- Macro Strategist
United States, Institutional
Change
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Inflation is the top concern of policymakers around the world as consumers and companies struggle with the effects of soaring input costs and severe supply disruptions. Supply-chain bottlenecks have become a mainstream topic and hopes for “normalization” have repeatedly been put on pause since the COVID outbreak. In this note, I consider the cyclical outlook (the next 6 – 12 months) as well as the enduring economic shifts that could result from these disruptions.
In the second half of this year, I expect to see inflation, which is extremely elevated, begin to decelerate — and a key component of that change will be reduced supply-chain pressures. From a goods-economy standpoint, slowing consumption and growing production imply that inventories are being built again, and in response, steep price increases should adjust to more modest levels. In the service economy, on the other hand, spending is likely to rise this year and, given the tight labor market, inflation may be stickier. As I discuss here, all of this has implications for consumers, a range of industries, and the Federal Reserve (Fed). It also raises the question of how companies and governments are addressing the issue of building resiliency in supply chains for the medium term. These efforts may ultimately prove to be an antidote for anemic global growth.
Spotting improvements in the goods economy
The unusual environment in 2021 was a byproduct of significant fiscal and monetary stimulus, but also a misalignment in the goods and services economy because of COVID. People had money in their pockets, thanks to policy support, but they couldn’t spend it on travel, recreation, and other services. Instead, they spent it on goods. That created a surge in goods demand just as factories in Asia and elsewhere were struggling to respond with more supply, as a result of stringent COVID policies, rising infection rates, and other factors. The end result was supply-chain bottlenecks, which have contributed to the fear among many today that there is no end in sight for high inflation.
But there are a number of signs that conditions are improving, including a sharp decline in the Supply-Chain Bottleneck Indicator, a metric I developed to gauge price pressures as companies were struggling with backlogs and input costs (Figure 1). In addition, consumption of goods is likely to decelerate from its torrid pace as consumer priorities shift toward consumption of services that were previously not available. Rising interest rates, which tend to hurt durable goods spending disproportionately, will further the demand adjustment and supply will rebalance as a result. I expect this will begin to show up in inventory-to-sales ratios. Already there has been some improvement in areas like general department stores, with inventories rising to “above normal.”
Figure 1
Meanwhile, freight costs have seemingly topped out and the relentless backup of ships in US harbors seems to have peaked, though it remains elevated. The pace of US import growth has also slowed, suggesting that a catchup will occur, especially if goods demand continues to dip. If more product is unloaded in areas where demand has cooled, it is likely that discounting will occur and price gains will not only slow but will, in some cases, decline in order to clear inventory.
Among the areas most affected by supply-chain bottlenecks was the automotive industry, which single-handedly added 200 basis points (bps) to the CPI in 2021. Encouragingly, auto production has been rising since the fourth quarter of last year, although progress has been spotty given shortages in the chip industry as well as the impact of the Russia/Ukraine conflict on the availability of certain parts. Inventories are still below average in the US, but I think we’re seeing things begin to turn. This is feeding into used car prices and leases, where price gains are slowing sharply. Ultimately, auto industry experts believe normalcy will return in 2023, but we will be left with a stark illustration of the complexity of supply chains and the potential for disruptions to hamstring production.
Inflation may linger in the service economy: Watch the housing market in particular
As noted, I expect that inflation will be more persistent in the service economy in the near term. Take the housing market, for example. Shelter is the single biggest component of the Consumer Price Index (CPI) and has a fairly large weighting in the Fed’s preferred Personal Consumption Expenditures (PCE) core measure of inflation. Past increases in rent and prices mean this component will rise through much of 2022.
The good news is that there are more new homes and apartments under construction than at any time in the last 45 years (Figure 2) and we are approaching a point where that should mean rising home completion rates. In addition, the Fed’s rate hikes are having the intended direct impact on housing demand, with sales declining meaningfully as rising rates deter buyers. With demand cooling and supply improving, I expect house price gains to slow this year and rent gains to stabilize and eventually slow, though likely not until 2023.
Figure 2
As for the inflationary impact of the tight US labor market, there are some reasons for hope. Last year, I estimated that five million “missing workers” could reenter the labor market as the economy reopened. As of June 2022, we were only about a half million jobs below the pre-pandemic peak. There have been recent signs that some older workers are returning as the pandemic recedes, and there is room for some improvement among immigrants, mothers with young children, and workers who hold multiple jobs.
Continued employment gains in childcare and nursing care, which remain well below pre-COVID employment levels, could help bring more workers back. It’s also notable that demand for temporary work visas is two to three times normal. A decision by Congress to allocate these visas in a timely fashion could make a meaningful difference, as could new STEM student visas proposed by the Biden administration.
Macro and market implications
I think this backdrop leads to several key takeaways:
- For companies that were penalized by severe supply-chain bottlenecks, the second half of 2022 and 2023 should offer some relief and an opportunity in the stock market. This includes some consumer, industrial, technology, and health care companies. Normalization will spill over into 2023, given the uneven opening of industrial capacity around the world.
- Companies that have faced severe labor market pressure should enjoy a reprieve (Figure 3). However, I wouldn’t get too comfortable, as the US economy seems, in the medium term, to be shifting from a period of surplus labor to one of relative scarcity of labor. In time, workforce development, flexible work arrangements, and childcare and other benefits are likely to be part of the solution, helping to raise labor force participation rates. Boosting immigration and automating labor-intensive industries would help as well.
- Small businesses, which were among those hit hardest by supply-chain and labor market conditions, are beginning to find their footing. We have seen the number of firms unable to fill jobs decline for a few months, a welcome sign that missing workers are returning to the labor market.
- In aggregate, I expect the service economy to outgrow the goods economy in 2022. Areas of potential growth (i.e., areas of shortfall relative to the pre-COVID economy) include travel, recreation, personal services, education, and pockets of health care.
- My baseline view is that the headline inflation rate will begin to recede in the second half of the year, though it will be a process, just as the rise in inflation was. I expect core goods and commodity price gains to ease into 2023, even as service price inflation (through shelter and wages) remains upwardly sticky this year. In 2023, shelter costs should start to ease, as should broader service economy price pressures.
- Decelerating inflation would restore purchasing power for consumers and mitigate input-cost pressures for companies. It would also help the Fed to eventually slow its rate-tightening moves. When inflation is this elevated, it will not be easy for the Fed to soft-land the economy. Its tools are blunt and take time to work. Ultimately, the Fed is tasked with keeping inflation expectations anchored and has expressed a willingness to accept economic pain, including a rise in unemployment and even a recession, as the price for doing so. That said, some of the current inflation may turn out to be an effect of the economic reopening, and that effect may wear off faster than feared and eventually give the Fed some breathing room.
Figure 3
Thoughts on the future of supply chains: Building resilience
I think the challenges we’ve seen during the pandemic, which were exacerbated by the Russia/Ukraine conflict, will drive the US, as well as other countries, to build more resilience into supply chains. To date, there has been a “just in time” approach, with goods ordered only as needed, to achieve cost efficiency. But over the past two years, we saw this approach falter.
Consequently, I think we’re witnessing a shift to a “just in case” approach, including a willingness to carry more inventory and to diversify supply chains with regional hubs. We could also see countries take a more strategic approach to supply-chain management — as in the case of the semiconductor issue, where we see US policymakers thinking about ways to boost US manufacturing capacity. “Critical supplies” onshoring is possible in strategic areas such as health care and smart technologies, for national security purposes. Rising geopolitical tensions, including Middle East tensions, have also raised the stakes for companies in terms of their geographical footprint and ability to ensure the security of critical inputs. “Friend-shoring” of new facilities is another area for companies to consider. It is imperative that government policy focus on issues such as port congestion and the availability of “last mile” transportation to complement the work being done by corporations.
On the labor market front, overreliance on cheap labor in China or Asia more broadly is likely being reconsidered. Companies are also seeking new ways to scale production, looking for alternative sources of labor, and focusing more on the human element of the decisions they make.
Several other factors indicate that corporate supply chains will continue to evolve. The focus on sustainable investments is forcing a rethink of physical risk related to water shortages, hurricanes, and other factors, suggesting a drive for more geographic diversification. In addition, the accelerated move toward automation is changing the types of inputs companies will have to source from their suppliers for future production. Both of these factors add to the need for companies to reevaluate suppliers, understand all the links in a vertically integrated process (instead of relying on outsourcing of operations to suppliers), and consider regional hubs of production as well as diversification of inputs.
Critically, the Russia/Ukraine conflict put the spotlight on the need to plan for energy and food security. This is especially true in Europe, which has been hardest hit by the crisis, but is evident in other countries as well. The coming decade could well see the unleashing of a capital expenditure cycle led by government spending in these areas of strategic importance. This could be an enduring shift that lifts nominal growth in many parts of the global economy where it has been weak for a long time. This, in turn, would imply somewhat higher interest rates over time.
How companies and economies could be affected
I believe the macro impact of supply-chain reorganization will last for many years, creating uncertainty and a variety of winners and losers at the country and company level. For example, I think the potential winners could include:
- Countries that are geographically closer to the core developed markets, such as Mexico and parts of Eastern Europe
- Countries that are geopolitically aligned — parts of Asia, for example
- Strategic industries, such as the semiconductor industry and industries related to climate-change adaptation
On the other hand, the potential losers are likely to include:
- Countries engaged in geopolitical conflict (both sides)
- Countries that are more vulnerable to the effects of climate change
- Companies in strategic industries that have exposure to geopolitical conflict
In aggregate, profitability could be negatively impacted with companies needing to find alternative sources of efficiency gains rather than relying on previously cheap input costs. While cyclical pressures should bring goods prices and aggregate inflation lower in coming months, it is worth considering whether a shifting geopolitical landscape means the end of the deflationary forces that prevailed for a prolonged period before the pandemic.
Finally, the repeating nature of these disruptions will bring forth government intervention. Active government policies on climate change, energy and food security, health management, national security, transport, and labor force development are likely to be themes that resonate over the coming decade.
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