CPI inflation remains elevated despite coming off the summer peak. Inflation has continued to rise at am annualized rate of 3-4% over August and September, despite a slowdown in jobs growth. Total nonfarm payrolls have increased at an average pace of +561k per month this year, though we’ve seen a significant slowdown over the past two months at +366k in August and just +194k in September.
At the same time, port congestions have been on the rise and the price of shipping has increased dramatically this year. On October 13, President Biden announced that the Port of Los Angeles and the Port of Long Beach (which process ~40% of U.S. imports) will begin operating 24 hours a day, 7 days a week, to address these concerns.
Given the attention and focus on the transience/permanence of inflation, this month we dive into the numbers to see drivers behind this dynamic and its potential impact on the outlook for inflation.
Cost of shipping rising exponentially – To begin our analysis, we first look at the data. The price of freight rates began to shoot up exponentially beginning Q4 of 2020. Routes originating in China and going to the U.S. (black) and the E.U. (red) are the most notable, having risen 11.5x and 9x, respectively, as compared to rates prevailing prior to COVID-19. To a lesser, but still material extent, routes originating from the E.U. to the U.S. have risen 4.5x.
Source. Reuters, Orthogonal
Unprecedented congestion and bottlenecks at ports – Moreover, the rise in freight rates appears to be contemporaneous with record levels of congestion in U.S. ports. Below we plot the number of vessels anchored at the Port of Long Beach waiting to unload. The latest reading shows a total of 38 container ships waiting to unload at Long Beach, up from an average of less than 1 pre-COVID.
Source. Reuters, Orthogonal
COVID restrictions not the culprit – While it may be easy to pin the blame on COVID restrictions, the data does not support this. While there was a short dip in the early days of COVID in Q1 of last year (circled in red), total throughput through the Port of Los Angeles recovered quickly and has been operating above its pre-COVID levels (green lines) for most of this year.
Blame the insatiable demand of the U.S. consumer – If the rising cost of shipping and unprecedented congestion at ports is not due to COVID restrictions (supply), then it stands to reason that the price pressures are due to increased demand. Indeed, the durable goods component of Personal Consumption Expenditures released by the BEA reveals that U.S. consumer demand for durable goods (items with long periods between successive purchases, such as cars and home appliances) have gone parabolic in the past year. As has been written about here previously, with (i) restrictions on travel, leisure and hospitality and (ii) household savings on the rise (thanks to Fed stimulus), U.S. consumers have plowed their newfound wealth into the consumption of durable goods.
Source. Federal Reserve Bank of St. Louis, Orthogonal
From a pre-COVID average growth rate of around +4% per annum that showed little variability aside from a dip in response to the global financial crisis of the 2007-08, the growth in the consumption of durable goods has shot up to an average of about +20% in the past year. Because there are limits to the extent to which ports can increase the number of berths for the mooring of container vessels and cranes for the unloading and loading of containers, it is not surprising that the supply chain has been unable to meet this rapid increase in demand. While President Biden’s order to keep ports operating 24-7 may help alleviate these pressures to some extent, given the slower pace of work that happens overnight, longshoremen are not confident that it will be sufficient to unclog the backlog anytime in the near future.
Whither from here – In our previous commentary, we were on the fence as to where we stood in the debate as to whether inflation would be temporary or persistent. We now believe the inflation will remain elevated, with pass-through to core-inflation for at least the next 12 months.
With the likelihood of herd vaccination fading due to vaccine resistance in the U.S. (see e.g. Cambodia is now better vaccinated than many US states), a full return to pre-COVID spending patterns appears unlikely in the near future. Many are getting used to the idea that COVID may be endemic for the foreseeable future. The demand for durable goods seems unlikely to shift sharply back towards travel, leisure, and hospitality any time soon. If final demand falls, it will be due to rising prices rather than lack of demand.
Moreover, there is evidence to suggest that we have yet to see the full pass-through effect of the 5x-11x rise in the cost of shipping. Research from the Kansas City Fed in 2016 found that (i) upward pressure on consumer prices from a shock in the cost of shipping does not show for 6 months and peaks at 11 months, and (ii) a 25% increase in shipping costs would lead to a 15 basis-point rise in core inflation after about 12 months. While extrapolation should be taken with a grain of salt, for sake of illustration, this would imply the 8x increase (average between 4.5x EU-US routes and 11.5x CN-US routes) in inbound shipping costs over the past 12 months would imply as much as +4.8% increase in core inflation over the next 12 months!
While we believe the actual number will be far below that, we no longer see the rise in inflation as merely due to a supply shock that will quickly reverse itself as restrictions are relaxed and workers return to work. To the contrary, much of the rise in inflation is attributable to a shock to the demand side from (i) monetary stimulus, (ii) fiscal stimulus and (iii) a sharp change in consumer spending habits and what is worse, research suggests that we have just begun to feel the inflationary impact of the rise in the cost of shipping.
Given this outlook, it may be wise to stay away from government bonds and other assets sensitive to inflation. To the contrary, look for assets that benefit from a sustained rise in inflation to protect your portfolios.