Quarterly Key Points
- 2Q GDP came in at -31.4% q/q annualized but the economy staged a comeback in 3Q. By many measures approximately half of the initial pandemic damage has been recovered. Current forecasts are calling for 30% q/q annualized GDP growth in 3Q followed by relatively normal growth of 4%-5% in 4Q.
- While the economic outlook continues to closely track the evolution of the virus, 3Q seemed to mark another stage in the pandemic as the battle to return to normal intensified and vaccine development took center stage. Considerable uncertainty remains regarding the public’s willingness to accept a vaccine and to resume pre-COVID-19 activity.
- The Fed continues to provide an unprecedented level of monetary support. It kept rates unchanged at its June and September meetings as expected, and published forecasts indicate that members almost universally agree that policy rates will remain near zero for at least the next several years.
- Congress has been unable to pass an additional round of stimulus to pick up where the CARES Act left off. There is growing concern that the lack of additional stimulus is beginning to weigh on the economy and markets have taken notice.
- Headline and core CPI have rebounded nicely over the past few months; however, inflation is not yet back to pre-pandemic levels y/y. Despite the Fed’s new FAIT framework, the market continues to price in subdued inflation expectations for the foreseeable future.
- Unemployment continues to march lower, dropping to 7.9% in September, and consumers have been resilient. Retail sales and many housing measures are back to or above pre-COVID levels. However, measures of business activity are mixed and there are signs that the labor recovery is starting to slow.
- COVID-19 will continue to evolve and economic measures will continue to expand at a more normal rate after accelerating considerably in 3Q; however, we are cognizant that an event of this magnitude could have a long tail with unintended consequences.
- Asset valuations continue to fully reflect easy financing conditions and Government stimulus, perhaps limiting the upside for now. Volatility could become elevated due to a highly uncertain path forward regarding virus treatment, the election, fiscal stimulus, and the economy. As a result, heightened focus on downside risk is paramount.
Third Quarter 2020 - Winter is Bringing Renewed Uncertainty
The third quarter seemed to mark another stage in the COVID-19 pandemic, with well-intentioned plans for a more “normal” level of life activity taking shape. Across the country, school systems began making tough decisions about in-school versus online, sports leagues at every level began playing in empty stadiums, businesses contemplated what a return to the office might look like, and families in search of summer vacations resurrected the road-trip, flooding state and national parks. Unfortunately, the virus had plans of its own, taking advantage of our complacency and what some health experts are calling “pandemic fatigue.” At present, 34 states have a seven-day average new infection rate that is higher than it was one month ago. With over 200,000 deaths and daily infections still running at approximately 40,000 per day in the United States, leading epidemiologists are calling for renewed diligence as we head into the winter months.
The economic outlook continues to closely track the evolution of the virus; however, as the battle to return to normal rages on, vaccine development has taken center stage. According to the New York Times vaccine tracker, there are currently 11 vaccines in Phase 3 trials. Estimates of widespread vaccine availability range from later this fall to perhaps sometime later next year. Regardless, considerable uncertainty remains regarding public willingness to accept fast-tracked vaccines and resume pre-COVID-19 activity, logistics of production and distribution, and which populations should get treated first. Until this process is complete, the cycle of relaxed restrictions leading to flare-ups that are met with renewed restrictions will likely continue.
Second quarter GDP came in at -31.4% q/q annualized, the most severe economic downturn since the Great Depression. Aided by historic monetary and fiscal stimulus, the economy staged an impressive comeback in the third quarter, with many measures recovering approximately half of the initial damage caused by the pandemic by September. Current forecasts are calling for 30% q/q annualized GDP growth in 3Q followed by relatively normal growth of 4%-5% in 4Q. Should these forecasts materialize, 2020 GDP would be down approximately 4% for the year. Although much better than earlier forecasts of -8% GDP growth, current forecasts come with a number of caveats. Growing concerns of additional outbreaks coupled with the pending influenza season, fall school starts, the efficacy of fast-tracked vaccines, fiscal stimulus gridlock, and what will likely be a heavily contested presidential election all add to the uncertainty heading into year-end.
Government and Central Bank Update
Congress has been unable to pass an additional round of stimulus to pick up where the $2+ trillion CARES Act left off. The Democrat led House has brought forth the HEROS Act, which initially targeted an additional $3 trillion in spending, while the Republican led Senate has countered with the HEALS Act, which is sized to $1 trillion. Subsequent negotiations have led to revised terms but, thus far, the fiscal gridlock has not been broken. Despite repeated calls for additional fiscal stimulus from the president and the Federal Reserve, a resolution seems increasingly unlikely until after the November election. Meanwhile, several emergency programs have expired, most notably the Paycheck Protection Program (applications closed on August 8th) and the expanded unemployment benefits (expired on July 31st). There is growing concern that the lack of additional stimulus is beginning to weigh on the economy and markets have taken notice. After reaching an all-time high on September 2nd, the S&P 500 fell approximately 6% by the end of the month. Additionally, Investment Grade Corporate excess returns were -0.40% in September, signaling a similar shift in credit markets. Although not entirely attributable to fiscal stimulus, changing market sentiment in September suggests investors are wary of a number of uncertainties.
The Federal Reserve continues to provide an unprecedented level of monetary support. Since cutting the policy rate to zero and enacting unlimited QE in March, the Fed has purchased roughly $2.0 trillion in Treasury securities and $1.1 trillion in Agency MBS (gross of paydowns). Recall that it also initiated a number of credit facilities, including the Primary Market Corporate Credit Facility (PMCCF), the Secondary Market Corporate Credit Facility (SMCCF), the Term Asset Backed Loan Facility (TALF), and the Money Market Mutual Fund Liquidity Facility (MMLF), all of which are designed to ease system-wide liquidity stress and facilitate functioning capital markets. In contrast to the unlimited QE program, these additional credit facilities have largely gone unused. Importantly they remain in place and will continue to provide a backstop if needed. As expected, the Fed kept rates unchanged at its June and September meetings, while published forecasts indicate that members almost universally agree that policy rates will remain near zero for at least the next several years. Indeed, in his Congressional testimony in September, Chairman Jerome Powell reiterated that the central bank will continue to provide support “for as long as it takes, to ensure the recovery will be as strong as possible, and to limit lasting damage to the economy.”
At its Jackson Hole Economic Symposium held in late August, the Fed announced a change to a Flexible Average Inflation Targeting (FAIT) policy framework. Importantly, this change was not in response to the pandemic, but rather it is the result of an ongoing formal policy review that started in 2019 about how best to implement inflation targeting. Under the old model, the Fed treated inflation target undershoots as bygones that would not ever get recovered. This is different than having an “average” inflation policy that targets an average inflation rate over a period of time. A hard inflation target suggests a prompt monetary policy response when met, whereas an average inflation target implies a response that allows inflation to overshoot the stated target in order to make up for previous periods of below target inflation (thus bringing up the average).
On the surface, the difference is subtle, but the implications for monetary policy could be significant. Switching to an average inflation target would allow the Fed to more patiently keep interest rates lower for longer, allowing inflation to run a little hot for a period of time in order to meet a desired average rate. This flexibility is particularly important with monetary policy rates at the effective lower bound (zero). Central banks target inflation in order to fulfill their mandate of price stability, but why is 2% the generally accepted target? Persistently low inflation provides limited policy cushion to cut rates in the event of an economic downturn leading to periods of deflation. On the other hand, persistently high inflation erodes the purchasing power of money eventually leading to unbalanced saving and consumption decisions.
When interest rates and inflation are sufficiently high, the Fed has ample cushion to lower the Fed Funds rate in order to spur on economic growth; however, over the last 30 years, central banks have exhausted conventional policy tools resulting in an extended period of time at the effective lower bound. Over the last 10 years in particular, interest rates in the United States have been stuck at historically low levels, coinciding with core PCE, the Fed’s preferred measure of inflation, consistently running below target. Importantly, consistently missing inflation targets leads to the expectation of missing inflation targets. In a self-fulfilling prophecy of sorts, low inflation begets low inflation expectations leading to continued low inflation. As explained in a recent San Francisco Fed article1, perceived central bank inability to combat economic downturn related deflation as a result of being at the effective lower bound eventually leads to inflation expectations below target. That being the case, managing inflation expectations is at the core of the Fed’s new framework. In order to create some policy breathing room and eventually retreat from the zero bound, the Fed needs to engineer higher inflation and higher inflation expectations. The new regime gives it flexibility to allow inflation to overshoot its 2% target so that “average” inflation will be around 2% over some period of time. Although the time period over which the average needs to be met remains in question, the idea that inflation will be allowed to drift above target should result in higher inflation expectations, thereby allowing the Fed to eventually increase policy rates to a higher level than it otherwise would.
Interest Rates and Inflation
Interest rates were practically unchanged between June and September, with 10-year and 30-year Treasury rates ending the quarter at 0.68% and 1.45% respectively. With the aforementioned Fed policies in place, the short-end of the curve is anchored at about 0.15% out to 3 years. After reading negative for most of 2Q, headline and core CPI have rebounded nicely with both measures coming in at 0.6% m/m in July followed by 0.4% m/m in August. However, at 1.3% and 1.7% y/y respectively, headline and core CPI are not yet back to pre-pandemic levels. Meanwhile, the Fed’s preferred measure of inflation, the Core PCE Index, also rebounded to 1.6% y/y in August, still well below target. Despite Fed comments and its framework revision, the market continues to price in subdued inflation expectations for the foreseeable future with 5-year and 10-year breakeven inflation rates ending the quarter at 1.49% and 1.63% respectively.
Uneven Recovery - Resilient Consumers, Lagging Business Activity
Since hitting a pandemic low point in April, the labor market has consistently outperformed expectations across a variety of measures, recovering approximately half of the initial damage done by COVID-19. The job reports for July, August, and September saw creation of 1.76 million, 1.49 million, and 661,000 jobs respectively, enough to drive the unemployment rate down to 7.9% by the end of the quarter. Although the turnaround in labor markets has been substantial, there are signs that employment gains could be slowing and still other measures indicating labor markets are far from healthy. For example, 12 million people continue to file unemployment claims and initial claims remain stuck in the 800,000-900,000 per week range. Perhaps more troubling, permanent job losses, a subcomponent of unemployment tracked by the Bureau of Labor Statistics, has shot up to almost 4 million at a pace that rivals that of the Financial Crisis.
Consumer spending has proven resilient, as evidenced by a strong series of increases since cratering in April. For example, personal consumption expenditures increased by 5.9% m/m, 1.1% m/m, and 0.7% m/m in June, July, and August respectively. As we highlighted last quarter, monthly changes during volatile periods can sometimes be hard to judge. Personal consumption is an excellent example of this. Measured year-over-year, the same PCE index is still 3.2% lower than a year ago. Furthermore, a graph of the absolute PCE index level highlights a nice “V” shaped recovery that has not yet reached pre-pandemic levels. Meanwhile, retail sales have fully rebounded beyond pre-COVID levels after a series of strong month-over-month increases since May to end up 2.6% higher y/y in August. Again, a graph of the Adjusted Retail Sales Index level illustrates the “V” shaped recovery in retail sales. Measures of consumer confidence, on the other hand, have not recovered fully. For example, after falling all the way to 71.8 in April, the University of Michigan Consumer Sentiment Index has rebounded to only 80.4, well below February’s mark of 101.0. While consumer confidence never sank to the depths of the Financial Crisis, clearly consumers are not feeling as good about things as before COVID-19. In our view, the combination of prolonged unemployment and below trend consumer confidence signal the need for additional Government stimulus as continued support for consumer spending.
Despite troubling unemployment, the housing market continues to be a bright spot in the economy. Measures of annualized unit sales for existing homes and new homes are the highest since before the Financial Crisis, reflecting substantial pent up demand following a complete shutdown of the housing market last spring. Anecdotally, there is also a pandemic driven flight away from urban population centers into the suburbs and beyond, as the work-from-home environment removes the shackles of commuting.
Currently measured at approximately three months’ worth of sales, new home supply and existing home supply are both at historically low levels, providing a strong technical backdrop for accelerating demand. Reflecting all of these forces, the S&P CoreLogic Case-Shiller Home Price Index was 3.95% higher y/y in July. Offsetting housing market exuberance, considerable uncertainty remains regarding prolonged high unemployment and the expiration of the mortgage forbearance programs, both of which could eventually drive elevated mortgage defaults.
After hovering near an all-time low for the last several months, primary 30-year mortgage rates ended the quarter at 2.88%. At 2.20% over the historically low 10-year Treasury yield, this still seems relatively high. Mortgage origination capacity remains constrained as a result of substantial home purchase activity in addition to massive refinancing volume. Over time, these constraints should relax, leading to continued contraction in the primary-secondary mortgage spread. In other news, the FHFA announced a 0.50% “Adverse Market Refinance Fee” applicable to some refinance mortgages for the stated purpose of covering projected losses due to COVID-19. The additional fee, originally slated to start on September 1st but subsequently moved back to December 1st, will effectively raise the mortgage rate for refinance mortgages.
In contrast to consumer spending and housing, business activity has not recovered completely from the damaging effects of the pandemic. To be sure, the ISM Manufacturing Index and the ISM Report on New Business Orders Index have remained in expansionary territory since rebounding in June, coming in at 55.4 and 60.2 respectively in September. A very positive story, indeed, but as we explained last quarter, these are “diffusion” indices that do not indicate the magnitude of change but rather are indicative of direction (trend). Inventory measures, like the Adjusted Retail Inventories Index suggest businesses have not been able to keep pace with retail sales, possibly because of supply issues. Meanwhile, the Federal Reserve’s most recent report on industrial production and capacity utilization published in September suggests that while businesses are slowly gaining traction, they continue to operate at well below pre-pandemic capacity. According to the report, industrial production has rebounded to 101.4% of base year 2012 but remains 7.7% lower y/y, while capacity utilization, at 71.4%, is 8.2% lower y/y and 8.4% below the long-run average. On a positive note, one could argue that this provides a solid runway back to trend; however, we believe business activity, along with labor, is far from being out of the woods.
In summary, we are optimistic that the economy will continue to recover and make progress into the end of the year. COVID-19 will evolve, with ebbing and flowing infection rates being combated with regional and local restrictions that move in tandem. Vaccine approval will continue to grab headlines, but the court of public opinion will ultimately decide any vaccine’s success. Economic measures, including GDP, will continue to expand at more normal rates after accelerating considerably in 3Q; however, we are cognizant that an event of this magnitude could have a long tail with unintended consequences. Unemployment trends will be a key variable to watch, and we are concerned that labor market gains could slow. The Fed will remain committed to providing easy financial conditions over an extended period of time and the Government will need to provide additional rounds of stimulus to keep consumers and businesses afloat. Asset valuations continue to fully reflect easy financing conditions and Government support, perhaps limiting the upside for now. Volatility could become elevated due to a highly uncertain path forward regarding virus treatment, the election, fiscal stimulus, and the economy. As a result, heightened focus on downside risk is paramount.
1. Source: Bloomberg
The information contained herein reflects the views of Galliard Capital Management, Inc. and sources believed to be reliable by Galliard as of the date of publication. No representation or warranty is made concerning the accuracy of any data and there is no guarantee that any projection, opinion, or forecast herein will be realized. The views expressed may change at any time subsequent to the date of publication. This publication is for information purposes only; it is not investment advice or a recommendation for a particular security strategy or investment product. Graphs and tables are for illustrative purposes only. FOR INSTITUTIONAL INVESTOR USE ONLY. © Copyright Galliard Capital Management, Inc. 2020 All rights reserved. ECON040720