Recap: Two key themes have dominated the view of the U.S. economy. First, GDP growth in the second quarter of 2021 disappointed, registering +6.5% (annualized), even though a large part of the miss was due to inventory drawdowns for which dwindling automobile stockpiles were the main culprit. The effect of limited product availability lingered into July as vehicle sales weighed down the overall retail sales picture for the month.
Supply chains have continued to disrupt vehicle production so this issue will likely persist into the coming months. However, as production is normalized in the latter part of the year, the pent-up demand being generated by the foregone sales should provide a lift to spending into 2022. Second, was the rotation from goods expenditures to services. After the initial lockdowns were lifted, retail sales skyrocketed and have continued to far exceed their pre-crisis trend. Getting back to normal means spending on services will continue to grow as behaviors shift back to pre-crisis norms.
As spending behavior normalizes so should employment. The economy added an impressive 943,000 jobs in July. While the employment recovery has lagged the recovery in economic output, July’s healthy gains, combined with upward revisions to May and June, have helped shrink the gap in employment to just 3.7% relative to the pre-pandemic level. Rapid overall employment growth pulled down the jobless rate to 5.4% from 5.9% in June.
Both the ISM manufacturing and services indexes have remained well above the 50-point threshold in July, pointing to continued expansion through mid-summer, even as the manufacturing index ticked down a notch. The ISM services index, which encompasses a larger part of the economy, reached a new record in July. The manufacturing side of the economy had a better run in the earlier phases of the recovery as consumers shifted toward goods. With most COVID-related restrictions being lifted through the spring and early summer, the services side of the economy has been primed to carry the torch as spending has reoriented toward services.
The pandemic, however, may throw the recovery cycle yet another curveball. New COVID cases have risen sharply from only a few weeks ago, with the more contagious Delta variant now making up more than 93% of all new infections. Hospitalizations have also risen. Vaccines are expected to play an important role in limiting hospitalizations in the current wave. Fortunately, the pace of jobs has also trended higher recently in hard-hit regions. As a result, future bouts of pandemic-related volatility may prove less disruptive to the economy than in the past.
In short, the fastest economic recovery in the modern era has already absorbed most of the economic slack caused by the pandemic. Businesses have responded with increased hiring and have tried to entice workers off the sidelines through higher compensation. Coupled with capacity constraints created by the stop-start nature of re-opening, this has created a recipe for near-term inflationary pressures. At the same time, the Federal Reserve has pulled forward the expected start of rate hikes and has indicated a plan to downshift asset purchases under its Quantitative Easing (QE) policy in the coming months.
Infrastructure Bill: The bipartisan infrastructure bill is unlikely to have a big impact on growth in the next few years. Longer-term, though, investments in highways, ports, and broadband could make the economy more efficient and productive.
The short-term boost to growth however will be relatively limited for two reasons. For one, the bill represents just $550 billion in new spending—compared with nearly $6 trillion that Congress has approved in the past year-and-a-half to battle the Covid-19 pandemic and its economic fallout.
Second, this spending will take place over five to ten years starting in 2022, a longer timeline than pandemic-era initiatives like stimulus checks, extra unemployment benefits, and small business support programs. That would make its direct effects on employment and demand less noticeable.
Retail Sales: Spending at U.S. retailers fell sharply in July, amid cooling purchases of goods and signs of some pullback in consumer demand as U.S. Covid-19 cases tied to the Delta variant rose. Retail sales fell 1.1% in July compared with June suggesting Americans continued to shift spending toward services in July.
Retail sales rose briskly earlier in the summer, as shoppers boosted spending on services and away from goods. That shift occurred as more Americans became vaccinated and state and local governments eliminated many Covid-19-related restrictions, some of which have now been reimposed with the recent rise in coronavirus cases.
Retailers and other U.S. businesses have faced uncertainty caused by the Delta variant, as the highly transmissible strain has caused setbacks for some companies, and data has suggested some pullback in spending on items such as travel. The increase in services spending should continue, but consumer spending will grow more slowly than earlier this year as the boost from federal aid to households’ wanes.
Inflation: Inflation remained elevated in July as the economic recovery continued. Prices have shown evidence of cooling amid pandemic-related supply problems and signs that the recent rise in coronavirus infections has started to crimp some business activity.
Consumer prices rose 5.4% in July from a year earlier, the same pace as in June, the highest 12-month rate since 2008. Monthly, however, price pressures weakened. The Consumer-price index climbed a seasonally adjusted 0.5% in July from June, a significantly slower pace than its 0.9% increase in June from May.
The latest inflation figures came amid growing concerns about the recent rise in Covid-19 infections, driven by the fast-spreading Delta variant, and reports that it has begun to dent economic activity. Inflation has heated up this year as booming demand outpaced the ability of businesses to keep up. Higher inflation could persist for a while and then begin to decline gradually.
Housing: Home prices have surged in almost every corner of the U.S. in the second quarter as robust demand has continued to overwhelm the supply of homes for sale. Home prices have climbed in the past year as low-interest rates and increased remote work spurred new homebuying demand. At the same time, the inventory of homes on the market has dropped as potential sellers canceled or delayed their plans to move. The homes that have hit the market sold quickly, often after a bidding war.
Still, the home buying frenzy has shown signs of a slowdown in recent months. High prices have attracted more sellers to the market and pushed some buyers to the sidelines. Consequently, housing affordability for first-time buyers has weakened.
Trade Balance: The U.S. trade balance widened to a record deficit of $75.7 billion in June. Both exports and imports rose during the month, but there was considerably more strength in imports of both goods and services. Exports rose $1.2 billion, while imports jumped $6.0 billion. With imports having outpaced exports for the quarter, net exports subtracted 0.4 percentage points from the second-quarter real GDP growth.
The trade report has been another example of how American consumers and businesses have stepped up spending and investment as the economy has recovered to its pre-Covid-19 size, fueling demand for imports. Exports have grown more slowly, reflecting weaker recoveries in some other regions that have made less progress against Covid-19.
Logistics and transportation bottlenecks have continued to disrupt trade flows, with the number of ships at anchor off the West Coast starting to creep higher again. In addition to shipping delays, firms have been faced with surging freight costs.
Looking ahead, the strong import figure in June has set up trade to be another drag on growth in the third quarter. It will remain to be seen how trade will evolve from here due to the rise in the Delta variant in the United States and the severe transportation bottlenecks the sector continues to face.
Eurozone: The latest batch of Eurozone data has shown the region's economic recovery back on course, with a favorable mix of activity and inflation data. Eurozone Q2 GDP rose 2.0% quarter-over-quarter and jumped 13.7% year-over-year; the latter was boosted by base effects. The sequential quarterly increase represented a return to growth after two straight quarters of contraction. Economic growth was also broad-based across the region.
In addition to the confirmation of strong growth in Q2, survey data has suggested that activity remained firm at least during the early part of the third quarter. Eurozone July economic confidence rose more than expected to 119.0, a record high since the series began in 1985. So far, stronger growth in the Eurozone has not been accompanied by significantly faster inflation. The Eurozone July CPI firmed moderately to 2.2% year-over-year, while the core CPI slowed to 0.7%.
What are the potential implications of this growth and inflation mix for European Central Bank (ECB) monetary policy? The moderate inflation trends mean there should be no need for the ECB to move to less accommodative monetary policy any time soon. Indeed, given that the latest COVID developments have added some element of near-term uncertainty, the ECB could refrain from tapering its bond purchases in September. Instead it may signal that Q4 buying would continue to be conducted at a significantly higher pace than during the early months of this year.
In addition, if recent COVID developments eventually have some influence on confidence and activity, and more importantly should underlying inflation trends fail to move meaningfully higher, the ECB would announce a further increase in bond purchases.
Growth has been expected to slow in the second half of the year, after a burst of growth fueled in the spring by widespread business reopening, rising vaccination rates, and government pandemic aid. As those effects fade, consumer spending gains should slow, and that should help tamp down price pressures.
Outlook: The Delta variant in the United States has cast a cloud over the outlook. New daily cases have continued to move higher and have been at their highest level since February. Hospitalizations have been on the rise, too, amid the more virulent strain, and some states have neared full capacity for intensive care beds. From an economic perspective, activity could evolve during this latest outbreak, with the surge in cases beginning in late July. The sideways move in economic activity, in conjunction with weaker-than-expected retail sales in July, would suggest some downside risk to personal spending.
Data has also suggested a continued improvement in industrial production, with output up 0.9% in July. The gain was led by a surge in motor vehicle production. But gains in output have extended beyond auto production, and on balance, core capital goods orders have continued to indicate a voracious appetite for capital goods, though production has been held up by supply chain problems and difficulty finding workers. Both these problems have shown some improvement in July, but the latest surge in COVID cases has put the timeline of further improvement at risk.
For the Fed, the increased uncertainty from the Delta variant would prevent an imminent tapering announcement. The labor market has remained nearly six million jobs short of where it was before the pandemic, and despite the more recent pickup in hiring momentum, the FOMC will want to see further progress toward its maximum employment goal before dialing back accommodation from the economy. The Fed should announce tapering near the end of this year and kick off the actual tapering of purchases at the start of next year.
Jobs gains should be 800,000 in the third quarter, which would be a large step toward substantial further progress. That said, the recent Delta outbreak has led companies to reevaluate return-to-work plans and schools to again consider virtual education, which may further delay some from returning to work. This would make the next few months of job gains even more important for the outlook to see how the labor supply issues evolve in the fall.
This Newsletter was produced for Atlantic Union Bank Wealth Management by Capital Market Consultants, Inc.
Sources: Department of Labor, Department of Commerce, Institute for Supply Management, European Central Bank, Morningstar, Bloomberg, Johns Hopkins University
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