The plunge the U.S. economy took during the pandemic in spring 2020 was precipitous, with economic charts that resembled steep cliffs.
In April 2020, industrial output fell 12.7%, the worst drop seen in a century of record-keeping. Entire industries shut down virtually overnight. In two months (March and April), employers cut 22 million jobs, more than in every recession in the last 50 years combined.
A year later, in May 2021, recovery appeared to be in full swing; restaurants opened again, and airports filled up. The United States regained two-thirds of the jobs lost in spring 2020.
But amid the euphoria, the closely watched monthly jobs report from the U.S. government showed that hiring in April 2021 fell sharply from March 2021 and reached only a quarter of what economists had expected.
It was a stark reminder: The pandemic is not over. A robust recovery is not guaranteed. The U.S. economy still faces a long climb back to health—and the most vulnerable workers will, inevitably, be the last to benefit.
Signs of Health
Still, judged against the comeback from the Great Recession of 2008, this recovery already looks like an improvement.
In the first quarter of 2021, U.S. Gross Domestic Product (GDP) grew by 6.4% on an annualized basis. This growth reflected the continued economic recovery, businesses reopening, and the impact of policies such as direct payments to consumers, expanded unemployment benefits, and loans under made under the Paycheck Protection Program.
Household income also rose, as did consumer confidence. In March, Americans’ personal income rose at a record pace of 21.1%, the largest monthly increase since record-keeping began in 1959. In April, the Conference Board Consumer Confidence Index rose sharply to 121.7 from 109.0 in March.
The consensus is that GDP will return to its pre-pandemic level sometime in the second quarter; possibly, it already has. The unemployment rate is on a pace to get to pre-pandemic numbers sometime next year. The debate among analysts is not over the risks of a weak recovery but over the possibility of runaway inflation, a problem usually associated with an economy that is running too hot, not one that is trying to get back on its feet after a crippling recession.
Fed Moves
Like other major central banks around the world, the Federal Reserve has loosed an immense amount of liquidity on the U.S. economy since the pandemic started. Now that interest rates have reached zero, quantitative easing has taken center stage as the main avenue of stimulus. Since April 2020, the Fed has increased its securities portfolio by almost $3 trillion; it now owns 17% of outstanding U.S. Treasury debt. The Fed continues to purchase $120 billion of new bonds every month and shows little inclination to taper this amount.
Paying for the new securities has resulted in outsized increases in the money supply cascading across the financial system. Some has been spent and some has been invested, putting upward pressure on the prices of goods and assets. Inflation readings have been pushed higher by base effects and bottlenecks created by the pandemic. In developed markets, demand is resurgent as economies reopen and pent-up demand combines with pent-up saving.
In some cases, supply is struggling to respond, leading to pressure on costs; in some cases, producers can pass those costs along to consumers.
The Fed views these stresses as temporary. Eventually, it reasons, kinks in supply chains will straighten. For services, labor supply should recover over the coming months as the impacts of the pandemic wane, schools reopen, and unemployment benefits increases are sunset.
At Bowen Asset Management, we generally agree with this view; however, we also believe some fits and starts may occur along the way.
Secular controls such as technology and e-commerce should continue to contain inflation over the longer term.
What’s Next?
But what if we (and the Fed) are wrong? In that case, monetary policy will have to be tightened sooner and more aggressively than currently planned. Unless the transition is carefully communicated and executed, markets could become unsettled.
Risks of rising prices are intensifying across the economy as a growing number of companies warn that supply shortages and logjams will compel them to raise prices. In fact, tight inventories have seen prices surge for raw materials ranging from semiconductors and steel to lumber and cotton. Manufacturers are scrambling to replenish stockpiles to keep up with accelerating demand as eager shoppers take out their stimulus-filled wallets following a broad vaccine rollout.
As commodities and materials become more expensive, the bigger question at the table is whether faster inflation sticks around.
Putting it in perspective: a sheet of three-quarter-inch plywood at Home Depot is now selling for around $60 (depending on the location), up from about $30 before the pandemic. That is an increase of 100%. Investors and policymakers alike are hoping that such price hikes prove transitory, though it is still too early to predict.
Longer lead times and orders booked far in advance could result in a robust demand floor encouraging companies to invest in ramping up production and capacity. Increased production would be great for economies coming out of the pandemic—but the opposite could also happen, in which volatility and uncertainty destroy demand as prices become too high for consumers. This phenomenon, called the “bullwhip effect,” could end up damaging the economy in the short-term, with violent swings in a range of goods.
Jobs, Jobs, Jobs
Job growth appears to be moving in the right direction. Led by gains in the leisure and hospitality sectors, payrolls rose by 559,000 in May, and the unemployment rate declined by 0.3 percentage point to 5.8 percent, the U.S. Bureau of Labor Statistics reported on June 4. Notable job gains also occurred in in public and private education as well as in health care and social assistance.
But opportunities are recovering slowly, leaving over nine million Americans not participating in the labor force. As a result, jobs on the bottom end of the wage spectrum are becoming hard to fill. Also, the nature of many jobs has changed. Employers increased investments in automation, and once a job is automated, it rarely comes back.
Labor force shifts in the pandemic are also preventing some hiring. Sectors such as restaurants and tourist attractions had the most severe layoffs last year and looked likely to face a long impairment. Employees in these sectors viewed the pandemic as a chance to move into jobs that were in greater demand and those migrated employees will remain in new positions.
The pandemic slowed immigration, which continues to weigh on recruitment, especially for seasonal and temporary work. Shutdowns also prompted many people to retire. The virus put older workers at greater risk, and now that an end of the pandemic is in sight, some may feel life is too short to go back to work.
Other workers remain sidelined for personal reasons. Many may remain hesitant to expose themselves to another virus outbreak by interacting with the public. Those with children may find lack of childcare to be a barrier to finding work outside the home—and sometimes to productively working from home.
Many of these factors will be temporary. As progress against the virus continues, fewer workers will stay away out of fear of infection. School closures should be a rarity by the start of the next school year, which coincides with the expiration of supplemental jobless benefits in early September.
However, no policy solution exists for workers who have retrained, retired, or passed away, leaving jobs unfilled.
Employers are putting more effort into recruitment, and it appears offering higher wages does compel more applicants to come forward. But the high number of workers on special unemployment programs highlights the issue that wages in a wide variety of sectors and professions are extremely low.
For many small business owners, the ability to raise wages is limited. But they will have to. Those who can increase starting salaries or wages are making the point that a higher minimum wage is affordable. Many employers have already put the minimum wage in the rearview mirror.
While hiring lots of workers, businesses managed to find a way to make them a lot more productive. Productivity surged in the first quarter at the second fastest rate seen in eleven years. The only faster increase came in the second quarter of 2020, when the economy started opening up after the spring lockdown.
A year ago, hiring was muted. Now, payrolls are booming, but so is productivity. Businesses are getting a lot more out of their new workers—as they need to, since (as noted) compensation is also surging. This increased productivity has kept labor costs under control.
Hiring should remain strong through the summer, but do not look for productivity to keep pace; firms may see their labor costs rise, further pressuring prices.
More Money, More Spending
Why is the economy booming? Just look at recent reports on income and spending. The big news was the massive rise in income that resulted from the stimulus plans. To put the importance of the government funds into perspective, the money coming from government transfer payments was nearly forty times as large as the additions to income from wages and salaries, even given the accelerated reopening of the economy.
American households are, on average, in the best financial shape in decades. Debt levels, excluding home mortgages, are lower than before the pandemic. Delinquencies and defaults are down, too. Americans, in aggregate, are sitting on a mountain of cash: $6 trillion in savings as of March, more than four times as much as before the pandemic.
With cash to burn, households went on a shopping spree in the first quarter of 2021. But they still had a lot of money left over, and the savings rate rose to the second highest on record. Many households should have sufficient funds to carry themselves through most of the rest of 2021.
However, as noted, inflation is also rising. Prices rose sharply in March, even excluding the more volatile food and energy components. The increase since March 2020 is now over the Fed’s average 2% target.
Conclusion
For investors, the reality is that the government has been feeding the economic beast, but now the political battles over spending are returning to familiar partisan diatribes.
How the political games play with the public and affect the pending infrastructure and family spending bills will determine the pace of growth for the next few years. And that should shape earnings growth and equity prices, maybe not this year, but in the following couple of years.
This euphoria has made riskier stocks very expensive. In contrast, higher quality, lower risk stocks—those with better profitability, cash flows, and balance sheets—remain quite cheap. Equity markets can quickly shift focus and reprice risk. In fact, that repricing may have already begun, as higher quality stocks outperformed in March and April.
We suspect that investors are starting to appreciate how high-quality stocks potentially limit losses during volatility shocks and have historically performed well amid inflation. We think that higher quality is well positioned if rosy economic expectations do not fully materialize.
However, we remain sanguine about equity markets overall. We feel some parts of the market are priced to perfection. But many potential sources of volatility still loom large. We suggest insulating equity portfolios from potentially violent repricing through a higher quality posture.
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