Quarterly Economic Review 02/22/21
It has been an unprecedented 12 months. True, 2020 started out routinely enough with just an orderly deceleration in business activity during the winter. But a difficult close to the first quarter followed, with COVID-19 spreading across Asia, Europe, and the new world. The bot- tom would subsequently fall out of our economy, with GDP plunging 31.4% in the second quarter. Then, as parts of the nation reopened and new incidences of the disease subsided briefly, the economy saw a dramatic, if partial, recovery over the summer, with GDP growth soaring by more than 33% in the third quarter.
Unfortunately, a second and then third wave of the disease, numerous business closures, and a frustratingly slow rollout of approved vaccines from Pfizer and Moderna followed and took much of the steam from the nascent recovery, limiting GDP growth to 4.0% in last year’s final period. In all, the nation saw its first 12-month decline in the economy in more than a decade. Worse, at 3.5%, the contraction was the largest since 1946 when the United States was starting to demobilize after World War II. Now, 2021 is under way, with changing hands in Washington and new challenges awaiting a shaken nation.
Our sense is that 2021 will be more settled than 2020. First, recent trends in COVID-19 are less ominous, overall, as new cases, hospitalizations, and now deaths are all declining. Also, after an agonizingly slow rollout, vaccines are getting into the arms of Americans at a faster pace. All told, significant progress in fighting COVID-19 should be in place by midyear and the relief these steps bring should well outweigh the impact of variants developing in the virus. That would give a boost to the second-half economy with the Congressional Budget Office projecting that business activity could return to pre-pandemic levels by that time. For now, however,
Economic trends are less than vibrant. For example, manufacturing activity is better but hardly eye-catching; job growth is list-less; and weekly jobless filings remain stubbornly high. In fact, even with further gains in homebuilding (as supply is inadequate to meet demand); a vigorous projected early 2021 recovery in consumer spending; improving vehicle sales; accelerating business re-openings (as the fight against this pandemic gains traction); likely stimulus and relief payments from Washington; and strong monetary support from the Federal Reserve, it is likely the economy will still face headwinds in the first quarter. Things should go a little more smoothly in the second three months, with more significant strides likely after midyear, especially if relief payments aimed at putting food on the table and avoiding evictions and foreclosures, approach the levels advocated by the Biden Administration.
Meantime, after last year’s severe recession, inflation is likely to remain under control and interest rates seem poised to stay near historic low levels through 2024. As such, it is possible the nation may sidestep a business downturn in our 3- to 5-year projection period. Of course, that scenario isn’t etched in stone. Making long-range forecasts is always a risky exercise, as 2020’s unpredictable path clearly showed. In the past, we’ve warned of exogenous shocks that could upset even the most carefully balanced investment program or business plan. While the pandemic is still in progress additional risks still include, but are not be limited to, droughts, international conflicts, oil embargoes (which wouldn’t have the impact they did in the 1970’s when OPEC’s influence was greater), and, as recent history has shown, future pandemics. Absent such shocks and with monetary and fiscal support likely to continue, the road to 2024-2026 should be comparatively uneventful.
Economic Growth: As the foregoing indicated, 2020 was a turbulent year, with a record decline in GDP in the second quarter, but an unprecedented revival in the July-through-September period. The lead story throughout the year, of course, was COVID-19 and the giant human and financial toll it exacted on the American people. For the year as a whole, the economy contracted by 3.5%—the largest drop since just after World War II. Even the so-called Great Recession of 2008- 2009 did not see anything approaching the collapse in business activity suffered in the first half of 2020.This hopefully was a once in a century phenomenon. What brought about these gyrations (e.g., the plunge in GDP in the second quarter, the record rebound in the economy over the summer, and the deceleration in activity late in 2020) were the early, unsuccessful efforts (through business closures and the like) to fight the pandemic, the subsequent re-opening of the economy, the arrival of two approved vaccines, and the resurgence in COVID- 19 infections and deaths during the winter.
Meanwhile, the fight against this disease persists. At first, moves to close down the economy last spring in order to dull the impact of the virus contributed to raising the financial costs of the outbreak. As vaccines are now getting into the arms of more Americans, governments took less drastic measures during the disease’s latest surge. It also helps that recent weeks have seen a lessening in the pandemic’s toll. Also encouraging are the better trends in the ser- vices sector, auto demand, and most housing categories. So, further modest GDP growth is likely this quarter and during the following three months. Holding things back figures to be a weak outlook on the jobs front, where January saw just 49,000 positions added. Not surprisingly, Fed Chair Jerome Powell has opined that the jobs picture has remained bleak. In all, GDP likely will rise by 4%-5% in the first two quarters of this year.
Looking ahead to the second half, the projected positive impact of the fiscal measures being sought by President Biden, the low interest-rate policies of the Federal Reserve, a projected further increase in consumer spending, ongoing strength in housing, and at least a partial victory over COVID-19 (as more Americans get vaccinated), should combine to lift GDP somewhat more strongly. A further, if slower, recovery is likely in 2022 and through mid-decade, absent debilitating exogenous shocks to the system.
Inflation: Recently, there has been speculation that inflation, largely dormant for decades, would soon start to push higher. To be sure, few are calling for a surge in prices over our projection period. There is simply too much underutilized capacity and labor availability, as well as few shortages in raw materials in place to strain our pricing structure. But there also is little doubt that years of record low interest rates, fiscal support in fighting the pandemic, and a shortage in housing stock will have an impact on inflation. To date, reports suggest little sustained upward pressure on prices. Indeed, the Consumer Price Index (CPI) for January rose 0.3% as generally forecast. Also, the index was up just 1.4% for the past 12 months. And if we exclude the volatile food and energy components, to get the so-called core rate of CPI change, we find the index was unchanged in January and likewise up 1.4% in the past year. In all, signs point to modestly higher prices in the next 3 to 5 years, as yields on U.S. Treasuries are edging upward, but not to the extent needed to make inflation the headline item it was in the 1970s.
Interest Rates: Here, as well, stability has been the rule. Specifically, hints of a slowing economy in 2019 led the Fed to lower the federal funds rate several times. When the lead bank was finished, rates were near zero, where they remain. Such historically low borrowing costs proved timely when the economy collapsed last spring and the availability of attractive credit was pivotal. Now, even with the worst of the economic turmoil behind us, low interest rates are helping to support the tenuous business upturn. That should be the case for some time. The Federal Reserve, in fact, has suggested it will keep interest rates at their present levels until 2024.
Corporate Profits: Following a difficult COVID-19-impacted 2020, Corporate America should give a much better account of itself during the current 12 months. Behind this projected improvement figure to be firming demand and better cost-containment. In all, companies in the S&P 500 continue to outperform expectations, with some 80% of the components in that index having exceeded their revenue and profit targets in last year’s fourth quarter. Further, more S&P members than not are signaling that the current three months will see out- performance once again. Higher earnings, in fact, should be the rule for 2021 as a whole. Notwithstanding such projected strength, price-earnings ratios remain stubbornly high. For example, at more than 21 times earnings, the recent market P/E is expensive when compared with the average for the past decade (15.8) and the last half decade (17.7). This suggests some overvaluation and a rise in risk. At a minimum, the market would seem to be priced for near perfection.
THE STOCK MARKET
Whereas inflation and interest rates have woven comparatively stable paths in the past year, the stock market, in line with the economy, has gyrated wildly. Prior to 2020, however, equities generally moved in sync with the economy by largely pressing higher and doing so with a degree of consistency.
That all changed in a flash in 2020, as COVID-19 proved too much for the economy or Wall Street, and both would quickly collapse as winter turned to spring and the disease toll mounted. Once the massive selling dried up on the Street, a sharp market rally ensued in the spring and for much of the summer. The economy also revived. Here, however, for all the noise sounded by a 33.4% third-quarter surge in GDP, the comeback undid just a portion of the damage inflicted by the shuttering of so many businesses and schools during the early weeks of the April-through-June quarter. Then, following a late-summer selloff in stocks as new virus worries sur- faced, stocks roared back on optimism created by the aforementioned vaccines. That upbeat sentiment has continued into 2021. As for the economy, it is still struggling, with improvement in certain business categories being countered by sloppiness on the employment front.
As to the outlook for equities, recent action has pushed an already pricey market even higher, leaving little room for missteps on the economic, earnings, monetary, or fiscal fronts. This should not suggest that stocks cannot go higher. Clearly, they can and for a time might well do so, as it always is hard to fight the tape. It is just that a good deal might have to go right to keep P/E’s where they are, especially as recent frenetic trading activity in risky and generally unsuitable stocks such as GameStop, AMC Entertainment, Virgin Galactic Holdings, and Tilray have persisted in unchecked fashion for weeks.
Conclusion: We think the bull market is sustainable, but likely to face challenges in the coming months, particularly if yields on fixed-income securities (e.g., Treasury notes) rise much further.