What Comes Next After Decelerating Growth And Persistent Inflation?

Last week reinforced one thing most people already knew, and one thing added a new wrinkle in the economic growth story. The inflation story is well worn by now, but the December CPI release added evidence that some portion of the increased pricing pressures is likely to be more persistent. The Atlanta Federal Reserve’s measure of sticky inflation has risen to 3.7%. Underlying price data from rents and wages point to inflation settling in above pre-Covid level even once supply chain disruptions are in the rearview mirror. The pick-up in Covid cases, which is now spreading to Asia, should temporarily add to pricing pressures.

The new wrinkle is the decline in consumer spending in December. The U.S. consumer had been a driving force behind the robust expected economic growth in the fourth quarter. In the wake of the -1.9% decline in retail sales for the month, the Atlanta Federal Reserve slashed its fourth-quarter GDP estimate to 5.0% from 6.7%. The result is even worse when one considers that retail sales are reported in nominal terms, so the rampant price increases are a built-in tailwind to this measure. The spike in Omicron cases does seem to have taken a toll on the numbers at the margin. The less than one percent decline in bar and restaurant sales provides circumstantial evidence. The massive monthly decline of -8.7% in nonstore retailers, including online sales, points to the primary driver being the pull forward of holiday purchases this year, with consumers well aware of supply issues. In addition, the absolute level of retail sales remains well above the pre-Covid trend, so some reversion seems reasonable.

While it is well and good to know why the consumer went on strike, it is more critical to the economy to know if this is a more permanent drag on growth. The massive Covid wave in the U.S. does seem to be cresting, so this marginal drag should ease in the coming weeks. The possible building wave in Asia might further disrupt supply chains, so it might somewhat impact here but to a lesser extent. There remains much reason for optimism with U.S. households in aggregate in excellent shape. Household net worth is at record levels, and the percent of disposable income currently used to support spending is not far off the historical lows.

The unemployment rate is extremely low and should trend even lower in 2022. There is more to this story, though, with the unemployment rate comprising the employed divided by the labor force. The labor force is below the level pre-Covid, so some have decided to stop working. Using the payrolls report data, the U.S. economy has only recovered 85% of the jobs lost to Covid. This shortfall amounts to almost 3.5 million jobs! If the labor force grows, it provides more upside to economic growth.

While the lower labor force is a risk to the economy, our measure of current job openings points to an abundance of employment opportunities. Rising wages and better therapeutic treatments for Covid seem likely to entice more prospective workers eventually. In any case, many available jobs and rising wages are a formula that should continue to support consumer spending.

Despite the weaker retail sales and Omicron crimping fourth-quarter GDP growth, the combination of low unemployment and high inflation still keep the Federal Reserve on the path of raising rates in March. So far, this environment has led to a rotation from high valuation multiple growth stocks to value stocks. The valuation differential had become historically wide. While the gap has closed somewhat with the recent outperformance of value, there remains room for further compression. In any case, past tightening cycles have seen quality stocks perform well. Having a balance of high-quality growth and value exposure in a portfolio makes sense currently. The fourth-quarter earnings season starts to kick into gear this week with thirty-nine S&P 500 scheduled to report. So far, bank earnings have been better than expected, but concerns about expense growth were a drag. A slew of additional bank earnings is coming this week, along with a peek at other industries.