The “Humpty Dumpty” Economy | Lord Abbett
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Economic Insights

After its great fall in 2020, the U.S. economy’s recovery has been wildly uneven, heightening uncertainty and inflation risk. Putting it all back together may be difficult.

Read time: 3 minutes

We are living in a Humpty Dumpty economy. Echoing the fate of the ovoid nursery rhyme character, U.S. gross domestic product (GDP) dropped into a pandemic-led chasm in 2020, and “all the King’s horses and all the King’s men” have been unable to put the economic pieces back together again. That’s because the COVID-19 crisis imposed what we believe are permanent reductions in the economy’s productive capacity, and actions taken to cushion the fall caused some of the pieces to become misshapen. This is leading to some of the sharpest changes in relative prices ever, prolonging a period of elevated uncertainty, and increasing the risk that inflation will trend higher than U.S. policymakers are comfortable with.

The pandemic forced parts of the U.S. economy to shut down and limited provision of services in order to contain health risks: restaurants, education, discretionary healthcare, and travel & leisure activities were some of the more prominent sectors where household spending was sharply limited by the risks of social consumption. In response, policymakers made unprecedented efforts to support vulnerable businesses with low-cost loans and grants to tide them over until activity returned to normal. The U.S. Federal Reserve (Fed) ensured that financial markets continued functioning by providing enough liquidity to keep financing available, even as investors’ assessments of risk changed drastically, inducing massive portfolio turnover. Those measures prevented the healthcare crisis from spiraling out into an even worse, economic and financial crisis.

At the same time, Congress passed legislation to sustain household income and spending. The income transfers were so large that disposable personal income rose sharply despite U.S. Bureau of Labor Statistics (BLS) data showing a rise in the unemployment rate to a peak of 14.8% in July 2020. As workers reoriented their workplaces to their homes and awaited the development of vaccines, spending shifted dramatically from services to durable and non-durable goods, and demand for housing surged.

A Not-So-Normal Recovery

Simultaneously, retailers and owners of office space were confronted by heightened uncertainty as they gauged how much future floorspace would be needed as online shopping gained share rapidly, and hybrid work arrangements took hold. A very sharp drop in vacation travel also upset capital spending and expansion plans in the United States and abroad in an industry that accounts for 2% of global GDP.

As vaccination and natural immunity increase at different rates across geographies both within and between countries, the “shape” of the recovery in GDP has been very different from the pre-pandemic structure of the economy. For example, data from the BLS show that spending on goods is far above the pre-pandemic level, or what might have been expected based on the prior trend, while spending on services is much lower. Residential construction spending, after almost 15 years of depressed activity, has surged while nonresidential construction is much lower. And the large shortfalls in imports and exports of services reflect low levels of leisure and business travel.

While the recovery in GDP to the previous peak has taken place on a somewhat normal timetable, the position of the various spending categories relative to trend is by no means normal for the stage of recovery that the economy has attained. Spending on goods is highly exaggerated compared to previous recoveries, straining supply chains and inducing very large price increases. Meanwhile, consumer spending on services, normally the most stable portion of aggregate demand, is deviating in the opposite direction. As complete recovery lags, and fiscal support ebbs, capacity in many parts of the services sector is being mothballed.

 

Figure 1. The Current Recovery Has Seen a Remarkable Surge in Spending on Goods …

… and a Dramatic Pullback in Spending on Services

Source: U.S. Bureau of Labor Statistics. Data as of June 30, 2021. Charts depict percent deviation from trend six quarters after peak levels for the goods (upper panel) and services (lower panel) components of the U.S. Personal Consumption Expenditures Index. For illustrative purposes only.

 

Exaggerated demand for goods and restricted supply of services have led to higher inflation in both areas, as confirmed by recent U.S. Consumer Price Index releases. And the rise in core services inflation is taking place before rising house prices force rents higher over the next 12-24 months.

Distortions in aggregate demand during a strong economic recovery are also leading to elevated turnover in the labor market and more rapid wage increases. (Listen to my recent podcast on the topic.) This is taking place as labor force participation appears to have dropped permanently due to a surge in retirement.

Economic & Investment Implications

The broad issue is that the post-pandemic world will be shaped differently than the pre-pandemic world was, and it will take time for the pieces to fit together smoothly again. It is impossible to forecast how long this process will take since it still depends on a virus whose properties are still not fully known, and how human behavior adjusts to its presence and persistence.

In the meantime, however, the friction that arises from trying to put everything back together involves an inflationary transition that may be more stressful than markets or policymakers are prepared for. The immediate implication is that the Fed may be forced to begin the process of removing monetary accommodation by tapering asset purchases sooner than currently expected. That would automatically accelerate the path for expected rate increases. How much yields increase in response to upwardly revised rate expectations depends on whether the market revises its benign view on inflation. If investors start incorporating a higher trend, then the yield curve would steepen as longer-term yields would rise more than those at shorter maturities.

 

Unless otherwise noted, all discussions are based on U.S. markets and U.S. monetary and fiscal policies.

Asset allocation or diversification does not guarantee a profit or protect against loss in declining markets.

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This material may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.

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This material is provided for general and educational purposes only. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, or any Lord Abbett product or strategy. References to specific asset classes and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations or investment advice.

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Glossary Definitions

The U.S. Consumer Price Index (CPI) is a measure that examines the weighted average of prices of a basket of consumer goods and services, such as transportation, food, and medical care. It is calculated by taking price changes for each item in the predetermined basket of goods and averaging them.

The U.S. Personal Consumption Expenditure price index (PCE), also referred to as the PCE deflator, is a United States-wide indicator of the average increase in prices for all domestic personal consumption. It is benchmarked to a base of 2009 = 100. Using a variety of data including U.S. Consumer Price Index and Producer Price Index prices, it is derived from personal consumption expenditures, the largest component of U.S. gross domestic product in the U.S. Bureau of Economic Analysis’ National Income and Product Accounts report.

Yield curve is a line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity dates. One such comparison involves the two-year and 10-year U.S. Treasury debt. This yield curve is used as a benchmark for other debt in the market, such as mortgage rates or bank lending rates. The curve is also used to predict changes in economic output and growth.

This material is the copyright © 2021 of Lord, Abbett & Co. LLC. All Rights Reserved.  

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