Mid- to late March of last year the Covid 19 shutdown of the economy was well underway. The government response was every bit as unprecedented as the shut-down. Today, I’d like to take a big picture view of what happened, where we are and what happens next. Let’s dive in.
What happened?
Decisions made by the US government and businesses to close schools and business and limit travel resulted in 19.5M people being out of work at one point. That is roughly 16% of the peak non-farm payroll of 129.39 million people.
Economic output dropped by 10% from Q4 2019 to Q2 2020. However, by Q4 of 2020 the output picked back up to roughly 97% of the pre-pandemic levels. The vaccine came sooner then expected and businesses found creative solutions for keeping output up.
The Federal Reserve and US Government responded very quickly with initial fiscal policies including expanded unemployment benefits and stimulus checks. The Federal Reserve created huge amounts of liquidity to ensure capital markets would continue to function. They also drove short term interest rates down to zero. These actions were taken to help people with lost wages as well as stimulate or ‘reflate’ the economy to get back to normal as quickly as possible.
Where are we today?
Total non-farm payroll has partially recovered to 120.37M jobs. Still, we have 7% fewer people employed in the US compared to pre-pandemic levels. Economist talk about the ‘output gap’ in the economy – this is the difference between what the total economy could produce if everyone was employed vs. current levels. When there is an output gap, growth and inflation are very difficult to achieve. Some economists argue that unless wages are rising you don’t get sustained inflation. It is difficult to get a rise in wages if there are more people willing to work then the economy has employed. When you hear Jerome Powell, the head of the Federal Reserve speak, he often talks about the economy not getting back to full potential until 2022. He is speaking about the output gap.
On March 17, the Federal Reserve revised their growth forecast for the US economy taking the number up to 6.5% for 2021 vs. the 4.2% number from December. A sign that the recovery is happening more quickly than expected.
Interest rates and the US stock market have responded in kind. In Q1, concerns were rising that inflation would be generated from the huge stimulus. The 10Y government bond rate rose from the pandemic lows of .5% to 1.75%. They have since settled back to 1.6% as of today.
The S&P 500 earnings have bounced back very rapidly. The total earnings in 2019 for the S&P 500 were $139.47 per share. Earnings fell to $94.13 in 2020. However, forecasts for 2021 now stand at $158.97. This estimate from April 8th is up over 10% from the December estimates alone. In the same timeframe, stocks are up 13%. Prices are stretched in anticipation of a full recovery.
What happens next?
We are at the early stages of economic recovery. Economists are now debating how long it will take for employment to get back to pre-pandemic levels. Government transfer payments such as unemployment and stimulus checks made up 30% of personal income in late 2020. The US is now running an unsustainable deficit and the debt to GDP is over 100%. The Biden Administration is proposing a large infrastructure spending bill and large increases in corporate and income taxes to help pay for it. It will be interesting to see how this all plays out. We had a fast initial recovery, but the last 30% to get back to prior levels will take multiple quarters.
How is it possible that the S&P 500 earnings are forecasted to be greater in 2021 then 2019 when the total number of employed is lower? There are several possible explanations. First small and mid-sized businesses were affected to a greater degree then the large corporations. Second, some price inflation results in corporate revenues increasing. Third, companies tend to reduce spending and investment when times get tough. In this way, the top 500 companies can be doing fine, even if the economy has a large output gap. However, this may not be able to last in the long run as 70% of the US economy is consumer spending. So, to me, the employment picture will be a key indicator to watch going forward.
And what about investment returns, what do they look like? The Fed has cut interest rates dramatically and they have said they are willing to keep the rates low for a long period of time even if we start to see inflation. As rates fell, bonds and stock prices went up. This is based on discounted cash flows. At the same time, future returns can now be expected to be lower.
As mentioned, today’s 10Y is trading at 1.6%. Inflation is hard to predict. The trimmed mean PCE inflation is 1.6%. The CPI rate is 4.4%, but economists argue this will come back down as the increase is temporary due to depressed prices when the economy shut down. The market implied rate of inflation is 2.34% over the next ten years. I think an estimate of somewhere between 1.8 – 2.3% is a good number. Even prior to the pandemic the Fed was having difficultly getting to their 2% target. So, 10Y bonds are paying 1.6% nominal or ~ -.4% in real rate of return.
Stock market PEs are elevated compared to historical levels, based on low interest rates. The earnings yield is a key figure to took at. Take the S&P 500 estimates for 2021 of $158.97 and the closing index today (April 19) and we see the yield is $158.97 / 4163.26 = 3.8% yield. This is a forward PE of 26. High by historical standards, but arguable justified by rates at 1.6% compared to 2 – 2.5% before the pandemic. Net it out for a real earnings yield of 3.8% – 2% inflation = 1.8% real earnings yield. Historically, the premium has run closer to 3-4%.
What kind of returns can we expect from stocks? Take the dividend yield of stocks, add inflation and then add the real GDP growth. We have 1.38% dividend yield on the S&P 500. We have our estimate for inflation at 1.8 – 2.2% and we estimate real GDP growth at 1.5 – 2.5%. Total 1.38% + (1.8 – 2.2%) + (1.5 – 2.5%) = 4.68 – 6.08%.
Conclusion
The last 12 months have been a wild ride and the economic impacts and responses have been staggering. We are now halfway back to getting the economy and people back to work. We’ll be watching inflation, interest rates and total non-farm payroll as critical indictors for the economy. Although the economic recover looks promising, we have a long way to go to get back to full employment. I expect rates to remain low with moderate inflation. Still there is some chance of inflation and continued rate increases. Given elevated PEs we are biased away from growth toward value and our risk weights are neutral. Slow and steady wins the race.