West of the Hudson
March 31, 2021
With the books closed on the first quarter, our first reflections attest to the value of cliché. The past few
months had an undeniable “best of times, worst of times” quality. While it has been a sprawling and
emotional period, we want to stay in our lane so, as these cyclonic waves converged with our fiduciary
roles, it went something like this: the political unrest which cloaked the new year in scandal and suspense
gave way to the growth in vaccine availability and additional pledged stimulus, unleashing a powerful
stock market rally. Investors were quick to declare the worst of the pandemic behind us, driving a
reflation-themed rally in last year’s most beaten-down equities. However rewarding, the rally also carried
the anxiety that comes from too much of a good thing, reminding us of this historic remark: “there are
decades where nothing happens; and there are weeks where decades happen”.
Covid continues to dictate economic outcomes and the hope is that a quicker recovery will leave less
permanent economic scarring. The challenge is that the response to the pandemic has not been uniform
with ~70% of direct-to-consumer CARES Act stimulus used to pay off debt. Those spending priorities are
not what massive stimulus bills are traditionally designed to achieve — they are meant to encourage
people to buy goods and services, support businesses, and ultimately drive job creation.
Still, there is good reason to be excited about an economic reflation: while it took Moderna three months
to manufacture the first 20 million doses of its vaccine, the company is now able to produce 40 million a
month, with a goal of producing 50 million a month by summer. The probability that broad distribution
will lead to herd immunity by the end of 2021 is no longer speculative and, with the end of the pandemic
nightmare in sight, consumers with the means can fully participate in the V-shaped recovery.
In 2008, everyone became an armchair expert on residential mortgages and credit default swaps. In 2020
it was viruses and epidemiology. Turning to 2021, the focus has shifted from mortality rates to
macroeconomics: employment, cash and debt levels, GDP growth, and the projected spillover effects of a
rapid expansion — and especially inflation.
Economic recoveries are historically a time of celebration for investors, and the healing now underway
should be no different: the economy is accelerating; business activity is rebounding; cheap money
remains available; and stocks are surging. However, while clearly not a major concern in the first quarter,
market participants are beginning to speak out on the recovery’s potential pitfalls, where pent-up demand,
high levels of savings, and on-going consumer stimulus lead to a spending binge which causes inflation
to spike, and pushes interest rates higher. Despite the recovery road still ahead, inflation and interest rate
worries have come to replace Covid as the primary market risk, resulting in head-spinning stock moves as
investors begin to question the duration of the Fed’s easy monetary stance. For long-term bond investors,
inflation is pretty much all bad news, eating into the value of future returns. For equity investors, inflation
can be managed, as certain companies can pass-through higher costs, but it puts a cap on valuations.
This is our fourth and hopefully last quarterly letter researched and penned entirely from quarantine, and
as we hopscotch across this historic sliver of time — economic reflation, recovery, and alleged inflationary
pressures ahead — it is here that we jump off for this, our first letter West of the Hudson TM in 2021.
The concept of pent-up demand is well studied in economics and refers to a situation where demand for
goods or services are unusually strong following a period of decreased spending. The term historically
applies to the consumption of “big-ticket” durable goods: cars, furniture, appliances, family vacations,
and residential investment.
Even with the high rate of unemployment, there are millions of consumers fortunate enough to have cash
to spend, even if their purchasing options were limited during the pandemic. Now with light beginning to
show at the end of the Covid tunnel, the words “pent-up demand” are echoing across the business and
investment world. According to a recent analysis of quarterly corporate earnings report transcripts, use of
the term “pent-up demand” is at an all-time high. Executives in industries devastated by the pandemic
disruption clearly want investors to believe that they are on the verge of a roaring comeback. And on the
face of it, the early evidence suggests they may be right.
It is widely reported that U.S. households have accumulated $1.6 trillion in excess savings in the past
year, as working from home has allowed many people to maintain earnings but cut costs dramatically.
However, the same study goes on to note that the top 20% of earners account for the entirety of
As evidenced by TSA airport traffic data, destinations are reopening, and Americans are moving around
in greater numbers. This early, high-frequency data helps fuel the market narrative that accumulated
savings will encourage additional spending and that, as we emerge from our Covid cocoons, consumption
will not only persist, but accelerate. Will the wealthy drive down their savings and spend at a higher rate
than last year, or turn their attention from housing and technology to long denied services? Time will tell,
but we are mindful that while the fortunate have managed to do well through the pandemic, a large swath
of the nation has not and, for the millions of lower income Americans, how much stimulus will be
redirected once rent, mortgage, and school loan payment holidays are lifted? Even with more stimulus
cash, “needs versus wants” drive many cohorts, and the outlook for employment, sustainable incomes,
and cost of living may well nullify the cravings intrinsic to pent-up demand.
We will of course dine out again, travel, go to concerts, movies, sporting events and theme parks, but how
does this fit into the context of a $20 trillion economy? Consumer spending represents ~66% of U.S. GDP
($13.28 trillion in 2019), and the Bureau of Economic Analysis (BEA) sub-divides this spending into
three categories: 13% on durable goods (long-lived items including cars, furniture, large appliances), 23%
on non-durable goods (short-lived items including clothing, food, fuel), and 64% on services (various
expenditures including banking, health care, utilities and education). In total, the largest components of
consumer spending are shelter (rent/mortgage), utilities, and health care which, on average, total ~33% of
the family budget. Add groceries (~8%) and 40% of spending is spoken for on necessities.
There is a tradeoff between “at-home” and “away from home” expenditures, so when it is reversed, the
incremental impact likely won’t be as substantial as analysts suggest. According to data amassed from the
BEA, industry association reports, and macro research, 4.3% of consumer consumption ($700 billion in
2019) was spent at bars/restaurants — but we spend nearly twice that amount on groceries. Amusement
parks are re-opening to great fanfare, but they captured just 0.3% of total 2019 consumption ($70 billion)
— a little less than we spent on hotels and motels ($120 billion). The combination of movies, sporting
events, museums, and the arts were even less — 0.1% share of consumption ($85 billion). We spent $80
billion at barbershops/salons, but we spent $145 billion on grooming supplies at the store. Pre-pandemic,
we spent $120 billion on air travel — but we spent $130 billion on home improvement. We spent $440
billion on sporting goods — five times what we spent on concerts and sports tickets. All totaled,
discretionary service spending lost to the pandemic was ~6% of consumer spending, which represents
approximately 4% of total GDP. It is of course desirable that this input grow substantially, but that
requires a complete reorientation in spending that, among other things, sees us eat out most nights, see
many more movies in the theater, ramp attendance at concerts and sporting events, and take multiple
domestic family vacations.
The categories of consumer spending that absolutely boomed in the pandemic were durable goods (autos,
home improvement, furniture, electronics, gardening supplies, kitchen appliances, and sports equipment),
and non-durable goods (groceries and clothing), which grew at an “above-trend” pace as consumers
“reshaped” spending behaviors around the pandemic. Only, it is in these purchases where history expects
pent-up demand to assert itself as the recessionary deferral of big-ticket goods subsides and consumer confidence increases. Yet sales of these goods soared 10% in the past year — triple the norm of the trailing decade, and double what the hard-hit travel/leisure services amount to. So, while consumers are going to go beyond goods delivered to their homes and resume spending on the experiences and services they’ve missed during the pandemic, unless the demand in these durable, big-ticket goods persist, we would seem to have limited room to sustain consumer growth above-trend.
Travel & Leisure
Setting aside absolute levels of growth, the plethora of businesses that were shut down for much of 2020
are vital to overall economic vitality. While absolute spending for travel/leisure services is not large, the
positive ripple effect of reopening on employment is crucial. According to Bureau of Labor Statistics
(BLS) data, there were more people working at theme parks, hotels, movie theaters, and restaurants at
year-end 2020 (13.13 million) than at hospitals and medical centers (5.15 million). At the end of 2019,
16.78 million people were employed in hospitality and leisure, so the current deficit of 3.65 million
represents 37% of the current, pandemic-driven unemployment pie of ~10 million.
Unemployment is often referred to as a simple abstract number, but having robust employment is
an important part of the economic and social fabric of any country. Having a job provides financial
freedom, empowers decision-making, personal growth, social status and (hopefully) satisfaction. But as
important, durable employment leads to a more potent wage pool and a virtuous economic cycle, as
higher rates of consumer spending benefits businesses, vendors in their supply chains, and other ancillary
services. This leads to a healthier overall local economy, allows more businesses to thrive, and drives
down the ranks of the unemployed even further.
While the vaccine rollout and re-openings in the U.S. has everyone excited, our economy draws great
sustenance from the rest of the world, and the absence of a synchronized global recovery is going to be an
impediment to full economic recovery. Vaccine distribution remains far behind in many countries —
especially Europe — and will impact foreign inbound travel and tourism industries. While the U.S.
economy has a prodigious volume of domestic tourism, international tourism is a huge contributor — ask
any Broadway theater owner in Manhattan about that.
Every economic recovery experiences a bout of inflation anxiety, and we have arrived at that point in this
cycle. The components feeding this apprehension include the vaccine rollout, Congressional legislation to
deliver another large fiscal stimulus, and near-zero borrowing costs. At its most fundamental, the thesis is
simple: the onset of Covid caused a collapse in growth, inflation, and interest rates so, as the pandemic
fades, we will see a rapid recovery in growth, inflation, and interest rates. While fiscal injections and
monetary support are typically met with enthusiasm, the outlook of a raging economy while borrowing
rates remain near all-time lows has stirred the long end of the bond market, driving the 10YR treasury
bond yield from 0.91% to 1.74% in the quarter. Still historically low, but the rapidity of the increase
certainly caught investors’ attention.
Once upon a time before Covid, Fed officials often suggested they would wait to see the whites of
inflation’s eyes before they would raise interest rates. Today, with so little inflation to show for so much
time and effort, officials seem inclined to hold off until they see the back of inflation’s head (or
“overshoot”). The Fed may still act as a chaperone, but they have embraced the ‘punchbowl’ and have no
intention of taking it away prematurely. While they do recognize some higher prices, they are dismissed
as “transitory” and attributable to the “base effect” of comparing last years’ quarantine recession to
today’s vaccinated recovery. The usual conditions for rising inflation — tight job markets and the
expectation of inflation (rising prices tend to pull future purchases forward) — are glaringly absent. Yet
anxiety about inflation is growing in the financial press and, despite the Fed’s position, the markets are
calling their bluff.
While inflation ultimately comes down to a long-term structural balance between supply and demand, it is
often forgotten that treasury yields include a perception about that future balance. As this quarter
unfolded, it became clear that investors anticipate there will be less supply to meet higher demand. And
yet, while the 10YR treasury yield rose quickly, it remains close to where the yield was as the pandemic
struck in February 2020 (1.65%). While the speed of the move is notable, where it has settled is hardly
alarming. The recent 5-year peak was 3.24% (November 2018), while the trailing 10 years saw a peak of
3.59% (2011). It was 6.56% at start of the 21st century (2000).
The worst-case scenario painted by inflationists can be broken into stages. First, inflation will rise as the
economic data from the spring of 2020 fall out of comparisons with a year earlier (the base effect). Next,
the demand from newly vaccinated consumers rebounds faster than services or production curtailed
during the pandemic can supply. Companies are forced to raise prices (because they can) and/or invest to
increase supply, which takes time. Temporary inflation turns more permanent if the higher prices prevail,
until new supply is added, and equilibrium is reached.
Forecasting the timing of this is a difficult task for which most prognosticators fail. While the above
scenarios are of course possible, there are many allied forces with a lot at stake that need to keep interest
rates low, including Wall Street’s embrace of record high asset values, and Washington’s embrace of
record high deficits. They both draw support from near-zero interest rates, which make stocks more
valuable and debt more affordable. Now more than ever, post-pandemic levels of government debt require
ongoing Fed intervention and ultra-low interest rates in order to keep servicing costs manageable. Despite
the Fed’s insistence that they can maintain low rates for the next couple years, investors remain concerned
the Fed will be forced to hike rates prematurely to combat inflation, setting off an unwelcomed chain of
events, including a re-rating of equity valuations, with higher multiple stocks especially vulnerable.
Milton Friedman famously said, “inflation is always and everywhere a monetary phenomenon”. The fact
is, despite a decade of easy money policies, inflation has been non-existent because consumer inflation is
not the same as asset inflation. Stimulus dollars are finding their way into assets and securities and
driving animal spirits, but as recent quarterly earnings illustrate, businesses are experiencing difficulty in
passing along higher raw material costs, which is traditionally the tip of the inflation iceberg.
We are not suggesting that cyclical inflation has not reappeared — it has, and there are pockets of inflation
where there are material shortages, and prices have crept up in essential goods and services like food,
gasoline, utilities, semiconductors, and housing. Certain supply chains — especially ocean-going
transportation — are in disarray as a result of the pandemic, and a boom in commodity prices has resulted,
causing areas of acute price pressures. But as we seen repeatedly this century (especially the 2002-07
cycle), while it is a cyclical tax, rising commodity prices don’t have the lasting inflationary impact like
they did in the 1970s. While the economic impact of wide-spread quarantines and high unemployment has
been masked by fiscal and monetary backing, without a steady surge in job and wage growth, the central
impediment to rising prices is sustainability.
One of many official measures of inflation is the Consumer Price Index (CPI), a composition of over 200
categories including education, housing, transportation, and recreation. As you might expect from the
prior citation on the components of consumer spending, the three largest components of the CPI are
housing, transportation, and food/beverages, with housing representing 33% of the “headline” CPI.
Despite this, today’s narrative is focused on the smaller components of CPI, which ebb and flow with
time and circumstance and have generally been transitory through the last forty years. In today’s
pandemic world, higher prices are driven more by rebounding demand occurring while there exist supplyside disruptions.
However, the type of sustainable inflation that is most concerning is kindled by employment growth and
wage growth, a dubious outcome with an excess capacity of ten million unemployed. This employment
rebound will take time and is a critical component to viable reflation; but, as pandemic forces compelled
companies to adapt and operate effectively with less labor, driving unemployment down to pre-pandemic
levels will be a challenge. Many businesses are continuing to, or are planning to, invest aggressively in
labor-lite productivity — a trend that will only extend the employment rebound. Hiring of temporary
workers has accelerated, but that sends a mixed signal about the labor market: using temporary labor is an
indication that businesses are seeing more demand, but they’re not confident about how long that demand
will last. That’s where more stimulus comes in, as it replaces the lost revenue of mass joblessness. The
president’s “shots in arms and money in pockets” slogan is a rephrasing of the traditional “guns and
butter” policies, where no sacrifice is required. The economy has been flooded with liquidity for years
through many forms of stimulus, with no inflation to show for it.
The structural factors impeding economic activity — excessive debt, aging demographics, extreme income
inequalities, accelerating technological change — remain relevant and are perhaps even more acute today.
If continuous deficit spending, ultra-low interest rates and unprecedented quantitative easing didn’t spur
inflation in the decade after the 2008-09 financial crisis, why should we expect a different outcome
today? We find the argument that excessive, pent-up consumerism and easy monetary policy will lead to
sustainable, non-transitory inflation to be suspect. We remain alert as always, but skeptical nonetheless.
Interest rates are the price of risk, but that a rise towards 2% causes such anxiety once again reveals the
downside to artificially depressing yields to all-time lows in the first place. A post-pandemic economic
bounce is already largely priced into stocks and is now being priced into longer-dated treasuries. It bears
reminding that the Fed’s initial bond buying (QE1) during the Great Financial Crisis caused the 10YR
yield to break below 4% in 2009 and continued buying (QE2) pushed the yield below 3% in 2012. GDP
averaged +/-2% the entire period. That the move back towards 2% is causing anxiety while GDP remains
more or less constant is the real story.
The ultimate question for investors facing record market highs is, what does the impending recovery look
like? While the income transfer (stimulus) is transitory, the debt on the books of the federal government is
permanent. And we have long passed the point where more debt leads to better growth. As Japan and
Europe have shown us — and as we have argued for years — excessive and unproductive debt leads
inevitably to structurally lower interest rates.
The U.S. economy is very large and resilient and will find its equilibrium in time. Covid has done its part
to define history and has inflicted damage that will take years to repair. Having highly effective and
deliverable vaccines in distribution is the first step — and our investment thesis remains steadfast. We can
and do participate and continue to buy on the thematics: growth companies with utility-like
characteristics, strong balance sheets and realistic earnings visibility (the up-market), combined with high
cashflow growth, high dividend yield, GDP+ growth themes (the down-market). Some may be seen as
more interest-rate sensitive than others, but owning a high-quality portfolio is a perfect foil to short-term
economic and market gyrations.
We have a few more months to get through this before we emerge into the daylight. From our families to
yours, we wish you all peace and good health in these coming springtime months.
Hirschel B. Abelson
Chairman , LCES
Adam S. Abelson
Chief Investment Officer, LCES
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current views and opinions. These views are subject to change at any time based upon market or other conditions. Past performance is not indicative of future results. Sources:
Bureau of Labor Statistics, Federal Reserve Bank, Rosenberg Research, Bloomberg, Wall Street Journal, Reuters, Moody’s Analytics, Oxford Economics, National Restaurant
Association, U.S. Travel Association, American Hotel & Lodging Association, National Sporting Goods Association, Association of Amusement Parks & Attractions,
National Association of Theatre Owners, American Barber Association, Sports Events & Tourism Association, National Residential Improvement Association, AlphaSense