The Winter Wave and the 2021 Rebound
On August 24th, 1992, Hurricane Andrew made landfall in the city of Homestead, just south of Miami. The headlines over the next few days spoke of the immense destructive power of the Cat 5 storm, the 65 people who tragically perished and the tens...
The Winter Wave and the 2021 Rebound
On August 24th, 1992, Hurricane Andrew made landfall in the city of Homestead, just south of Miami. The headlines over the next few days spoke of the immense destructive power of the Cat 5 storm, the 65 people who tragically perished and the tens of thousands of homes demolished and businesses disrupted.
The lives lost and disrupted was, of course, the most important part of the story of Hurricane Andrew. However, for economists, there was an interesting epilogue. Ever since the recession of 1990-91, the Florida economy had languished, in part because of the impact of very low interest rates on retiree income. However, in the wake of the storm, rebuilding began in force and that rebuilding actually caused economy to strengthen. In the year before the storm, Florida employment rose by 1.5%. In the following year, it rose by 2.8%. One cold reality of macroeconomics is that after any disaster, the strength of the recovery is rarely reduced by the degree of human suffering that that disaster inflicts.
Sadly, the next few months are likely to see the worst of the pandemic in cases and fatalities. In addition, over the same few months a heightened disruption to certain industries will likely lead to a sharp slowdown in both GDP and employment growth. Despite this, the distribution of a vaccine in 2021 will almost certainly trigger a very strong economic revival and by 2022, the economy should be well on its way to a full recovery. That being said, investors should recognize the implications of emerging from the pandemic with much higher government debt, much lower interest rates and much more stretched valuations. Most importantly, we should acknowledge that any economic recovery will not repair the personal and economic losses that will be suffered by millions from the renewed pandemic and we should all, as neighbors and citizens, do what we can to slow the spread of the disease.
Currently, a 7-day moving average of the number of confirmed cases of Covid-19 exceeds 170,000 while a 7-day moving average of fatalities is above 1,500. While most people are very worried about this, spotty compliance with mask-wearing and millions of families getting together over the holiday season could well boost these numbers in the days ahead. This will sadly lead to traumatic scenes in hospitals and will also have a significant impact on the economy.
In particular, sit-down restaurants are likely to be very badly affected, particularly in much of the country where out-door dining is ceasing to be an option. The gradual recovery in travel, entertainment and hotels may stall out and traditional holiday retailing at malls will be far weaker than in a normal year.
However, this may not be enough to trigger outright employment declines, as much of the economy has gradually adapted to a pandemic environment. Notably, sales and construction of single-family homes are both booming, seeing their highest levels of activity since before the Great Financial Crisis. Light-vehicle sales also remain remarkably strong, given diminished commuting. Other consumer spending will also likely remain solid with very strong on-line sales making up for much of the shortfall in stores and, likely, a certain amount of hoarding as people fear shortages of essentials. Importantly, given “covid fatigue” and political pushback on efforts to lock down parts of the economy, many businesses that were forced to shut down in the spring and then reopened with new safety measures in place will likely stay open in this third wave.
One wild card in the short run, is the issue of a new Coronavirus relief bill. While it is obvious that the Senate and House should find a compromise as soon as possible, it may be that politics pushes the bill beyond the inauguration of President Biden on January 20th. If that happens, the danger of declining GDP or employment over the winter will be exacerbated. However, even in this circumstance, the passage of a bill early in the new Congress should allow for a revival.
This resurgence will likely strengthen markedly over the spring, summer and fall of 2021 as the vaccine is distributed. Moreover, as this happens around the globe, a “pent-up demand to party” should be unleashed, as families finally get to travel, eat out at restaurants, and have long-postponed family celebrations and get-togethers. In this environment, the economy could log high-single-digit growth in the second half of 2021, cutting the unemployment rate to below 5% early in 2022.
For many, this will seem like a return to a pre-pandemic world. However, it is important for investors to recognize some differences from the financial environment at the end of 2019.
First, at the end of 2019, the national debt, (defined as federal government debt in the hands of the public) was $17.2 trillion, or roughly 80% of GDP. Just two years later, at the end of 2021, we expect this number to have grown to $24.0 trillion, or roughly 108% of GDP. This higher debt level implies higher taxes in the years to come and, to the extent that this includes higher taxes on corporate profits, interest, dividends and capital gains, this should be factored into long-term expectations of after-tax returns.
Second, the pandemic has left valuations much more stretched. At the end of 2019, the yield on a 10-year Treasury bond was 1.92% and has since fallen to 0.86%, well below the current rate of inflation. If yields stay at current levels, the return on fixed income investments over the next few years will be miserably low. If, as we expect, yields rise and bond prices fall, some of these returns could be negative. In addition, as of Friday, the forward P/E ratio on the S&P500 was roughly 21.6 times compared to an already somewhat lofty 18.2 times at end of last year. If, over the next five years, the P/E ratio just reverts to its level at the end of last year, then stock prices will have to grow 3.5% slower than earnings.
In short, while the economy should stage a strong rebound when a vaccine is distributed, investors should recognize the greater challenge of achieving strong long-term after-tax returns given the future prospect of higher taxes and the current reality of higher valuations.
Finally, it is important to note the global and cyclical impacts of an eventual rebound. The very good recent news on vaccines suggests that it will be possible to end the global pandemic, and not just the U.S. pandemic, over the next one to two years. For U.S. investors, this is an added reason to look at both emerging market equities and developed country equities outside the U.S. where valuations are a lot more reasonable. In addition, a cyclical rebound, with still very low short-term interest rates, should lead to a steepening yield curve, benefiting value stocks and particularly financial stocks.
It may take some months for the investment themes of the global recovery to play out, particularly given the increasingly grim news on current infections and fatalities around the world. However, for long-term investors, it is important be positioned appropriately to take advantage of this recovery today and to trust in the logic of the 2021 recovery rather than the sad emotion of this pandemic year of 2020.