On the Economy’s Skewed Expectations, Spending Shifts and Riding Out Inflation
Friday’s high inflation reading for May—8.6% year over year, the highest number since late 1981—added another exclamation-point piece of data to the debate about where the U.S. economy stands and where it might be headed. Yes, supply shocks are factoring into a lot of the equations surrounding prices, demand and more. But just what are the underlying factors telling us about the rest of 2022? And how should executives—many of whom are still saying encouraging things about their customers’ appetite for goods and services—let today’s extraordinary environment shape their mid- and long-term decisions?
To try to find a few answers to those big questions, we reached out to economy watchers Chris Kuehl, managing director at competitive intelligence firm Armada CI and economic analyst for the Fabricators and Manufacturers Association, and Danny Bachman, a senior manager with Deloitte Services overseeing U.S. economic forecasting for the global firm’s eminence and strategy functions. Here are their thoughts, lightly edited for clarity and brevity:
Picking up on Jamie Dimon’s recent comments about the economy, does the next phase of the business cycle look to you more like a hurricane that will cause real damage or like a few showers that will relatively gently cool things down?
Kuehl: I just love all the metaphors for economic activity but most of them are not very descriptive or helpful. The most salient of these right now is the "black swan" description. Whatever normal business cycle pattern that existed prior to 2022 has been thrown out the window by the pandemic and then the Ukraine war—more specifically by the reactions to these events.
In retrospect, it is obvious that shutting down the economy in 2020 was a major mistake and it can be argued that flooding the system with cash to offset the damage was also a mistake given the role that played in everything from labor shortage to inflation. Next we have the Ukraine war and the damage inflicted by sanctions. Nobody expected Russia to ignore these assaults this long, and now the world has a major energy crisis to deal with. The fact is that conditions could swiftly improve with some end to the war and a resumption of supply from China, but neither of these developments are guaranteed and nobody has any sense of when this might occur.
Bachman: Risks of a recession are higher than normal at the present time, but a recession is not inevitable. While the Federal Reserve adopting a tightening stance increases risks, the financial system does not appear to be displaying the imbalances and mispriced risk that has made rising interest rates so dangerous in the past.
With consumer spending as prominent in the economy as it is, it’s natural that a lot of attention is being paid there. But how tightly correlated are consumer spending and the broader business investment cycle – particularly when big trends such as reshoring and the energy transition are longer-term plays?
Bachman: Consumer spending tends to follow, not lead, the business cycle. The main story in consumer spending is that consumers are—as we predicted—shifting from spending on goods to spending on services. This is likely to create some pressures on consumer goods producers and retailers, but that does not indicate that a recession is occurring.
Kuehl: Ultimately, the consumer rules in the U.S., accounting for over 70% of the economy. The correlations are quite tight. Trends such as reshoring are directly related to consumer demand and the need to have better control of the supply chain. Energy is also consumer-driven. Inflation at the pump has already curtailed spending and we have been smacked in the face when it comes to alternative energy. Replacements for fossil fuels may be coming in the future but certainly not now and this crisis may push development of alternatives back by many years.
What’s the likelihood that the corporate/industrial sector doesn’t see much of a downturn in the next few years because many companies haven’t been able (or willing) to invest and produce as much as they’ve wanted to of late, thus avoiding some of the excesses we would see in a more traditional cycle?
Kuehl: This is an interesting theory that has been discussed a lot of late. The supply chain mess kept a lot of companies from the inventory build they would have preferred last year but now this may be a blessing in disguise. There have been many reductions and cancellations reported by retailers worried that demand is slipping and that soon affects the producers as well.
There has not been the usual boom in expansion that would have been expected with growth of nearly 6.0% in 2021. Most companies were still severely inventory short as they had reduced output in 2020. The whipsaw of severe downturn followed immediately by massive growth skewed expectations.
Bachman: Business investment has been growing relatively quickly recently but that masks a significant change in the type of investment. Investment in nonresidential structures has been falling and is now 22% below the pre-pandemic (2019 Q4) level, while investment in equipment and intellectual property has grown quickly. This change in investment may leave some capital “stranded” giving investors less than before the pandemic.
Are you hearing about higher interest rates already affecting corporate investment plans? Or are they still historically low enough to support capital spending at a high level?
Bachman: A relatively large share of business spending is for information technology equipment and appears to be relatively insensitive to the modest rises in longer-term interest rates that we have seen so far.
Kuehl: The levels of capital investment are still at record highs and interest rates are not even close to average levels of the past few decades. Thus far, there has not been much evidence of slowdown but inflation worries are convincing some to postpone (but not abandon) expansion projects.
Many businesses, particularly in B2B sectors, have expressed confidence they can pass along much of the inflationary pressures they’re facing. How long do you think that can continue?
Bachman: If the Federal Reserve is successful in stemming inflation (which appears likely), some businesses will face a reduction in profitability as weakening demand prevents them passing through cost increases. This is, in fact, a condition for keeping inflation under control.
Kuehl: The fact that inflation is rooted in some unusual and likely temporary factors (supply chain and energy) means it is reasonable to assume that companies can ride this out for a quarter or two. The issue is how long these threats last and whether some of the traditional motivators emerge (labor costs, mostly). Consumers still have a lot of spending power—they are at the "bitter complaint" stage but have not yet altered their spending habits all that much.
Given the noise in and conflict among some economic indicators in the past few years, what’s a measure you’re paying relatively less attention to right now? And what’s one that has risen in importance to you?
Kuehl: I pay a lot of attention to the Purchasing Managers' Index and Capacity Utilization. To be honest, I really like the Strategic Intelligence System we designed a couple of years ago. It has been tracking at 96% accuracy.
Bachman: A classic mistake of business decision-makers is to try to find one (or a few) key economic indicators that supposedly show what is happening. There is no substitute for the hard work of understanding how all of the available measures of the economy fit into a picture of the whole.
