Podcast: Can We Put the “Humpty Dumpty” U.S. Economy Together Again?
VOICEOVER: Welcome to the Investment Conversation. I’m Tony Fisher.
the combination of very strong demand and snarled supply chain is really, resulting in a much bigger inflationary impulse than people anticipated when we got this big demand stimulus to carry the economy through the Covid period
but the Labor market in broad terms, is really just another manifestation of the Humpty Dumpty economy that's not coming back together again in the way that it existed before we fell into the Covid chasm.
Voiceover: Much like everything about the COVID-19 pandemic, the rebound of the U.S. economy from the shutdown-imposed weakness of 2020 looks quite different from any previous recoveries. The irregular shape and pace of the recovery calls to mind a famous nursery rhyme character who also faced difficulties in becoming whole again after a precipitous fall. Lord Abbett Partner & Director of Strategic Asset Allocation Giulio Martini picks up the story in this conversation with my colleague Will Andrews.
Will Andrews: Giulio, in a recent commentary on lordabbett.com you invoke a famous egg-shaped wall sitter to describe the current US recovery. Can you elaborate on that?
Giulio Martini: Well, thanks for having me and you're right it's called the Humpty Dumpty economy and I’ve done so because, you know when the economy fell into the chasm that was triggered by the shutdowns that were necessary to deal with the healthcare crisis in early 2020 a lot of pieces shattered and now that we're up and out over the other side, what we're finding is that the pieces are not fitting together again very easily, and so the Humpty Dumpty analogy seemed appropriate.
Andrews: So I guess we go from fairy tales to the real world, then. Before we sat down today, you spoke of the larger narrative about the current US economic recovery. And one of the things you mentioned was a divergence in demand for two key sectors of the US economy and the destructive effects they've had on the shape of the recovery, could you also elaborate on that?
Martini: Well that's right, and you know I think in very broad terms what we're seeing is that, as the pieces come back together and don't fit well the friction that's being created is an inflationary impulse in different segments of the economy, and let me explain why that's happening.
What we're seeing is consumer demand almost back to its pre Covid trend and consumers and households have been very well supported by fiscal transfers things like generous unemployment insurance programs, the new child tax credit that just became effective in July before that emergency assistance payments to households and those stimulated consumer spending greatly, but it was channeled into demand for tangible things for goods things like cars, furniture, renovations around the home meals cooking at home really boom, so people bought a lot of household appliances and kitchen utensils and things like that.
And the demand for those things simply outran the supply and so what we saw was a very big increases in prices for those items that consumer demand was channeled into at the same time, the decline in spending on services did not depress prices in those areas they nearly stayed where they were and so we've seen this inflationary impulse now it's not just a demand side story.
We're also seeing that global supply chains are being strained enormously by the increase in demand and, in fact, in many cases, surprisingly, so things like semiconductors are in very short supply. You know, there are some photos, for instance, that required dozens of different kinds of chips to be manufactured and just being out of one or two of those means that the car the truck can be produced and so we've seen a big decline in order, production and a big increase in new and used car prices because shortage of chips but it's not it doesn't stop there.
You know, when people try and go on vacation and rent a car, the shortage of automobiles in the shortage of used cars is increasing the price of Rentals it's increasing the price of you all's it's increasing. You know the price of a broad range of goods that need to be shipped international because freight rates for trucking and for shipping are increasing, as the demand for goods outstrips the supply, so the combination of very strong demand and snarled supply chain is really, resulting in a much bigger inflationary impulse than people anticipated when we got this big demand stimulus to carry the economy through the Covid period.
Andrews: I think we want to talk here in terms of not only that the goods part sector of the economy, but I think some of the aspects of the effect on services right and some of the disruptions that we've seen there.
Martini: Well, the disruptions and servicing some the pieces not fitting back together again easily and services has a lot more to do with the Labor market. You know the services are very human being and passive whether it's restaurant meals or visits to a doctor or sports events you know, a very large component of what's being produced is being produced with Labor input, so you need people to produce services and what we're seeing is after this big increase in unemployment in 2020 it's proven can be difficult to get people back on the job and it's difficult because people have healthcare concerns you know the virus is still infecting a lot of people, you know the vaccination rate is still around you know 60% for people with two shots of the vaccine.
A lot of people have childcare responsibilities or family responsibilities, because schools have been closed, and you know loved ones, have been ill and so they're not able to come back to work, a lot of people are re prioritizing is what we hear that you know they want to be able to work remotely at least for part of the week, and that wasn't necessarily the situation beforehand.
And then, of course, there have been quite generous unemployment insurance benefits and all of those things that made it difficult to get people back to work. And that's particularly affecting the services sector, now the way we're seeing it is that wage inflation has really come back much more quickly and much more forcefully after the recession ended then we've seen at the end after past downturns and so that source of cost pressure which, of course, in the past has also added to you know inflationary types of situations is also becoming much more advanced and so that adds to the pressure on goods prices from the services side and through Labor costs as well, but the Labor market in broad terms, is really just another manifestation of the Humpty Dumpty economy that's not coming back together again in the way that it existed before we fell into the Covid chasm.
Andrews: We actually discussed this situation with the U.S. labor market in an earlier podcast in August called “U.S. Inflation: Working Out the Impact of Labor Costs,” of course, that is available both on lordabbett.com and on listeners’ favorite streaming media services.
So the third and maybe final thread that we've talked about is, you know how China and china's resilience through all the pandemic and the sort of outsized growth, economic growth that it's seen how does this factor into things here Giulio, what are your observations on this?
Martini: I think, in many ways, China has been really big economic surprise. You know, as the pandemic started a lot of people believed that global supply chains were going to rerouted be rerouted away from China, both as a result of you know, growing tension between China and the rest of the world, and also because you know too much of the global healthcare supply chain really being dependent on production in China and the response to the virus, they are a combination of all those things made people believe China will be disadvantaged by this situation, but what we're finding is that the opposite has taken place in fact.
China has boomed during this period, its manufacturing sector has been incredibly resilient, incredibly reliable, it's really been the go-to manufacturer in the world by far, both because of its size and because of the dependability of the firm's there and the workers that you know have jobs in those factories and as a result, China has boomed and, if you look at the numbers, you know, China had a very, very bad first quarter of 2020 but it bounced back almost immediately and then started to grow quite rapidly, so that the Chinese economy is you know 6% or 7% larger than it was at the peak at the end of 2019 now the US economy is as also performed really well but GDP just returned to the prior peak in the second quarter of 2021.
So this has been a period where the Chinese economy has just kind of forged ahead in terms of growth and, as a result, you know we was already the second largest economy in the world, before the downturn, as a result it's been catching up much more rapidly after Covid than it was before cove women, of course, you know this is kind of a new situation for the world economy where, you know, for most of the post-World War Two period, the United States has been unchallenged really as the world's largest economy, the kind of, you know the economy that no one could really live without having both demand and supply side linkages to and now there's another you know really big kid on the block who's almost as large as the United States, and you know, looking at the projections now the year in which the Chinese economy overtakes the U.S. has been accelerated by considerably you know by the whole Covid experience and how the Chinese economy is reacted so you know that's another way that the pieces are not really fitting back together again the same way that they were arranged before Covid it is that you know the relative size of different countries in different regions is really changing in a faster way than it was before.
Andrews: So Giulio you said in a recent note that in speaking about the current economy, “if Humpty Dumpty doesn't get put back together again soon, the low inflation, low volatility fairy tale, the financial markets have been living in since the mid-1990s could give away to a darker stagflationary interlude” Giulio, I haven't heard the word stagflation, I think, since I was, you know, listening to Fleetwood Mac on my 8-track tape player. So my question to you is, what is stagflation, and why should we worry so much about it?
Martini: Well, well, I didn't realize that Fleetwood Mac had a song about stagflation. As an economist I'm going to have to go back and listen to it. But just you know, to give you a sense of it, you know stagflation is a situation where the economy is operating below potential output. Growth is slow, but inflation is accelerating nevertheless and so it's kind of the worst of all worlds, because you know if inflation is accelerating because demand is strong and the economy is ripping you know forward and growing at least you know their benefits in terms of higher earnings more jobs, rising wages in that situation, but instead creates a situation where the economy is below trend and inflation is accelerating you kind of have the worst of both worlds, because of slow growth going hand in hand with rising prices and likely rising bond yields as well.
Martini: I wonder how Fleetwood Mac will all of that into one song, but you know Stevie Nicks was a great songwriter so I'm certainly found a way to be really clever and doing so.
Andrews: Giulio, what should investors take away from all this?
Martini: Well, what you're seeing right now will, and you know this is very much the feds interpretation and interpretation of most of the economics profession investment strategist investors.
Market, and you know participants, is that they view these inflationary frictions as being transitory, in other words, you know what we're seeing right now is you know price increases. You know, four to 6% year over year that's way beyond the feds 2% medium term target but everybody believes that these are transitional phenomena that are related to this period in which the pieces are not fitting together well but that going into all these frictions broke its way to a much smoother functioning of the economy that will involve inflation coming back down to around 2% by the end of next year.
Now, the problem with that is that if the frictions last for longer, or I shouldn't say the problem, the risk with believing that 2% inflation is coming back so quickly is that the frictions and this transition last for longer it starts to affect the inflation expectations, because it's more persistent than people believe and rising inflation expectations find their way into wage demands in a tight labor market that, then you know go around and create more inflation in a second round situation, and then we get into sort of a little bit of an inflationary spiral, particularly if the economy remain strong throughout this period, so I think the risk is that you know this surge of inflation, which has already lasted for longer and been more significant than people believed it would be turns out to be longer still and even more forceful and then it starts to create some of the inflationary dynamics, which create a trend kind of acceleration of inflation that's greater than what we're looking for right now, and if the signs emerge that the risk of bad is increasing.
Can I think what we're going to see is the Fed become a little less accommodative a little bit more insistent that it has to start, you know, removing accommodation for reducing asset purchases and eventually increasing interest rates, and you know we've got financial markets that are very, very sensitive to interest rate increases and very, very dependent on a low rate low volatility low inflation, environment and when and if that gets challenged and I want to say if that gets challenged because it's by no means sure that it will be yet, but if it does get challenged that will expose a source of vulnerability, which could prove to be significantly greater than people believe it is right.
Andrews: Giulio, this has been great, a fascinating chat, as always, and I don't think we'll ever quite think of Humpty Dumpty in the same way again. Thanks for being here.
Martini: Well, thanks for having me on will and look forward to talking with you again soon, I think the Humpty Dumpty theme is going to be with us for a while.
Voiceover: If you’d like a transcript of today’s podcast or have any further questions on the topics covered today, please contact your Lord Abbett representative. And as always, you can read more Economic Insights from Giulio Martini on lordabbett.com.________________________________________
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Humpty Dumpty - Jazz Channel LA. Com.
Joel Alpers-drums, Joseph Pernicano-Bass, Scott Gilman-Tenor Sax, Dan Boissy-Alto Sax, Cengiz Yaltkaya-
Piano, Paul Ellis-Guitar. /p>
Composed by Chick Corea. Recorded at the Jazz Channel LA Studio
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