We have been here before; America was ripped by social unrest in the 1960s and 70s. But today feels different; it feels worse, at least in part due to the element of surprise. Our current situation seemingly came out of nowhere – one of the strongest economies on record without a storm cloud in sight. And then the Coronavirus hit, followed by protests which in many quarters turned from peaceful to violent within a blink of an eye. The virus prompted economic shutdowns, and together all these events have shown fear, heightened political divides, and caused severe economic dislocations. But storms pass, and so will this one. We are on the mend, and a firm recovery is taking hold, despite lingering feelings of angst.
The Current Economic Data
The quick recap of economic data shown below makes clear that the recession, which started in March, is the sharpest downturn since the Great Depression, but is also the shortest with the recovery beginning in May.
• Industrial production increased 1.4% in May
• Industrial production increased 5.4% in June
• The Service Sector Index rose to 57.1 in June (anything over 50 signals expansion)
• Housing starts increased by 4.3% in May
• Housing starts increased 17.3% in June
• Existing home sales increased 20.7% in June
• Retail sales rose 18.2% in May
• Retail sales rose 7.5% in June
• Non-farm payrolls rose 4.8 million in June
• Overall unemployment rate fell to 11.1% in June (from a 14.7% high in April)
Stock Market Data
The broad stock market reflects all of this in its movements from the beginning of the year. The Dow started the year at 28,462, climbed to a new high of 29,551 in February, dropped with the shutdown to 18,591 on March 23 (a 37% drop), and then recovered much of that lost ground, hovering around 26,500 today. That represents a 42% climb from the bottom and places us only 10% off from the beginning of the year. That’s pretty impressive historically.
This doesn’t mean the U.S. has fully recovered; a full recovery will take a while longer with estimates ranging from a couple more quarters to a couple of years. But we can have a very reasonable expectation of continued recovery confirmed by more positive numbers throughout the summer and into the fall.
In fact, the Fed’s economic data show that the early stages of the recovery were in fact sharp and “V” shaped, while their projections going forward indicate greater than average economic growth for the next several years. Longer term, they see no permanent damage to the U.S. economy and an unemployment rate returning to 4.1%.
Support From The Fed
On the monetary side of things, the Fed is committed preventing their policy actions from impeding the recovery. Their recent policy statements acknowledge the importance of maintaining sufficient liquidity in the system, even as they grapple with how to avoid excess inflation. They have no intention of becoming “tight”, nor of raising interest rates appreciably until 2023.
Herein lies the rub – one of the challenges to the economic recovery and to longer-term economic growth. It is possible that this loose monetary policy will cause an outbreak of inflation. We don’t see it happening right away, but there will come a time when prices start to rise. Whether that remains manageable or busts out of control will depend on how quickly industrial production returns to pre-shutdown levels, how fast consumers and businesses start spending the cash at their disposal, and how quickly the Fed recognizes these changes and adjusts monetary policy.
The essence of this challenge lies in the interaction between “supply” and “demand”. Everyone who passed Econ 101 knows that supply and demand seek to equal one another. Several recent reports show a gap is building between supply and demand. Retail sales (cited above in our recap of data) are a measure of demand. From their April bottom, they have rebounded sharply, rising 18.2% in May and 7.5% in June. Retail sales are actually higher than a year ago.
On the supply side, industrial production (also cited above) has not increased correspondingly. From its April bottom, production has rebounded only 6.8% as of the end of June. Production is still 11% lower than a year ago.
This situation cannot continue for long. The only reason it has occurred is because of government Covid-based relief programs. The government has borrowed money in order to provide relief checks and higher/longer unemployment benefits to those affected by the shutdown. With this “extra” money, Americans have been able to resume retail purchases even during a time of heightened unemployment.
Normally, a large difference between the growth in retail spending and growth in industrial production would signal that higher inflation is around the corner. We have not witnessed that yet, because the lingering sense of fear and anxiety has caused people to save much of the extra money they have received. They still feel they need for some protection in case things get worse. We see evidence of this in the personal savings rate. Historically on average, this rate is about 8%. It stands at roughly 20% now.
When people begin to spend these extra savings, that will put extra pressure on prices if supply (production of stuff we want to buy) hasn’t increased. This is how supply and demand work. But if suppliers have been driven out of business, or are held back by ongoing lockdown measures, prices will start to rise quickly.
This is the challenge that the government faces at this time. It is two-fold. On the one hand, restrictions must be removed to allow supply to bounce back. We have to get back to work. On the other side, the Fed needs to properly time how it removes the extra money that’s pushing up demand. It’s easy to see how mistakes could happen.
Mitigate The Risk
Despite this, we remain upbeat in our assessment. We do not believe that government policies will cause a recession. There is too much focus on preventing that. If anything, inflation will become the problem, but here is where a properly balanced portfolio can mitigate that danger. Stocks and real estate will tend to rise – with some volatility of course – with any experienced inflation. There are also bond options, in the forms of TIPS, “step-ups” and other variable rate bond offerings which will adjust to rising inflation. Good equity managers know this; good bond managers know this. The right balance between good managers should allow a portfolio to weather any short-term surprises and thrive over the long-term.
Believe it or not, we’ve been here before. The US has gone through tremendous social and political turmoil before; we’ve gone through periods of inflation before. We’ve always come out on the high side, and faith in the future has been amply rewarded. That is our outlook, and it is a good future.
