Investing in a High Pressure Economy

11 June 2021 | by Sean Stannard-Stockton, CFA

You don’t have to be an economic expert to recognize that very, very big things are happening in the US economy. While our economic outlook does not typically play a big role in our investment process, as we’ve written about in the past, (see here and here) we think it is critically important for investors to understand the economic context in which they are investing.

For much of the last decade, the key question investors needed to ask themselves to understand growth prospects was “by how much might demand increase over time?” But with the economy growing at historically unprecedented speed, the critical question has now been turned on its head so that investors need to understand “by how much might this company be able to increase supply?”

This key question, and its new mirror image, are a microeconomic expression of the macroeconomic question on everyone’s mind, “Can America expand our economic output capacity fast enough to meet the rapidly rising demand? Or, will demand overshoot supply leading to inflation?”

Without making any forecast about the future, investors can still seek to understand the critical aspects of the current economic context.

For instance, Americans have never made so much money! While the recession that struck in March 2020 was the fastest economic decline in history and very deep, American households brought in more income in 2020 than any year on record. That this was achieved due to massive transfer payments from the government is important for understanding context. But regardless, income received via wages or transfer payments represents American consumers’ purchasing power. And in the first quarter of 2021, income shot even higher.

This 30-year chart shows just how dramatic and historically unprecedented the surge in income has been.

Consumers have been both restricted in their ability to spend money and have likely desired to hold higher levels of savings due to the high levels of economic uncertainty. But this delay in spending means that American households currently have approximately $3 trillion more in their checking and savings accounts than they did pre-pandemic. And now, as those savings are starting to be spent even while wages begin to accelerate, consumer spending has rocketed to new all time highs. Indeed consumer spending today is almost certainly higher than it would have been if COVID had never happened.

With pre-pandemic consumer spending running at about $15 trillion a year, the $3 trillion in excess savings would fuel a 20% jump in spending. Or, if released slowly over the next 3-5 years, would be sufficient to provide a 4%-7% annual boost to consumer spending, which makes up 70% of the US economy.

While the stimulus bills passed during COVID were focused on helping households and businesses survive the COVID shock so that they could continue operating once the pandemic passed, the $4 trillion in infrastructure bills currently being debated are not meant to support the economy during COVID, but to invest the equivalent of nearly 20% of annual GDP into the physical and human capital of the United States.

Since this money is expected to be spent over eight years, it is better understood as a 2.5% of GDP ongoing investment for most of the next decade. While the full $4 trillion is unlikely to be passed, even just the Republican counteroffer of nearly $1 trillion still qualifies as a large, ongoing driver of additional demand. And don’t lose site of the fact that the Senate just voted on a bipartisan basis to approve $250 billion of new spending over the next five years to invest in scientific research and development. In any other year, a $250 billion research and development bill passing on a bipartisan basis would have been big news, but in today’s economic context, it is given only passing attention by many observers.

So, you don’t need to make any sort of forecast to simply observe that a tidal wave of money is going to be coursing through the US economy, not just in 2021 but for an as yet unknown period of time. A truly macro agnostic investor would simply ignore all of this and thus, implicitly assume that the most likely state of the economy in the years ahead would be the historically “normal” economic trends we’ve seen in the past. But to us, ignoring multi-trillion dollar tidal waves of money is not the mark of an investor who understands the difficulty of economic forecasting, but rather is a myopic point of view that ignores the unprecedented reality of the current US and global economy.

At the macroeconomic level, the amount of excess output capacity in the US economy to absorb increased demand is simply unknown. Up until the Financial Crisis, the Congressional Budget Office and other nonpartisan economic observers believed that the capacity of the US economy to deliver output increased by about 3% a year. This was made up of roughly 1% from population growth and 2% from enhanced productivity.

However, in the decade after the Financial Crisis, economic observers watched real economic output increase by just 2%, rather than 3%, per year and over time came to the conclusion that something structural had changed, which meant that the US economy was now permanently unable to increase our economic output in the ways that generations of Americans had done successfully ever since we emerged as a developed economy and global world leader in the wake of World War II.

In this chart, the red line shows the actual GDP of the united states. The other lines are the nonpartisan Congressional Budget Office’s (CBO) estimates of what potential GDP – our countries capacity to produce goods and services – would be over time. Each of the other lines are marked with a year, which is the year in which the CBO made the potential GDP estimate. As you can see, prior to the Financial Crisis in 2007, the CBO and most economic observers expected potential real GDP to grow by about 3% a year for the foreseeable future. Even in 2009 and then in 2011, the CBO saw only a minor degradation to potential GDP. But as demand continued to grow slowly, the estimate of potential GDP was revised lower year after year.

This idea, that the US had experienced a permanent degradation of our productive abilities became known as the New Normal, and in various posts over the years (here, here and here) we explored why investors needed to consider the possibility that over time a return to the Old Normal would occur and we examined the impact on the valuation of stocks based on varying assumptions about economic activity under both a New Normal and Old Normal paradigm. So, it is important to note that for 2021, the estimate is now above the 2017 estimate, as the CBO begins to recognize that their estimate was too low. So, the trillion dollar question these days is just how much higher might potential GDP be raised or is the current estimate correct and we’re about to fly past potential GDP and start seeing serious inflation.

One of the best illustrations of just how large the gap is between an assumption that the New Normal is here to stay vs an assumption that we can return to the Old Normal pattern of economic output, is this chart maintained by economist Scott Grannis showing the pre financial crisis trend and the nearly $5 trillion of missing economic activity due to the economy charting a much slower rate of growth for the last decade.

(Source: Scott Grannis)

This question of just how large the gap is between current levels of economic activity and the economic output potential of our country is not a question that anyone can credibly claim to know the answer to. In fact, the Federal Reserve made this explicit last year when they admitted that their inflation models had simply stopped working and that the only way to probe the level at which American economic output capacity is actually fully utilized is for monetary and fiscal authorities to put the pedal to the medal until high levels of persistent inflation are observed, not just predicted.

At its core, the potential GDP of a country is a function of the number of workers it has and the productivity of those workers. So, one way to think about the downward revisions of potential GDP is that they reflect an assumption that America’s big productivity advancements are behind us. One of the simplest ways to illustrate productivity growth is to measure real GDP growth divided by the number of American workers. In the chart below, you can see 30 years of progress in America becoming more productive.

(Source: Evercore/ISI, Ensemble Capital)

Note how from 2010 to 2020, the line rises more slowly than in the past, this is the apparent slowdown in productivity growth. But note the red boxes which are located during the last four recessions. During recessions, companies and their employees figure out how to do more with less. And as demand comes back, rather than give up these productivity gains, companies and their employees maintain them and add more. We can already see the explosion in productivity that has been occurring during COVID. How much further these gains go and at what ongoing rate productivity grows over the next decade is the key factor in thinking about inflation and our country’s ability to match supply to the tidal wave of demand.

Inflation is simply the economic outcome of demand exceeding supply. So, it is not until meaningfully high levels of inflation are observed that you can be sure that you have pushed past a country’s output capacity.

But it is important to distinguish between short-term and long-term output capacity. Right now, the abrupt attempt to restart the economy has not been able to keep up with the rapidly increasing demand, causing sellers to raise prices in some industries. But companies are also investing aggressively in hiring new employees and adding to capital investments to expand their output capacity.

Our job is not to accurately forecast the details of the economic cycle. But with the economic paradigm in the US flipping from a decade of demand shortages to a tidal wave of demand testing how much we can grow before we run into supply shortages, we think it is important for equity investors to understand that a new set of questions have become important. Rather than wondering how much demand there might be for a company’s goods and services, the question becomes how much demand does a company actually have the capacity to meet? And given companies operate within competitive markets, the relative ability for a company to increase capacity and meet demand takes on heightened importance.

For instance, restaurants are currently facing a huge surge in demand as vaccinated Americans go out to eat. In February 2021, spending at US restaurants totaled $46.3 billion. But as COVID cases came down and vaccinations went up, spending in March jumped 29% to $59.7 billion or equaling the all-time high monthly restaurant spend.

But this was back in March. Since then, vastly more people have become vaccinated, restrictions have lifted, and many more Americans have returned to pre-pandemic habits. With $3 trillion in excess savings and eating out being the activity that many Americans say they most missed during COVID, what will restaurant spending be like this summer?

While this sounds like fantastic news for restaurants, the dominant media narrative has not been boom times for restaurants but rather restaurants’ inability to hire enough people to meet the surging demand. After a decade of weak economic growth, many investors are conditioned to think that increased demand is great, not a problem. But while some restaurants will be able to surf this tidal wave of demand to record profits, others will struggle to meet demand and may destroy whatever goodwill they have with customers and employees.

But is this a short-term or long-term issue? Restaurants had 12.3 million employees on the eve of COVID. They were at 10.0 mil at year-end 2020 down 2.3 million employees. So far in 2021, they have hired an average of about 200,000 new employees a month. Despite this rate of new hires being about five times faster than any pre-COVID restaurant hiring binge over the last 40 years, restaurants are still short about 1.5 million employees.

With 7.6 million fewer Americans working today than were working on the eve of the pandemic and new workers joining the restaurant industry at the fastest rate in history, it is laughable to suggest America simply doesn’t have the labor available to meet restaurant demand. But even hiring 200,000 new employees a month means it will take the restaurant industry until the end of the year just to hire back up to pre-COVID levels, while current demand already exceeds pre-COVID levels.

Thus, there is no doubt at all that the restaurant industry is currently capacity constrained and that they are likely to stay that way for many months. But over the next one, two years and more, there is really no reason to think that the American economy simply can’t meet the demand for eating out.

But not all restaurants are struggling to find labor. In our portfolio we own both Starbucks and Chipotle. While restaurant industry employment is still down 12% from pre-COVID levels, both Starbucks and Chipotle ended their 2020 fiscal years with more employees than they had pre pandemic. Notably, both companies have long been considered employee centric employers, offering pay and benefits well above industry averages.

Asked about the impact of the labor shortage on their most recent earnings calls, here’s what Starbucks said.

“In certain markets at certain times we are experiencing some labor shortages. But it is not a widespread issue at this time. We’ve invested ahead of the curve with our industry-leading benefits and total pay approach. And I feel confident that we will continue to make the necessary investments required to remain a premium employer of choice.”

Meanwhile Chipotle offers a wide range of employee benefits and career paths:

  • They pay tuition costs for employees to pursue degrees in Agriculture, Culinary, and Hospitality.
  • The company already offers above average pay and benefits, but announced last month they’d be raising average pay for hourly workers by about 15%.
  • The company pays their store level general managers, a position that a front line employee can reach in as little as three and a half years, $100,000 a year.
  • The company credits their success in recent years to their focus on improving the employee work environment, pay and benefits.

Over the last decade, we spent research efforts on companies like Starbucks and Chipotle to try to forecast how much demand might increase. While this continues to be important, in the high pressure economy that we are operating in today, and which may remain in place for a multiyear period, it is critical for investors to consider the supply side of the equation and whether a given investment has the capacity to meet rapidly rising demand.

But of course, to remain an employee centric business, Starbucks and Chipotle will have to lean into these efforts as wages move higher. So, both companies will still be subject to some cost inflation, which is why it is so critical that they both have strong pricing power, or the ability to raise prices without overly depressing customer demand as Chipotle alluded to in their comments.

Pricing power is something we always look for in the companies we invest in, as is strong employee value creation. But in a demand surging, supply constrained world, these key attributes will be extraordinarily important. This issue is not limited to the restaurant industry, it is just playing out there right now in dramatic fashion. But nearly every industry will be impacted by these changing economic dynamics.

What comes next is uncertain, but it is critical to recognize that it is not a forecast to observe what has already happened and what monetary and fiscal authorities have stated in no uncertain terms they intend to continue doing. Successfully navigating this tidal wave of demand will leap to huge profits. But many companies are simply not prepared and do not have the tools to manage through a demand surge of a magnitude that has not been seen outside of war time.

A booming economy sounds like an easy ride to higher stock prices, but, in fact, this next stage of the COVID economy will test companies in entirely new ways. You want to be sure you are backing those companies prepared for this new challenge.

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