It’s been a while since we issued an update on fundamentals. The better we understand the exact mechanisms at play, the better we will understand the unfolding economy over the near term future.
As we all know, Covid-19 and the ensuing public health shutdowns had a major negative impact on the economy. In economics terms, factory shutdowns lead to lower supply of many products, while at the same time, demand patterns shifted such as the shutdown of large portions of the travel and restaurant sectors. The net effect ended as a decrease to US GDP by $500 billion or 2.3% for the year which would have been considerably lower without government intervention. For reference, GDP growth was -2.75% in 2008.
To avoid the risk of igniting a negative feedback cycle, the government took three major actions: Congress funded $5,335 billion of business and personal income (including the recent American Rescue Plan), the Federal Reserve financed $2,700 billion in purchases in the government and corporate bond market, and the fed lowered interest rates from 1.5% to zero.
So where are we now?
These actions were successful in the following areas: equity prices generally rebounded and continued rising, corporations raised a large amount of debt while debt to equity levels dropped (due to equity prices soaring higher than debt levels), and American households managed to stock away $1,600 billion of savings.
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Some government interventions are still in place. For example, the Fed continues to purchase an additional $120 billion worth of treasuries and mortgages a month. The latest round of stimulus is still making its way through the economy. Finally, segments of the economy remain restricted both by government and by slowly returning demand.
Normalization will have some predictable effects on the future economy. With the assumption of a certain amount of mean reversion, we can uncover some clues to the future. Continued vaccinations and natural immunities are leading to continued economic normalization. As government payments cease and businesses increase capacity, unemployment will continue to decrease. The American Rescue Plan will continue to impact spending, and Americans will spend down a portion of their excess savings.
These three factors are all working in harmony to increase the “demand” side of the equation. Keep in mind, the size of consumer savings is currently 3x the size of the gap in GDP last year. On the “supply” side, while we are hopeful that the worst of the COVID shutdowns are over, we are worried that shutdowns due to shortages are on the increase. We see this currently with car factories shutdown over missing computer chips, which are predicted to last at least a year. With demand up and supply uncertain, the potential for price increases, otherwise known as inflation, is high.
The recovery has also been very uneven. Oxford Economics estimates that the top two income quintiles in the U.S. own all of the $1.6 trillion of extra savings. In terms of sectors of the economy, the US Real Estate index “FTSE NAREIT” has only just returned to levels from February 2020 as of April 2021, while the NASDAQ Tech index has gained over 80% in the same period. The price of lumber has increased even more dramatically. Government bonds, one of the most stable asset classes, lost -4% for the past year ending March 31 2021, with long duration debt hit worse down -16% for the same period. Worryingly, margin debt has increased dramatically which can be sign of speculation driving the market. Low interest rates contribute to speculation, as uncertain future payments are worth more in the present than they would be under higher interest rates.
Duration movement in bonds was particularly dramatic in the first quarter driving almost all of the loss. Despite the Fed again promising lower for longer, the market has decided to disagree by betting on rates moving higher more quickly. With rates this low, we are reminded of several reports we wrote in 2012 while rates were at this level, including one with the appropriate title “Return-Free Risk.”
The Federal Reserve does have at least two separate tools to manage this. Their next step will be ending their open market purchases. When Ben Bernanke, then Federal Reserve Chair, mentioned ending these purchases in 2013 after the Financial Crisis, interest rates briefly spiked. After that, the Fed can also cool the economy (and presumably inflation) by raising interest rates. However, we must remember that they have promised not to do so for a while. Regardless of whether rate increases happen sooner or later, the change will hurt long duration bonds and equities anticipating future payouts, while shorter duration bonds and companies earning more today with slower growth will look more attractive.
Say Jamie Dimon, CEO of JPMorgan JPM /Chase Bank: “I have little doubt that with excess savings, new stimulus savings, huge deficit spending, more QE, a new potential infrastructure bill, a successful vaccine and euphoria around the end of the pandemic, the U.S. economy will likely boom. This boom could easily run into 2023 because all the spending could extend well into 2023. The permanent effect of this boom will be fully known only when we see the quality, effectiveness and sustainability of the infrastructure and other government investments.”
This leaves the question of what happens after the effect of the economic stimulus “sugar high” wears off.
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