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In a Resurgent Economy, Inflation Looms

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What You Need to Know

  • Wages are increasing, but current data show that inflation is rising faster, threatening to erode spending power.
  • Consumer activity constitutes the vast majority of GDP, so, in the coming months, we need to be alert to signs of diminishing demand.
  • Inflation is a key worry point heading into the new year.

Despite real inflation concerns, consumer demand is showing remarkable resiliency and strength this quarter. COVID cases may be spiking globally, but the U.S. is well out of the summer doldrums, and we are now on track to more than double GDP growth this quarter compared with the third quarter. 

The president has finally signed the $1.2 trillion infrastructure package, which will bring more jobs and liquidity to multiple sectors, creating a tail wind for the markets.

As an equity investor, however, I am closely watching the push-pull dynamic between inflation and consumer demand. Wages are increasing, but current data show that inflation is rising faster, threatening to erode spending power. Consumer activity constitutes the vast majority of GDP, so, in the coming months, we need to be alert to signs of diminishing demand, which could negatively impact corporate earnings in 2022.

The Federal Reserve is set to start reducing bond purchases this week. Keep in mind, however, that this is just a taper; the Fed will still be injecting $105 billion per month into the system through mid-2022. Depending on how serious inflation gets, we could see the Fed scaling back its asset-purchase program or hiking rates sooner to ensure the economy does not overheat.

Strong Consumer Demand Bolsters the Economy

Several factors contributed to resurgent consumer demand in October and November. Delta variant cases began to subside; we still have approximately $2 trillion in pent-up demand with a higher-than-normal savings rate at 7.5%; and work is plentiful. The U.S. Bureau of Labor Statistics’ latest Job Openings and Labor Turnover Survey showed 10.4 million job openings, versus 6.6 million 12 months earlier. 

In October, retail sales rose an enormous 16.3% year on year and jumped 1.7% from the previous month and, importantly, 22% from 2019 levels. 

October industrial production came in 5.1% above its year-earlier level its highest reading since December 2019. Last week, the Philadelphia Federal Reserve released its Manufacturing Business Outlook Survey of up 5.1% y/y; its diffusion index for current activity surged in November, well surpassing expectations.

In the services sector, economic activity grew for the 17th month in a row, with the rate of expansion setting a record for the fourth time in 2021, according to the Institute for Supply Management (ISM). The ISM’s non-manufacturing activity index soared to an all-time high of 66.7 in October versus a 61.9 reading in September.

We continue to hear from company executives that services are in demand — airlines, travel sites and resort companies report that consumers are booking with them solidly through next summer.

More on this topic

With such brisk economic activity, ongoing supply chain issues and labor shortages, it’s no surprise that inflation is spiking. The U.S. October producer price index rose 8.6% year over year on an unadjusted basis, while the consumer price index rose 6.2% for the 12 months ending in October — the biggest 12-month inflation surge since 1990. Costs are up broadly across the economy, including shelter costs, with rents trending at an annualized 5%. We can expect rents to continue to climb into next year, considering that new-home sales are up 20% year-over-year. 

Likewise, wage inflation is increasing across all key measures. Average hourly earnings increased 4.9% year on year in October, according to the latest non-farm payrolls report. Unit labor costs increased dramatically, at an 8.3% annualized rate last quarter after rising at a pace of just 1.1% in the second quarter. For the 12-month period ending in September 2021, wages and salaries increased 4.2%

Despite concerns over inflation, we’re seeing a snapback across multiple sectors, with much stronger GDP growth expected for the fourth quarter. Last week, the Atlanta Fed forecast Q4 GDP at 8.7%. I’m not convinced it will be that high, but it will certainly surpass Q3’s rate of 2%.

This holiday season, we’re confident that retail isn’t going to disappoint on the demand side, given the excess consumer savings. But there will be ongoing challenges with the increasing cost to get goods on the shelves due to supply-chain issues, wage inflation and labor shortages.

How I’m Allocating My Portfolio, Looking Ahead to 2022

Though inflation is a concern, many companies have pricing power and significant free cash flow for M&A, share buybacks and dividends across multiple sectors. We’ve seen large conglomerates such as GE and Johnson & Johnson spinoff non-core, slower-growth businesses to increase shareholder value, which is good news for investors.

The global increase in COVID cases has prompted a rotation to growth stocks. I’ve been long the same sectors the past few months, with my barbell tilting toward value and cyclicals. I continue to favor reopen stocks, such as airlines, hotels, online travel booking and home retailers, which stand to benefit from the surge in consumer demand. At the same time, I like secular growers with significant total addressable markets, buying when prices are attractive.

I am also looking carefully at retail companies, as the industry has broadly outperformed the S&P 500 and the rest of the consumer discretionary sector this year. Earnings for home-improvement retailers are strong, thanks to the solid housing market, demand for home maintenance products and low interest rates.

Off-price retailers also are showing strength driven by consumer demand for the “treasure-hunt” experience, ample inventories and higher-priced transactions. I also see positive trends in auto-parts retailers due to the high price and shortage of new vehicles, and the fact that many car owners are choosing to repair and maintain their existing vehicles.

As is often the case, the economic picture is mixed right now, with consumer demand roaring back, industrial production strong and prospects bright for first-quarter 2022 earnings. My key worry point heading into the new year is inflation, waiting and watching to see if the Fed will act sooner rather than later to get inflation under control. Time will tell.


Stephanie Link is chief investment strategist and portfolio manager at the national wealth management firm Hightower. She leads the firm’s Investment Solutions Group, which specializes in outsourced chief investment officer services, model portfolios, separately managed accounts, investment research and due diligence for Hightower advisors. Follow Stephanie on LinkedIn and Twitter @Stephanie_Link.