Prior to 2020, few people outside of a small group of specialists would have guessed that a global pandemic could bring the world’s economy to its knees. Today, emerging from the slump, we are equally unprepared to confront an unforeseen disruption of supply. So far it seems like a temporary glitch, but it could turn into a real issue with broad implications for the global economy.
Months of laid-off workers, idled factories and order cancellations affected the production of many inputs (such as computer chips used everywhere from appliances to cars) which in the face of resurgent demand is causing widespread problems. Bottlenecks in industries that were ill-prepared to increase capacity quickly, like packaging materials, are laid bare. A combination of unemployment checks, children stuck at home and unsafe working conditions is keeping workers at home, creating labor crunch. Rental car rates are going through the roof for various factors, including a shortage of cars. In many cities, the price of homes has surged as inventory has fallen to historic lows. The list goes on.
We often tend to judge the economy by the ebbs and flows of consumption: Things are good when people buy and invest, and bad when they retreat. But we rarely consider the possibility that the supply of everything could be disrupted, as it is right now.
The stock market also focuses on demand, and it is pleased to see that it is soaring. While the stock market rally has slowed down in the last month or so, it is still in rally mode and overall demand for investments is high. For a while, even the most speculative such as Dogecoin (a cryptocurrency that started as a joke), stocks like Gamestop GME (a “meme” stock fueled by a Reddit hype), blank-check company IPOs and six- or seven-figure NFTs (don’t ask) were all the rage.
It would be simplistic to say that investors are simply being swept in a mania. Instead, they are responding to all the money that was injected to into the economy to bring it back to life. This is sure to keep demand going strong for a while.
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The stars are pretty well aligned for more stock gains. The recent rally pause was welcome as it wiped off some of the froth from overheated sectors like technology. The outlook for earnings is bright, only marred by the inability of companies to ramp up production in the face of input shortages, which include labor. Banks are healthy, and many consumers emerged from the pandemic with bigger savings accounts burning holes in their pockets. The Fed has sworn to keep rates low, and a large government-pushed infrastructure boom may be around the corner. There is little evidence that the higher taxes the package will require could offset the push it can give to the economy. What could go wrong?
What the market fears, of course, is inflation. There is little chance for 70s-style runaway inflation, but if the supply lines take too long to return to normal, temporary price increases caused initially by scarcity may morph into more persistent expectations that inflation will settle at a higher rate.
Some efforts to resolve supply-chain problems can contribute to escalating prices, especially if they focus on relocating production back into the U.S. (“reshoring”), an idea that has gained traction. Some car manufacturers, for example, are reportedly considering this, as they look for ways of alleviating the shortage of parts as well as making their supply chain more resilient against the next shock. Reshoring, in fact, is an idea permeating current U.S. policy, nowhere more evident than in the Jan. 25th“Made In America” executive order.
But it is very doubtful that production relocated in the U.S. could beat imported prices. The cost of U.S. labor alone is likely to be higher. While reshoring has many productivity and growth benefits, there will literally be a price to pay.
Is the market right in fearing inflation? Researchers who looked into this issue are not quite sure. Historical data suggests some correlation between inflation and equity returns, but this is not constant across time and it may be skewed by the 1970s, an era of high inflation and low returns, and also of stagnating disposable income. In contrast to the 1970s, today’s consumers enjoy large savings from months of little spending, fattened unemployment benefits and stimulus checks.
There is far more money today than in the 1970s finding its way into stocks. Also, if investors start believing that companies can pass price increases to the consumer, the idea that stocks could be a good inflation hedge may set in. The way hotels and car renters have jacked up prices as of late suggests that businesses do not face a lot of pushback, at least when it affects discretionary items and consumers feel flush.
The economy screeched to a halt in record speed, and is now revving up quickly to the fastest growth in decades. This violent back-and-forth created all sorts of dislocations that make it difficult to guess where it will settle. What lies ahead could be the old normal or a new normal. The next couple of quarters will give more clarity, of course; but from what we can tell today the bulls have better odds.