COVID-19 and Current Markets
by Craig MacKinlay
In the February issue of Partner Talk, I noted that for this year, “the prognosis for the economy as whole and for the corporate sector is relatively positive.” Then, I followed that statement with a word of caution, stating that “uncertainty due to pandemic related issues continues to be present.” It is fair to say that the word of caution has come to the forefront as we enter August 2020. With now tens of thousands of cases of the delta variant of COVID-19 striking the U.S. population, the big unknown is where the economy and markets are going. “The Great Reopening” discussed by Jonesy Lerch in the June issue of Partner Talk may be delayed. In this month’s issue we will consider the current economic outlook and shed some light on the forementioned unknown.
How have markets done this year? Year-to-date the stock market has been surprisingly strong. The market as measured by the S&P 500 Index has increased by 18 percent through the end of July. In contrast, the bond market as measured by the Bloomberg Barclays US Aggregate Bond Index year-to-date decreased 0.5 percent. However, this low return is driven by a very weak first quarter. The bond index increased by more than 2 percent in the second quarter.
The strong stock market reflects the bounce-back in real economic growth. As measured by real GDP, the annualized growth this year is 6.3 percent and 6.5 percent for the first two quarters respectively. However, growth in GDP is expected to moderate somewhat for the final two quarters of 2021. For the calendar year 2021, real GDP growth is expected to be approximately 6 percent. While this level of growth is strong by historical standards, it is lower than many had earlier forecasted for this year as uncertainty associated with the pandemic has impacted economic activity.
Looking beyond 2021, GDP real growth is expected to be significantly lower in 2022 and 2023. Growth forecasts for 2022 are between 3 and 3.5 percent and for 2023 are below 3 percent. While these forecasts are low relative to this year, they are generally in line with the historical growth of the U.S. economy. Considered on its own, if this lower growth is realized that should not be a problem for financial markets. Nonetheless, going forward, a high level of uncertainty for economic growth is expected and may play a role.
As discussed by Paul Snitzer in the May issue of Partner Talk, there is unusually high dispersion of forecasts for inflation going forward. Earlier in the year, the Federal Reserve argued that inflation would remain low, near 2 percent. With inflation surging in recent months, the Fed has updated its forecasts and now expects inflation for 2021 to be above 3 percent. But it has maintained its argument that any short-term increase in inflation will be transitory in nature and going forward its 2 percent target level of inflation is expected to be met. On the other hand, given current inflation, many economists believe that changes in inflation will persist and a rate of inflation above 4 or 5 percent should be anticipated over the next few years. Increased government spending is often put forward as one cause of this anticipated higher rate. Since an annual inflation target of 2 percent is one of the Fed’s mandates, this is an important issue. High inflation will necessitate the Fed to reduce its quantitative easing program and lead to upward pressure on interest rates.
Unemployment continues to be a concern. We have an unusual situation where the problem is not a lack of available jobs, but rather a shortage of workers willing to take available jobs. One source of this problem is the special unemployment benefits associated with COVID-19. These benefits will end in September and potentially mitigate this problem. As far as recent employment data is concerned, things do appear to be on track. In June total nonfarm payroll employment increased by 850,000, and the unemployment rate declined to 5.9 percent, according to the U.S. Bureau of Labor Statistics report on July 2.
What about equity markets? Since earnings are the key driver of stock prices, we need to consider future earnings’ prospects. In aggregate, at this time, the earnings power of the corporate sector looks exceptionally strong. For companies in the S&P 500 index, earnings relative to the same quarter last year are expected to grow at more than 20 percent for both the current quarter and the fourth quarter which would lead to earnings growing by more than 40 percent in calendar year 2021. Earnings growth is expected to normalize in 2022. But forecasts are still for a healthy growth rate of 10 percent. What might curtail this positive outlook? The short answer is COVID related issues. If the spread of the virus leads to more shutdowns, that will slow economic activity and reduce earnings. Inflation is a lesser concern for equities. Since equities are generally claims on real assets, and the value of most real assets increase with inflation, equities can be an inflation hedge.
While equity values on average will increase with inflation, the same can’t be said of the value of bonds. Bonds provide interest payments that are nominal cash flows to the bond holder at specified times in the future. With inflation the purchasing power of these future flows will decline leading to the value of the bond falling. The sensitivity of the value of the bond to inflation will depend on the bond maturity since the further in the future the flow is expected the greater the loss of purchasing power with inflation. This suggests that one method to reduce a bond allocation’s sensitivity to inflation is to hold short maturity bonds. A second method is to hold inflation protected bonds which have future flows that rise with inflation to protect purchasing power.
The role of COVID for current economic environment is multidimensional. At PMA, this environment is being closely monitored and, as warranted, adjustments are made to allocations to achieve our goal of delivering high risk-adjusted performance.