The light at the end of the tunnel
Last year, the economy faced several challenges. Today, the data signals an economic recovery has begun and there is light at the end of the tunnel. However, risks remain and we may still be in the tunnel.
What are the lights on the horizon signaling an economic recovery?
In 2020, COVID-19 was the darkness that shut down global economies, putting us into a brief, yet severe recession. However, we believe there are a number of important “lights” that point toward an economic expansion, including:
- COVID vaccine: Roughly 60 million Americans have been vaccinated. With the help of a vaccine, economies are re-opening, and many economic restrictions are lifting.
- Labor market: Unemployment spiked to almost 15% in April of 2020 and has now come down to 6.3%. We expect unemployment to continue to recover, ending the year at close to 5%. Typically, after a recession, it takes time to repair the labor market. However, we believe this cycle will be different as the economy is already in active recovery.
- Disposable income: With the massive amount of stimulus that was dispersed, we saw disposable income increase dramatically. For the first time, in the middle of a severe recession, total disposable income was up 15%. Actual wages and salary income have also recovered dramatically and are now 2% higher than the start of the crisis. This tells us that the average household’s balance sheet is healthy. This will lead to consumption and economic activity. In addition, we expect more stimulus in the first quarter of 2021.
A bright spot for the consumer
There was a rapid decline of consumption expenditures when the economy shut down, followed by a swift recovery, but we are not quite back to where we were pre-pandemic. One reason is that the broad index of consumption expenditures includes some hospitality or leisure services that are still hindered or shut down. There is a bright spot, however: retail sales. Given the uptick in disposable income, retail sales are stronger than they were pre-pandemic. This demonstrates that consumers have the ability and willingness to spend.
Consumer confidence did wane over the last few months as COVID-19 cases spiked, but we are now seeing a rapid rebound in expectations. Historically, after a recession, it takes years for consumer confidence to rise to more normal levels, but we are already seeing confidence bounce back. When consumers feel confident about the future and they have income to spend, it sets the stage a robust economic expansion.
Small businesses are the backbone of the U.S. economy. In fact, 52% of the labor force is employed by small businesses. Notably, small business optimism dropped significantly, according to the National Federation of Independent Businesses‡ small business optimism index. The index shows a recovery over the summer as vaccines were on the horizon, but we now have the lowest reading of small business optimism since May 2020–which stands at 95.0, three points below the 47-year average of 98–as we had a second wave of COVID-19 cases in the fourth quarter of 2020. As vaccines roll out and the economy re-opens, we expect small business confidence to improve.
Big business, specifically CEO confidence, tells a different story. Big business has fared well throughout the pandemic and is now higher than it was in 2019.
A spark for manufacturing
Manufacturing is a leading indicator in economic stability and global economic activity. Global manufacturing data has rebounded dramatically and is conditioned to expand back to levels we saw during the last expansion period in 2018. U.S. manufacturing indicators are similar, if not better. New orders, a subcomponent of the manufacturing data, which is a leading indicator, is at an almost 20-year high.
While the manufacturing sector will always play a key role in our economy, it’s important to bear in mind that as our economy has changed over the decades. Today the service sector represents 45% of GDP. The non-manufacturing data, or services, show a swift and strong rebound, indicating our economy as a whole is recovering.
The Federal Reserve in the spotlight
The Fed has played a central role in this recovery, injecting trillions of dollars into the economy. To do this, they’ve engaged in a massive amount of deficit spending, much larger than any previous recession. By the end of 2021, it’s predicted that the U.S. will lead global deficit spending at about 22-25% of gross domestic product (GDP). While this is helpful in the short term, it can cause significant challenges in the long run.
A look into the financial conditions index
The Fed watches the financial conditions index very closely and continues to pour money into the economy to orchestrate softer financial conditions. Historically, every time the financial condition index declines, economic conditions improve, and the S&P 500 performs well. Currently, we have very favorable financial conditions, with low interest rates and available credit that continue to support the economy and markets. In addition, the Fed has promised low interest rates for the foreseeable future, which tends to support economic activity.
GDP shines on
The global pandemic has changed everything from how we consume to how we go to work and educate our children. In the second quarter of 2020, we saw an unprecedented GDP contraction of 31.4% with a great recovery to follow. The third quarter boosted a 33.4% gain and grew 4% in the fourth quarter. We expect the recovery to continue, with 4-5% GDP growth in 2021.
Historically, an economic crisis is followed by periods of weaker economic growth that last for years or decades. We believe this recovery will shape up to be different as the recession was caused by a global pandemic. Typically, a recovery takes time for three reasons:
- Pre-crisis trends are not sustainable
- Higher and persistent levels of unemployment
- Households and businesses need time to repair their balance sheets
Unemployment is improving, people are going back to work, and balance sheets are stronger than ever. Household net worth is at an all-time high. This cycle may look a little different.
What are the political lights?
Politics and the election don’t carry much weight in the markets over the long term, but we do see impacts in the short term. Our expectations of a new administration are as follows:
- More stimulus: There is $1.9 trillion stimulus package on the table. This is a significant catalyst providing fuel for the recovery.
- Change in tax policy: We could see higher marginal tax rates for high-wage earners as well as higher corporate tax rates. We saw this in 2013 and it did not impact the economy and markets.
- Support for climate policy: There is support of green, renewable energy and electric vehicles.
- Increased infrastructure spending: This will create jobs and inject liquidity into the economy. We could expect to see $1-2 trillion spent.
- Healthcare expansion: We could see expansion of the Affordable Care Act.
What are the blinding lights or risks?
The labor market suggests that there is light at the end of the tunnel, but we are still in the tunnel. In fact, 5.1 million people are receiving continued claims and in addition to that the Coronavirus Aid, Relief, and Economic Security (CARES) Act created additional assistance, bringing the total to 16.6 million people receiving some type of assistance.
The vaccines are both a shining light and a blinding light as there is some resistance to them. Currently, just 60% of the population is willing to take a vaccine and 80% is required to achieve herd immunity. There have also been some bumps in the vaccine rollout.
There is also the question of inflation. Inflation typically rises slowly as the economy grows but when the recent stimulus package came into play, we had a dramatic, unprecedented increase in the money supply in the U.S. We are currently sitting at nearly $22 trillion of cash, which is larger than the entire U.S. GDP for the year. With the amount of money printing, cash on the sidelines and stimulus coming our way, ultimately an uptick in inflation will happen. Inflation expectations have been rising since March 2020, but we believe we’re two years away from inflation becoming an issue. This will continue to be something we watch closely.
Trade is also an important factor and President Biden will have to negotiate with our trading partners. China is the second largest economy in the world and right now there is broadening distrust of China not only with the U.S. but with several countries, so this could be a difficult problem for Biden to combat and something we will watch closely. We also face debilitating debt. Right now, our debt burden is manageable but could be a serious issue in the long term.
The light at the end of the tunnel signals an economic recovery.
We expect to see robust GDP growth of 4-5% for 2021. Within the bond market, we believe the 10-year yield is going to creep higher throughout the year as inflation expectations change, finishing around 1.50%. We also anticipate that, per the Fed’s communication about short-term interest rates, they will keep short-term rates low throughout 2021.
Earnings drive stock prices. Last year, we had a contraction in earnings, but we can expect robust growth in earnings this year at north of 25% in 2021. We anticipate $170 of earnings per share from the S&P 500, which would be a record high and drive the stock market close to 4100 at the end of 2021, which will be a 7-9% rate of return for the year.
2021 economic forecast summary
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