Economic & Market Update
Economic & Market Update: Using the Guide to the Markets to explain the investment environment
1. The pandemic continues to take a toll on public health and the economy
2. The economy is emerging from recession into gradual recovery
The economy has likely emerged from one of the deepest, but also one of the shortest, recessions over the last century. Because of how severe the recession was, and the fact that we do not have a more permanent solution to the virus yet, the economic recovery should be gradual. Economic output may not reach its 2019 peak level until late 2021.
Part of the reason for this is consumption drives nearly 70% of the economy, and with many service-oriented businesses only reopened partially, and with high unemployment reducing households’ ability to spend, the engine of the economy impaired. Some areas of the economy, however, like housing and autos, have been able to rebound strongly, while others, like hospitality and leisure, may continue to struggle until there is a vaccine.
3. The second half of the labor market recovery is likely to be slower
4. Profits should gradually improve from here
5. Higher inflation is a risk down the road
The onset of the recession, combined with a collapse in oil prices, has triggered a decline in already low inflation. Although inflation normally troughs after the end of a recession, things may be a little different this time around, particularly given the potential for further economic stimulus after the election, the continuing extra costs of operating during a pandemic and the likelihood of an economic surge post-pandemic.
6. The Federal Reserve has committed to remaining accommodative
In the first half of 2020, the Federal Reserve took very strong action to support the economy including cutting the federal funds rate to a range of 0-0.25%, opening or expanding a very wide range of facilities designed to support different parts of the bond market and doubling its balance sheet.
In addition, in August, the Fed adopted an “Average Inflation Targeting” operating strategy, by which they will aim to achieve inflation of above 2% for some time to make up for years of undershooting this target. In order to achieve this they have pledged to hold the federal funds rate at its current 0-0.25% target range until inflation is at 2% and on track to moderately exceed 2% for some time.
Critically, the Fed’s willingness to buy almost unlimited quantities of Treasuries is enabling the Federal Government to deploy the most aggressive fiscal stimulus since World War II. Assuming that this continues, the Fed may well achieve its above 2% inflation goal within the next few years.
7. Massive fiscal support has boosted debt and deficits
The heart of the economic damage is with consumers and businesses, so the U.S. government delivered a multi-trillion dollar fiscal package to mitigate permanent economic damage.
This legislation provides very significant but temporary help to individuals, companies and state and local governments, but it hasn’t prevented the economy from falling into a sharp recession, in terms of lost output and higher unemployment. However, it should allow both households and companies to avoid the worst effects of recession until a vaccine has been developed and the economy can embark on a robust recovery. A follow-on package is expected at some point as many provisions of early packages have expired, but could come after the election.
Needless to say, however, this stimulus has come at a very high fiscal price, leaving the economy with the highest debt to GDP and deficit to GDP since World War II.
8. Short-term election volatility should not disrupt investment plans
Markets are likely to experience increased volatility around the upcoming November election. That is because markets do not like uncertainty, but the outcome of an election always reduces uncertainty. Even if we do not have results on Election Day, the interim volatility or the eventual outcome should not disrupt investment plans because markets rely on fundamentals, not politics. And investment time horizons extend far beyond election cycles or presidential administrations.
This page show S&P 500 returns and real GDP growth during periods of Republican, Democrat, or divided government control. We define Republican control, for example, as a Republican president with a Republican-majority Senate and House of Representatives. Over time, markets have enjoyed solid returns and the economy has continued to grow under all configurations of government.
9. Low for even longer
10. U.S. equities have recovered significantly
11. International stocks offer long-term opportunities
Both U.S. and international stocks sold off at the height of the COVID crisis, but the valuation gap between U.S. and international stocks that persisted throughout the recent expansion still persists today. However, this dynamic could shift in the next expansion.
The long-term growth prospects of EM economies still look better than for the U.S., valuations remain cheaper overseas, and the dollar has been retreating, which amplifies the return on international equities. Europe, which has been long unloved, may have a catalyst for turnaround with more promising efforts towards fiscal integration.
12. Risks ahead call for diversification
Despite a rebound in markets, the economic, labor market, and earnings recoveries will likely be much slower. With additional risks ahead such as a resurgence of the virus and the election in November, investors would likely benefit from a focus on quality in equity and fixed income, with a balanced approach to confront a range of outcomes.