In recent weeks, the number of new cases and hospitalizations has been falling, and ongoing vaccinations offer hope for a return to more normal conditions later this year. However, the economic recovery has remained uneven and far from complete, and the path ahead seems highly uncertain.
Household spending on services has remained low, especially in sectors like leisure and hospitality. In contrast, household spending on goods picked up encouragingly in January after moderating late last year. The housing sector has more than fully recovered from the downturn, while business investment and manufacturing production have also picked up. The overall recovery in economic activity since last spring has been due in part to unprecedented fiscal and monetary actions, which have provided essential support to many households and businesses.
Although there has been much progress in the labor market since the spring, millions of Americans have remained out of work. The economic downturn has not fallen equally on all Americans, and those least able to shoulder the burden have been hit the hardest.
The pandemic has also left a significant imprint on inflation. Following large declines in the spring, consumer prices partially rebounded over the rest of last year. However, for some of the sectors that have been most adversely affected by the pandemic, prices remained particularly soft. Overall, on a 12-month basis, inflation has remained below 2.0%.
While challenges ahead should not be underestimated, developments point to an improved U.S. outlook for later this year. In particular, progress in vaccinations should help speed the return to normal activities. In the meantime, following the advice of health experts to observe social-distancing measures and wear masks continues to make sense.
Recent data has pointed to a sharp slowing in foreign economic growth in the fourth quarter, after a strong rebound in the third quarter. Amid a further intensification of the pandemic, many foreign governments have tightened social-distancing restrictions. In a few countries, the emergence of new and more contagious virus strains has been accompanied by a surge in COVID-19 cases and deaths. The increased viral spread and restrictions appear to have taken a toll on foreign economic activity, particularly in Europe. The global slowdown was most notable for services, with further declines in purchasing managers indexes for this sector through January in many advanced foreign economies. By contrast, manufacturing output in both advanced and emerging foreign economies has continued to expand at a solid pace, supported by resilient demand for durable goods, high-tech goods, and medical supplies. Amid the generally weak economic situation, inflationary pressures have remained subdued in most foreign economies.
Inflation: After falling precipitously through the pandemic, inflation has picked up in the last few months. Total Consumer Price Index (CPI) was up 1.4% year-over-year in January. With rebounding energy prices, the year-over-year change in the CPI should move towards 2.5% in the coming months. Pass-through of higher costs by businesses most impacted by the pandemic appears likely and ramping up capacity after several months of the shutdown could be difficult in the face of rapidly improving demand. The real risk to inflation will come from the significant amount of monetary and fiscal stimulus. This has allowed households to amass record levels of savings while their spending has been restricted by the reality of the pandemic. Rapid deployment of this “excess saving” once restrictions ease later this year could pose an upside risk to both economic growth and inflation. Over the medium-term, the inflation outlook will depend on the path of fiscal and monetary policy and, in particular how effectively current extraordinary supports are unwound. CPI inflation should hover between the 2.0% and 2.5% mark as the economy continues to recover.
Labor Market: The labor market’s recovery has only stumbled along. Over the three months ending in January, employment rose at an average monthly rate of only 29,000. Continued progress in many industries has been tempered by significant losses in industries such as leisure and hospitality. The unemployment rate has remained elevated at 6.3% in January, and participation in the labor market is notably below pre-pandemic levels.
COVID’s impact on the labor market has been uneven. High-contact service industries like leisure & hospitality have borne the brunt of social distancing efforts, while industries related to the goods side of the economy, including manufacturing, transportation, and retail have held up significantly better.
While there is still a significant amount of ground to recover, the labor market recovery should get back on track. Vaccinations have picked up and additional fiscal relief should support employment directly through business aid and indirectly through aid to households. As health concerns ebb alongside the pandemic, stronger hiring conditions should pull workers back into the labor market and participation rates should resume their recovery later this year.
Housing: The U.S. housing market has been a consistent economic bright spot during the pandemic. Low mortgage rates and strong demand have helped propel sales and boost construction activity but have also led to higher prices for lumber and other building materials. House-buying demand has surged in recent months while the supply of homes for sale has dropped, prompting buyers to compete for houses and buoying prices.
Small Business: The NFIB’s small business optimism index deteriorated for the third month in a row in January, falling by 0.9 points to 95.0. Despite the many challenges in their path, small business owners have remained focused on hiring more workers and boosting worker compensation to ensure smooth business operations. The path ahead will continue to be heavily dependent on the evolution of the health crisis. Another likely jolt of fiscal stimulus would be an added boon.
Eurozone: The eurozone economy could face a risk of sliding into its second recession since the pandemic first struck, as high Covid-19 infection rates and government restrictions have left its services sector mired in a fifth straight month of contraction during January.
The eurozone’s GDP contracted by 0.7% in the three months through December from the previous quarter, resulting in an annual decline of 6.8% for the bloc in 2020. The eurozone’s economy has diverged sharply from the U.S. and China, as stubbornly high coronavirus infections, extensive Covid-19 restrictions, and a painfully slow vaccine rollout delayed Europe’s recovery from last year’s historic economic downturn. Fresh data highlighted an economic gap between the eurozone and the U.S. and China that could widen this year, given that the U.S. has proceeded more quickly than the European Union in rolling out vaccines and China has remained largely free of the virus.
Since the start of the pandemic, European policymakers have generally pursued more draconian restrictions to stop the virus’s spread than has the U.S. Nonetheless, the death toll in Europe is approaching that of the U.S., while its economic performance—already lagging behind the U.S. before the pandemic—has been much worse than other advanced economies.
Now, a sluggish rollout of vaccines, the threat of highly contagious new variants of the virus, and the possibility of weeks or months of continued restrictions bode ill for the near term and could delay an economic recovery.
China: China has weathered the economic fallout from Covid-19 better than any other major economic power. But it will need to address an array of challenges to get onto a more-sustainable growth trajectory and help the world fully rebound.
China’s job market has remained fragile. Consumer spending has not kept pace with the broader recovery in economic output. Debt levels, already a problem before the pandemic, grew at their fastest pace in more than a decade during the first nine months of 2020, while asset bubbles in stocks and real estate kept growing. China’s central bank could face a tricky balance between reining in stimulus without causing growth to sputter.
And now, a resurgence of Covid-19 infections in some parts of China, combined with a slow rollout of vaccines, has raised fresh worries about the economic outlook. All this matters because China has become a bigger part of the global economy and a more important driver of growth worldwide. If its performance in 2021 disappoints, it could hurt economic growth in some countries.
Outlook: The U.S. economy appears to be hitting an inflection point, with prospects for a significant acceleration in real GDP as winter turns to spring.
There are several reasons for optimism. On the public health front, new COVID cases have come down significantly in the last few weeks. The distribution of COVID vaccines has continued to slowly but steadily ramp up. Continued progress on the vaccination front will go a long way toward promoting an economic rebound in the second half of the year.
Fiscal policy is also positioned to provide a significant boost to the U.S. economy in the months ahead. After months of wrangling, Congress passed a $900 billion COVID relief package at the end of 2020. The Biden administration has proposed another stimulus and COVID relief bill expected to be approved by Congress sometime in March. The deal would include another round of direct checks, an extension of the enhanced federal unemployment benefits and its expanded programs, state and local aid as well as money for vaccines, testing, and other public health measures.
Pulling all of this together, GDP is expected to grow by 5.0% in 2021. This outlook is based on the rapid decline in COVID cases, the continued progress on vaccine distribution, and the tremendous loosening in fiscal policy from enacted and anticipated legislation. The U.S. consumer will lead the charge in this growth rebound by relying on a mix of previously accumulated savings, still-flowing fiscal support, and a pick-up in job growth starting in spring and peaking over the summer months.
The strength will extend beyond the U.S. consumer. Business fixed investment growth is expected to remain solid in Q1 before slowing down. The robust housing market recovery appears poised to continue amid still-low interest rates and strong household income growth. State and local governments’ revenues have held up reasonably well in the aggregate, and their budgets should be bolstered further by projected federal aid. Inflation, as measured by the core PCE deflator, should pick up and grow towards 2.5% starting later this year.
No increases in the federal funds rate are expected through at least the end of 2022. Core inflation is not expected to rise well above 2%, and in that environment, the Fed will remain content with a tightening labor market and relatively tame inflation. That said, if the economic recovery is in full swing in the second half of the year, the Federal Reserve may begin discussing when to start tapering its monthly asset purchases of $80 billion in Treasury securities and $40 billion of mortgage-backed securities.
Of course, downside risks exist, particularly on the public health front. New variants of COVID could lead to a reversal in new case growth, and a worst-case scenario could render vaccines and therapeutics ineffective. But even if vaccines are only half as effective against a new variant, this would still mark a significant improvement over the minimal protection people have had over the past year. Also, better weather in the months ahead could buy enough time for pharmaceutical companies to develop booster shots for the most threatening variants. The new administration’s fiscal relief efforts could fail due to political obstacles, but a smaller-than-expected deal would still help close an output gap that is expected to exceed $400 billion in 2021.
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, Institute for Supply Management, Bloomberg, Morningstar, China’s National Bureau of Statistics
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