Any economic forecasts of where we are going must be prefaced by acknowledging where we were and where we are now.
Where We Were
We entered 2020 with one of the best performing economies in history. The unemployment rate in February stood at an astonishingly low of 3.5%. While the lowest recorded was 1.2% during WWII, The Federal Reserve states that the “natural rate” of unemployment is 3.5% to 4.5%. At that rate, theoretically, anyone who wants a job can find a job. Anyone unemployed is there voluntarily. All other economic indicators were at similarly positive levels, and inflation was at 1.7%.
The Covid lockdowns changed all that, and the second quarter of 2020 will go on record as the largest quarterly drop since the Great Depression. Real GDP dropped almost 32% on an annual basis. Unemployment quickly shot up and hit a high of 14.7% by May.
Where We Are
Today, we are somewhere in the midst of recovery; a recovery which so far has been one of the fastest and most robust on record. As of this writing, 3rd quarter industrial production will be up 37% on an annual basis, retail sales will be up 60% on an annual basis, and that assumes there is no more growth in the week remaining in the quarter. Reasonable economic forecasts project that real GDP will have grown 25% on an annual basis in the 3rd quarter.
These are truly impressive numbers, but two things must be noted. First, these won’t continue at this pace, and second, we have a way to go until attaining a full recovery. We need to keep in mind that it is easier to recover rapidly in the early stages than it is in later stages. When you have shut down a business, you get an immediate pop when you reopen. But you can’t reopen again, and again. The early pops have already occurred. Present trends continued, the economy should continue to improve, but at more historically normal rates in the 3% to 5% range.
Where We Are Going
Full recovery will take a while – probably through 2021, with unemployment most likely dropping below 4% in 2023. Full recovery is not just a return to the original level, because before the crisis the economy was growing at roughly 3%. Had nothing happened, GDP would be 3% greater than it was in 2019. We have to make up the loss actually incurred plus the amount of growth that should have occurred. Depending on growth rates in the 4th quarter and beyond, we believe the economy will not fully recover until late 2021.
Our fully recovered economy will also look different than the economy we had just before to the shutdowns. The shutdowns have changed behavior and eliminated some options. The way the shutdowns were imposed undeniably hurt small businesses more than large publicly traded companies. The local restaurant does not have the staying power, nor the available bank credit lines, that a large firm does. Many shuttered small businesses will simply not re-open. Furthermore, some of the larger retailers or tech firms benefitted from the shutdown. Behavior changed. People may have stopped going to restaurants, but they apparently turned to home improvements. People stopped going to theatres, but they turned on Netflix. Business people have decreased traveling and are zooming more. This is bad for hotels and airlines, but good for web conferencing providers. The question is how many of these behavior changes will remain. Will we ever return to movie theatres at the same level we used to attend?
One of the very few silver linings was the forced adoption of productivity-improving practices. The move toward working remotely will likely have some permanence to it. Many employees will return to their offices and factories, but a good number will not. The demand for office space will undoubtedly be affected.
Also affected are housing patterns. A recent Wall Street Journal article chronicled what is being called “the great urban exodus”. A significant number of people are moving from where they perceive danger or that lockdowns were badly managed (some specific states and major cities) to places they perceive are safer and better managed (other specific states and more suburban environments). A good indicator of this trend is new housing permits, as shown below:
National Average +8.6% from one year ago
The Northeast +4.6% from one year ago
The West (dominated by CA) +0.5% from one year ago
The Midwest +32.5% from one year ago
The northeast has been hurt (roughly half the national average), while California has been decimated. The midwestern plains states have a new-found appeal, and this is especially strong among younger Americans, and many of these people will not be moving again for decades, or a lifetime.
Products, services, sectors, and whole industries are going to be reshaped by these trends. The companies that recognize these trends and adapt to changing needs and demands will reap solid rewards, and stock investors will benefit.
Stock Market Math
The stock market in its aggregate is a valuation in present terms of the profits which will be earned in the future. Some analysts are expressing fear that the market may be overvalued and that present trends cannot be sustained. We beg to differ. The math here can be mind-numbingly boring, but here is the Cliff Notes version.
Given the profit levels reported by major publicly traded companies in the 2nd quarter, and assuming a 2% Treasury rate, a reasonably and “fairly-priced” level would be 4,000 for the S&P 500 and would be 31,000 on the Dow. But that assumes profits simply remain where they were as of June 30th. Current measures for the 3rd quarter seem to indicate that profits will be higher, and several analysts are predicting substantial profit growth in the 4th quarter and throughout much of 2021. We believe the danger to this market from economic forces is minimal, and the market is under-valued.
Risks And Perils
As you might expect, economic forces are easier to predict than political ones. We can, and have above, projected the trends under present economic factors. But the political landscape can change that. The question becomes whether it will change, and how fast that change might come. Without venturing into the social or political virtues of any party’s stated policies, we can unequivocally state that as profits are reduced, stock prices drop. Whatever is seen as a viable threat to publicly traded companies’ ability to earn a profit for their shareholders will impact the value of stocks.
Three major threats exist: taxes, regulation & inflation. Candidate Biden’s stated position is that he will raise taxes, which would, if enacted, depress the stock market. But this assumes that a President Biden would have a willing Senate. If history is any guide, President Obama waited until several years into his presidency to raise taxes. Too many of his own party (Democrats controlled the Senate with 59 seats) were reluctant to raise taxes when the economy was still recovering from the 2008-09 housing market crisis.
On the regulatory front – and again without commenting on the social or political virtues – we point out what should be obvious. Increased regulations impact profits and drive stock prices down. The more punitive and the more arbitrary the regulations, the worse the impact. The ease with which previous administrations issued executive orders to impose regulations does not exist today. The legal environment facing any president is much more restrictive today. Any significant increase in the regulatory burden will have to be fully vetted and approved by Congress.
To the question of what will happen to the economy as a result of the election, it is a cautionary tale at worst. There are no easy answers, but fortunately, it does not appear that anything will happen fast. Expect continued volatility to and through the election, but do not try to place a bet on the future before votes are cast, winners are sworn in, and specific policy proposals are actually written into law.
This leaves inflation as the last remaining threat, and it is real; fortunately, it is most likely a slow-burning one. The Federal Reserve has communicated that it is in no hurry to raise rates and that it is increasing its inflation target from 2% to 2.5%. Taken at face value, it means inflation will have to rise above 2.5% before the Fed feels the need to increase interest rates. We doubt they will be able to wait that long. The money supply has grown 23% from last year, representing considerable upward pressure.
Normally, this would have already resulted in a significant increase in inflation, prompting the Fed to raise rates to combat it. This has not occurred – yet- because the crisis has prompted many people to save more than normal. Pouring more money into the economy only impacts prices if people spend that money. If, out of fear, they sit on it instead, the impact is muted.
The challenge for the Fed is their ability to recognize the point at which people start spending more money and their ability to withdraw those excess dollars before they drive up prices too much. The Federal Reserve does not have a stellar track record in this regard. While we do not foresee hyper-inflation, we do believe that 3% to 5% inflation rates are possible.
The ramification of that inflation level is more muted for stocks than for long-term bonds. If any category represents a potential over-valuation, it would be long-term bonds that are already in existence. As interest rates rise, the value of existing bonds decreases, and the longer the term of the bond (think 10, 15, 20, or 30 years) the worse that price drop.
There is still a solid place in a balanced portfolio for bonds, but the composition and tenure of those bonds become very important. Most bond managers know this well and should be able to position their portfolios to hedge against this. But in this area, an ounce of review right now may save a considerable headache later.
The Crystal Ball
What does the future hold? Nobody can know that with any degree of assurance. What can be said is that present economic forces are solid, stock valuations are lower than they need to be, and there are some natural checks on politicians. The most likely scenario is a continuation of our current recovery, but at what level we cannot possibly say.
As has been invoked innumerable times in our country’s history, we close by asking that God grant our elected leaders discernment and wisdom in the days ahead, and for all of us patience and peace.