Is economic recovery on schedule or at risk?

Updated September 22 | Market news

Investors can be excused if they’re having a difficult time trying to understand what to expect from the U.S. economy. Since early 2020, we’ve transitioned from the most dramatic short-term recession in history to an economy growing at its fastest annual rate in nearly 18 years.

This see-saw of economic activity can be directly attributed to the sudden emergence of the COVID-19 pandemic early in 2020, and a resurgence of economic activity as the world adjusted to the new environment created by the health crisis.

The rate of economic growth accelerated in the first half of 2021. The inflation rate (cost of living) also jumped to its highest levels since 2008. Rising demand resulted in higher prices for single-family homes, lumber (for new home construction and renovation work) and energy. These are examples of areas of the economy where a supply-demand imbalance drove prices up for a time. It resulted in the surfacing of inflation worries for one of the few times in a generation. At the same time, employers have millions of job openings, yet the total number of Americans in the workforce remains well below the peak level reached just prior to the pandemic.

How should investors assess the state of the economy today and where might we go from here? What risks does the market face and what is the potential impact on investment strategies? Our market analysts provide their perspective about the state of the economy and how it might affect your portfolio.

Where we came from – an unusual slowdown

The past 18 months have not been in any way a “run-of-the-mill” economic environment. Businesses forced to shut down during the pandemic or change the way they conduct day-to-day activity (i.e., many employees working from home) had a dramatic impact. The U.S. economy as measured by Gross Domestic Product (GDP) declined from total output of $21.729 trillion at the end of 2019 to $19.520 trillion just six months later. On an annualized basis, this represented a decline of more than one-third of the economy’s size. 22 million jobs were lost in just a two-month period. At that time, inflation was a non-factor as price changes (as measured by the Consumer Price Index) were relatively flat during the early months of the pandemic.

“This was not a normal recession,” notes Rob Haworth, senior investment strategy director at U.S. Bank. “Rather than being driven by some form of excess in the economy, this recession was all a response to the pandemic, a completely different scenario than we’ve experienced before.” Because of that, he says the recovery has taken on different characteristics as well.

Contributing to the economy’s ability to rebound quickly from this uniquely challenging environment was dramatic fiscal and monetary policy. This included trillions of dollars in COVID relief stimulus from the federal government. It provided support for families, those who lost their jobs, and businesses. The Federal Reserve did its part by reinstating a zero interest rate policy and boosting its purchasing activity in the bond market to help support the economy and stabilize financial markets.

The economic recovery resumed quickly after the second quarter of last year. Bouncing off its low point last summer – which included an unprecedented 31.2 percent (annualized) drop in GDP in the second quarter of 2020 – GDP grew at an annualized rate of 33.8 percent in the third quarter. These dramatic quarterly changes were considered anomalies, demonstrating the odd circumstances of both the recession and the recovery.

Current state of the economy

As we moved farther away from the depths of the pandemic recession, the environment began to normalize, albeit at a faster-than-normal pace. The economy grew 6.3 percent in the first quarter and 6.6 percent in the second quarter. Discounting the rare circumstances of 2020, growth rates in the first and second quarters were the strongest quarterly rates on record since 2003. “A likely scenario is that the rate of growth will scale back a bit from the pace at the start of the year,” says Eric Freedman, chief investment officer at U.S. Bank. Even so, Freedman believes the economy will continue on a positive track for the foreseeable future.

While the economy (as measured by GDP) has more than regained all of the ground it lost in the early weeks of the pandemic, this does not mean we’re back to normal. Haworth points out that the labor force remains more than five million jobs short of returning to pre-pandemic levels.

Another major discussion point is the inflation rate, often represented by the Consumer Price Index (CPI). The prospect of higher inflation turned into a reality with the May CPI report that showed inflation growing at a five percent annualized rate – the highest in nearly 13 years and a level rarely reached in the past three decades. Inflation moved up to 5.4 percent annualized rate in June and July, then dropped a bit, to 5.3 percent in August.

“This will be one of the larger swing factors in the second half of 2021 and early 2022,” says Freedman. All eyes are on the Federal Reserve (the Fed) and its monetary policy actions should inflation concerns persist. Despite the rapid spike in inflation, in general there is not yet clear evidence of a demand-driven inflation spiral. “We continue to view the inflation situation as transitory,” says Freedman, “but it is something the markets will be watching closely in case the Fed should decide it needs to respond to inflation trends.”

Haworth notes there may be a bit more uncertainty about how long higher living costs will persist. “Higher prices over the summer were attributed in large part to spikes in air fares, lodging and used car prices. All three of those came down in the August report.” He says oil prices are one key category to watch to get a sense of whether inflation rates will remain elevated or begin to return to more normal levels.

The Fed indicated that it planned to maintain its zero interest rate policy (a nearly 0 percent target Fed Funds rate, which affects rates banks charge each other to lend dollars overnight) into 2023. Freedman thinks the Fed will only move in incremental steps to alter its current policy. “Their first step will be to taper off their bond buying program,” says Freedman. The Fed has indicated this could occur as early as the end of 2021. This might put some interest rate pressure on the market for Treasury and mortgage-backed securities, where the Fed is currently making purchases. “We think the Fed will err on the side of maintaining lower interest rates until there is more data than we’ve seen so far indicating that inflation is a sustainable risk,” says Freedman. “What the Fed does, other central banks around the world are likely to follow.”

COVID-19 continues to impact economic activity

Another major factor for the economy was the surprising summer spike in COVID-19 cases, as the Delta variant spread dramatically. The general sense of optimism in light of declining COVID-19 infection rates and rising vaccination activity in the spring gave way to increasing concerns that the pandemic was far from over. “The summer spike has thrown a wrench into the economy,” notes Haworth. “We’re seeing more restrictions on activity by states and localities, but also in the personal choices many are making in their own activity.” He is keeping a close watch on the impact of the “back-to-school” season on COVID numbers and whether that may create economic headwinds.

At the same time, Haworth points out that other factors, such as more workers returning to the office, could spur the economy. “More people working means more activity in general and commuting going up. If the recent surge in COVID-19 can be subdued, we could see another surge in economic activity.” However, since some major companies have postponed a requirement that employees return to the workplace, such a surge could be delayed.

Freedman also anticipates Americans will remain somewhat cautious in their spending for now, but that economic growth will remain solid throughout 2021. Inflation may remain elevated but is showing signs of leveling off.

Investment ramifications

The stock market continued to be in record-setting territory into September before giving back some of its significant gains for the year. While periods of short-term volatility can be expected, U.S stocks generally remain well positioned compared to other asset classes. “The biggest risk for the stock market today is that corporate earnings fail to live up to expectations,” according to Haworth. He believes that stock valuations are somewhat elevated, although not at particularly risky levels. “Higher inflation, consistently at a level above 3 percent, might be another issue,” says Haworth. In that environment, corporate profit margins may be squeezed if companies can’t raise their own prices to keep pace with higher costs.

The bond market is clearly affected by Fed interest rate policy and the risk of higher inflation. “It’s a much more complicated market for bond investors today,” says Freedman. “Simply owning Treasury bonds and high-quality corporate bonds may not deliver sufficient results for many investors.” He says there is a need to broaden bond allocations to include mortgage-backed securities, parts of the loan market and select high-yield bonds, which typically perform well when the economy is strong.

In times like these, it can be helpful to talk with your financial professional to review your current portfolio and determine if it’s well positioned given our expectations for where the economy may be going from here.

 

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