July 14, 2022
CRISIS. REACTION. CRISIS. REACTION. REPEAT.
Just two years ago, in Q2 2020, we saw GDP drop 11.1% from Q1. Unemployment reached 14.7% that April. Fifteen million people were unemployed and 30 million were collecting unemployment benefits. Hospitals were filling up with Covid patients, 100,000 had died from Covid, and a vaccine was six months away from being developed.
Today the crises are different. We are faced with inflation, a potential recession, the Putin war, 100,000 annual Covid deaths, and a worldwide shortage of food. History repeats itself and so do reactions, but these cycles have been with us a long time. We need long-term planning and strategy.
The pandemic created supply-side constraints that are the main reason we have inflation now. It used to be said that the solution for high prices was high prices. We eventually figure out a way to produce more either by increasing production or other alternatives. This time is different: The physical scarcity of so many items is causing our problems. The capacity to produce more oil, fuel products, farm products, and many metals for EVs is lacking. Labor shortages persist even with job growth and a 3.6% unemployment rate. A slowdown in demand will relieve part of the supply chain problems, but many industries are far from catching up.
HIGH GAS AND ENERGY PRICES ARE HERE FOR A LONG TIME
This inflation cycle will be a lot different than previous ones, mainly because of gas prices. Gas prices influence every product we consume. They are the highest they have ever been not only because of oil prices, but also because refining capacity is playing a much larger role in gas prices. Refineries process oil and produce gas, diesel, and jet fuel. No new refinery with significant capacity has been built since 1977 because of the investment cost. And who wants a refinery in their backyard, anyway?
Gas demand plummeted in 2020 as we went into lockdown. With reduced demand, many marginally profitable refiners shut down and the capacity to refine oil was reduced. Now, demand has returned but supply has not. Consequently, the price of refined products has skyrocketed as the economy has revived. Between 1985 and 2021, refining costs averaged $10.50 per barrel. The cost currently stands at $70 per barrel and represents a large part of why gas prices are, and will continue to be, so high.
Paul Krugman points out another reason for high gas prices in a summary of the rockets and feathers theory in a paper written by Severin Borenstein, Richard Gilbert, and A. Colin Campbell: “When oil prices shoot up [rockets], owners of gas stations feel empowered not just to pass on the cost but also to raise their markups, because consumers can’t easily tell whether they’re being gouged when prices are going up everywhere. And gas stations may hang on to these extra markups for a while even when oil prices fall [feathers].” Now, consumers are changing their driving habits, and that will somewhat slow demand for refined products. Still, prices will remain abnormally high.
Only two years ago, when we were all in lockdown, there was so much excess oil that the US ran out of room to store it. The spot price for oil actually went below ZERO. Some oil producers actually paid to have the oil taken away.
The Consumer Price Index (CPI) for June rose to 9.1% year-over-year, the most since 1981 and 1.3% from last month. Volatile food, energy, and rent prices were up the most. When stripped of this, core inflation rose 5.9% from last year and .7% over last month.
The Producer Price Index for June rose 11.3% on a 12-month basis and 1.1% from May. The core price index excluding food, energy, and supplier margins rose 8.2% from last year and .4% from May.
PCE, Personal Consumption Expenditures, which is the Fed’s preferred measure of inflation, rose 0.6% in May and is up 6.3% from a year ago. Core prices, which exclude food and energy, rose 0.3% in May and are up 4.7% from a year ago. Even though the Fed will be using the lower PCE inflation rate to get to its 2% target, it will still be very difficult to hit.
The vast majority of inflation has been caused by the pandemic, supply chain issues, labor shortages, and the Putin war; the war alone added about 1%. The rest of the world has also experienced inflation of over 8%. Germany is one of the largest global economies, and Robin Brooks, chief economist of the Institute of International Finance, stated: “Germany’s growth model has been to import cheap energy from Russia, use that to assemble manufactured goods, and export those goods to the rest of the world.” Natural gas prices soared 700% in Europe since the Putin war, and Germany just recorded its first budget deficit since 1991.
Consumers are spending less on goods while they increase their spending on services, food, energy, and rent; the average monthly spending increased $400 to $500. Two years ago, most economies did not experience a quick turnaround in spending. Reducing inflation will take a lot longer.
Outside of headline inflation, some prices have been dropping. Computer chips were down 10.6% in Q2 as supplies increased. But they are still not readily available for the auto industry, which is not expected to catch up for another two years. Retailers’ clothing inventories have increased. Ocean freight rates have dropped. A backlog of 1.7 million houses is coming onto the market, which will reduce the upward pressure on rents. Also, inflation for many items is measured in year-over-year increases, and those percentages are not nearly as high as measuring 2021 vs. 2020. We should start seeing a drop in core inflation throughout the rest of the year and into next. It just won’t feel like it.
For those of you who want a more in-depth look at what can or should be done to get ourselves out of this inflation mess besides what the Fed is doing, read this article in The Overshoot by Matthew C. Klein.
I have been talking about a potential recession for months, as have others. The are many factors affecting the calculus, and it will be extremely difficult to tame inflation without a hard landing. Labor shortages persist in key manufacturing areas, commodity prices plummeted over 33% in Q2, and supply chain issues still persist. Core inflation rates will drop based on these factors and how inflation is calculated, as well as the decrease in spending.
The psychological impact of headline inflation on consumer confidence will be difficult to change and could cause the feared wage price spiral, which Fed Chairman Jerome Powell has said he will not allow to happen. Referencing the balancing act to prevent a recession, Powell said, “So the risk is that because of a multiplicity of shocks you transition – you start to transition into a higher inflation regime, and our job is literally to prevent that from happening. And we will prevent that from happening. We will not allow a transition from a low inflation environment into a high inflation environment.” At a recent central banking forum in Portugal, he added, “The biggest mistake to make… would be to fail to restore price stability.” This translates into, “There will be no wage price spiral on Powell’s watch.” Interest rates will keep going up while slowing the economy and bring the hot job market down along with inflationary wage increases. Powell was late to the party, but now he is laser focused.
As the economy contracts, unemployment rates should go up. However, there are still 11 million job openings. Employment rose by 372,000 jobs in June, and the unemployment rate is still just 3.6%. Over 2.7 million jobs have been created this year, mainly in leisure and hospitality, but also manufacturing and construction. With the cost of inflation, I expect more people will want to return to the job market. If many do return, some pressure will come off the higher wages.
Lawrence Summers, who was one of the first to talk about inflation over a year ago, told the London School of Economics recently: “We need five years of unemployment above 5% to contain inflation — in other words, we need two years of 7.5% unemployment or five years of 6% unemployment or one year of 10% unemployment.” He mentioned that this was a back-of-the-envelope calculation, but it is the same strategy for increasing unemployment to reduce inflation.
We are in a strong economy with high employment and strong consumption and production. Savings are still very high. ITR, one of the most accurate forecasters, says “the current rising trend in interest rates most likely ties in with the recession ITR Economics has been forecasting for post 2024. The rising trend in rates does not have a bearing on our economy in 2022 and 2023.”
Durable goods once again exceeded expectations.
- Shipments of “core” non-defense capital goods ex-aircraft (a key input for business investment in calculating GDP), rose 0.8% in May following a 0.8% increase in April.
- May orders were up for primary metals (+3.1%), machinery (+1.1%), and computers and electronic products (+0.5%). Orders for fabricated metal products were flat.
- Car sales were down 11% for the first half of the year, mainly due to an inventory shortage.
Business investment continues to look strong through 2022 as we try to catch up with the backlog created after the worst of the pandemic slowdown. That will be a good tailwind for the rest of the year.
Existing home sales slumped near a two-year low as interest rates rose and the median sales price rose 15% year-over-year. However, May new home sales jumped 10.7% to 696,000 annualized. There is still a shortage because 5 million fewer homes were made during the decade following the 2008 housing crisis. Even so, with housing prices continuing to rise due to labor and material shortages, inflation, and higher interest rates, the housing market does not look good.
The ISM Purchasing Managers Index fell to 53 in June from 56.1 the previous month. That still shows expansion but does reflect the shift in spending from goods [- .7%] to services [+.7%]. The new orders index fell to 49.2 in June, dipping into contraction territory for the first time since the early days of the pandemic. However, the production index rose to 54.9 in June. Plants are still busy and the backlog of existing orders fell. That is a sign that factories are catching up. There is still a great need for skilled workers. The Shapiro Nonferrous Scrap Activity Index for June was down 6% from May and up 3% year-over-year. Manufacturers continue to fight the same supply chain and labor issues.
Chinese real estate investment fell 7.8% year-over-year in May, while housing starts and sales contracted by a whopping 41% year-over-year. The 100 biggest real estate developers saw new-home sales plummet 59% in May from a year earlier, according to preliminary data from China Real Estate Information Corp. The drop matched April’s decline as the biggest this year. The housing industry makes up 30% of China’s GDP.
Car sales rebounded to an annual rate of 24 million, and production has recovered 46% from last year. China also just placed an order for 300 planes from Airbus. Both the official China PMI and Caixin PMI moved over 50 into expansion territory, even while much of the population is under tight Covid restrictions, which can’t be good for consumer confidence.
Metal prices in Q2 were down over 30% from Q1, which is the most on a percentage basis since 2008. They’re driven down by the slowdowns in China and Europe and the fear of a recession. Commodity hedge funds also were heavy sellers of metals.
Aluminum prices are the lowest since the beginning of 2021, as are copper, steel, and stainless steel. Nickel is the only metal that is still higher than at the beginning of this year.
Prime aluminum scrap prices fell 20% in June compared to May.
The Midwest premium dropped to 30 cents per pound and still looks weak.
Scrap spreads widened due to weaker demand and secondary prices fell across the board: aluminum 15%, copper 18%, nickel 23%, steel 25%, and stainless steel 23%.
The lessons Shapiro learned in 2008 were to keep inventories very low and hedged. That strategy is consistent and works in up– and especially down — markets.
“There is nothing wrong with America that cannot be cured by what is right with America.” -Bill Clinton
Life is good. Family and health are precious.
Comments are appreciated. If there are other people you know that would like to read this, let me know and I will add them. This report was prepared by Bruce Shapiro and reflects my current opinion of the economy. It is based on sources and data I believe to be accurate and reliable. Opinions and forward-looking statements expressed are subject to change without notice.