The sharp acceleration in economic activity has been most evident in the latest ISM surveys. The manufacturing index hit a 37-year high in March, with the more encompassing services survey reaching its highest mark since records began in the late 1990s. Moreover, high-frequency data, particularly for the hard-hit travel and hospitality sectors, have also indicated the pace of recovery has quickened over the past month. The jobs recovery has also shifted into a higher gear with employers adding 916,000 new jobs in March, nearly twice the pace of February.
Consumer spending has been on track to follow suit. Spending should strengthen to a double-digit pace over the second and third quarters, driven not only by the latest round of fiscal support but also by savings built up throughout the pandemic.
To some extent, the near-term growth outlook could be even stronger. While services spending is expected to be the main driver of overall GDP growth in the coming months, goods spending by consumers and businesses has remained solid. Yet businesses have had trouble meeting demand.
For months, producers have struggled to get their hands on materials and to find workers. While there have been some signs that labor constraints are easing as the health situation improves, bottlenecks across supply chains have intensified. The six-day blockage of the Suez Canal was just the latest event with which logistics managers have had to contend. Semiconductor shortages, congested ports, and offline facilities from February's harsh weather have lengthened supplier delivery times in the manufacturing sector - the greatest impact since 1974.
Ongoing strains in supply chains have capped the ability for businesses to restock depleted inventories, which have collapsed compared to sales. Net exports could also take a bigger bite out of GDP growth, as super-charged U.S. spending is set against a slower global recovery. However, these dynamics should ease in the second half of 2021, with the manufacturing and transportation industries benefiting from restocking efforts even as goods spending takes a back seat to services.
For now, the Federal Reserve remains in wait-and-see mode. The Fed will need to see inflation rise above 2% and feel confident inflation will stay there for some time. And while the labor market's recovery has stepped up a notch, it remains far from the Fed's broad-based and inclusive goal of maximum employment. As a result, the Fed is expected to hold off on tapering asset purchases until next year and keep the fed funds rate on hold at least through 2022. Of course, markets have already priced in the reality of a surging economy and stronger inflation. With this outlook turning into reality, rates are expected to continue to climb, with the 10-year Treasury yield surpassing 2% by year-end.
Housing: Housing inventory, which has sat near record lows and record-highs for price growth, and which has weighed on affordability, are likely the biggest culprits behind the weak showing of some housing sector indicators, e.g., existing-home sales. With home prices rising at a red-hot pace, key material costs such as lumber getting more expensive recently, and interest rates poised to grind higher, affordability will bear watching, given its potential to act as an added hurdle.
Supply-side issues have also remained a major challenge for getting new homes on the market, as building materials and skilled labor shortages have continued to plague builders. Supply-chain bottlenecks for building materials should at least modestly improve during the second half of this year, as more sawmills reopen, and manufacturers ramp up production of other key inputs.
Moreover, an improving economy, on account of rising vaccinations and the latest stimulus package, should lend more support to housing demand going forward. Supply, however, is likely to remain a constraining factor, especially in the near term.
Inflation: Consumer price inflation has remained modest, with the core PCE deflator, the Fed's preferred inflation benchmark, up just 0.1% in March and 1.5% year-over-year. Consumer prices should keep climbing in the months ahead. Pandemic-related supply shortages seem likely to reverse the negative thrust in goods prices that have held down inflation for the past decade. Services prices are also likely to head higher, especially in sectors that have been restricted and where capacity has been impacted.
Inflation forecasts have been upgraded to reflect intensifying price pressures across supply chains and rising inflation expectations. While the year-over-year rate of inflation should peak this year, consistent with the Fed's view of a "temporary" burst of inflation, core PCE inflation is expected to remain 2.0% or higher through 2022.
Whether this rise should prove temporary is one of the key questions for markets. Inflation would rise temporarily this year because of growing demand fueled by increased vaccination rates, falling restrictions on businesses, trillions of dollars in federal pandemic relief programs, and ample consumer savings.
But to be clear, inflation has not been forecast to get out of hand. Inflation expectations, although higher than a few months ago, have generally remained contained, and a rise in the labor force participation rate once the pandemic has subsided should help keep a lid on outsized wage gains.
Federal Reserve: Federal Open Market Committee (FOMC) is expected to maintain its current target range for the fed funds rate between 0.00% and 0.25% through at least the end of 2022. The FOMC seems to be more or less focused entirely on its “full employment” objective at present. That is, unless inflation shows signs of rising meaningfully on an ongoing basis, which is not expected, the FOMC will continue to maintain an accommodative policy stance until the labor market has strengthened significantly.
The Federal Reserve is also expected to 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. By the start of 2022, a gradual tapering of purchases is likely to begin.
U.S. Dollar: The U.S. dollar is expected to strengthen further in the near term and to soften only gradually over the medium term. Higher inflation expectations and elevated U.S. Treasury yields will support the dollar over the next few months.
Rising yields have already resulted in renewed strength for the dollar, and this trend is expected to persist in the near term. However, an uninterrupted global economic recovery and progress on the vaccine front should eventually be supportive of risk-sensitive currencies, especially with the Federal Reserve unlikely to tighten monetary policy for an extended period, pointing to some modest U.S. dollar weakness. In that case, the trade-weighted Dollar Index is expected to gradually move lower in the second half of this year as well as into 2022.
Eurozone: The Eurozone has started 2021 on a soft footing, with the effect of COVID-related restrictions evident in economic figures. The renewed spread of COVID cases and slow vaccine rollout have suggested economic growth will remain weak for now and recover only gradually over time. Eurozone GDP is expected to fall another 1.25% quarter-over-quarter in Q1-2021, reflecting high infection rates and a slow start to their vaccination program.
But the April survey has pointed to a return to growth in the second quarter. Businesses have appeared to be preparing for a pickup in activity, with purchasing managers reporting the strongest new hiring since November 2018, driven by factories that saw new orders rise at a record pace. The eurozone economy is likely to grow at an annualized rate of 6% in the second quarter of 2021 and 3.0% in the entire 2021.
The European Central Bank will keep its aggressive monetary stimulus in place; it should keep its key interest rate at minus 0.5%, continuing to buy eurozone debt under an emergency €1.85 trillion bond-buying program through at least March 2022. The ECB’s recent actions have helped to slow a rise in sovereign-bond yields across Europe this year. Further weakness in the euro is expected in the near term with limited prospects for any rebound over the longer term.
China: The Chinese economy is expected to grow 9.0% this year, down from 9.3% last month. This downward adjustment has reflected a slowdown in some economic indicators and assumed central bank monetary tightening.
Relative economic outperformance should attract capital flows to China. Besides, the global economic recovery and improving demand should also help investors allocate capital toward China, while the opening of local financial markets to foreign investors should help attract flows to renminbi-denominated assets.
The prospects for the Chinese renminbi have been positive over the medium term. China's economy is still outperforming on a relative basis, which should attract capital flows to the country. This economic outperformance could result in more pronounced monetary tightening from the People's Bank of China (PBoC) and could help the Chinese renminbi strengthen over time. Also, China's financial markets have continued to become more accessible to foreign investors, which could eventually lead to additional investment into renminbi-denominated assets.
Emerging Markets: Although largely good for the global economy, the torrid growth in the U.S. has strained some weaker countries. As investors rush to buy U.S. assets, they have driven U.S. Treasury bonds yields sharply higher this year. Should that continue, the higher returns offered for riskless investments in the U.S. could lead to a sharp tightening of financial conditions, and significant capital outflows from emerging and developing economies, where vaccine campaigns have barely begun.
Over the past few weeks, multiple central banks within the emerging markets have started the process of tightening monetary policy. This trend may well spread to other emerging market central banks despite their respective economies still recovering from the COVID-induced slowdown.
With interest rates from major developed central banks likely to stay effectively at zero percent, for the time being, emerging market central bank rate hikes can swing interest rate differentials back in the favor of emerging market currencies. Currencies associated with more hawkish central banks should display reasonable resilience over the medium term. Currencies associated with central banks not tightening monetary policy now will likely underperform over the long term.
Outlook: The long-awaited reopening boom has finally arrived. Fueled by an improving health picture, better weather, and another round of significant fiscal support, recent employment, and economic survey data show activity shifting into a higher gear. Growth is expected to surge this spring and summer, and real GDP should completely recover to at least its pre-pandemic high by the end of this summer. GDP growth in the U.S. of at least 6.0% is expected for 2021.
The acceleration in economic growth is being driven by the consumer, fiscal stimulus, diminishing risks of COVID, pent-up demand for discretionary services, and a large build-up in personal savings. Most states have loosened operating restrictions on businesses, which means more of the economy is reopening than at any other time since the pandemic began.
A variety of factors will determine the way forward. Key variables include: 1) the spread of the virus itself; 2) the deployment and effectiveness of COVID-19 vaccines and treatments; 3) the impact of fiscal and monetary support; 4) the status of labor markets and household consumption, and 5) the pace at which mobility and travel restrictions are lifted.
Of course, downside risks have to be considered, 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. Moreover, the U.S. government has incurred gaping budget deficits, and the ratio of federal government debt-to-GDP has climbed to its highest level since the end of the Second World War. Globally, China has an excessive amount of debt in its non-financial corporate sector, and a debt crisis in China, although unlikely, could impart a sharp slowing effect on the global economy.
This Newsletter was produced for Atlantic Union Bank Wealth Management by Capital Market Consultants, Inc.
Sources: Department of Commerce, Department of Labor, Morningstar, Bloomberg, Institute for Supply Management, The Federal Reserve Board
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