wage P&NS workers (6.1) (Fig. 17). The hourly pay hikes for lower-wage workers, especially in leisure & hospitality and transportation & warehousing, are clearly outpacing the PCED inflation rate.

Monetary Policy: Powell’s Dilemma. The FOMC meets on September 21 and 22. After the meeting, the FOMC will release its latest quarterly dot plot showing the projections of the federal funds rate by the committee’s 18 participants. The number of them expecting to start hiking this rate next year rose from four at the March meeting to seven at the June meeting. Melissa and I expect to see that number increase to 10 at the next meeting.

At his next post-meeting press conference, Fed Chair Jerome Powell is likely to say that the committee is preparing a schedule for tapering the Fed’s bond purchases but that the start date is still under discussion as a result of Friday’s weaker-than-expected employment report for August. All eyes will be on September’s employment report, which will be released on October 8. If it is strong, as we expect, then the FOMC should start tapering after the November 2-3 meeting.

The fact that the number of unemployed remained elevated at 8.4 million during August and included 5.6 million persons “unable to work because their employer closed or lost business due to the pandemic”—up 400,000 m/m—will likely cause the FOMC’s doves to conclude that there is no rush to start tapering since the pandemic is still a big drag on employment.

The hawks are likely to counter that the latest wave of the pandemic may have crested during the summer and that the FOMC needs to move ahead with tapering so that the committee will be able to respond more quickly with rate hiking next year if inflation turns out to be less transitory than the doves have been predicting.

So what will the Fed do? Ask us again after the next employment report.

Movie. “A Private War” (+ + +) (link) is a 2018 biopic about Marie Colvin, who was an extraordinary American war correspondent for The Sunday Times of London. She wore an eyepatch after losing her left eye in 2001 when she was covering the civil war in Sri Lanka. Despite suffering from PTSD, she covered the conflicts in Iraq and Libya, interviewing Qadhafi before he was killed. In February 2012, she was interviewed on CNN from Homs, Syria, where she reported that Assad’s army was committing war crimes against civilians on a massive scale. Rosamund Pike’s performance as Marie is top notch.

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Financials, China & Carbon

September 02 (Thursday)

Financials: Ahead of the Pack. As we enter September, the S&P 500’s second-best-performing sector on a year-to-date basis is a bit counterintuitive. It’s not Energy, supported by the rebound in the price of crude oil. Nor is it the high-growth Technology sector. Despite a 10-year Treasury bond yield hovering around 1.3%, Financials is near the front of the pack (Fig. 1).

Here’s the performance derby for the S&P 500 and its 11 sectors ytd through Tuesday’s close: Real Estate (30.7%), Financials (29.9), Communication Services (29.3), Energy (26.6), Information Technology (21.6), S&P 500 (20.4), Health Care (18.9), Materials (17.7), Industrials (17.6), Consumer Discretionary (12.7), Utilities (8.7), and Consumer Staples (7.4) (Fig. 2).

The Financials sector’s performance is broad based, with almost all of the sector’s industries returning more than the S&P 500’s ytd return of 20.4%: Investment Banking & Brokerage (49.4%), Consumer Finance (46.9), Asset Management & Custody Banks (33.9), Diversified Banks (30.8), Regional Banks (27.3), Insurance Brokers (26.9), Financial Exchanges & Data (21.9), and Reinsurance (13.2) (Fig. 3). The outperformance of Financials is notable for some of the following reasons:

(1) Rates remain low. Despite the strong rebound in the US economy, interest rates have remained surprisingly low. In addition, the spread between the 10-year Treasury bond yield and the federal funds rate, at 118bps, is up from 92bps in late January but largely unchanged from last year despite indications that the Federal Reserve will reduce the amount of Treasury bonds it purchases this year (Fig. 4 and Fig. 5).

(2) Lending remains soft. With capital markets wide open and balance sheets flush, companies haven’t needed to turn to the banks for funding. Banks’ commercial and industrial (C&I) loans have declined from their peak of $3.1 trillion during the May 6, 2020 week to $2.4 trillion as of the August 18 week (Fig. 6). C&I loans are down 13.5% y/y despite the strong economic rebound over the past four quarters (Fig. 7).

(3) Unwinding reserves. Banks took large loan-loss reserves early in 2020 in anticipation of loan losses that never arrived thanks to all the financial support the government gave to individuals and businesses. As banks have unwound those reserves, earnings have benefitted. But investors and analysts usually look past those non-cash gains.

Analysts are forecasting that the Financials sector earnings will grow 57.2% this year only to fall 6.6% in 2022 (Fig. 8). The sector’s revenues—up 3.9% this year and 3.1% in 2022—are probably more reflective of the sector’s underlying performance (Fig. 9). Perhaps Financials stocks reflect investors’ expectations that earnings will improve over the next year because higher interest rates are in our future.

China: Xi Knows Best. Father Knows Best is a TV show that ran from 1954-60 about the Andersons, an ideal American middle-class family. Robert Young played the wise, unflappable father who never yelled but disciplined by dispensing wisdom to his three kids. Jane Wyatt was his perfect wife.

In recent weeks, China’s President Xi Jinping has been dispensing new rules about how Chinese individuals and companies should behave, restricting video game playing by teens, prohibiting celebrity fan clubs, and requiring tech companies to register their algorithms with the government—and that’s just this week. In weeks past, the Chinese government has squashed private tutoring companies, coerced tech companies into making huge charitable donations, and prohibited the IPO of Ant Financial Group, among other moves. Father Xi is not so subtly putting his imprint on Chinese business and culture.

Perhaps Xi could use a lesson in US history. The placid 1950s and early 1960s depicted in Father Knows Best were followed by an era of raucous rebellion in the late 1960s and 1970s among the kids who had watched the Andersons. Xi undoubtedly has more control over China’s citizens than any US president would dare to dream of. But we’d be surprised if all these new restrictions, reaching deep into the crevices of Chinese daily life and business, don’t provoke a backlash at some point.

The velocity of the rule-issuing torrent might imply that Xi aims to divert attention away from something else. The economy is slowing, the country’s largest real estate developer Evergrande appears to be on the brink of bankruptcy, and Covid-19 has returned to China’s shores. Here’s Jackie’s latest on Xi’s new rules and the developments he might be hoping to distract us from noticing:

(1) Limits on video games. Earlier this week, China barred minors from playing video games on Monday through Thursday, allowing play only from 8 p.m. to 9 p.m. on Friday through Sunday. The state will enforce these rules by requiring that all online videogames connect to an “anti-addiction” system run by the National Press and Publication Administration. To access games, users must register with their real names and government identification documents, an August 31 WSJ article explained. Tencent Holdings has the technology to automatically kick players off games after a certain time period and facial recognition to confirm users’ identities.

The move didn’t come as a complete surprise, as Chinese state media previously has called video games “opium for the mind” and blamed them for “societal ills including distracting young people from school and family responsibilities.” It described the government’s new rules as protecting the physical and mental health of minors.

Some disgruntled teens were brave enough to comment online. “This group of grandfathers and uncles who make these rules and regulations, have you ever played games? Do you understand that the best age for e-sports players is in their teens?” said one comment on China’s Weibo, according to an August 31 Reuters article. “Sexual consent at 14, at 16 you can go out to work, but you have to be 18 to play games. This is really a joke.”

But at least one Chinese parent supported the effort. Li Tong, a hotel manager in Beijing with a 14-year-old daughter, told Reuters: “My daughter is glued to her phone after dinner every day for one to two hours, and it’s difficult for me or her mother to stop her. … We told her it’s bad for her eyes and it’s a waste of her time, but she won’t listen.” Now he can take her phone and blame Xi.

(2) Cleaning up algos and entertainment. The Cyberspace Administration of China (CAC) is increasing its control over tech algorithms—and starlets. It has proposed new rules to regulate algorithms used by online companies—including those for recommendations, content aggregation, and search rankings—as part of “Beijing’s efforts to redirect people’s attention to online content that the state deems fit for broad public consumption,” an August 27 South China Morning Post article reported.

Under the rules, consumers can request that an Internet company stop offering personalized recommendations. Internet companies that influence public opinion must register their algorithms with regulators, some undergoing a “security assessment.” Algos must not be used to “encourage indulgence and excessive spending,” and they must “actively spread positive energy.” Algos can’t allow platforms to offer different prices to different users based on an assessment of a consumer’s willingness to pay.

The CAC also prohibited excessive content about celebrities, online fan clubs, and app alerts about celebrity gossip, violence, and vulgar content. China’s NetEase, Weibo, and Tencent Holdings have removed celebrity ranking lists from their platforms, and NetEase limited the purchases of digital albums to one per user.

Some celebrities’ online presences—particularly those that have broken the law or received large pay packages—are being erased. “Zhao Wei, one of China’s most prominent actresses, saw her presence mostly scrubbed from the country’s internet overnight,” an August 30 CNN article reported. Her Weibo fan page was shut down, and “movies and television shows she starred in—some going as far back as two decades ago—were taken off streaming platforms, with her name also removed from the cast lists.” CNN didn’t know why Zhao was targeted, but it noted that Xi has pledged to redistribute wealth, and celebrities with large paychecks may be targets.

Additionally, last weekend, China’s Communist Party deemed celebrity culture “toxic” and accused it of “advocating wrong values” in Chinese youth. “If not guided and changed, it’ll have a huge destructive impact on the future life of young people and social morality.”

(3) Ignore the data behind the curtain. China’s nonmanufacturing purchasing managers index (PMI), which includes the construction and services sector, fell to 47.5 in August, down from 53.3 in July. The data came in below forecasts that called for continued expansion, signaling contraction for the first time since Covid-19 closures damaged the economy in February 2020.

The country’s manufacturing PMI fell to 50.1, just barely remaining in growth territory, but lower than the 50.4 registered in July (Fig. 10). Also, two PMI components—-new orders and new export orders—were below 50.

An August 31 WSJ article attributed the drop in services activity to the spread of Covid-19’s Delta variant. Identified in China on July 20, Delta already has infected more than 1,200 people in half of the country’s provinces. Millions of residents were placed under lockdown, while citizens were tested and traced and domestic travel was restricted. Daily infections have fallen sharply, from north of 100 in August to 20-30 in recent days, so perhaps the economic data will improve again.

(4) Shaky giant. China Evergrande Group is China’s second-largest real estate developer; it also produces electric cars, holds an equity stake in a football club, and sells insurance and bottled water. The company is facing a liquidity crisis that could mean it defaults on $88 billion of debt—42% of which comes due within the next year.

As China’s largest junk bond issuer, Evergrande borrowed both in domestic and offshore markets, and its bonds are distressed, trading below 40 cents on the dollar. It borrowed from more than 128 banks and more than 121 non-banking institutions, including many in China’s shadow banking market, a July 27 Reuters primer explained.

Work stopped on some of Evergrande’s real estate projects after the company delayed payments to suppliers and contractors, an August 31 WSJ article reported. It’s likely Xi would prefer we focus on online gaming restrictions instead of the ramifications of Evergrande’s potential $88 billion default.

Disruptive Technologies: Finding Uses for Captured Carbon. In the August 19 Morning Briefing, we discussed how companies were capturing carbon from the air, from tailpipes, and from factories’ flues in a race to prevent Earth from overheating. The technology to purify the air certainly exists, but it’s expensive.

Part of the solution may involve selling the collected CO2 for use in other products. The revenue from sales would help offset the cost of CO2 collection. Companies pay for CO2 to make drinks bubbly, to increase the growth of plants in greenhouses, and to make fuel, toothpaste, and plastics.

Recycling CO2 is referred to as carbon capture and utilization (CCU). Under optimistic estimates, CCU could generate revenue of more than $800 billion by 2030 and reduce CO2 emissions by up to 15%, according to an August 25 ScienceDaily article.

Climeworks has a giant plant that takes CO2 out of the air, but just one of its 30 ventilators costs $220,000 and requires lots of electricity to run, an August 31 WSJ video notes. To offset costs, Climeworks sells recycled CO2 to Coca-Cola, which uses the gas to make its bottled water bubbly. In the future, Coke hopes to use the recycled CO2 in its other drinks as well. Coke uses Climeworks’ recycled CO2 even though it is “significantly” more expensive than getting new CO2 from traditional sources. Nonetheless, Coke is using the recycled CO2 to lower its carbon footprint and expects the cost to come down over time.

Scientists at the University of Michigan studied which products made using recycled CO2 would be the most beneficial to the climate, according to the ScienceDaily article noted above. The study compared 20 ways recycled CO2 could be used in making concrete, chemicals, and minerals to identify which ones produced a net benefit to the environment—i.e., the emissions avoided by using recycled CO2 were greater than those that would have been generated by capturing CO2.

Net benefits were produced by two methods that used CO2 to mix concrete, one method that produced formic acid through hydrogenation of carbon dioxide, and one method that made carbon monoxide from methane. Formic acid is a preservative and antibacterial agent in livestock feed and is used to tan leather and dye textiles. Carbon monoxide is used in synthetic chemical manufacturing, metallurgy, and other industrial processes.

“Our rankings will help prioritize R&D strategies toward products with the greatest climate benefit while avoiding pathways that incur a significant climate burden and that offer little hope for improvement,” said Dwarak Ravikumar, lead author of the study.

There are critics of Climeworks’ methods of capturing carbon and even capturing carbon at all. Some say that it’s much more efficient to capture CO2 from an industrial plant’s chimney, where the concentration of CO2 is denser than it is in the air that Climeworks pumps through its systems. Others note that it’s better for the environment to use renewable power sources to generate electricity than fossil fuels that produce CO2 and then require expending additional energy to recapture it.

Our guess is that it’s going to take many different methods of reducing CO2 in our atmosphere to limit climate change. In time, we’ll be capturing CO2 from flues of concrete factories, using solar panels on homes, extracting CO2 from the air, and employing many other methods of CCU before the problem ameliorates.

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Modern Monetary Theory In Practice

September 01 (Wednesday)

Strategy: Forward Earnings by the Numbers. The meltup in the stock market continues to be led by forward earnings, the time-weighted average of industry analysts’ consensus expectations for this year’s and next year’s earnings. They’ve been raising their S&P 500 estimates for 2021 and 2022 because companies have significantly beat Q1 and Q2 expectations (Fig. 1). As a result, during the final week of August, they estimated that S&P 500 operating earnings per share will be $201 this year and $220 next year, putting forward earnings at a record $213 (Fig. 2).

I asked Joe to calculate the percent changes in the forward earnings of the S&P 500 and its 11 sectors since their post-lockdown lows last year through the week of August 19: Energy (1,558.2%), Materials (91.2), Consumer Discretionary (89.2), Financials (67.7), Industrials (66.1), Communication Services (54.8), S&P 500 (50.9), Information Technology (41.3), Real Estate (25.9), Health Care (25.5), Consumer Staples (17.6), and Utilities (4.0) (Fig. 3).

Fiscal Policy: Moderate vs Progressive Dems. “Never let a serious crisis go to waste.” Rahm Emanuel famously said so when he was was President Barak Obama’s chief of staff. But the idea has been a guiding principle for politicians since the second oldest profession came into being. The pandemic has unleashed US politicians, resulting in unprecedented programs of monetary and fiscal stimulus. Modern Monetary Theory on steroids and speed has been implemented. Our supreme leaders have made sure that this serious health crisis will not go to waste. Let’s start with the latest machinations of our congressional representatives.

We are grateful for our friend James Lucier at Capital Alpha Partners because he keeps us up to date on all the sausage making in Washington, DC. Lately, there is a whole lot of pork being tossed around. In his August 24 Macro update note, Jim writes that “House moderates who are keen to vote on the $550 billion bipartisan infrastructure plan may get their way sooner than expected—perhaps by September 27.”

Jim adds: “House progressives want no such vote anytime soon—not until after a later and much larger budget reconciliation bill passes or is assured of passage. The larger bill is often described as a notional $3.5 trillion package.” That’s because the “resolution passed by the Senate calls for up to $3.5 trillion in new spending, which is a maximum and not a guaranteed minimum.” The notional package allows the new spending to be fully paid for with up to $3.5 trillion in new taxes—but “the Senate’s budget resolution allows for the possibility of $1.75 trillion in new spending that is not paid for at all,” he explains.

“The reconciliation bill would be a single package that fulfills the terms of the budget resolution once the House and Senate have acted. It would be the vehicle for the bulk of the president’s climate and clean energy spending programs … More prominent will be an ambitious social agenda, which includes tax credit programs designed to establish a form of a universal basic income (UBI) program, universal pre-kindergarten schooling, free community college, paid family and medical leave, childcare, elder care, and the expansion of Medicare—all paid for by higher taxes on individuals and corporations,” Jim writes.

He adds: “House progressives want the bipartisan infrastructure plan linked to budget reconciliation because they fear that House moderates will not otherwise vote for the ambitious package that the progressives want.” Jim observes that the “parts of the reconciliation package that will be most difficult to pass will be the tax provisions.”

One of the major steps to “victory for the moderates would be securing a time certain for the infrastructure vote. There was no time certain mentioned in the original rule. Instead, [House Speaker Nancy] Pelosi initially offered an unwritten assurance that the House would vote by October 1. The moderates rejected this. A second plan was to offer a non-binding House resolution that still committed to a vote by September 28. Finally, the Rules Committee adopted language that set the legislative day of September 27 as a deadline House consideration of the bill.”

Headwinds for securing the vote on time include the developments in Afghanistan and the health and economic consequences arising from the Delta Covid-19 variant. Both issues will take congressional attention away from infrastructure. However, the headwinds could quickly become a tailwind if congressional Democrats (progressives and moderates alike) decide that a quick win is necessary to restore the popularity of the President.

Monetary Policy I: Powell’s Inflation Dashboard. Melissa and I have long wanted Fed Chair Jerome Powell to provide a dashboard of specific metrics that he is watching. He came close to doing so last week in his Jackson Hole virtual speech. Now when Powell explains whether “substantial further progress” (SFP) has been made toward the Fed’s rather subjective goals of maximum employment and stable prices, we can see what he is seeing as evidence for why. (Fed officials have been using the catchphrase “substantial further progress” regarding these goals since the end of last year.)

Powell stated in his opening speech that inflation had passed the SFP test, while employment had made progress short of “substantial.” Nevertheless, Powell indicated that if the labor market continues to improve it would be appropriate to reduce the Fed’s pandemic-related asset purchases (i.e., to taper) by the end of “this year.”

Although Powell said inflation had met the SFP criterion, he contended that its pace remains moderate. That seems to be the main reason interest rate hikes aren’t in the Fed’s view for now. We’ll be watching all the metrics that Powell discussed—especially those related to the Fed’s “maximum employment” goal—for further signs of recovery (or shortfall), which could push Powell’s taper timeline up (or back) from this year and affect rate-hike timing.

Let’s start with what Powell is seeing on inflation before turning to employment:

(1) Durable goods prices. Powell observed that price inflation for goods, primarily for durable goods, is pushing the broader measures higher. Booming consumer spending on goods has resulted in supply bottlenecks, in his opinion. He didn’t acknowledge that excessively stimulative monetary and fiscal policies were behind the boom.

During July, the CPI and PCED for goods surged 9.1% y/y and 5.3% y/y, while services registered more moderate increases of 3.0% y/y and 3.5% y/y (Fig. 4 and Fig. 5). Drilling down further into goods inflation, the CPI and PCED for durable goods surged 14.3% and 7.0% through July while nondurables rose 7.2% and 4.4% (Fig. 6 and Fig. 7). Powell pointed to consumer demand for used autos as a key driver pushing up prices following the pandemic.

(2) Trimmed CPI. Powell cited an alternative measure of inflation as evidence of the narrowness of the recent inflation surge. The Trimmed-Mean CPI, calculated by the Federal Reserve Bank of Cleveland, measures core inflation by excluding the most volatile CPI components (i.e., those with the highest and lowest one-month price changes). The measure has risen 3.0% y/y through July, while the core CPI and core PCED, which exclude food and energy prices, have risen 4.3% and 3.6% y/y through July (Fig. 8).

(3) Wage inflation. Powell also watches wage inflation because, he said, significant wage inflation that leads to increases in producer prices that are passed onto the consumer could prove to be a dangerous trend that has played out in the past.

But, for now, inflationary red flags are not lurking in wages. Powell observed that the moderate rises in the Atlanta Fed’s Wage Growth Tracker of 3.7% y/y through July and the Employment Cost Index for wages and salaries of 3.6% y/y through Q2 were no cause for alarm (Fig. 9).

(4) Inflationary expectations. The Fed chair also observed that measures of expected inflation remain moderate. The Philadelphia Fed Survey of Professional Forecasters’ CPI expectation over the next 10 years and the University of Michigan’s Consumer Sentiment Index measure of expected inflation over the next five years were 2.4% and 2.9% during August (Fig. 10).

However, he chose to ignore the survey of inflationary expectations conducted monthly by the Federal Reserve Bank of New York (FRB-NY). During July, it showed one-year-ahead and three-years-ahead inflationary expectations of 4.8% and 3.7% (Fig. 11).

(5) Global inflation. Global disinflationary forces are keeping a lid on inflation in the US, Powell pointed out. Specifically, he showed that inflation has remained low in Canada, Sweden, the Eurozone, Japan, and Switzerland.

By the way, in addition to ignoring the FRB-NY’s series on inflationary expectations, he never mentioned the regional business surveys conducted by five of the Fed district banks showing elevated inflationary pressures in both their prices-paid and prices-received indexes, as we discussed yesterday.

Monetary Policy II: Powell’s Employment Dashboard. Here are the metrics that Powell watches to assess the state of the Fed’s maximum employment goal:

(1) Employment. Payroll employment has not yet fully recovered from the pandemic, Powell emphasized. Joblessness has been hardest hit for lower-income service industries like restaurants, air travel, and dentists, he noted. Of the 5.7 million shortfall in total payroll employment compared to the February 2020 level, 4.2 million is in services (Fig. 12). Powell also mentioned that leisure and hospitality employment has been improving but remains short of the SFP bar (Fig. 13).

The recent pace of new hiring has boosted employment levels, Powell said. However, he remains especially concerned about long-term unemployment and labor force participation rates. The rate of short-term unemployment has nearly entirely recovered to its pre-pandemic rate, but the long-term unemployment rate hasn’t fully recovered (Fig. 14). The longer that the unemployed remain so, the more likely they are to drop out of the labor force entirely.

(2) Participation. Powell observed that unemployment would be substantially higher, even near 10%, if labor force participation, which currently stands at 61.7%, were a few points higher (Fig. 15). Before the pandemic, during February 2020, the labor force participation rate stood at 63.3%. Powell hopes that the rise in vaccinations, reopening of schools, and end of extended unemployment benefits will drive more people out of long-term unemployment and back into the labor force. By the way, we find it curious that Powell said nothing of early retirements, which could result in structurally lower participation rates.

(3) Cohorts. African Americans, less educated Americans, and low-income Americans have experienced greater unemployment and a slower recovery in joblessness than other groups of Americans, Powell also pointed out (Fig. 16).

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Corporate Finance For Fun & Profit

August 31 (Tuesday)

Strategy I: More Profit Margin Records. Joe and I were impressed last week by Standard & Poor’s release of S&P 500 revenues per share and earnings per share. The former was up 18.5% y/y, while the latter soared 88.4% y/y (Fig. 1 and Fig. 2). Both are likely to mark cyclical peaks in these growth rates for a while. However, both should continue to grow through 2023. Here are our projected growth rates for S&P 500 revenues and earnings during 2021 (18%, 47%), 2022 (3%, 5%), and 2023 (3%, 7%). (See YRI S&P 500 Earnings Forecast.)

We can use the two series to calculate the profit margin of the S&P 500 (Fig. 3 and Fig. 4). Before the pandemic, the margin peaked at a then-record high of 12.5% during Q3-2018. President Donald Trump’s corporate tax cut was a big booster of the margin that year. As a result of the pandemic, the margin fell to 8.9% during Q2-2020, but that was well above the 2.4% low during the Great Financial Crisis (GFC). The margin has rebounded from last year’s low to a record-high 14.1% during Q2.

We can use the data from the National Income and Products Accounts (NIPA) to calculate profit margins as well. Corporate after-tax book profits divided by nominal GDP also jumped to a record high of 11.8% during Q2, up from 8.1% a year ago (Fig. 5). Why the divergence between this measure of the margin and the S&P 500 one? The two series have generally followed the same path, though they do diverge, as they did in the years between the GFC and the Great Virus Crisis.

We give much more weight to the S&P series than the NIPA one. That’s because NIPA profits includes both C and S corporations, as I discuss in my forthcoming book, In Praise of Profits: A Capitalist Manifesto for Progressives (late September release date). The S&P 500 are C corporations along with 1.8 million similar corporations. There are 5.0 million S corporations. Their profits are included in the NIPA series, but they are pass-through businesses, i.e., they pay most of their profits as dividends to their limited number of shareholders. Since the start of the data during Q4-1994, S&P 500 aggregate reported pre-tax income has accounted for about 60% of NIPA’s corporate book pre-tax profits (Fig. 6).

As we observed last week, the rebound in the S&P 500 profit margin to a new record high is impressive given all the headline news about rising costs. This suggests that either companies are passing the costs through to their prices or they are boosting productivity significantly. A third possibility is that they are both raising their prices and boosting their productivity. This most likely explains what is happening currently. Another factor to consider is that the S&P 500 includes commodity producers that are seeing their profit margins widen along with commodity prices. Now consider the following related developments:

(1) Sectors. Sure enough, the biggest upswings in profit margins among the S&P 500 sectors have been Energy and Materials, reflecting soaring commodity prices (Fig. 7). The margin for Energy is up from -8.6% during Q2-2020 to 6.9% during Q2-2021. Over the same period, the margin for Materials is up from 8.6% to a record-high 14.9%. However, there were other sectors at record highs during Q2, including Communication Services (18.6), Financials (22.3), Health Care (11.7), and Information Technology (25.0).

(2) Pricing. We now have August data for the regional business surveys conducted by five of the regional Federal Reserve Banks. The average of the prices-paid indexes has soared from a low of -4.9 last year during April to a record high of 84.1 this May (Fig. 8). It has stabilized around that level through August.

Meanwhile, the average of the prices-received indexes has continued to soar through August to a new record high. The spread of the average of prices-paid indexes to the average of the prices-received indexes rose from a low of 2.0 last year during March to peak at 40.8 this May (Fig. 9). It fell to 24.2 during August, suggesting that many companies are passing on the price increases they are paying by increasing the prices they are receiving.

The apparent peaking of the average prices-paid index suggests that the CRB all commodities index and the CRB raw industrials spot price indexes may be starting to peak (Fig. 10). The same can be said for the price of crude oil (Fig. 11). If so, that might be attributable to a slowing of economic activity resulting from a combination of the latest wave of the pandemic around the world and parts shortages, which are also partly related to the pandemic.

(3) Labor costs. Notwithstanding the many stories about widespread labor shortages, most of the upward pressure on wages so far has been occurring in only two major industries, namely leisure & hospitality and transportation & warehousing. This can best be seen in the annualized three-month percent changes in average hourly earnings (AHEs) through July. The total index rose 4.9%, which isn’t particularly alarming, especially if productivity is making a comeback too.

Here are the results for the major industries from highest to lowest: leisure & hospitality (15.7%), transportation & warehousing (12.1), professional & business services (7.1), manufacturing (5.6), other services (5.2), retail trade (4.8), financial activities (4.8), wholesale trade (4.6), construction (4.2), utilities (3.7), education & health services (3.4), natural resources (3.1), and information services (-0.3).

(4) Wage-price spiral. The strength of the S&P 500 profit margin in the face of severe labor shortages suggests that companies are finding ways to increase the physical and mental productivity of their labor force.

Among the biggest risks to the stock market would be a wage-price spiral reminiscent of the Great Inflation of the 1970s. In this scenario, productivity growth would be insufficient to offset wage pressures, forcing companies to raise prices. The resulting wage-price spiral would force the Fed to raise interest rates sooner rather than later. This actually is the most plausible reason for the Fed to start tapering its bond purchases sooner rather than later, as then it could proceed with raising interest rates if necessary.

Strategy II: Cash Flow. To derive corporate cash flow, the NIPA accounts adjust book profits using the Inventory Valuation Adjustment (IVA) and Capital Consumption Adjustment (CCAdj), which restate the historical cost basis used in profits tax accounting for inventory withdrawals and depreciation to the current cost measures used in GDP. NIPA calls this series “profits from current production.” On a pre-tax basis, it rose 43.4% y/y to a record $2.8 trillion (saar) during Q2, while the book profits measure rose 69.3% to $2.7 trillion (Fig. 12).

Corporations paid $1.4 trillion (saar) in dividends during Q2, resulting in a record $1.0 trillion in undistributed profits (using the current production measure) (Fig. 13). Tax-reported depreciation (a.k.a. the capital consumption allowance) totaled $2.1 trillion, resulting in a record $3.1 trillion in corporate cash flow (Fig. 14).

Where did all that cash go? It went into record capital spending. Private nonresidential fixed investment in current-dollar GDP rose to a record $3.0 trillion during Q2 (Fig. 15). The bulk of this spending is attributable to nonfinancial corporations.

Strategy III: New US Corporate Security Issuance. In addition to record cash flow, corporations have been raising lots of money in the bond and stock markets. Over the past 12 months through June, they raised $2.2 trillion in the bond market (Fig. 16). They’ve used the proceeds to refinance outstanding bonds at record-low yields. They’ve also paid down their bank loans. Some of the remaining proceeds financed capital spending and stock buybacks or are sitting in liquid assets.

Corporations raised $441 billion in the stock market over the past 12 months through June (Fig. 17). Data available through March show that the bulk of the nonfinancial corporate issues were seasonal equity offerings (Fig. 18).

Thanks to the Fed, there is plenty of punch in the punchbowl, and corporations are enjoying the party.

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Some Thoughts on Valuation

August 30 (Monday)

YRI Podcast. In our latest video podcast, Dr. Ed discusses the main points of today’s Morning Briefing.

Strategy I: Tracking Dividend Yield. In his speech on Friday at the virtual Jackson Hole conference, Fed Chair Jerome Powell acknowledged that enough progress has been made on the inflation and employment fronts that the Fed is likely to start tapering its bond purchasing before the end of this year. However, he also said that it could be a while longer before the Fed will be raising interest rates:

“The timing and pace of the coming reduction in asset purchases will not be intended to carry a direct signal regarding the timing of interest rate liftoff, for which we have articulated a different and substantially more stringent test. We have said that we will continue to hold the target range for the federal funds rate at its current level until the economy reaches conditions consistent with maximum employment, and inflation has reached 2 percent and is on track to moderately exceed 2 percent for some time. We have much ground to cover to reach maximum employment, and time will tell whether we have reached 2 percent inflation on a sustainable basis.”

Not surprisingly, the major stock market indexes proceeded to rise to fresh record highs on Friday, with the S&P 500 rising above 4500 to close at 4509.37. The 10-year bond yield edged lower, closing at 1.31%, notwithstanding Powell’s assertion that tapering would start this year, not next year.

Until tapering actually begins, the Fed is committed to purchase $120 billion per month in the bond market, as it has been doing since December of last year. That has resulted in significant increases in bank deposits at a time when loan demand is weak (Fig. 1). Especially weak is the demand for business loans because funding is so readily and cheaply available in the corporate bond market (Fig. 2). So the banks have joined the Fed in purchasing bonds that have yields north of zero, unlike most money market instruments, which have interest rates close to zero. Since March 23, 2020, when the Fed implemented QE4ever, through the August 11 week of this year, banks purchased $1.1 trillion in US Treasury and agency bonds, while the Fed purchased $3.8 trillion of these securities (Fig. 3).

The dividend yield of the S&P 500 was down to 1.35% during Q2, the lowest since Q2-2001. That’s almost identical to the current bond yield. The Dividend Yield Model shows that the S&P 500 is currently appropriately valuing the index’s dividends given the current bond yield (Fig. 4).

Strategy II: SMidCaps Again. Last week in the August 24 Morning Briefing, Joe and I observed that the S&P 500 LargeCaps stock price index has been outperforming the S&P 400 and 600 indexes, collectively the “SMidCaps,” since March 15 (Fig. 5 and Fig. 6). Here are the performances since March 15 through this past Friday’s close of the three S&P 500/400/600 indexes: 13.6%, 3.1%, and -1.6%.

The S&P 500’s outperformance relative to its smaller-cap counterparts has lacked apparent earnings justification: That is, the V-shaped recoveries in the forward earnings of the S&P 400/600 SMidCaps have been even more impressive than the impressive rebound in the S&P 500’s forward earnings since they all bottomed last year during May and June (Fig. 7). Over that same period, the forward profit margins of the S&P 500/400/600 have soared (Fig. 8). Here are the increases in their forward earnings and forward profit margins from their lows of last year through August 19: S&P 500 (51.2%, 28.2%), S&P 400 (95.2, 69.2), and S&P 600 (152.3, 124.1).

The outperformance of SMidCaps’ fundamentals has been more than offset by the drop in their forward P/Es from 20.8 and 21.6 on March 15 to 17.1 and 16.2 on Friday (Fig. 9). The forward P/E of the S&P 500 is down from 22.0 to 21.1 over this same period.

So last week, we concluded that “SMidCaps are cheap relative to LargeCaps.”

It was subsequently brought to our attention by a few of our readers that the WSJ posted an August 22 story titled “Small-Cap Stocks May Be Pricier Than They Appear.” It focused on the valuation of the Russell 2000 SmallCaps versus the Russell 1000 LargeCaps. Here is our analysis of the Journal’s polar-opposite conclusion relative to ours on the relative valuations of these indexes:

(1) Leaving out losers. For starters, the WSJ article observes: “[W]hen calculating the price-to-earnings ratio, analysts sometimes … cut out the companies that don’t turn a profit. This can have a dramatic effect on how pricey a broad swath of the market appears, especially since the share of the small-cap index without profits, high to begin with, surged in the aftermath of the pandemic-induced recession.” That makes sense, though we’ve never done so. That’s because most of our analytical work is based on the S&P 500/400/600.

(2) S&P 500 vs Russell 1000. There’s no controversy about the S&P 500 and the Russell 1000. Their forward P/Es have been almost identical since the start of the Russell series during 2002 (Fig. 10). The forward earnings ratio of the former to the latter has been stable since 2006 at roughly 0.97 (Fig. 11).

(3) S&P 600 vs Russell 2000. There has been a significant spread between the forward P/Es of the Russell 2000 and the S&P 600, with the former consistently exceeding the latter by a wide margin (Fig. 12). The spread between the two has averaged 5.6 ppts since 2002, but has jumped since the pandemic to well over 10 ppts (Fig. 13). The obvious explanation is the one offered by the WSJ article: There are many more unprofitable companies in the Russell 2000 than in the S&P 600. The forward earnings ratio of the S&P 600 to the Russell 2000 has risen from roughly 0.35 before the pandemic to 0.42 currently (Fig. 14).

(4) MidCaps. In years past, the forward P/Es of the Russell and S&P 400 MidCaps tended to be fairly close (Fig. 15). They’ve diverged significantly since the start of the pandemic, with the former’s current reading at 21.2 and the latter at 16.5. The forward earnings ratio of the S&P 400 to the Russell MidCap is 0.42 now, up from 0.38 prior to the pandemic (Fig. 16). By the way, the Russell MidCaps consists of the Russell 1000 less the 200 companies with the biggest market capitalization.

(5) Biotech. The WSJ article observes: “A factor contributing to the upward drift in the Russell 2000’s share of negative earners has been the growing presence of biotechnology stocks. The group makes up about 10% of the Russell 2000, up from 3% in January 2012, according to FTSE Russell. …

“Many Russell 2000 companies that reported losses in the second quarter are in biotech, according to Institutional Brokers Estimate System data from Refinitiv.

“Analysts note that investors in biotech companies aren’t usually basing their decision on past or even near-term earnings. They are betting instead on the likelihood that the companies will achieve breakthroughs in research that could lead to outsize future gains.”

(6) Bottom line. Our conclusion remains the same: the S&P 400/600 are cheap relative to the S&P 500.

Inflation: Mission Accomplished. In his speech on Friday, Powell stated: “We have said that we would continue our asset purchases at the current pace until we see substantial further progress toward our maximum employment and price stability goals, measured since last December, when we first articulated this guidance.” Then he declared: “My view is that the ‘substantial further progress’ test has been met for inflation.” That’s great, unless you are a consumer!

The Fed has been trying to get inflation above its 2.0% target since January 2012, when the Fed adopted this inflation target. It has finally done so decisively as a result of the massive amount of monetary and fiscal stimulus aimed at offsetting the initial adverse economic and financial consequences of the pandemic. Let’s review the latest inflation data to assess whether there is any evidence so far that the pickup in inflation is likely to be transitory, as Powell reiterated once again in his speech:

(1) Blast off. The PCED measure of inflation, on a y/y basis, first rose above 2.0% during March (Fig. 17). By July, the headline rate was up 4.2%, while the core rate was 3.6%. These were the highest readings since January and May 1991, respectively.

(2) Three-month view. A better way to track whether inflationary pressures are mounting or easing is to calculate the latest three-month percentage changes at annual rates in the various components of inflation through July and to compare them to June’s numbers.

The results are mixed. The core PCED inflation rate edged down from 6.7% during June to 5.6% during July (Fig. 18). The PCED categories with downticks included: used motor vehicles (66.9%), gasoline (16.9), sports & recreational vehicles (8.5) clothing & footwear (8.4), furniture and home furnishings (6.4), motor vehicle parts (6.2), tenant rent (2.5), physician services (0.2), personal care products (-2.2), and prescription drugs (-2.4).

The following categories showed upticks: new motor vehicles (up to 21.2% annualized), household appliances (12.5), food services & accommodations (12.2), food & beverages (7.3), alcoholic beverages (4.8), owner-occupied rent (3.7), and education services (2.3).

(3) Bottom line. The jury is still out on Powell’s assessment of the transitory nature of the recent jump in inflation. Four of the five regional business surveys conducted by the Fed’s district banks are available through August (Fig. 19). All four registered readings for their prices-paid indexes slightly below their highs of a month or two ago. However, prices-received indexes for three of the four regions (New York, Richmond, and Kansas City) rose to new record highs, while Philadelphia’s was the highest since the mid-1970s.

Movie. “Respect” (+ +) (link) is a biopic about the life and times of Aretha Franklin, the Queen of Soul. It really doesn’t do justice to either. Instead, the movie focuses on Aretha’s soulful songs, which clearly reflected the challenges she faced in her life. She was haunted by “demons” and bad relationships with various men, including her father. She contributed greatly to Martin Luther King’s civil rights movement by appearing at fundraisers for his organization. Jennifer Hudson does a great job playing Aretha and belting out her songs.

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The Beats Go On

August 26 (Thursday)

Earnings: The Fat Lady Sings. They say that the opera ain’t over until the fat lady sings. The opera ain’t over for the bull market in stocks, but it’s hard to imagine that the y/y growth rates in S&P 500 revenues per share and operating earnings per share will beat Q2’s 18.5% and 87.7% anytime soon (Fig. 1 and Fig. 2). Both revenues and earnings rose to new record highs during Q2 (Fig. 3). Joe and I are particularly impressed by the S&P 500’s profit margin, which set yet another record high, of 14.0%, during Q2 (Fig. 4). Here’s more:

(1) Record number of beats. Q2’s positive and negative revenues surprises were 86.7% and 13.3%, the most and the least since the start of the data in 2009 (Fig. 5). Q2’s positive and negative earnings surprises were 87.1% and 9.8%, also the most and the least since the start of the data in 1987 (Fig. 6).

(2) Significant upside surprises. Q2’s revenues beat expectations by 5.2%, the most on record (Fig. 7). The earnings beat was 16.9%, marking the fifth quarterly double-digit beat, which is unprecedented (Fig. 8).

(3) Sector beats. Here are the latest realized y/y earnings growth rates during Q2 for the S&P 500 and its 11 sectors and the growth rates that were expected at the start of the Q2 earnings season: S&P 500 (87.7%, 60.5%), Communication Services (73.1, 39.8), Consumer Discretionary (356.3, 270.9), Consumer Staples (19.8, 10.1), Energy (244.4, 225.5), Financials (156.7, 100.3), Health Care (26.0, 10.8), Industrials (678.1, 568.5), Information Technology (48.1, 31.6), Materials (139.2, 115.2), Real Estate (39.1, 24.7), and Utilities (12.7, -0.9) (Fig. 9).

(4) Widening profit margins. Here are Q2’s profit margins for the S&P 500’s 11 sectors from highest to lowest: Real Estate (31.3%), Information Technology (25.0), Financials (22.3), Communication Services (18.6), Utilities (15.7), Materials (14.9), S&P 500 (14.0), Health Care (11.7), Industrials (9.2), Consumer Discretionary (8.0), Consumer Staples (7.9), and Energy (6.9) (Fig. 10). Five of the sectors were at record highs.

(5) The beat goes on. Our weekly series for S&P 500 forward revenues, forward earnings, and the forward profit margin all rose to new record highs in early August, suggesting that Q3 will also be a record-setting quarter for the S&P 500 (Fig. 11).

Fed I: Powell’s Lullaby. “Summertime” is an aria composed in 1934 by George Gershwin for the 1935 opera Porgy and Bess. The song is actually a lullaby. Here are the first four lines:

Summertime, and the livin’ is easy

Fish are jumpin’, and the cotton is high

Oh, your daddy’s rich, and your ma is good lookin’

So hush, little baby, don’t you cry

It’s nearly the end of summertime, and monetary policy remains easy, GDP growth is jumping, and inflation is high. This morning, in his speech at the virtual Jackson Hole conference, Fed Chair Jerome Powell will try to calm us all about the outlook for monetary policy. He has been singing the same lullaby since his December 16, 2020 press conference, assuring us that the Fed won’t taper its bond purchases until “substantial further progress has been made toward our maximum-employment and price-stability goals.”

Melissa and I expect him to change the lyrics a bit, acknowledging that progress has been made. Nevertheless, those of us who’ve been crying out loud for the Fed to start tapering will be told to hush. After all, the Minutes of the July 27-28 FOMC meeting showed that the committee was still singing the blues, bemoaning that “substantial further progress” (SFP) in the labor market has not yet been met:

“In their discussion of monetary policy for this meeting, members agreed that with progress on vaccinations and strong policy support, indicators of economic activity and employment had continued to strengthen. They noted that the sectors most adversely affected by the pandemic had shown improvement but had not fully recovered.”

Consider the following:

(1) This year or next year? The most interesting section of the meeting Minutes was titled “Discussion of Asset Purchases.” It noted that “most” participants saw tapering as appropriate “this year,” as the inflation goal had been achieved and SFP in employment was “close” to being achieved. “Various” participants believed tapering would be appropriate in the coming months. However, “several others” said it would be prudent to wait until “next year,” holding the views that SFP was “not close” and the inflation goal remained “uncertain.” Interestingly, only “a few” participants saw the recent rise in inflation as transitory.

We are inclined to go along with the consensus view of “most” participants that seems to suggest that tapering will happen this year, provided that the Covid-19 Delta variant does not significantly dampen the recovery. Notably, it was pointed out by “many” participants that any rate increase decision would not be tied to a taper decision. Fed officials are doing their best to mollify the markets about rate hikes to minimize any tapering tantrum.

(2) Assessing market expectations. The Minutes stated that “market participants” (i.e., investors and traders) expected “communications on asset purchases to evolve gradually.” It also noted that “almost 60 percent of respondents anticipated the first reduction in the pace of net asset purchases to come in January, though, on average, respondents placed somewhat more weight than in the June surveys on the possibility of tapering beginning somewhat earlier.”

(3) September data needed. There are three FOMC meetings remaining this year, during September 21-22, November 2-3, and December 14-15. The FOMC might announce that tapering will immediately start after the September meeting if August’s employment report at the beginning of the month is very strong, which is possible.

But if they wait until the November meeting, they’ll have employment data for August and September in hand. September data are important for several reasons. September will be the first month that federal unemployment insurance will expire in all states. Some states opted out of the added benefits early. September also marks the start of school for most states around the country. The return to in-person learning in most areas may allow for working parents who stayed home to care for kids during the pandemic to return to work.

September may also bring diminished virus fears. That’s because by September’s end many folks still unvaccinated today may have gotten a double dose of the Pfizer-BioNTech vaccine, having been convinced to do so by the Food & Drug Administration’s (FDA) full approval of the vaccine on August 23.

(4) Factoring in retirements. Increased retirements were also noted as a reason for supply-side constraints on labor. That trend isn’t entirely tied to the pandemic, as many Baby Boomers are simply reaching retirement age. A pickup in retirements may mean that pre-pandemic levels of employment no longer are a good benchmark for post-pandemic employment. If that’s true, then tapering this year would certainly be more appropriate than next year, in our opinion. In any case, it will be the FOMC’s subjective decision on when SFP has been achieved that will determine when tapering begins.

Fed II: Powell’s Dashboard. The FOMC has often called its policy decisions “data dependent.” Before the pandemic, the FOMC set policy with a focus on how the incoming data influenced the outlook for the US economy. Since August 2020, when the Fed released a revised statement on its longer-run goals, the FOMC has taken an “outcome based” approach, more closely considering the actual data against its goals.

The FOMC’s goalposts shifted with the new statement too. Most importantly, employment was reprioritized, and inflation was put on the back burner. The inflation goal was altered from a “symmetric” one of 2.0% to a FAIT (flexible average inflation targeting) approach whereby overshoots would be tolerated to “make up” for lost ground and allow for “maximum and broad based” employment to be achieved.

That commitment was reiterated by Powell during his April 28 press conference when he outlined various metrics that he is watching as a signal that “substantial further progress” has been achieved toward the Fed’s employment goal. Powell outlined the same metrics again in remarks during his June 16 press conference and July 28 press conference following the respective FOMC meetings. In his latest press conference, Powell noted—as the recent Minutes did—that progress has been made but the goal has not yet been achieved. Here is an update on those metrics:

(1) Employment. Powell has been watching the headline unemployment rate but has said that it understates the shortfall in employment (Fig. 12). Instead, he seems to prefer the Bureau of Labor Statistics’ payroll employment measure. It has recovered 16.7 million through July after recently bottoming last April but remains 5.7 million below its pre-pandemic level (Fig. 13).

(2) Sector employment. Powell also has been watching employment in specific sectors where unevenness has occurred. Specifically, for example, in the leisure and hospitality sector, recent notable gains have brought employment closer to pre-pandemic levels (Fig. 14).

(3) Racial employment. Powell is paying attention not just to unevenness in sectors but also in race. Employment levels for African American and Hispanic workers recovered by 7.5 million since the pandemic low during April but remain 1.8 million below pre-pandemic levels (Fig. 15).

(4) Participation rate. One of Powell’s main concerns also is the labor force participation rate (Fig. 16). Powell has said that it has been weak due not only to skills mismatches, geographical differences, virus fears, and stagnant wages but also because of the childcare issues created by school closures and the incentive not to work presented by supplementary federal unemployment assistance.

(5) Vaccinations. The percentage of the population 16 years and older that is fully vaccinated against Covid-19 is also on the radar of Powell and his colleagues (Fig. 17). That very well may improve substantially given the FDA’s recent full approval of the Pfizer-BioNTech vaccine.

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Alpha, Beta, and Delta

August 25 (Wednesday)

Strategy I: Delta Infects Stocks. The stock market rallied on Friday because Dallas Federal Reserve President Robert Kaplan said that he is having second thoughts about tapering the Fed’s bond purchases. He has been one of the Fed’s most vocal hawks on the need to move forward with tapering the central bank’s bond purchases but said he may need to adjust that view if the Delta variant of the coronavirus slows economic growth significantly.

“It’s unfolding rapidly,” Kaplan said on the Fox Business network’s Mornings with Maria program. He added, it’s “a good thing” there’s still a month to watch it before the Fed’s next policy-setting meeting. “So far, it’s not having a material effect” on consumer activity like dining out, he said, but “it is having an effect in delaying return to office, it’s affecting the ability to hire workers because of fear of infection,” and may be affecting production output, he said.

The stock market rose again on Monday on news that the US Food and Drug Administration (FDA) approved the first Covid-19 vaccine. The FDA’s press release stated: “The vaccine has been known as the Pfizer-BioNTech COVID-19 Vaccine, and will now be marketed as Comirnaty (koe-mir’-na-tee), for the prevention of COVID-19 disease in individuals 16 years of age and older. The vaccine also continues to be available under emergency use authorization (EUA), including for individuals 12 through 15 years of age and for the administration of a third dose in certain immunocompromised individuals.”

The press release stated that “[b]ased on results from the clinical trial, the vaccine was 91% effective in preventing COVID-19 disease. More than half of the clinical trial participants were followed for safety outcomes for at least four months after the second dose. Overall, approximately 12,000 recipients have been followed for at least six months.”

Also on Monday, Dr. Scott Gottlieb said in a CNBC interview that he believes the Delta variant surge in Covid cases that hit the American South has peaked. “I thought there was an indication the South was peaking, and I think it’s pretty clear right now the South has peaked,” the former FDA commissioner said. “It doesn’t feel that way because we still have a lot of new infections on a day-over-day basis, and the hospitals still have some very hard weeks ahead,” he acknowledged. “They’re still going to get maxed out as the infections start to decline.”

Gottlieb’s assessment was confirmed by the recent decline in the 10-day moving average of new positive results through August 20 (Fig. 1). Hospitalizations, on a comparable basis, are still rising. In other words, the fourth wave of the pandemic in the US hasn’t peaked based on hospitalizations. However, the number of deaths over the past 10 days through August 16 has stabilized at a relatively low rate of 2,401 (Fig. 2).

The FDA’s seal of approval has quickly emboldened businesses, governments, and schools to mandate vaccines: On Monday alone, vaccine mandates were issued for staff in New York City and New Jersey schools as well as for some employees of Chevron, Virginia’s former governor urged all employers in that state to require Covid vaccinations, and the Pentagon announced that US service members soon would have “actionable guidance” about a vaccine requirement.

So, the stock market rallied on Friday because the Fed might start tapering later rather than sooner if the pandemic worsens. It rallied on Monday to a new record high because there’s a light at the end of the Covid tunnel. The bulls continue to charge ahead in the stock market on good news and bad news about Delta. The bond market seems to be on another planet. The 10-year US Treasury bond yield has remained remarkably stable around 1.27% in recent days (Fig. 3). More sensible has been the reaction of the oil market, where prices were weak on Friday on the bad news and rebounded on Monday on the good news (Fig. 4).

Strategy II: It’s All Greek to Us. Investopedia explains that “[a]lpha and beta are two of the key measurements used to evaluate the performance of a stock, a fund, or an investment portfolio. Alpha measures the amount that the investment has returned in comparison to the market index or other broad benchmark that it is compared against. Beta measures the relative volatility of an investment. It is an indication of its relative risk.”

That’s useful information for long-term investors. For day traders and algorithmic trading systems, it’s all about risk-on or risk-off. Since the pandemic started early last year, it’s been all about pandemic trades versus reopening trades. In recent weeks, the market’s trading action has mutated into Delta-on versus Delta-off. Long-term investors should stick with the first two letters of the Greek “alpha-beta.”

Joe and I prefer to focus on investment themes for long-term investing. One of our major themes is that labor shortages will remain a chronic problem that will require companies in all industries to use technological innovations to augment the mental and physical productivity of their labor force.

In other words, our “Productivity Portfolio” includes not only technology producers but also technology users. Using technologies to improve productivity is a technological innovation. Indeed, traditionally low-tech sectors like finance and healthcare have been developing robust fintech and medtech industries. There’s a flourishing agtech industry. Led by Amazon, retailing has gone increasingly online, which has stimulated technological advances in logistics that have boosted the productivity and profit margins of railroads and trucking companies.

Inflation: Coming or Going? Over the next few months, the inflationary pressures attributable to the “base effect” should moderate. Most of the consumer prices that were depressed by last year’s lockdown recession have rebounded by now. Consider the following:

(1) Base-affected prices. Here are the three-month annualized percent changes in the CPI prices that have contributed most to the recent rebound in inflation through July: used cars & trucks (75.2%), lodging away from home (55.3), car & truck rental (49.8), airfares (39.0), new motor vehicles (21.6), gasoline (17.0) motor vehicle parts (10.7), household furniture & bedding (8.1), clothing & footwear (7.9), and household major appliances (5.1) (Fig. 5 and Fig. 6).

The last few categories in this list clearly peaked a few months ago. The others may be doing so now as the base effect wears off.

(2) Shortage of autos. Debbie and I aren’t so sure about new and used car prices. The shortage of chips continues to depress the supply of new cars, which may continue to put upward pressure on motor vehicle prices.

(3) Rents heating up. Another area of concern is rent inflation. The rapid increase in new and existing home prices isn’t directly included in the CPI measure of inflation. The average and median existing single-family home prices rose 12.5% y/y and 18.6% y/y through July, both to record highs (Fig. 7).

Soaring home prices have discouraged many would-be homebuyers from searching for a home. Instead, they are staying put in their rentals. Older homeowners who are selling their homes are opting to downsize to rentals rather than smaller homes. The result is likely to be more upward pressure on both rent of primary residence and owners’ equivalent rent (Fig. 8). The three-month annualized inflation rates have been moving higher for both of them in recent months.

(4) Wild cards. The three-month annualized inflation rates in the CPI for hospitals (3.7%), physician services (2.5), and drugs (-2.4) have been remarkably subdued. We aren’t sure why that is, but whatever the reason it could represent a wild card.

The CPI for food away from home rose 8.2% during June, using the three-month percent change annualized. Restaurants are experiencing rising costs, especially for labor, and may be forced to continue raising their prices rapidly to stay in business.

(5) Price surveys. There are no signs that inflationary pressures are abating in August’s three available regional business surveys conducted by the Federal Reserve Banks of NY, Philly, and Richmond (Fig. 9). The average of their prices-paid indexes remained unchanged at 85.9, while the average of their prices-received indexes jumped from 51.8 to 64.1. Both are at record highs for the data, which start in July 2001.

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Double, Double Toil & Trouble

August 24 (Tuesday)

Strategy I: Doubling Dow. The S&P 500 recently passed a milestone: Following the bottom on March 23, 2020, it doubled in 353 trading days on August 16, 2021 (Fig. 1). During the Great Financial Crisis (GFC), the S&P 500 bottomed at 676.53 on March 9, 2009, and the benchmark index did not double that number on a closing basis until April 27, 2011, 539 trading days later. A CNBC analysis concluded that, on average, “it takes bull markets more than 1,000 trading days to reach [the doubling] milestone.”

I asked Joe to calculate the increases in the S&P 500 in the 12 months after the previous six times that it has doubled. Here is what he found. The market rose five of those six times, by 3.5%-36.0%, and fell once, by 29.4%.

It will be a long time before the S&P 500 doubles again. We are still aiming for 5,000 for the index by the end of next year, which would be an 11.6% increase from Monday’s close. To get there, assuming that the S&P 500 forward P/E remains at 21.0, S&P 500 forward earnings would have to reach $238 per share by the end of next year (Fig. 2). That’s up 11.6% from the latest reading of $213.25 per share during the week of August 19 (Fig. 3).

To double to 10,000, S&P 500 forward earnings would have to double to $476 per share, again assuming that the forward P/E is still at 21.0. How long might that take to happen? Since the start of the data in 1979, forward earnings has tended to grow at compound annual growth rates of 6%-7% (Fig. 4). That implies that forward earnings could double over the next 10-12 years. Of course, it might take longer than that to get to 10,000 if the forward P/E, which is currently historically high, is lower by the time that forward earnings double.

By the way, a doubling of the Dow Jones Industrial Average would put it at 70,000. Some of us can remember when it first crossed 1,000, on November 14, 1972. It has doubled five times since then!

Strategy II: Hotter Peak Earnings. Joe and I are certain that peak earnings growth occurred during Q2. The quarter’s peak growth rate is turning out to be much higher than industry analysts expected at the beginning of the latest earnings season. Usually, the fourth quarter of every year tends to be the best one for earnings. The latest data for the three S&P 500/400/600 indexes show that their Q2 earnings surpassed analysts’ expectations for Q4 even as analysts raised their Q4 estimates (Fig. 5). Their latest y/y growth rates during Q2 are 87.7%, 189.7%, and 290.2% (Fig. 6).

Q2 undoubtedly marked peak earnings for the current cycle. Industry analysts are expecting lower, though still double-digit, growth rates during Q3 and Q4. Here are their latest S&P 500/400/600 earnings growth rates for 2021, 2022, and 2023: (44.2%, 9.1%, 7.6%), (71.9, 7.1, 8.5), and (112.1, 12.8, 8.7). Joe and I are expecting 46.7%, 4.9%, and 7.0% for the S&P 500.

Strategy III: Still V-Shaped Revenues, Earnings & Margins. The forward revenues and forward earnings of the S&P 500/400/600 all have had V-shaped recoveries (Fig. 7 and Fig. 8). They all have been rising in record-high territory since late last year. It took them much less time to recover their losses during the Great Virus Crisis than following the GFC.

Joe and I calculate forward profit margins by dividing the analysts’ consensus series for forward earnings by forward revenues (Fig. 9). The results are impressive. The forward profit margins of the S&P 500/400/600 also have had V-shaped recoveries and also have been rising in record-high territory since late last year.

The weekly forward profit margins we calculate are very good coincident indicators of the actual quarterly profit margins for the S&P 500/400/600, though the weekly series consistently exceed the quarterly ones. In any event, the quarterly ones rose to new record highs of 13.0%, 8.1%, and 5.1% during Q1. The weekly series suggest that they rose even higher during Q2.

Strategy IV: What’s Ailing SMidCaps? As we’ve previously observed, the V-shaped forward earnings recoveries of the S&P 400/600 SMidCaps have been even more impressive than the impressive rebound in the S&P 500. So why are the former stock price indexes performing so poorly compared to the latter?

Here are the performances since March 15 through Friday’s close of the S&P 500/400/600: 11.9%, -0.3%, and -5.4% (Fig. 10). The outperformance of SMidCaps fundamentals has been more than offset by the drop in their forward P/Es from 19.7 and 19.2 at the start of the year to 16.5 and 15.6 on Friday (Fig. 11 and Fig. 12). The forward P/E of the S&P 500 is down from 22.5 to 20.8 over this same period.

Why are investors assigning LargeCaps such a high valuation multiple relative to the SMidCaps? In the past, SMidCaps tended to trade at valuation premiums to LargeCaps. The current situation is somewhat reminiscent of the tech bubble of the late 1990s when investors piled into the stocks of LargeCap technology companies. The difference this time is that the outperforming LargeCaps are more diversified and have solid earnings growth.

Perhaps investors are concerned that the SMidCaps will be hampered more than the LargeCaps by labor shortages. We doubt that since smaller companies now have access to many of the same technologies necessary to augment the physical and mental productivity of workers as larger ones do. Besides, the rebound in the forward profit margins of the SMidCaps has outpaced that of the LargeCaps.

So once again, we conclude that SMidCaps are cheap relative to LargeCaps.

US Economy: More Peak Growth Readings. The S&P 500 is one of the 10 components of the Index of Leading Economic Indicators (LEI). The LEI rose 0.9% m/m during July to another record high. However, its growth rate on a y/y basis peaked at 16.7% during April and was down to 10.6% during July (Fig. 13).

Also looking peakish are August’s flash PMIs for the US and the regional business surveys conducted by the Federal Reserve Banks of New York and Philadelphia (Fig. 14 and Fig. 15).

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Red Flag

August 23 (Monday)

YRI Podcast. In our latest video podcast, Dr. Ed discusses the main points of today’s Morning Briefing.

 Strategy: Storm Is Coming. I am writing our commentary before Hurricane Henri hits us on Long Island on Sunday. The lights will probably go out, though we did get a generator after we were pounded by Hurricane Sandy in 2012. However, we could lose our Internet connection through the cable company.

Officially, the Atlantic hurricane season started on June 1 and runs until November 30. In the stock market, September and October tend to be among the stormiest months. Joe and I aren’t expecting a significant correction, but we wouldn’t be surprised to see lots of sideways action. After all, the S&P 500 rose 100% from March 23, 2020 through August 16, 2021. A prolonged period of consolidation would be a healthy development. We are still targeting the S&P 500 to hit 5000 by the end of next year or sooner. That would be a 12.6% gain from Friday’s close.

For now, the bull market has some challenges to deal with. These include the three peaks—in economic growth, earnings growth, and policy stimulus. On a y/y basis, nominal GDP growth undoubtedly peaked at 12.2% during Q2, while S&P 500 earnings growth most likely peaked around 85% during the quarter on a comparable basis. There may be more fiscal stimulus coming, but it won’t have the immediate punch that was delivered by the three rounds of pandemic-relief checks. The Fed is likely to start tapering its bond purchases in coming months. Geopolitical risks are increasing as a result of the Biden administration’s disastrous troop withdrawal from Afghanistan.

The policy-fueled V-shaped recovery in the US stimulated the global economy greatly, especially Chinese exports to the US. However, a demographic storm has been brewing in China for many years, as discussed below. The result is that inflation-adjusted retail sales has stopped growing in China. A slowdown in the US economy could turn out to be a bigger problem for China than for the US.

In any event, Debbie and I will be monitoring commodity prices closely for signs of weakness, and the dollar for signs of strength. The signs are already there. The nearby futures price of a barrel of Brent crude oil is down from this year’s peak of $77.16 on July 5 to $65.18 on Friday. The nearby futures price of copper is down 13.6% from $4.78 on May 11 to $4.13 on Friday. The DXY dollar index bottomed this year on May 25. It is up 4.3% through Friday’s close.

China I: Economic Consequences of One-Child Policy. Jackie and I have been waving the red flag about Red China for some time. We’ve focused on both the political and the economic risks for investors. In our August 15, 2018 Morning Briefing, we observed that President Xi Jinping consolidated his hold on power on March 11, 2018 by becoming leader for life and outlining a grandiose vision for China’s global ambitions. That move followed Xi’s elevation during October 2017 to a status on a par with the founder of the People’s Republic of China, Mao Zedong, and the inclusion of Xi’s “new era” political ideas and philosophy in the party constitution.

In December 1978, two years after Mao Zedong died, China’s communist leadership decided that it was time to modernize the country’s economy. Deng Xiaoping, China’s new leader, announced an Open-Door Policy that aimed to attract foreign businesses to set up manufacturing operations in Special Economic Zones. This was the first step along the path that eventually led China to join the World Trade Organization (WTO) in 2001. Along the way, market reforms were implemented, and foreign trade expanded.

China’s economy flourished. However, in recent years, China’s economic achievements were partly attributable to the theft of intellectual property from other countries as well as other abusive practices that were inconsistent with the free-and-fair trade rules of the WTO. Under Xi, the Chinese Communist Party (CCP) has been moving rapidly, especially this year, to undo Deng’s market reforms—establishing the supremacy of the party, led by its Supreme Leader, in all economic and political matters.

Before we delve into the latest developments on the political side, let’s do so on the economic front:

(1) Retail sales flagging. The October 1, 2018 Morning Briefing was titled “China Syndrome.” We wrote that “inflation-adjusted retail sales in China may be the most important variable for tracking the impact of China’s increasingly dismal demographic profile on its economy.” Every month, the Chinese report nominal retail sales and the CPI, which we use to calculate real retail sales. We’ve been monitoring the yearly percent change in this series for the past few years (Fig. 1). To smooth out the impact of the pandemic on this series, Mali and I calculate the 24-month growth rate in the 24-month average of the series (Fig. 2). The result must be downright alarming for Xi and the CCP. At an annual rate, this growth rate peaked at a record high of 18.7% during May 2011. It has been trending down since then, falling to almost zero during July of this year!

(2) Demography is destiny. We’ve been monitoring this series for some time as an indicator of how China’s rapidly aging population might weigh on the country’s economic growth. The destiny of Xi’s would-be dynasty is challenged by the legacy of the CCP’s disastrous one-child policy, which was imposed from 1979 through 2015. This has frustrated the CCP’s efforts to transform the Chinese economy from export-led growth to consumer-led growth. The ongoing strength in China’s exports explains why industrial production growth, calculated on the same basis as real retail sales, remains relatively strong around 5%—though that too is down significantly from a peak of 15.0% during March 2012 (Fig. 3).

(3) Make babies. China’s fertility rate has been falling since the mid-1950s in part because of urbanization (Fig. 4). The one-child policy pushed the fertility rate below the replacement rate of 2.1 children per woman during 1994 (Fig. 5). The UN projects that it will remain below the replacement rate through the end of the current century.

One of the consequences of this development is that the percentage of the population that is 65 years old and older started to exceed the percentage that is under five years old, and the gap between the two is widening (Fig. 6). Another one of the terrible consequences of the one-child policy is that there aren’t enough women to have babies because it caused far more boys than girls to be raised, resulting in a gender-imbalanced society. The number of women between the ages of 20 and 39 is expected to drop by more than 39 million over the current decade, to 163 million from 202 million, according to an August 11, 2018 NYT article titled “Burying ‘One Child’ Limits, China Pushes Women to Have More Babies.”

When China introduced the one-child policy back in 1979, it was to slow the country’s surging population growth. The government limited most urban couples to one child and rural couples to two if their firstborn was a girl. China officially ended its one-child policy on January 1, 2016, when the country, trying to cope with an aging population and shrinking workforce, passed a law allowing all married couples to have a second child. On May 31, 2021, the limit was raised to three children.

The latest policy change comes with “supportive measures” including lower educational costs for families, stepped-up tax and housing support, strengthened legal protections for working women, a clamp-down on “sky-high” dowries, and “marriage and love” education for young people.

Thanks to the government’s one-child policy, most young adults have no siblings and two old parents to support. If they get married, the couple will be burdened with four old parents. In China, children are still expected to take care of their elderly parents, since public support programs are very limited. Under these circumstances, the government’s campaign to boost births is unlikely to succeed.

(4) Nursing home. The legacy of the CCP’s one-child policy is that China is rapidly turning into the world’s largest nursing home as the population ages without enough young adults to support the elderly.

China II: Progressive Authoritarianism. President-for-life Xi and his CCP seem to have decided that the state must do everything in its power to increase the birth rate in China. That means that the cost of having children has to be lowered at the same time as incomes are boosted for more families. That requires reducing income inequality so that the rich don’t drive up the prices of goods and services that are necessary for childrearing. The result has been a barrage of regulations on business. They are seemingly unrelated. The common theme though is to change China’s destiny by changing its demographic profile with more babies.

An August 1, 2021 Bloomberg article called the government’s recent assault on capitalism “progressive authoritarianism.” It observed: “From exhausted couriers in the gig economy, to stressed parents struggling with ever-rising housing prices and tuition fees, to small businesses battling tech monopolies, Xi is swinging the cudgel of state power in support of the squeezed middle class.” Xi previously declared that China had begun a “new development phase” this year, entailing: (i) national security (including control of data and greater self-reliance on technology), (ii) common prosperity (aiming to curb inequalities), and (iii) stability (reducing discontent among the middle class).

Here are some of the latest developments:

(1) Private tutoring. Last month, the government ordered tutoring companies to become nonprofits and banned them from pursuing IPOs or taking foreign capital. FP’s China Brief dated July 28, 2021 explains why the Chinese government is cracking down on the private tutoring industry in China as follows:

“If the new regulations work to lessen the cost burden on parents and the strain on children, the government hopes it can reverse demographic decline. The price of raising children in China is a powerful factor restricting family size, even after the government increased family-planning limits. Authorities are concerned not only about growth but also about so-called population quality—they want well-off families, not the rural poor, to have more children.”

In China, higher education hinges on the gaokao, the all-important college entrance examination. Chinese parents can spend thousands of dollars a year on private tutoring just to keep their kids competitive. The government’s program includes measures to encourage extracurricular activities while reducing the stress of curriculum cramming. The state has also prohibited nonprofit tutoring firms from holding lessons on holidays or during winter and summer vacations. By the way, a year ago, the CCP restricted the study of US and world history to prevent the influence of foreign ideas.

(2) Technology. Among the most successful companies in China are those in the technology sector. Their executives are among the richest people in China. So they are natural targets in the government’s campaign to force greater income equality. On Friday, the state-run Economic Daily stated that China’s regulatory crackdown on the country’s technology sector, which so far has wiped out around US$1.5 trillion of value from tech stocks, is a short-term cost that must be paid to ensure the healthy long-term growth of the digital economy.

The August 20 South China Morning Post observed: “Regulators in Beijing have rushed to publish new regulations and initiate new campaigns to clip the wings of Big Tech. Since last year, regulators have revoked approval to go public, levied a huge antitrust fine, forced a company to relinquish exclusive deals, initiated a cybersecurity probe just days after an overseas listing, and signed the death warrant of an entire industry sector with just one single policy change.”

 China III: Taiwan. President Joe Biden’s disastrous withdrawal from Afghanistan provoked a belligerent response by China. Chinese state-run media Global Times published an editorial on August 16 blaming the defeat of the Afghan government on the withdrawal of US forces. The article suggested that the US would not defend Taiwan should Beijing invade the island and that Taiwan could see the same “fate” as Afghanistan. The Chinese military conducted assault drills near Taiwan on Tuesday in response to “interference from external forces,” Chinese state media said.

By the way, in a Tuesday night speech, Hassan Nasrallah, secretary-general of Hezbollah, said the Israelis are watching most closely and drawing conclusions” from the aftermath in Afghanistan. “In order not to have Americans fighting for other [nations], Biden was able to accept a historic failure. When it comes to Lebanon and those around it, what will be the case there?” Nasrallah said, according to The Times of Israel.

Movie. “Stillwater” (-) (link) is a movie that turns the old proverb on its head. In this case, still waters don’t run deep. It stars Matt Damon as the oil-rigger father of an American girl who was convicted of murdering her college roommate in Marseille, France. It’s loosely based on what really happened to Amanda Knox in Italy. Damon’s acting is stiff and one-dimensional as he does his best to find evidence of his daughter’s innocence. She is played by an actress who must have studied melodrama.

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Retail, Earnings & Carbon

August 19 (Thursday)

Consumer Discretionary: Retailing Tales. The strength of US consumer spending last year despite waves of Covid-19 illness and death was truly amazing. The Internet, the advent of curbside pickup, and plentiful government subsidies allowed consumer spending to surge in 2020 outside of a brief two-month span (Fig. 1). Now that Covid-related deaths remain low and the unemployment rate has fallen to 5.4%, consumers have changed what they’re buying, but they’re still out shopping.

July’s retail sales fell 1.1% from June’s level, but they were hurt by the 3.9% drop in auto sales, as dealerships struggle with a lack of inventory thanks to the semiconductor chip shortage. Retail sales excluding motor vehicles dropped 0.4% last month (Fig. 2). Meanwhile, retailing giants Walmart, Target, Home Depot, Lowe’s, and TJX all showed continued sales gains in Q2, and none warned that August sales showed signs of slowing down.

Let’s take a look at what a few retailing CEOs had to say on recent conference calls:

(1) Hitting the bullseye. Target’s Q2 comparable-store sales jumped 8.9% y/y, off a Q2-2020 base that itself saw sales growth of 24.2%. Adjusted earnings jumped almost 8% to $3.64 per share in the quarter, beating analysts’ estimate of $3.51 a share.

While CEO Brian Cornell acknowledged the potential for volatility in H2 due to the uncertainty of the Delta variant, Target nonetheless increased its H2 forecast slightly. It now expects comparable sales growth in the high-single-digit range, compared to the single-digit comp growth it forecast during the Q1 earnings conference call. “[W]e’re seeing tremendous resilience in the consumer today and in our traffic patterns,” said Cornell.

Target executives described back-to-school sales as “really strong” and “broad based.” There has been less buying of household essentials and more buying of dresses and beauty products. Sporting goods enjoyed high-teens sales growth, while electronics sales fell in the mid-single-digit range because last year some of Target’s electronics competitors were closed.

(2) Lowe’s: Building on success. The home retailer is undoubtedly facing tough comparisons to last year when DIY projects gave us something to do while trapped at home. Total sales edged up only 1.1% in Q2, and comparable sales in the US fell 2.2%.

Nonetheless, Lowe’s increased its full-year outlook and now expects 2021 revenue of $92 billion, up from the $86 billion it expected in May and prior guidance of $84 billion. If the company hits its 2021 target, it would mark an increase from 2020’s sales of $89.6 billion, which was a 24.2% jump from 2019’s results.

CEO Marvin Ellison spoke very positively about the US housing market, citing historically low mortgage rates, demand that’s exceeding supply, and rising prices. “[B]ecause of this, consumers have an increased confidence in repairing and remodeling their homes.” That’s good news for Lowe’s because two thirds of the company’s sales are generated from home repair and maintenance activity.

(3) Consumers love bargain hunting. TJX stores were largely closed in Q2 last year, and the company has little in the way of e-commerce sales. So unlike for many other retailers, TJX’s Q2-2021 comparisons were easy. Q2 sales jumped 23% y/y to $12.1 billion, even though some of the company’s stores are currently closed in Australia.

CFO Scott Goldenberg described robust Q3 sales so far: “[W]e are very pleased that overall open-only, comp-store sales trends are up very strongly to start the quarter at the mid-teens level.” The company isn’t providing guidance for Q3 or H2.

Strategy: Earnings Forecasts Still on the Rise. If you’re looking for a reason to remain positive despite the stock market selloff, consider analysts’ forward earnings estimates, which continue their upward trend. “Forward earnings” is the time-weighted average of consensus earnings-per-share estimates for this year and next; it’s a more precise rendering of the projected earnings that investors actually are basing decisions upon than analysts’ estimates for full years or quarters.

Over the past four weeks, the S&P 500’s forward earnings have increased by 3.8%, and over the past 13 weeks, the change is 7.7%. Here’s a quick look at which S&P 500 industries’ forward earnings have been revised by the most and the least over the past four weeks (for full details, see our S&P 500 Sectors & Industries Forward Earnings & Revenues):

(1) Acting like Covid has passed. The third wave of Covid-19 continues to take a toll, particularly on the unvaccinated. The number of new cases, using a seven-day average, topped 125,000 this week, up sharply from 12,000 in June (Fig. 3). But so far, the number of deaths remains relatively low compared to the January peak (Fig. 4).

Analysts aren’t panicking—yet. They continue to boost the forward earnings of industries that will be hurt if consumers start staying home for fear of catching Covid. Here’s how earnings have changed over the past four weeks for some of the S&P 500 industries related to economic reopening: Hotels (60.5%), Casinos & Gaming (24.4), Restaurants (4.9), and Movies & Entertainment (3.7).

(2) Oil is down, but oil-related earnings aren’t. The price of Brent crude oil futures has fallen 10.5% from its high on July 5 through Tuesday’s close, though is still up 52% y/y (Fig. 5). The recent decline is attributed to recent signs of an economic slowdown in China and rising Covid-19 cases around the world. But so far, analysts’ confidence in the sector’s earnings power continues to grow.

Looking at the four-week percentage changes in forward earnings of the S&P 500 and all 11 of its sectors, it’s notable that every single one is a positive change, with Energy leading the pack: Energy (10.8%), Real Estate (8.7), Communications Services (7.3), Industrials (5.4), Materials (5.1), Information Technology (4.0), S&P 500 (3.8), Consumer Discretionary (2.8), Health Care (2.5), Financials (1.6), Consumer Staples (0.8), and Utilities (0.5).

Within the Energy sector, earnings estimates have risen over the past four weeks for Oil Exploration & Production (15.8%), Oil & Gas Equipment & Services (12.1), and Integrated Oil & Gas (9.8).

A number of industries typically associated with US economic health also have benefitted from positive earnings estimate revisions over the past four weeks, including: Specialty Stores (21.4%), Human Resources & Services (18.5), Home Furnishings (8.6), Consumer Finance (8.1), Steel (7.8), Automobile Manufacturers (7.4), Apparel & Accessories (6.6), Homebuilding (5.6), Trucking (5.1), Semiconductor Equipment (4.7), Advertising (4.2), and Railroads (3.5).

(3) Not much negative to tell. There’s not much negative in this snapshot of earnings revisions over the past four weeks. Only seven industries have seen their earnings revised downward over the past four weeks. Those industries include Broadcasting (-0.2%), Gold (-0.8), Diversified Banks (-1.0), Household Products (-1.3), Internet & Direct Marketing Retail (-4.6), Alternative Carriers (-4.8), and Apparel Retail (-5.9).

Internet and Direct Marketing Retail is home to Amazon, for which analysts have been shaving their earnings forecasts recently. They now expect the company’s 2021 earnings to be $53.13 a share, down from $55.84 one month ago, and its 2022 earnings to come in at $67.40 a share, down from $73.22 a month ago, according to the WSJ. The share price performance of the Internet retailing giant turned negative ytd as of Tuesday’s close (-0.5%), underperforming the S&P 500’s 18.4% ytd gain.

Disruptive Technologies: Capturing Carbon. On August 9, the United Nations’ (UN) Intergovernmental Panel on Climate Change (IPCC) issued its Sixth Assessment Report (AR6), titled Climate Change 2021. UN Secretary-General António Guterres described the report as “a code red for humanity.” Guterres added, “The alarm bells are deafening, and the evidence is irrefutable: greenhouse gas emissions from fossil fuel burning and deforestation are choking our planet and putting billions of people at immediate risk.” In just the last few weeks, floods have wreaked havoc in Europe, China, and India; toxic smoke plumes have blanketed Siberia; and wildfires have burned out of control in the US, Canada, Greece, and Turkey.

President Joe Biden has pledged to reduce US greenhouse gas emissions by at least 50% by 2030. So far, he has announced plans to increase the fuel efficiency of cars, and his $1 trillion infrastructure bill contains lots of funding to improve the electrical grid and energy production. The legislation earmarks about $7.5 billion for building electric vehicle charging stations and $7.5 billion to replace carbon-spewing school buses and ferries with lower-emissions vehicles. There’s growing bipartisan support for a separate proposal of placing a carbon tax on companies that produce greenhouse gases and carbon dioxide (CO2). Proceeds from the tax would be invested in clean energy solutions.

However, the IPCC had a decidedly doomsdayish spin, concluding, “Many changes due to past and future greenhouse gas emissions are irreversible for centuries to millennia, especially changes in the ocean, ice sheets and global sea level.” I asked Jackie to see if there might be technological solutions to this problem. After all, technology has a long history of averting doomsday scenarios such as population explosions, global famine, and more recently pandemics (notwithstanding the obvious counterexample of the atom bomb). Here is her report:

Many experts say that companies—particularly those in industries like steel and concrete manufacturing—will need to adopt technologies that are able to capture the carbon thrown off by their manufacturing processes. Carbon-capture technology is a quickly evolving area, with small and large energy companies trying to invent ways to capture large volumes of carbon from the air at a reasonable price. Companies that succeed might apply for the Xprize, the $100 million worth of prizes that Elon Musk will award to those with the best ideas.

Critics of carbon-capture technology argue that it encourages companies to continue producing CO2 and it is an inefficient way to clean the atmosphere. The critics would prefer that CO2 not be created at all or be extracted from the air by planting trees.

(1) Don’t pump oil, capture carbon. Not surprisingly, some of the largest companies focused on developing carbon-capture technology are the oil and gas giants. Exxon Mobil is investing $3 billion through 2025 in a business unit formed this year that focuses on low-carbon solutions. The new business will capture CO2 emissions from industrial processes as well as directly from the air and deposit it underground, a February 1 WSJ article reported.

In March, Shell, Total SE, and Equinor AS launched a joint venture to capture carbon and store it thousands of feet beneath the sea off the coast of Norway. The Northern Lights project, scheduled to start in 2024 and largely funded by Norway, counts as customers Fortum Oslo Varme, a waste company, and HeidelbergCement AG. The joint venture marks the first time that companies outside of the oil industry would pay to have their carbon captured and stored, an April 19 WSJ article reported.

But there are concerns about CO2 escaping during the intricate processes, which involve collecting the CO2, shipping it, pumping it offshore, and injecting it into an aquifer under the seabed.

Like other energy giants, Chevron and BP are developing carbon-capture projects in the hopes of their becoming profits-producing businesses. Their bottom lines will be helped by tax credits from countries around the world. “The U.S. offers companies a tax credit of as much as $50 a metric ton of carbon captured, while the U.K., Norway and Australia have collectively committed billions of dollars of funding for carbon-capture projects,” the aforementioned April 19 WSJ article explained. A record 17 new carbon-capture projects were slated for development last year.

(2) Capturing carbon on tailpipes. The startup Remora has developed a device that attaches to the tailpipes of 18-wheelers to capture up to 80% of emitted CO2. The CO2 is compressed and stored in a tank that must be unloaded by the truck’s driver into a stationary tank, where it’s cooled and liquified. A tanker then pumps out the liquified CO2 to be sold for reuse, an August 9 WSJ article explained. Ryder Systems, Werner Enterprises, NFI Industries, ArcBest, and Cargill plan to test the new system.

(3) Capturing CO2 from chimneys. Companies are working on different ways to collect CO2 before it leaves an industrial plant’s chimney and pollutes the air. Compact Membrane has a membrane that it says can capture the CO2 from gas exiting a factory’s flue at a cost of $20 a ton, making it a cost-effective option.

Membrane Technology & Research also makes CO2-absorbing membranes that can reduce the CO2 produced by coal- or natural-gas-fired power plants and other industrial plants. And Carbon Clean has a carbon-capture solution that’s installed in industrial plants’ flues.

(4) Building a better tree. Carbon Collect has created the MechanicalTree, which takes CO2 out of the air that’s blown past it by the wind. Because it uses the wind, it doesn’t need to run fans or blowers at additional cost. The CO2 is pumped and stored underground or recycled and turned into a synthetic fuel for use by companies that produce products using CO2 (e.g., manufacturers of food and beverages, cement, concrete, steel, pharmaceuticals, carbon fiber, and fuels), the company’s website explains. One cluster of 12 MechanicalTrees can capture 1 metric ton of CO2 per day.

(5) Pulling CO2 out of thin air. Carbon Engineering has two direct-air-capture plants that use large fans to pull air into a structure where it passes over a thin plastic surface covered with a potassium hydroxide solution, which chemically binds with the CO2 and removes it from the air. The CO2 in the solution undergoes a number of chemical processes that yield CO2 gas that can be used or buried. The company’s website claims it can remove as much as one million tons of CO2 per year at a cost of about $100 per ton.

The company is working with LanzaTech (discussed below) to investigate the feasibility of a large-scale facility in the UK that would remove CO2 from the air and turn it into aviation fuel. If it moves ahead, the facility would be up and running by the end of the decade. British Airways and Virgin Atlantic are part of the project team, according to a July 26 press release.

Climeworks, a Swiss startup, also performs direct-air capture of CO2. Fans pull air through a filter that attracts only CO2. When the filter is saturated, it is heated to 100 degrees Celsius and pure CO2 is released and collected. The CO2 can be either buried or sold for other uses, a July 23 CNBC article explained. The company’s plant in Switzerland removes about 900 tons of CO2 per year, which it hopes to increase to several gigatons.

(6) Recycling the carbon. Instead of stuffing the CO2 back into the ground, LanzaTech combines the captured gas with bacteria to make fuels and chemicals. It has two plants in China that capture CO2 gas spewed by steel mills and convert it into ethanol for use in making various products—e.g., jet fuel, household cleaners, laundry detergent, perfumes, and polyester—according to a company press release.

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Searching for Peak Inflation

August 18 (Wednesday)

US Economy: Consumers Taking a Break? Retail sales peaked at a record high of $7.5 trillion during April and have dropped 1.8% since then through July (Fig. 1). In yesterday’s Morning Briefing, Debbie and I discussed the possibility that consumers have satisfied most of their pent-up demand for goods that built up during last year’s lockdowns. That seems likely given the recent weakness in retail sales.

However, some of that weakness reflects a 10.4% drop over the past three months in the sales of motor vehicles and parts dealers, which need to rebuild their depleted inventories once the automakers get the parts they require to produce more cars. On the other hand, the recent weakness in housing activity resulting from soaring home prices can explain the weakness in housing-related retail sales in recent months (Fig. 2). That’s certainly one area of retail sales where lots of pent-up demand has been met for a while.

We are counting on consumer spending on services to pick up some of the slack in consumers’ spending on goods. The Delta variant could dampen the rebound in the former, while the latter could also be offset by vigorous inventory restocking. During June, business sales jumped 1.4% m/m to a new record high (Fig. 3). That increase was led by a 2.0% jump in the sales of wholesalers and a 1.6% increase in manufacturing shipments (Fig. 4). Their recent strength has more than offset the weakness in retail sales in recent months.

Inventory-to-sales ratios, adjusted for inflation, soared during last year’s lockdowns and plummeted thereafter as demand for goods shot up once lockdowns were lifted (Fig. 5 and Fig. 6). These ratios might have bottomed in May. There’s plenty of space on shelves to rebuild inventories.

Factories continued to hum in July: Manufacturing output was up 1.3% m/m and 7.3% y/y to the highest reading since August 2019. Even the auto industry was able to increase assemblies slightly, by 870,000 units to 9.7 million units (saar), during July (Fig. 7). The categories leading the way to higher output were high-tech equipment (up 12.1% y/y), which includes communications equipment (14.3); computer & peripheral equipment (14.3); and semiconductors & other electronics (10.6) (Fig. 8).

 

Inflation I: Moving the Goalpost. Last year during August, Fed officials announced that they were aiming to overshoot their 2.0% inflation target for the PCED because they had undershot it for so long. Well, all it took was a pandemic, and they finally did that by flooding the economy with an unprecedented amount of liquidity.

According to an August 16 Reuters article, a study by two former senior staffers at the Fed recently made a case to raise the inflation goalpost from 2.0% to 3.0%. They argued that doing so would allow more marginalized groups to reenter the workforce, reducing economic inequities. Doing so could certainly push inflation higher for longer. Since Fed officials have embraced flexible average inflation targeting, accepting the idea of overshooting inflation for a while to make up for undershooting it for so long, they’ve basically moved the goalpost already.

Inflation II: Some Good News. Previously, Debbie and I predicted that the headline PCED inflation rate would range between 3.0%-4.0% through the summer and then settle down to 2.0%-2.5% later this year. We are still in that “transitory” camp.

The headline and core PCED inflation rates rose on a y/y basis to 2.4% and 2.0% during March; they continued to move higher during May, to 3.9% and 3.4%, and even higher during June, to 4.0% and 3.5%. We are still awaiting July’s PCED rates but learned last week that the headline and core CPI inflation rates rose 5.4% and 4.3% y/y during July, with the former holding at June’s rate and the latter down from 4.5%.

As Fed Chair Jerome Powell has often noted in recent months, the problem with annual rates of inflation now is that they are being boosted by the “base effect.” That is, recent price rises may partly reflect the process of recovering from lockdown-depressed price levels a year ago. That’s why we prefer evaluating inflation rates on a three-month annualized basis for now.

Even that way, there’s no question that the Fed is surpassing its inflation goal. But will the overshoot be sustained or transitory? Powell has acknowledged that in addition to the base effect, inflationary pressures reflect current supply bottlenecks resulting from a surge in demand as the economy has reopened. He believes that both effects are inherently transitory.

Interestingly, three-month annualized CPI inflation data for July are looking slightly less menacing than they did for June. But that could be not only because the initial post-lockdown pent-up demand surge in some categories of inflation is beginning to wane but also because concerns about Covid variant Delta have depressed demand some. If so, then inflation could pick up again, especially if Delta’s spread scares more people into getting vaccinated, allowing them to go out into the world more comfortably and to spend more freely. If the latest inflation rates instead mostly reflect a weakening of pent-up demand, then we may have hit the peak in post-pandemic inflation.

For now, here’s what the three-month annualized CPI data are showing:

(1) Three-month inflation rate. Over the past three months through July, the headline and core CPI annualized inflation rates are 8.1% and 7.8% (Fig. 9). Those increases were less startling than June’s comparable increases of 9.3% and 10.2%. However, the increases continued to be concerning considering that the cost of medical care services rose only 0.6% over the past three months. That was more than offset by the rebounds in rent of primary residence and owners’ equivalent rent to 2.5% and 3.7% (Fig. 10). The latter category remained on an upward climb, while the former eased a bit from June’s three-month figure.

(2) Base effect. Arguably, some CPI components are up sharply because of the base effect, but some of the base effect began to abate during July using the latest three-month numbers (annualized) versus June’s comps: lodging away from home (55.3%, 62.4%), airfares (39.0, 84.3), and car & truck rental (49.8, 148.0). In addition, the price of gasoline, which peaked at a 98.8% rate of rise during the three months through March, was up 17.0% through July (Fig. 11).

(3) Off base. On the other hand, the following annualized price increases over the last three months seem to reflect more of the demand shock and supply shortages than the base effect: new vehicles (21.6%), motor vehicle parts & equipment (10.7), food (7.8), tobacco (4.8), and tuition & childcare (3.1). Each of these CPI categories saw continued increases in their three-month (annualized) inflation rates during July compared to June. Meanwhile, the following consumer categories experienced historically high rates, but decreased a bit from June’s comparable three-month gauges: used car & trucks (75.2), household furniture & bedding (8.1), apparel (7.9), and energy services (6.5).

Inflation III: Some Bad News. Now for the bad news: Here are some of the latest readings of alternative measures of inflation, which—unlike the CPI on a three-month basis—show no signs of cooling off:

(1) PPI. The final demand PPI rose to 7.8% y/y during July (Fig. 12). The final demand for goods PPI soared 11.9% y/y, while services rose 5.8 y/y. Some portion of those increases was due to the base effect, but not the increases in their entirety.

The PPI release includes items for personal consumption prices. The overall index jumped 6.8% y/y during July. It is highly correlated with the CPI, which was up 5.4% over the same period. The core PPI for personal consumption was up 5.2% during July, while the core CPI was up 4.3% (Fig. 13 and Fig. 14).

(2) Commodity and input prices. Both the CRB all commodities spot price index and the CRB raw industrials spot price indexes remained on very steep uptrends through mid-August (Fig. 15).

During July, the average of prices-paid indexes in the M-PMI and NM-PMI surveys was 84.0, down only slightly from June’s record high of 85.8 (Fig. 16).

(3) Small business survey. July’s survey of small business owners, conducted by the National Federation of Independent Business, found that 46% of business owners have been raising their average selling prices. The reading was just a hair below last month’s 47%, the highest reading since January 1981. Seasonally adjusted, a net 44% of respondents plan to hike prices, unchanged from last month (Fig. 17).

(4) Expectations. Looking ahead, the Federal Reserve Bank of New York’s July 2021 Survey of Consumer Expectations shows that median one-year-ahead inflation expectations were unchanged from last month at 4.8%, while the three-years-ahead median inflation expectations increased slightly to 3.7% (Fig. 18). The Conference Board survey found that 12-months-ahead inflation expectations fell slightly during July to 6.6%, after rising to 6.7% last month (Fig. 19).

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Reviewing Valuation

August 17 (Tuesday)

The Fed: Starting To Look Forward? More Fed officials are suggesting that their assessment of monetary policy is turning from outcome-based back to outlook-based. Instead of looking backward, they are starting to look forward. Let’s review how the Fed’s thinking has evolved on this important subject so far this year:

(1) Fed Chair Jerome Powell essentially discarded the outlook approach in his March 17 press conference when he was asked whether the latest dot plot suggested that the Fed would start raising interest rates soon. He responded: “I have to be sure to point out that [the dots are] not a Committee forecast. … It’s just compiling these projections of individual people. We think it serves a useful purpose. It’s not meant to actually be a promise or even a prediction of when the Committee will act. That will be very much dependent on economic outcomes, which are highly uncertain.”

(2) Fed Governor Lael Brainard clarified how the two approaches differ in a speech on March 23 this year titled “Remaining Patient as the Outlook Brightens.” She stressed very important distinctions in meaning between “outlook” and “outcome” and between “preempting” and “reacting.” She concluded her speech with this punchline: “By taking a patient approach based on outcomes [emphasis ours] rather than a preemptive approach based on the outlook, policy will be more effective in achieving broad-based and inclusive maximum employment and inflation that averages 2 percent over time.”

(3) Fed Vice Chair Richard Clarida gave an April 14 speech titled “The Federal Reserve’s New Framework and Outcome-Based Forward Guidance.” At the time, I wrote, “Is that a whacky title or what? Overall, the speech was just plain whacky. For starters, how can forward-looking guidance be based on an outcome, which requires a backward-looking assessment? All this amounts to a backward-looking, rather than a forward-looking, monetary policy approach. Ironically, all the talking Fed heads now are saying that their ‘forward guidance’ is no longer relevant since that was based on their outlook, which has not been relevant since the pandemic started. What matters now is the outcome, which can only be known after it happens! Forward-looking guidance has now morphed into backward-looking guidance. In effect, Fed officials are saying, ‘We’ll let you know when we are ready to raise interest rates after we get the outcome we were seeking.’”

(4) On April 14, Powell reiterated that the federal funds rate would stay near zero until three “outcomes are achieved.” They are: (i) “The recovery in the labor market is effectively complete.” (ii) “[I]nflation has reached 2% ... sustainably.” (iii) “[I]nflation is on track to run moderately above 2% for some time.” Only after all three goals are met will the Fed consider raising interest rates, he said. “[T]hat’s when we will raise interest rates. Until then, we won’t.”

(5) More Fed officials seem to be thinking ahead now, having recognized that not doing so has put them in a box. They’ve clearly stated that the Fed won’t start raising interest rates until after it’s done tapering its bond purchase program, and the tapering hasn’t even started yet. Some of them seem to be realizing that if the labor market achieves full employment in coming months while inflation stays hot, the Fed will fall well behind the inflation curve before it can even start raising interest rates to counter runaway inflation—an unexpected, though certainly possible, outcome.

(6) In yesterday’s WSJ, Nick Timiraos reported: “Federal Reserve officials are nearing agreement to begin scaling back their easy money policies in about three months if the economic recovery continues, with some pushing to end their asset-purchase program by the middle of next year.”

According to the article, the hawkish members of the FOMC include Chicago Fed President Charles Evans, Boston Fed President Eric Rosengren, Dallas Fed President Robert Kaplan, and St. Louis Fed President James Bullard. Among the doves mentioned are Powell, San Francisco Fed President Mary Daly, and Fed governor Lael Brainard.

Strategy: Valuing Styles. The S&P 500’s valuation multiple is historically high. Yet investors seem to be complacent about it. That’s because this multiple has been historically high for the past year without much volatility. The same cannot be said about SmallCap’s and MidCap’s valuation multiples, which are remarkably cheap relative to LargeCap’s. The so-called SMidCaps’ valuations haven’t been as high as the S&P 500’s multiple over the past year, and they have been more volatile. Meanwhile, Growth’s forward P/E (i.e., based on forward earnings per share, or the time-weighted average of consensus estimates for this year and next) has soared relative to Value’s forward P/E over the past year. And the Stay Home valuation multiple well exceeds the one for Go Global.

Joe and I have discussed these developments before. However, let’s update our analysis and do some more drilling down into the valuations of the four investment styles, namely LargeCaps vs SMidCaps, Growth vs Value, Sectors, and Stay Home/Go Global. For good measure, let’s also have a look at the impacts on these styles of an important group of stocks—the “Magnificent 5” highest-capitalization stocks (namely, the FAAMGs, i.e., Facebook, Amazon, Apple, Microsoft, and Google):

(1) LargeCaps vs SMidCaps. Before the pandemic—during February 2020—the daily forward P/Es of the S&P 500/400/600 peaked at 19.0, 17.4, and 17.8 (Fig. 1). They crashed as a result of the pandemic-induced lockdowns and bottomed at 12.9, 10.3, and 11.0 on March 23 in response to the Fed’s ultra-easing QE4ever response to the pandemic. They shot up to peak last year—on September 2 at 23.2 for LargeCap and on June 8 at 23.3 and 27.3 for the SMidCaps.

Since their peaks last year, the S&P 500’s forward P/E held up the best, ranging between 20.2 and 23.2 through Friday’s close when it was at 21.0. The forward P/Es of the MidCaps and SmallCaps fell from their peaks to 17.0 and 16.1 on Friday.

Based on weekly data starting in 1999, the average forward P/Es of the S&P 500/400/600 were 16.6, 16.5, 16.9 (Fig. 2). Over this same period, the spread between the forward P/Es of the S&P 500 and the S&P 400 & 600 was usually negative with the exception of the tech bubble of 1999-2001 and now over the past year (Fig. 3 and Fig. 4). The current spreads at 4.0ppts and 5.0ppts are the widest since 2001.

Perversely, the forward P/Es of the SMidCaps have been brought down because their forward earnings recoveries since March 23 of last year have been much better than that of the S&P 500, while their stock prices stopped outperforming the S&P 500 on March 15 of this year (Fig. 5, Fig. 6, and Fig. 7).

Are SMidCaps signaling a recession is coming? We doubt that, given our analysis in yesterday’s Morning Briefing of the upbeat outlook for consumer spending and prospects for another big round of fiscal spending. The SMidCaps might be relatively weak if investors are concerned that the widespread labor shortages could weigh on them more so than on the LargeCaps. We doubt that too, since smaller companies now have access to many of the same technologies necessary to augment the physical and mental productivity of workers as larger ones do.

So once again, we conclude that SMidCaps are cheap relative to LargeCaps.

(2) S&P 500 Growth vs Value. The forward P/E of S&P 500 Growth usually exceeds that of Value (Fig. 8 and Fig. 9). Both were relatively high on Friday’s close at 28.1 and 16.6. Similar to the overall S&P 500, Growth’s forward P/E has been remarkably stable in a range of 28.0 +/- 2.3 over the past year. The same can be said about Value’s forward P/E (17.0 +/- 1.3), though it has been declining since January 6 of this year.

The weekly data show that the nearly 12ppt spread between the forward P/Es of Growth and Value hasn’t been this wide since 2001 (Fig. 10). Again, we have to conclude that Value is cheap.

(3) Magnificent Five. The Mag-5 stocks are the largest ones in the S&P 500 by market capitalization. They’ve had an outsized impact on the investment styles since the end of 2017, when their market-cap share of the S&P 500 was 14.6% (Fig. 11). It rose to a record high of 25.9% on August 28, 2020. It remained near that peak at 24.3% on Friday. Since the Mag-5 is currently composed totally of Growth stocks, they’ve had a significant impact on the recent outperformance of Growth relative to Value, especially since the end of 2019 (Fig. 12).

The FAAMG stocks had a forward P/E of about 21.0 during 2015 (Fig. 13). It peaked at 34.3 during the week of February 21, 2020, just before the pandemic. It soared to 44.3 during the August 28 week of last year. It was still very high at 36.0 during the August 13 week of this year.

Excluding the Mag-5, the forward P/E of the S&P 500 was 18.4 during the August 5 week, and including them it was 21.0 (Fig. 14). Growth’s forward P/Es with and without the Mag-5 are 27.9 and 23.1 (Fig. 15).

The Mag-5 underperformed the S&P 500 from September 2, 2020 through March 15, 2021. Since then, Mag-5 is up 21.5% through Friday’s close. Here is the performance derby of the other major S&P indexes over this same period: S&P 500 (12.6), S&P 500 ex Mag-5 (10.3), S&P 400 MidCaps (1.8), S&P 600 SmallCaps (-3.4), S&P 500 Growth (18.4), and S&P 500 Value (6.6).

(4) S&P 500 sectors. The Mag-5 has also had a significant impact on the relative performances and forward P/Es of the 11 S&P 500 sectors. The FAAMGs are the 800-pound gorillas in the following S&P 500 sectors: Information Technology (Apple and Microsoft together accounted for 44.6% of the sector’s market cap on Friday), Consumer Discretionary (Amazon weighed in at a 37.1% share), and Communication Services (Facebook and Google had a record-high 67.5% combined share).

Here is the performance derby for the 11 sectors of the S&P 500 since March 15, showing that the gorillas were among those in command: Real Estate (19.2%), Information Technology (16.8), Health Care (16.1), Communication Services (15.2), S&P 500 (12.6), Financials (11.7), Consumer Staples (10.5), Materials (10.0), Utilities (9.0), Industrials (7.8), Consumer Discretionary (7.4), and Energy (-6.2). (See Table 1 for this performance derby for the 11 sectors and 100+ industries of the S&P 500.)

(5) Stay Home vs Go Global. The forward P/E of the US MSCI stock price index closely tracks the comparable valuation multiple for the S&P 500. The former has also been hovering around 22.0 for the past year (Fig. 16). Meanwhile, the All Country World (ACW) ex-US forward P/E has dropped from a recent peak of 17.2 on January 20 to 15.0 on Friday (Fig. 17). The 7.0ppts spread is the widest on record since the start of the data during 2001 (Fig. 18).

As we have observed in the past, the forward P/E of the ACW ex-US MSCI closely tracks the comparable P/E for the S&P 500 Value (Fig. 19). The former has been declining in step with the latter. If Value is cheap in the US (currently at 16.6) and ACW ex US is even cheaper (at 15.0), isn’t it time to overweight Go Global relative to Stay Home? For now, Joe and I would rather overweight Value in the US than overweight Go Global.

Correction. The correct title of the movie I reviewed yesterday is “Mudbound,” not “Mudland.” It looked like lots of muddy land to me.

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A Long & Winding Road

August 16 (Monday)

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YRI Podcast. In our latest video podcast, Dr. Ed discusses the main points of today’s Morning Briefing.

US Consumer: Cabin Fever vs Delta Variant. The Consumer Sentiment Index (CSI) plunged to 70.2 in its preliminary August reading (Fig. 1). That is down from July’s result of 81.2 and below the April 2020 mark of 71.8 that was the lowest of the pandemic period so far. “Over the past half century, the Sentiment Index has only recorded larger losses in six other surveys, all connected to sudden negative changes in the economy,” Richard Curtin, chief economist for the University of Michigan’s Surveys of Consumers, said in a release. Two of those larger month-over-month movers were April 2020 amid the pandemic and October 2008 during the financial crisis.

The unusually big m/m drop has been triggered by the rapid spread of the Delta variant of Covid-19. Hospitals in many southern states are reporting a shortage of beds to handle patients. Some states and cities have recently reinstated mask mandates and other health restrictions. This fourth wave of the pandemic in the US started after many July 4 celebrations turned out to be spreader events for the rapidly spreading Delta variant (Fig. 2). So far, it is much less severe than the third wave, which crested at the start of this year.

The big difference between now and then is the widespread availability of vaccines. As of August 13, 75% of the American population has had at least one dose, while 64% has been fully vaccinated (Fig. 3). So far, that’s provided some good news, as the number of deaths continued to decline to 2,240 through the week of August 9 based on the 10-day average (Fig. 4). That’s the lowest rate since April 13, 2020. Furthermore, the pace of vaccinations has picked up as the Delta variant news has become more alarming.

One of the few experts with any credibility on this subject, in my opinion, is Dr. Scott Gottlieb. He was the commissioner of the Food and Drug Administration from 2017 to 2019 during the Trump administration and now sits on the boards of several companies, including vaccine maker Pfizer. He was interviewed on CNBC on Friday.

Gottlieb was relatively reassuring: “You’re going to see the Delta wave course through probably between late September through October. Hopefully we’ll be on the other side of it … in November, and we won’t see a big surge of infection … on the other side …By September, hopefully you’ll see the other side of that curve in the South very clearly, but cases will be picking up in the Northeast, the Great Lakes region, maybe the Pacific Northwest. … It’s probably going to coincide with a restart in school, some businesses returning if you look at last summer as well.”

How will all this affect consumer spending? Consider the following:

(1) CSI vs CCI. Keep in mind that the Consumer Confidence Index (CCI) was very strong in July at 129.1, up from 87.1 at the start of this year and the best reading since February 2020’s 132.6 (Fig. 5). Debbie and I expect that it remained strong in August too. That’s because it is much more highly correlated with labor market indicators—themselves very strong—than is the CSI.

Payroll employment rose sharply during June and July by a total of 1.9 million, and probably continued to do so during August. The unemployment rate fell in July to 5.4%, the lowest since March 2020. The CCI’s current conditions component is highly correlated with the spread between the survey’s “jobs plentiful” and “jobs hard to get” percentages (Fig. 6). That spread rebounded during July back above where it was during January last year, to its best reading since July 2000. The jobs-hard-to-get percentage held at 10.5% during July, the lowest since July 2000 (Fig. 7). It is highly correlated with the jobless rate.

(2) Dopamine relief. We expect that the recent drop in confidence won’t depress consumer spending for very long, if at all. We agree with Curtin’s assessment: “Consumers have correctly reasoned that the economy’s performance will be diminished over the next several months, but the extraordinary surge in negative economic assessments also reflects an emotional response, mainly from dashed hopes that the pandemic would soon end. In the months ahead, it is likely that consumers will again voice more reasonable expectations, and with control of the Delta variant, shift toward outright optimism.”

As I’ve often observed, when we Americans are happy, we spend money, and when we are depressed, we spend even more money. Shopping releases dopamine in our brains, which makes us feel good. Of course, we can only shop until we drop if we have the wherewithal to spend on goods and services.

(3) Plenty of income. Wages and salaries in personal income rose to a record high during June (Fig. 8). That should more than offset the drop in government social benefits, which propped up consumers’ incomes since the start of the pandemic. Our YRI Earned Income Proxy for wages and salaries in the private sector jumped 0.9% m/m during July to yet another record high (Fig. 9).

In addition, consumers have plenty of pent-up saving and borrowing power to keep spending going. Personal saving dropped during June to $1.7 trillion (saar), the lowest since February 2020 (Fig. 10). It had been spiked by the three rounds of government support checks sent to most American taxpayers for pandemic relief. Nevertheless, the 12-month sum of personal saving remained near recent record highs, at $2.8 trillion during June. Meanwhile, revolving consumer credit, which fell during last year’s lockdown, bottomed during January, and has been edging higher since then (Fig. 11).

(4) Pent-up demand. The question is: Will concerns about the Delta variant outweigh consumers’ need to go shopping to overcome their cabin fever? A related question is: Have consumers satisfied all their pent-up demand resulting from the pandemic? We are betting that consumer spending will continue to grow along with consumers’ wages and salaries, as it is wont to do during economic expansions.

Personal consumption expenditures (PCE) rose to a new record high during June (Fig. 12). It is back to its pre-pandemic uptrend line and should resume climbing along that line. While consumers may have satisfied much of their pent-up demand for goods, they’ve been frustrated by a shortage of auto inventories. In any event, there is probably still plenty of pent-up demand for services. PCE on services appears to be on the verge of rising to record highs, while PCE on goods has been doing that since January (Fig. 13).

US Fiscal Policy: More Stimulus Coming. On August 10, the Senate passed a bipartisan infrastructure bill. Senate Majority Leader Chuck Schumer celebrated the passage, saying: “It's been a long and winding road, but we have persisted and now we have arrived. … Today, the Senate takes a decade’s overdue step to revitalize America’s infrastructure and give our workers, our businesses, our economy the tools to succeed in the 21st century. The bill will make large and significant differences in both productivity and job creation in America for decades to come.”

The bill is more than 2,000 pages long.

The vote, 69 to 30, was uncommonly bipartisan. Those voting “yes” included Senator Mitch McConnell of Kentucky, the Republican leader, and 18 others from his party who shrugged off increasingly shrill efforts by former President Donald J. Trump to derail it.

While the bill is billed as spending $1 trillion on infrastructure, it actually would increase new federal spending by just over half that, or $550 billion, over the next 10 years. It would also renew and revamp existing infrastructure and transportation programs set to expire at the end of September.

The bill includes $110 billion for roads and bridges, and $73 billion to update the nation’s electricity grid so it can carry more renewable energy. Another $66 billion is for passenger and freight rail (mostly for Amtrak), and $65 billion is allocated for expanding high-speed internet access. There’s plenty more for water systems and infrastructure ($55 billion), Western water storage ($50 billion), public transit ($39 billion), airports ($25 billion), clean buses and ferries ($18 billion), removing lead pipes ($15 billion), and electric vehicle charging stations ($8 billion).

President Joe Biden initially had proposed a $2.3 trillion infrastructure plan. The bill now includes far less funding than he and his fellow Democrats had wanted for lead pipe replacement, transit, and clean energy projects, among others.

Here are a few of the major issues regarding this bill:

(1) Financing. On August 9, the Congressional Budget Office (CBO) estimated “that over the 2021-2031 period, enacting Senate Amendment 2137 to H.R. 3684 would decrease direct spending by $110 billion, increase revenues by $50 billion, and increase discretionary spending by $415 billion. On net, the legislation would add $256 billion to projected deficits over that period.”

Based on current law, the CBO estimates that budget deficits could total $15 trillion from 2021 through 2031 (Fig. 14). Federal debt rose to 100% of nominal GDP during 2020, the highest since 1946 (Fig. 15). The CBO projects that it will remain slightly above 100% through 2031. The latest spending bill would increase federal government debt some more, but it might also boost GDP somewhat.

The August 2 WSJ reported: “The spending will be paid for with a variety of revenue streams, including more than $200 billion in repurposed funds originally intended for coronavirus relief but left unused; about $50 billion will come from delaying a Trump-era rule on Medicare rebates; and $50 billion from certain states returning unused unemployment insurance supplemental funds.” In addition, nearly $60 billion is projected to come from economic growth spurred by the spending and $87 billion from past and future sales of wireless spectrum space.

(2) Interest expense. Increasing deficit-financed fiscal stimulus runs the risk of boosting interest rates on a rapidly growing mountain of federal debt. Over the past 12 months through July, the federal government’s outlays on net interest paid rose to $351.7 billion, up from a recent low of $312.7 billion during April (Fig. 16). This implies that the average interest paid on the debt rose from a low of 1.48% during April to 1.62% during July (Fig. 17).

(3) Labor shortages. While Schumer expects his bill to create more jobs, there are plenty of unfilled job openings now. There may not be enough qualified construction workers to even start all the new infrastructure projects that are shovel ready anytime soon. During July, payroll employment in the construction industry totaled 7.4 million, still down by 227,000 from the pre-pandemic high during February 2020 (Fig. 18). There were 339,000 job openings in the construction industry during June (Fig. 19).

(4) Shovel ready? Back in 2009, former President Barack Obama made some lofty promises about the infrastructure overhaul that his $800 billion economic stimulus plan would provide. Obama used the phrase “shovel-ready projects” in reference to construction projects that could begin right away. In the end, however, only $98.3 billion of the $800 billion stimulus was dedicated to transportation and infrastructure. Of that $98.3 billion, only about $27.5 billion actually was spent on transportation infrastructure projects.

“The problem is that spending it out takes a long time, because there’s really nothing—there’s no such thing as shovel-ready projects,” Obama said in a 2010 NYT interview. When it comes to economic stimulus, local governments may take years to begin actual construction even once they receive funding.

(5) Political intrigue. Now for the hard part: House Speaker Nancy Pelosi (D-CA) has repeatedly said she will not take up the bill just passed by the Senate until the Senate clears another stimulus bill stuffed with $3.5 trillion in social spending. That second bill will require the Democrats to use the reconciliation process since it is likely to be opposed by every Republican senator. Leaders of the Congressional Progressive Caucus in a letter to Pelosi warned that a majority of its 96 members confirmed they would withhold their support for the bill passed by the Senate until the second, far more expansive package gets through the Senate.

The Democrats view the first bill as focused on physical infrastructure, while the second bill is aimed at “human infrastructure.”

The second bill includes spending on free community college, childcare, paid family leave, efforts to slow and mitigate climate change, Medicare expansion, extensions of beefed-up household tax credits, and universal pre-K. It is unclear whether all those provisions will be permitted under the reconciliation rules.

The Democrats need the unanimous support of all 50 Democrats in the Senate to approve any elements of the budget framework, and McConnell has vowed to oppose a debt-limit increase if Democrats proceed with plans to increase spending.

Despite Schumer’s victory speech, it’s still a long and winding road, and the finish line hasn’t been reached yet.

Movie. “Mudbound” (+ + +) (link) is a 2017 drama on Netflix about life in rural Mississippi during and right after World War II. It’s about the corrosive impact of poverty and racism on people’s lives. It’s an unrelenting tale of misery without much relief other than from family support, which is tested often and hard. Particularly poignant are the parallel struggles of two World War II veterans–one white, one black–who return home and are forced to deal with racism and PTSD.

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Consumers, Valuation & mRNA

August 12 (Thursday)

Consumer Discretionary: Delta vs Cabin Fever. Delta is a downer. The Covid-19 variant is causing cases to spike and leading consumers to change some of their behaviors once again. Southwest Airlines was the latest company to warn that there was a deceleration in “close-in” bookings and an increase in “close-in” trip cancellations in August. The company attributed these changes to the rise in Covid cases.

But with the US economy remaining open, not all industries are being equally affected. Recent news out of the restaurant industry has been more optimistic. Looking at its business through July, Sysco said its restaurant supply business in the US hadn’t slowed down despite the spike in Covid cases. And on Wednesday, Wendy’s increased its full-year earnings outlook and increased its dividend.

Consumers certainly have the wherewithal to spend on a meal out or clothing at the mall. And while the S&P 500 Airline industry is the second-worst S&P 500 industry performer with a 19.7% decline in its price index since it peaked on April 6, the S&P 500 Restaurants index has risen 6.3% and the S&P 500 General Merchandise Stores index has gained 18.5%. Over the same period, the S&P 500 is up 8.9% (Fig. 1, Fig. 2, and Fig. 3).

Let’s take a look at how Delta, the US consumer, and S&P 500 Restaurants industry are faring:

(1) Delta spiking. Summer—and our return to normal social activities—has brought on a surge of Covid-19 cases. The seven-day average number of cases in the US hit 118,067 as of Tuesday, up sharply from 11,000-12,000 earlier this summer. While headed the wrong direction, today’s cases still aren’t anywhere near January’s seven-day average case count, which topped 200,000.

There are some signs of optimism. New case reports are leveling off or dropping in Missouri, Nevada, and Arkansas, states that were among the first to experience a jump in cases this summer, according to data from the NYT. Because the Delta variant is highly transmissible and because it’s prompting some unvaccinated people to get vaccinated, Delta could run its course quickly.

While Covid cases could continue climbing over the next few months, “[w]e’re going to reach some level of population-wide exposure to this virus, either through vaccination or through prior infection,” Dr. Scott Gottlieb told CNBC on Monday. “I don’t think Covid is going to be epidemic all through the fall and the winter. I think that this is the final wave, the final act, assuming we don’t have a variant emerge that pierces the immunity offered by prior infection or vaccination.”

(2) Consumers able to spend. US consumers have a little extra change in their pockets and they’re ready, willing, and able to spend—assuming that Covid-19 doesn’t get in the way.

More and more consumers are returning to work. The unemployment rate tumbled 9.4ppts from April 2020’s record high of 14.8% to 5.4% in July, leaving it only moderately above the recent low of 3.5% last January and February (Fig. 4). The YRI Earned Income Proxy jumped 10.6% y/y in July and has continued climbing to new highs (Fig. 5 and Fig. 6).

During the Covid lockdowns, consumers, unable to spend as much as they normally might, saved. The personal savings rate surged to an all-time high of 33.8% last April, falling to 13.0% by November, before rising again to 26.9% this March; it fell to 9.4% in June (Fig. 7). Meanwhile, consumer credit outstanding at $4.3 trillion, has only recently climbed back above its 2020 peak of $4.2 trillion (Fig. 8).

(3) Food-at-home fatigue helps restaurants. This round of Covid-19 might impact the economy in a more targeted fashion, assuming that there are no broad shutdowns. As we mentioned above, Southwest Airlines warned that “near-term” bookings had dropped, but Sysco, a large supplier to restaurants, said its business remained strong and hadn’t been impacted by the Covid-19 surge.

“The restaurant sector of our business is near full recovery … The volume recovery has happened much faster than the industry predicted, despite the presence of the Delta variant,” said Sysco CEO Kevin Hourican in the company’s fiscal Q4 (June 30) conference call on Tuesday.

Many consumers are still getting over their pandemic-induced cabin fever by going out to shop and eat. Consumers continue to “seek relief from food-at-home fatigue,” and the US restaurant industry recovery is in “full swing,” explained CFO Sysco Aaron Alt. Meanwhile, other areas of the company’s business, like international and business, are still in the early stages of recovery. Sysco was confident enough to both increase its sales forecast for fiscal 2022 and increase its dividend payout.

Wendy’s also gave no signs that Covid was derailing its recovery. Wendy’s stock rose 2.7% on Wednesday after the company reported adjusted Q2 earnings per share of 27 cents, exceeding analysts’ forecast of 18 cents. Same-restaurant sales of 17.4% beat forecasts of 15.8%, an August 11 Barron’s article reported. Wendy’s upped its earnings-per-share forecast for 2021 by seven cents on both ends of its 79-81 cents range, and it boosted its dividend 20% to 12 cents a share.

The S&P 500 Restaurants stock price index is at an all-time high, and analysts are calling for revenue to jump 22.0% this year and 8.3% in 2022 (Fig. 9). Earnings are growing even faster, 70.2% in 2021 and 12.2% in 2022 (Fig. 10). Optimism is running high with the industry’s forward P/E at at 29.1, near the highest levels of the past 25 years (Fig. 11).

Strategy: Taking a Look at P/Es. We noted in Monday’s Morning Briefing that the S&P 500’s forward earnings (i.e., the time-weighted average of consensus earnings-per-share estimates for this year and next) has been growing so quickly that despite the index’s 18.4% ytd increase, its forward P/E based on these earnings has hardly budged since last fall, hovering around 21. As it turns out, the same is true for many of the sectors and industries that make up the broader index. And in those cases where the forward P/E did make a big move since last fall, the move was often to the downside. Let’s take a look:

(1) Sector forward P/Es on the move. Among the S&P 500 sectors, Energy and Materials have experienced the biggest changes in forward P/E y/y. Their earnings jumped dramatically as the prices of oil and materials soared over the past year, and their forward P/Es accordingly plummeted.

Conversely, the forward P/E of the Information Technology sector was one of the few to increase over the past year, but the increase was small, less than two percentage points.

Here are the forward P/Es of the S&P 500 and its sectors as of August 5 and a year earlier: Real Estate (51.1, 49.6), Consumer Discretionary (29.9, 35.7), Information Technology (26.1, 25.8) Industrials (21.5, 23.4), Communication Services (21.3, 22.0), S&P 500 (21.0, 22.0), Consumer Staples (20.5, 20.5), Utilities (19.7, 18.4), Health Care (17.6, 16.3), Materials (16.8, 21.4), Financials (13.7, 13.9), and Energy (13.1, 50.3) (Table 1).

(2) Tech industries see P/Es rise. Among the industries that have seen the largest jumps in their forward P/Es, REITs feature prominently, with the Health Care, Residential, and Retail REITs all experiencing the top 10 largest y/y increases in forward P/Es. The forward P/E for Automobile Manufacturers has increased by the most of all the S&P 500 industries, 205.9% y/y to 32.2, as production slowed and earnings fell due to a lack of semiconductor chips (Table 2). The industry’s shares, however, didn’t fall, as investors appear to be looking through the temporary parts-induced slowdown and giving the car companies more credit for their electric vehicle offerings.

Some of the largest increases in forward P/Es occurred in industries that resided in the Technology sector, including Electronic Equipment & Instruments (37.8% y/y to 29.0), Semiconductor Equipment (23.7, 20.6), Communications Equipment (14.1, 17.6), Application Software (8.3, 49.2), Semiconductors (5.6, 20.4), and Systems Software (4.0, 31.5).

(3) Materials and Energy earnings rise, P/Es fall. Industries in the Energy and Materials sectors have seen their forward P/Es drop the furthest over the past year, including Oil & Gas Exploration & Production (-94.7% y/y to 9.8), Integrated Oil & Gas (-80.4, 13.3), Oil & Gas Equipment & Services (-55.5, 17.9), Commodity Chemicals (-55.4, 7.5), Steel (-48.1%, 8.7), Oil & Gas Refining & Marketing (-33.2, 19.2), and Copper (-33.2, 10.4). Other industries that have seen their earnings increase faster than their stock prices include Apparel Retail (-36.1, 20.8), Homebuilding (-29.5, 8.0), and surprisingly Internet & Direct Marketing Retail, home of Amazon (-21.2, 54.1).

Even though the forward P/E of the Internet & Direct Marketing industry has fallen sharply over the past year, the industry continues to have one of the loftiest P/Es among S&P 500 industries. Here are the industries with the 10 highest forward P/Es: Health Care REITs (131.2), Airlines (87.4), Residential REITs (81.0), Casinos & Gaming (73.4), Hotels (66.8), Industrial REITs (59.2), Internet & Direct Marketing Retail (54.1), Office REITs (53.2), Specialized REITs (50.5), and Application Software (49.2).

(4) P/Es in the single digits. Among the S&P 500 industry indexes with the lowest forward P/Es are a couple of insurance industries and a number of very cyclical industries. Here are the 10 lowest P/E industries in the S&P 500: Oil & Gas Exploration & Production (9.8), Integrated Telecommunication Services (9.4), Drug Retail (9.2), Household Appliances (8.7), Steel (8.7), Life & Health Insurance (8.1) Reinsurance (8.1), Homebuilding (8.0), Alternative Carriers (8.0), and Commodity Chemicals (7.5).

Disruptive Technologies: Expanding mRNA Uses. Now that mRNA vaccines have proven to be effective against Covid-19, companies are investigating how to use mRNA and proteins to solve a diverse array of health problems. Under development are mRNA vaccines for the flu, HIV, and CMV. Scientists are also hoping that mRNA can be used to cure cancer, cystic fibrosis, and other ailments.

Moderna and BioNTech, known for their Covid-19 vaccines, are leading the way, followed by small biotech companies including Gritstone Oncology and Kernel Biologics as well as drug giants Pfizer, Sanofi, Gilead Sciences, and Merck.

Let’s take a look at how these companies are harnessing our cellular biology:

(1) Moderna: Curing Covid, cancer, and more. Moderna is using mRNA to restore the activity of missing enzymes responsible for various rare diseases like propionic acidemia, methylmalonic acidemia, glycogen storage disease type 1a, and phenylketonuria. It’s using mRNA to develop treatments for autoimmune diseases, and it plans to use mRNA to create vaccines for flu, HIV, and CMV, or cytomegalovirus, which leaves 6,000-7,000 babies with lifelong disabilities each year.

Moderna’s most ambitious plan is to use mRNA to stimulate a patient’s own immune system and fight cancer. First, it identifies the mutations in a patient’s cancer cells. It then loads mRNA with instructions for up to 34 mutations and injects it into the patient. Cells respond to the mRNA by creating portions of the proteins on their surface that look like the mutations in the cancer. When the patient’s immune cells come in contact with the mRNA-created proteins, the immune cells identify them as foreign. In the future, when the immune cells encounter the same proteins in the cancer cells, they know to kill the protein as well as the cancer cells. Moderna can create this personalized vaccine and deliver it in just a few weeks.

The company believes personalized cancer vaccines will work best when used when in combination of other treatments, so it’s partnering with Merck, which makes Keytruda. It’s also working with Merck on an mRNA vaccine that will generate and present KRAS neoantigens to the immune system in hopes of curing epithelial cancers, like non-small cell lung cancer, colorectal, and pancreatic cancers.

Moderna was added to the S&P 500 in July and has risen 534.3% over the past year.

(2) BioNTech targets malaria, cancer and more. Like Moderna, BioNTech is studying the use of mRNA to target and cure cancers including melanoma, prostate, breast, ovarian, and pancreatic cancers.

BioNTech is planning Phase 1 trials for a flu vaccine in Q3 using its Covid-19 technology and in partnership with Pfizer. By the end of 2022, it aims to begin trials for a malaria vaccine, which also uses mRNA technology. As part of that program, it plans to build vaccine production facilities in Africa. The company is also working with the Bill & Melinda Gates Foundation to develop therapies for tuberculosis and HIV.

(3) Lots of little guys researching. There are many startups working with mRNA to solve many different problems. Gritstone bio and Gilead Sciences are creating a mRNA vaccine to treat HIV. The company is conducting trials for its therapy treating colorectal, lung, and gastroesophageal cancers. Kernel Biologics is developing mRNA-based immunotherapies for cancer. Arcturus Therapeutics Holdings is using mRNA to develop vaccines for flu and Covid-19 as well as cures for cystic fibrosis and liver disease.

In some cases, the big drug companies are partnering with or buying these small biotech companies. Sanofi announced earlier this month that it plans to buy Translate Bio for $3.2 billion. The two companies are also looking at mRNA vaccines for several infectious diseases, and in June started a Phase I trial evaluating a possible mRNA-based vaccine against the flu. Translate is also testing an inhaled treatment for cystic fibrosis using mRNA.

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Speed Bumps & Headwinds

August 11 (Wednesday)

Strategy: Speed Bumps Ahead. So now what? The stock market has done a brilliant job of anticipating the current business cycle. The S&P 500 has had a V-shaped recovery since it bottomed on March 23, 2020. The economy has had a V-shaped recovery since it bottomed in April of last year. The same can be said about earnings.

The rally initially was relatively narrow and led by the S&P 500’s forward P/E, which jumped from 12.9 on March 23, 2020 to 23.2 on September 2 and has been hovering around 21.0 since then (Fig. 1). Along the way, S&P 500 forward earnings bottomed at $141.00 per share during the May 14 week of 2020 and has soared 50.0% since then to $211.49 during the August 5 week of this year (Fig. 2).

Debbie and I note that last year’s unprecedented two-month lockdown recession during March and April was followed by an unprecedented V-shaped recovery now that real GDP has fully recovered its lockdown freefall by Q2 (Fig. 3). Fiscal and monetary policymakers clearly are overheating the economy to achieve their goal of full employment by next year. In other words, their policies have put the current business cycle on a mind-altering cocktail of steroids and speed! We view it as the first ever “future-shock” business cycle.

But that was then, and this is now. The tailwinds behind the economy and stock market are diminishing, while the headwinds are growing stronger. Consider the following:

(1) Pandemic. There are 24 letters in the Greek alphabet. So far, the Covid-19 virus has morphed into the Delta variant. Lambda is another letter in the Greek alphabet. The Lambda variant was first identified in Peru in December. The World Health Organization designates Delta as a “variant of concern.” Lambda is designated a degree lower as a “variant of interest.” Lambda is not nearly as worrisome as Delta, which has been driving a rise in US cases nationwide; but early studies suggest that both variations have mutations that make them more transmissible than the original strain of the coronavirus.

Delta is spreading rapidly among unvaccinated people around the world. In the US, it may be leading the fourth wave of the pandemic, as the number of new positive results (using the 10-day average) has risen from 14,617 on July 2 to 87,143 on August 6 (Fig. 4). While some ICU units are seeing big increases in Covid patients, the overall number of hospital patients with the virus remains relatively low, though it is rising. The good news is that the number of deaths related to the pandemic remained relatively low at 2,334 on August 2 (Fig. 5).

The bad news about the Delta variant may be boosting the pace of vaccinations, which should be good news (Fig. 6). The US is currently averaging 486,332 people initiating vaccinations a day, which is a 10% increase over last week’s pace and the highest daily average since June 18, according to data published Monday by the Centers for Disease Control & Prevention. Just over half of the total population is fully vaccinated, and 31.2% of the vaccine-eligible population remains unvaccinated.

(2) Peak growth. Nominal GDP rose 16.7% y/y during Q2 (Fig. 7). That’s bound to be peak GDP growth for the current business cycle since GDP bottomed last year during Q2. The same can be said about real GDP growth, which was up 12.2% y/y during Q2 (Fig. 8).

And the same can be said about S&P 500 earnings growth, which was 48.3% y/y during Q1 and probably peaked around 85.0% during Q2 (Fig. 9). That is confirmed by the yearly percent change in S&P 500 forward earnings, which peaked at 41.9% y/y during May, edging down to 41.1% during July. It is also confirmed by the M-PMI, which was down a bit during July from its recent cyclical high during March. This index is highly correlated with the growth rate in S&P 500 earnings (Fig. 10).

A slowdown is coming in both GDP and earnings growth. However, that’s normal. It’s just the simple arithmetic of growth rates. The questions are: Will the slowdown bring growth back to pre-pandemic normal growth rates? Or will growth be abnormally high or low over the remainder of this year—and particularly next year when y/y comparisons should be more normal?

Debbie and I are in the back-to-normal camp, expecting real GDP to be up 3.0%-4.0% during the second half of this year and 2.5% next year. However, we expect to be raising our outlook for 2023 if we see better-than-expected productivity growth, consistent with our Roaring 2020s scenario. We are predicting that S&P 500 earnings will be up 46.7% this year, 4.9% next year, and 7.0% in 2023. (See YRI Economic Forecasts and YRI S&P 500 Earnings Forecast.)

(3) Parts shortages. The answers to the questions above will depend, in part, on whether parts shortages persist. In the August 5 Morning Briefing, Jackie and I observed, “Despite hopes that the semiconductor shortage would be resolved in 2H-2021, the tightness looks likely to continue at least through year-end.”

On August 3, General Motors warned that the chip shortage will cause it to idle three North American factories that make its highly profitable large pickup trucks. The chip shortage has slowed auto production, leaving dealers with slim inventories. Domestic auto and light truck production has dropped to 8.7 million units (saar) in June from 10.4 million units at the start of 2021 (Fig. 11). The domestic auto inventory-to-sales ratio has fallen to 0.8 from a long-term average of 2.5 (Fig. 12).

The good news is that when parts become more readily available, there will be lots of pent-up demand to boost economic growth. We can certainly see the pent-up demand in July’s M-PMI indexes for supplier delivers and backlog orders (Fig. 13).

(4) Labor shortages. Another major headwind for economic growth ahead is widespread labor shortages. The National Federation of Independent Business (NFIB) released its July survey yesterday. Small business owners across the US grew less confident in the economic recovery in July as labor shortages remained an issue, according to the survey. The NFIB Optimism Index fell 2.8 points to a reading of 99.7 in July, almost erasing all of June’s gain (Fig. 14). Six of the 10 index components declined, three improved, and one was left unchanged. “Small business owners are losing confidence in the strength of the economy and expect a slowdown in job creation,” Bill Dunkelberg, the NFIB’s chief economist, said in a statement.

Last week, the trade group said in its monthly jobs report that a record-high 49% of small business owners reported unfilled job openings in July on a seasonally adjusted basis (Fig. 15). The quality of labor ranked as businesses’ “single most important problem,” with 26% of respondents selecting it among 10 issues, near the survey high of 27%. Some 57% of respondents said they had few or no qualified applicants for open jobs in July, up one point from June.

By the way, Dunkelberg also observed: “As owners look for qualified workers, they are also reporting that supply chain disruptions are having an impact on their businesses. Ultimately, owners could sell more if they could acquire more supplies and inventories from their supply chains.”

(5) Peak liquidity growth. M2 monetary growth is slowing. It was up $2.2 trillion y/y during June, down from a record high of $4.2 trillion during February (Fig. 16). Melissa and I view this as just another peak-growth indicator, so it doesn’t worry us. It certainly isn’t a harbinger of a recession or abnormally weak economic growth ahead, as a few perma-bears have started to growl recently. Keep in mind that M2 was at a record $20.4 trillion during June, up $4.9 trillion from February 2020, just before the pandemic started (Fig. 17). It was equivalent to a near-record 89.3% of nominal GDP during Q2 (Fig. 18). There’s plenty of liquidity in the financial system to keep the economy growing and to drive stock prices higher.

(6) Taper-talking Fed. In the May 11 Morning Briefing, we wrote: “Melissa and I think that Fed officials will start thinking about tightening monetary policy around September or October.” Since then, doubts about that timeframe were raised by May’s weak payroll employment data. But June and July have come in strong, so now our schedule for the start of tapering looks reasonable.

More and more Fed officials have been distancing themselves from Fed Chair Jerome Powell’s no-rush-to-taper stance. The latest one was Fed Governor Christopher Waller. In an August 2 CNBC interview, he said, “In my view, with tapering we should go early and go fast in order to make sure we’re in position to rate rates in 2022 if we have to.”

(7) Taxing matters. Progressives are flexing their political muscles in Washington. On Monday, Senator Elizabeth Warren (D-MA) proposed an additional corporate profits tax rate of 7% on earnings above $100 million. She also proposed in March an ultra-millionaire tax on the wealth of the top 0.05% of American households.

US Economy: Productivity Rising. Unlike our outlooks for GDP and earnings, what Debbie and I expect in terms of productivity growth is that the peak rate is a few years off and could be twice the current pace. Indeed, we expect that the current decade will see one of the best productivity growth booms in US history. That’s why we call it the “Roaring 2020s.” Q2 productivity data was released yesterday. Here is a quick update:

(1) Productivity. On a year-over-year basis, nonfarm business productivity rose 1.9% during Q2 (Fig. 19). To get a better view of the underlying trend in this series, we prefer to look at the 20-quarter percent change at an annual rate (Fig. 20). It rose to 2.0%, up from 0.5% during Q4-2015. This is the series that we expect will double to 4.0% in coming years. We are certainly on the right track.

(2) Compensation. The growth rate in nonfarm business hourly compensation tends to be quite volatile. Skip the following paragraph if you want to be spared the details of what it includes:

Direct payments to labor include wages and salaries (including executive compensation), commissions, tips, bonuses, and payments in kind representing income to the recipients. Supplements to these direct payments consist of vacation and holiday pay, all other types of paid leave, employer contributions to funds for social insurance, private pension and health and welfare plans, compensation for injuries, etc. The compensation measures taken from establishment payrolls refer exclusively to wage and salary workers. Labor cost would be seriously understated by this measure of employee compensation alone in sectors such as farm and retail trade, where hours at work by proprietors represent a substantial portion of total labor input. The Bureau of Labor Statistics, therefore, imputes a compensation cost for labor services of proprietors and includes the hours of unpaid family workers in the hours of all employees engaged in a sector.

This comprehensive measure of hourly compensation was up just 2.0% y/y during Q2, down from 6.4% during Q1 and 8.5% during Q4-2020 (Fig. 21).

(3) Unit labor costs. Because productivity rose faster than hourly compensation, unit labor costs were flat with a year ago (Fig. 22). That augurs well of Powell’s “transitory” view of the current upturn in inflation.

 US Labor Market: Substantial Further Progress. In Fed Watching for Fun & Profit, I wrote: “The Fed chairs and their colleagues have tended to communicate their policy intentions by repeating certain keywords, like ‘gradual, ‘patient,’ and ‘appropriate.’ This word game has been going on for quite some time. Indeed, I sometimes suspect that the Fed has a wordsmith on staff. If so, this position was most likely created by Fed Chair Alan Greenspan. The role of the wordsmith is to come up with one word or a short phrase that best describes and communicates both the current stance and the future course of monetary policy. That word or phrase is then repeated in the FOMC statements and minutes, and by the Fed chair and other Fed officials regularly in their speeches and interviews. It is their monetary policy mantra.”

Since the December 16, 2020 FOMC Statement, the Fed’s mantra has been “substantial further progress.” That’s when the Fed specified that QE4ever bond purchases would be $120 billion per month “until substantial further progress has been made toward the Committee’s maximum employment and price stability goals.”

Are we there yet? Melissa and I think so, especially following the 1.9 million increase in payroll employment during June and July, with the unemployment rate down to 5.4%. Even more startling is that the number of job openings jumped to a record 10.1 million during June, exceeding the month’s 9.5 million unemployed workers (Fig. 23).

Here are the job openings among the major industries: total private (9.2 million); trade, transportation, & utilities (1.9); professional & business services (1.8); education & health services (1.7); leisure & hospitality (1.6); retail trade (1.1); manufacturing (0.8); and construction (0.3).

As noted above, Fed Governor Waller thinks that further substantial progress has been achieved and that it is time to start tapering. In his interview cited above, he said, “My concern is just anecdotal evidence I’m hearing from business contacts, who are saying they’re able to pass prices through. They fully intend to. They’ve got pricing power for the first time in a decade … Those are the sorts of issues that make you concerned that this may not be transitory.”

Waller’s concerns were confirmed in the NFIB survey, which showed that, during July, 46% of small business owners were raising prices, while 44% were planning to raise them (Fig. 24).

Correction. In yesterday’s Morning Briefing, the fertility rate for India should have been stated at 2.2, not -0.2.

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Voluntary Self-Extinction Of the Human Race

August 10 (Tuesday)

Demography I: VHEMT. The Voluntary Human Extinction Movement (VHEMT), founded in 1991, believes that human extinction is the best way to solve the Earth’s climate-change problem. The motto displayed on their website is “May we live long and die out,” and they sell t-shirts stating, “When You Breed, the Planet Bleeds” and “Thank You for Not Breeding.” Sure enough, the pace of human breeding has slowed, but for reasons that have nothing to do with the VHEMT.

Fertility rates have dropped below the population replacement rate almost everywhere around the world as a result of urbanization. Why would urbanization lower fertility rates? Families are likely to have more children in rural communities than urban ones. Housing is cheaper in the former than in the latter. In addition, rural populations are much more dependent on agricultural employment; their children are likely to be viewed as economic contributors once old enough to work in the field or tend the livestock. Adult children are expected to support and care for their extended families by housing and feeding their aging parents in their own huts and yurts. In urban environments, children tend to be expensive to house, feed, and educate. When they become urban-dwelling adults, they are less likely to welcome an extended family living arrangement together with their aging parents in a cramped city apartment.

In my opinion, the urbanization trend since the end of World War II was attributable in large part to the “Green Revolution.” The resulting productivity boom in agriculture eliminated lots of jobs and forced small farmers to sell their plots to large agricultural enterprises that could use the latest technologies to feed many more people in the cities with fewer workers in the fields. Ironically, then, the Green Revolution provided enough food to feed a population explosion, but the population instead moved from the farms to the cities and had fewer kids!

In other words, technological innovation has been boosting productivity in agriculture significantly in recent decades. The result has been migration from rural to urban areas, where children are all cost and no benefit in economic terms. Some may represent economic benefit to their parents in an urban setting, those that get jobs and support their parents in their old age. However, young adult children are less prone to do so the more that the elder care of their parents is outsourced to the government.

Demography II: Pandemic & Climate Change. How might the pandemic and climate change affect the global demographic outlook? The initial impact of the pandemic seems to be a further decline in fertility rates around the world. Uncertainty about the health and economic consequences of the pandemic seem to have convinced many couples to postpone having babies. Contributing to their caution about having children might be similar uncertainty and concerns about the effects of climate change on their lives as well. Widespread extreme weather events such as devastating floods, massive wildfires, and droughts are likely to increase anxiety about climate change.

Indeed, on Monday, the United Nations’ (UN) Intergovernmental Panel on Climate Change (IPCC) issued its Sixth Assessment Report (AR6), titled Climate Change 2021. Here are a few of the report’s distressing conclusions:

(1) “It is unequivocal that human influence has warmed the atmosphere, ocean and land.”

(2) “The scale of recent changes across the climate system as a whole and the present state of many aspects of the climate system are unprecedented over many centuries to many thousands of years.”

(3) “Human induced climate change is already affecting many weather and climate extremes in every region across the globe. Evidence of observed changes in extremes such as heatwaves, heavy precipitation, droughts, and tropical cyclones, and, in particular, their attribution to human influence, has strengthened since AR5.”

(4) “Global surface temperature will continue to increase until at least the mid-century under all emissions scenarios considered. Global warming of 1.5°C and 2°C will be exceeded during the 21st century unless deep reductions in CO2 and other greenhouse gas emissions occur in the coming decades.”

(5) “Many changes in the climate system become larger in direct relation to increasing global warming. They include increases in the frequency and intensity of hot extremes, marine heatwaves, and heavy precipitation, agricultural and ecological droughts in some regions, and proportion of intense tropical cyclones, as well as reductions in Arctic sea ice, snow cover and permafrost.”

(6) “Many changes due to past and future greenhouse gas emissions are irreversible for centuries to millennia, especially changes in the ocean, ice sheets and global sea level.”

Almost all countries have signed the 2015 Paris climate accord, which aims to limit global warming to an increase of 2 degrees Celsius (3.6 Fahrenheit) above the pre-industrial average by 2100. The agreement says that ideally the increase would be no more than 1.5 degrees Celsius (2.7 degrees Fahrenheit). But the IPCC report’s 200-plus authors looked at five scenarios, and all concluded that the world will cross the 1.5-degree threshold in the 2030s—sooner than previous predictions. Three of those scenarios also involve temperatures rising 2 degrees Celsius.

UN Secretary-General António Guterres described the report as “a code red for humanity.” Guterres added, “The alarm bells are deafening, and the evidence is irrefutable: greenhouse gas emissions from fossil fuel burning and deforestation are choking our planet and putting billions of people at immediate risk.” In just the last few weeks, floods have wreaked havoc in Europe, China, and India; toxic smoke plumes have blanketed Siberia; and wildfires have burned out of control in the US, Canada, Greece, and Turkey.

The global fertility rate is likely to remain below the population replacement rate for the foreseeable future as a result of urbanization, the pandemic, and climate change.

Demography III: MMT to the Rescue. In addition to having fewer babies, people are living longer almost everywhere. That is also making demographic profiles more geriatric around the world, which is pressuring governments to borrow more and accumulate more debt to provide retirement support programs for their rapidly increasing senior cohort. Their central banks have provided plenty of monetary accommodation to enable increased deficit-financed government spending. This development was greatly accelerated by the pandemic, as governments rushed to provide lots of additional monetary and fiscal stimulus to revive economic growth following the lockdown recessions imposed to enforce social distancing.

The result has been a mix of monetary and fiscal policies that can best be described as “Modern Monetary Theory (MMT) in practice.” MMT postulates that a government that issues its own currency can run much larger budget deficits to fund fiscal spending than generally believed, especially if the central bank provides accommodative monetary policies by keeping interest rates low and purchasing the government’s bonds. That seems like a sure way to boost inflation. Sure enough, inflation has increased in recent months in the US, though the jury is out on whether this is just a “transitory” pandemic-related development as Fed Chair Jerome Powell claims or a longer lasting one.

In any case, could it be that MMT actually is the right policy response to the voluntary self-extinction of the human race in countries like Japan, where fertility rates remain below the population replacement rate? The Japanese government and the Bank of Japan (BOJ) joined the battle against demographically induced deflation many years ago with MMT. Consider the following:

(1) Demographics and debt. Japan has a rapidly declining and aging population. The total population has decreased by 2.4 million since July 2007 through July of this year, while the population aged 15 years and older is down 0.2 million over the period through June, less than the total population has dropped because people are living longer (Fig. 1). The percentage of seniors 65 years old and older has increased from 25.0% of the total population during October 2013 to 29.0% during July of this year (Fig. 2).

The 12-month sum of deaths has exceeded births since July 2007, with deaths at a record high of 1.16 million and births at a record low of 0.68 million through March (Fig. 3). The 12-month sum of marriages dropped to a record-low 493,807 during February, moving up to 517,294 in March—which was down from 613,237 a year ago (Fig. 4). The growth rate of the labor force peaked recently at 2.2% during November 2018. The labor force has been essentially flat between 65 million and 70 million since the mid-1990s (Fig. 5)!

The Japanese government has been running huge budget deficits for many years, mostly to offset the deflationary consequences of Japan’s rapidly aging demographic profile. In effect, the government has been building bridges and roads to nowhere that nobody needs because old people don’t venture out much. As a result, the national government debt has skyrocketed from 50% of nominal GDP during 1993 to 225% during Q1-2021 (Fig. 6).

(2) Monetary policy. The BOJ first introduced its zero-interest-rate policy at the start of 1999. During the first half of the 2000s, the BOJ implemented its first round of quantitative easing (QE), resulting in a 69% increase in the monetary base. The BOJ’s second round of QE started during April 2013 and continues to this day. The monetary base has increased 336% since then through July of this year (Fig. 7). The ratio of the national government debt to the monetary base has dropped from 7.2 to 1.9 this May (Fig. 8).

(3) Negative bond yields. Japan’s 10-year government bond yield has been hovering around zero since mid-2016 (Fig. 9). And by the way, the yield in Germany, which also has a very geriatric demographic profile, has been negative since May 2019. The geriatric trend in global demographic profiles does support a case for negative nominal and real interest rates if the trend leads to a combination of slow economic growth and deflation. Negative interest rates on that debt might reflect the voluntary self-extinction of the human race attributable to the collapse of fertility rates around the world. Dwindling populations, particularly of younger people, will put downward pressure on the prices of real assets, owing to less demand for them.

(4) Bottom line. All of the above implies that the BOJ in effect embraced MMT many years ahead of the other major central banks, which did so only after the pandemic started early last year. Yet inflation remains remarkably subdued near zero in Japan (Fig. 10). Japan may very well be a trend setter for other governments that have embraced MMT to offset the contractionary and deflationary impacts of the pandemic, climate change, and their increasingly geriatric demographic profiles.

Demography IV: The World According to Garp. John Irving’s best-selling novel The World According to Garp (1978) is a strange story about a man born out of wedlock to a feminist icon. T.S. Garp was his mother’s only child. That’s half as many children per couple as required for population replacement. In most of our similarly demographically dysfunctional world, humans are not having enough babies to replace themselves. A few places represent significant exceptions, such as India and Africa. Working-age populations are projected to decline along with general populations in coming years in Asia (excluding India), Europe, and Latin America. The US has a brighter future, though the pace of its population growth is projected to slow significantly in coming years. Consider the following:

(1) World fertility. The world fertility rate was around 5.0 children per woman in the mid-1950s through the 1960s (Fig. 11). It dropped to 2.5 by 2016. The UN projects that it will fall to 2.0 by the end of this century. Many countries are already below 2.0. Here is a selection of them with their fertility rates during 2020: US (1.8), Japan (1.4), Germany (1.6), France (1.9), Spain (1.3), Italy (1.3), UK (1.8), China (1.7), India (2.2), Russia (1.8), Asia (2.2), Africa (4.4), and Latin America (2.0). (See our Global Demography: Fertility Rates.)

(2) World population. The world population is expected to grow by 3.1 billion from 2020 through 2099, reaching 10.9 billion (Fig. 12). However, the annual growth rate is projected to decline from 1.1% during 2020 to half that by mid-century and nearly zero by the end of the century (Fig. 13). Here is a selection of the latest available population growth rates during 2020 and the projections for 2050: US (0.6%, 0.3%), Japan (-0.3, -0.7), Germany (0.3, -0.3), France (0.2, -0.1), Spain (0.0, -0.5), Italy (-0.1, -0.6), UK (0.5, 0.2), China (0.4, -0.4), India (1.0,0.2), Russia (0.0, -0.2), Asia (0.9, 0.1), Africa (2.5, 1.7), and Latin America (0..9, 0.2). (See our Global Demography: Population Growth Rates.)

(3) World working-age populations. As a result of the global birth dearth in recent years, working-age populations have peaked or will soon peak around the world. Here is a selection of the percent changes in working-age populations from 2020 through 2050: US (7.7%), Japan (-28.3), Germany (-16.2), France (-5.1), Spain (-27.5), Italy (-26.1), UK (1.2), China (-17.2), India (19.7), Russia (-15.5), Asia (8.0), Africa (106.0), and Latin America (11.0). (See our Global Demography: Working-Age Population.)

(4) World urbanization. There are many explanations for the decline in fertility rates around the world to below the population replacement rate—estimated to be 2.1 children born per woman in developed countries and higher in developing countries, where mortality rates are higher. I believe that the most logical explanation is urbanization. The UN estimates that the percentage of the world population living in urban communities rose from 30% in 1950 to 53% during 2013. This percentage is projected to rise to 66% by 2050 (Fig. 14). Here is a selection of urbanization rates during 2020 and projected for 2050: World (56%, 66%), US (83, 87), Europe (75, 82), Africa (43, 56), Latin America (81, 86), China (61, 76), and India (35, 50) (Fig. 15).

(5) Government incentives. Some governments are starting to provide incentive for couples to have more babies, but without much success so far. In 1980, China introduced a one-child policy to slow its surging population growth. The government limited most urban couples to one child and rural couples to two if their firstborn was a girl. China officially ended its one-child policy on January 1, 2016, when the country, trying to cope with an aging population and shrinking workforce, passed a law allowing all married couples to have a second child. On May 31, 2021, the limit was raised to three children.

The policy change comes with “supportive measures” including lower educational costs for families, stepped up tax and housing support, strengthened legal protections for working women, a clamp down on “sky-high” dowries, and “marriage and love” education for young people.

Demography V: Birth Dearth & Senior Surplus. Debbie and I are optimistic about the outlook for productivity growth in the US because we are pessimistic about the outlook for labor force growth, which the pandemic has worsened, at least over the short run. Since early last year, births have declined and deaths have increased. More seniors have been retiring. The population under 16 years old isn’t growing, reflecting the downward trend in births since early 2008. The resulting shortage of workers is driving wages up at a faster pace, which is already forcing companies to scramble to boost their productivity.

The average age of Americans is increasing. Older consumers are more likely to resist price increases than younger ones. That makes it harder for companies to pass wage costs through to selling prices—all the more reason to boost productivity. Consider the following facts of life and death:

(1) Births and deaths. The 12-month sum of births fell through March to 3.6 million, the slowest pace since August 1980 and down from a record high of 4.3 million during February 2008. Over the same period through March, the number of deaths totaled 3.5 million, which is a record since the start of the monthly data in December 1972 (Fig. 16).

Based on the 12-month sums, births are down 180,000 since one a year ago, while deaths are up 636,000 since a year ago. The difference between births and deaths, on a 12-month basis, fell almost to zero through March.

(2) Seniors. The oldest Baby Boomers turned 65 years old in 2011. Since January of that year through January 2020, the population of seniors has increased by 17.1 million to 56.2 million (Fig. 17). It is up 1.6 million over the past 12 months. Quite a few of them stayed in the labor force. The number of seniors in the labor force (ILFs) rose 3.4 million from January 2011 through July 2021, while the number not in the labor force (NILFs) rose 13.7 million over that same period.

The trends may be changing as a result of the pandemic and the aging of the Baby Boomers, the oldest of which turn 75 years old this year. From January 2020 through July of this year, the population of seniors and the number of senior NILFs increased 2.4 million and 3.2 million, respectively, while the number of senior ILFs fell 645,000. The labor force participation rate of seniors was down to 18.3% during July from a recent peak of 20.8% during February 2020 (Fig. 18).

(3) Youngins. The populations aged 0-15 years old and 16-24 years old have been essentially flat for the past two decades. The labor force hasn’t been replenished by a crop of more young people. Instead, it’s been boosted by senior Baby Boomers working longer. But now they are dropping out of the labor force either because they are retiring or because they’re passing away.

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Man of La Mancha

August 09 (Monday)

YRI Podcast. In our latest video podcast, Dr. Ed discusses the main points of today’s Morning Briefing.

Back from Spain. My wife and I vacationed in Spain last week. We both have had our Pfizer Covid-19 shots for a while now, which only intensified the cabin fever we contracted during last year’s lockdowns. So notwithstanding the Delta variant, we ventured off to Spain. Before we flew back home, we had to take a Covid test, which we passed. So we are back in the USA. Our Plan B, had we flunked our tests and been denied reentry, was to rent a house on the beach in Porto, Portugal.

The first thing we did after landing in Madrid was to head to Zaragoza for a great tapas lunch. Zaragoza is the capital of Spain’s Aragon region, which is very desert-like and very windy. Fields of wind turbines dotted both sides of the highways we took. Don Quixote would have had a field day. We then visited Pamplona, which is famous for the annual Running of the Bulls during the San Fermin festival. It was cancelled this year because of the pandemic. We might go back to see it next year during July 7-14. Given my year-end 2022 target of 5000 for the S&P 500, I expect to be running with the bulls next year.

Our tour included visiting Bilbao, León, Santander, and Segovia. They are all very beautiful cities, immaculately maintained, with magnificent old towns, cathedrals, palaces, plazas, and lots of outdoor cafés serving delicious pinchos. Segovia’s ancient aqueduct is very impressive and a reminder of the ancient Romans’ remarkable knack for building future tourist attractions in their empire.

Strategy: Running of the Bulls. While the Running of the Bulls was cancelled in Pamplona this summer, the bulls are still running on Wall Street. The S&P 500 rose to yet another record high on Friday. It closed at 4436.52, up 18.1% ytd and 98.3% from last year’s March 23 low. A week ago, Joe and I did the math and came up with a year-end 2022 target of 5000 for the S&P 500. Let’s take stock of the stock market’s latest performance:

(1) Blue Angels. The S&P 500 price index is equal to S&P 500 forward operating earnings per share (E) multiplied by the S&P 500 forward price-to-earnings ratio (P/E). E is equal to S&P 500 forward revenues (R) multiplied by the forward profit margin (Fig. 1). During the week of July 29, R rose 13.6% y/y to another record high, while E jumped 42.2% y/y to another record high of $212.68 per share. The forward profit margin was 13.1%, remaining at its recent record high.

The forward P/E was 20.9 on Friday (Fig. 2). It had soared from last year’s low of 12.9 on March 23 to a high of 23.2 on September 2. It has been hovering around 21.0 since then.

Joe and I monitor the relationship between PE x E and the S&P 500 with our Blue Angels framework. It shows that last year’s rebound in stock prices was led by the P/E until E bottomed during the week of May 15, 2020 (Fig. 3). E is up 50.8% since then, while the S&P 500 is up 54.9% over the same period. In other words, the remarkable rebound in forward earnings has been leading the bull market’s charge since last spring and continues to do so. On a y/y basis, the S&P 500 is up 32.3%, with E up 42.2% and the P/E down 5.2% (Fig. 4).

(2) Quarterly and annual earnings. Meanwhile, this year’s quarterly S&P 500 earnings continue to stampede over the consensus forecasts of industry analysts. The Q1 results were 23.6% better than they expected at the start of that quarter’s earnings reporting season (Fig. 5). The latest blend of actual and estimated results for Q2 during the July 29 week is 13.5% above the consensus estimate before the start of the latest season. The latest y/y earnings growth rate for Q2 is 82.1% (Fig. 6).

As a result, industry analysts have been raising their Q3 (now up 26.9% y/y) and Q4 (19.8%) earnings-per-share estimates for this year as well as for each of 2022’s quarters (Fig. 7). Here are their latest annual estimates: 2021 ($200.53), 2022 ($221.59), and 2023 ($239.69) (Fig. 8). Industry analysts now are expecting earnings to grow 43.8% this year, 9.5% in 2022, and 8.2% in 2023 (Fig. 9). They are expecting revenues to grow 14.0% this year, 6.6% next year, and 5.1% in 2023 (Fig. 10). As a result, they are projecting that the profit margin will increase from 12.9% this year to 13.2% in 2022 and 13.8% in 2023 (Fig. 11).

(3) Sectors. The rebound in forward earnings is widespread among the 11 sectors of the S&P 500 (Fig. 12). At new record highs during the July 29 week were Consumer Discretionary, Consumer Staples, Health Care, Information Technology, and Materials. Just as impressive has been the rebound in the forward profit margins of the sectors (Fig. 13). In our opinion, this confirms that companies have been responding to the pandemic by accelerating their use of technological innovations to boost productivity, offsetting the higher costs resulting from soaring commodity prices and shortages of labor and parts.

(4) LargeCaps vs SMidCaps. The rebound in the forward earnings of the S&P 400/600 SMidCaps has outpaced that of the S&P 500 since last spring (Fig. 14). However, the LargeCaps have outperformed the SMidCaps since March 15 this year. The recent spreads between the forward P/Es of the former to the latter have never been wider, at around 3.5ppts (Fig. 15). In our opinion, SMidCaps are very attractive.

(5) Growth vs Value. The ratio of the forward earnings of S&P 500 Growth to S&P 500 Value soared last year but has been relatively flat since last September (Fig. 16). That’s reminiscent of what occurred during and after the Great Financial Crisis. That suggests that the currently very wide spread (11.7ppts) between the forward P/Es of Growth (28.4) and Value (16.7) may be too wide (Fig. 17). Growth includes lots of fast growing technology companies. But Value includes many companies that are using technology to boost their productivity and profit margins.

(6) Stay Home vs Go Global. While my wife and I ventured abroad last week for a sightseeing vacation in Spain, Joe and I continue to favor the Stay Home investment strategy over Go Global. It underperformed a bit last week, but the ratios of the US MSCI to the All Country World MSCI (in both dollars and local currencies) remain on solid upward trends that began in 2010 (Fig. 18).

US Economy: Not as Hot? The S&P 500 stock price index on a y/y basis is highly correlated with the manufacturing PMI (Fig. 19). That’s because the M-PMI is highly correlated with the y/y growth rate in S&P 500 revenues (Fig. 20). The M-PMI peaked at a cyclical high of 64.7 during March. It was back down to 59.5 during July, in line with previous cyclical peaks in this index. The M-PMI is a diffusion index that reflects the m/m comparisons of business conditions by purchasing managers. Its recent weakness may be reflecting a cooling in economic activity, though Debbie and I doubt that.

More likely, it reflects labor and parts shortages. That’s confirmed by the M-PMI supplier deliveries and backlog of orders indexes, which remained elevated during July at 72.5 and 65.0 (Fig. 21). The M-PMI customer inventory index fell to a record low of 25.0 during the month (Fig. 22). The imbalance between supply constraints and strong demand is confirmed by the average of the unfilled orders or delivery times indexes in the five regional business surveys conducted by the Federal Reserve Banks (Fig. 23).

There’s also plenty of forward momentum in durable goods orders excluding transportation (Fig. 24). It rose to yet another record high during June, exceeding the pre-pandemic February 2020 reading by 17.2%.

Oh, and by the way, the NM-PMI rose to a record high during July. It was 64.1, which topped the June reading by 4 percentage points and eclipsed the previous record of 64.0 in May 2021.

US Labor Market: Getting Hotter. Friday’s employment report confirmed that the labor market—which has been one of the few laggards in the recovery from last year’s lockdown recession—is getting hotter. Payroll employment jumped 943,000 during July, and June and May preliminary numbers were revised higher by a total of 119,000. The household measure of employment soared 1.0 million, led by a 1.3 million increase in full-time employment. The unemployment rate fell to 5.4% during July from 5.9% the month before. The number of unemployed fell 782,000 to 8.7 million, the lowest reading since March 2020. Job openings remain plentiful for those who remain jobless. Indeed, part-time employment for economic reasons fell to 4.5 million, the lowest since February 2020.

Importantly, our Earned Income Proxy (EIP) increased solidly by 0.9% m/m during July to another record high (Fig. 25). Our EIP is highly correlated with wages and salaries in personal income. Consumers have the wherewithal to keep spending. If many of them are still suffering the aftereffects of cabin fever from last year’s lockdowns, then they should continue to spend.

US Inflation: Warming or Cooling? The 10-year US Treasury bond yield rose last week from a recent low of 1.19% on Tuesday and Wednesday to 1.31% on Friday. More Fed officials are distancing themselves from Fed Chair Jerome Powell’s no-rush stance on tapering the Fed’s bond purchases. Friday’s employment report certainly suggests that enough “further substantial progress” has been made to start tapering sooner rather than later.

Increasing the heat on the Fed to taper are plenty of inflation indicators, which have yet to confirm the “transitory” nature of the post-pandemic inflation story that Powell has been telling. Consider the following:

(1) National prices-paid indexes. The M-PMI prices-paid index edged down from a cyclical high of 92.1 during June to 85.7 during July (Fig. 26). That’s still very hot. The NM-PMI prices-paid index inched up to 82.3 last month, the highest reading since September 2005. The average of the five regional business surveys conducted by Federal Reserve Banks showed that the prices-paid index slipped from a record high of 84.1 during May to 81.9 during July (Fig. 27). On the other hand, the regional average of the five prices received indexes rose to a record high of 49.7 last month.

(2) Commodity prices. Both the CRB all commodities index and the CRB raw industrial spot price index remain on their near-vertical trajectories of the past year or so (Fig. 28).

(3) Wages. Notwithstanding the many stories about widespread labor shortages, most of the upward pressure on wages so far has been occurring in only two major industries, namely leisure & hospitality and transportation & warehousing. This can best be seen in the annualized three-month percent changes in average hourly earnings (AHEs) through July. The total index rose 4.9%, which isn’t particularly alarming, especially if productivity is making a comeback too (Fig. 29).

Here are the results for the major industries from highest to lowest: leisure & hospitality (15.7%), transportation & warehousing (12.1), professional & business services (7.1), manufacturing (5.6), other services (5.2), retail trade (4.8), financial activities (4.8), wholesale trade (4.6), construction (4.2), utilities (3.7), education & health services (3.4), natural resources (3.1), and information services (-0.3).

Movie. “The Titans That Built America” (+ + +) (link) is a History Channel docudrama series about the remarkable entrepreneurs who transformed American industry after World War I. The new generation of Titans included Pierre Du Pont, Walter Chrysler, JP Morgan Jr, Henry Ford, and William Boeing. They literally drove the prosperity of the Roaring 1920s by inventing the auto industry. However, FDR attacked them as “economic royalists” to get elected as president and blamed them for the Great Depression. He then had to do an about-face when he needed their skills to build an “arsenal of democracy” to defeat Hitler. They did so, producing tens of thousands of bombers and other weapons. One of the remarkable heroes of this story is Edsel Ford.

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Semis, Travel & Digital Dollars

August 05 (Thursday)

Semiconductors: Shortages Continue. Investors keep looking for a sign that the semiconductor cycle has peaked—so far, for naught. The Semiconductor Industry Association’s (SIA) report on June worldwide sales showed continued robust growth, while companies that make semiconductors describe Q2 demand levels that they’re unable to meet with supply. Let’s take a closer look:

(1) Auto companies scrounging for semis. Despite hopes that the semiconductor shortage would be resolved in 2H-2021, the tightness looks likely to continue at least through year-end. Stellantis NV reiterated on Tuesday that the semiconductor shortage would continue to hurt its production. Also on Tuesday, General Motors noted that the chip shortage will cause it to idle three North American factories that make its highly profitable large pickup trucks, an August 3 WSJ article reported.

The chip shortage has caused auto production to slow, leaving dealers with slim inventories. Domestic auto and light truck production has dropped to 8.7 million units (saar) in June from 10.4 million units at the start of 2021 (Fig. 1). The domestic auto inventory-to-sales ratio has fallen to 0.8 from a long-term average of 2.5 (Fig. 2).

(2) Chip companies see tightness continuing. NXP Semiconductors and ON Semiconductor both reiterated on Q2 earnings conference calls this week that strong demand is outpacing supply of semiconductors.

Product supply was a “challenge” in Q2, and it will remain so for the “foreseeable future,” said NXP CEO Kurt Sievers in the August 3 conference call. “With customer demand outstripping current supply, a situation that we see across all our end markets, we are working diligently to secure additional supply to achieve a healthy balance of demand versus supply.”

Sievers discussed the growing number of semiconductors in cars, particularly in electric vehicles (EVs), which have twice as many chips as conventional vehicles. Since just-in-time method inventory management has proved incompatible with semiconductors’ three- to six-month manufacturing cycle, he believes customers want to hold additional inventory on hand but can’t right now. There’s no extra inventory available to hold.

NXP’s Q2 revenue rose 43% y/y, its adjusted Q2 operating income jumped 121% y/y, and the company forecasts Q3 revenue will jump 26% y/y. It sells semis into the industrial, Internet of Things, auto, mobile, and communication infrastructure markets.

ON Semiconductor also posted a strong Q2, with revenue jumping 38% y/y and adjusted operating earnings soaring 449.4% to $275.8 million. Adjusted earnings per share of 63 cents beat analysts’ consensus estimate of 49 cents, and the company’s Q3 forecast was higher than analysts’ forecasts. ON shares rallied 11.7% on Monday.

“The strong demand that we have seen over the last few quarters continues to outpace our ability to supply certain products, especially those manufactured by our foundry partners. Based on current booking trends and macroeconomic outlook, we expect that the demand will continue to outpace supply through the first half of next year,” said ON CEO Hassane El-Khoury in the August 2 conference call.

El-Khoury also highlighted demand from the auto industry, noting the company’s success supplying power management chips for EVs and chips used in safety features, such as image sensors and ultrasonic sensors. He added that sales into the cloud server market and the industrial automation space were strong, benefitting from machine vision and scanning applications.

While analysts were concerned that customers might be double ordering to ensure they received product, both CEOs claimed it wasn’t occurring. Moody’s Investors Service highlighted the risk that China’s efforts to dominate the semiconductor market could lead to overcapacity in certain chips, an August 2 South China Morning Post (SCMP) article reported. The ratings agency compared the country’s push to expand semiconductor manufacturing to the push it made to expand the manufacturing of solar photovoltaic equipment in the early 2010s. That effort led to overcapacity, price declines, drops in profit, and bankruptcies in the domestic solar market. It will certainly be an area to monitor.

(3) Semi sales still robust. Global semiconductor sales in June rose 29.2% y/y and 2.1% m/m using a three-month moving average, according to the SIA’s latest report. June’s m/m sales were broad based, rising in all geographic areas: Americas (5.4%), Japan (2.5), Europe (2.0), China (1.1), and Asia Pacific/All Other (1.0) (Fig. 3). The industry’s strength is confirmed by the steady increase in production of semiconductor and other electronic components to new record highs this year (Fig. 4).

Analysts have sharply revised upward their expectation for S&P 500 Semiconductors revenue and earnings growth. The industry’s revenues are expected to jump 18.9% this year and 8.6% in 2022. That’s far higher than estimates at the start of 2021: 8.9% and 8.3% (Fig. 5). Likewise, earnings are forecast to climb 30.4% this year and 12.7% in 2021, compared to estimates of 14.6% and 15.5% as 2021 began (Fig. 6).

With the industry’s factories running near full capacity, margins have improved sharply, nearly reattaining their peak of 32.2%, in 2018 (Fig. 7).

The S&P 500 Semiconductors stock price index has responded to the strong market for semiconductors, climbing 19.4% ytd through Tuesday’s close and modestly outpacing the S&P 500’s 17.8% gain (Fig. 8). The S&P 500 Semiconductor Equipment stock price index has climbed an even more impressive 39.1% ytd (Fig. 9). It’s expected to grow earnings 54.5% this year and 15.9% in 2022 (Fig. 10).

Travel: Wary Optimism. There has been a nice rebound in all manner of travel as people crave vacations somewhere beyond their newly decorated backyards. Activity hasn’t returned to 2019 levels, but it has certainly improved from the dark days of 2020. The arrival of the Delta variant of Covid-19 will test those gains, as it appears to be infecting and spread by both vaccinated and unvaccinated individuals. Here’s a quick look at some recent Covid data and travel statistics as well as Q2 earnings reports from Marriott International and Royal Caribbean Group:

(1) Delta proves challenging. The Centers for Disease Control and Prevention (CDC) reports that three-quarters of the 469 people infected with Covid-19 during an outbreak in a Cape Cod town were fully vaccinated. Of those 346 vaccinated individuals infected, 274 had symptoms; but only four hospitalizations and no deaths were reported, according to a July 30 CNBC article. The Delta variant was present in 90% of specimens taken from 133 patients. The findings led the CDC to issue renewed recommendations to wear masks indoors.

Since there were no deaths among the vaccinated, it’s possible that the recovery in travel activity will continue now that we’ve all had a taste of post-Covid freedom. But as we saw in the first go-around, travel may be determined by rules imposed by local politicians. The New York International Auto Show, scheduled to start August 20, was canceled Wednesday. Organizers cited concerns about Delta and Mayor Bill de Blasio’s mandated vaccinations for a range of indoor activities beginning August 16.

(2) Travelers hitting the road and the skies. As we can all tell by increased traffic on highways, individuals have returned to the roads. The amount of gasoline supplied in the US rose in July to 9.5 mbd based on a four-week moving average. That’s just shy of 2019’s level of 9.6 mbd (Fig. 11).

Air travel has also enjoyed a sharp rebound, but activity has not completely returned to pre-Covid levels. A total of 1.8 million people passed through TSA checkpoints on August 3, up sharply from the same day in 2020 when only 543,601 passengers passed through. This year’s traffic, while improved, still remains noticeably below the 2.4 million passengers who flew on August 3, 2019, prior to the pandemic (Fig. 12).

(3) Where are travelers staying? Travelers must be staying with family and friends, because the number of guests at hotels has not completely recovered from 2020 lows. Marriott International reported that its worldwide occupancy rate climbed to 50.8% last quarter, up 32.8 percentage points from last year but still 24.1 percentage points below 2019 levels. Its total US occupancy topped 63% in June, held back by a slower recovery in business and group bookings. The hotel company also said that comparable systemwide revenue per available room rose 262.6% worldwide from a year earlier but remained 43.8% below 2019 levels, an August 3 WSJ article reported.

The number of people taking a cruise has also improved, but remains far from a full recovery. Royal Caribbean Group reported that it’s operating 29 ships, representing 42% of its total capacity, and by year-end it hopes to have 80% of its capacity back in service. Management reported seeing “a modest impact on closer-in bookings” due to the Delta variant, but 2022 bookings remain strong. The company, which reported a larger-than-expected Q2 adjusted loss of $5.06 a share, didn’t offer a Q3 earnings forecast beyond saying it expects to incur a net loss. Royal’s shares have hit rough seas, falling from $96.98 in June to $74.49 as of Tuesday’s close.

Disruptive Technologies: Digital Currency Developments. If countries hope to compete with cryptocurrencies, then they’ll have to digitize their own currencies. So far, China appears to be the furthest ahead in developing a digital currency, while the Federal Reserve is taking its sweet time. Let’s take a trip around the world to see what progress central bankers are making:

(1) BOC: Testing underway. Among the world’s large nations, China appears to be the furthest along in developing a digital currency. The digital yuan is currently distributed only by state-owned banks, a July 8 Bloomberg article published by the SCMP reported. Trials are occurring in 10 cities, including Beijing, Chengdu, Shanghai, and Shenzhen. Over the past two years through June, 34.5 billion digital yuan ($5.3 billion) had been spent in 70.8 million transactions.

Next step: Foreigners visiting for the 2022 Winter Olympics will be able to test the digital yuan without having a local bank account. “During next year’s Winter Olympics, self-service carts, vending machines and stores will be authorised to issue wearable payment devices such as gloves, badges and clothes that will allow easy use of the digital yuan,” a July 16 SCMP article reported.

It looks like China will continue to tightly control its currency, even if it goes digital. The digital yuan cannot be used for cross-border payments, only domestic transactions, though the country has started “technical testing” with Hong Kong and is collaborating with Thailand and the United Arab Emirates. Before the digital yuan can be officially adopted, the People’s Bank of China needs to revise its laws to give the digital yuan legal status and the digital yuan’s impact on domestic monetary transmission and financial stability needs to be studied, the SCMP article noted.

The advent of the digital yuan threatens to replace the digital payment systems that most Chinese citizens use, Ant Group’s Alipay and Tencent Holdings’ WeChat Pay. Both companies are participating in testing the digital yuan, but China’s banks were given a head start in the testing, a July 25 WSJ article reported.

(2) Fed: A lot of talk. The US Federal Reserve is studying the idea of a digital dollar to death. It’s currently collecting public comments on the potential costs, benefits, and design of a digital dollar, with plans to publish a “discussion paper” in early September. In other words, a digital dollar is many years away from landing in your digital wallet.

Fed Governor Lael Brainard seems to understand the need to move faster. “The dollar is very dominant in international payments, and if you have the other major jurisdictions in the world with a digital currency, a CBDC (central bank digital currency) offering, and the U.S. doesn’t have one, I just, I can’t wrap my head around that,” Brainard told the Aspen Institute Economic Strategy Group, according to a July 30 Reuters’ article. “That just doesn’t sound like a sustainable future to me.”

If the US doesn’t develop a digital dollar, cryptocurrencies called “stablecoins,” some of which are pegged to a US dollar, could proliferate, she noted. That could be problematic because stablecoins aren’t backed by banks or governments, which eliminates a level of safety enjoyed by the dollar. Stablecoin transactions typically occur outside of the financial system, which has regulators around the world concerned that they will lose control over regulating transactions. US, UK, and Japanese regulators all have called for greater regulation of stablecoins and other areas of decentralized finance.

(3) BOJ: Testing started. The Bank of Japan (BOJ) is in testing mode. In April, it began testing the technical feasibility of issuing, distributing, and redeeming a central bank digital currency. Tests will continue through March 2022. The BOJ also formed a committee of policymakers and lobbyists from the banking and finance sector to help with the project. However, the BOJ’s formal stance is that it has no plans to issue a central bank digital currency.

(4) ECB: Multi-year project begun. The European Central Bank (ECB) has conducted experiments over the past year and found no major technical obstacles to using a digital euro’s ledger, which could be centralized, distributed, or some combination of the two, a July 14 Reuters article reported. The central bank is now working on the design of the digital euro, defining the roles of banks and fintech companies, and talking with EU lawmakers about any changes needed to EU treaties. The investigation phase of the project should last two years, followed by three years of implementation, Reuters reported.

(5) Bahamas: First to the finish line. Last year, the Bahamas became the first country to issue a digital currency, the “sand dollar.” A digital currency is easier for some Bahamian citizens to access than cash in a bank because the country is an archipelago. A digital currency should also be easier to access after a hurricane. In the wake of Hurricane Dorian in 2019, it took some banks more than a year to rebuild their physical branches.

“If you have a fully servicing electronic infrastructure for payments that everyone has access to, that’s just as simple as restarting the communications link,” said John Rolle, governor of the Bahamas Central Bank, in a July 19 Dow Jones Newswires article. The country is rolling out mobile wallets for citizens, introducing new financial providers, and addressing interoperability between different digital financial service providers.

“I’ve used [the digital sand dollar] in my central bank’s cafeteria ... I’ve used it once to pay for groceries. I’m looking forward to using it even more to pay in cases where I don’t need to use a credit card or a debit card,” said Rolle. “It’s going to substitute for those instances when the credit card or debit card is not an option. For some other Bahamians, it’s going to be the first time that they moved from something other than cash.” Hopefully, other nations’ central bankers are watching.

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There Is No Place Like Home

August 04 (Wednesday)

US Housing I: Home Prices Rising. Melissa reports that her neighborhood in suburban Atlanta is hot. It’s always hot there this time of year weatherwise, but the mercury has soared in the housing market too: Home prices are up 25% y/y owing to demand for bigger homes, with backyards for the kids, resulting from the pandemic. Boosting prices is also a shortage of both existing and new homes for sale.

Melissa’s Baby Boom neighbors considered selling their home, downsizing, and moving closer to their grandkids. But they haven’t been able to find a smaller home at a reasonable price. Even finding affordable rentals on their fixed income has been difficult, as folks making similar moves have driven up rental prices.

The national housing market has been a frantic and tumultuous mess since the end of last year’s lockdowns. However, it may be starting to calm down. That’s partly because the best cure for high home prices and a shortage of housing inventory may be record-high home prices.

Recent home price appreciation has incentivized some homeowners to sell to capitalize on their gains, which has increased the supply of available homes. Meanwhile, aggressive competition for homes and rising prices are bumming out many would-be homebuyers, dampening the intense pandemic-induced demand for homes that drove prices up. “[T]he affordability [of homes] is squeezing some of the buyers out of the market,” said Lawrence Yun, the National Association of Realtors’ chief economist. “Homebuyers qualify for a mortgage based on their income, but with prices rising 20% or higher, it is simply pricing them out,” reported a July 12 CNN article.

Consider the following:

(1) Home sales. In June, new US home sales unexpectedly fell as many would-be buyers stepped out of the market due to a lack of affordable homes (Fig. 1). The number of new homes sold during June dropped to 676,000 units, saar, from a post-pandemic peak of 993,000 units at the start of this year.

Total existing home sales and sales of existing single-family homes ticked up ever so slightly during June to 5.9 and 5.1 million units, saar, respectively, but remained significantly below their recent post-pandemic onset peaks of 6.7 million and 6.0 million, respectively, during October (Fig. 2).

(2) New and existing home prices. Both new and existing home prices have been rising since the market bottomed at the start of 2012, and the gains have accelerated over the past year as Covid-19 has prompted cramped urban dwellers to move into larger suburban homes. The 12-month moving average of the median price of existing single-family homes rose 16.5% y/y during June to $326,300, with new home prices also rising at a double-digit rate, of 10.0% y/y, during June (Fig. 3).

(3) Housing inventories. As a result of the pandemic, housing inventories have been extremely tight in both the new and existing markets. However, that’s changing in residential markets given new dynamics. High prices are inducing some homeowners to put their homes on the market and some homebuilders to build more. But at the same time, many would-be buyers are now backing off from their search because of a lack of affordable homes.

New homes for sale rose to 353,000 units, sa, during June, the highest since the end of 2008 (Fig. 4). And the ratio of new homes for sale to new homes sold, an indicator of months’ supply, rose to 6.3 during June up from the record low of 3.5 from August through October (Fig. 5). A similar dynamic is showing up in existing home inventories (Fig. 6 and Fig. 7).

(4) Traffic & mortgages. Meanwhile, traffic of prospective new home buyers declined in July, falling from last November’s record high (Fig. 8). Record-low mortgage rates may be helping the refi market, but evidently not low enough to offset the rise in home prices. The four-week seasonally adjusted average of mortgage applications on new purchases fell during the week of July 23 along with single-family home sales (Fig. 9 and Fig. 10).

US Housing II: Rents Rising. The demand for affordable housing is pushing up rents. Nationally, during Q2, the median monthly rent for vacant units held at Q1’s record high of over $1,200 (Fig. 11). Tenant rents also were partly responsible for the higher yearly percent change in the Consumer Price Index during June (Fig. 12).

Invitation Homes, the largest US single-family landlord, raised rents in Q2 by 8% nationwide amid strong demand for suburban rentals, reported Bloomberg. On new leases, rents rose by nearly 24% in Phoenix and more than 22% in Las Vegas, the highest increases out of the 16 markets in which the company operates.

During Q2, renter vacancy rates fell to just 6.2%, the lowest since Q2-2020 and a near-record low (Fig. 13). Invitation Homes reported an average occupancy rate of 98% for Q2, reported Bloomberg. The percent of households renting rather than owning a home remained on a steep ascent during Q2 (Fig. 14).

US Housing III: Tenants Facing Eviction. Vacancy rates may be low partly because of the federal moratorium on evictions. Implemented last August on executive order by President Donald Trump, the moratorium prohibited evictions for tenants who fell behind on rent. About 8.2 million adults were behind on their rent or mortgage as of July 5 and have low confidence they can pay on time next month, a Census Bureau survey showed, according to a July 30 WSJ article. Federal recovery funds sent to state and local authorities intended as aid for struggling tenants and landlords reportedly has failed to make it into the appropriate hands, the article said.

Originally set to expire on December 31, 2020, the moratorium was extended by Congress until late January, and the Centers for Disease Control and Prevention (CDC) further extended the order three times. In June, the Supreme Court ruled that the moratorium was beyond the scope of the CDC’s authority, but allowed it to be in place through July in any case. In a statement on Friday, President Joe Biden said that state and local governments had legal authority to do their own moratoriums, reported the WSJ.

More than 3.6 million Americans are at risk of eviction, reported CNBC on Sunday. Nationally, about 16% of adult renters live in households that are behind on rent payments, reported a separate WSJ article, noting that renters in southern states appear the most vulnerable, as the region has the most landlord-friendly laws countrywide. Rents in Atlanta increased 12.7% during the past year, exceeding the national average of 10.3%, according to listings website Apartment List. Rents in some Atlanta suburbs have risen more than 20% during that period.

For homeowners, however, “[t]he departments of Housing and Urban Development, Agriculture and Veterans Affairs extended their foreclosure-related eviction moratoriums through the end of September on households living in federally insured, single-family homes late Friday, after Biden had asked them to do so,” CNBC said.

Late breaking news: The WSJ reported late yesterday that the Biden administration is expected to announce a new federal moratorium on evictions. The action is expected to buy states and localities more time to distribute about $47 billion in rental assistance designed to help tenants harmed by the pandemic who have fallen behind on their rent. As of June 30, just $3 billion of that money had reached tenants and landlords.

US Housing IV: Builders Building More Slowly. Building affordable homes was a challenge long before the pandemic. Making matters worse, pandemic-induced supply-chain problems have caused a rise in materials prices, further exacerbating the affordability challenge for builders and buyers.

Melissa reports that in her suburban Atlanta area, some local homebuilders visibly have paused residential projects mid-build. Homebuilders may be on the road to restarting, some indications suggest, but that road may be awfully bumpy, especially as building permits are falling. Consider the following:

(1) Housing starts. “Despite rising costs and limited availability of key materials and labor, the nation's home builders exceeded expectations and found ways to break ground on the third-most new homes in a single month since 2006,” said Zillow Senior Economist Matthew Speakman.

Indeed, single-family housing starts rose 6.3% in June m/m. However, all year the series has been volatile within a range near the average of historical norms. Could June be the start of an actual uptrend? Maybe, but challenges remain for homebuilders, chief among them the recent dip in demand and high costs to build (as discussed below).

Interestingly, multifamily starts edged up in June and look to be gaining more momentum than single-family builds. That jibes with the situation in the rental market, where demand is high and vacancies are low, for now (Fig. 15).

(2) Permits. Permits are the big “but” when it comes to housing starts. The indicator of future months’ building activity fell dramatically during June for both single and multifamily homes to a total 1.59 million units, saar, from a recent high of 1.88 during January (Fig. 16). It is “a clear signal that difficulties persist, and that construction activity could be even higher given a bit more long-term certainty and an easing of critical supply chain volatility,” Zillow’s Speakman added. Completions also fell in June (Fig. 17).

(3) Input prices. Nevertheless, starts that were stopped could get restarted, as some, but not all, prices of commodities important to the housing industry recently have come down from record highs. Since reaching their recent off-the-charts record-breaking high on May 7, lumber futures have plunged 62%, but they remain higher than most of their pre-pandemic peaks (Fig. 18). Hot rolled steel prices do not yet seem to have peaked, soaring to a recent record at the end of July from early-2020 lows (Fig. 19). At the same time, the 200-day moving average of the copper futures price also has soared (Fig. 20).

Speakman noted: “While lumber prices have fallen back to earth after the prolonged surge that began last spring, disruptions are now pushing up prices of other key building materials including steel, concrete and lighting, and making other important supplies very difficult to come by.”

(4) Labor costs. Many builders cite problems related to a continued shortage of available workers. That’s most likely why the yearly percent change in average hourly earnings for all construction workers rose 3.9% during June (Fig. 21). Keep in mind that the yearly rate has been distorted by its “base effect” and therefore hard to measure. But real average hourly earnings for both all construction workers and those just in production and nonsupervisory roles have climbed dramatically since 2012 as well (Fig. 22 and Fig. 23). The cost of labor represents about 30%-40% of the cost of a typical new home, according to the Home Builders Institute.

US Housing V: More Upside for Homebuilders? Construction and housing stocks have had a pretty good year. The iShares US Home Construction ETF has risen 28.5% ytd as of the August 2 close, compared to a 16.8% rise in the S&P 500. Investors slightly pulled back last month on the concerns about rising costs but regained confidence in July.

The S&P 500 Homebuilding stock price index is up 35.1% ytd, surpassing the previous cyclical high during July 2005 (Fig. 24).The industry’s forward operating earnings per share recently hit a new high, furthering its vertical ascent (Fig. 25). But while analysts’ earnings growth forecasts for 2021 have risen to 60.8% as of the July 22 week, forecasts for 2022 have moderated since earlier this year to 9.7%. The industry’s forward P/E of 8.0 remains within its trading range over the past five years (Fig. 26).

If demand for homes is dwindling at current price levels while input costs are elevated, what positives are investors hanging onto? Over the longer term, generational trends suggest to us that the most bullish opportunities can be found in apartment developers. Over the medium term, we are watching for any lasting negative outcomes for rentals from both rising rents and the looming eviction cliff. But if employment resolves as the US economic recovery continues unfazed by the latest evolutions of the virus, as we expect, then let the multifamily-unit building commence! Let’s look at the industry dynamics that investors in the housing space may be weighing at this point:

(1) If supply-chain issues go poof, will stocks go up? Analysts may be anticipating that forward earnings for homebuilders could only go up from here, assuming that commodities prices decline once supply bottlenecks are resolved and that builders take that benefit to their margins rather than passing it along to buyers in lower selling costs, as the July 14 WSJ indicated is likely.

Because apartment developers order wood by the boxcar all at once, many multifamily projects were tabled as the price of lumber soared, explained a market analyst for the WSJ. Many multifamily builders have been “barreling back into the market” as the price of lumber has retreated.

(2) Will Millennials suddenly embrace the American Dream? What about the new demand from would-be Millennial homebuyers that single-family homebuilders have been dreaming of? Millennial demand started to show signs of growth during the pandemic, as many of those who could afford to do so moved out of city apartments and into suburban homes.

But now that the cohort has witnessed two major crises that induced wild home price swings—the Great Financial Crisis of 2008 and the Great Virus Crisis—renting for life may look like their best option. Many have lots of student loan debt and not much wealth or income. Many of those who finally have saved a down payment now find themselves priced out of this pandemic-distorted housing market, at an age when their parents already owned starter homes—as a July 11 Associated Press article explored.

Some would-be Millennial homebuyers could still be waiting on the sidelines for home prices to come back to Earth. Some may turn to their Baby Boomer parents for financial help to purchase a home. But a big problem is that starter homes are in short supply, largely because of zoning laws for smaller lots, said Robert Robert Dietz, chief economist for the National Association of Home Builders (NAHB), according to MSN.

Nevertheless, Millennials need a place to live, and if renting is it, then multifamily building may be a good bet for investors. New household formation is driving demand for rental apartments, suggested yesterday’s WSJ. “You’ve had young professionals who were living with parents being called back to their employer or who feel more secure and now they’re going to rent,” an analyst said.

(3) Will Baby Boomers’ lifestyle shifts boost multifamily demand? Many Boomers are opting to age in place for now, but many may eventually need to move if their homes become too large to manage or if they need eldercare services. Downsizing Boomers may drive up demand for multifamily units, too, eventually, especially for those providing assisted living services. With anticipation, Alliance Residential Co. recently broke ground on an upscale Portland based 16-story senior living project.

Interestingly, multifamily construction sentiment reached its highest point in seven quarters in Q1-2021, especially reflecting strong demand for rental housing in the suburbs, according to results from the Multifamily Market Survey released by NAHB. NAHB now expects a gain in multifamily starts this year.

(4) Will infrastructure legislation boost housing market? President Biden’s pending infrastructure agenda certainly should boost construction activity. However, the initial bipartisan infrastructure bill proposed this week is nowhere near $4 trillion in scope that Biden originally campaigned on. Rather, the text of the first bill allocates several billions of dollars to roads and bridges, public transit, expanded broadband access, and other such hard infrastructure.

But Democrats are hopeful that future legislation will include large investments in affordable “green” housing and eldercare housing.

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Income & Wealth in America

August 03 (Tuesday)

US Income Distribution I: Mobility vs Inequality. I am wrapping up my latest book, titled In Praise of Profits. One of the issues that I address is income inequality in the US.

My conclusion is that our system of free-market capitalism, driven by the profit motive, increases widespread prosperity, i.e., aggregate income, better than any other economic system. It naturally causes income inequality, especially during good economic times. That’s when high-income households tend to get richer faster, while low-income households tend to get richer as well but more slowly.

Periods of prosperity are often associated with new goods and services introduced by entrepreneurial capitalists. The ones that succeed do so because they bring to market products that benefit lots of consumers. They get rich by increasing the standards of living of their customers with those products. They may very well get richer much faster than their employees and their customers do, but they are the key drivers of technological innovation, productivity, and widespread prosperity.

I’ve also concluded that upward economic mobility in our economic system tends to offset the negative consequences of income inequality.

US Income Distribution II: Many Happy Returns. In my forthcoming book, I discuss the extraordinary growth of pass-through business entities. These are all owned and managed by entrepreneurial capitalists. The latest available data for 2017 show there were 1.6 million C corporations that year, down from 2.2 million in 1980 (Fig 1). They are the ones that are publicly traded and pay taxes on their profits. They pay dividends to their shareholders, who are taxed on these proceeds. That same year, there were 35.1 million pass-through business entities, up from 10.9 million in 1980.

Pass-throughs are not publicly traded and are taxed just on the dividends paid out to their limited number of shareholders. They include S corporations, sole proprietorships, and partnerships. Internal Revenue Service (IRS) rules limit the number of shareholders of an S corporation to 100. They may be individuals, certain trusts, or estates. They may not be partnerships, corporations, or non-resident alien shareholders. The S corporations must be domestic and have only one class of stock. They cannot be certain financial institutions, insurance companies, and domestic international sales corporations. A sole proprietorship is an incorporated business owned by a single person. A partnership is like a sole proprietorship in function but allows for the association between two or more persons who agree to combine their resources and skills for a mutual profit (and loss).

For simplicity, let’s assume that during 2017, the 4.7 million S corporations were owned by just one shareholder, as were the 26.4 million sole proprietorships, and that the 3.9 million partnerships had only two partners. That adds up to 38.9 million Americans, or 25.4% of 2017’s household employment measure, which reflects the number of people with jobs rather than the number of jobs.

America has evolved into a nation of pass-through business owners. They have had a significant positive impact on income distribution, in my opinion. To see this, let’s examine annual data on tax returns provided by the IRS:

(1) Total returns. During 2017, Americans filed 152.9 million tax returns, up 22.6 million since 2001. The total number of pass-through business entities during 2017 totaled 35.1 million, up 11.6 million since 2001. So they accounted for about 23% of all returns and for about half the increase in total returns from 2001-2017. Keep in mind that they all must file individual income tax returns. S corporations also file corporate returns, but their owners pay taxes on the dividends they receive on their personal returns.

(2) Returns by income group. The IRS provides the number of returns by five different income brackets, based on adjusted gross income (AGI) from 2001 through 2017. Here are the number of returns, in millions, by AGI group during 2001, then 2018, as well as the change over that period (Fig. 2):

$0-$50K (92.8, 88.9, -3.9)

$50K-$100K (26.4, 35.2, 8.8)

$100K-$200K (8.5, 21,2, 12.7)

$200K-$500K (2.0, 6.9, 4.9)

$500K or more (0.6, 1.7, 1.1)

The decline in the lowest income group might reflect progressive changes in the tax code that meant that fewer households in this bracket had to file returns. It could also reflect upward income mobility.

(3) Share of returns by income group. Another way to slice and dice the tax returns data is to compare the filings of each AGI group as a percentage of total returns during 2001 and as a percentage of total returns during 2018, then to calculate the change in these percentages (Fig. 3):

$0-$50K (71.2%, 57.8%, -13.4)

$50K-$100K (20.3%, 22.9%, 2.6)

$100K-$200K (6.5%, 13.8%, 7.3)

$200K-$500K (1.6%, 4.5%, 2.9)

$500K or more (0.4%, 1.1%, 0.7)

These numbers suggest a significant amount of upward income mobility. The percentage of total tax returns filed by the lowest income group dropped from 71.2% to 57.8%, while all the other income groups rose from 28.8% to 42.2% (Fig. 4).

(4) Total AGI. The IRS also provides total AGI (Fig. 5). It increased 88.7% from $6.2 trillion during 2001 to $11.6 trillion in 2018. The average AGI per tax return increased 59.7% from $47,353 in 2001 to $75,683 in 2018 (Fig. 6). Over this same period, the PCE deflator rose 37.9%. Overall, Americans have been solidly beating inflation.

(5) AGI per return by income group. Then again, this conclusion does not hold up for the average AGI per return for each of the five brackets, which rose by much less than the rate of inflation from 2001 through 2018, as follows (Fig. 7):

$0-$50K (1.0%)

$50K-$100K (2.7%)

$100K-$200K (3.9%)

$200K-$500K (-2.0%)

$500K or more (8.8%)

Relative to inflation over that period, real average AGIs per income group show calamitous declines, not stagnation!

(6) Eureka moment. It is time for a “Eureka!” moment. The IRS data clearly show that it is upward income mobility, not rising average AGIs per income bracket, that has been increasing both nominal and real AGIs. The averages of the nominal AGIs per income group have been remarkably flat over the past 17 years through 2018, misleadingly implying income stagnation. Almost all the gains in total AGI per income group have been attributable to triple-digit percent increases in the number of households filing returns with AGIs in the top three income ranges.

I submit that the data strongly suggest that the AGIs of the great majority of Americans have improved significantly since 2001. Income mobility has lifted most of them into higher tax brackets. That can be explained in part by the significant proliferation of pass-through businesses.

US Wealth Distribution: Finding More & Less Inequality. Now let’s turn to some of my findings on US wealth inequality from 1989 through early 2021. The bottom line is that wealth inequality has worsened slightly during this period. That’s because the major source of wealth inequality is ownership of equity in publicly traded corporations and in closely held ones. As a result, wealth inequality, like income inequality, tends to worsen during periods of prosperity, i.e., when strong profits growth increases the market value of corporate equities.

Progressives have had more success in redistributing income than in spreading the wealth. Recently, a few of them have proposed imposing a wealth tax. Their studies on wealth inequality have been based on flimsy data sets and lots of questionable assumptions.

Meanwhile, a large team of the Fed’s researchers have been busy constructing a new database containing quarterly estimates of the distribution of US household wealth since 1989. They launched it with the release of a March 2019 working paper titled Introducing the Distributional Financial Accounts of the United States.

The Distributional Financial Accounts (DFA) is an impressive accomplishment combining quarterly aggregate measures of household wealth from the Financial Accounts of the United States and triennial wealth distribution measures from the Survey of Consumer Finances. The DFA’s balance sheet of the household sector is much more comprehensive and timelier than previously existing sources. I believe that the new database can be used to resolve lots of controversial issues about wealth distribution in the US. Here are just a few that I explore in my forthcoming book:

(1) Has wealth inequality gotten worse? From Q3-1989 through Q1-2021, the net worth of households increased 534% to a record $129.5 trillion. The share held by the top 1% of wealthy households rose from 23.4% to 32.1% over this period (Fig. 8). The share held by the top 90%-99% group has been relatively steady between 35.0% and 40.0%. It was 37.7% during Q1-2021. The share held by the 50%-90% group declined from 35.5% to 28.2% over the period. The bottom 50% had only a 2.0% share of household net worth.

Put more simply, the top 10% held 69.8% of net worth during Q1-2021, up from 60.8% during Q3-1989. Yes, wealth inequality is significant and has gotten worse. Not only do the top 10% of wealthy households have a disproportionately high share of household assets but they also have a very small share of household liabilities. During Q1-2021, they had 64.8% of household assets and only 25.2% of household liabilities (Fig. 9 and Fig. 10).

But the story isn’t quite as simple as claimed by progressives who favor wealth taxes.

(2) Inequitably distributed equity holdings. Much of America’s wealth inequality has been attributable to equities. This asset class totaled $37.4 trillion, or 25.7%, of household assets during the first quarter of 2021. The share of corporate equities and mutual funds held by the top 10%, i.e., the wealthiest households, rose from 82.1% in the third quarter of 1989 to 88.7% in the first quarter of 2021 (Fig. 11).

(3) More equitably distributed real estate and pension entitlements. The next biggest asset class in the household sector’s balance sheet is real estate, at $33.8 trillion during the first quarter of 2021. This has been and continues to be among the most equitably distributed assets in America, with the top 10% of households’ share at 44.8% and everyone else sharing a collective 55.3% as of the first quarter of 2021 (Fig. 12). The same can be said for pension entitlements, which totaled $29.9 trillion during the first quarter of 2021. The top 1% had only a 5.0% share, while the bottom 50% had only a 3.0% share; but everyone else had a 92% share (Fig. 13).

(4) MIA: Social Security. The Fed’s DFA database on household wealth does not include the present discounted value of Social Security income provided to so many American households, especially those that progressives claim aren’t getting their fair share of household wealth. Progressive economists never even consider this value as a household asset. A just-released (July 27) working paper by five economists from the University of Wisconsin and the Federal Reserve makes a very good case for including Social Security in studying the distribution of household wealth inequality and finds much less of it as a result!

(5) Bottom line: Better than the alternatives. Bull markets in stocks coincide with periods of prosperity in America when corporate profits are growing solidly. Households with significant holdings of equities in their portfolios see their wealth rise faster than those of households with less significant holdings.

Is this a problem that needs to be fixed with a tax on wealth? I don’t think so.

There’s risk in constraining the ability of the wealthy to seize their opportunities, as that would affect us all. The wealthy tend to diversify their stock market windfalls, benefitting diverse industries. They invest in private equity deals and fund startups; the easy availability of capital provides up-and-coming entrepreneurs with the capital they need to fund their ventures, helping them to flourish and employ.

I conclude that in such ways, our system of entrepreneurial capitalism increases and distributes prosperity faster and better than any other economic system. Both rising income and wealth inequality occur during prosperous times. That beats the alternative, i.e., bad times for all—which constraining the prosperity-seeding activities of the wealthy would invite. In any event, income inequality tends to be more than offset by upward income mobility. The same can be said of the distribution of wealth.

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S&P 5000!

August 02 (Monday)

Earnings I: Raising Estimates. S&P 500 operating earnings per share continue to outpace the consensus expectations of industry analysts, and ours too. So Joe and I are raising our estimates by $10.00 each to $205.00 this year and $215.00 next year from our previous forecasts of $195.00 and $205.00 (Fig. 1). We expect earnings to grow 46.7% this year and 4.9% next year.

We are now targeting the S&P 500 to hit 5000 by the end of next year (Fig. 2). That would be a 13.8% increase from Friday’s close. Consider the following:

(1) Valuation assumption. Our outlook for the S&P 500 assumes that the forward P/E of the index remains around 22.0, as it has since last spring (Fig. 3). If it does so, then S&P 500 forward earnings (i.e., the time-weighted average of analysts’ consensus estimates for this year and next year) would have to rise 10.5% from $205.72 currently (during the week of July 22) to $227.27 (Fig. 4).

Our forward earnings projection seems plausible, not requiring much explanation. However, the forward P/E assumption may seem like a bit of a stretch. It may be hard to imagine that the forward P/E can remain as elevated as 22.0 through the end of 2022. Then again, it has remained remarkably stable at this level since last spring, notwithstanding concerns that the Fed’s next move will be to tighten monetary policy (eventually) as well as uncertainty over whether this year’s jump in inflation will be transitory or longer lasting.

(2) Valuation boosters. We are counting on ample Fed-led liquidity to continue to prop up the elevated forward P/E even once the Fed starts tapering (eventually). We also expect that a rebound in productivity growth will offset inflationary pressures up ahead, boost real wages, and lift profit margins.

In addition, the heating up of the Cold War between the US and China may convince more global investors to invest in the US rather than in China. That’s especially so if the Chinese government continues to tighten its regulatory stranglehold on the country’s businesses, as Jackie and I discussed in Thursday’s Morning Briefing.

Our Roaring 2020s outlook is largely based on a technology-led business revolution in the US. That should offset the weak growth of the labor force resulting from a slowdown in the growth of the working-age population. In addition, the US-China Cold War will force businesses to bring supply chains back home; lots of technology will be required to make that happen both efficiently and cost effectively.

All this suggests that technology stocks and technology-related stocks, which have relatively high valuation multiples, could continue to gain market-cap share of the S&P 500. Joe and I have recently suggested that more and more low-tech companies effectively will be transformed into high-tech ones as they use more and more technology to boost their productivity.

(3) Forward earnings. You might be wondering why we are using our forecast of forward earnings at the end of next year ($227.27 per share) to derive our 5000 target for the S&P 500 at the end of next year rather than using our new forecast of $215 per share for all of 2022. It’s because the stock market discounts analysts’ consensus forward earnings, not our annual forecasts for earnings.

By the end of next year, the market will be discounting forward earnings for 2023, which will be the same as analysts’ consensus estimates for 2023. That could easily be $227.27, or 5.7% above our 2022 estimate.

(4) Profit margin. We should mention that our calculations lead us to an even more bullish outlook for profit margins, since we are sticking with our S&P 500 revenues-per-share forecasts of $1,600 this year and $1,650 next year, i.e., growth rates of 17.7%% and 3.1% (Fig. 5).

As a result, our profit margin forecasts rise to 12.8% and 13.0% in 2021 and 2022 (Fig. 6). That’s not outlandish given that the profit margin rose to a record 13.5% during Q1-2021.

Companies with higher valuation multiples and higher profit margins are gaining market-cap weight in the S&P 500. The result is a higher valuation multiple and a higher profit margin for the S&P 500. That’s bullish for stocks. (See our YRI S&P 500 Earnings Forecast.)

Earnings II: 2022 Is Coming. As we enter the dog days of summer, we decided to flip the calendar and look at what analysts expect for S&P 500 sector and industry earnings in 2022. A few things jump out. First, analysts remain optimistic about overall earnings growth. They’re calling for the S&P 500 to grow earnings 10.4% in 2022, an admirable showing after the 40.8% surge expected this year. As mentioned above, we’re calling for earnings per share to rise 4.9% next year.

Second, the earnings winners and losers amid the S&P 500 sectors change quite a bit next year. Analysts see earnings growth slowing sharply in the Materials sector and turning negative in the Financial Services sector, but remaining strong in Industrials, Consumer Discretionary, and Energy.

Here’s the expected-earnings-growth derby for the S&P 500 and its 11 sectors’ in 2021 and 2022: Industrials (87.4% in 2021, 35.8% in 2022), Consumer Discretionary (76.8, 30.9), Energy (returning to a profit, 28.9), Communication Services (24.2, 13.2), Information Technology (30.1, 11.3), S&P 500 (40.8, 10.4), Utilities (0.9, 7.7), Consumer Staples (8.3, 7.6), Health Care (19.4, 5.2), Real Estate (6.4, 4.7), Materials (71.5, 0.8), and Financials (53.7, -5.3).

Here’s a quick look at the causes behind the expected leadership shuffle among the sectors next year:

(1) Boeing’s earnings takeoff. The Industrials sector finds itself in a leading role thanks in part to the Aerospace & Defense industry, which is expected to grow earnings by 58.2% this year and 31.6% in 2022. Boeing, one of the industry’s largest constituents, is bouncing back from the problems with its 737 MAX airplane and the lack of demand for large planes for international travel due to Covid-19. Analysts are calling for Boeing’s earnings to rebound from a loss of $0.92 a share this year to a profit of $5.67 a share next year. Estimates have been rising in response to a surprise Q2 profit reported on Wednesday.

The S&P 500 Aerospace & Defense stock price index has rebounded from its 2020 lows, but it has yet to surpass the highs reached in February 2020 (Fig.7). Analysts expect the industry’s revenue to jump by 8.9% next year and its earnings to climb 31.6% (Fig. 8 and Fig. 9). The industry’s forward P/E of 21.1 remains near its highest levels of the past 25 years, but we imagine it will fall as earnings continue to improve next year (Fig. 10).

Industrial Conglomerates—home to giants like GE, Honeywell International, and 3M—is also expected to enjoy an earnings rebound. The industry’s earnings, which fell 36.6% last year, are expected to climb by 32.4% this year and 23.7% in 2022 (Fig. 11). Here too, the S&P 500 Industrial Conglomerates stock price index has rebounded sharply from its 2020 lows but has yet to surpass its June 2017 high-water mark (Fig. 12).

(2) Amazon and cars lead. The Consumer Discretionary sector stays on top in 2020, helped by the Internet & Direct Marketing Retail industry, Automobile Manufacturers, and Auto Parts & Equipment. Earnings in the apparel-related industries also are set to have solid 2022 earnings growth as we all emerge from our Covid-19 bunkers: Footwear (17.2%), Apparel & Accessories (17.1), and Apparel Retail (16.5).

In Amazon’s first earnings report since Jeff Bezos stepped down as CEO, the company reported Q2 earnings that beat expectations but provided a Q3 forecast that disappointed, as consumers are finding things to do in a reopened economy besides shop online. The shares fell 7.6% on Friday, and analysts have been trimming their earnings forecasts. This year’s earnings-per-share forecast is $53.56, down from $55.82 a month ago, and 2022 earnings are expected to come in at $68.45 per share, down from $73.04 a month ago. Even after recent estimate reductions, Amazon’s earnings are forecast to rise 27.8% next year.

These moves do imply that the earnings growth forecasts for the S&P 500 Internet & Direct Marketing Retail industry of 33.2% this year and 29.4% in 2022 will also see trimming in upcoming weeks (Fig. 13). This industry’s stock price index has fallen 10.5% ytd from its record high on July 8, officially placing it in correction territory (Fig. 14).

While the semiconductor chip shortage has been a headache for S&P 500 Automobile Manufacturers, it likely pushed the sales of vehicles that are currently unavailable into 2022. Industry earnings are expected to climb 78.8% this year and 22.2% in 2022, after falling 11.6% last year (Fig. 15).

(3) Energy companies enjoy the bounce. Energy-related industries are forecast to turn in some of the fastest earnings growth next year. The price of Brent crude oil futures, at a recent $76.05, has held onto its gains from the past year even after news that OPEC+ plans to raise crude oil production (Fig. 16).

The S&P 500 industry expected to post the strongest earnings growth in 2022 is Oil & Gas Refining & Marketing (485.9%), as it continues to rebound from losses in 2020. Strong 2022 earnings growth is also expected from Oil & Gas Equipment & Services (60.4), Oil & Gas Exploration & Production (23.1), and Integrated Oil & Gas (17.7).

(4) Materials & Financials reverse. The strong earnings gains enjoyed by the S&P 500 Materials and Financials sectors in 2021 will end next year if analysts are right. Despite current signs of inflation, earnings in numerous commodity industries are expected to turn negative or slow to mid-single-digit growth in 2022.

After surging by 426.1% this year, the S&P 500 Steel industry’s earnings are forecast to drop 49.5% in 2022. Likewise, Commodity Chemicals earnings are expected to tumble 19.1% next year after jumping 270.6% this year.

Here are the S&P 500 Materials industries with earnings growth projected to slow but stay in positive territory next year: Gold (32.8% in 2021, 5.1% in 2022), Diversified Chemicals (41.5, 5.8), and Fertilizers & Agricultural Chemicals (68.4, 5.8). One exception is the Copper industry. Even after earnings growth of 452.3% this year, the Copper industry is expected to turn in solid earnings growth of 17.1% in 2022.

The reserve releases that boosted Financials’ earnings this year don’t repeat in 2022. Instead, the sector continues to be plagued by perennially low interest rates, and it might face an even flatter yield curve if the market starts pricing in Fed tightening by the end of next year. Analysts are expecting Financials will be the worst performing S&P 500 sector next year.

Here are earnings growth forecasts for some of the sector’s industries: Diversified Banks (97.4% in 2021, -14.9% in 2022), Investment Banking & Brokerage (53.8, -14.2), Consumer Finance (205.9, -8.8), and Regional Banks (33.9, -5.2).

Earnings III: Normal Forward P/E Has Normalized. When the US economy was shut down due to Covid-19 last year, analysts reacted by slashing their earnings forecasts. Forward P/Es based on estimated 12-months-ahead earnings jumped sharply, making valuations appear extremely elevated.

In the May 20, 2020 Morning Briefing, we introduced a normalized forward P/E to show that the market wasn’t as overvalued as it appeared. We looked past the depressed earnings and calculated expected earnings for the 12-month period ending 18 months ahead. Twelve months’ worth of earnings ending 18 months ahead are typically higher than those ending 12 months ahead. During September 2020, the forward P/E based on the latter was indeed a record-high 13% higher than our normalized P/E then (Fig. 17).

Today, with the US economy once again open for business, consensus earnings expectations are rebounding to new highs. The spread between the forward P/E and the normalized P/E based on earnings ending 18 months ahead is back to normal for the S&P 500 and for most sectors.

However, since the Q2 earnings season started, the spread has actually turned negative for the S&P 500 Financial Services sector due to higher-than-expected earnings from banks’ reversal of loan loss reserves taken during 2020. With earnings expected to decline for Financials, its forward P/E of 13.8 rises to 14.0 on a normalized basis. Strange days, indeed (Fig. 18).

Earnings IV: Long-Term Growth Expectations Up, Again. The S&P 500’s expected long-term earnings growth (LTEG) has been soaring again. During the week ending July 22, industry analysts collectively were expecting the 500 companies in the index to produce LTEG of 21.2% over the next five year. That’s way up from 15.4% during the week of February 11 and almost back to its record high of 23.9% during the week of February 4 (Fig. 19). Why? Consider the following:

(1) Joe’s timely call. Expected LTEG soared after Tesla was added to the S&P 500 on December 21, 2020. Following the February 4 record high for expected LTEG, Joe sent a note to his contacts at I/B/E/S. He questioned whether Tesla’s consensus expected LTEG median forecast of 409% was still timely considering that the company was graduating from hyper-growth to fast growth and noted the impact of that consensus growth estimate on the S&P 500’s LTEG.

I/B/E/S polled the analysts again, and they revised Tesla’s LTEG much lower, to 45% from 409%. This revision, along with the decline in Tesla’s market cap, caused the S&P 500’s expected LTEG to drop to 15.4% during the February 11 week from its 23.9% record high the week before.

(2) LTEG’s NERI. The rise since the February 11 week to the S&P 500’s current 21.2% reading is impressive. But what accounts for the strength? To dig deeper into what was going on, Joe applied our NERI (net earnings revisions index) formula to the S&P 500’s LTEG estimate (Fig. 20). This index ignores the size of a company and compares the net number of the forecasts raised or lowered to the total number of forecasts.

The NERI for expected LTEG has racked up some impressive readings since it turned positive in August 2020 for the first time since late 2018. Last month, a record-high 20.9% of estimates were revised higher, which has since eased to a still-impressive 19.9% during July.

(3) Roaring 2020s Earnings Boom Ahead? A long-term earnings boom is very possible; it has happened before. Using I/B/E/S data from Refinitiv, we see that the actual trailing LTEG exceeded 15% from 1990-1991, 1995-2002, and 2006-2009 (Fig. 21). It has averaged at an annual rate of 12.6% since 1985 (Fig. 22).

Joe explains that the actual trailing LTEG is based on the annualized rate of change in the weighted average of I/B/E/S’ operating earnings per share over the last five years, using the last 20 quarters of earnings per share. It is updated weekly because the time weighting changes each week.

Following the Covid-19 economic shutdown, companies went into crisis mode and reorganized their businesses to survive. This positioned companies for even greater profitability when the economy recovered, as witnessed by the S&P 500’s surge to a record-high profit margin during Q1-2021. Consumers also have made notable changes to their living, working, and buying habits. The effects of these shifts bode well for future profitability; we believe that accounts for the recent strength in the S&P 500’s LTEG.

(4) Reasonable LTEG For Mag-5 Plus the Next Five. Here are the current LTEG rates for the Mag-5 companies and the next five biggest, in descending market-cap order: Apple (19%), Microsoft (18), Amazon (40), Alphabet (21), Facebook (24), Berkshire Hathaway (not available), Tesla (45), Visa (19), NVIDIA (27), and JPMorgan Chase (3).

(5) Did These Analysts Miss the LTEG Memo? LTEG is meant to be a secular growth rate, normalized over course of business cycle, rather than based on a particular year’s historical earnings. It appears that some analysts didn’t get the memo given the gargantuan LTEG they estimate for these companies—the five S&P 500 firms with the highest LTEG: General Electric (330%), Hilton Worldwide (279), Booking Holdings (209), SBA Communications (179), and TJX (126).

Here are the lowest-LTEG firms: MGM Resorts (-175%), Wynn Resorts (-120), Marathon Oil (-78), Expedia (-15), Philips 66 and Laboratory Corp (both at -11). Negative growth rates might suggest those companies will be out of business shortly, but that’s hard to believe. More likely, the analysts got the sign wrong in their spreadsheet formula.

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