Pre-Omicron Economy: Running Hot

The Commerce Department released a flurry of economic data before the Christmas holiday. Everything from consumer spending to home sales and investment were strong in November before the onset of the Omicron variant. It is important to note that much of the data coming out reflects the world before the onset of Omicron and its rapid spread. Financial markets have begun to react to the uncertainty surrounding the new variant, which is overtaking Delta in other countries and looks poised to do the same here.

The emotional reaction, or fear of contagion, has already triggered cancellations. Open Table reservations dropped to the lowest levels since last spring when we were emerging from the winter wave; hospitals are just beginning to get overwhelmed. Movie theater ticket revenues plummeted, while indoor theater and sporting events have been delayed or canceled. New York was on the cutting edge of that; New Yorkers know too well what it means when hospitals are overwhelmed. The strongest protection against hospitalization is natural immunity with a vaccine or boosters with current vaccines. Only about a third of the population has received the booster, although many public and private sector institutions are revising their guidance on vaccine mandates to include boosters.

The bulk of the economic consequences with regard to the winter wave are expected to show up in late December and January. The first quarter of 2022 is the most vulnerable to weakness; we have marked down our forecast to include a larger pullback and a subsequent rebound in growth in the first and second quarters. We had assumed something closer to last summer; that now appears optimistic, depending upon how the contagion affects the supply chain. Lumber mills in the South were left short-staffed for production lines as workers became ill or tragically died due to COVID. That added to the lumber shortages during the summer.

Data Dump
Price Surge Dampens Spending and Income Gains

The personal consumer expenditure (PCE) index, which the Federal Reserve targets for the inflation part of its mandate, jumped 0.6% in November and 5.7% compared to a year ago. That is the fastest pace since July 1982, after inflation started to come down in the wake of the twin recessions under former Fed Chairman Paul Volcker, who broke the back of inflation with double-digit interest rates and those two close recessions, one in 1980 and another in 1981-82.

The core PCE (excluding food and energy) rose 0.5% in November and was up 4.7% from a year ago. That was the hottest read we have seen since 1989. Much like the CPI, gains were more broad-based, which has raised red flags at the Federal Reserve. The consensus among members of the Fed is that variants are more disruptive to supply chains, including labor, than to demand and, therefore, more inflationary. Fed officials have left ample room to reassess if need be, before they start raising rates, which we expect to start in June.

Personal disposable incomes fell 0.2% after adjusting for the surge in inflation. That marks the fourth consecutive inflation adjusted drop in a row. The largest drop occurred in September when COVID-related expansions and supplements to unemployment insurance lapsed. The concern moving forward is both payroll growth and wage gains, especially in areas hardest hit by Omicron. Theaters and sporting arenas closed while restaurants have seen a sharp drop in in-door reservations as Omicron spreads. The slowdown in the week before the Christmas holiday was acute.

Consumption expenditures were unchanged after adjusting for inflation, and a bit stronger than retail sales, which focuses on goods spending. Travel and tourism for the Thanksgiving holiday was particularly strong. The services component of the consumption data moved up at the fastest pace since July, before the dampening effects on services spending associated with the Delta wave over the summer. Watch for signs of a pivot back toward goods and some softness in services once we start to see the effects of Omicron take hold in late December. Hospitals in hot spots were once again forced to limit elective surgeries, which is extremely costly, while travel abroad hit a wall. Many countries went into modified lockdowns as the new variant spread.

The saving rate fell to 6.9%, the lowest level since the onset of the pandemic and below the level we saw in February 2020. The saving rate is the residual of incomes less consumer spending. It soared as incomes were buoyed by pandemic aid, while spending was constrained by mitigation efforts. We are rapidly draining that savings, with lowest income households expected to run out of much of what they accumulated at the turn of the year.

Consumer sentiment as measured by the University of Michigan remained close to the lowest levels of the pandemic in late November. This measure of consumer attitudes has been much weaker than the measure of consumer confidence compiled by the Conference Board, which improved during the month. The gap between the two measures has been at a record high since late spring. The consumer sentiment measure is more sensitive to inflation, while consumer confidence measures are more sensitive to employment. Pandemics usually spur labor shortages and raise wages, but don’t trigger inflation because of the accompanying blow they deal to livelihoods and demand. Those shifts have fueled the divide, most notably in expectations about the future.

Businesses Remained Bullish

Durable goods orders jumped a much stronger-than-expected 2.5% pace in November and were revised up to post a slight increase instead of a decline in October. A sharp rebound in aircraft orders, which have long lags to complete - they take years - accounted for much of the surge. Core durable goods orders, which exclude aircraft and defense orders, contracted slightly but were revised up significantly for October.

Gains in new orders were strongest in communications equipment, which surged at a double-digit rate for the month alone. Motor vehicles and equipment continue to rise as chip shortages eased and plants continued to ramp up after disruptions during the Delta wave this summer. Machinery orders fell but remained up more than 18% from a year ago.

Defense orders rebounded, despite the fact that the defense spending bill was not approved until mid-December. Aircraft orders drove those gains. Much of government spending has been constrained by a continuing resolution. The Senate is not expected to complete reconciliation and move forward with what it will or will not adopt in the administration's proposals until early spring.

Core durable goods shipments increased by 0.3% in November, while October was revised up slightly. Those figures feed directly into the business investment calculation of real GDP and are consistent with our forecast for an acceleration in business investment between the third and fourth quarters. Inventories continued to be replenished but lagged overall demand by a substantial margin. Shortages are still common and adding to inflation pressures.

Home Buying and Prices Move Higher

New home sales grew 12.4% in November after October sales were revised sharply down. New home sales are recorded at the contract signing and now sit at the highest level since April of this year. Over half of the homes sold continue to be in the above $400,000 price range, as builders cannot keep up with the strong pace of demand, especially at the lower end. Lack of materials and workers continues to delay construction projects, while lumber prices have spiked again after additional tariffs were announced in November.

Separately, existing home sales, the largest portion of the housing market, grew for the third month in a row to a 1.9% pace in November. Strong sales growth in the South and the West led the charge. These sales reflect contracts signed earlier in the fall when mortgage rates were slightly lower. Even with the threat the Omicron variant poses on economic activity, mortgage rates are expected to climb modestly in 2022 as the Federal Reserve finishes tapering its asset purchases by March and raises rates in June. More existing home inventory will come online as future homebuyers are priced out from rising rates, alleviating some of the record-high home price growth we have seen this year.

Bottom Line
The data released today support our view that the economy was running on all cylinders in the fourth quarter; it will likely be the strongest quarter of the year. The bad news is that much of the weakness associated with the spread of the Omicron variant is still ahead of us. Some of the weakness could show up in data for December, but the bulk of the weakness will show up as canceled events, travel and less spending on services in January.

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