IN THIS ISSUE
A bout of deflation from February through May caused "core" inflation as measured by the Consumer Price Index (CPI) to decline from a 2.4% year-over-year (YoY) rate before the shutdown to just 1.2% in June. As demand for a number of deeply affected goods and services improved with the reopening of the economy, "core" inflation increased from May to June at a faster-than-expected 2.9% annualized pace, raising inflation concerns. However, the gain was led by apparel and travel-related prices in a sharp reversal of particularly big declines during the shutdown and, in our view, is unlikely to persist. Our analysis suggests that inflation, measured by YoY changes in the CPI and "core" personal consumption expenditures index (PCE), is likely to drop further, possibly dipping much below 1% over the next year. YoY "core" PCE inflation, the Federal Reserve's (Fed's) preferred measure of inflation, appears on track for the lowest inflation rate in 60 years before turning up toward 1.5% as 2021 progresses.
This view is based on a number of factors. First, because of lagged effects from the shutdown shock, the trend in average hourly earnings (AHE) growth appears sharply lower now compared to the pre-pandemic outlook. AHE growth was running at about a 3.5% YoY pace before the pandemic and was on track to finally move into the 3.5% to 4.5% range that prevailed during the late-expansion phases of all business cycles since the 1980s. Distortions caused by the massive shift in the mix of wage earners toward higher-wage workers during the shutdown—as lower-paid, typically service sector jobs vanished—temporarily increased the average of AHE compared to the same period a year ago by almost 8% in April. As the economy opened and some of the lost service-sector jobs were recuperated, almost a half of this aberrant surge got erased by June, however, with sharp further weakening ahead, in our view. Indeed, underlying macroeconomic forces that typically lead AHE growth (including high unemployment, a drop in labor-force participation rates, elevated uncertainty) suggest a likely drop in YoY AHE growth from 5.4% currently to a 1% to 2% range over the next 12 months, with a return closer to 3% unlikely before sometime in 2022.
Such deceleration in wage growth would in itself be inconsistent with rising inflationary pressures for the foreseeable future. In addition, prospects for a strong reacceleration in productivity growth as a result of higher business operational leverage as the economy more fully opens up suggests suppressed inflation pressures over the next two years. Even taking into account our expectations for a continued gradual dollar depreciation, as discussed in our June 22 Capital Market Outlook—which would help nudge up the non-petroleum import-price index after a two-year downtrend, thus eliminating a key disinflation force—the negative lagged effects on inflation from the collapse in consumer spending on services and its much slower recovery potential compared to the sharp "V-shaped" rebound already observed in durable-goods spending point to additional "core" inflation weakness ahead. For example, as shown in Exhibit 1, rent-of-shelter inflation, which accounts for a large share of the consumer spending basket (about 40% of "core" CPI), is likely to remain under extreme downside pressure over the next two years based on past correlations.
Exhibit 1: Rent-of-Shelter Inflation Likely to Weaken Further.
That said, shifts in the mix of the consumer-spending basket can cause some prices to accelerate and others to decelerate, clouding the overall inflation outlook. As shown in Exhibit 2, the Fed has not accommodated an increase in the general price index. For inflation to average below 2%, as it has during the past decade, some prices had to decrease when others increased. In contrast, when monetary policy is loose/ accommodative, price increases in certain goods or services do not inhibit spending more on other categories, resulting in a general rise in inflation. Because central-bank policy determines the ultimate overall inflation outcome, it is more useful to look at changes in monetary policy, inflation expectations, the economic outlook, and financialmarket signals to estimate the inflation outlook than to dissect a consumer price index and analyze price changes or trends in its subcomponents.
Exhibit 2: Overall Macro-Environment, Largely Affected by Fed Policy, Determines the Ultimate Inflation Outcome Despite Churn in Inflation Subcomponents.
Ultimately inflation is always and everywhere a monetary phenomenon. Also, it is a longlagging indicator because it responds slowly to changes in economic conditions, which in turn respond with a lag to changes in monetary policy. Since it is the monetary-policy setting and the economic outlook it engenders that determine inflation, the pandemicinduced setback in economic conditions is likely to continue to suppress inflation into late next year, when the fuller effects of the stimulus and more advanced economic recovery start to be felt. In other words, the inflation outlook over the next year or two is somewhat baked in the cake.
For inflation to get back up just to the 1.5% to 2% range by late 2021 it would take a big, immediate drop in uncertainty levels, a sharp dollar depreciation (at least down to the 2018 level on a dollar trade-weighted index basis), and much stronger consumer spending/economic growth than currently appears likely. Otherwise, while the inflation trend should turn up as 2021 progresses as a result of the fiscal and monetary backstop to date, "core" inflation is likely to remain below the Fed's 2% target well into 2022, in our view.
In sum, without the massive fiscal and monetary stimulus to date, the recent dip into deflation territory, with its destructive effects on corporate revenues growth, economywide debt-servicing ability, and financial conditions would have persisted, eliminating any chance for a swift recovery. The pickup observed in the Treasury Inflation Protected Securities (TIPS) implied inflation expectations, rising metals prices, uptick in consumer inflation expectations, and positive financial-market signals (narrowing credit spreads, rising equity prices) continue to corroborate our view that the stimulus is working and the economy is likely to avoid a self-reinforcing deflationary down spiral in the wake of the pandemic. Still, it is typical in the early stage of a new economic expansion for inflation to drop because of residual forces for disinflation from the recession and high unemployment. Initially, monetary stimulus mainly raises real growth and as the economy reaches fuller capacity utilization, the effect of monetary expansion begins to raise prices too. Thus, inflation is likely to get worse before it starts to get better. With the Fed unlikely to achieve its inflation objective anytime soon, the outlook for monetary policy to remain aggressively accommodative for the foreseeable future suggests continued support for risk assets and reflation beneficiaries.
The 100-day countdown to the 2020 U.S. presidential election began yesterday. Odds of a democratic sweep and a Joe Biden presidency have been rising since early March, while President Trump's approval rating has slid in the face of the global pandemic (Exhibit 3). President Trump is trailing in most swing states, and the senate race has begun to favor the Democrats, who need a net gain of four seats to win the majority. This recent shift has grabbed investor attention, with almost half of investors (polled by Strategas Research Partners in July) citing a Democratic sweep as the greatest risk to the equity market.
Exhibit 3: Rising Odds of a Democratic "Blue Wave."
Given uncertainties surrounding the coronavirus recovery, the overall economic and market impact of a Democratic sweep has been difficult to gauge. Prospects for greater fiscal stimulus, an easing of trade tensions and reduced business uncertainty could potentially offset some of the less growth-friendly policies such as more regulations and greater taxes. In our view, the virus trajectory will be the most important factor for the markets in the near to medium term; however, markets could start pricing in election risks for specific industries and sectors as we head closer to the election. Taking a micro view, we outline some key sectors and industries most sensitive to the election agenda.
Currently, investors may not be fully pricing in the costs of a Democratic sweep to equity markets. We believe that investors may begin to factor in election outcomes post Labor Day. In general, growing investor fears of a Democratic sweep could be initially negative for equities given the potential for increased taxes and regulations, while bonds could benefit in the short term. The longer-term picture is less clear however, as other factors such as the virus trajectory, reduced trade tensions, fiscal stimulus, and reduced business uncertainty may prove to be more important for the markets over the long term. We would view any significant consolidation in U.S. equities as potential buying opportunities, especially in sectors with strong growth opportunities.
Other asset class implications: In a Democratic sweep, the U.S. dollar could weaken initially on the prospects for higher taxes and higher deficits, though U.S. growth differentials versus the rest of the world would be a key determinant in the medium term. Emerging markets could benefit from a weak dollar, but China-U.S. tensions may prove to be a continued headwind. International developed equities could benefit from an easing of trade tensions, a rebuilding of alliances, and less uncertainty under a Biden presidency. Volatility is likely to increase in the months leading up to the election.
That said, the outlook is still highly uncertain. With a little over three months to go, a lot could change in terms of the economy and polling. The stock market tends to be a fairly accurate indicator of who could win the presidency. The economy is another accurate predictor—incumbent presidents with recessions in the two years prior to the election have lost the presidency all but once, while all of those that had no recession were reelected (See our Capital Market Outlook May 18). As we get closer to November, we will continue to closely monitor the equity market movements and the economic recovery.
Since the onset of the pandemic, there's been a renewed appreciation for space. No, not the recommended six-foot social distancing measure, but the premium on space in the industrial real estate market levered to tailwinds such as: increased e-fulfillment demand and the resulting shift from physical retail to logistics space; IT infrastructure spend around data centers and cell towers; and lastly, near-shoring supply chain production over the longer term.
U.S. e-Commerce accounted for 15% of retail sales at year-end 2019, and for the better half of the last decade has been growing faster than brick-and-mortar sales. Layer on the pandemic and Euromonitor estimates e-Commerce may represent 19% of retailing by year-end, pulling forward years of share gains made during the pandemic (Exhibit 4).
Exhibit 4: U.S. e-Commerce Sales.
A higher e-Commerce adoption rate means more space, and an intensive use at that, comparatively requiring more than three times the logistics space to brick-and-mortar sales. Prior to the pandemic, Jones Lang LaSalle (JLL) attributed 35% of its industrial leasing to e-Commerce and now expects leasing activity near 50%. With all things digital and cloud migration clear secular stories, this is reflected in market performance year-to-date (Exhibit 5). While the broader Nareit Index inclusive of office real estate, retail, lodging etc., is down 15.3% year-to-date, the Industrial Real Estate Investment Trusts (REITs) sector, which includes warehousing and distribution centers, rose 6.6%, versus the Data Center REITs sector, which jumped 23.3% year-to-date.
Exhibit 5: Secular Beneficiaries in Space.
And lastly, as we've discussed, we think the re-shore and near-shore production will play out over the longer-term and businesses will be inclined to create more domestic supply chains. Out of necessity, companies could house higher levels of inventory with the shift from just-in-time to just-in-case. Although inventory-to-sales ratios have largely declined since the early 1990s, we think this is likely to reverse coincidentally with the nearshoring of supply chains as manufacturers and retailers worry about last-mile logistics. According to CBRE Research, even a 5% increase in business inventories requires an additional 400 million to 500 million sq. ft. of warehouse space—all of which benefits these secular winners in space.