The Pandemic and Financial Waves
Dr David Kelly
Chief Global Strategist at J.P. Morgan Asset Management
As a former keynote speaker at RAO Gloabl - the Americas in 2021, it good to keep a tabs on what this measured, calm man has to say about the outlook and here is his latest assessment from the US with a global perspective.
It feels like so long ago, but back in 2019, the economic and financial environment was remarkably placid. Real GDP growth was plodding along at 2.3% pace, unemployment drifted down to end the year at 3.6% and corporate profits were growing slowly from very high levels. Consumption deflator inflation was still running below the Fed’s 2% target and, in recognition of this fact, as well as market volatility at the end of 2018 and a sluggish global economy, the Fed cut the federal funds rate three times to end the year in a range of 1.50%-1.75%. While the political weather in America was stormy, the investment environment was remarkably calm.
In early 2020, this calm was shattered by two huge shocks – the coronavirus pandemic and the policy reaction to it. These shocks set off giant waves in economic output, employment, inflation, and profits and these waves are still rolling forward today, albeit with diminished amplitude. As we move into 2022, the waves should fade further, returning the investment environment to some degree of relative tranquility. However, it will be a different environment in many important ways from the pre-pandemic world and these differences make all the difference in thinking about asset allocation for 2022 and beyond.
Before considering the how the waves will roll forward from here, it is important to review where we stand on the shocks that set them in motion.
On the Pandemic: Daily confirmed cases have fallen to just over 70,000, down from 160,000 at the start of September. Fatalities have also fallen to roughly 1,400 a day and should, given lags, fall further in the next few weeks. Unfortunately, however, progress in reducing these numbers appears to be slowing, reflecting waning immunity from vaccines administered over the spring and a continued fading of social distancing behavior. This week’s expected CDC approval of a vaccine for children aged 5-11 could help, as could a widespread take up of booster shots. However, it looks increasingly likely that the U.S. and the world will have to learn to live with Covid, with the vaccinated at least having the comfort of a much reduced risk of hospitalization and death.
On Fiscal Policy: Last Thursday, after intensive negotiations, President Biden announced a framework for his reconciliation bill which he believes can pass both the House and the Senate. The framework purports to offset $1.75 trillion in spending over the next 10 years with $1.95 trillion in revenue. Three points are worth noting with regard to this announcement.
First, Democrats still don’t have an agreement on a path forward. While the House leadership would like to schedule votes on both the infrastructure and reconciliation bills this week, Democratic House progressives are well aware that if they pass the infrastructure bill, it will head to President Biden’s desk, while any reconciliation bill they pass would need 50 votes in the Senate and could still be amended.
The end game will likely be reached when the House approves the reconciliation bill, the Senate amends it and House Democrats are finally in a position to send both bills to President Biden’s desk on the same day. It does look possible that this could happen within the next few weeks.
Second, the framework outlined by the President, involves only moderate fiscal stimulus compared to other recent legislation. The spending is front-loaded, with roughly $400 billion of the $1.75 trillion plan expected to hit the economy in calendar 2022, including a one-year extension of the child tax credit and the enhanced earned income tax credit. The revenue offsets would be collected over a decade, meaning less than $200 billion in additional revenue in 2022. However, this net increase in the deficit of about $200 billion looks puny compared to the $5.3 trillion in fiscal stimulus already spent since the outset of the pandemic and, even with it, the deficit is likely to fall from 12.4% of GDP in the last fiscal year to roughly 5% of GDP in the current one.
Third, the proposed revenue offsets look less threatening to investors than earlier proposals. This plan would neither increase the top corporate income tax rate nor increase capital gains taxes for households earning over $450,000. It would raise taxes on taxpayers earning over $10 million per year and, allegedly, raise $400 billion from enhanced IRS enforcement. For corporations, it would impose a 1% tax on stock buybacks, establish a minimum 15% tax on overseas income, and levy a 15% minimum tax for corporations with profits of over $1 billion per year.
Overall, the impact of fiscal policy on the economy and markets, like that of the pandemic, appears to be fading and would likely fade further if Democrats lose their majorities in either the House or Senate in the mid-term elections next November.
On Monetary Policy: The Federal Reserve is likely to announce a plan to taper bond purchases at this week’s FOMC meeting. Based on the minutes of the last FOMC meeting in September, it seems likely that the Fed will announce a reduction in bond purchases of $15 billion per month, from their current $120 billion pace, with the reduction probably commencing in mid-November.
The messaging is much less clear on when the Fed might begin to raise short-term interest rates. However, if, as we expect, the economy continues to recover, unemployment continues to drift down and inflation remains above the Fed’s 2% long-run target, a first rate hike could be implemented at the last Fed meeting of 2022 in mid-December.
The Growth Wave
With fading effects from both the pandemic and policy reactions, the economic waves they triggered should also fade in 2022.
The wave pattern is easiest to see in economic growth. Real GDP plunged in the second quarter of 2020, soared in the third quarter and then slowed to a 4.2% pace in the fourth quarter as pandemic conditions worsened. Growth then reaccelerated, with real GDP logging back-to-back quarters of 6.3% and 6.7% in the first half of 2021 before slumping to just 2.0% growth last quarter.
We expect one more wave from this pattern with growth surging to a better than 5% pace over the next two quarters and then sliding down to a running rate of about 2% for the rest of this economic expansion.
The idea of a renewed surge is predicated on three themes – a gradual easing of supply-side constraints, pent-up demand for consumer and capital spending and a fading impact of the pandemic on the service sector.
Supply-chain issues clearly impacted third-quarter real GDP, most notably in the auto sector where unit light-vehicle sales slumped to 13.3 million units annualized from 16.9 million units in the second quarter. This, in turn, largely reflected a collapse in inventories, with autos on dealer lots falling to below 40 days of sales in September compared to an average of almost 64 days of sales over the last decade.
More generally, inventories around the economy continued to fall in the third quarter and supply-chain issues likely impacted home construction which fell in both the second and third quarters despite soaring home prices.
While industry reports suggest it will take some time to iron out supply chain issues, the intense focus of global business on this problem and the profits earned by those who can get product to market are very likely to turn the tide in the months ahead. The first signs of progress may come in this week’s October employment report which should see substantial hiring in the energy, construction, manufacturing and transportation sectors.
The urgency with which businesses tackle supply chain issues should be enhanced by very strong consumer and business demand. Consumer wealth continues to surge with the S&P500 soaring by 6.9% in the month of October alone. Confidence should also improve as pandemic effects wane and employment and wages rise in the months ahead. The outlook is also very strong for capital spending as low interest rates and high profits make it easy to finance projects and a very tight labor market enhances the attractiveness of investments in labor-saving technology.
Finally, while the pandemic continues, it is having less of an impact on public behavior, partly because so many people, having already been either vaccinated or infected, feel able to get back to normal life. This transition is numerically very obvious in airline travel with people passing through TSA checkpoints over the last week down just 16% from 2019 levels compared to a 30% falloff in mid-September. However, this is only part of a very broad transition back to normal as people are also returning to sporting events, restaurants and theatres and fall weekends for many are dominated by weddings postponed during the pandemic.
The Labor Market Wave
While economic growth is likely to surge into early 2022, it should slow thereafter largely because of labor market constraints.
The job market has seen its own violent wave over the pandemic with unemployment soaring from a 50-year low of 3.5% in February 2020 to a post-World War II high of 14.8% two months later. It then fell back sharply to just 6.7% by the end of last year. However, since then, progress has been slower with joblessness falling to 4.8% in September, likely reflecting the impact of government stimulus checks and enhanced unemployment benefits which allowed some workers to take more time in looking for a job. With the expiration of these benefits and dramatically strong labor demand, we expect the unemployment rate to drift down further over the next year, averaging 3.7% by the fourth quarter of 2022 and 3.5% by the fourth quarter of 2023.
This decline in unemployment should reflect moderate gains of 1.9% and 1.3% in total employment over the next year and the following year respectively. Employment gains will be boosted by a continued return to work of many who left the labor force due to the pandemic. However, increasingly this trend will be countered by very low natural growth in the working-age population with baby-boomers aging into retirement and immigration still very low relative to its pace in the middle of the last decade.
The pandemic did see some productivity gains which should endure. Even with this, however, output per worker grew by just 0.8% per year in the five years before the pandemic. A return to this trend should see the economy retreat to a trend growth rate of close to 2% by 2023.
The Inflation Wave
The pandemic and the policy response has also set off a wave of inflation with the personal consumption deflator rising 4.4% year-over-year in September, more than double the Federal Reserve’s long-run target. This reflects year-over-year increases of 80% for crude oil, 8.7% for new cars and 24% for used cars as well as a more general impact of fast-rising wages throughout the economy.
While this is well known and widely discussed, it is important to recognize that many of these strong gains are temporary. Very high oil prices beget increases in supply. The OPEC+ group meets on Thursday of this week. Even if they don’t agree to step up output, non-OPEC producers will likely ramp up production themselves. It is not an accident that the U.S. rig count on Friday rose to its highest level since the onset of the pandemic and it will likely continue to increase in the months ahead.
More generally, the longer it takes to adjust production and distribution across the economy to clear supply-chain bottlenecks, the greater is the likelihood of over-investment. Two years from now, it is quite likely that prices will be falling in many areas because of overcapacity in a mirror opposite of the situation today.
That being said, we do expect the post-pandemic economic environment to manifest somewhat higher inflation than over the last decade due to higher wage growth, faster-rising rents and higher inflation expectations.
The Profit Wave
The profit wave has also been dramatic, with S&P500 operating earnings per share falling from an all-time high of $157 in 2019 to $122 in 2020 before soaring to what we now expect to be over $200 per share in 2021. The third-quarter earnings season has been very strong so far. As of this morning, with 74% of market cap reporting, 82% of companies have beaten earnings expectations and 66% have surpassed revenue expectations. Still, the earnings surge is likely to slow dramatically in 2022 as companies face higher interest rates, faster-growing wages, slowing economic growth and higher taxes. Indeed, the Biden framework includes roughly $800 billion in additional corporate taxes over the next decade. If these revenues are spaced out evenly this would mean roughly $80 billion in higher taxes in 2022 – about 3.3% of after-tax profits for all corporations and close to 5% of the profits of S&P500 companies on whom almost all of the additional taxes would be levied.
Asset Allocation amidst the Waves
In summary, as the financial waves unleashed by the pandemic and the policy response diminish, the economy should settle down to slower growth and higher interest rates than prevail today and somewhat higher inflation than before the pandemic. However, valuations, particularly for long-term bonds and U.S. large-cap growth stocks are higher than before the pandemic and the general dispersion of valuations across capital markets is greater. Given all of this, investors may want to increase allocations to those assets that still look attractively priced. These include U.S. value stocks, international equities and some alternatives. Equally important, investors should remain well diversified. One of the lessons of the pandemic is the same as the lessons of 9/11 and Lehman Brothers – the biggest shocks to markets are normally those that no one sees coming and the best protection comes not from hedging against known risks but from diversifying against unknown dangers.
Disclosure
Any performance quoted is past performance and is not a guarantee of future results.
Diversification does not guarantee investment returns and does not eliminate the risk of loss.
Opinions and estimates offered constitute our judgment and are subject to change without notice, as are statements of financial market trends, which are based on current market conditions. We believe the information provided here is reliable, but do not warrant its accuracy or completeness. This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The views and strategies described may not be suitable for all investors. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, accounting, legal or tax advice. References to future returns are not promises or even estimates of actual returns a client portfolio may achieve. Any forecasts contained herein are for illustrative purposes only and are not to be relied upon as advice or interpreted as a recommendation.
