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Looking Beyond COVID-19 —Grandfather Clock Economics — Fed’s New Framework — Maximizes Employment — a New Fed Chair?

Date Posted: April 12, 2021

Grandfather Clock Economics

Over the years, I subscribed to the grandfather clock theory of economics. In effect, the economic and political environment swings from one extreme to the other over some lengthy period of time

Roosevelt—During the great depression, the new deal, under FDR, swung the economic and political pendulum to the left. The new deal revolutionized this country with massive new spending and social programs as well as increased financial and economic regulations. His upper-class associates called FDR a traitor to his class. In reality, he likely prevented serious social upheaval that could have threatened that class. The new deal also obliterated the Republican party nationally for a generation.

Reagan—Nearly fifty years later, the pendulum shifted away from “big” government when President Reagan declared in his inaugural address: “Government is not the solution to our problems; government is the problem.” Deregulation of major industries expanded. Even future Democratic administrations such as Bill Clinton moderated the role of government in social programs.

Biden—Today, we see the pendulum swinging back again to “big” government with its sharply higher economic and social role. This pendulum shift back to big government attempts to deal, in part, with the wealth/income gap. By revising the social contract between the government and the people, the new administration sees itself preventing social upheaval.

First—Massive Relief Spending

The first sign of the pendulum swinging to big government came with the most recent COVID spending program. The American recovery plan (ARP) reached beyond direct COVID needs and totaled $1.9 trillion – 10% of GDP. The plan sent $1400 checks to most Americans (see Figure 1).

Figure 1

Us: Weekly Stimulus Checks and Refunds

Source: Oxford Economics\Haver Analytics

Then – New Big Government Spending Programs

The administration’s $2-3 trillion infrastructure plan closely followed. This plan underlines their belief that big government, not private industry, can better lead the big projects. That plan will shortly be followed by a roughly $1 trillion-dollar American Families Plan. That plan will focus more on what the administration sees as critical social needs in education and healthcare. The spending for both programs will total approximately $4 trillion over 8-10 years, financed in part with higher tax rates as well as increased debt.

Bigger U.S. GDP In 2022 Than Pre-Pandemic

With the flood of spending this year from the most recent two rounds of COVID relief programs combined with vaccinations reaching over 3 million daily, economists seem to be trying to outdo each other in raising their economic forecasts. Using a conservative forecast from the IMF, the American economy in 2022 will reach a level 6% greater than experienced in 2019. In comparison, Europe will likely only be back to 2019 levels (see Figure 2).

Figure 2

GDP Forecast—2022 – U.S. Compared to Europe

Source: Economist

More Than U.S.—a Strong Global Recovery

Historically, south Korean exports provided a leading indicator of global growth. If that still holds, their recent march export numbers suggest a very strong global recovery seems likely. Korean exports in March jumped 16.6% from a year earlier (see Figure 3). Supporting that conclusion, the IMF recently upgraded its forecasts for global growth (see Figure 4). With growing supplies of vaccine, it would seem likely the U.S. will begin exporting vaccines to less developed countries such as Mexico to further support economic growth in less developed countries.

Figure 3

South Korea Exports (US$)

Figure 4

IMF Annual Growth Forecasts For 2021 YoY%

Source: Mizuho Securities, IMF, Daily Shot

Service Industry Recovery Key to Employment Growth — a Now Happening — Forecasts May Underestimate “Boom”

Many economists now call the outlook for the remainder of the year a “boom.” With vaccines now flowing, the service economy will particularly “boom” as consumers reduce their concerns about leaving their caves to mingle with other consumers. ISM services index recently reached its highest level on record last month – beating economists’ forecasts (see Figure 5). With service industry employment decimated during the pandemic, its recovery will prove key to employment growth (see Figure 6). Importantly, therefore, nearly half of the 1.4 million jobs created in February and March originated in leisure and hospitality services. With both the “unprecedented” pandemic followed by a “boom,” not only will economists likely underestimate the recovery’s strength so will analysts’ earnings forecasts (consensus S&P 500 2021 earnings forecast +25%). That shortfall will likely prove particularly beneficial for cyclical/value stocks.

Figure 5

ISM Services Index – 7/97-3/21

Figure 6

Change In Employment Level by Industry Since February 2020

Source: Wall Street Journal, Daily Shot

How Far Economic Momentum Carries Into 2022 — Key to Market Outlook — Greater Market Volatility May Result

As we move into the late summer months, investors will try to judge how far the momentum from this year will carry into 2022. Figure 7 shows estimates of the ARP spending impact on quarterly GDP growth. Those estimates show the economic impact will ebb early next year. At the same time, the Fed will still keep its highly accommodative monetary policies in place to maintain economic momentum. The uncertainty as to how far the momentum will carry into next year will likely lead to greater dispersion of 2022 economic and earnings estimates. Therefore, greater market volatility will likely result this fall.

Figure 7

Contribution of the American Rescue Plan to Real GDP Growth

Fed’s New Framework Will Attempt to “Fully” Maximize Employment Levels — Markets May Underestimate this Focus

In 2022, the economic momentum will likely reflect reduced new fiscal spending support as well as higher taxes (see Figure 8). As the economy transitions to a more normal recovery, the Fed will more clearly show its new framework, which focuses on a broad-based and inclusive concept of maximum employment. Fed governor Lael Brainard said the new framework “seeks to eliminate shortfalls of employment from its maximum level, in contrast, the previous approach called for policy to minimize deviations when employment is too high or too low.” With this new framework, the Fed will use a broad range of employment measures to determine maximum employment levels. Until and unless inflation forces the Fed to pull back, the Fed will seek to strongly support an economy that can bring broad-based unemployment measures below levels previously experienced. In our view, investors underestimate the importance of this framework change on the economic outlook.

Figure 8

Hutchins Center Fiscal Impact Measure

Fiscal Policy Contribution to Real GDP Growth Percentage Points

A New Fed Chair?

Chair Powell’s term ends February 2022. At this point, it seems likely he will be renominated for that position. At the same time, with the Fed gradually moving past its dual full employment and stable price mandates into such activities as climate change, perhaps a progressive administration will look for a chair more fully committed to its agenda.

Investment Conclusions

Earnings Market Key — Last year, stocks benefitted primarily from multiple expansion rather than earnings growth. Our commentary earlier this year, therefore, suggested that 2021 equity market performance depended more on EPS growth than multiple expansion (see Figure 8). If forecasts calling for 25% EPS growth for the S&P 500 index hold up or, in our opinion, the “boom” drives those numbers even higher, equity markets will respond very positively.

Figure 8

S&P 500 Total Return Attribution

Volatility — As we move through the summer, investors will attempt to make judgments about 2022. It seems likely that there will be a dispersion of economic forecasts as to how far into 2022 the current economic momentum will carry. This will likely lead to greater market volatility.

Inflation—The second question will surround how temporary will “boom” inflation prove to be. Financial markets will not wait to see. Rising interest rates will result until inflation proves to be transitory — or not. The equity market response will depend on whether higher inflation accompanies a continued strong economic recovery (see commentary 3/15/21 on inflation).

Growth, Pricing, and Labor Costs — If the economic outlook for the second half of 2022 projects slower economic growth, then investors may return to faster-growing companies. At the same time, if inflation also raises its ugly head, then investors will likely seek out companies with pricing power as well as those with lower labor costs — among others, growth companies fit that outline.

Fixed Income — Having Federalized fixed income markets, the Fed may still hold off attempting to moderate the yield curve’s upward tilt unless unexpected pressures result. With that and an uncertain inflation outlook, investors should stick with shorter-duration fixed-income investments. This will avoid price risks longer duration debt faces from potentially rising interest rates.