This week, I, like about 20,000 others, will attempt to complete the virtual Boston Marathon. I had signed up again with the Dana Farber Marathon Challenge team to run it in April, after a rather ragged performance in 2019. But then the race, like so much this year, first got postponed and then went virtual. And so, next Saturday morning, I will nervously walk out my front door, turn left and jog off, on my own, into the dawn’s early light.
This will be my fourth marathon, and although markedly different from the others, I can predict three things with near certainty:
(a) The second half will be slower than the first,
(b) Considerable discipline early will be necessary to avoid trouble later and,
(c) The marathon will, in due course, come to an end.
Something similar could be said about the economic recovery and investing in this pandemic.
The August employment report, released last Friday, showed that the U.S. has now recovered 10.6 million, or 48% of its pandemic job loss. However, that still leaves us with 11.5 million fewer payroll jobs than six months ago and regaining these jobs will be a slow process. Most of these jobs were in the restaurant, retail, hotel, entertainment and transportation industries. With the pandemic still raging, recovering jobs in these areas will be difficult. Over the last three months, payroll jobs grew by 4.8, 1.7 and 1.4 million jobs sequentially. We expect the pace of job growth to fall below one million per month between now and the end of the year and it is hard to see it reaccelerating in 2021 until the widespread distribution of a vaccine and the suppression of the pandemic allow the most affected industries to get back to normal.
It should be noted that while the number of payroll jobs is down 11.5 million since February, the number of unemployed workers has only risen by 7.8 million. This, in part, reflects the fact that 3.7 million people have dropped out of the labor force since February. While this may be due to many people regarding searching for a job in their old industries as pointless, the expiration of the $600 weekly payment in supplemental unemployment benefits could force some of these people to reenter the labor market to look for any job, causing the unemployment rate to rise from its current 8.4%.
Overall, then, the labor market is likely to see much slower improvement in the months ahead following a strong initial bounce.
A similar pattern should be observed in GDP figures.
Following declines of 5% and 31.7% annualized in the first two quarters of 2020, we now expect real GDP to rise by as much as 31% in the third. However, growth could downshift sharply to about 3% annualized in the fourth quarter and we expect that real GDP will not exceed its 2019 peak until sometime in the second half of 2021.
The downshift, in part, reflects a hangover from a stimulus-fueled surge in consumer spending in the third quarter. However, pent-up demand for autos and homes, following the sharp but short recession, should now be used up while consumer non-durable goods spending could take a double hit from less spending after stockpiling and a lack of further federal government stimulus. In addition, U.S. exports are being hurt by the global nature of the pandemic and state and local government spending could be hit by tightening budget constraints.
On the issue of a further federal stimulus, we had assumed that neither party would want to risk going into the last stretch of the election campaign without passing a bill. However, at this stage, political calculations appear to be impeding a near-term agreement. Many Senate Republicans seem unwilling to support a big bill, perhaps because it would seem to contradict their narrative that the economy is well on the road to recovery. Meanwhile, House Democrats appear unwilling to compromise in favor of a skinny bill for fear that it would allow the President to goose up the economy just before election day and suggest that the status quo in Washington is working.
In addition, according to press reports, the Speaker of the House and Treasury Secretary have agreed informally to a continuing resolution to keep the government open until after the election. This could allow the old Congress to consider a skinny bill in the lame duck session after the election and the new Congress to address the issue more broadly in January.
Of course, financial markets generally care more about interest rates and profits than jobs and economic growth. Here investors may feel much more positive but they should recognize potential problems ahead.
On interest rates, CPI data due out this week should confirm steady core inflation and a gradual recovery in headline inflation, at 1.6% and 1.3% year over year, respectively. While inflation remains lower than before the pandemic, supply constraints and government stimulus have combined to prevent the kind of cratering in inflation normally associated with recessions and inflation should move back towards the Fed’s 2% consumption deflator inflation target over the course of 2021. As this occurs, and notwithstanding their adoption of an average inflation targeting policy approach, the Fed may well consider tapering their Treasury purchases from the current pace of over $1 trillion per year. This, combined with presumably less political uncertainty after the election and a continuing economic recovery, should push long-term interest rates higher.
Corporate profits, in the short run, are likely to bounce in line with real GDP and S&P500 operating earnings could be down by less than 20% year-over-year in the third quarter following a 33% decline in the second quarter. However, thereafter, the pace of earnings gains should slow sharply in response to a deceleration in economic growth. Moreover, Washington will need to address the yawning budget deficit, which the CBO estimates at $3.3 trillion this fiscal year and $1.8 trillion in fiscal 2021, even without further stimulus. If the federal government increases corporate taxes in 2022 as part of an attempt to tame the budget deficit, it would clearly have a negative impact on after-tax corporate earnings. However, if they neglect to tackle the issue, there is a growing risk of a fiscal crisis within the next few years that could hit corporate profits with the unpleasant cocktail of even higher taxes and recession at the same time.
Even with some volatility last week, U.S. markets seem somewhat oblivious to these concerns.
· Despite record budget deficits and the potential for higher inflation and interest rates in 2021, the yield on a 10-year government bonds is still just 0.72% while a 10-year TIP carries a real yield of -0.98%.
· Spreads on both high-quality and high-yielding corporate bonds remain remarkably tight despite obvious distress in a number of sectors and rising defaults.
· Even after a small correction last week the S&P500 is still up 6.1% for the year. Moreover, the Russell 1000 growth index is up by more than 24%, boosting valuation measures for growth stocks to their highest levels relative to value stocks since the tech bubble.
For investors in the pandemic recovery, like those running the early miles of a marathon, this is a time for discipline. There are cheaper parts of capital markets, including value stocks in the U.S. and international stocks in both developed and emerging markets, and this may be a good time to rebalance towards them, subject of course to personal financial and tax considerations. This could serve to steady portfolios if any setbacks on the medical or economic front or perhaps political volatility lead to a major correction in the months ahead.
Finally, though, long-term investors should recognize that we will get past this pandemic. While it is unlikely that the first crop of vaccines will include one with near 100% effectiveness, even a safe and reasonably effective vaccine could be used as leverage, combined with the now familiar public health measures, to drastically reduce infections in the year ahead. This, combined with better therapeutics, should cause an even sharper fall in the death rate, allowing us finally to put this sad episode behind us.
The pandemic marathon will come to an end one way or the other. However, for long-term investors, success in the rest of the race and beyond may depend on recognizing that the recovery will be slower from here on out and having the discipline to maintain discipline when others are embracing sectors which have shown very strong momentum in the short-run but seem over-priced for a slow return to normal.