Briefly put, the economic expansion continues, but at a disappointing rate. Early in the third quarter a resurgence of Covid-19 infections brought on by the delta variant fostered renewed restrictions, delayed openings, and reductions in consumer expenditures. In addition, some of the effects of government stimulus support are starting to wane. Meanwhile higher inflation, supply chain disruptions, and the threat of higher taxes add uncertainty to a picture that is otherwise still quite good.
When I last wrote, real Gross Domestic Product was growing at a 6.4% rate and an even higher rate was expected for the near future. Instead, third quarter GDP growth came in at 2%, well below expectations, as industrial production, which had been growing for 6 straight months, dropped 1.3% in September and consumer confidence declined throughout the quarter. Housing, which had been robust in the economic recovery, also took a pause as higher prices, lack of available inventory, and rising input costs slowed activity. Trailing 12-month GDP growth of 4.7% is historically still quite healthy, but the sharp deceleration surprised many.
The employment situation highlights the complex situation faced by policy makers. Last month, the unemployment rate dropped from 5.2% to 4.8%, and it fell more than a percent during the quarter. Still, the number of people in the labor force is presently about 3 million less than in February 2020, prior to the onset of the pandemic. Meanwhile our population is about 1.4 million higher, implying a gap of over 4 million potential workers. With many now comfortable staying home, whether they work there or don’t, employers are being forced to increase wages. Average hourly pay is now 6% higher than a year ago. In September wages jumped at an 8% rate.
The increase in labor costs is undoubtedly a factor in rising prices in general. The consumer price index is now 5.4% higher than twelve months ago. Year-over-year inflation has been near or above 5% for more than 6 months. For quite some time, the Federal Reserve has set its target for inflation at 2%, but the Fed also has a mandate to maximize employment. The Fed has viewed the surge in inflation as transitory in nature. Temporary and easily identified supply issues lend credence to this view, but the breadth of labor shortages and escalating wages perhaps indicate otherwise. At present the bond market is accepting the Fed view that the current elevated levels of inflations are largely transitory, thus interest rates moved little since I last wrote.
Given this economic and rate backdrop, the equity markets moved sideways during the third quarter. For the three months, the S&P 500 nudged up 0.58% but the S&P 400 Mid-Cap index was down 1.85% while the Russell 2000 Small-Cap index dropped 4.3%. Overall equity valuation levels remain significantly elevated by most measures. However, in the context of the current interest rate environment, they are in line with historical norms.
Investing is a long-term process, of course. The prospects and uncertainties highlighted above are best addressed by maintaining an asset allocation with which you are most comfortable.