Flaherty & Crumrine Total Return Fund : & Crumrine Third Quarter 2021 US Economic Update

Third-Quarter U.S. Economic Update

November 2021

Summary of Recent Economic and Market Developments

The U.S. economy cooled in the third quarter as inflation ran hot, turning rapid nominal growth into sluggish real growth. Real GDP rose 2.1%, down considerably from an average 6.5% gain in Q1 and Q2. Hiring picked up, the unemployment rate fell to 4.8%, and job openings hit a record high in Q3. Personal income rose modestly, led by wages and salaries, but real personal consumption slowed as goods prices rose quickly. Home sales rose, and residential construction spending was strong, but high inflation pushed real residential investment down again. Industrial output rose but remained constrained by widespread supply-chain bottlenecks. Business investment increased modestly. Inflation remained high and steady in Q3, but it has accelerated since and is likely to remain elevated well into 2022. Rising employment and faster inflation prompted the Federal Reserve to begin tapering its asset purchases, with rate hikes likely to follow in 2022. Long-term Treasury rates were little changed in Q3 but declined since then, despite higher inflation. Credit conditions remained favorable, with declining bankruptcies and few problem loans. Nonetheless, credit spreads widened, leading to mediocre returns for credit in Q3 and YTD.

Figure 1: Key Macroeconomic Indicators and Interest Rates

Economic Indicator*	2021:3	2021:2	2021:1	2020:4	2020:3	2020:2	2020:1	2019:4
Real GDP, Chg QoQ (%, SA, AR)	2.1	6.7	6.3	4.5	33.8	-31.2	-5.1	1.9
Real Personal Consump Expnds, Chg QoQ (%, SA, AR)	1.7	12.0	11.4	3.4	41.4	-33.4	-6.9	1.7
Real Business Inv ex Stuctures, Chg QoQ (%, SA, AR)	2.8	11.8	14.5	17.4	28.1	-25.5	-9.8	0.0
Real Residential Investmt, Chg QoQ (%, SA, AR)	-8.3	-11.7	13.3	34.4	59.9	-30.7	20.4	1.1
Real Private Domestic Final Sales, Chg QoQ (%, SA, AR)	1.1	10.1	11.7	6.2	38.1	-32.6	-5.9	1.2
Nominal GDP, Chg QoQ (%, SA, AR)	8.1	13.4	10.9	6.6	38.7	-32.4	-3.9	3.6
Corporate Profits, After Tax, Chg YoY (%, SA, AR)	19.1	43.4	14.7	1.1	2.1	-18.3	-3.8	-0.3
Nonfarm Productivity, Chg QoQ (%, SA, AR)	-5.0	2.4	4.3	-3.4	4.6	11.2	-1.8	0.6
Nominal Personal Income, Chg YoY (%, AR)	5.2	3.1	29.5	4.8	6.2	8.6	1.9	3.0
Personal Savings Rate (%, SA)	8.2	9.5	26.6	14.0	14.3	19.3	13.1	7.3
Unemployment Rate (%, SA)	4.8	5.9	6.0	6.7	7.8	11.1	4.4	3.6
Nonfarm Payrolls, Chg QoQ (000, SA)	1,886	1,845	1,554	638	4,025	-13,000	-1,079	590
Household Employment, Chg QoQ (000, SA)	2,078	754	1,018	2,287	5,443	-13,436	-3,199	505
Federal Budget, 12-moDeficit(-) or Surplus (% of GDP)	-12.5	-12.0	-19.9	-16.6	-15.6	-14.8	-4.8	-4.8
Consumer Price Index, Chg YoY (%, AR)	5.4	5.4	2.6	1.4	1.4	0.6	1.5	2.3
CPI ex food & energy, Chg YoY (%, AR)	4.0	4.5	1.6	1.6	1.7	1.2	2.1	2.3
Capacity Utilization (%, SA)	75.2	75.6	74.8	74.1	72.1	68.7	73.4	76.5
Rate or Spread (End of Quarter)	2021:3 2021:2 2021:1 2020:4 2020:3 2020:2 2020:1 2019:4
Federal Funds Rate Target (upper bound, %)	0.25	0.25	0.25	0.25	0.25	0.25	0.25	1.75
3-month LIBOR (%)	0.13	0.15	0.19	0.24	0.23	0.30	1.45	1.91
10-Yr Treasury Note Yield (%)	1.52	1.45	1.74	0.93	0.69	0.66	0.70	1.92
30-Yr Treasury Bond Yield (%)	2.08	2.06	2.41	1.65	1.46	1.41	1.35	2.39
ICE-BofAML US Corporate Index Spread to Worst vs Gvt	84	82	91	98	139	155	302	99
10-Yr Interest Rate Swap Spread (bp)	2.3	-2.6	3.6	0.8	2.5	-1.8	2.5	-2.8
* Figures are either quarterly or, if more frequent, end of period.	f = Forecast1 ; N/A = not available	Source: Macrobond, ICE, Bloomberg LP

Legend for all Figures: AR = Annual Rate; SA = Seasonally Adjusted; MA = Moving Average; C.O.P. = Change over Period

Third-Quarter U.S. Economic Update

Page 1

November 30, 2021

Economic Outlook

The U.S. economy slowed considerably in the third quarter as supply-chain disruptions continued, the Delta coronavirus variant raised COVID worries, and high inflation sapped real growth. Inflation-adjusted gross domestic product (real GDP) rose by 2.1% in Q3, down from the second quarter's 6.7% pace. Economic growth appears to have picked up in October and November, but so has inflation, which has taken a sizable bite out of real growth. Economists now expect Q4 GDP to expand by 4.8%.1 Above-trend U.S. growth is expected to continue in 2022, with the consensus GDP forecast currently at 3.9%, down from October's survey mostly due to expectations for higher inflation. Although the U.S. economy surpassed 4Q2019's level of real GDP in the second quarter, it has yet to recoup growth lost to the pandemic. Current forecasts now project that will not happen until 4Q2022, a full year later than seemed possible as the economy accelerated last spring.

Before we begin our review of the major sectors of the U.S. economy, we want to highlight the divergence between inflation-adjusted, or real, economic growth and mostly rapid gains in current-dollar, or nominal, growth. The table below shows real and nominal quarterly GDP growth since 1Q2020. The gap between nominal and real growth is inflation, which has run much hotter in 2021 than previously. The implicit GDP deflator averaged 5.5% so far in 2021, compared to an average of 1.6% in 2019, before the COVID pandemic struck.

Figure 2: Chained and Current Dollar GDP Growth - Mind the Gap!
	2021:3	2021:2	2021:1	2020:4	2020:3	2020:2	2020:1	2019 Avg.
Real GDP	2.1%	6.7%	6.3%	4.5%	33.8%	-31.2%	-5.1%	2.6%
Nominal GDP	8.1%	13.4%	10.9%	6.6%	38.7%	-32.4%	-3.9%	4.2%
Implicit Deflator	5.9%	6.2%	4.3%	1.9%	3.7%	-1.7%	1.3%	1.6%

Economists expected inflation to pick up in 2021 as the economy recovered from recession, but inflation has been higher, broader, and more persistent than anticipated. There are three reasons for this. First, the demand side of the U.S. economy rebounded briskly in response to large fiscal and monetary stimulus, as well as rapid development and deployment of effective coronavirus vaccines. Further, while it has been faster in some places than in others, this demand recovery is global in scope. Second, the supply side of the economy has recovered more slowly. Labor supply remains constrained, employers report difficulty hiring workers, and job openings hit a record high in the third quarter. Shortages of materials ranging from basic commodities to advanced semiconductors hampered production, and supply chain bottlenecks proliferated. Finally, monetary policy remained very loose, and money supply growth accelerated sharply. A rapid increase in inflation followed, turning strong nominal GDP growth into more-moderate real growth. Although inflation should come down in 2022, it is likely to remain elevated well into 2022, and perhaps beyond. We expand upon these themes in the paragraphs that follow.

• Unless noted otherwise, forecasts are from the Bloomberg® U.S. Monthly Economic Survey, November 12, 2021.

Third-Quarter U.S. Economic Update

Page 2

November 30, 2021

The labor market recovery continued apace in the third quarter (Figure 2). Nonfarm payrolls rose by 1.89 million jobs, slightly faster than the second quarter. An additional 531,000 jobs in October brought total nonfarm employment to 148.3 million, about 4.2 million below the February 2020 peak. Rapid hiring pushed the unemployment rate down to 4.6% in October, compared to 5.9% at the end of Q2 and 3.6% in February 2020.

Despite rapid hiring in the third quarter, job openings hit a record high, averaging over 10.7 million unfilled jobs (6.8% of total nonfarm employment), or about 1.3 times the number of unemployed persons. Job quitters are also on the rise, as workers expressed confidence that they can find better and/or higher-paying jobs at a new employer. Greater competition for workers boosted wages, and average hourly earnings were up 5.5% in October compared to three months earlier (Figure 3). Normally, rising employment and wages prompts people to reenter the labor force, but labor participation remained subdued at 61.6%, little changed since August 2020. A tight labor market is an important supply-side constraint.

Figure 2: Job Recovery Continuing

Levels of Employment and Initial Jobless Claims

	160	6
	155	5
		154 million
million	150	4	of .No
	148 million
ofNo.Persons,	140		millionPersons,
	145	3
		2
	135	1
	130	252250
	0
	JanFebMarAprMayJun JulAugSepOctNovDecJanFebMarAprMayJunJulAugSepOctNov
	2020	2021

Unemployment, National, Jobless Claims, Initial, Total, 4 Week Moving Average, rhs Employment, National, 16 Years & Over, lhs

Employment, Payroll, Nonfarm, Payroll, Total, lhs

Source: Macrobond

Figure 3: Unfilled Jobs Pushing Wages Up

		Job Openings, Quit Rate and Earnings
	7		30
			6.6
			25
percentRates,	6			AverageinChange
		20
	5
			15
& Quit	4		10	Hourly
OpeningJob	2		5.5	percentEarnings,
	3		3.2
			0
			-5
	1		-10
	Jul Sep Nov Jan	Mar May Jul Sep Nov Jan Mar May	Jul Sep Nov
	2019	2020	2021

Quits, lhs

Openings (Worker Flows), SA, lhs

Average Hourly Earnings, All Employees, Total Private, USD, rhs [a.r. 3 months]

Source: Macrobond

Personal income posted modest gains in the third quarter, driven by big gains in wages and salaries (Figure 4). Nominal personal income rose by 2.6% in Q3 despite a 15.6% drop in transfer payments as stimulus spending ebbed. Over 12 months ending in October, those were up 5.9 and 3.4%, respectively. Wages and salaries were up 11.6% in Q3 and 9.8% YoY in October. Looking ahead, we expect continued job gains and rising wages will support good growth in personal income, although inflation will offset much of those gains in real terms.

Spending rose briskly in nominal terms but only modestly in real terms. Nominal personal consumption expenditure (PCE) rose 7.1% in Q3 and 12.0% over 12 months ending in October (Figure 4). Adjusted for inflation, real PCE in Q3 was up by 1.7% and 6.6%, respectively. Spending on goods (-1.7%) lagged services (7.6%), but goods have gained on services in recent months as rising COVID infections from the Delta variant prompted a retreat from some in-person activities (Figure 5). For example, retail sales in eating and drinking establishments were nearly flat from August through October after surging during

Third-Quarter U.S. Economic Update

Page 3

November 30, 2021

spring and early-summer months. A new coronavirus variant, Omicron, threatens to further dampen services spending over coming months. Although COVID remains a risk, ongoing gains in personal income should keep PCE growing at a solid pace, even after inflation.

Figure 4: Wages Driving Consumption

	Nominal Personal Income, Consumption and Savings, YoY
	35			30
				25
	30			20
				PercentGrowth,Spending& Income
PercentRate,Savings	25			15
		12.0
				9.8
	20			5.9
				0
	15			-5
	10			-10
				7.3
	5			-20
	Jan Mar May Jul	Sep Nov Jan	Mar May Jul	Sep Nov
	2020		2021

Total, Personal Saving Rate, lhs

Personal Outlays (PCE), Overall, Total, Current Prices, AR, SA, USD, rhs [c.o.p. 12 months] Income Approach, Employee Wages & Salaries, Total, SA, AR, USD, rhs [c.o.p. 12 months]

Personal Income, Total, USD, rhs [c.o.p. 12 months]

Source: Macrobond

Figure 5: Goods Spending Resumes on Delta

	Personal Consumption Expenditures, SA
150
125
100
75
50
%
25	21.3
12.9
0	8.7
6.9
-25
-50
-75

Jan

Mar May

Jul

Sep

Nov

Jan

Mar

May

Jul

Sep

Nov

2020

2021

Real, Total, Chained, Constant Prices [a.r. 3 months]

Goods, Total [a.r. 3 months]

Services, Total [a.r. 3 months]

Total [a.r. 3 months]

Source: Macrobond

With spending outpacing income in recent months, the savings rate slipped to an average of 9.6% in Q3 and 7.3% in October (Figure 4). We continue to think rising employment and wages will prompt consumers to spend down some savings accumulated during the pandemic. As that happens, the savings rate will fall even though consumer balance sheets should remain in good shape. However, that strength in demand is likely to keep inflation elevated, especially for goods, until the supply side of the economy can catch up.

Figure 6: Inflation Burglarizes Housing	Figure 7: Home Sales Up; Prices Surging
Residential Investment, Nominal (Gray) & Real (Blue) SA	New + Existing Home Sales, Inventories and Prices

	80		percent	22.5	8	New
	60			19.1
	70			20.0	7.09 million
			Index,YoY	17.5		Existing+
	50		15.0	6
	40		Price			Home
	30		12.5	5
			Home		Sales
%	20		10.0
			-city	4	and
	10		2.5	1.64 million
		4.9	S&P/Case-Shiller 20	millionInventory,
	0			7.5
					3
	-10	-8.3		5.0
	-20				2
	-30
				0.0	1

-40

Jan

May Sep

Jan May Sep

Jan May Sep

Jan May Sep

Q1

Q3

Q1

Q3

Q1

Q3

Q1

Q3

Q1

2018

2019

2020

2021

2018

2019

2020

2021

S&P/Case-Shiller20-city composite Home Price Index, lhs [c.o.p. 1 year]

Expenditure Approach, Gross Private Domestic Investment, Fixed Investment, Residential [a.r. 1 quarter]

Inventory of New + Existing Homes for Sale, rhs

Saving & Investment, Private Fixed Investment, Residential, Constant Prices, Chained [a.r. 1 quarter]

United States, Real Estate Transactions, New + Existing Home Sales, SA, Volume, rhs

Source: Macrobond

Source: Macrobond

Third-Quarter U.S. Economic Update

Page 4

November 30, 2021

The housing market picked up in the third quarter, as home sales and construction spending rose. In nominal terms, residential investment was up by 4.9%. However, after 14.4% inflation in this sector, real residential investment fell by 8.3% (Figure 6). Housing is the current poster child for inflation: strong demand for homes, a limited supply of skilled labor, and shortages of building materials together sharply raise both construction costs and existing home prices. Combined new and existing home sales ran above 7 million units, and inventory of homes for sale remained low (Figure 7). The S&P/Case-Shiller20-city composite home price index rose 19.1% over 12 months ending in September, just below July's record 20% pace. It is nearly impossible for real residential investment to expand amid inflation this high. We will have to wait for it to cool before we can expect this sector to contribute to real GDP growth. While home price inflation has not been elevated for very long, the longer it runs hot, the greater the risk to home prices from tighter monetary policy, which is inevitable. It is something the Federal Reserve should be getting nervous about - and something we will be watching closely over coming quarters.

Figure 8: Manufacturers Struggle to Keep Up	Figure 9: Core Business Investment Slowed
Industrial Production, ISM, and Nondefense Capital Goods Orders & Backlog	Growth of Private Business Fixed Investment, Constant Prices, SA, Chained

	50					65.0			30
	40					62.5			20
	30					60.8
Percent
20					57.5			10
&OrdersBacklog,	-10					50.0	IndexISM	%
						13.1			0
	10					8.7
	0					1.7
								-10
Production,
								-30
									-20
	-20					47.5
	-30					45.0
	-40					42.5			-40
	-50					40.0
	2016	2017	2018	2019	2020	2021			-50

Unfilled Orders, Non-Defense Capital Goods Excluding Aircraft, USD, lhs [a.r. 3 months, m.a. 3 obs]	2012	2013	2014	2015	2016	2017	2018	2019	2020	2021
Business Surveys, ISM, Report on Business, Manufacturing, Purchasing Managers', Index, rhs			Total, AR [a.r. 1 quarter]
New Orders, Non-Defense Capital Goods Excluding Aircraft, SA, USD, lhs [a.r. 3 months, m.a. 3 obs]			Structures, Total, AR [a.r. 1 quarter]
Industrial Production, Total, Constant Prices, Index, lhs [a.r. 3 months, m.a. 3 obs]				Non-Residential Investment, Total excl. Structures, Constant Prices, SA, Chained, USD [a.r. 1 quarter]
Source: Macrobond												Source: Macrobond

Industrial production rose modestly in the third quarter, with good gains in manufacturing partly offset by weaker mining. Industrial output rose 3.9% in Q3 but slowed to 1.7% over three-months ending in October (Figure 8). Output was up 5.1% in October compared to a year earlier. Labor and materials shortages continued to constrain output, although they appear to have stabilized or improved slightly, which is progress after a long period of rising bottlenecks. The Institute for Supply Management's manufacturing survey remains firm at

60.8 in October (50 is neutral) and suggests moderate gains in output ahead. Factory orders slowed but also remained strong, with orders for core capital goods (nondefense, excluding aircraft) up 8.7% over three months ending in October. Backlogs for core capital goods rose 13.1% over the same period. The data highlights both ongoing production constraints and

strong demand for industrial businesses over coming quarters.

Third-Quarter U.S. Economic Update

Page 5

November 30, 2021