While the current high rate of inflation has raised concerns, we believe longer-term trends would contribute to deflation.
The Federal Reserve (Fed) is ready to roll back its economic stimulus efforts on a faster timetable and may raise the benchmark federal funds rate three times next year. That was the news that emerged from the conclusion of the Federal Open Market Committee (FOMC) meeting held on December 13 to 14.1
The Fed will double the pace at which it is reducing its bond-buying program, which would now conclude by early 2022 rather than mid-year as had been originally planned. The Fed has been under pressure to act more aggressively to address inflation. A report by the Bureau of Labor Statistics that showed inflation in November had been running at an annual pace of 6.8% further heightened investors’ and consumers’ concerns about the level of inflation. In testimony before Congress in November, Fed Chair Jerome Powell acknowledged that the high inflation was not “transitory,” as the Fed had been insisting it was in previous communications.
The stock market reacted favorably to the news of the eventual rate hikes. In the historically bullish year of 2021, there were no rate increases, and the next one will still be at least three months away.
Today’s conditions are not like the 1970s
The high rate of inflation has many analysts comparing today to the 1970s, but conditions then were far different. The 1970s saw a combination of high inflation and low growth. In our view, the high inflation we are seeing today will likely be a short-term issue, and one that creates a political problem, as public concern about the price hikes puts increasing pressure on the Fed, the Biden Administration and Congress to take decisive action to address inflation.
On a longer-term basis, we see a number of factors that could be deflationary. Even amid today’s labor shortages, workers have seen negative wage growth, as pay increases have not kept pace with inflation. Robots, technology, and weaker labor unions, relative to decades past, have all hindered workers’ ability to command higher earnings. That negative wage growth will also ultimately cause people to spend less, and a decline in consumption could eventually bring lower prices for goods and services. As often happens, higher prices take care of higher prices.
The same technologies, like robotics and AI, that are keeping a cap on wage hikes, also help increase productivity, and that can decrease inflation, as well. Yet another potential source of deflation could be any future tax increases that might be passed by Congress to pay for some of the increased spending that was approved this year.
The current high level of debt, both at the corporate and household level, is yet another reason why an extended period of higher inflation might not be in the cards. Outstanding corporate debt is now $11.4 trillion, while it was only $400 billion in the ’70s. Household debt as a percentage of gross domestic product (GDP) is now 75%, while it was only 43% in the ’70s. This borrowing binge has a ripple effect across the economy as people take out loans to finance home purchases, cars, consumer goods, and businesses issue debt for investment purposes. With the credit impulse this high, incremental changes to interest rates have a larger impact on people’s and companies’ decisions to borrow and refinance. Given today’s high level of debt, the Fed now has much more leverage to influence the direction of the economy and to slow things down, if needed, in response to inflation.
Another deflationary development has been the decline in personal savings as a percentage of disposable income. As we have progressed through the pandemic, the savings rate has come down to 7%. In the earlier height of the pandemic, it had been more than 25%. While we have been in the midst of pent-up consumer demand getting unleashed after the end of lockdowns and stay-at-home orders, the lower savings rate and higher interest rates will eventually translate into less spending and lower inflation.
Lower unemployment and historically low new jobless claims
Two different jobs reports from the Bureau of Labor Statistics provided a conflicting picture of what happened in November, but overall there were enough good indicators on employment levels for investors to be confident in the current strength of the economy.2 Nonfarm payrolls increased only by 210,000 in November, down from 546,000 in October. Wall Street analysts had expected November’s job gains to match October’s. However, a survey of households suggested an increase of 1.136 million jobs.
In less ambiguous news, initial unemployment claims dropped to 184,000 for the week ending on December 4. That was down by 43,000 from the previous week. It was the lowest level of new jobless claims since 1969. The unemployment rate also fell to 4.2% from 4.6%, and the labor-force-participation rate increased for the month to 61.8%, its highest level since March 2020.
Omicron remains a concern
First reports about the Omicron variant of COVID-19 had a significant negative impact on the financial markets. Over subsequent weeks, a steady flow of better news about the variant has calmed nerves. Some reports indicated that this variant might not be as deadly as was initially feared, and Pfizer reported its booster shots had a high degree of effectiveness against Omicron. On December 14, however, the Director-General of the World Health Organization, Tedros Adhanom Ghebreyesus, warned that Omicron is spreading faster than other variants of COVID-19 did, and it is already present in most countries around the world. That news only gave investors more cause for worry, along with the prospect of continued inflation and higher interest rates in 2022.
Value rotation may be complete
The end of 2021 has proven to be difficult for tech stocks, particularly those in the Goldman Sachs Non-Profitable Technology Index, comprising tech companies that have yet to realize a profit, as well as some well-known innovation-focused ETFs, like the ARK Innovation ETF, which have seen precipitous declines. Some see that as an indication that the market’s tech bubble has finally burst. It may also be a sign that the market’s more recent back-and-forth shifts between growth and value outperforming may have ended and could result in a more sustained period of value stocks consistently outperforming their growth counterparts.
If economic growth remains strong next year, that will continue to help value stocks. However, if economic growth slows substantially, growth stocks may reemerge as market leaders, given the fact that investors are often willing to pay a premium for high-growth stocks during periods when economic growth rates are low and investments that provide growth are more difficult to find.
Awaiting passage of the Build Back Better plan
President Biden’s Build Back Better plan, a $2-trillion package to address climate change, health care and education is awaiting final legislative approval. The bill already passed in the House of Representatives. If Senate Majority Leader Chuck Schumer is able to muster support from all members of his 50-seat Democratic caucus, the bill should pass before the end of the year. The $555 billion in the plan to fight climate change will add to the spending on infrastructure that was already committed to by the $1.2-trillion infrastructure package the President signed into law in mid-November.
As with many bills in the Senate this year, the one key vote for passage will be West Virginia Senator Joe Manchin. He has expressed concern about the size of the legislation, given other government priorities that may require additional spending, including geopolitical issues like Russia’s buildup of troops along the Ukraine border and China’s threats against Taiwan. He also insisted high inflation will need to be addressed. He has suggested that the Build Back Better plan be reduced to $1.7 trillion to ensure that Congress acts within the limits of what the government can afford.
Elon Musk, the CEO of Tesla, also came out as a vocal critic of the Build Back Better plan, and its specific proposal to provide tax credits to consumers for the purchase of electric vehicles (EVs) and to spend $7.5 billion on the construction of a national network of EV-charging stations.3 Musk expressed concern that the bill would add to the already sizable federal debt. Still, many saw his remarks as a thinly veiled attempt to protect his own turf. The $12,500 tax credit could be used by consumers when they purchase EVs built by unionized workforces. Detroit’s big-three automakers – Ford, Fiat Chrysler and General Motors – all have unionized workforces. Tesla does not.
The final details of the bill will be hammered out in the days ahead. Still, its passage appears to be likely. Spending from both packages – Build Back Better and the infrastructure legislation -- would provide significant stimulus for the economy in 2022.