Global economic activity is on track for a continued strong rebound in 2021, after the COVID-19 global recession led to an economic roller coaster ride in 2020.
For the full year 2020, US GDP likely fell 3.5%, with larger contractions in Japan (-4.9%), the Eurozone (-6.6%), the UK (-10.1%), and in many emerging markets. China and Taiwan were exceptions, as their economies expanded by 2.3% and 3.1%, respectively, last year, benefiting from an earlier recovery, better overall management of the pandemic, and from their position as critical tech hubs, which thrived during the pandemic due to the accelerating trend in digitization.
Following last year’s synchronized third-quarter growth surge, Q4 2020 growth was somewhat mixed, with most major economies experiencing solid growth but with output contracting by 2.6% in the Eurozone, as a third wave of the virus led to renewed lockdowns and related restrictions.
In early 2021, investor optimism about the recovery was tempered by concerns surrounding a spike in COVID-19 infections and the virus mutating into more transmissible and/or more virulent strains. Further, significant progress on vaccine testing and approval was followed by a slow and bumpy initial rollout of the vaccines in the United States, raising questions about how quickly restrictions on economic activity could be lifted. But, optimism about the recovery ratcheted higher during the quarter in tandem with progress on vaccine distribution. Since reaching a peak in January following the holidays, new COVID-19 cases in the US have plunged, with the surge in vaccine administration as the key driver of the decline.
Global COVID-19 cases have also fallen from their peak in January, largely driven by developed markets that have made substantial progress in administering vaccines, especially the US and the United Kingdom, albeit with some isolated outbreaks (France and Italy). However, emerging markets, led by Brazil, with less access to vaccines are experiencing a fresh wave of increasing COVID-19 cases in March.
The accelerated rollout of the vaccine has moved forward the timeline for reopening economic activity in the US and the United Kingdom. A slower rollout of the vaccine in Europe, in contrast, leaves the Eurozone economy likely facing a double-dip recession, with negative growth expected to continue in the first quarter of 2021 after a decline in Q4 2020. We expect European growth to rebound thereafter, with a sharp bounce back in Q2 continuing into the second half supported by fiscal and monetary stimulus and a relaxation of restrictions once vaccines are more widely administered.
We see upside risks to consensus growth forecasts, especially in the US, with positive spillovers for key trading partners. Increased vaccine distribution, falling COVID-19 infection rates, and the passage of the $1.9 trillion stimulus bill have the potential to turbocharge the recovery. Pent-up demand, reopening of economic activity, and a steady increase in employment provide potent fuel for a potential economic boom. Further, given the cumulative impact of government relief over the past year and limited opportunity to spend given virus restrictions, the US now has around $1.5 trillion in excess savings. Aggregate household savings are now three times the level they were pre-pandemic and should get another boost from the payments to households in the latest fiscal package.
Supported by easy financial conditions and the ongoing job market recovery, the US housing market continues to surge. Housing prices have soared in the past year. The national Case-Shiller index is up 11.2% in the past twelve months, the largest gain since 2005-06. The FHFA index is up 12.0% in the past twelve months, the largest on record (going back to 1991).
Given these gains, some are wondering whether housing is back in a 2000s-type bubble. But a deep dive into the data suggests we are not.
To assess home prices, we use the market value of all owner-occupied homes calculated by the Federal Reserve. We then compare that to the “imputed” rent calculated by the Commerce Department for the GDP report. (Imputed rent means what people would pay to rent their homes if they rented them from someone else.) In the past 40 years, home values have typically been 16.4 times annual rent. At the peak of the bubble in 2005, they were 21.4 times annual rent, or 33% above normal. Now, home prices are 17.8 times annual rent, about 11% above normal.
We also compare home prices to the Fed’s measure of replacement cost. In the past 40 years, home prices have typically been 1.59 times replacement cost. In 2005, they peaked at 1.94 times replacement cost, a premium of 22.5%. Now homes are selling for 1.63 times the replacement cost, only 2.5% above normal, which is minimal.
Does this mean housing is at risk? We don’t think so. The recent price surge is based on fundamentals and the housing market should continue to boom.
The primary problem is a lack of homes. Based on population growth and scrappage (voluntary knockdowns, fires, floods, hurricanes, tornadoes…etc.), we would normally expect housing starts of 1.5 million per year. But in the past twenty years (March 2001 through February 2021), builders have only started 1.256 million per year. Builders haven’t started more than 1.5 million homes in a calendar year since 2006.
No wonder the inventory of homes for sale is so low! Single-family existing home inventories are at rock bottom levels, with only 870,000 for sale in February. To put this in perspective, the lowest inventory for any February on record from 1982 through 2016 was 1.55 million. Meanwhile, there are only 40,000 completed new homes for sale, versus 77,000 a year ago and an average of 87,000 in the past twenty years.
Two other factors are likely at work. One issue is that there’s a moratorium on evictions, so some tenants are paying less in rent than they normally would, which is temporarily holding down rental values versus home prices (therefore elevating the price-to-rent ratio). This is also holding down the housing component of the Consumer Price Index, which is calculated using rents, not home prices.
Another factor is that people have moved away from places where renting is popular to places where home ownership is popular. If you leave New York City or San Francisco for Nashville or Boise, there’s a good chance you went from renting to owning. This helps boost home prices as well.
Yes, home prices are up and, yes, they look somewhat expensive relative to normal, but this is more about the unprecedented events of the past decade, not some problem with the market. With the Fed so easy, and the stock of housing constrained, prices will continue to rise. The housing boom will continue.
Given the strong rebound in growth and fuel for continued strength, bond yields and market-implied inflation expectations have seen sharp increases. What do you get when you take rising vaccinations and immunity, add in additional stimulus, all in an economy where supply chains are still working to get back online? Inflation rising at the fastest pace in more than a decade, on the tails of sizeable increases in January and February.
The 0.6% increase in the March CPI ties for the largest single-month increase going back to 2009. The monthly gain in March, as well as the “base-effect” impact of comparing to last March (when prices were declining), pushed the 12-month increase in the CPI up to 2.6%. With the largest monthly decline coming last April, even a flat reading in the CPI in the month ahead would put the 12-month CPI increase above 3%. It’s going to take time for supply-chain issues that have created shortages – and lifted prices – for things like semiconductors, lumber, and household appliances to resolve, but that is a temporary (or as the Fed likes to say “transitory”) factor.
What is less temporary is the massive 27% increase in the M2 money supply and ongoing proposals for trillions more in government spending. Simply put, math wins, and today the math says inflation above the Fed’s 2% target is likely to be with us for some time. Will that change the Fed’s plans to hold rates at zero for the foreseeable future? Don’t count on it.
The Fed seems to believe that this rise will ease later this year and into the next as re-openings help ease supply-chain pressures. We believe they are writing off the upward pressure in prices from the money supply growth too quickly.
Taking a look at the details of the most recent report shows energy led the consumer price index higher in March, rising 5.0% on the back of higher costs for gasoline and natural gas. Food prices rose a more modest 0.1%, as higher costs for fruits and vegetables were largely offset by lower prices on dairy products. Strip out these typically volatile categories, and “core” prices still rose 0.3% in March. Here, housing costs were the main contributor, despite the government’s measure for housing (which focuses on what homeowners would have to pay if they rented the house from someone else) being artificially subdued by the moratorium on evictions.
We like to follow “cash inflation,” which is everything in the CPI except for owners’ equivalent rent. Cash inflation increased 0.7% in March and is up at a 4.9% annual rate since prices began to rise again last June. Prices for used cars (impacted by the semiconductor shortage slowing the production of today’s ever more tech-heavy vehicles), auto insurance, and medical care also moved higher. Inflation will be front and center in 2021 as the Fed – and markets – try to untangle just how quickly, and how sustained, will be the impact of the unprecedented spending in response to COVID-19. There is no free lunch.
The federal budget deficit hit an all-time record high of $3.1 trillion last year. With the passage of the recent blowout “stimulus” bill, it’s set to be even higher in 2021. Now we watch and wait for a potential infrastructure bill, which could run as much as an extra $4 trillion over the next ten years. A trillion here, a trillion there…you know how the old saying goes.
As night follows day, higher spending – unless offset with future spending cuts – is going to lead to higher taxes. That’s certainly the course the Biden Administration looks set to follow.
So far, consistent with his campaign pledge, President Biden says he’s not going to raise taxes on people making less than $400,000 per year. But that’s not where the money is.
Let’s say they raise the top personal tax rate of 37% back to 39.6%, which is where it was for eight years under President Clinton, the last four years under President Obama, and the first year of President Trump. That change would generate only an additional $20 billion in extra revenue per year, based on 2018 tax data. If they also raised the 35% income tax bracket to 39.6%, that would raise an extra $13 billion per year. And this year the 35% tax rate kicks in at $209,426 for singles and $418,851 for married couples, which means that path would violate the $400,000 promise. Either way, it’s like trying to fill a swimming pool using a teaspoon.
If they were to go for broke and raise both the 35% and the 37% brackets to a 100% tax rate, and people keep working and paying everything they made in taxes, that would have raised about $681 billion in 2018. Big money, but still not close to bridging the budget gap.
That’s why we think Transportation Secretary Pete Buttigieg’s trial balloon about taxing auto mileage has to be taken seriously. The big spenders in Washington, D.C., know that tapping into the incomes of people making less than $400,000 per year is necessary to pay for all their spending promises.
At this point, we think it’d be very tough to get to 50 Senate votes for a whole new federal tax system on mileage. The same goes for a Senator Elizabeth Warren-style wealth tax, which is also of dubious Constitutionality. And, unless they get rid of the filibuster, the same goes for applying the Social Security tax to wages and salaries above $400,000.
Instead, we think the tax hike, which will likely be implemented on January 1, 2022, includes the following parts:
1. A top rate back up to 39.6%
2. A corporate rate, now 21%, close to 28%.
3. A top rate on capital gains and dividends at about 24% versus the current 20%
4. A lower exemption for the estate tax.
The one thing we can say for sure about all this is that some of these projections will be wrong. But we think most of it’ll be right. The Biden team has suggested getting rid of the step-up basis at death for capital assets, but we think that would be an administrative nightmare. Moderate Senators would listen to horror stories about trying to adjust the basis for small farms and business owners and say, no.
The Biden team has also supported applying the 39.6% tax rate to the capital gains and dividends of the highest earners. That’s one proposal that, if enacted, could hurt the stock market and the wider economy. The long-term capital gains tax rate hasn’t been that high since the late 1970s; the dividends rate since 2001. Raising them both that high at the same time? If you haven’t already decided that all this spending is damaging to long-term growth and investments, this would certainly be worrisome. We see a rise to 24% as the compromise that gets the votes.
Bargaining on tax hikes has already started in Washington, at least behind the scenes. It’s going to be a long process, but we can say with high conviction that taxes are going up.
With bond yields surging across markets major central banks sought to reassure investors that they will not allow rising rates to stymie the ongoing economic recovery, especially with unemployment rates still high. Federal Reserve Chair Powell, in his recent semi-annual testimony to Congress and at the March 17th Federal Open Market Committee meeting, sought to downplay inflation fears, noting that the job market still needs to heal.
In the Eurozone, where the recovery is lagging, the sharp rise in longer-term interest rates prompted the European Central Bank to announce a significant increase in bond purchases over the next quarter. Bank of Japan Governor Kuroda emphasized that it is important to keep long-term interest rates “stably low,” as the economy is still suffering from the impact of the pandemic.
Government bond returns have been hit by rising rates. The ten-year US Treasury yield hit 1.7% on March 18th, while starting the year at 0.9%, up from 2020’s low of 0.5%. TLT, the iShares 20yr+ Treasury Bond ETF, has fallen 20% from its peak in August of 2020. Given the surging growth environment, benchmark ten-year rates could hit 2.0% this year (or even 2.5% in an overshoot scenario), though upside to sovereign bond yields should remain limited by the prospect of increased central bank bond purchases or jawboning, at a minimum. However, we remain overweight fixed income risk assets, including US high yield bonds, as the pro-risk and strong-growth environment could bring spreads lower, despite spreads that are already back at pre-pandemic levels.
A strong economy helps everyone and mitigates our country’s financial problems, but it will not be a straight line up for investors. Even if driven by a welcomed rapid economic expansion, rising interest rates will unsettle the bond market and the stock market in the short run. The taper tantrum of 2013 is frequently discussed in today’s investing news because a similar market reaction may accompany rising rates this time around too.
The government’s fiscal policies of support will be withdrawn later this year. Higher taxes are in the offing for high earners and corporations. Walking back some of the 2017 tax cuts is moderately popular, but even so, the increases that actually pass will likely be less than the worst case.
The ending of fiscal and monetary policy support will be guided by the central causation factor of this recession, which is the prevalence of coronavirus and the effectiveness of the mass vaccination program well underway. The economy remains vulnerable to a “wrong turn” caused by a virus variant. There is little to be done specifically about this possibility. It’s a reminder that diversification and avoiding too much speculation must go hand and hand with exuberance about emerging from the pandemic.
As we begin the second quarter and look forward to the rest of 2021, we are optimistic. There are still a great many companies trading at very attractive levels. 2021 should be the year of the vaccines and, as such, will give all of us a new start on a hopefully long economic expansion. However, for investors, generating strong returns in the decade ahead will require a renewed commitment to basic investment principles, particularly given an altered economic landscape, elevated valuations, and the policy changes that have emanated from the year of the pandemic.
We are as excited and hopeful as everyone else about putting this pandemic behind us and returning to more normal ways of living. We look forward to seeing everyone in person soon!