Economy

Dear Client, There will be no US Investment Strategy next week as we take our summer vacation. We will return on Monday, September 6th. We wish everyone a happy and safe conclusion to the summer. Best regards, Doug Peta Highlights Economy – COVID-19 and the official and individual responses to it continue to exert considerable influence over economic activity: We expect that labor force participation and employment will rise as people return to the workforce, provided that resurgent infection rates don’t provide a new reason to stay on the sidelines. Markets – Financial asset valuations are elevated, but a de-rating catalyst may not emerge any time soon: Massive infusions of fiscal aid and a Fed that is determined to err on the side of being too easy should support the fundamental backdrop, even as the Delta variant runs wild in communities with low vaccination rates. Strategy – Be alert, but stay the course unless policy makers change direction or their measures lose their force: We continue to expect that risk assets will outperform Treasuries and cash. Feature Labor Day, just two weeks away, will mark the unofficial end of summer in the United States and this year the end of August will mark its own milestone: eighteen months of the pandemic. COVID-19’s year-and-a-half residency has been filled with uncertainty and misdirection, but it now seems clear that it will be staying for good. It is disheartening to concede that we will have to accommodate an unwanted malign presence, especially when we seemed to be on the verge of cornering and trapping it. The emotional letdown may have accounted for the slide in consumer confidence, but it is important to note that the virus we’ll be living with indefinitely has morphed from a peril to a nuisance. One constant amidst the pandemic confusion has been the federal shock-and-awe campaign to protect the economy from its ravages. The Fed went big immediately, cutting the fed funds rate to zero, instituting $120 billion of monthly securities purchases and unveiling a range of novel programs to ease financial stresses. Before the first month was out, Congress passed the gigantic CARES Act package, raining money down on the unemployed and households in all but the top quartile of the income distribution. It followed up with a more modest stopgap measure in late December before embarking on the largest round of economic impact payments this spring. The net effect has been to do more than enough to buffer the economy from the pandemic and push any potential hangover beyond the range of our twelve-month investment timeframe. Away from the constant of the policy efforts, however, there is much that is uncertain about key elements of the economic and market outlook. We do not have a definitive answer about what the future holds for the labor market, consumption, or equity valuations. For each topic we consider what is known, what is unknown and list the series we’ll be monitoring to assess whether our base case is on track. We remain constructive on financial markets and the economy, though we recognize that our conviction levels must be lower given the lack of close empirical comparisons to the current backdrop. We will shift with the data series if they move in ways that convincingly challenge our base-case scenarios. The Work Force Known Factor(s): The pandemic has driven a reduction in labor force participation. After catching up from the cyclical damage inflicted by the Global Financial Crisis, the share of people age 16 and above who are working or looking for work has once again fallen well off its implied demographic pace (Chart 1, top panel). GDP and S&P 500 earnings are making new highs, but labor force participation is still down by 2%, after having fallen a whopping 4.9% at the April 2020 trough (Chart 1, bottom panel). Labor force participation typically slips during recessions, but the pandemic’s peak-to-trough decline was more than five times the decline experienced during the GFC, which held the previous record. Chart 1The Pandemic Washed Away A Chunk Of The Work Force Unknown Factor(s): The explosion in unemployment while communities were sheltering in place was a foregone conclusion, and it’s easy to see how people might have slipped out of the labor force as they withdrew from jobs that lost their luster. There are more job openings than unemployed people now, though (Chart 2), and there are still 3.2 million fewer people in the labor force than there were before the pandemic. The persistence of high unemployment and low participation is a mystery that no study has fully explained. The most frequently cited hypotheses involve generous unemployment insurance (UI) benefits, difficulty securing care for children or adults, and fear of infection. Chart 2The Labor Market Is Unusually Tight We are skeptical of claims that supplemental UI benefits and the additional cushion provided by the three rounds of direct payments to households are a principal driver. $3,200 per adult ($1,200 in Round 1, $600 in Round 2 and $1,400 in Round 3) is nice but it won’t replace even $10 hourly wages for more than a couple months. UI benefits can’t be blamed for the low participation rate (you can’t collect them if you drop out), and their impact on the unemployment rate may also be less than it’s been cracked up to be. We found a very weak negative relationship between state-level replacement rates (the value of average UI benefits relative to average compensation) and changes in state unemployment rates while the most generous $600 weekly federal UI benefit supplement was in effect (Chart 3). Chart 3State Unemployment Rates Were Indifferent To Replacement Rates July’s state unemployment rates were inconclusive on the question of whether exiting the federal supplemental UI benefit program reduced unemployment. The 25 states that ended their participation early (Chart 4, top panel) saw a smaller decline in their average unemployment rate than the 26 (including Washington, DC) that remain in the program (Chart 4, bottom panel), but the early-exit states had a lower starting average unemployment rate. Of the 18 states that had statistically significant month-on-month unemployment rate declines, 8 have already exited the supplement UI benefit program and 10 remain. Of the 39 states with statistically significant employment gains, 17 have already exited the supplement UI benefit program and 22 remain. We expect the end of augmented benefits in early September will give the labor market a modest boost, but curtailing benefit supplements does not appear to be a silver bullet for reducing unemployment or increasing participation. Chart 4Much Ado About Nothing Chart 5Fewer Care Options, Fewer Workers We suspect family care burdens have been more of a drag on participation and/or exiting the unemployment rolls. Young children attending school remotely had to have adult supervision, sidelining adults who could not work remotely. Similarly, many workers who relied on outside providers to care for adult family members during the day found themselves unable to work or petrified of exposing their homebound loved ones to the virus if they did. Family care burdens regularly fall more heavily on females than males and the greater decline in aggregate female participation (Chart 5, top panel) and across the below prime-age (second panel), prime-age (third panel) and above prime-age (bottom panel) categories suggests care issues are restraining employment. Infection fears likely waned with the development of effective vaccines and their initially rapid distribution, but the spread of the Delta variant may have rekindled them, especially in areas with low vaccination rates. It will take progress in vaccinating the reluctant and the dissemination of antibodies via new infections to hasten the peak in the Delta wave, which should align with a peak in infection fears. What We’re Watching: Net nonfarm payrolls gains; labor force participation; COVID-19 infections, hospitalizations and deaths; vaccinations; schools’ ability to host in-person learning; ongoing data from states exiting the federal UI benefit; approval of vaccines for children under 12. Consumption Chart 6More Came In, Less Went Out Known Factor(s): Increased income from fiscal transfers and decreased spending from activity constraints have allowed households to amass $2.3 trillion of excess pandemic savings (Chart 6). Some of the savings went to pay down outstanding debt, with households cutting their credit card balances by 14% before slowly starting to build them back up over the last few months (Chart 7). The combination of less debt and low rates has pushed debt-service burdens to their lowest level in four decades (Chart 8). Powered by savings, financial market gains and home price appreciation, household net worth grew at its fastest five-quarter rate ever from 1Q20 through 1Q21. Chart 7Households Actively De-levered During The Pandemic Chart 8Plenty Of Room To Service New Debt Unknown Factor(s): Changes in household net worth lead changes in personal consumption expenditures by two quarters, though 2020 consumption fell way short of the level predicted by the best-fit regression line. We do not know how much of last year’s consumption was lost to the pandemic and how much was merely deferred. We also don’t know where the savings rate will stabilize going forward or how much it might overshoot to the downside before settling into its new longer-run range. Simply put, we don’t know how much households will spend from their newly accumulated stash. We do know, however, that the savings rate fell steadily from the mid-seventies, when the baby boomers began entering their prime working years, to the onset of the GFC (Chart 9). In recent client meetings we have made the conservative assumption that half of the $2.3 trillion of excess savings will be spent by the end of 2022. That would amount to a tailwind equivalent to 5% of a year’s GDP and keep the US growing at well above trend in 2021 and 2022. It remains to be seen, however, how much of their excess savings households will spend and when. Chart 9The Savings Rate Will Come Down What We’re Watching: Household income, consumption, savings rate, credit card and other consumer loan balances, borrower performance, lender willingness, spending on services and spending on goods. Asset Prices Known Factor(s): Ample and immediate monetary and fiscal accommodation put a floor under financial asset prices at the beginning of the pandemic. Thanks to the policy actions, stock prices have soared, investment grade and high yield bonds have delivered solid excess returns and home prices have surged (Table 1). The S&P 500 has risen 36% on a fundamental boost from an 18% increase in forward four-quarter earnings estimates and a valuation boost in the form of a 15% forward multiple expansion (Chart 10). Investment grade and high yield spreads have tightened to near their all-time lows (Chart 11) while trailing and forecasted defaults are low and rating upgrades are outpacing rating downgrades. Table 1Riskier Assets Are Having A Great Pandemic Chart 10Fundamentals Have Taken The Baton From Valuation Unknown Factor(s): We have argued that the next four quarters’ S&P 500 earnings estimates, which project a 1.9% decline from last quarter’s annualized run rate, will have to be revised higher to align with expected nominal annualized GDP growth near 9% in the second half of this year and 6% in the first half of next year. The future direction of forward earnings multiples is a much harder call, as it is largely a function of sentiment. It is also influenced by investors’ asset allocation options, and it does not look to us like TINA is going to be dislodged any time soon, as caution at the major developed world central banks will keep interest rates from gaining much upward momentum and a surfeit of liquidity will keep fixed income spreads tight. We argued with high conviction in a recent Special Report that housing poses no immediate threat to US financial stability because banks have no more than modest exposure to residential mortgages and the loans they have made are eminently sound. We stand by that view and further note that home prices are well supported in the near term by tight supplies and limited new construction activity. Finally, mortgage rates are extremely low and though we expect they will rise, we think they will do so at a slow, grinding pace throughout the second half and across 2022. What We’re Watching: Corporate earnings, interest rates, mortgage availability, flows into and out of risky assets, Fed guidance and anything bearing on risk appetites. Chart 11Don't Look For Further Capital Gains On Bonds Investment Implications Investors’ default position seems to be to assume that policy interventions will be exposed as artifice and elevated valuations will soon deflate. Neither has happened yet, however, and it doesn’t look like either will over the next twelve months. The Fed’s measures will have an extended influence because the fed funds rate will likely be zero until at least late 2022, monetary policy works with a lag and it will be a while before policy settings become truly restrictive. As for the fiscal transfers, they’ve largely been squirreled away as excess savings and their effect will only be felt as they’re consumed and/or funneled into financial markets. We don’t see elevated valuations retreating without a catalyst, given the ocean of liquidity in the US and the rest of the major developed economies. The money has to go somewhere as rapidly accelerating home prices around the world attest. Upward pressure on asset prices, especially for homes, has been a reliable source of instability but we don’t yet have concerns in the US, where mortgages have been extended to highly rated borrowers and the banking system has comparatively little exposure to residential loans. We are not saying multiples (or spreads) will remain elevated (tight) forever. We believe that today’s high prices will suppress long-term returns. Conditions look favorable for the next twelve months, however, and we think investors should take advantage of them before the longer-term adverse consequences emerge to weigh on returns. Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com