New GDP data released last week confirmed that the 2020 recession has been the deepest in over 70 years, with a peak-to-trough decline in real output of 10.6%. This, of course, was already evident in monthly data on consumption, employment, trade and inflation and has been reflected in a very sharp decline in corporate profits. Consumer confidence fell in July as it became clear that the pandemic, far from fading away, has intensified over the summer, at least in terms of the numbers contracting the disease.
However, even in this gloomy environment, economic data make it clear that the economy is embarking upon a recovery. It is a long climb back for real output, employment and corporate profits and the economy will be feeling the after effects of the pandemic recession and the monetary and fiscal measures taken to mitigate it for years to come. Nevertheless, the pace of the recovery across the many dimensions of the economic and financial landscape will have a significant impact on investment returns in the years ahead. This being the case, this seems like a good time to take a look at the recovery across dimensions of economic activity and government policy. In particular, a good checklist would include: Growth, Jobs, Profits, Inflation, Fiscal Policy and Monetary Policy.
Starting with economic growth, real GDP could rise by as much as 25-30% annualized in the third quarter following declines of 5% and 32.9% in the first and second quarters respectively. While this bounce sounds impressive, it would still leave real GDP 5% lower in the third quarter than in the fourth quarter of last year, a significantly bigger drop than the total decline in output in the Great Financial Crisis. Moreover, the pace of recovery should, unfortunately, slow sharply in the fourth quarter. The third quarter bounce will largely reflect the reopening of industries that were shut in April but which can, with the adoption of social distancing protocols, operate fairly efficiently even in a pandemic. This includes sectors such as manufacturing, home-building and auto sales.
However, despite valiant efforts, it is very difficult to operate other businesses in the entertainment, restaurant, retail, leisure and transportation industries in this environment and the lack of recovery in these areas, along with knock-on effects of the recession on the energy and state and local government sectors, will act as a drag on the economy until the widespread distribution of a vaccine hopefully puts an end to the pandemic in 2021. In addition, while both auto sales and home-buying are possible in a pandemic, we expect weak demographics and the recession to weigh on both of these sectors in 2021. Inventory levels will also likely continue to be somewhat suppressed by long-term problems in retail outlets.
Overall, we expect economic growth to about 5% annualized in the fourth quarter and continue at about that pace in 2021, with output finally surpassing its 2019 peak in the third quarter of 2021.
The July employment report, due out on Friday, should add some clarity to a very confusing employment picture. The economy lost 22.1 million non-farm payroll jobs between February and April and regained 7.5 million of them by June. We believe a further 1 million+ jobs may have been regained in July and, given the at least temporary expiration of enhanced unemployment benefits, August may see a similar gain. However, this should still leave the unemployment rate at above 10% and it is quite possible that the measured unemployment rate could rise in the months ahead as the pace of economic activity decelerates and more of those who have dropped out of the labor market return to look for employment.
The recovery in employment levels following a recession usually lags behind any recovery in GDP because of productivity gains and we believe this may be exacerbated this time around by very weak growth in the working age population due to a sharp decline in immigration. Consequently, we expect that payroll employment will not return to its early 2020 peak until 2022, with the unemployment rate averaging over 10% in the fourth quarter of this year and still nearly 8% in the fourth quarter of 2021.
With 78% of S&P500 market cap now reporting earnings for the second quarter, operating earnings per share are tracking a 39% year-over-year decline. While this is, of course, a huge fall, it is significantly less severe than in the Great Financial Crisis, when operating earnings actually turned negative in the fourth quarter of 2008. This less negative performance largely reflects the mix of industries in the index, since the most important sectors, including technology, health care, consumer staples and even financial companies can operate reasonably efficiently in a pandemic environment.
Earnings should also begin to rebound in the second half of 2020, supported by the U.S. economic recovery, potentially stronger recoveries overseas, a weaker dollar and a modest rebound in oil prices. This recovery should continue into 2021, aided by some productivity gains and low wage growth. However, we don’t believe that 2021 earnings will quite reach their 2019 peak. Moreover, while we are not assuming a corporate tax increase in 2021, this is a real possibility in 2022 if a new government in Washington attempts to reduce the nation’s yawning budget deficit. This could prevent earnings from setting a new all-time high in 2022 also.
Since the 1970s, the U.S. inflation rate has generally fallen, normally downshifting the most in the immediate aftermath of recessions. However, while inflation has declined in the 2020 recession, we actually expect it to stabilize and move up slightly over the next few quarters. This reflects, in part, the impact of a falling dollar and recovering oil prices. However, it also is the result of very aggressive fiscal stimulus, which has added to consumer demand even as social distancing measures have boosted the cost of supplying many goods and services. Consequently, while inflation as measured by the core consumption deflator hit a trough of 0.9% year-over-year in the second quarter of 2020, we expect this to rise to just over 2% by the second half of 2021.
One significant difference between the recession of 2020 and recessions in previous decades has been the willingness of the Federal Government to provide very substantial support to the economy. The four coronavirus relief bills passed so far have had a combined price tag of $2.4 trillion. We expect, despite a current stalemate, that Congress and the Administration will agree to a further bill in the first half of August, adding perhaps another $1.5 billion to the total. Moreover, after the election an additional bill will likely be needed to tide the economy over until the widespread distribution of a vaccine. We estimate that this could result in budget deficits of almost $4 trillion this fiscal year and $2 trillion next fiscal year, pushing the debt-to-GDP ratio above 110% by the middle of 2021.
Even this level of debt is manageable, provided inflation and interest rates remain very low. However, there is a growing risk that higher inflation could both increase long-term interest rates and induce the Federal Reserve to tighten monetary policy in late 2021 or 2022. This scenario could result in both higher taxes and lower spending, as Washington tries to repair some of the fiscal damage caused by the pandemic response.
Federal Reserve forecasts of short-term interest rates published in June show that no members of the Federal Open Market Committee believe any rate increase would be appropriate in either 2020 or 2021 and that only two members are ready to contemplate such a move in 2022. Moreover, it is widely expected that the Fed will adopt average inflation targeting later this year, a policy which will allow inflation to run above the Fed’s 2% target for a while to offset the impact on inflation expectations of years of inflation running below that pace. We assume that the Fed sticks to this policy through 2021, although it may reduce Treasury purchases later in the year, putting some upward pressure on interest rates.
Markets are supposed to be priced based on expectations and, even in the midst of this extraordinary pandemic with the added uncertainty of the upcoming election, it is completely reasonable to expect a recovery from here. However, it is a long climb back for the economy, for employment and for profits. In addition, an eventual tightening of both monetary and fiscal policy should represent headwinds for both stocks and bonds. This being the case, investors would do well to temper any expectations of strong long-term gains on U.S. assets and also be willing to diversify internationally into markets where the climb up Recovery Mountain looks a little less steep.