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The growth outlook for the fourth quarter is opaque, because there is no way to determine when supply chain disruptions will begin to unwind. A reluctant recognition of higher inflation by the Federal Reserve is developing, as supply chain bottlenecks are holding up inflation longer than previously thought. There are currently 72 container ships off the port of Los Angeles which cannot deliver some 550,000 containers coming from Asia. This is due to a lack of investment in US ports over the past 10 years, as well as a shortage of qualified truckers, and may continue into 2022.. Consumers have been warned that Christmas shopping may be severely impaired by empty shelves this year.

Complicating matters is the increase in business inventories which are starting to build as consumers shift their post Covid consumption from goods to services (airlines, restaurants, hotels, travel) at the same time that Covid stimulus to individuals is over, and 9.1 million people are losing unemployment benefits. When those benefits were extended last March to September 30, no one foresaw the Delta variant. Job growth in August began slowing sharply as COVID-19 infections soared again, which still remain elevated in the US at around 75,000 new cases and 1,500-2,000 deaths per day.

Covid is the root cause of global supply shocks, keeping factories closed in countries who provide critical links in the global supply chain. Vietnam, for example, where much outsourcing takes place in garment manufacturing (Nike, Under Armor, etc.), is less than 1% vaccinated. Taiwan, critical for the manufacture of semiconductors, is only 14% vaccinated, delaying plant re-openings. Automobiles use, on average, 1,400 semiconductor chips each, so the shortage of chips is leading to bottlenecks in the manufacture of cars.

China’s growth is slowing as a result of these supply shocks, and China contributes 40% of the increase in global economic growth. Some believe that supply shocks in the first half of the year may cause a near stall in the Chinese economy. The recent drama in China of the world’s largest construction company, Evergrande, has brought to light the fragility of the debt laden construction sector in that country, which constitutes 24% of that economy. Evergrande has missed payments on some of its $304 billion of debt in the past two weeks, and signs of trouble are also appearing at other Chinese property companies. Recently, Shenzhen-based Fantasia Holdings defaulted on a $206 million bond payment, Sinic Holdings has defaulted on a $250 million bond issue, Modern Land (China) is asking bondholders for a three-month extension to pay off a note due in October, and Xinyuan Real Estate Co is proposing a troubled debt swap for a US Dollar bond due last week. It remains to be seen if the Chinese Communist Party bails out its own domestic bond holders and defaults on dollar bond holders. If this comes to pass, global markets will be unsettled, to say the least, because Chinese corporate debt is sometimes perceived as being quasi-sovereign.

While all of this is transpiring, the Chinese Communist Party is casting a shadow over how business is conducted. Chinese technology companies are reeling from iron-fisted regulations. Large numbers of Chinese executives are being jailed. Most companies now have internal “Communist Party Departments “, which participate in business decisions. Whether state intervention begins to hamper Chinese growth is now an open question. For example, the crackdown by the CCP on carbon is producing electricity blackouts throughout the country and in response, electric utilities are being told to re-divert energy to households rather than to industry to prevent civil unrest. This represents yet one more supply shock. China is the world’s largest producer of silicon, whose manufacture requires large amounts of electricity. Due to the CCP’s (politically motivated) refusal to import coal from Australia, silicon production has been cut leading to a 300% increase in prices in less than two months. This impacts chip manufacturers around the entire globe, but also car manufacturers who use silicone in engine blocks, medical implant manufacturers, and solar panel manufacturers. As a consequence, global companies now seek to relocate their supply chains outside of China as quickly as possible.

There is an energy crisis underway in Europe and China. The price of UK natural gas is now six times last year‘s price, which is alarming EU governments. This is due to a concurrence of events. Covid reduced the maintenance of North Sea gas infrastructure, so production slowed. The largest gas fuel in Europe in Groningen, Netherlands, will be shut down in 2022, eight years ahead of plan. And lastly, gas storage levels in the EU are at historically low levels after last year’s cold and snowy winter. The concern is that Europe may not have enough natural gas this winter for its heating needs.

Under-investment in energy over recent years is now having a systemic global impact on prices. Both crude (US) and Brent (Europe) prices are ramping as demand outstrips supply. OPEC+ has decided to increase production, but only to previously expected levels.

Prices of goods and services are climbing at the fastest pace in 50 years. The Federal Reserve’s favorite inflation measure, the personal consumption expenditures index, rose at its highest level since 1991, at 4.3% year to date through August. Inflation is climbing due to Covid worldwide, due to factory shutdowns and shipping bottlenecks. Commodity costs are rising, especially for energy. Soaring natural gas prices mean higher input prices for fertilizer, which then carry through to grain prices. Rents are rebounding sharply, pushing up housing inflation, a major component of the consumer price index. Shipping rates have doubled over the last year.

The $3.5 trillion Social Infrastructure bill is stuck for the moment in Congress, which is likely to pass in the near future, but in a more modest form. Fears over Democrat tax hikes should be tempered by the approaching midterm elections next year, making tax increases unlikely until that time.

Earnings forecasts for the third quarter have been trending lower, as inflation is perceived to be impacting corporate margins. In the last quarter, 224 companies talked about inflation during their earnings calls. But the two most important questions on the minds of investors right now are:

When will the Fed stop buying bonds to keep interest rates low? (a.k.a. “tapering”)

When will the Fed increase short term interest rates?

Central banks worldwide have begun raising interest rates. New Zealand, Poland, Norway, Brazil, Mexico, and Iceland have all begun to combat inflation with higher interest rates.

The US and the EU central banks, however, are still creating excess cash, which increasingly is chasing fewer goods. As evidence of that, money supply (M2) in the US is still growing in the high teens:

Conclusion:

As long as the Fed continues to do so, the stock market, driven largely by Fed created liquidity, should continue to rise until such time that the Federal Reserve takes measures to tighten monetary policy. Money supply growth is closely related to the stock market, as demonstrated by the following chart:

There are still 8.4 million unemployed people, and the Fed does not preview a rise in interest rates until the end of 2022. Despite stretched valuations and extreme pessimism (usually a bullish sign), the stock market is still well oriented.

Grant Rogers