West of the Hudson

Dear Clients:

The Delta variant of the coronavirus has given rise to a rapid increase in new cases since early summer. While this disruption hasn’t knocked the U.S. economy back on its heels, it has slowed the reopening down enough so that the bright future that many businesses imagined has been deferred. Unlike early in the year, when it seemed fairly certain that the vaccination rollout would stop the pandemic in its tracks, Covid’s course now seems less certain. The stock market may be trading at new highs, but the narrow breadth of the rally reflects its uncertainty. Many of the cyclical reflation stocks that surged early in the year on reopening hopes have been treading water or worse and figuring out how these companies’ prospects might change over the next several months is next to impossible, in part because the businesses themselves lack visibility beyond “hope”.

The pandemic has made a mess of past predictions. Remember when the fall was going to be the return to normal in the U.S? Throughout the spring, September was widely expected to be the economic turning point: vaccinations were rising, schools prepared to receive students, and many large companies prepared for a return to the office. The shortage of workers — brought on by closed schools, a mismatch between the robust snapback in consumer demand and the number of Americans willing and able to work — was expected to “disappear by the fall”, according to numerous companies.

Instead, the rise of the variant has the economy tapping the brakes. Businesses and consumers are reworking plans to adjust to renewed mask mandates, travel restrictions, event cancellations and delayed office openings. Consumers are retrenching, and economists are downgrading their forecasts. The loss of steam could drag out the recovery and continue to hobble companies unable to grow or unwilling to invest.

A steady flow of GDP downgrades for the quarter have resulted just as the Fed’s taper warnings gather steam. And a less accommodative Fed steps up as Congressional fiscal talks stall and the debt ceiling drama mounts; a fractured Congress makes clear that the easy work on fiscal stimulus is behind us. All the while, the virus, the variant, and its subsequent progeny, endures.

There was no shortage of subjects to discuss this quarter, including Evergrande, China, demography, inflation, wage-price spirals, stagflation, debt ceiling, fiscal cliff, tapering, bond yields, productivity, technology, earnings, profit margins, labor costs, commodity prices, West Coast ports, natural gas, and more. But the virus remains disruptive, impacting businesses and lives. That’s not likely to change in the near-term, forcing us to face the fact that the pandemic economy isn’t over — we’re just entering another stage where we “learn to live with it”. The variant’s persistence has challenged a host of assumptions, and the ramifications were on full display throughout the recently concluded 2Q earnings season. So, despite the laundry list of subjects, the overarching themes were disproportionally weighted towards supply chain and labor disruptions – all resulting from the resurgent virus.

A few months ago, many thought vaccinations meant victory. Everyone would get a shot, herd immunity would follow, the economy would recover, and all would be well. The failure to bring Covid cases under control is scrambling business expectations for a rapid economic revival, forcing companies to reset plans and revise forecasts as they also grapple with a miasma of disruptions and guidelines. First and foremost, the breakdown in worldwide logistics is central to what we call the “Covid economy”, so it is here that we jump off for this, our third letter West of the HudsonTM in 2021.

The Great Supply Chain Disruption

The leading issue for an overwhelming number of businesses is what some have termed the “great supply chain disruption”. It’s a significant and pervasive level of disorder that effects our ability to make, sell, and ship things near and far. This interruption frames the current outlook and has a starring role in our Covid economy, with its two steps forward and one step back attributes that makes it impossible to maintain the current expansion. Every month gives rise to new shortages: lumber, minerals, new/used automobiles, semiconductors, natural gas, plastics/PVC, and critically, the building blocks of sea cargo — the ubiquitous shipping container. Crucially, these persistent shortages have begun to effect corporate margins and forward outlooks at a time when equities are priced for perfection.

Last spring, the conventional wisdom had it that the trouble was largely the result of a surplus of orders reflecting extraordinary shifts in demand. Many assumed factories would catch up, and shippers would work through the backlog. That is not what happened. Despite powerful demand, factories around the world are limiting operations because of infection management or they cannot source the required materials. Just as the health crisis has proved stubborn and unpredictable, the turmoil in international commerce has gone on longer than many expected because shortages and delays in certain products have made it impossible to make other products, and so on down the line.

Everyday life in the U.S. is acutely dependent on the perpetual motion of supply chains, in which food and medicine and furniture and clothing all compete for many of the same logistical resources. When sand gets thrown into the gears of commerce — when a finite supply can’t keep up with demand, when there aren’t enough longshoremen or truck drivers or postal workers, when a container ship gets wedged sideways in one of the world’s busiest shipping lanes — the effects ripple outward for weeks or months, emptying shelves and raising prices.

Infection-prevention measures have recently closed high-volume shipping ports in China, the country that supplies the bulk of imported goods. In Vietnam and Malaysia, where workers churn out products as varied as a third of all shoes imported to the U.S. and chip components that are crucial to auto manufacturing, controlling the more transmissible Delta variant has meant sharply curtailed manufacturing capacity, reduced manpower, and orders stuck in limbo. These problems are exacerbated by the near-total evaporation of maritime shipping’s quickest alternative: stowing shipments in the bellies of commercial passenger jets flying between Asia and the U.S.

Things aren’t a lot better Stateside. Offshoring has systematically decimated America’s capacity to manufacture most things at home, and even products that are made in the U.S. likely use at least some raw materials or components that need to be imported. Pharmaceutical manufacturing has been stymied at times because many active ingredients are imported from China, or because some drugs are only manufactured overseas. Companies that want to expand their capacity to manufacture or store more inventory are facing shortages of their own, as steel and sheet metal used to build warehouses and factories are in scant supply.

The game of supply-chain whack-a-mole that manufacturers and shippers have been playing for the past year and a half has metastasized in interesting ways: book publishers have delayed their fall releases, and millions of holiday catalogues remain unprinted and will not reach homes in time for the year’s biggest spending season, because the pulp used to manufacture paper has been gobbled up by online shopping’s endless appetite for cardboard. Toilet paper and paper towels — prized commodities at the start of the lockdowns — are again in short supply in some locations, with a handful of grocers reinstating purchase limits to crack down on hoarding. We are in an extraordinary place so late in the pandemic progression!

If you look hard enough at the problems plaguing any other part of the supply chain, you eventually find the point at which the people who do the actual work of making and moving things just can’t keep up. More than 70 container ships bob outside of the Port of Los Angeles, some for months, because the port doesn’t have the capacity — the longshoremen, the warehouse staff, the customs inspectors, the

maintenance crews — to unload ships any faster. Truck drivers who distribute those goods were in high demand even before the pandemic, and now there are simply not enough of them to do all the work available. It’s the same story and same shortages at the Port of Newark, were 60 container ships anchor.

Indeed, this is visible in ports around the world — dozens of ships stacked high with containers wait at anchor for their turn to unload. Unsurprisingly, the cost to ship a box from China to the west coast has jumped roughly tenfold from pre-pandemic levels. Such severe price hikes aren’t supposed to happen. Western countries offloaded much of their manufacturing to Asia and Latin America precisely because container shipping has made moving goods between hemispheres so inexpensive. When that math tips into unprofitability, either companies stop shipping goods and wait for better rates, or they start charging us a lot more for the things they ship. Both options constrain supply further and raise prices on what’s available. You look at the price of cars, you look at the price of food — the price of practically anything is up significantly from two years ago. The Bureau of Labor Statistics (BLS) estimates that as of July, consumer prices had grown almost 5% since before the pandemic, with some types of goods showing much larger increases.

We have long taken for granted the ability to order whatever we want and have the goods arrive without any thought to the product’s lifecycle. We tend not to think about the complex choreography that makes modern shopping possible. You just click and not long after a package (or three in our house) arrive on your doorstep. We are mostly unaware of the massive, and profoundly human, apparatus that brings us basically everything in our lives. Both at home and abroad, labor is the ghost in the machine. The supply chain is really just people, running sewing machines or loading pallets or picking tomatoes or driving trucks. Often, it’s people in the workforce of foreign factories, eating and sleeping in “pods” where they work, so companies can keep manufacturing sneakers through quarantine. The fact that we can go on vacation does not mean that people half a world away can make new bathing suits and towels.

In our domestic supply-chain jobs, there is a scarcity of available workers in the food chain. Food packing and processing rely disproportionately on poor visiting workers or immigrants, whose communities have borne the brunt of some of the pandemic’s worst outcomes. When industrial meatpackers have a tough time hiring, it affects what we can buy at the grocery store. This type of work was brutal and dangerous before the pandemic, and when the virus struck, some meatpacking plants had outbreaks so intense that they briefly drove spikes in statewide infection data all by themselves. The have been slow to adapt and even slower to replenish their ranks. The pandemic has tied the supply chain in knots because it represents an existential threat to the lives of the humans who toil in it.

The world has gained a painful lesson in how interconnected economies are across vast distances, with delays and shortages in any one place rippling out nearly everywhere. It was pointed out by one logistics executive that a shipping container that cannot be unloaded in Los Angeles because too many dockworkers are in quarantine, is a container that cannot be loaded with soybeans in Iowa, leaving buyers in Asia waiting. Rail companies have been forced to halt containers moving inland from California ports in order to clear a logjam of boxes outside Chicago, as the influx of goods overwhelmed the system.

Real economy developments are also a worry. The combined effect of Covid shocks and massive monetary and fiscal stimulus has broken long-established supply and demand relationships. Shortages of materials, components and labor may persist for a while. Given the demand, massive backlogs, and long lead times to bring on new capacity, the semiconductor supply and demand mismatch may not be fixed until late 2022, if not 2023. Shipping executives tell a similarly concerning story.

Such disorder is proving costly for firms. Automakers are sitting on big inventories of many components but must wait for chips, which either cannot be bought or are stuck at some port or airfreight terminal. This means that revenues are either delayed or forgone, while the company must still finance inventories of components not in short supply and depreciate fixed assets. Meanwhile, those further down the chain are running out of goods to sell. This should encourage capital spending to relieve bottlenecks, but that can take time and potentially drive up the cost of capital — which presents its own concerns!

The system underpinning globalization — production on one side of the planet, connected to consumers on the other by trucks, ships, planes, cranes, and forklifts — is too rigid to absorb today’s rolling tremors from Covid, or to recover quickly from the jolts to consumer demand or the labor force. We, and the people we have interacted with on this topic, estimate it will take 18 months for conditions to moderate. In the meantime, firms are improvising and adapting with varying success, and passing on the costs where they can. It is a steep and costly learning curve, but at no time have we been led to believe that this period reflects the beginning of the end of globalization. What it does do is crimp margins as equities sit at/near all-time high profitability. This does not appear to be widely reflected by the market and is a risk catalyst that warrants monitoring.

Help Wanted

Another critical input into this “Covid economy” is a mystery that’s sits at the heart of the recovery: there are 10 million job openings, yet more than 8.4 million unemployed are still actively looking for work. Business owners complain they can’t find enough workers, pay at the bottom end of the scale is rising, and customers are greeted with “please be patient, we’re short-staffed” signs at many stores and restaurants. There are still 5 million fewer jobs compared to before the pandemic, producing a genuine jobs paradox.

A few months ago, we were being told the labor shortage had one simple explanation: people didn’t want to work because Covid-enhanced unemployment benefits paid them to stay home. If that was indeed the explanation, the simple solution was to cut those benefits and governors in many states did so. Data since then shows little effect on employment, and employers in those states still can’t find help. Indeed, the recent slowdown in job creation hit harder in states that pulled the plug early, with new state-level BLS data showing the group of states that dropped enhanced unemployment benefits over the summer have added jobs at less than half the pace of states that retained the benefits! According to forecasting firm Oxford Economics, the nationwide expiration of enhanced benefits that ended in mid-September will offer a much larger case study, as an additional ~11 million lose some form of federal unemployment benefits compared to the ~3.5 million people who lost benefits in the 25 states that cut them over the summer.

An explanation put forward by a leading human resource company cites a mismatch between the industries hiring and those seeking jobs, a development apparently borne out by the uneven recovery in different industries and the fact that many workers moved away from the cities where they worked. The rise of the gig economy — where minimum-wage workers are choosing the freedom of one-off jobs over the “ball and chain” of regular employment — also seems to play a significant role. Problematically, at least 40% of Americans are refusing to take the vaccines, so the economic risk is that an insistence on vaccine passports will render this segment of the population, potentially, unemployable.

We are also mindful that many businesses are forecasting they will need fewer employees in the future. As with past economic shocks, the pandemic-induced recession was a catalyst for employers to invest in automation and other productivity enhancements that curb hiring. In industries ranging from hotels to aerospace to restaurants, businesses have reviewed their operations and discovered ways to save on labor costs for the long term.

This has been one of the most difficult periods in history for small business owners — they’re not national retail chains or banks, and they cannot raise wages in order to compete with these large companies. Small businesses absolutely need a supply of labor to keep themselves afloat, but the shifting nature of the job market is such that the viability of many is a genuine issue. Were the extra benefits part of the explanation? Undoubtedly for some. But the fact is, high unemployment and record job openings is an enigma that is not easily dismissed and makes one wonder what if any permanent change results.

Conclusion

The one-two punch of a resurgent pandemic and waning aid has led Wall Street forecasters, who were once rosy about the economy’s prospects this fall and winter, to turn increasingly glum. Goldman Sachs recently said that it expected third-quarter data to show a decline in consumer spending, the linchpin of the recovery for the past year. We would add it’s a deceleration rather than retrenchment.

Still the day in which we can declare “victory” over the pandemic has been pushed further out. We see this in the data, with consumer sentiment readings at or near pandemic lows and a pullback in retail sales and housing. But unlike early on in the pandemic, the government fiscal spigots are running dry; extended benefits have expired, a moratorium on evictions lifted, and vaccines, though widely available, have run up against new variants and resolute levels of hesitancy.

The Covid-recovery was exactly that: a recovery from an exogenous event. But the course of the pandemic is no longer exogenous: we have vaccines that help protect the people who get them, but the macro benefit is limited because they aren’t being administered widely enough or quickly enough. This limits trade and travel, without which sustainable recovery is difficult. Yes, we’ve learned to cope, and we are adjusting, but we are still a long way from normal.

Huge fiscal support has left the corporate sector in good shape. The Paycheck Protection Program (PPP) gave firms cheap financing that were then converted into grants. Most of these loans became transfers from the government to the corporate sector and so added to the asset side of firms’ balance sheets. At the same time, enhanced unemployment benefits boosted personal income, and so helped prop up consumer demand, which fed through to decent corporate profits. M&A is at the highest level in 23 years. As we said at the start, the U.S. economy continues to perform well even though the pandemic clearly isn’t over. The TSA checkpoint travel numbers at US airports are strong as is traffic on the rails as railcar and intermodal loadings are back at pre-pandemic levels.

Nonetheless, the stimulus effect is ending. The last round either spent or banked. Unlike the large companies, the small and medium businesses who received payroll support are reaching the end of their tether. Yes, Congress is considering a pair of infrastructure bills whose price tags, if they pass in the proposed form, will outweigh the prior Covid bills. But passage is increasingly dubious and, even if passed, the spending will be spread over many years and won’t come close to replacing pandemic programs which put money directly in consumer pockets.

The summer of 2021 has been anything but normal, and while progress slowed, business didn’t stop. Still, the slowing is a problem. The entire globe is a complex web of entry restrictions, mandatory quarantines, vaccination requirements, and medical screening. And even if you can get where you want to go, returning home may be another problem. Commerce hasn’t stopped — far from it — ports are clogged with more container ships than ever, bringing goods to feed our new spending patterns. But production of many goods is starting to shift even as finely balanced supply chains need predictability above all else.

In the near term, the risk of additional supply chain disruptions will remain, especially in more risk-averse countries that maintain severe lockdown strategies. The risk will decrease somewhat as other countries — especially in hard-hit Southeast Asia — shift their strategy from enacting strict lockdowns to learning to live with Covid. But even with a new approach, disruptions related to structural issues and efforts to emphasize resilience over timeliness will persist.

We frequently tell clients that we don’t make predictions about the future, but we do prepare for those moments when the conventional wisdom disappoints. This is what we refer to as “participation with protection” and the issue investors must confront is that the market is out of catalysts. The economic re- opening has happened and is priced in; we are at the end of the fiscal stimulus theme; the Fed is talking about taper, not easing, and the variant is a cloud on the economic outlook even with no lockdown. The market is priced for an escape velocity but ignores these truths and provides a textbook framework for growing volatility and the ability to capture both sides of the market.

We are not out of the woods yet. The virus isn’t going away until most of the world gets either infected or vaccinated, which will take several more years. Big companies have to plan ahead. The decisions they make now will lock them into certain directions for years to come. The changes we’re seeing now won’t be easily or quickly reversed. Where all this will lead is unclear. But it’s already bringing big adjustments and will probably bring more — especially if this assumed transitory “new normal” holds because the true recovery is pushed, the less likely it is that we return back to baseline. One thing that we have learned over time however is, when all the experts agree, something else is going to happen.

Yours truly,

Hirschel B. Abelson
Chairman

Adam S. Abelson
Chief Investment Officer


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