Virus Third Wave

Unlike more regional virus waves during the spring and summer, the present third wave impacts the country as a whole. Past experience shows the U.S. seems to lag western Europe virus activity by 3-4 weeks. With confirmed case growth beginning to decline in Western Europe, the U.S. will hopefully experience a similar decline by the end of December (see Figure 1). Nonetheless, consumers' concern over the third wave will likely put a damper on holiday spending at bricks and mortar retailers (see Figure 2). Fourth-quarter GDP will still likely show modest but positive momentum spurred by auto and housing sales as well as inventory rebuilding.

Figure 1

COVID-19 cases per 100,000 people

Source: Chetty, Friedman, Hendren, Stepner and the Oi Team (2020)

Fiscal Supplemental Incomes Package Likely Post Inauguration

Rapidly growing pressures brought by the virus on both economic activities and health care systems will ultimately result in Congress passing a fiscal package likely over $1 trillion soon after Biden’s inauguration. With this first quarter stimulus package, investors can look to both improved second-quarter sequential growth and real and psychological boosts from broad vaccine distribution. Our past commentaries emphasized that the economic outlook post broad vaccine distribution – likely sometime in the second quarter — would depend importantly on economic momentum pre-vaccine. The second quarter will likely provide a bridge into a more favorable second half and 2022.

Important Service Industry Recovery Likely Determines Speed of Economic Upturn

The pandemic decimated the most important part of the economy—services— which normally represent over two-thirds of GDP (see Figure 2). The speed and acceptance of vaccinations will help determine how rapidly customers feel comfortable returning to dining out, tourism, entertainment, and other services. In turn, that will likely determine how fast the economy recovers in the 18 months post-vaccine.

Figure 2

Real Personal Consumption Expenditures—Services

Service Industry Recovery – Adjusting to Pandemic Disruptions

After being decimated by the pandemic, measuring the speed and degree of recovery for various consumer services will provide important milestones to overall economic recovery. At the margin, change and substitution will play a decisive role in marking that recovery. Just one example, how big a dent will streaming movies at home make into audiences returning to the movie theaters, importantly, with a very profitable bag of popcorn in their hands. Each industry post-COVID-19 faces that issue. Many will find ways to not only adjust but increase their business by offering new ways to deliver their services. Commercial real estate of various forms will likely experience important shifts in space utilization as consumer services adjust to the pandemic disruptions.

Great Financial Crisis Destroyed Household Balance Sheets

The post-COVID-19 recovery will likely differ importantly from that following the 2008 Great Financial Crisis (GFC). The slow recovery from the GFC created an unusually large gap between actual and potential GDP (see Figure 3). The housing market collapse at that time, destroying household balance sheets helped slow the recovery.

Figure 3

Great Financial Crisis — Gap Between Actual and Potential GDP

(GDP In Billions of 2012 Dollars)

Source: Center on Budget and Policy Priorities

Household Balance Sheets Show Strong Financial Condition

Today, in comparison, early lockdowns and continuing limited services led consumers either to spend on goodies or save—and save they did. Households both increased their personal savings rate and improved their balance sheets (see Figures 4 and 5). With vaccines distributed by mid-year, the resulting strong consumer balance sheets should particularly benefit a broad group of consumer service sectors that nearly disappeared early in the pandemic.

Figure 4

Personal Savings Rate

Figure 5

Households; Net Worth

COVID-19 Recession Spotlighted Unresolved Social and Economic Needs

Different from the Great Financial Crisis, a non-economic event — COVID-19 — sparked this short but deep recession. While short in length, this deep downturn exposed economic and social needs, which last decade’s very accommodative monetary policies did not solve with its focus primarily on rebuilding the financial systems. According to former N.Y. Fed president Bill Dudley, the Fed exhausted its ammo. Under the new administration, this will likely lead to a shift towards greater dependence on fiscal rather than monetary policies—a rifle rather than a shotgun approach.

The Fed Out of Ammo – Fiscal Policies Step-Up Under the New Administration

As both a Keynesian and former Fed Chair, Treasury Secretary-designate, Janet Yellen, understands the need for increased fiscal spending to offset the limits monetary policies currently face. Therefore, the Biden administration will likely look to longer-term fiscal spending programs over the coming decade to meet these specific post-COVID-19 needs. Such fiscal stimulus could include, among others, new infrastructure and green energy spending programs. These and other programs will lead to major increases in capital spending by private industry.

Investment Conclusions

Favorable consumer balance sheets plus likely new long-term fiscal spending programs and open-ended accommodative Fed policies should lead to a stronger recovery than after the great financial crisis.

Cyclical Companies – Capital Spending Recovery

This economic outlook, in our view, will continue to benefit cyclical companies—many of which also fall into the value category. While these stocks surged with the recent equity market upswing, in our view, this recovery cycle will not prove short-term. A long-term capital investment cycle should also result from a number of fiscal spending programs as well as capital spending to meet disruptive changes brought about by the pandemic. This spending should sustain a longer cyclical stock recovery with a focus on those benefitting from a more vigorous level of capital spending.

Commodities — Underinvested Production Capacity

Stimulative monetary and fiscal spending programs globally joined by the current recovery in China should lead to a rebirth of global growth later in 2021. This outlook should benefit many hard commodities as well as oil. Underinvestment in production capacity for both groups should prove key to their attractiveness. For example, while green energy likely represents the future, it would not be surprising to see what may prove to be the last hurrah for oil during this cycle. Higher oil prices will likely reflect the largest decline in energy investment on record — 20% – this year, according to The International Energy Agency. Despite the likely rise in commodity prices, inflationary pressures should remain controlled as long as wages show little pickup. The slack in the labor market should preclude any near-term wage pressures.

Fixed Income – Shorter-Duration

The cyclical recovery will also likely lead to rising interest rates in reaction to possible signs of gradually increasing inflation. Admittedly, the Fed will manage the yield curve to keep such increases moderate. Nonetheless, with that outlook, investors should stick with shorter-duration fixed income investments. This will avoid the price risk longer duration debt could face from rising interest rates.

Pandemic Disruption---Opportunity for Active Managers

The disruptive nature of the pandemic will force many business sectors and companies to reposition themselves to meet this change. The result should create opportunities for active managers to differentiate their investment selection skills both from less-skilled competitors and passive investing alternatives. It may lead to investors selectively reconsidering greater use of actively managed funds.