Markets Rise as Economy Continues Seeking an Equilibrium

If you scrolled through your newsfeed Tuesday morning, you may have caught two Reuters headlines juxtaposed together: “Automobile Shortages Weigh on U.S. Retail Sales” and “U.S. Manufacturing Production Accelerates on Autos in July.”

In just 15 words two headlines neatly explain why we, and the Federal Reserve, believe inflation is temporary and growth can continue for some time.

Supply bottlenecks, material shortages and a host of other factors are leading to product and services shortages (see headline 1) amid a wave of demand.  That’s triggered a sharp, year-over-year rise in prices, particularly in energy and autos. A key storyline is playing out in sectors where prices are spiking due to shortages: Production rises (see headline 2) to meet demand, and prices start falling back to a long-term mean.

Where there’s demand, there’s an opportunity, and it doesn’t take long for companies in a competitive, free market to seize them. For the past year, we’ve been seeing in real time an economy paw for equilibrium following a once-in-a-century type of disruption, and that’s created turbidity in the data and thrashed well-calculated projections. Still, through it all markets seem to be seeing through the fog, given the rather steady climb through this summer when inflation concerns scaled.  

WALL STREET WRAP

Retail Sales Slow in July: Retail sales in July dipped 1.1 percent from the month prior but were still 15.8 percent above July 2020 levels, according to the U.S. Commerce Department. So spending came back in a bit as coronavirus cases rose, but spending remains well ahead of 2020 and even 2019 levels. Overall, consumers are in a position of financial strength heading into the critical months ahead for retailers.

Auto category purchases fell back 3.9 percent from June, but that may be a net positive in the shorter term. Auto prices have been a key driver of headline inflation over the past several months due to strong consumer demand amid a semiconductor shortage that’s limited production. While auto inventory shortages contributed to reduced sales in June, consumers likely held back purchases in response to price. However, a mild decline in sales buys time for auto companies to ramp up production (recall headline 2), replenish inventory and bring prices closer to the mean. Which leads us to …

Production Surges at U.S. Factories: Industrial production in July advanced 0.9 percent, more than economists had expected. Manufacturing output surged 1.4 percent after falling back 0.3 percent in June, driven by an 11.2 percent jump in vehicle and parts production. While a semiconductor shortage continues to hang over the auto industry, several companies canceled typical July shutdowns. Overall, data show there’s plenty of inventory to replenish and backlogs to work through, which are solid indicators of growth over the next few months.

FOMC Minutes: The biggest reveal from the Federal Open Market Committee’s July meeting minutes is that tapering, or reducing the pace of Fed asset purchases, could come sooner than projected, and that pulled markets down for a day last week. Roughly 60 percent of FOMC members still anticipate a start to tapering the pace of the Fed’s asset purchases in January 2022, but some members shifted their estimates into 2021 this year. And as the market’s logic goes, if tapering begins sooner, a rate hike could also come sooner.

We remind that tapering is simply removing some supports, or basically taking the training wheels off when they simply aren’t needed anymore. The Fed has promised to proceed carefully and gradually when the time to taper arrives.

Builder Confidence Dips: Demand is still elevated, but material and labor costs are beginning to ding homebuilder confidence. The NAHB/Wells Fargo Housing Market Index dipped to 75 in August, its lowest point in 13 months. Prices, like for autos, are putting construction and even new home sales on hold for many consumers.

“While these supply-side limitations are holding back the market, our expectation is that production bottlenecks should ease over the coming months, and the market should return to more normal conditions,” said Robert Dietz, NAHB chief economist.

Case in point: Lumber prices, which touched nearly $1,700 in May, recently fell below $500 — to nine-month lows as mills catch up and buyer demand slows due to prices. Lumber accounts for roughly 15 percent (give or take a few percentage points based on the economic backdrop) of a new home’s overall cost, so a reduction in lumber prices could help reinvigorate new construction over the next several months.

THE WEEK AHEAD

Looking Ahead: We’re looking ahead to another busy week across markets. The week will open with the Markit services and manufacturing reads for August, followed by existing home sales and new home sales. Rising prices have slowed sales slightly, but the housing market remains (and has been throughout the pandemic) in a position of strength. Manufacturing and durable goods orders will be insightful later in the week, and keep an eye out for any new commentary from Fed Chairman Jerome Powell during the Jackson Hole Economic Symposium, which kicks off Thursday.

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