News & Insights

The economic recovery continues, but the pace of the recovery is slowing. First quarter GDP was estimated at $22.1 trillion annualized, surpassing its pre-pandemic high of $21.7 trillion. Reclaiming our economy’s full potential might take a long time, however. GDP has rebounded sharply but remains approximately 2% below its pre-pandemic growth path. Gains have not been distributed equally, and inflation is squeezing the budgets of consumers left behind by the post-COVID recovery so far. Where we go from here is a bit of a mystery.

Employment statistics have recently plateaued at a level that would have been considered very unsatisfactory before the pandemic. June’s Bureau of Labor Statistics report showed the unemployment rate ticked slightly higher versus May at 5.9%, with labor force participation also about flat at 61.6%. Before the pandemic, unemployment averaged about 4% and participation about 63%. Wages were a bright spot in June, up 1%. Those who remain engaged in the workforce are being rewarded with paychecks growing faster than the cost of living, which is also increasing at a rate that would have caused major alarm before the pandemic.

The economy continues to improve, helped by the rollout of vaccines as well as fiscal and monetary support. Unlike typical recessions, this one was not born of financial factors but rather was the result of what was effectively a natural disaster. Economic activity was interrupted but much of the underlying demand for goods and services remained essentially intact. As highlighted in last month’s Investment Comments, the unique nature of this economic slowdown, and subsequent rebound, make parsing the data particularly difficult. When pandemic restrictions initially hit the economy, there were concerns it would take years for workers and businesses to heal. However, in the current quarter the size of the economy is now anticipated to surpass pre-pandemic levels and by year end GDP is expected to achieve its pre-pandemic path, if not exceed it.

According to the CDC, nearly 65% of U.S. adults have received at least one vaccination, and state and local governments continue to ease restrictions on businesses. Consumer balance sheets remain in good shape, aided by stimulus payments. Given a strong start to 2021, the National Retail Federation recently revised higher its expectation for retail sales this year, now anticipating an increase of 10.5%-13.5% versus its February forecast of 6.5%-8.2% growth. As consumers venture out categories such as beauty products have done well, as has spending on restaurants, lodging, and airlines. The Census Bureau announced May retail sales below expectations, down 1.3% from April, but up 24.4% versus a year ago.

President Biden is negotiating for a $2+ trillion spending bill centered around infrastructure. It is hard to argue with infrastructure, which explains why that word features so prominently in the bill’s marketing push. The positive economic value from infrastructure improvements may be diminished by the potential chilling effects of tax increases to pay for the bill. Investors should keep a close eye on the risk of higher corporate taxes. The market responded robustly to the tax cuts that were implemented four years ago, and from the market’s perspective it is very hard to find a silver lining in the prospect of a rollback.

Wouldn’t it be nice to get the benefits of more spending without the cost of higher taxes? The difference between outlays and tax collections is the deficit, and the government’s ability to run expanding deficits depends on its borrowing rate staying low. Bond owners have not been very demanding in recent years, but their continuing good nature is forever being tested. In early May Treasury Secretary Janet Yellen admitted that the improving economy, boosted further by a large infrastructure bill, could necessitate higher interest rates. This sounds to us like basic common sense, or maybe Macroeconomics 101, but it stirred up quite a controversy. Investors are very sensitive about interest rates, inflation, and asset prices, and the Secretary’s remarks touched off a modest stock market decline that was stemmed by Yellen quickly “clarifying” her comments, saying she was not predicting higher rates. She was only speaking hypothetically.

In the first quarter the S&P 500 returned more than 6%, a respectable start building on last year’s impressive gains. All eyes remain focused on the vaccine rollout and how quickly the economy can reopen more fully. Uncertainty persists regarding the course of the pandemic given the emergence of more contagious strains of the virus, but happily trends are in the right direction. The U.S. is on track to vaccinate three-fourths of the population by late June, though achieving that number requires overcoming vaccine hesitancy. However, much of the world is further behind, with emerging-market countries on pace to have closer to 30% of their population vaccinated by year end. Regardless, vaccine progress continues and should serve as a strong tailwind through 2021.

Helped by vaccines and trillions of dollars in government support, expectations for growth have been improving. The International Monetary Fund (IMF) recently bumped its forecast for world economic growth this year to 6% from prior estimates of 5.5%. This would represent the fastest expansion in at least four decades. Closer to home, the IMF estimates U.S. growth at 6.4%, fully recovering last year’s 3.5% contraction and then some. Economists surveyed by The Wall Street Journal anticipate momentum will continue into 2022 but slow to just over 3% growth. This would mark the strongest two-year growth in the U.S. since 2005.

Government intervention has made it more difficult to read and predict economic tea leaves. Record low interest rates not only allowed homeowners to refinance their mortgages, but companies also refinanced their debt and increased their borrowings. This extended into “junk bonds” where yields edged below 4% before rising recently. Such a rate used to be reserved for only the most creditworthy companies, which were recently able to borrow for less than 1% on a short-term basis and less than 2% on a long-term basis.

Statistics for unemployment, retail sales, and personal income must now be interpreted in the context of stimulus payments and COVID-related restrictions on businesses. Retail sales fell a stunning 3% in the month of February compared to January. However, January was up 7.6% from December on a seasonally-adjusted basis that takes into account normal patterns like holiday spending. Government statisticians struggled to keep up, as the January surge was originally reported as a 5.3% gain.

It is quite clear that as COVID-19 goes, so goes economic activity, which leads political response and tests the remarkable ability of people to adapt.

The path of the virus over the past few months is evident when examining what is surprisingly fairly solid economic data. Fourth quarter GDP grew 4%, capping a year that saw GDP fall 3.5% as large sectors of the economy, particularly travel and hospitality, were off limits to consumers. After COVID-19 case counts declined during the summer, a resurgence of the virus in the late fall and through the holidays spurred the reimposition of stay-at-home orders and retail closures for restaurants, gyms, and other gathering places. With less opportunity to move about, consumers still boosted their spending a respectable 2.5%, but this was short of what economists expected during the critical holiday season.

In 2020 governments around the world responded to COVID-induced economic shock with fiscal rescue policies that injected trillions of dollars into their economies and added similar amounts to sovereign debts. The Department of the Treasury’s Data Lab (datalab.usaspending.gov) recently estimated the total bill for U.S. fiscal relief at $2.6 trillion of stimulus plus $900 billion of tax relief, for a total of $3.5 trillion. That total grows closer to $4 trillion including the stimulus that President Trump signed in December.

On January 5, a surprise result in the Georgia Senate runoff turned what initially looked like a mixed U.S. election result into a “blue wave.” With a willing Congress behind him, President-Elect Joe Biden has promised to make more fiscal stimulus his top priority, proposing a $3 trillion stimulus and infrastructure plan.

As we wrap up 2020 it is worth highlighting what a roller coaster year it was for the market. Midway through December the S&P 500 has advanced more than 13%, a result that ap­peared highly unlikely during late March when shares fell sharply on COVID-19 fears. However, the market is forward-looking and global support in the form of fiscal and monetary stimulus has helped drive markets higher since the spring. Currently, the prospect of further stimulus combined with the fastest development of a vaccine ever recorded has boosted investor optimism and provided hope that a return to a more normal environment is on the horizon.

While several vaccines are on the way, the U.K. was the first country to authorize the Pfizer-BioNTech COVID-19 vaccine, starting distribu­tion on December 8th. U.S. health regulators authorized use of the same drug on December 11th with the first vaccinations taking place December 14th. Initial supplies of the vaccine are limited, but production is expected to increase meaningfully over the next several weeks. Pfizer shipped out three million doses initially with an expectation of 25 million doses available in the U.S. by yearend. Health workers are first in line for vaccinations followed by other higher-risk populations. Americans are expected to broadly be able to get the vaccine by the end of March

The election season is almost over, with a few disputes remaining to be resolved along with several incomplete congressional elections. Control of the Senate is up in the air, with 50 Republicans and 48 Democrats seated and two runoff races in Georgia set for early January.

Voters opted for divided rule. Democrats picked up the White House and at least one Senate seat, and retained control over the House. Republicans added one governorship and several state legislatures, sharply narrowed Democrats’ majority in the House, and likely retained a slim majority in the Senate. Neither party has run the table; both parties will have to work together to accomplish anything. This setup increases the odds of cooperation, moderation, and stability, a rarity in these partisan times.

We have a long way to go, but so far the post-COVID economy looks surprisingly robust. If colder weather does not bring a resurgence of the virus, then it feels safe to say that we are firmly on the road to economic recovery.

From peak to trough, U.S. GDP contracted by 10%, the third largest decline since at least 1910. The second-quarter average was -9%. More recently, September’s unemployment report published by the Bureau of Labor Statistics measured unemployment at 7.9%, down from a peak of 14.7% in April. This probably overstates the rebound slightly, as the labor force participation rate ticked down to 61.4% and is about 2% below its pre-pandemic levels. Some workers have stayed on the sidelines and aren’t counted as unemployed.

While the economy had a rough time in the first half of 2020, the recovery since stay-at-home orders began lifting has been much swifter than expected. GDP contracted at an annualized rate of 31.7% in the second quarter but since June has rebounded strongly. As of September 16th, the Federal Reserve Bank of Atlanta’s GDPNow third quarter GDP estimate calls for annualized growth of 31.7%. Continued recovery will depend on the rate of new COVID-19 cases that, for the most part, have continued to decline, encouraging states to loosen restrictions on service-based businesses such as restaurants and gyms.

Other economic indicators confirm the recovery while at the same time differentiating the impact of COVID-19. The August Institute for Supply Management index of manufacturing rose to 56 from 54.2 in July, extending its rebound since the 41.5 level of March (above 50 signifies growth, lower than 50 contraction). Commerce Department figures show that monthly spending on goods for July is 6.1% above February’s peak level while spending on services has fallen 9.3%. This dichotomy reflects pent-up demand for goods that would have been purchased during business lockdowns while also reflecting the inability and/or lack of desire of consumers to purchase services like air travel, restaurant meals and haircuts.

Uncertainty makes people uncomfortable, and there is plenty of uncertainty to go around. The virus continues to stubbornly stick around; we don’t know how widely it will spread if schools and colleges are opened to in-person learning; we don’t know if one or more vaccines will be effective; and then there is an election this fall in case you haven’t heard.

It is said, “The market runs from uncertainty.” Yet the S&P 500 and NASDAQ indexes just reached all-time records. The Dow Jones Industrials Average is about 5% below its all-time high while the Russell 2000 index of small stocks is 8% below its high. Stock indexes at all-time highs don’t sound like a market running from uncertainty!

“If you see that kind of disconnect, it doesn’t go on indefinitely. Those normally will get reconciled, and this will too.”

These were the words of Federal Reserve Board Bank of Dallas President Robert Kaplan when interviewed by CNBC on July 13th. He was referring to the disconnect between the financial markets, with an upbeat view of the future, and the performance of the economy, which remains under stress. The question for investors, of course, is will the markets move towards the economy or the economy towards the markets?

The U.S. has officially tipped into recession, defined as two straight quarters of negative economic growth. Q1 GDP contracted at a 5% annualized rate. Q2 will feel the full brunt of lockdown. Trading Economics reports consensus Q2 GDP growth estimates as -17%. Continuing jobless claims are hovering in the 21 million range, more than ten times their pre-pandemic level. Supplementary unemployment benefits of $600 per week are scheduled to cease at the end of July, unless lawmakers negotiate some kind of modified extension. It won’t be easy to spur a broad-based return to work. The jobs have to be there, and people have to be incentivized to accept them.

The stock market, meanwhile, is anticipating a robust recovery. After a jarring 35% March plunge, the market’s subsequent recovery has been just as stunning. The S&P 500 is currently down just 4% on the year. The Nasdaq 100, burgeoning with beloved, recession-resistant software companies, is up 13%. Japan’s Nikkei 225 has performed similarly to the S&P. European stock averages have been a little weaker, mostly down low-double digits so far this year. Valuations were not exactly cheap before the pandemic started. So what happens next?

After a dizzying late February and March that saw the stock market fall into bear market territory (down 20% or more) at the fastest pace in history, the recovery from the S&P 500’s low of 2,237 on March 23rd has been almost as breathtaking, a roughly 30% advance. For 2020 the index is down about 10% for the year, substantially better than might be expected given the health and economic damage inflicted by the COVID-19 pandemic.

Recent statistics on the health impact of the virus are daunting. Johns Hopkins’s COVID-19 dashboard reports over 4.2 million cases worldwide and approximately 290,000 deaths. The U.S. alone now has over 1.35 million cases and approximately 81,000 deaths, 27,000 of which have occurred in New York State. The human toll COVID-19 has wrought is tragic.

The S&P 500 followed up its more than 30% total return in 2019 with a decline of 20% in the first quarter of 2020. That understates the severity of the move, as small- and mid- cap stocks were down 30%, and at its lows the S&P 500 was 35% off its recent peak. In March, the S&P 500 moved an average of 5% per day, the most of any month on record.

Nobody is certain about the extent of the damage done to the economy as a result of efforts to combat COVID-19. We do know that there has been a severe demand shock that will result in a sharp economic contraction and a meaningful decline in corporate earnings. In response to these concerns, the Federal Reserve Board, Administration, and Congress moved to support workers and businesses with programs to preserve as much of the economy as possible while large portions of the country are shut down.

We are all concerned about the potential impact of the coronavirus outbreak on our families and friends, particularly those who are elderly or who are already dealing with other medical issues. We hope you are well and urge everyone to exercise appropriate caution. Although it is uncomfortable to lose our social avenues, we hope the closing of public facilities will severely limit the opportunity for this virus to spread further.

Investment Comments typically focuses on economic and market developments, and the outlook. Recent economic statistics primarily reflect the pre-coronavirus economy, which is now a matter of historical record rather than an indicator of where we are headed. The economy has clearly taken a hit—we can see it with our eyes, and the market movement has confirmed it.

In January, after spending much of two years wrestling with trade issues, the U.S. signed two important pieces of legislation. The first, and likely more important, is the United States-Mexico-Canada Agreement, an update to NAFTA covering trade rules for North America. The second was a “Phase 1” agreement with China that reduced the likelihood of further tariff escalation and laid out a negotiating timeline to work through difficult discussions such as protection of intellectual property. The markets breathed a sigh of relief and began to rally on the thinking that businesses could now rely on (relative) certainty of trade and tariffs to support long-term product sourcing decisions.

Then along came the coronavirus (COVID-19). According to the World Health Organization, as of February 18, the virus has sickened more than 73,000 and killed 1,853. With most of these cases concentrated in the country of origin, China, the world has responded with various degrees of isolation. More than 30 airlines have suspended service to China and a 78-nation matrix of rules and quarantines from the U.S. to Singapore have all but banned Chinese travelers from foreign soil.

The S&P 500 produced a total return of 31.5% in 2019.  That huge advance is particularly astonishing considering that aggregate corporate earnings barely grew at all.  According to the 1/10/20 edition of FactSet Earnings Insight by John Butters, analysts expect full-year 2019 earnings to average a meager 0.2% growth with revenue growth of 3.9%.  Roughly speaking, this means the year’s entire rally is currently manifested in higher P/E multiples.  We can think of some reasons why the current investment climate supports higher valuations than the climate of just 12 months ago, but 31.5%? That is a lot to explain.

For starters, those modest corporate growth numbers are a bit of a red herring, weighed down by low energy prices and industrial sector softness that will probably turn out to be temporary.  More on this below.  Overall, the U.S. economy remains on solid footing.  Measured unemployment is holding steady at 3.5%. Normal wage growth is running at approximately 3%, fairly strong.

This has been a very good year for investors, with the S&P 500 on pace for its strongest year since 2013.  Total returns including dividends through November stood at more than 27%.  The headline number is aided by 2018’s lackluster performance, which was the S&P’s first decline in a decade despite posting 20% earnings growth.  Earnings in 2019 appear headed for low single-digit growth, and early projections for 2020 are for a near double-digit advance.  The forward P/E multiple is approximately 17.5x, above the 5-year average though lower interest rates support the case for a higher-than-average multiple.  Yields on 10-year Treasury bonds started the year at 2.6% but more recently were closer to 1.8%.

Despite concerns about slowing global growth, which have been reflected in modest business investment and a contraction in manufacturing activity, the economic backdrop looks generally favorable.  GDP growth in 2019 should be in the neighborhood of 2%, consistent with expectations for 2020.  This isn’t particularly inspiring, but it could certainly be worse.