Fed’s Diminishing Tools — the Washington Political Class Provides No New Assistance

Over the last decade, despite using a broad mix of monetary tools, the Fed failed to reach its 2% PCE inflation target (see Figure 1). The Wall Street Journal recently quoted Bill Dudley, former president of the New York Fed, who said “they’ve reached the area of very rapidly diminishing returns” for the power of their tools. To meet its new 2% flexible average inflation targeting, therefore, the Fed will need greater help from new fiscal spending programs to restart the economy. The recent strong August jobs report reduces the probability that Congress will pass such a meaningful — $1 trillion-plus — fiscal spending program to support the Fed’s efforts before the elections. That being the case, most of the inflationary response to stimulative Fed policies will, once again, primarily show up in the equity markets.

Figure 1

Personal Consumption Expenditures Excluding Food and Energy (Price Index)

Decade Long Fiscal Policy Drag Reversed in the Second Quarter

For most of the last decade, fiscal policy acted as a drag on economic growth according to the Hutchins Center’s fiscal impact measure (see Figure 2). In a reversal, the same impact measure shows the recent fiscal income replacement packages (CARES) contributed importantly to reducing the dramatic second-quarter economic decline. According to the Brookings Institution’s Hutchins Center, that fiscal stimulus boosted GDP growth by nearly 15%. Despite that positive contribution, real second-quarter GDP still declined by nearly 32% annualized. The importance of those CARES supplemental unemployment payments shows up when comparing total unemployment payments before and then after July, when they ended (see Figure 3).

Figure 2

Hutchins Center Fiscal Impact Measure

Components of Fiscal Policy Contribution to Real GDP Growth

Figure 3

Weekly Unemployment Payments Fell by $600 In August

Failure to Enact Further Incremental Fiscal Spending Could Slow the Recovery — That Outcome Should Then Lead to a New Fiscal Stimulus Package

Without Congress providing additional fiscal stimulus, economic contributions from CARES and other programs rapidly decline and will likely reduce the rate of fourth-quarter economic growth. That erosion, according to Hutchins Center estimates, will likely continue into 2021 with second-quarter GDP growth reduced by an estimated six percent below its potential. In our view, such a possibility will lead the political class to face up to the economic difficulties experienced by a substantial number of Americans and pass additional fiscal spending support by sometime in the fourth quarter.

Traditional Early Recovery Industries — Housing and Autos — Key to Sustaining Economic Recovery Absent Incremental Fiscal Stimulus

Lacking additional fiscal stimulus, the economy, more than ever, will depend on traditional early-stage industries such as housing and autos to lead and sustain the economic recovery. For example, housing contributed 18% of GDP growth post each prior recession since 1970 — except 2008 (see Figure 4). Since April, record low mortgage rates spiked the sales of new one-family housing (see Figure 5) as well as existing home sales. If history repeats, such housing rebounds signal the support needed for the initial stages of this economic recovery.

Figure 4

RFI Housing Share of GDP Growth Out of a Recession

Source: Harvard Joint Center for Housing Studies, Note: RFI-Residential Fixed Income Spending on Housing Construction

Figure 5

Housing Starts—July and NAHB Housing Index-August

Source: Federal Reserve Bank St. Louis, NAHB, Goldman Sachs Research

Similar to housing, auto sales so far responded positively to the Fed’s low interest rate policies (see Figure 6). The strength of used car prices provides important support to the current new car sales momentum. Similar to housing, improving auto sales may also signal the first early signs of an economic recovery.

Figure 6

U.S. Auto Sales (SAAR, MM)

Other Cyclical Sectors Also Showing Signs of Strength

Manufacturing

Positive signs in other sectors also suggest the early stages of a cyclical recovery. For example, retailers worked down their inventories faster than expected. Best Buy reported that growth suffered from a lack of inventory. Growing new manufacturing orders likely shows a response to those inventory needs (see Figure 7).

Figure 7

Manufacturers New Orders: Nondefense Capital Goods Excluding Aircraft

Freight Volumes

Freight volumes also show new life. The Port of Los Angeles, the largest U.S. container port, saw a record level of container inflows in August. Currently, conservative expectations from the port call for a similar level this month. A recent article in The Wall Street Journal reported truckers see retailers and manufacturers restocking depleted inventories. The average spot market price for hiring large trucking rigs in august increased by over 22% YoY. The CASS freight index through July 20 shows the beginnings of overall improvements for freight shipments (see Figure 8).

Figure 8

Cass Freight Index-Shipments

Investment Conclusions

With the traditional early recovery cyclical industries showing life, investors face a key question as to whether the potential lack of further fiscal stimulus will put a damper on these early recovery signals. A possible new fiscal program likely after the election — if not sooner — may fill that gap. In addition, hoped for vaccines seem just over the horizon in the first half of 2021. Those vaccines may stimulate any lag in the cyclical recovery from the absence of fiscal response. With the increasing probability of this outcome, cyclical stocks will likely show further strength.

The potential initial cyclical recovery will likely gain strength in the second half of 2021 with the hoped-for broad-based distribution of vaccines. Interest rates will likely rise in reaction to that next step of recovery as well as possible signs of gradually rising inflation. With that possibility, fixed income investors could see some steepening in the yield curve as the Fed keeps short rates locked at near zero. Such higher long-term rates could lead to cooling off of major technology stock valuations. At the same time, that change could lead investors to further shift into cyclical stocks for some limited period of time. Longer-term, financially strong quality stocks with sustained growth outlooks make sense as slower rates of growth, past the first stages of economic recovery, seems probable.

As if investors need more uncertainty, the approaching November presidential election will likely bring greater equity market volatility, particularly if the outcome remains in doubt for some time. In our view, more important than who wins, initially, will be a decisive early decision as to the winner. In the last contested presidential election — 2000 — then Vice-President Gore did not concede to George W. Bush until December 13, 2000.