The Long View
Third quarter economic activity was underwhelming. Earlier this year, investors looked forward to a robust reopening of the economy generated by a vaccine-led victory over the pandemic. While new Covid cases have recently fallen, the Delta variant was a clear headwind to third quarter activity along with supply chain disruptions and labor shortages. Reviving the economy has proven to be more difficult than shutting it down, revealing many intricacies and fragile contingencies. However, economic cycles have historically run for many years and the current one is still in the early stages. More importantly, we are at the point now where it has become more self-sustaining and with growth that could be above-trend for a few years.
As much as we are learning to work around the pandemic, its detrimental impact on the economy remains intermittently in effect. The U.S. economy grew at a disappointing 2.0% annual rate in the third quarter. The Federal Reserve’s real-time GDP tracker, GDPNow, had estimated 6.1% growth for the quarter as recently as early August.
The 2.0% growth in economic activity last quarter was also well below that of the prior three quarters, which saw growth rates increase sequentially each quarter from 4.5% to 6.7%. Extrapolating that slowdown from one weak period would give a false impression of the longer-term outlook, though. While the sudden recession we experienced last year only encompassed two months, that marked the end of 128 months of growth. The three prior expansion periods covering the past 30 years lasted for 73, 120, and 92 months. Going back even further, the average economic expansion since World War II ran for 64 months. Interestingly, the two longest periods of sustained growth both happened in the last 20 years. So, with this expansion only 18 months old, it’s likely that we still have years of growth ahead before the next recession occurs. And if recent history is any guide, expansions last longer now than in former times.
Consumer net worth and savings are critical drivers for the economy, and both are flush right now. With house prices up, higher stock prices and consumer bank accounts showing over $2 trillion in excess savings, consumer net worth is continuing to extend its unprecedented surge. Although stimulus checks ended and consumers spent vigorously in the first half of the year, savings continue to accumulate. It is worth noting that expanding consumer net worth generally leads GDP growth by six months as that money gradually winds its way through the economy. Consequently, retail sales in recent months have been at elevated levels.
With demand quickly picking up, many businesses aren’t able to hire workers fast enough. The unemployment rate is plunging much faster than anyone expected. A year ago, the Fed optimistically forecasted the unemployment rate to end this year at 5.5%, last month it came in at 4.6%. There are a number of dynamics at play with the labor market, many of them likely Covid/pandemic related, that make it difficult to easily explain why the participation rate hasn’t expanded more quickly to fill the 10 million job openings that exist today. With 8 million workers still out of work, expect the unemployment rate to continue to drop as job opportunities remain plentiful and Covid retreats.
Persistent adverse supply shocks and strong underlying demand have resulted in increased inflation, something we haven’t seen in many years. The Consumer Price Index (CPI) is up 6.2% from a year ago led by energy, shelter and vehicle costs. Core CPI, which excludes volatile food and energy prices, is up 4.6%. Some of this increase is transitory and will dissipate as supply increases and demand normalizes. However, it is improbable that we will return to 2% inflation until well into 2023 at the earliest. In the unlikely event of sustained surging inflation, the economy would need to be restrained and a recession could result. Investors already anticipate that the Fed will begin to raise interest rates modestly next year.
History suggests that the current economic expansion is likely to last for years to come. No longer in need of much fiscal or monetary stimulus, economic growth has become more self-sustaining. Consumer spending has increased due to savings and wealth that have accumulated. Additionally, lean inventories need to be replenished. For businesses to meet the increasing demand, additional investments in labor and equipment must occur. As a result, corporate profits will continue to increase, as will the cash that is generated. At the same time, pandemic restrictions around the world are being lifted. Hence, many different factors are simultaneously providing sustainable momentum to the economy. The resulting economic growth may be above historical norms and could endure for some time.
Holger Berndt, CFA
Director of Research
hberndt@rssic.com
