December 2nd, 2022
Mixed signals on the economy and from the Fed kept traders guessing this week following the Thanksgiving holiday. Monday saw stocks open in the red over concerns that China’s Covid restrictions and widening protests could once again disrupt supply chains and add to inflationary pressure on consumer goods. Wednesday’s Q3 GDP revision showed that the economy expanded at a 2.90% annual rate. This is higher than the previous estimate of 2.60% which is paradoxical given the declining consumer confidence figures reported on Tuesday. Not to be outdone, Fed Chairman Jerome Powell chose to stir expectations in his speech before the Brookings Institution. Powell took the opportunity to signal that the central bank would decrease the magnitude of future increases in December – which sent markets tearing higher – but he also reaffirmed that the Fed’s battle against inflation remains far from over. In making his statement, Powell was already aware that Thursday’s personal consumption index (the Fed’s preferred inflation metric) would show a welcomed easing in pricing pressure during October. The price index still grew at a blistering 6.0% but this was down from September’s reading of 6.3%. While the inflection is likely what the Fed is using to justify a downshift, the Fed will need to remain persistent given that the central bank was also aware that Friday’s labor market report would show that employers added 263K to the payrolls in November. The report blew past estimates of 200,000 hires, but wage growth was unusually rapid as well which remains a huge, complicating factor. It was a headscratcher for investors, but one that left the Dow little changed on the week.
Wage Gains Could Make it a December to Remember
Rising rates were meant to cool demand for hiring as consumers cut back on spending due to higher borrowing costs. That has yet to play out, however. In November, businesses added 263K to the payrolls, beating estimates of 200K new jobs. Meanwhile, the unemployment rate held steady at 3.70%. The month’s employment gains were concentrated in two sectors – leisure and hospitality and healthcare and social assistance. Combined they accounted for 170K of the total job gains. Both sectors were battered by the Covid pandemic, shedding thousands of jobs. Education and health have just recently recovered to pre-pandemic levels while the leisure and hospitality sector has still yet to fully recover. With services and experiences continuing to be in high demand, these sectors are likely to continue seeing gains in the months to come which may help offset losses in other sectors. The shift in consumption from goods to services has resulted in employment in the goods producing sectors taking a hit. Both retail trade and transportation shed jobs during the month. Meanwhile, professional and business services showed minimal gains, up just 6K, as strong hiring seen during the pandemic has waned. Despite payroll gains having been concentrated in just two sectors, average hourly earnings rose 5.10% from the year ago period. That’s higher than October’s 4.90% increase. Overall hiring was very strong in November, and the strong wage gains are likely to concern the Fed.
Manufacturing Cools as the Stockings Are Stuffed
After a two-year binge of buying goods, consumers look to have had their fill of material items. As a result, factory floors have slowed to a crawl with the ISM Manufacturing Index registering 49 in November. Numbers below 50 indicate contraction while numbers above 50 indicate expansion. Month-to-month, the index was down -1.2 points and is now at its lowest level since May 2020, which coincides with the early days of the pandemic. Weakness was broad-based, led by declines in order backlogs and imports, down -5.30 and -4.2 points, respectively. The closely watched prices index also fell -3.6 points to 43 as pricing pressures continued to abate due to easing supply chain constraints and lower demand. With store shelves well stocked and demand expected to continue to moderate, it looks like fewer elves will be needed on the factory floor. While most manufacturers have avoided mass layoffs, many are moving to cut their employment levels through hiring freezes and attrition. Those moves helped push the employment gauge to 48.4 and into contraction territory. With demand for goods expected to continue to cool, 2023 looks to be a tough year for manufacturers.
Listening to Powell’s comments this week, we laughed as we were reminded of the old SNL skit “First CityWide Change Bank”. Filmed as an advertisement for a bank, whose sole purpose was to provide exceptional customer service by making change for clients from bills in any denomination the customer could desire. The bank’s value proposition is told through a series of interviews by customers and bank employees. At one point, the camera pans to the bank’s customer service representative, Paul McElroy, who says:
“People don’t realize that change is a two-way street. You can come to us with 16 quarters, 8 dimes and four nickels. We can give you a $5 bill. We can give you 5 singles, or two singles, eight quarters, and 10 dimes. You’d be amazed at the variety of options you have. I’ve had people come in with wrinkled $10 bills who want new crisp bills to put in birthday cards and we can handle a special request like that – usually the same day. All the time our customers ask us, ‘How do you make money doing this?’ The answer is simple – volume.”
Instead of First CityWide Change Bank, it was the Fed making change this week. It is generally believed the Fed’s terminal fund rate will be somewhere in the 5.0-5.5% range, while we’re in the 3.75-4.0% range today. For all intents and purposes, there is a 150-bps spread between where we are today and where the Fed believes we need to be. One can only imagine what a good SNL producer could do with this same fact pattern, parodying Powell as saying:
“If inflation requires a 5.5% terminal rate, we’re going to work with the economy. We don’t have to do two 75 bps hikes. We can do three 50s. We can raise two 50s and two 25s, one 50 and four 25s, or simply six 25s. Investors ask, ‘How is this going to work?’ The answer is simple – we’re data dependent.”
Admittedly, that may only be funny to us as economists but, as the Dow tore higher by 700 points on Powell’s comments, we were left scratching our heads. Nothing has changed fundamentally on the Fed’s outlook on where they see rates needing to be to get inflation back under control, so in the meantime the Fed is just making change.
The Week Ahead
Inflationary pressures have trended lower as consumers increasingly opt for experiences over goods. We’ll see if the trends continue in the latest PPI and ISM Services reports.
The Bullwhip Effect
Many U.S. retailers began the quarter with heavy inventory left over from “the bullwhip effect” brought on by COVID-induced supply chain issues and shifts in consumer demand. The term is derived from the concept in which small movements of a hand cracking a whip become amplified from the origin – in this case, the retailer and end consumer – to distributors and then to the tail of the whip which represents manufacturers and suppliers.
The term was first coined by MIT professor Jay Forrester. “The bullwhip effect” describes a phenomenon in which each step up in the supply chain overestimates demand from the previous step, creating increasingly larger fluctuations in inventory levels. What starts out as a small change in demand at the retail level leads to an even more substantial variation and uncertainty in supply, demand, and lead time further up the chain.
U.S. retailers are sitting on a record $732 billion of inventory as of July 2022, which was a 21% increase from a year ago according to data from the Census Bureau. When the onset of the pandemic caused a drop in demand for goods, retailers and manufacturers alike cancelled orders. However, during the early stages of COVID, shoppers began spending heavily on items such as TVs, athleisure wear, kitchen items and home goods, and more in an unprecedented pandemic spending spree that was fueled in part by several rounds of stimulus. With the global supply chain coming to a halt, retailers worried they wouldn’t have inventory due to supply chain constraints and placed huge orders. Wholesalers and manufacturers also increased their orders on top of retailer forecasts, with everyone wrongly forecasting that consumers would maintain their pandemic level spending and incorrectly forecasting the items consumers would want. Retailers typically order goods anywhere from three to nine months in advance using forecasts based on historical behavior, but there was no template for what consumer behavior would look like coming out of a pandemic. By the time the goods made their way into stores, consumers didn’t want them. Consumers had shifted their dollars away from goods and into services, such as travel, dining out, and other forms of entertainment. “Revenge travel” became popular as a way of making up for lost time during the pandemic. Spending at restaurants and bars jumped nearly 20% in April 2022, and in March, spending on services hit a record $8.6 trillion, topping the previous mark set in February 2020. Retailers were also hit hard by inflation which caused shoppers to slow their discretionary spending.
The bullwhip effect resulted in excess inventory at the highest levels retailers have ever experienced. This has led to heavy discounts and sales promotions to entice shoppers and help alleviate the glut of inventory. An Accenture survey released in October 2022 showed that 99% or nearly all retail executives planned to increase promotional activity this holiday season, and 35% of retailers surveyed said their companies are deeply discounting or taking other measures to get rid of excess inventory. It seems to be working because the National Retail Federation reported that a record 196.7 million Americans shopped in stores and online during the five-day holiday shopping period from Thanksgiving Day through Cyber Monday, and Cyber Monday’s spending represented the biggest online shopping day of all-time with $11.3 billion spent online, a 5.8% growth from last year. Adobe Analytics noted that discounts on electronics peaked at 25% compared to 8% in 2021, toys at 34% compared to 19% last year, and computers at 20% this year compared to 10% in 2021. The bullwhip effect can be a boon to shoppers looking for deals, but it will lead to squeezed margins and decreased profitability for retailers struggling to balance inventory with ever changing consumer demand.