October 8, 2021

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George Mokrzan, Ph.D., Director of Economics

The Economic Outlook The Economy Continues to Recover from COVID-19 Economic recovery continues, but with significant supply constraints and inflation. These 3 themes have dominated the economic environment in 2021 and will likely continue to do so. In the third quarter, the economic recovery gained momentum as significant portions of the service sector returned to ‘normality,’ even as COVID-19 continued to be a challenge for many. However, supply constraints intensified for labor, critical electronic components used in production and energy supplies. Inflation rose to new heights during the quarter and remains a risk going into 2022. We update these issues in the following report.

The Economic Forecast Economic recovery from the COVID-19 downturn is expected to continue unabated, ultimately bringing the economy close to full employment, but persistent inflation and supply constraints are moderating the economy’s overall growth pace from previous projections. Real GDP is forecasted to expand at 5.6% in 2021 and 3.3% in 2022, downwardly revised from 6.0% and 3.7%, respectively. Inflation is revised upwards from 4.0% to 4.25% this year, and from 3.5% to 3.7% in 2022, as rising energy prices and tight natural gas supplies boost inflation risks further in the near term. Despite supply side challenges, overall consumer and business spending growth is expected to continue. Inflation has eroded purchasing power of incomes in the last year, but average consumer finances are the healthiest in decades. Employment is expected to sustain its rebound from the COVID-19 recession with the unemployment rate declining to 4.5% by year-end. Business investment in equipment, intellectual property, research and development, and inventory replenishment should catalyze business spending growth. International trade activity in a world economy struggling with COVID-19 in areas where vaccination availability remains low will probably not reach full potential until next year. Interest rates are generally forecasted to remain low for the remainder of 2021 before commencing on a rising trend in 2022, with the 10-year Treasury yield moving above 2.0%. We expect the Federal Reserve to begin the taper of bond purchases in November. The monetary policymakers will likely complete this tapering in mid-year 2022. Subsequently, they are forecasted to raise the Fed Funds rate target by a quarter point in the second half of 2022. The forecast is generally positive but forecast risks for interest rates and inflation are tilted to the upside given extraordinarily high levels of aggregate demand relative to constrained aggregate supply in the economy. Monetary and fiscal policy uncertainty remains especially high. Supply constraints to labor, semiconductors, energy, and international freight transport create downside risks to economic growth in the near term.

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Economic Expansion Continues Economic Recovery Momentum has strengthened according to the Private Bank Leading Economic Indicators

Despite headwinds, the United States economy is exhibiting strong fundamentals. Average Household and Business balance sheets are the strongest in decades. Leading indicators generally point towards continued economic growth in the next year and potentially beyond. The following summarizes the eleven Private Bank Leading Indicators of the United States economy, and their respective ratings at Economic Expansion, Economic Contraction or Neutral:

1. Initial Unemployment Claims: Economic Expansion Initial unemployment claims are down significantly from 2020 and on a downward trend, though volatile from week to week. Steadily rising initial unemployment claims often signal economic downturns, whereas declining initial claims indicate continued economic expansion.

2. Treasury Yield Curve: Economic Expansion

The yield curve maintains an upward spread from 0.0-0.25% on the short end to 1.5% on the recent 10-year Treasury yield. A positive slope reflects continued economic expansion. The curve generally inverts prior to an economic contraction.

3. Yield Spread Between High-Yield Corporate Bonds over Treasury Bonds: Economic Expansion

Spreads remain historically low, reflecting strong overall corporate finances.

4. Real GDP Annual Change: Economic Expansion Inflation-adjusted GDP grew 12.2% between the second quarter of 2020 and the second quarter of 2021, reflecting complete recovery in total GDP from the COVID-19 recession.

5. Growth in National Income Corporate Profits Excluding Taxes: Economic Expansion

Corporate pre-tax profits rose 43% from the second quarter of 2020 to the second quarter of 2021, a record high level reflecting strong corporate earnings in a healthy corporate business sector.

6. Non-Farm Proprietor’s Income Growth (Small Business): Economic Expansion

Small Business income rose 21.2% from the second quarter of 2020 to the second quarter of 2021, a record high reflecting a recovering and generally healthy small business sector. The small business sector was supported significantly by the PPP program during the pandemic period.

7. Real Personal Income Excluding Current Transfer Receipts: Neutral

Up 6.2% YoY in Q2 to a record high level, the rise in wages and jobs reflects core real income growth creation that is independent of transfer policies. A rating of ‘Neutral’ instead of ‘Expansion’ reflects an expected surge in inflation in the second half of 2021. Inflation erodes real purchasing power of incomes, especially for low to moderate income individuals and households.

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8. New Private Housing Permits: Economic Expansion

Up 17.5% in August 2021 compared to August 2020, New Building permits indicate increasing future housing starts, household formation and homebuilding. Volatile, but holding at high levels overall, Building Permits in Q1 2021 were the highest since the housing boom in Q2 2006.

9. Closed-end Consumer Non-mortgage Loan Delinquency Rate: Economic Expansion

Consumer delinquencies on loans have been historically low. Recent delinquency rates as of March were 1.9% for accounts and 1.6% for balances, with both decreasing during the quarter (Source: ABA). FFIEC Bank Consumer Delinquency rates in the second quarter were the lowest on record back to 1987 in Q2. Charge-off rates in Q2 2021 were the lowest since Q3 1985. High government support from CARES 1, CARES 2, and ARP helped maintain liquidity/solvency for many consumers highly impacted by the pandemic.

10. University of Michigan Consumer Expectations: Economic Contraction

A Conference Board indicator for consumer spending in the upcoming 6 months, Consumer Expectations declined to a pandemic low in August on consumer concerns regarding inflation, supply constraints, the COVID-19 Delta-variant and geo-political events.

11. Demand for Commercial & Industrial (C&I) loans from the Bank Senior Loan Officer Survey:

Economic Expansion Net Demand for C&I loans was positive in the third quarter for mid-to-large businesses and small businesses (Less than $50 million in annual sales). The third quarter was the first quarter during the pandemic that net demand for loans was positive (Source: Federal Reserve).

The Overall Private Bank Leading Indicators Count is 9 Expansion, 1 Neutral and 1 Contraction, representing the strongest Net Expansion reading since December 2019, the final reading before the unforeseen COVID-19 pandemic began. The strong improvements over a wide range of key indicators reflect an economic recovery that is broadening and strengthening, thereby increasing the likelihood that it has self-sustaining strength in the face of new adverse circumstances. We turn next to review some of these new challenges.

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The Private Bank Leading Indictors Are the Strongest Since the Fourth Quarter 2019

Supply Constraints Continue Supply Constraints Restrain Growth from Full Potential Supply constraints have slowed but not stopped the economic recovery. In the following, we examine three areas of major supply constraints in the economy: Labor markets, Energy and Semiconductors.

Here are the Jobs. Where are the Takers? Job Openings rocketed upwards during June and July. Total Job Openings according to the Bureau of Labor Statistics were a record high 10,934,000 in July. Job openings have been rising rapidly throughout 2021, adding an incredible 3,780,000 job openings to the 7,154,000 job openings at the eve of the COVID-19 pandemic in January 2020. Job Openings have been broad-based across sectors of the economy, rising to record highs in Manufacturing, Trade Transportation & Utilities, Professional & Business Services, Education & Health Services, Leisure & Hospitality and Government. Job Openings in Manufacturing alone had more than doubled from the period prior to the pandemic. Construction was the only major sector that did not experience record high job openings.

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Growth Neutral Contraction

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Job Openings Rise at a Blistering Pace

To put the high job openings in context, the ratio of Total Unemployed to Total Job Openings is a frequently cited gauge of the total supply of workers relative to the total demand of workers. This ratio dropped to a record low 0.796 in July as 10,934,000 job openings exceeded 8,702,000 unemployed during the month (Source: BLS). Hence, the primary challenge in labor markets is not of demand, but of supply.

The Ratio of Unemployed to Job Openings Drops to a Record Low in July

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Unemployment to Job Openings Ratio Source: BLS (EOP, SA, Thousands)

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One potential way to fill the many job openings in the economy is a rise in the labor force participation rate, especially among those in their prime working years, typically in the 25 to 54 year-span for many individuals. The labor force participation rate for this demographic group declined from 83.0% in January 2020 to a low of 80.6% in May 2020. Since May of last year, labor force participation in this prime working age segment has risen back up to 81.8%, with participation rising for both males and females. As evident in the chart below, labor force participation rose 0.5% from 81.3% to 81.8% between May and July. This early summer period also corresponded to increased normalization of social activity following improved vaccination rates in the early months of the year. It also corresponded to the phasing out of federal unemployment insurance supplements in many states. Although COVID-19 still imposes constraints on social activities, the trend towards normalization should continue to promote increased labor force participation by all demographic groups, thereby helping to ease the labor shortages across the economy. The return of workers will likely be aided by increased compensation from employers, which is highly probable given tight overall labor market conditions.

Labor Force Participation of the 25 – 54 Years Demographic Group is on a Rising Trend

Where is the greatest potential for improvements in labor markets? It will likely be in the small business sector, where most job openings and hiring in the economy occur. According to the July JOLTS survey by establishment size, six million job openings were in small business establishments with between 10 and 249 employees. (Please see the following below). The number increases to 9 million for establishments between 1 and 999 employees. The number one problem of small companies is finding qualified labor, as expressed

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consistently by NFIB surveys of small businesses both before and after the pandemic. The ultimate solution to the aggregate supply shortage in labor markets will likely require addressing this fundamental mismatch of labor demand and supply.

Small Businesses Provide the Most Job Openings

New Supply Challenges and Inflation in the Energy Sector High demand for energy concurrent with limitations in its supply are lifting energy prices strongly again, intensifying a relatively new source of inflation in the current economic recovery. After bottoming at $66.56/barrel on August 9 of this year, the Spot Price for West Texas Intermediate Crude Oil rose to $79.17 on October 5, close to the $80 per barrel threshold. However, the price of natural gas at $6.37/mmbtu on October 5th has created the greatest degree of surprise, rising more than threefold from $1.92 exactly one year ago (Source: Henry Hub, LA). If a one-day unusual spike in February of this year is excluded, the price of natural gas was at its highest price since February 14, 2014. High natural gas prices on the doorstep of the winter heating season in the northern hemisphere are increasing fears that natural gas prices could rise even further, with shortages occurring if the winter is significantly colder than average. Inventories of both natural gas and crude oil have been diminished, as evident in the following charts on oil and natural gas markets. Inventory of natural gas has undershot levels during the same time last year by over 15%, as inventory building during the normal seasonal restocking period proceeded more slowly than has typically been the case. Several natural and geo-political factors have contributed to the low supplies. Weather related events have been significant. Hurricane Ida temporarily shut down energy production in the

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Gulf of Mexico. As of October 1, more than a third of the Gulf’s natural gas production remained offline. June and July were the hottest months on record, raising demand for power during the summer months. The severe drought in the West significantly curtailed hydro power, which is a direct renewable substitute for natural gas. An unusually weak year for wind power in Europe reduced a significant renewable source of energy on the continent. The transition from carbon to renewables worldwide has not been operationally smooth in the last year. Russia reduced supply of natural gas to the EU nations, further stressing energy markets in an area not well endowed in natural gas. Russia has been somewhat conciliatory since, but risks remain. With fears of a cold winter rising, the price of natural gas in Europe is multiple times higher than in the United States. LNG exports from the United States and other countries are buffering the strains in Europe, but the shortages are worldwide and impacting all energy markets. China has ordered its coal mining operations to resume and its power companies to secure supplies of natural gas at all costs. The upcoming winter Olympics in China may be a factor in its urgent actions, but as a strong buyer in energy markets, China will likely sustain upward pressure on natural gas and other substitutes worldwide in the coming months. While many factors can be cited for the current energy shortages, the major overriding cause is the massive worldwide surge in aggregate demand in 2021 created by recovery from the COVID-19 pandemic shutdowns, which simultaneously raised energy demand from consumers and businesses around the planet. Replicating the challenges in other key sectors of the economy, suppliers were not prepared for these sudden large increases in demand. Stung by severe declines in energy prices during the shutdowns of 2020, including brief bouts with negative energy prices, energy producers have been cautious in raising their production capacity this year. Capital discipline has been strong, even among United States natural gas producers, who have been highly responsive to changes in market prices in past years. A positive supply response to high prices will come from U.S. producers in the coming months, but questions remain as to how big the supply increases will be.

Crude Oil Prices Moving Higher as Inventories Decline

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Natural Gas Prices Moving Higher as Inventories Decline

Auto Market Supply Cannot Keep up with Demand In another example of demand outstripping supply, New Motor Vehicle sales declined sharply during the third quarter as semiconductor shortages cut down on available inventory. Sales declined from a 16.9 million annual sales pace in the second quarter to 13.3 million in the third quarter. The trajectory was downwards to 12.2 million in September as the worldwide shortage in semiconductors crimped vehicle production, inventory and ultimately sales. The decline in vehicle sales was the primary factor in reduced estimates for GDP growth in the third quarter. Sales of new vehicles will likely stay at low levels until supplies of semiconductors are boosted. Low inventory is causing prices to rise sharply for used cars and trucks, whose prices rose 41.1% in August 2021 from January 2020, the month before the COVID-19 pandemic began. Semiconductors are complex components that are present in modern durable goods, in addition to vehicles. Many semiconductor suppliers are located primarily in Asian countries. Production was generally sufficient to meet world demand during the normal periods prior to the pandemic. However, when the pandemic began, semiconductor production was cut sharply in anticipation of reduced demand from a world economy plagued by the pandemic. The opposite happened. Demand for semiconductors surged with the general demand for not only vehicles, but also for computers, games, phones, appliances, and business equipment. Suppliers have not been able to catch up with demand to date. The continuation of Delta-variant related factory closures in Asia and general transportation bottlenecks have only elongated the period before semiconductors become readily available. Ultimately, capital investment can increase capacity for semiconductor production, but large capital investments cannot be implemented quickly in the near term. Semiconductor availability should ultimately increase at some point in 2022, but shortages in the near term will likely continue to cut sales of products that require it, such as vehicles.

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Vehicle Sales Decline Sharply in the Third Quarter on Semiconductor Shortages

Despite shortages of critical components, manufacturing growth has remained strong. Total new orders for durable goods reached a record high in August. Production is growing solidly across products and sectors. While some products are negatively impacted by parts shortages, other products often fill the void. Firms have also become adept at producing as much as possible with the resources on hand, while waiting for essential parts to arrive before production is completed, essentially the tact taken in the vehicle industry. However, despite continued economic growth in the face of shortages, the lessons from the current supply chain strains will likely lead to improvements in supply chains in the future, including less reliance on just-in-time inventory, greater geographic diversification of sources, and increased vertical integration of key production processes. Changes will certainly also include increased domestic capital investment in semi-conductors and other materials critical for modern manufacturing.

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Inflation Remains High Inflation has been broad-based and significant, even as it will likely decline from current levels as the overall economy normalizes in 2022. In the 12 months ending August, the Consumer Price Index (CPI-U) rose 5.2%, the Producer Price Index rose 8.3%, and the prices of imports rose 9.0%. Prices rose 4.1% for GDP in the second quarter compared to the same period last year, but GDP inflation was accelerating at a 6.1% annualized rate during the quarter.

Inflation Rises Sharply

Consumer expectations for inflation are also rising to a level more in line with the first decade of the millennium than the low inflation leading up to the pandemic. Concern over rising inflation was likely the primary factor reducing Consumer Confidence during the summer months, as consumers learned first-hand that their dollars did not stretch quite as far as they did in the past. With the prices of energy likely to rise significantly in the coming months, these expectations of inflation will likely continue to move higher.

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Consumer Inflation Expectations are Rising

The supply-side sources of inflation have been multiple. The previous section on Supply Constraints addressed how challenges in labor, energy and semiconductors are contributing to inflationary pressures. These are augmented further by bottlenecks in key ports around the globe, high freight costs, and generally high prices for many commodities. Retailers are more challenged to build inventory for the upcoming holiday shopping season than they have been in recent years. COVID-19 itself is still imposing constraints to production and other economic activity internationally. However, supply constraints are not the only source of potential inflation. Expansionary monetary policy was essential to the economic recovery. Without the strong monetary stimulus response to the crisis from the Federal Reserve since the pandemic began, the economic recovery in the last year would probably not have occurred. However, inflation is ultimately a monetary phenomenon. Given historically high levels of liquidity, risks of sustained inflation are likely rising. Among the key money supply measures, M2 has risen 35% from January 2020 to August 2021. Unless it is gradually reduced, high levels of liquidity could ultimately result in sustained non-transitory increases in inflation. This is confirmed by the Federal Reserve Bank of New York’s Underlying Inflation Gauge (UIG), shown in the chart below. According to the Federal Reserve Bank of New York in the Haver Analytics data base, the UIG reflects “sustained movements in inflation” based on a broad set of consumer prices, real factors in the macroeconomy, and financial data. The UIG had its highest percentage increase in the last year in its entire history going back to the mid-1990s. The chart below also shows the Fed Funds rate target, which generally follows the lead of the UIG.

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The Underlying Inflation Gauge Rises Strongly in the Last Year

To reduce inflationary pressures, the Federal Reserve is forecasted to begin to taper its bond purchases after the upcoming Federal Open Market Committee (FOMC) meeting on November 2 - 3. The Federal Reserve is expected to end its monthly purchases of $80 billion in U.S. Treasuries and $40 billion in mortgage-backed securities by mid-year 2022, based on guidance provided at the most recent post-FOMC meeting press conference by Chairman Powell on September 22. The end of these purchases would effectively stop the injections of high-powered reserves into the financial system, used by the Fed as payment for the securities. The Federal Reserve is subsequently forecasted to begin raising the Fed Funds rate target in the second half of 2022 in a sequence of steady quarter point increases that will probably occur quarterly. The general firming of monetary policy is expected to be replicated by many central banks worldwide next year as central banks gradually turn their focus from achieving successful economic recoveries to protecting against rising inflationary pressures.

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Forecast Summary Table

Key Economic Indicators

October 8, 2021

272019 20120208 202021*19 202022*20*

Total Real GDP Annual Growth Rates 2012 Chained Dollars

2.3% -3.4% 5.6% 3.3%

Consumption 2.2% -3.8% 7.9% 3.1%

Non-Residential Fixed Investment 4.4% -5.4% 7.9% 5.1%

Residential Fixed Investment -0.9% 6.8% 11.7% 4.0%

Exports -0.1% -13.6% 4.6% 6.2%

Imports 1.2% -8.9% 12.9% 6.3%

Government Purchases 2.2% 2.5% 1.4% 3.5%

Change in Private Inventories (Billions 2012 Chained Dollars)

$75.2 $-42.3 -$64.1 $27.5

Nominal GDP Current dollars

4.1% -2.2% 9.6% 7.1%

Consumer Price Index for Urban Consumers (CPI-U) – Average Annual Rate

1.8%

1.2% 4.25% 3.7%

Federal Funds Rate Target Year-end range

1.50% to 1.75%

0.00% to 0.25%

0.00% to 0.25%

0.50% to 0.75%

10-year Treasury Note Year-end interest rate yield

1.92% 0.93% 1.8% 2.7%

National Income Pre-tax Corporate Profits Average annual growth rate

2.7%

-5.2% 23.7%

6.6%

Net New Average Monthly Non-Farm Payrolls (Thousands of Workers)

178K -785K +600K

+150K

Unemployment Rate – Year End 3.6% 6.7% 4.5% 4.3%

Trade-Weighted Dollar Index (Jan. 2006 = 100) Year-End Source: Federal Reserve

114.67 111.56 111.5 107.0

• Historical Data Sources: Haver Analytics, Federal Reserve, Factset Inc., and other sources noted in text.

* Forecasts: Huntington Investment Management of the Private Bank, Division of Huntington National Bank

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