Recap: The U.S. economy appears to be losing some momentum as the calendar turns to 2021. The cause of the recent slowdown is clear. The public health situation continues to deteriorate, which has led to a patchwork of new business restrictions, diminished consumer confidence, and weaker-than-anticipated consumer spending.
Economic activity in the U.S. has rebounded robustly in the third quarter and has continued to recover in the fourth quarter from its depressed second-quarter level, though the pace of improvement has moderated. U.S. Real GDP grew 4.0% (annualized) in the fourth quarter. Overall, for 2020, the economy contracted at an annual average rate of 3.5%, the worst performance since 1946. Household spending on goods, especially durable goods, has been strong and has moved above its pre-pandemic level, supported in part by federal stimulus payments and expanded unemployment benefits. In contrast, spending on services has remained well below pre-pandemic levels, particularly in sectors that required people to gather closely, including travel and hospitality.
In the labor market, more than half of the 22 million jobs that were lost in March and April have been regained, as many people were able to return to work. Inflation, following large declines in the spring of 2020, picked up over the summer but has leveled out more recently; for those sectors that have been most adversely affected by the pandemic, price increases have remained subdued.
Recent economic figures have indicated decidedly mixed trends for some key foreign economies around the turn of the year. Leading the way forward, China's Q4 GDP rose 2.6% quarter over quarter, though with upward revisions to prior quarters, the 6.5% year-over-year increase was better than expected. Lagging were the Eurozone and U.K. economies, both of which appeared likely to suffer renewed economic contractions in Q4-2020 and/or Q1-2021. January Purchasing Manager Index surveys, for example, have pointed to a renewed pullback for these regions.
Nevertheless, financial markets appeared to be more focused on the medium- to long-run outlook, which looks much brighter. Although vaccine dissemination has been slow in most countries, it should accelerate in the months ahead. Combined with warmer weather, naturally acquired COVID immunity and elevated household savings, the second half of 2021 and 2022 should see much better days for the global economy.
Consumers: Consumer confidence at 89.3 in January was an incremental improvement from the downwardly revised reading of 87.1 in December. As the rollout of the vaccine progresses, it is anticipated consumers will gradually regain some of their lost confidence, although a full return to pre-pandemic swagger will likely require a more robust recovery in employment.
There has been a growing sense among consumers that although the winter will be difficult, the tide is turning. Central to the expectation for a soft patch in Q1-2021 followed by much stronger consumer spending in the middle part of the year has been the notion that the robust goods spending, which underpinned the consumer rebound in the second half of last year, will gradually transition to the much larger services categories once restrictions on travel and dining out have been lifted.
Housing: Throughout 2020, housing emerged as one of just a few bright spots in an otherwise horrible year. Driven by record-low mortgage rates and shifting preferences for more livable space to accommodate virtual activities, home sales, housing starts, and builder confidence quickly recovered from the deep losses experienced during the lockdown months last spring.
So far in 2021, the housing market appears to be cooling off a bit. Still, even with some moderation, most indicators of housing activity have been running at a robust pace. During December, existing-home sales beat expectations and rose 0.7%. What is more, mortgage applications for purchase have continued to trend higher, which means the pace of home sales is likely to remain elevated over the coming months. Similarly, residential construction has continued to heat up as builders move to satiate rising buyer demand. Home sales and new home construction should strengthen further in 2021. The inventory situation should improve moderately as the vaccine rollout enables more people to put their homes up for sale resulting in more housing turnover. Foreclosure and distressed sales should also increase from their current low levels.
Affordability remains the biggest challenge for the housing market. Shortages of buildable lots, some key building materials, and skilled workers will also remain a challenge for home builders. Overall, housing is expected to remain at the forefront of the recovery.
Inflation: As vaccinations rise and economic activity returns to some semblance of “normal,” inflation is expected to firm throughout 2021. Multiple rounds of direct government aid have left many households flush with excess savings which, coupled with pent-up demand, especially for services, could lead to robust consumer spending that would cause prices to shoot higher as the year progresses. A period of steadily rising inflation could be set in motion by demand-side factors.
But there have also been issues on the supply side of the economy that could lead to higher inflation as well. For example, the permanent shuttering of thousands of businesses this year could reduce competition in some sectors of the economy. Many businesses may try to rebuild profit margins by raising prices as the recovery gathers steam. Labor costs in some key sectors of the economy could accelerate, which could also put upward pressure on prices.
The rate of Personal Consumption Expenditures (PCE) inflation is expected to rise to 1.7% in 2021 from an estimated rate of 1.2% last year. Core PCE inflation is likely to hit the Fed’s 2% goal as early as the second quarter. Although core inflation in coming months should be noticeably higher than in 2020, it will likely struggle to stay at 2% in the second half of this year and into 2022.
Federal Reserve: As expected, the Federal Open Market Committee (FOMC) made no major policy changes at its January meeting. That said, the committee did note that the recovery has moderated in recent months and stressed that the outlook would remain critically dependent on the course of the virus.
The FOMC is expected to maintain its current target range for the federal fund rate between 0.00% and 0.25% through at least the end of 2022. The Fed is likely to continue purchasing Treasury securities and mortgage-backed securities at a monthly rate of $80 billion and $40 billion, respectively. In sum, the U.S. economy likely will remain in a low-interest-rate environment for the foreseeable future.
U.S. Dollar: While the outlook for the U.S. dollar has become more mixed, given the likelihood of further U.S. fiscal relief, which could be supportive for the greenback, and mixed global trends which could weigh on some foreign currencies, the U.S. currency is expected to weaken over the longer term. Stronger U.S. growth and the possibility of faster inflation has been a double-edged currency sword. While it could provide some support for the greenback, stronger growth and inflation could also be supportive of commodities and risk-sensitive currencies, such as the Australian, Canadian, and New Zealand dollars, as well as emerging market currencies more broadly.
Indeed, those commodity and risk-sensitive currencies could benefit, in particular, if firmer economic trends are not accompanied by U.S. monetary tightening. Most major central banks are likely to maintain an accommodative monetary policy for an extended period, meaning medium-term economic trends and market sentiment should remain reasonably favorable. Thus, a favorable global economic and market backdrop should eventually see a trend of U.S. dollar softness return.
China: China’s GDP rose 2.3% last year. It was enough to make China the only major world economy to gain any ground at all last year. A surge in state investments has helped lift the Chinese economy from the effects of Covid-19. China finished 2020 with a 10th consecutive month of expansion in its manufacturing sector. The Chinese economy also showed strength outside its factories. China’s nonmanufacturing PMI marked the 10th month of expansion and has remained near the highest levels in more than a decade. Taken together, it would suggest a strong start to 2021, with economic growth of around 8% or more in 2021.
But the rebound in China has been unbalanced. It has relied heavily on government expenditures and state-sector investments, while private spending has remained weak. The impact has amplified a trend of declining growth in productivity.
Eurozone: The eurozone economy has suffered a weak start to the year, with high coronavirus infection rates and government restrictions increasing the risk of a second recession since the pandemic first struck last year. Data firm IHS Markit said its composite Purchasing Managers Index, which measured activity in the manufacturing and services sectors, for the eurozone fell to 47.5 in January from 49.1 in December.
A resurgence of the pandemic in Europe was squeezing business investment and crimping consumer spending. The region's $13 trillion economies could slide back into recession in the first three months of 2021, as businesses and households remain cautious. Eurozone inflation has been below zero for the past five months, through December, far from the ECB’s target of just below 2%. The euro has also staged a rally against the dollar in recent months, hurting the competitiveness of Europe’s large exporters in crucial overseas markets such as the U.S.
But recent developments such as the start of a Covid-19 vaccination campaign, a trade deal between the European Union and the U.K., and a new administration in the U.S. have been viewed as positive signs in Europe. The ECB would continue to buy up to $2.25 trillion of eurozone bonds through March 2022 under a plan unveiled in December. Its key interest rate is set at minus 0.5%.
Outlook: While the recently enacted fiscal relief bill is likely to bolster U.S. consumer spending in 2021, personal consumption appears likely to weaken in Q1-2021. So far, the relatively quick rebound in consumer spending has been propelled by an upshift in spending on durable goods. Meanwhile, spending on services, especially close-contact services, has remained depressed by COVID-related safety precautions.
Although a slight contraction in Q1-2021 is expected, personal consumption expenditures are poised for substantial growth over the remainder of the year. Direct to consumer checks, expanded unemployment benefits, and a revamped Paycheck Protection Program will boost personal income and savings, which should support stronger consumption. An immediate increase in consumer spending seems unlikely, given many close-contact activities are currently limited by COVID. The eventual widespread distribution of vaccines, however, should unleash pent-up demand for these services and help drive consumer spending higher over the year.
A modest upturn in business fixed investment is expected this year. The rise of remote work initially led to a boom in spending on laptops and communication equipment, so some payback now appears in order. Strengthening in industrial and transportation equipment should help offset some of this weakness, however. By contrast, nonresidential investment spending looks set to weaken further this year alongside a collapse in new commercial construction starts and still-low levels of oil and gas drilling activity.
Strength in the housing market should extend throughout 2021. Mortgage rates would continue to test new lows and the race for more space to accommodate virtual activities will continue to spur robust home sales, single-family home building, and home improvement spending. Even if mortgage rates move meaningfully higher or the work-from-home era comes to an abrupt end, neither of which seems likely–demographics will remain supportive of housing activity in the years ahead. In short, the latest round of fiscal relief should lead to a slightly stronger pace of overall economic growth in 2021.
The core PCE deflator should average 1.7% for the year in 2021 and 1.8% in 2022, below the 2% average inflation target which would likely prompt the Fed to tighten monetary policy. Along similar lines, the unemployment rate, which currently stands at 6.7%, is expected to end the year at 6.2% and 5.0% in 2022. Bearing all of this in mind, the Fed is expected, as they have previously stated, to maintain a Fed funds target range of 0.00%-0.25% through at least the end of 2022.
The Biden election platform has promised an ambitious spending agenda, funded by higher taxes. A thin Senate majority will pose a challenge to several elements on the list, but increased spending to support the economy through the pandemic appears likely. Tax changes, such as the planned tax hikes on corporations and high-income individuals, appear less likely. While they can be rolled through in the budget reconciliation process with a simple majority, more conservative-leaning Democratic Senators would have to be on board, making it a harder sell than temporary supports to bridge the economy while vaccines continue to be rolled out.
This Newsletter was produced for Middleburg Financial by Capital Market Consultants, Inc.
Sources: IHS Markit, Department of Labor, Department of Commerce, European Central Bank, Institute for Supply Management, Bloomberg, Morningstar, Federal Reserve of Chicago, China’s National Bureau of Statistics, China Federation of Logistics & Purchasing, and China Logistics Information Centre
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