Recap: Since Spring, the U.S. economy has shown sustained improvement. Widespread vaccinations have joined unprecedented monetary and fiscal policy actions in providing strong support to the recovery. Indicators of economic activity and employment have continued to strengthen, and real GDP this year appears to be on track to post its fastest rate of increase in decades. Much of this rapid growth has reflected the continued bounce in activity from the very depressed levels of last year. The sectors most adversely affected by the pandemic have remained weak but have shown improvement. Household spending has risen at a rapid pace, boosted by the ongoing reopening of the economy, fiscal support, and accommodative financial conditions. The housing sector has remained strong, and business investment has increased at a solid pace. In some industries, near-term supply constraints have restrained what would otherwise be stronger activity.
Along with overall economic activity, conditions in the labor market have continued to improve, although the pace has been uneven. The unemployment rate remained elevated in June at 5.9%, and this figure has understated the shortfall in employment, particularly as participation in the labor market has not moved up from the low rates that have prevailed for most of the past year. Job gains should pick up in the coming months as vaccinations rise, easing some of the pandemic-related factors currently weighing them down. Also, the economic downturn has not fallen equally on all Americans, and those least able to shoulder the burden have been the hardest hit.
Inflation has increased notably in recent months. This reflects, in part, the very low readings from early in the pandemic falling out of the calculation, the pass-through of past increases in oil prices to consumer energy prices, the rebound in spending as the economy has continued to reopen, and the exacerbating factor of supply bottlenecks, which have limited how quickly production in some parts of the economy can respond in the near term. As these transitory supply effects abate, inflation should drop back towards the Federal Reserve’s longer-run goal of 2%.
The pandemic has continued to pose risks to the economic outlook. Progress on vaccinations has limited the spread of COVID-19 and will likely continue to reduce the effects of the public health crisis on the economy. However, the pace of vaccinations has slowed, and new strains of the virus remain a risk. Continued progress on vaccinations will support a return to more normal economic conditions.
GDP: U.S. GDP grew at a 6.5% annual rate in the second quarter, up slightly from earlier in the year, pushing the economy’s size beyond its pre-pandemic level. The growth came as business re-openings, vaccinations, and government aid powered a surge expected to gradually slow in the coming months, with Covid-19 variants and materials and labor disruptions clouding the outlook.
This surge of growth has propelled GDP beyond pre-pandemic levels, a milestone that underscores the speed of the recovery that began last summer. Although growth should remain strong, fueled by job gains, pent-up savings, and continued fiscal support, it likely peaked in the second quarter and will cool as the initial boost from re-openings and fiscal stimulus fades. Rising inflation has continued supply-chain disruptions, and a shortage of available workers have been additional factors that could restrain growth. The highly contagious Delta variant of Covid-19 will also pose an increasing risk to the economic outlook.
A slowdown in growth could bring some upsides. As demand moderates, firms will have more time to work through order backlogs and increase production. Inventory replenishment should boost output in the coming quarters.
Housing: In contrast to the headlines about soaring home prices, most other measures of housing activity have moderated since the start of the year. Sales of both new and existing homes have fallen in each of the past four months, while permits for new single-family homes appear to have topped out in January, after reaching their highest level since August 2006. Homebuilders have also reported a drop in prospective buyer traffic and applications for mortgages to finance the purchase of a home have been trending lower over the past few months. The most likely culprit behind this moderation has been the reduced affordability brought about by soaring home prices. New home construction has also been curtailed, as builders continue to grapple with sharply higher prices for lumber, appliances, and many other building inputs.
Home sales should rise modestly during the second half of this year despite rising affordability challenges due to strong underlying demand. The housing market has continued to enjoy a strong demographic tailwind, with a growing number of millennials reaching a point in their lives where they are marrying, having children, and buying homes. Higher existing home prices have also brought out more sellers, which has helped to improve the supply picture. With more homes on the market, bidding wars and price appreciation should moderate somewhat. Home prices will continue to rise solidly as the risk tilts to the upside.
Moreover, mortgage rates should remain low this year, which should help offset higher prices and reinforce strong demand from entry-level buyers. Home construction could be set for a rebound. Builders have a growing backlog of projects that are slated to move forward once supply and labor shortages ease. Lumber prices have plummeted around 70% since early May and may drop further as more sawmills reopen and boost shipments. Price appreciation for other key materials could also start easing slightly, although it may take some time to flow through to builders.
Labor market: Conditions in the labor market have continued to improve, but there is still a long way to go. Labor demand have appeared to be very strong; job openings have been at a record high, hiring has been robust, and many workers have left their current jobs to search for better ones. Indeed, employers have added 1.7 million workers from April through June. However, the unemployment rate remained elevated in June at 5.9%, and this figure would understate the shortfall in employment, particularly as participation in the labor market has not moved up from the low rates that have prevailed for most of the past year.
Inflation: A pick-up in inflation has always seemed likely as the full reopening of the U.S. economy got underway, but the magnitude of the move has been bigger-than-expected. The core PCE deflator increased 3.4% on a year-ago basis through May, marking the highest reading since April 1992.
The current degree of inflation should not persist beyond the next 12 months or so, consistent with the FOMC's “transitory” characterization, as many of the drivers of the recent acceleration in prices fade away. Generous federal aid drove household income to unprecedented levels, but as this one-time aid diminishes household income will return to more normal levels. Labor supply challenges related to enhanced unemployment benefits, childcare, and COVID concerns should keep easing. The normalization of household consumption away from goods and towards services should help ease ongoing issues in the global supply chain, as will more widespread vaccine availability outside the United States, particularly in developing economies. Headline or core inflation should not move significantly higher from current levels, and year-over-year numbers would recede significantly by mid-2022.
Federal Reserve: In many ways, policymakers at the Fed have probably been pleased with the current economic situation. Output and employment have recovered much faster than the Fed's projections throughout 2020. And although inflation has been above-target, to some extent this is a desirable outcome, given the Fed's new average inflation targeting regime was adopted in response to years of below-target inflation.
Although the labor market has made great strides, it is far from full recovery. Nonfarm payrolls should grow at an average monthly pace of 550,000 for the remainder of the year. If realized, the U.S. economy would still have about 3.5 million fewer people working in December 2021 than it did before COVID struck. Will the FOMC err on the side of caution on inflation or employment? Erring on the side of employment would be the most likely choice. The Fed would maintain its current target range for the fed funds rate between 0% and 0.25% through at least the end of 2022. The Fed would also likely continue its quantitative easing program, in which it purchases $80 billion worth of treasury securities and $40 billion worth of mortgage-backed securities every month, through the end of this year, before reducing the pace of its bond purchases from early next year.
U.S. Dollar: COVID concerns related to the Delta variant have re-emerged globally, which has created some downside risk pressure to growth and could also weigh on financial market sentiment. During this period, the U.S. dollar could benefit further from safe-haven support. The U.S. dollar's strength versus most G10 and emerging currencies could extend at least through Q3. Should the latest wave of COVID cases prove transitory, the U.S. dollar would revert to a softer path for Q4, in part as several foreign central banks shift to less accommodative monetary policy. Currencies for Norway, Canada, and New Zealand should benefit from higher commodity prices and less accommodative monetary policy while emerging currencies could also recover. For the euro and yen, where monetary policy has remained easy, medium-term gains versus the greenback will likely be modest.
Eurozone: Eurozone economic figures have generally been firm over the past month, pointing to a strong rise in GDP during the second quarter. Eurozone Q2 GDP should grow by 1.6% quarter over quarter. However, there may be some uncertainty surrounding Q3 growth as the pace of new COVID cases has picked up markedly in the Eurozone in recent weeks. The extent of the impact on growth will depend on how long the outbreak lasts and whether the Eurozone government imposes any meaningful restrictions in response. The European Central Bank has also adopted a more dovish monetary policy guidance, which could eventually lead to further easing. Against this backdrop, a further decline in the euro may be in the cards, for now, with recovery of this decline by early 2022.
Outlook: Over the first half of 2021, ongoing vaccinations have led to a reopening of the economy and strong economic growth, supported by accommodative monetary and fiscal policy. Real GDP this year has appeared to be on track to post its fastest rate of increase in decades, with a 6.0% annualized growth rate in Q3. Nonfarm payrolls grew by 850,000 in June, the fastest pace of monthly job growth since August 2020, and roughly 70% of the jobs lost in March and April 2020 have now been recovered. Even many of the hardest-hit sectors of the economy have seen demand normalize. All told, the drivers of the recovery have remained intact: new COVID cases and deaths are at the lowest levels of the pandemic, households are flush with cash from federal aid and pandemic-induced saving, employment is growing solidly, and businesses are spending robustly on new investments.
However, the rapid recovery in the demand-side of the economy has brought with it some growing pains as the supply-side has struggled to catch up. Supplier deliveries have been historically slow, inventories have been unusually low and job openings have been at record levels.
Job gains should be strong in the coming months as public health conditions continue to improve and as some of the other pandemic-related factors currently weighing them down diminish.
Inflation has increased notably and will likely remain elevated in the coming months before moderating. Inflation has been temporarily boosted by base effects, as the sharp pandemic-related price declines from last spring drop out of the 12-month calculation. In addition, strong demand in sectors where production bottlenecks or other supply constraints have limited production has led to especially rapid price increases for some goods and services, which should partially reverse as the effects of the bottlenecks unwind. Prices for services that were hard hit by the pandemic have also jumped in recent months as demand for these services has surged with the reopening of the economy. Finally, near-term strength in the U.S. dollar is expected, but eventually as a stronger economic recovery reaches the shores of other countries the dollar should soften in the medium term.
This Newsletter was produced for Atlantic Union Bank Wealth Management by Capital Market Consultants, Inc.
Sources: Department of Labor, Department of Commerce, European Central Bank, Morningstar, Bloomberg, Johns Hopkins University
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