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Recap: Concerns around the spread of COVID-19 took center stage once again in November as infections surged to new records.  Optimism over vaccine progress and broadly positive economic data generally played second fiddle.  

The economic recovery has continued but lost steam after rebounding strongly in the third quarter from the pandemic-induced downturn.  On the economic data front, retail sales improved by 0.3% in October, extending their winning streak to six months.  The results, however, marked deceleration in the pace of gains from the 1.5% averaged in the three months prior.



The housing market, home-improvement businesses, and online retailers’ have had a particularly robust rebound, reflecting the broader economy’s K-shaped recovery that has seen some businesses thrive and grow, while others have struggled or failed.

Still, other data has indicated the broader economic recovery remains on fragile ground. Consumer sentiment fell in early November.  Americans’ outlook on the economy soured in the period straddling the national elections, as Republicans grew more pessimistic and Democrats worried about the rise in coronavirus infections.

Signals from the labor market were also not as upbeat.  While continuing jobless claims trended lower at the beginning of the month, the still-elevated level of initial claims, a proxy for layoffs, pointed to softer labor market momentum.  The rising spread of COVID-19 has been an added near-term risk, which has weighed on business activity and hiring.

With more containment measures, no new fiscal supports, and the expiration of several Fed emergency lending programs, the near-term outlook is looking darker.  Indeed, it appears that a sustained improvement in economic activity will likely have to wait for a vaccine.  Fortunately, major positive developments on the vaccine front in recent days suggest potentially earlier availability and the return to normal in 2021.

Coronavirus Cases Surge: The third wave of coronavirus cases has been building speed for more than a month now and has led to increased restrictions as hospitalizations have reached a new peak nationally.  Restrictions have been generally more targeted than in the spring, but some jurisdictions have taken stronger measures.  

The second wave of infections in the summer did not lead to as much of a slowdown as first feared. However, there are a couple of reasons why there may be more of an impact now.  First, the current surge has been more widespread across the country.  The “second wave” was really the first wave in many states not hard hit in the early spring.   Second, in the summer surge, Americans had recently received relief checks and unemployed people were still receiving a generous $600/week extra in addition to their usual benefits.  This boost to income helped to offset reduced activity in some sectors.

That is no longer the case, and Democrats and Republicans in Congress are still far apart on the size of a package. The need to pass a spending bill to fund the government beyond December 11th presents an opportunity to tack on a relief package, but it looks unlikely at this point.

Housing: New and existing home sales continued to be robust in October.  Also, housing starts have increased in five of the last six months, powered by an impressive rebound in single-family starts - a clear signal of the shift in housing preferences during the pandemic.  Boosted by strong sales growth, builder confidence has soared to new all-time highs in each of the past three months.



Despite this optimism, the near-term outlook has presented some distinct challenges. With home prices continuing to climb higher, housing affordability has deteriorated and fell to nearly a two-year low last quarter.  Homebuilders have been faced with supply constraints which have pushed construction costs higher, contributing to higher prices.  These factors could weigh on housing demand growth in the coming months. 

Inflation: Consumer prices were flat month/month in October.  Total CPI was up 1.2% year-over-year in October, decelerating slightly from a 1.4% pace in September.  Core inflation was also unchanged.  As a result, core inflation has cooled slightly to 1.6% on a year-over-year basis, after running at 1.7% for a couple of months. 

The soft inflation pressures in the U.S. economy, driven by cooling in price inflation for services, have been what would be expected during recovery from a deep recession.  Since core services prices accounted for about 60% of the consumer price basket, it has been difficult for inflation to pick up speed without some price pressures there.  Stronger services inflation was not expected with unemployment elevated, and the pandemic in a third wave across the country.  This could help keep a lid on economy-wide inflation pressures over the next couple of years.  
   
Manufacturing Index: The ISM Manufacturing Index increased by 3.9 points in October to 59.3, the highest reading since September 2018.  Among the subcomponents, new orders, new exports, and the backlog of orders increased.



The manufacturing sector has been well entrenched in expansion territory, registering its sixth consecutive month above the 50 mark.  However, the sector’s outlook has not been without a few hurdles.  The rapid resurgence in new COVID-19 cases in the U.S. and across the Atlantic have constituted a downside risk to the broader economic recovery.  Additionally, growth in durable goods spending will likely shift into a lower gear as much of the pent-up demand from spring and summer has been satisfied.  Combined with elevated pandemic-related uncertainty, and the fading of previous fiscal stimulus, manufacturing uncertainty over the next few months seems likely to be on the rise.  

Labor Market: The U.S. labor market continued to rebound in October, as employers added 638,000 jobs amid signs the economy was healing from the pandemic-induced downturn.  Jobs grew for the sixth straight month, the workforce expanded, and the unemployment rate fell a percentage point to 6.9%.



The labor market still has a long road ahead. The jobless rate and the 11 million workers counted as unemployed were both roughly twice as high as they were in February.  A recent rise in virus infections, persistent social distancing restrictions, and the fading effects of federal relief spending appear to be weighing on the labor market recovery.

Vaccine and the U.S. Economy: The news that a coronavirus vaccine could be authorized before the end of 2020 has sparked hopes that the U.S. economy could bounce back strongly next year. But while a successful vaccine could indeed give the economy a shot in the arm in 2021, it will take longer to heal from a historic blow to jobs, investment and businesses—a task complicated by the continued surge in infections in much of the U.S.

It could be many months before any vaccine is administered to enough people to ease the need for lockdown measures that have been recently reimposed. Meanwhile, businesses most directly constrained by the virus —particularly in-person services such as hospitality and entertainment—must endure months of weak demand.

Even if the full economic effect of a vaccine will not be felt for months, there could still be some near-term benefit from a resurgence of optimism since it would promise an eventual end to the “stop-start cycle” of restrictions being imposed on businesses, and being lifted only to be imposed again as infections rise.

Eurozone: In Europe, new lockdowns mostly came into force in the final week of October.  Although narrower than those introduced in the spring, the new measures have appeared to hit services that required close physical proximity almost as hard, while having less effect on most other activities.

Manufacturing activity has continued to be much less negatively affected than earlier in the year, but the decline in services appeared sufficiently large to cause a drop in GDP.  If that should materialize, the eurozone will be further from returning to the levels of output seen before the pandemic struck in the first quarter.  In the second quarter, eurozone GDP declined by 11.8%, and it rebounded by 12.6% in the third quarter. The eurozone economy is expected to shrink by 2.6% during the fourth quarter.

To offset the economic impact of new restrictions the European Central Bank is expected, in December, to increase as well as extend its asset purchases under its Pandemic Emergency Purchase Program.  Over time, monetary and fiscal stimulus measures should filter through to the real economy and have a positive impact on Eurozone growth.  In 2021, the Eurozone economy is forecast to expand at least 3.5%; however, in the near-term, easier monetary policy and lingering uncertainty over the outlook should keep the euro restrained.

2020 Presidential Election: As President-elect Joe Biden prepares to assume office on January 20, 2021, the economic policy outlook in Washington, D.C., has continued to be uncertain.  Negotiations over another COVID relief bill are likely to restart during the lame-duck session of the Congress, but will Democrats want to wait until after the Georgia special elections and Joe Biden takes office?  And how will President Trump feel about signing a COVID relief bill on his way out of office?

Furthermore, the federal government needs to be funded past December 11, creating both a natural deadline by which COVID relief could be achieved, but also adding another wrinkle to the ongoing negotiations.

Two run-off Senate elections in Georgia in January will determine whether there will be a divided Congress or a Democratic Sweep.  If the first scenario comes to fruition, major economic policy legislation might not pass in Congress.  Even another COVID economic relief bill could face long odds, to say nothing of an expansion of the Affordable Care Act, tax increases, or major new infrastructure investments.  Under this scenario, President Biden might need to focus his efforts on making policy changes in areas where the executive branch has significant unilateral power, such as trade and foreign policy, appointing cabinet members, judges, and regulators.

A Democratic sweep, however, could bring about a scenario in which some of Joe Biden’s top legislative proposals would face a more realistic road to becoming law.  On the individual tax code, most of Biden’s policies center on expanding existing tax credits and raising taxes on high earners. Biden has also proposed expanding the Earned Income Tax Credit, the Child Tax Credit and re-establishing the First-time Homebuyers’ Tax Credit.  For the corporate side of the tax code, Biden supports raising the corporate tax rate to 28% from 21%.

On the spending side of the ledger, Biden has numerous policy ideas that would lead to higher spending.  Some of the biggest would include two years of tuition-free community college, a public health insurance option, increasing the size of Affordable Care Act subsidies for purchasing health insurance, and a roughly $2 trillion public investment plan to promote clean energy, support infrastructure projects, and provide housing support, among other objectives.

When it comes to trade policy, Biden’s priority will be to mend relations with America’s allies such as the EU, Canada, and Mexico.  This will likely result in a rollback of existing tariffs.

Further, Biden will likely seek a coordinated approach against China and work closely with allies such as the EU rather than continue the bilateral approach under President Trump.  Although  American trade flows are expected to pick up again as the pandemic-induced global recession comes to an end and as trade tensions with allies subside, the COVID shock could lead to some reorientation of supply chains.  General relaxation in trade tensions likely would lead to some downward pressure on the U.S. dollar, although the dollar could find some safe-haven support if trade tensions with China were to take center stage again.

Outlook: The U.S. economy continues to recover from the downturn caused by the coronavirus pandemic.  While the resurgence in infection cases in the last two months may lead to another round of partial shutdowns, another comprehensive lockdown is not expected, although it remains a risk.

Optimism about COVID-19 vaccines is raising hopes the global economy will recover faster than expected once they are rolled out.  But the vaccines may not be widely available until well into next year.  In the near term, the increased spread of the coronavirus could pose a significant risk to the economy in the months ahead.  It is difficult to handicap just how the rollout of the vaccine will influence the economic outlook at this point.

The fourth quarter got off to a strong start, and right now is tracking a 3.7% (annualized) pace, but risks appear tilted to the downside.  Real GDP growth for Q4-2020 is expected to be around 4.5%. Consumer spending growth may slow in the final months of the year.  Some holiday spending may have been pulled forward in time, leading to slower growth in November and December, while the recent spike in COVID cases may weigh on services consumption.  Should these concerns prove unfounded, or should another COVID relief bill come together quickly, there would be upside bias to near-term growth expectations.

For the full year 2021, the real GDP growth forecast is at least 4.2% (year-over-year percent change). Above-trend growth should chip away at slack in the economy, but not fast enough to fully eliminate the output gap by the end of Q4-2022.

The year-over-year rate of PCE inflation should remain below 2% for quite some time.  A gradual recovery in the labor market should continue and the unemployment rate is forecast to be below 6% at the end of 2021 and under 5% by the end of 2022.

The FOMC is expected to keep the federal funds rate unchanged through at least the end of 2022. However, if no further fiscal support is forthcoming, the FOMC may feel compelled to add further monetary policy accommodation by increasing the size of its asset purchases or more heavily weighting existing purchases to longer-dated securities to lower long-term interest rates.



This Newsletter was produced for Middleburg Financial by Capital Market Consultants, Inc.


Sources: Department of Labor, Department of Commerce, Institute for Supply Management, European Central Bank, Bloomberg, Morningstar, Johns Hopkins University Corona Resource Center


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