An Exuberant Rally in an Incomplete Recovery
English, as spoken in Ireland, is full of colloquialisms, phrases which are plain and clear to the local population and entirely mysterious to visitors. Of course, Irish people don’t realize this and, over the years, I’ve become used to...
English, as spoken in Ireland, is full of colloquialisms, phrases which are plain and clear to the local population and entirely mysterious to visitors. Of course, Irish people don’t realize this and, over the years, I’ve become used to the bemused smile of Americans who clearly hear what I say but, equally clearly, have no notion of what I mean.
A good example of this is when you say a man “has lost the run of himself”. Roughly translated from Hibernian English, this means someone who, chuffed by recent success, has giddily run to excess, with a good likelihood that fate will bring him down with a bump. As summer of 2020 draws to an end, many investors may be wondering if U.S. markets haven’t lost the run of themselves.
On Friday, the S&P500 closed at an all-time record high of 3,508, now up 8.6% for the year – this despite the country being in the midst of a pandemic and in the throes of a tense election campaign. Meanwhile, the 10-year Treasury yield closed the week at 0.72%, well below the current rate of inflation and further still below the Fed’s inflation target which they effectively raised last week.
There are other signs of excess too. Within the U.S. stock market, growth stocks are trading at their highest valuation premium relative to value stocks since the tech bubble. U.S. stocks overall, have also rebounded more strongly from their pandemic lows than international stocks while credit spreads remain remarkably tight given clear economic distress in many sectors.
Meanwhile, the economic rebound, while impressive in absolute terms, remains only a partial recovery from the deepest recession since World War II.
Following back-to-back declines of 5% and 31.7% annualized in the first two quarters of the year, we expect real GDP to rise by roughly 30% in the third quarter. However, this would still leave real GDP 3.9% lower than at the end of 2019, which is only slightly better than the 4.2% loss seen from peak to trough in the Great Financial Crisis. Moreover, it is looking increasingly likely that this rebound will decelerate dramatically in the fourth quarter.
Consumer spending, which, as always, is at the heart of the U.S. economic cycle, has surged in recent months as stimulus checks have allowed many households to buy new electronic equipment and assorted items for their homes. In addition, families have stocked up on a wide range of non-durable goods, perhaps out of fear that the pandemic would, at some time, limit their ability to buy them. However, with talks on a further round of economic stimulus stalled in Washington and the expiration of the $600 enhancement to unemployment benefits, consumer spending could slow sharply in the months ahead.
As for the rest of the economy, business investment spending will likely remain sluggish, given the continued uncertainty caused by the pandemic and politics, inventories will likely recover but only in tandem with imports, yielding little net gain in economic output, and government spending will likely be restrained, as declining revenues force state and local governments to retrench.
Of course, the outlook would brighten somewhat with the passage of a new stimulus bill but, in a highly political environment, it is now by no means certain that such a bill will be passed before the election. With or without it, the economy will not fully heal until a vaccine is widely distributed, allowing the U.S. and global economy to return to normality. We expect this to occur in 2021, although real GDP won’t likely top its 2019 peak until the third quarter of next year.
This Friday’s Jobs report will provide a fresh perspective on employment, and should also show a solid, but incomplete, recovery. We expect to see a drop in the unemployment rate from 10.2% to 10.0% and a gain of roughly 1.7 million jobs for the month of August, with the economy now recovering half of the 22.1 million jobs lost between February and April. However, regaining the other half of the jobs lost will be a much slower process. Moreover, it is sobering to note that even with this further progress, the number of jobless Americans in August likely topped 16 million people – more than in any month in U.S. history prior to 2020.
On corporate profits, the news continues to be surprisingly good, all things considered. S&P500 operating earnings per share fell 33% year-over-year in the second quarter which, while an enormous decline in absolute terms was still just one third of decline seen in the worst quarter of the great financial crisis, when operating EPS turned negative. More broadly, on average in the eleven previous recessions since World War II, real corporate profits fell 3.8 times as much as real GDP. In this recession, the drop in profits has been only 2.1 times as large.
That being said, profits are still down and we expect that, even in a best case scenario and assuming no increase in corporate taxes, operating earnings per share won’t exceed their 2019 peak until 2022.
Such a recovery, though welcome, shouldn’t quite justify the recent strength of the stock market. Moreover, while both the market and the economy have benefited from Washington largesse for many years and even more so in recent months, these Washington tailwinds should turn to headwinds over the next few years.
The Fed’s adoption of a new “average-inflation targeting” policy last week may have been seen, initially, as good news for the bond market. Presumably, to achieve this goal, the Fed would be willing to hold short-term interest rates at extremely low levels even as inflation creeps over its average target of 2%. However, investors should recognize that expansionary monetary policy, if implemented through monetizing the deficits of a profligate government, can actually be a very powerful tool in stimulating aggregate demand and inflation.
Meanwhile, this Wednesday, the Congressional Budget Office is set to release what could be an eye-opening report on the fiscal outlook. We expect that it will project deficits of more than $3 trillion this year and a debt-to-GDP ratio rising from 79% of GDP a year ago to 105% of GDP by the third quarter of next year and rising further, assuming no new stimulus and the expiration of many current tax breaks, to over 120% of GDP in the decade ahead. Moreover, this is likely an underestimate of the pace at which the national debt will increase. Very likely there will be another stimulus package after the election, with the Federal Reserve continuing or increasing their $20 billion per week purchase of Treasuries to finance it.
However, as the economy recovers next year and into 2022, the Fed will likely achieve its inflation goal and begin to taper its Treasury purchases. This should push long-term interest rates higher and make the cost of financing the now swollen national debt a source of concern. Ultimately, this should mean higher taxes, including higher corporate taxes, regardless of who wins the November election.
Needless to say, a combination of higher long-term interest rates and higher taxes would not be positive for either the bond market or the stock market. Investors have every reason to expect a continued recovery in the economy and corporate earnings. However, they should think carefully about whether some parts of the U.S. equity and bond markets are now priced too high relative to that outlook, and make sure they also have exposure to other parts of U.S. and global capital markets where pricing seems a little less exuberant given the likely road ahead.