Bank of Blue Valley
2021 Mid-Year Economic Update

Interest rates appear to be stable now with the Federal Reserve committed to quantitative easing. That will change in 2022 when chatter around tapering becomes more apparent. That should produce the long-awaited increase in interest rates and net interest margin.

Only a guess, but over the next two years, the highest level the 10-Year Treasury will achieve will be south of 3%.

We will observe growth and profits in:

1. Social media platforms (advertising behemoths).
2. E-commerce (Bezos wins).
3. Cybersecurity (issue of the day).
4. Domestic manufacturing (reshoring is real).
5. Two-year colleges/apprenticeship programs (growing aversion to student debt).
6. A bevy of emerging technologies, including electric vehicles, 3D printing, artificial intelligence, augmented reality, virtual reality, drones, cloud computing, robotics and software/applications.

The current bout of inflation is concerning, but it does not appear to be enough to impact broader economic momentum. True: Manufacturers, homebuilders, swimming pool owners (chlorine) and others are complaining, but aggregate demand is powering through it all. Inflation should begin to subside later in 2021 and into 2022 as global supply chains become more orderly and additional capacity comes online.

The Delta variant’s ongoing spread through American society will take some of the edge off the pace of economic recovery during the year’s second half, but the pace of recovery should still be rapid as quantity supplied rises up to meet (or more nearly meet) quantity demanded.

Commodity price inflation is largely transitory, but inflation in labor-intense settings like food production and restaurants, less so. Capital intensive output like brass, aluminum and steel should be experiencing deflation at some point next year.

Interest rates have to be headed higher relative to inflation. It’s an economic equation. As the Federal Reserve removes accommodation at some point over the next two to four years, interest rates will rise and inflation will soften. Indeed, inflation will soften before then.

Inflation target is 2.9% for 2022 and closer to 2% thereafter (guess).

Inflation is damaging to real estate values to the extent that it raises the cost of capital. When cost of capital rises, cap rates tend to as well. To date, inflation has not been problematic because interest rates have actually declined as excess inflation has manifested itself. That can’t continue forever. I don’t think it’s a great time to be a buyer. Upside is limited as we approach affordability constraints.

Small business blind spots include:

1. doing what is necessary to hold onto the best workers, including raising pay;
2. cybersecurity is a genuine consideration; and
3. always maintain a great working relationship with one’s banker and key suppliers of insurance.

The outlook for surviving small businesses is very good. Economic recovery will continue to be brisk, and there is less competition!

Federal spending has supplied much to small businesses, particularly through the PPP. Federal spending also supported employees who were let go by such businesses by supplying federal supplements to state unemployment insurance benefits. To date, this spending has occurred without raising interest rates, which confounds economic theory (5.4% CPI vs. 1.3% 10-Year Treasury yield.)  However, all this stimulus has placed additional inflationary pressures on small businesses and likely rendered it more difficult for them to staff up as the economy reopens.

It has been difficult to get labor back into the game in sufficient numbers for many reasons, including: a) stepped up unemployment insurance benefits; b) cultural factors, including greater choosiness among jobseekers; c) lingering fears of both vaccination and the virus; d) substantial stimulus payments and attendant savings; e) childcare issues. Necessity is the mother of invention. Paying bills is necessary.  Ergo, expect labor force participation to rise meaningfully this fall.

There is a big debate in the economics community, but I believe the stepped-up unemployment insurance benefits have induced many people to stay out of the labor market for the time being. As those federal benefits disappear (September 6), many should be induced back into the labor market.  That should improve circumstances for retailers, restauranteurs, hoteliers and others, especially since the summer rush will be over by then.

I’ve spoken to many commercial real estate brokers striving to downplay the likely impact of remote working/hybrid models on office space leasing. I think the negative impact on office space utilization will be massive, and that could trigger financial issues for many building owners as lease rates slide and as many tenants choose not to renew their lease or opt for less square footage.

The great resignation is real, especially among Baby Boomers. Some Boomers retired early because of asset price increases, but the majority of those who retired early lost a job toward the initial stages of the pandemic and just threw in the towel. It seems to me that many young people will be induced back into the labor force to pay bills, but many Boomers are out of the game altogether.

At some point, expect a rotation to safer stocks with lower beta. The equity value boom in tech can’t last forever, right?

Single-family construction will be stronger than multi-family during the year ahead.

The construction industry will be hamstrung by elevated materials prices through at least 2021’s fourth quarter. I still see some pain into 2022, however. Recent surge in copper prices is worrisome. Softwood lumber prices could also bounce back as residential permitting picks up steam.

In an inflated market, the agricultural sector is likely to experience additional consolidation. In other words, corporate ag processors will continue to gain market share. That is all the more likely because of the demographics (age) of America’s farmers.

Owner-occupied residential real estate market looks very strong in ’21 and ’22, but commercial real estate (office, hotels, retail) remains a vast underperformer.

The real estate run will eventually be slowed by a combination of elevated prices, rising housing production and an inevitable rise in mortgage rates.

Real estate financing has remained reasonably disciplined in recent years. I don’t see that changing.  The marketplace was chastened by lending practices of 15 years ago.