Jim Solloway, Chief Market Strategist and Senior Portfolio Manager in SEI’s Portfolio Strategies Group, answers questions from Heather Corkery, Managing Director of Client Portfolio Management, in a two-part video series on the economic and investment outlook.
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Heather: Hi, I’m Heather Corkery, Managing Director of Client Portfolio Management at SEI. Today, we’ll be discussing the economic outlook with Chief Market Strategist and Senior Portfolio Manager Jim Solloway.
Jim, thanks for taking the time to talk. I’d like to start by getting your thoughts on what seemed like a bit of a retrenchment that we saw this summer—certainly not a return to full-fledged lockdowns by any stretch, but a pause or at least a slowdown in the return to normal. How long do you expect this dynamic to last?
Jim: We suspect the gloom is already a bit overdone. The delta wave is in decline, which will help revive consumer’s spirits. Household wealth is at an all-time high owing to booming stock and home prices.
Heather: It’s certainly good news that rising asset prices have been bolstering household wealth. I wonder, though, if price pressures are a cause for concern, not necessarily in stocks and real estate, but more in general inflationary terms.
Jim: That’s entirely possible. We expect inflation to run at a higher rate for a longer period than has been commonly assumed, not just over the next one or two years, but well into the decade.
Heather: The Fed’s economic projections show inflation returning back to 2% or so within a couple years. What are you seeing that raises concern about the prospect of persistent higher inflation?
Jim: We think the labor market is telling us an important story right now.
Jim: In the chart, we show the three-year trend in unit labor costs and the core Personal Consumption Expenditures Price Index. Changes in unit labor costs reflect changes in total labor compensation minus productivity, or output per hour. Plotting this against core PCE prices gives us a sense of how expensive workers have grown relative to inflation.
Growth in unit labor costs typically nosedives as the economy emerges from recession because compensation is low and productivity picks up sharply.
Something different is happening this time. Hourly compensation growth is already close to its previous cycle highs looking back over the past three decades. Labor productivity is also rising, but not nearly as fast as compensation.
As a result, unit labor costs have risen at a 2.7% annualized rate over the past three years, the fastest pace since the peak of the 2002-to-2007 expansion.
Jim: We don’t know if the labor shortage will ease enough to quickly reduce the pressure on compensation growth. Since US demand will probably stay robust as economic growth normalizes, it wouldn’t be surprising to see companies continue passing along their increased costs. Inflation over the long haul could be closer to 3% than the 2% or so currently expected by the Fed and most investors.
If that turns out to be the case, the current yield structure in the bond market may also prove to be unsustainably low, and the Fed may be forced to raise interest rates higher and faster over the next three years than anticipated. Inflation impacts how assets are priced.
Heather: Do you see a similar inflation overshoot outside the U.S.?
Jim: Other developed countries are broadly on the same path as the U.S., and reacting to the same catalysts. The challenges posed by COVID-19 and disruptions to production have pushed inflation in various countries to levels not seen in many years.
Jim: The U.K. has tended to be more inflation-prone over the past decade than the rest of Europe and even the U.S.
On a year-over-year basis, consumer prices surged almost 6% in the U.S. versus 4.7% for Germany, 3.0% in the U.K. and 3.6% in the EU. More than a percentage point of the difference between the U.S. and other regions comes from the soaring price of used cars and trucks. Some industries in the U.S.—primarily within services (that’s hotels, apparel, airfare, restaurants and catering)—are seeing prices rise faster compared to other parts of the world.
Jim: This reflects an earlier reopening in the U.S. economy compared to Europe. Inflation in the U.S. may be near a peak, but a further acceleration appears to be in store for Europe. The immediate concern for households in the region is the cost of energy.
Heather: Thanks Jim. We always appreciate your insights.
Glossary of financial terms
- Bull market refers to a market environment in which prices are generally rising (or are expected to do so) and investor confidence is high.
- Congressional Budget Office (CBO) is a federal agency within the legislative branch of the U.S. government that provides budget and economic information to the Congress.
- Cyclical stocks or sectors are those whose performance is closely tied to the economic environment and business cycle. Managers with a pro-cyclical market view tend to favor stocks that are more sensitive to movements in the broad market and therefore tend to have more volatile performance.
- Discount rate is the minimum interest rate set by the Federal Reserve for lending to other banks.
- European Union (EU) is a group of 27 countries that operates as a cohesive economic and political block. Nineteen of the countries use the euro as their official currency.
- Growth stocks exhibit steady earnings growth above that of the broader market.
- High-yield bonds are rated below investment grade and are considered to be riskier.
- International Monetary Fund (IMF) promotes international financial stability and monetary cooperation. It also facilitates international trade, promotes employment and sustainable economic growth, and helps to reduce global poverty. The IMF is governed by and accountable to its 190 member countries.
- Issuance is the sale of securities, typically with regard to debt instruments such as bills, notes and bonds.
- The Personal Consumption Expenditures Price Index
- Price-Pressures Measure (PPM) was developed by the Federal Reserve Bank of St. Louis to measure the probability that the expected personal-consumption expenditures price index inflation rate (12-month percent changes) over the next 12 months will exceed 2.5%. It is composed of 104 separate data series grouped into nine different buckets: (1) consumer-price indexes, (2) producer-price indexes, (3) commodity prices, (4) housing and commercial property prices, (5) labor-market indicators, (6) financial variables, (7) inflation expectations, (8) business and consumer survey data, (9) foreign price variables
- The Forward price-to-earnings (P/E) ratio is the ratio for valuing a company that measures its current share price relative to its forecasted earnings per-share (EPS) over the next 12 months.
- Yield is a general term for the expected return, in percentage or basis points (one basis point is 0.01%), of a fixed-income investment.
- Yield curves represent differences in yields across a range of maturities of bonds of the same issuer or credit rating (likelihood of default). A steeper yield curve represents a greater difference between the yields. A flatter curve indicates that yields are closer together.
- Value stocks are those that are considered to be cheap and are trading for less than they are worth.
- The Chicago Board Options Exchange (CBOE) Volatility Index reflects a market estimate of future volatility, based on the weighted average of the implied volatility of the S&P 500 Index. Investors use the CBOE Volatility Index to measure the level of risk, fear, or stress in the market.
- The Citigroup Economic Surprise Index measures data surprises relative to market expectations. The index was designed for currency trading, and its signals may not be relevant to other financial instruments. A positive (negative) reading means that data releases in the prior three months have been stronger (weaker) than expected.
- The Citigroup Inflation Surprise Index measures the level of actual inflation compared with inflation expectations.
- The Consumer Confidence Index is an economic indicator published by The Conference Board to measure consumer confidence, defined as the degree of optimism on the state of the U.S. economy that consumers are expressing through their activities of savings and spending.
- The Consumer Price Index measures changes in the price level of a weighted-average market basket of consumer goods and services purchased by households. A consumer price index is a statistical estimate constructed using the prices of a sample of representative items whose prices are collected periodically.
- The Consumer Sentiment Index is a monthly survey of consumer confidence levels in the U.S. conducted by the University of Michigan. Consumer sentiment is a statistical measurement of the overall health of the economy as determined by consumer opinion.
- The Harmonized Index of Consumer Prices (HICP) measures the changes over time in the prices of consumer goods and services acquired by households, and is an indicator of inflation and price stability. It gives a comparable measure of inflation as it is calculated according to harmonized definitions.
- The ICE BofA Emerging Markets Corporate Plus Index tracks the performance of U.S. dollar and euro-denominated emerging-market non-sovereign debt publicly issued within the major domestic and eurobond markets.
- The MSCI China Index captures large- and mid-cap representation across China H shares, B shares, Red chips, P chips and foreign listings such as ADRs. With 469 constituents, the Index covers about 85% of this China equity universe. Currently, the Index also includes large-cap A shares represented at 5% of their free float-adjusted market capitalization.
- The MSCI Emerging Markets Asia Index is designed to measure the performance of the large- and mid-cap segments across nine emerging-market countries in Asia.
- The MSCI Emerging Markets Index is a free float-adjusted market-capitalization-weighted index designed to measure the performance of global emerging-market equities.
- The MSCI USA Index measures the performance of the large- and mid-cap segments of the U.S. market.
- The MSCI World Index is a free float-adjusted market-capitalization-weighted index that is designed to measure the equity-market performance of developed markets.
- The MSCI World ex USA Index is a free float-adjusted market-capitalization-weighted index that is designed to measure the equity-market performance of developed markets, excluding the U.S.
- The Personal Consumption Expenditures (PCE) Price Index is the primary inflation index used by the Federal Reserve when making monetary-policy decisions.
- The Purchasing Managers' Index (PMI) is an indicator of economic health for manufacturing and service sectors. Its purpose is to provide information about current business conditions to company decision makers, analysts and purchasing managers.
- The PMI Manufacturing Index is a monthly indicator of U.S. economic activity based on a survey of purchasing managers at more than 300 manufacturing firms. It is considered a key indicator of the state of the U.S. economy.
- The PMI Services Index is based on monthly questionnaire surveys collected from over 400 U.S. companies that provide a leading indication of what is happening in the private sector services economy.
- The S&P 500 Index is an unmanaged, market-weighted index that consists of 500 of the largest publicly traded U.S. companies and is considered representative of the broad U.S. stock market.
- The S&P 500 Value Index measures U.S. value stocks using three factors: the ratios of book value, earnings, and sales to price.
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