What to Expect in Coming Months and Years

By Mark Bern, CFA

The Q4 GDP growth was revised higher by 0.4% to 2.9% by the Bureau of Economic Analysis this week.  What does this mean?

First, it means the economy was growing faster than originally reported and much closer to the forecasts of 3% that preceded the actual report.  Most (2.8%) of the GDP growth came from consumer spending.  This is good but not as good as it would appear on the surface.  In Q4 of last year there was a lot of spending on repairs and replacements due to Hurricanes Harvey, Irma and Maria.  There may be some more in Q1 but not as much and going forward there will be less and less until the impact of those natural disasters is completely healed. 

The revision is in the right direction and gives the Federal Reserve more flexibility to continue to raise interest rates as scheduled.

Jobs growth continues strongly throughout Q1 also which portends continued economic expansion, growth in consumer spending and potentially minor upward pressure on wages.  Anecdotally, my son (who works as a supervisor at Target) told us he got a raise today as did everyone else at Target.  The base pay went up by another $1/hour for all employees.  It is not just the one company.  Many major employers are raising the company-wide minimum wage in hopes of attracting and retaining better quality employees.  Those pay raises should continue to fuel economic growth as millions more workers have a little more to spend each month.  And those same companies (including Walmart) are planning to continue to raise base pay for all employees every year for the next several years.

That brings us to inflation.

Labor costs will continue to rise, as mentioned above, on the low end of the wage scale.  It will also probably rise for certain skills as well in the mid-tier range.  It may even rise in the upper end as well.  But the key to keeping overall wage cost low is through improved productivity.  It is somewhat harder to achieve at the lower end unless companies do, in fact, attract and retain higher quality employees who are more productive that those with poor attitudes about work.  The same is probably true, to an extent, for the mid-range wage jobs. 

The larger cost savings often comes when companies automate processes and automation plus robotics are beginning to make a difference.  I expect that the adoption of robotics and automation to replace a lot of jobs at all levels of the pay spectrum.  While many may consider this to be a negative for the economy I believe it will provide the much needed slack in the workforce to keep feeding the growth and hold down wage growth to reasonable levels.

Instead of inflation ramping higher we should experience a more modest increase to the 2.5 – 3% range over the next few years.  Also because of the major demographic shift that is taking place in most developed economies I expect inflation to remain relatively tame from a historic perspective.  But that could begin to change by about 2022.  How high inflation will go after that depends upon how rapidly the adoption of robotics and automation takes place.  Too fast and we will find ourselves worrying more about deflation than inflation.  Too slow and inflation may become a real problem in the future. 

Still, I do not expect to see another episode of rapid inflation like we had in the late 1970s and early 1980s.  For those of you who were not around yet then, or do not remember, inflation got to an extreme in the U.S. of over 14% in 1980.  But that was not the worst bout of inflation in history.  Double-digit inflation came to the U.S. several times.  In 1920 inflation reached 20%+ and then turned to double-digit deflation in 1921.  As a matter of fact, deflation was the norm from 1927 through 1932.  Then double-digit inflation struck our shores again in 1942 and again from 1946 through much of 1948.

More recently, inflation remained stubbornly above 4% from 1968 through 1982, with the only exception of 1972 when it actually dipped to about 3% for much of the year.

The point being that inflation comes and goes.  When an economy overheats of its currency loses too much value, inflation creeps in and takes its toll.  Subdued inflation of 2-3% is manageable but when it gets up around 5% it becomes a problem and generally puts a lid on growth and stocks values.  The worst sustained period of inflation in modern U.S. history occurred during the 1970s.  That was also one of the worst times to be an investor in stocks. 

Could we see inflation of that magnitude again?  Anything is possible, especially if we were to enter another recession before the Fed has a chance to unwind at least half of its balance sheet.  I do not expect things to get that out of hand but do expect inflation in the 2020s decade to reach the 5% level at some point.  These things are cyclical and even the Fed cannot stop the cycles, but it can keep the veracity at reasonable levels.  It will take a supreme balancing act but I suspect they are up to the task as long as we have political leaders who will do what is right for the country rather than only what will get them re-elected.  That is where the real problems lie, in my humble opinion.