It really is different this time. While this is not the first pandemic the U.S. has faced, our reaction to it — the restrictions placed on portions of the U.S. economy, and the policy response — are truly unprecedented.
First, there are lots of reasons to be optimistic about the U.S. economy over the longer term. Official productivity statistics likely understate the impact of innovation occurring in the U.S., and the economy’s flexibility and dynamism have allowed it, again and again, to rebound from difficult times. This will be the case again.
Then there is 2021. The most important variables for the economic outlook are the virus itself (which has been the case for a while), and now, the vaccine. While vaccine approvals and early inoculation are encouraging, it could still be six to nine months before it is widely distributed enough to allow a broad-based “return to normal”. That is still a long time for the economy to function under the cloud of the virus, particularly with some of the current restrictions in place and no further fiscal support.
Fiscal policy is really the only thing that can fill the demand and income gap created by the virus’s resurgence and enhanced restrictions. Large-scale coronavirus relief legislation has a greater chance of passing under a Biden administration and a Democratic majority in both houses of Congress. Nevertheless, any near-term growth hiccup will likely elicit a “whatever it takes“ monetary policy easing by the Federal Reserve. However, there is a limit to what monetary policy can do to mitigate the impact of business closures and lost income. Even with the $900 billion package passed in December, we still need to see if the money reaches those who need it most, and is large enough to get us to the vaccine-created finish line that we are all longing to reach. In short — the first half of 2021 could still be bumpy.
In the first half of 2020, fiscal stimulus did a good job supporting the economy when activity was severely hampered by government-ordered shutdowns of businesses. People received checks of $1,200 or $2,400 whether they were employed or not. If they were unemployed, they received an additional $600 a week in unemployment benefits through July. The Paycheck Protection Program (PPP) provided financial support to small businesses in the form of grants. All of that came together to create a huge surge in disposable income. In fact, disposable income grew faster in mid-2020 than it would have had the pandemic never occurred!
That support was meant to get the economy through the pandemic, but clearly, the virus is still here. Unfortunately, the recovery is beginning to take on a ‘W’-shape: portions of the economy reopen, only to be shut down again, which prevents the economy from generating the type of momentum that ultimately feeds on itself and builds a robust recovery. It also makes it difficult for businesses to plan. They will be reluctant to hire, build inventory, et cetera if they believe they may be shut down again. Thus, it would not surprise me to see some of the economic data weaken in coming months. My baseline expectation for annualized U.S. gross domestic product growth for 2021 is around 3%, with most of the growth coming in the second half of the year.
The official unemployment rate was 6.7% in November. However, if one is not in the labor force, they are not counted as unemployed, and we have seen a record-shattering drop in the labor force during the pandemic. We should probably assume that a fairly large number of those people who dropped out of the labor force did so involuntarily — for example, to take care of children unable to attend school — and are essentially unemployed. If you make that adjustment, the unemployment rate is actually around 9%.
However, it is not just the job market that could be problematic. Consumers have also been accruing liabilities, such as delayed rents, and mortgage and student debt payments, that will need to be made current. Catching up on these past payments could exert a drag on any recovery in consumer spending in 2021.
Again, when I “look across the valley” at the post-vaccine world, I remain optimistic. However, the U.S. still needs to travel through the valley, and that is what makes me more cautious near term. Of course, there is also the possibility that the vaccine is distributed much more quickly than we are currently expecting, which would certainly brighten the 2021 outlook.
We have received questions about the prospects for an uptick in inflation. That is not a surprise given the unprecedented volume of monetary and fiscal stimulus we have seen. However, given that most economies are producing at well below their potential output, I do not expect inflation to rise meaningfully anytime soon. Low rates of resource utilization tend to lead to muted inflation.
With its focus on supporting the economy, the Fed has moved to an average inflation targeting framework. This means that they are unlikely to raise interest rates until inflation, as measured by the core personal consumption expenditure (PCE) price index, reaches, or maybe even exceeds, 2% over some period of time. Since the last recession ended, core PCE inflation has been at, or above, 2% only 10% of the time. If one goes back to the mid-1990s, it has been at or above the 2% threshold less than 25% of the time.
In short, the Fed has set itself a goal that history suggests is difficult to achieve. Assuming that they stick to that framework, it is possible that they will not raise rates for three to five years. This would likely have implications for the equity market. As an aside, I do not think negative interest rates are likely in the United States. The experience in Europe over the last few years has shown that they do not provide a lot of support to the economy, and they can create complications in the banking system.
There is no doubt that stock market valuations are high. Some of that reflects vaccine-related optimism — an expectation that we get back to normal quickly, and that earnings come roaring back. That could be the case, but in past recessions, it has taken three to four years for earnings to return to their prior peak. Currently, the consensus expects that to happen in 2021. That would be an unusually fast recovery, but this has also been an unusual recession.
Another factor possibly supporting equity valuations is the $3.0 trillion expansion in the Fed's balance sheet over the past few months and the liquidity that has created. The Fed is buying Treasuries, mortgage-backed securities and corporate bonds, but we should at least entertain the notion that the investors selling those bonds are putting some of the proceeds back into equities, especially given the low level of interest rates and the lack of returns available in many other asset classes.
We know that low interest rates tend to support higher price-to-earnings (P/E) ratios. As such, I think low interest rates will prevent the S&P 500 P/E ratio from falling back to historical averages of 15x to 18x. In fact, persistently low interest rates could mean that investors may need to get comfortable with markets trading at P/E multiples of 25 or 30, or maybe even higher -- even though, relative to history, that is very expensive. That said, at these valuations, if earnings do not come back as strongly as the consensus expects, there could clearly be some near-term risk to equities, but nothing that is not part of normal equity market volatility.
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