- Unprecedented shutdowns from the COVID-19 pandemic produced the steepest decline in economic activity in the post-war era in the first half of 2020. Fortunately, a vigorous policy response generated a swift recovery in the second half, and investors believe vaccines will allow a return to normalcy by midyear.
- What stands out is the U.S. economy has been remarkably resilient. The recent spike in COVID-19 cases and hospitalizations has resulted in targeted shutdowns of businesses, but passage of a $920 billion relief package should provide a bridge until vaccines become more widespread.
- With Democrats now in control of both houses of Congress, President-elect Biden’s plan for increased government spending financed by tax hikes will be debated. However, the narrow Democrat margins cloud what type of fiscal package will be legislated. Amid this, the Fed has been clear it will keep short-term interest rates near zero even if inflation increases.
- A return to normalcy suggests somewhat higher bond yields this year and the stock market is poised to post further gains, albeit more muted than in the past two years. A diversified investment strategy is appropriate if there is a rotation away from leading tech stocks.
2020 Recap: A Year Like No Other
The past year will go down as one of the most devastating with the coronavirus pandemic producing the worst public health disaster in 100 years: The death toll at the end of the year stood at more than 340,000 Americans.
The impact on the U.S. economy mainly stemmed from unprecedented shutdowns of businesses in March-April. They resulted in a steep decline of GDP of nearly 10% (not annualized) and a surge in the unemployment rate to 14.7% in April. Faced with this predicament, Republicans and Democrats coalesced to produce a fiscal package that exceeded what was enacted during the 2008 financial crisis. For its part, the Federal Reserve expanded its arsenal of tools to bolster financial markets. Once the shutdowns were lifted the economy experienced a quick recovery, and the unemployment rate fell to 6.7% by year’s end.
These developments contributed to a robust stock market rally following a steep decline from mid-February to late March (Figure 1). By year’s end, the S&P 500 Index and the Nasdaq Index posted returns of 18% and 49%, respectively, during 2020. Bond market performance was also above average due to declines in interest rates, with Treasuries and investment grade corporates generating returns of 8.0% and 9.4%, respectively.
| STOCK MARKET | Sell-off Phase (feb 18 - mar 23) |
recovery phase (mar 23 - dec 31) |
full year |
|---|---|---|---|
| U.S. (S&P 500) | -33.5 | 70.2 | 18.4 |
| Russell 2000 | -40.3 | 99.0 | 19.9 |
| NASDAQ | -29.4 | 89.1 | 45.1 |
| International (EAFE $) | -32.5 | 62.2 | 8.4 |
| Emerging Markets (MSCI $) | -30.6 | 73.7 | 18.5 |
| U.S. Bond Market | SELL-OFF PHASE (FEB 18 - MAR 23) |
RECOVERY PHASE (MAR 23 - DEC 31) |
full year |
|---|---|---|---|
| Treasuries | 5.3 | 0.2 | 8.0 |
| IG Credit | -11.2 | 19.9 | 9.4 |
| High Yield | -20.7 | 33.5 | 7.1 |
The Economic Landscape Entering 2021
Heading into 2021, many forecasters are optimistic about the outlook for the economy and markets. The principal reason is that vaccines are now being deployed to bring COVID-19 under control that could unleash pent-up demand. Most forecasts call for real GDP growth in 2021 to be between 4%-5% while some see even stronger growth.
The next few months are more uncertain due to a surge in cases, hospitalizations and deaths that have resulted in targeted shutdowns of businesses in parts of the country. Prior to the latest outbreak, the overall economy was operating near levels before the pandemic struck (Figure 2 below). During the third quarter, for example, real GDP was down only 2.7% from levels in the fourth quarter of 2019, and 21 of the 22 industries that are classified posted large gains.
Still, several sectors – transportation, arts, entertainment and recreation, and accommodations and food services – currently are operating at levels well below those before the pandemic hit. Collectively, they account for 7.5% of GDP, and leisure and hospitality alone represent 35% of job losses.
Amid this, it is not clear how much pent-up demand there is, as sectors such as housing and autos that typically lead recoveries already are back to pre-pandemic levels. And while industries such as travel and leisure are depressed, they will take longer to recover.
Overall, the economy appears to be weathering the latest COVID-19 resurgence, although jobs creation and consumer spending have stalled in the past two months. Until recently, the main concern was conditions could worsen for 14 million jobless workers if the Pandemic Unemployment Assistance (PUA) and the Pandemic Emergency Unemployment Compensation (PEUC) were not extended. Passage of a $920 billion relief bill, however, should buttress the economy, and it is estimated to boost overall GDP growth by 2%-3%. Consumer spending is also supported by unspent income transfers households received from the CARES Act.
Figure 2: U.S. GDP by Industry (trillions of dollars)
| fourth quarter 2019 ($) | third quarter 2020 ($) | percent change | |
|---|---|---|---|
| GDP | 21.75 | 21.17 | -2.7 |
| Private Industries | 19.08 | 18.52 | -3.0 |
|
3.76 | 3.58 | -4.8 |
|
15.32 | 14.94 | -2.5 |
| Hardest Hit | 1.63 | 1.27 | -22.1 |
|
.71 | .58 | -18.4 |
|
.24 | .14 | -41.7 |
|
.68 | .55 | -14.1 |
Priorities of the Biden Administration
Biden’s main objective is to counter growing income inequality in America and a hollowing out of the middle class. His fiscal plan, if enacted, would boost federal spending to 24% of GDP by 2030 from 21% in 2019. To help finance it, Biden would roll back the Tax Cut and Jobs Act (TCJA), the signature legislation of the Trump presidency. Key elements are the corporate tax rate would be increased to 28% from 21%. On the personal side, households with adjusted gross income (AGI) of $400,000 or more would see the top marginal tax rate on capital gains and dividends be nearly doubled from 24% to 43%.
In the wake of the Georgia run-off elections, Democrats are now in control of both houses of Congress by narrow margins. President-elect Biden has made clear that the priority in the first 100 days will be to bolster the economy by providing added support by raising income transfers to individuals from $600 to $2,000 and by seeking funding for state and local governments. Beyond this, Democrats reportedly are laying the groundwork for an infrastructure bill early next year.
Plans to boost personal and corporate taxes may be delayed or pared back, however, for two reasons. First, they run counter to the Biden administration’s efforts to bolster the economy. Second, they are likely to encounter strong resistance not only from Republicans but also from moderate Democrats.
The Fed to Stay Accommodative
The new goal is to achieve an average inflation target of 2%. This means the Fed will allow inflation to overshoot 2% temporarily if it was below that level previously. Employment will now be viewed in a broader context that will focus on maximizing employment as long as inflation risks are not evident. This means the Fed will no longer preemptively raise interest rates as the unemployment rate reaches low levels. Instead, it will wait until price pressures emerge.
The Fed’s main challenge is to demonstrate it can achieve its inflation target after years of undershooting 2%, without stoking fears that it will lose control of the process. Thus far, there has been only a modest change in inflation or inflation expectations. The most visible impact has been on the U.S. dollar, which has fallen by 10% on a trade-weighted basis over the past six months.
Some observers see potential for higher inflation on grounds that the U.S. money supply (M2) increased by more than 20% in the second quarter. Much of this increase, however, stems from businesses drawing on existing lines of credit when the pandemic hit and from households saving a large portion of the transfer payments they received. The prospects for a resurgence of inflation are greater over the long term when the economy has fully recovered from the pandemic.
Meanwhile, federal debt outstanding has increased by $8 billion over the past four years to $28 billion, while the Federal Reserve has financed about 40% of the increase. And further large increases in federal debt and the Fed’s balance sheet are in train this year.
Portfolio Positioning: Balancing Risks and Rewards
Regarding the equity market, most forecasts call for continued above-average returns as economic growth boosts corporate profits back to pre-pandemic levels or higher. However, a lot of good news has been priced into the stock market: The S&P 500 Index, for example, has increased by nearly 50% over the past two years while profits were flat-to-down.
That said, we do not consider the stock market to be in bubble territory: Valuations as measured by one-year forward earnings are above average but not extreme, and the stock market continues to be attractive relative to bonds.
Finally, one issue to consider is overall equity returns in 2020 mask a substantial divergence of performance by sectors. For example, on-line retail and technology stocks increased by 69% and 44%, respectively, while energy and hotel stocks declined by more than 30% each. One possibility, therefore, is that as the economy normalizes there could be a rotation away from tech stocks to other sectors. If so, this suggests the need for a more diversified approach to investing in the coming year.
