The Three I’s

The University of Michigan’s consumer sentiment index unexpectedly fell in August.

The headline index fell from 81.2 in July to 70.2 in August. Some of the decline seems to be related to price increases with the percentage of consumers saying that now is a good time to buy a car or house dropping sharply. This is likely reflecting the sharp rise in both used car and truck prices and home prices. The Survey of Consumer’s Chief Economist Richard Curtain suggested that some of the negative assessments could also be reflecting an emotional response from consumers’ dashed belief that the pandemic would soon end.

The National Federation of Independent Business (NFIB) reported that small business confidence moderated a bit in July falling from 102.5 in June to 99.7 in July.

Employers continue to report that the quality of labor is their main challenge.

The Taliban made significant advances in Afghanistan and appears to have claimed the capital city of Kabul as well.

After being ousted in 2001, the group has reclaimed much of the country as a rising number of refugees seek to leave the country. Afghanistan President Ashraf Ghani left the country as well following a decision from the U.S. to have U.S. forces exit the country on August 31, 2021. The situation remains fluid.

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Investors remain focused on the three I’s: infrastructure, inflation, and interest rates. Let’s start with the infrastructure bill. The U.S. Senate passed an infrastructure bill to the tune of $550 billion in entirely new federal spending (on the country’s roads, bridges, ports and broadband). The bill will also repurpose unspent coronavirus relief money and tighten enforcement on reporting gains from cryptocurrency investments. Including this funding, the bill approaches $1 trillion.

It seems very likely that this “hard” infrastructure bill will eventually be passed into law, but it gets a little complicated from here. Some of the more progressive Democrats only want to pass the “hard” bill after the larger $3.5 trillion social spending bill is passed on a party line, reconciliation basis that adds to other programs and outlines potential tax changes. House Speaker Pelosi has agreed to accommodate this by planning to pass the social spending bill before turning to the most recent bill passed in the Senate. However, nine House moderate Democrats, which is five more than Pelosi can lose, have said that they will only vote for the social spending reconciliation bill AFTER the Senate bill is passed. So Congress appears to be at an impasse currently, but the House returns from recess on August 23 and we expect to hear more then. It seems unlikely that either bill will be passed before September.

On the inflation front, the debate about its longevity has yet to be resolved, but the July consumer price index (CPI) showed some tentative signs of moderation. While the headline index remained elevated at 5.4% higher year on year, the core consumer price index (which excludes the volatile food and energy categories) fell from 4.5% to 4.3% higher year on year. It is probably too early to say definitively that we have reached peak inflation, but it’s looking increasingly likely.

Looking at the Manheim Wholesale Used Vehicle price index, which tends to lead the used car and truck p rice component of the CPI by about 3 or 4 months it has been moderating since the end of April (see figure 1). Combined with a peaking of lumber and copper prices, this should continue to pull down inflation over time. T he Atlanta Fed’s sticky CPI index (which excludes food, energy, and used car and truck prices) shows a much more moderate 2.4% rise in core prices year on year and may be a sign of where inflation is headed as distortions fade in 2022 and 2023 (see figure 2). While higher than the Fed’s average inflation target of 2.0 %, it is more in line with what the Fed has said it is willing to tolerate in terms of an inflation overshoot . We should also point out that the Bureau of Labor Statistics’ CPI measures tend to run about 25 to 40 basis points higher than the Fed’s preferred inflation measure, which is the Bureau of Economic Analysis’ personal consumption expenditure (PCE) chained price indices.

This chart shows the Manheim Used Vehicle Index versus Used Car and Truck Prices (Lagged Four Months) from 1997 to 2021

This chart shows the Atlanta Fed's Sticky CPI versus Core CPI from 2000 to 2021

For the first time in awhile, interest rates have actually been headed modestly higher since the 10-year U.S. Treasury yield hit 1.17% on August 3 2021. In fact, prior to unexpected drop in the August reading of consumer sentiment, the 10-year yield had climbed to just shy of 1.36%. Since then it has once again drifted a bit lower, but it looks like the 10-year U.S. Treasury yield may be in the process of stabilizing after four consecutive months of decline (see figure 3). We think there a few reasons for the firming.

This line chart shows the 10-year Treasury yield from January - August 2021, which seems to be stabilizing after four months of consecutive declines

1. Concerns about an economic slowdown have eased some. Consumer spending rose at an annualized rate of 11.8% in the second quarter of 2021 – implying still robust demand – and the July employment report showed the U.S. economy adding back a significant amount of jobs (943,000 jobs). If the economy continues to add back jobs at that pace, the remaining pandemic-related jobs deficit of 5.7 million would be closed in about six months (or by February 2022). Importantly, the Delta variant remains a wild card. However, high frequency economic data have yet to show a material slowing in economic activity due to the Delta variant. For example, the number of seated diners in the U.S. has slipped some, but not materially (see figure 4). Likewise, we have yet to see a collapse in the number of people flying (see figure 5). In addition, weekly initial jobless claims have yet to show the labor market weaken as a result of the variant. Most signs seem to imply that we have learned to live with Covid, but last week’s surprise drop in August consumer sentiment is a reminder that that the true impact of the variant may not be fully understood until individuals attempt to return to offices and schools in coming days.

This chart shows the Number of Seated Diners in the U.S. and Gobally (Percent Change from 2019) from January 2020 to August 2021

This chart shows the U.S. TSA Checkpoint Total Number of Traveler Throughput from January 2020 to August 2021.

2. The Fed looks like it will announce a tapering of bond purchases in September. It is possible that the Fed makes a tapering announcement at the Jackson Hole meeting held between August 26^th and 28^th but financial markets appear to have settled in on September as the most likely timing. While not a guarantee given the surprise drop in consumer sentiment and the surge in Delta cases, investors seem to be increasingly comfortable with the idea of a tapering announcement in September and that may be helping to calm the rates market some (see figure 6).

This chart shows the U.S. Bond Market Volatility Index from January to August 2021. The Bond market volatility remains elevated, but has come down a bit of late.

3. Inflation is likely to be somewhat lasting. While we do expect reach peak inflation rates soon, Citi Global Wealth’s Chief Economist Steven Wieting expects inflation to average around 3.0% in 2022 and somewhere between 2.0% and 2.5% in the years that follow. That is in line with the St. Louis Fed’s price pressure measure that shows over an 80% chance that PCE inflation will still be above 2.5% twelve months from now (see figure 7). With the Fed actively targeting a higher personal consumption expenditure inflation between 2.0% and 2.5% we should see higher yields if the bond market eventually becomes convinced that growth will be sustainable moving forward (albeit at a more modest pace).

   To summarize, we remain confident in the economic outlook and believe that the Federal Reserve’s monetary policy will stay accommodative for quite some time. Even if the Fed eventually announces tapering it will take somewhere between 8 to 10 months to unwind the current level of purchases meaning that the first rate hike will not occur until the back half of 2022 at the earliest and rates are likely to remain low for much of this economic recovery. Given the strong run that equity markets have had since March 23, 2020, some market volatility and downward pressure might be unavoidable, but we still think that backdrop argues for investors to remain overweight U.S. large cap equities (including the Healthcare sector) and focused on dividend income.

This chart shows the St. Louis Federal Bank’s Price Pressures Measure from January 2020 to August 2021. The St. Louis Fed Price Pressures Measure continues to predict PCE inflation above 2.5% twelve months from now.

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