Written by: Brent Schutte | Northwestern Mutual
When we started 2020, we believed the economy was strong. This recession wasn’t caused by deteriorating economic fundamentals. Rather, COVID-19 and its subsequent severe disruptions to our daily lives triggered the recession. If you rewind to late February and early March, disruption and uncertainty peaked because we didn’t know much about COVID-19. We had limited information on how it was transmitted, who was vulnerable, or how to treat and prevent it. Because we were flying in the dark, we resorted to a combination of broad stay-at-home orders and closures as a best defense.
This abrupt slowdown in activity carved a deep economic and market valley. Growth plunged in the second quarter, which caused the U.S. stock market to fall from record highs on Feb. 19 into a bear market (down 20 percent) at a record pace — just 16 days — before ultimately reaching the bottom, down 34 percent, on March 23. Extreme pessimism prevailed at the time, but through it all we expressed optimism that monetary and fiscal policymakers would act to fill the valley, the economy would adapt and markets would eventually push higher. In our Q1 commentary, we wrote:
“Even in the face of the uncertainty … we are optimistic that this bear market may be unique relative to the prior two bear markets. So far it has proven to be unique in its pace to the downside; we believe the same could be true on the flip side.”
During Q3, economic growth snapped back at a torrid pace, and it appears the U.S. economy indeed logged that oft-discussed V-shaped recovery. And this action was reflected by a similarly robust recovery in the stock market, especially by companies positioned to thrive as people continued to spend but in different ways from home.
Economic growth stormed back as the U.S. economy adapted to a “new normal” amid COVID-19. The economic displacement of Q1 and Q2 has been transformed into economic replacement in Q3.
As we head into the final quarter of the year, the four-milestone roadmap we laid out in our Q1 commentary has also proven prescient. The depths of the economic valley were filled by aggressive monetary and fiscal policy both here and abroad. The width of the valley (or duration of the crisis) has lessened as our knowledge of the virus grows. That’s allowed us to adapt and re-open large swaths of the U.S. economy even while the virus continues to pulse around the planet.
Finally, doctors are getting better at treating the virus; and a viable vaccine, according to congressional testimony from health experts, looks like it could be broadly available to Americans by late spring or early summer 2021. That doesn’t mean we’re out of the woods, but with each passing day the sun shines a little brighter through the tree canopy.
From Economic Output Displacement To Economic Growth Replacement
From the very beginning of COVID-19, we have believed that many forecasters were missing a very important point regarding the U.S. economy: its ability to adapt as companies and consumers learn to operate in a COVID-19-influenced world. Once again, we return to our Q1 2020 market commentary:
“We are not trivializing the potential for the virus to take us on a path of twists and turns in the coming quarters; rather, we are expressing our optimism for our ability to adapt to the changing circumstances … put differently, society is always shifting, but a capitalistic economy is able to adapt.”
This is precisely what occurred over the past quarter. Economic growth stormed back as the U.S. economy adapted to a “new normal” amid COVID-19. The economic displacement of Q1 and Q2 has been transformed into economic replacement in Q3. But the economy looks different today. While growth has returned, a dive below the headline numbers shows the sectors leading the charge are changing as COVID-19 impedes some segments of the economy while providing tailwinds to others. Airlines, travel, restaurants, office and shopping mall real estate remain challenged, while housing companies, grocery stores, e-commerce and work-from-home enablers are experiencing rapid growth. It would’ve seemed unlikely in April, but many segments of the U.S. economy have now completely recovered pandemic-driven economic losses. The housing market, for example, has even powered well ahead of its prior highs.
Many forecasters were missing a very important point regarding the U.S. economy: Its ability to adapt.
And the strongest parts of the U.S. economy are doing some heavy lifting, pulling the weaker segments along with them. While we won’t get our first estimate of overall Q3 U.S. economic output until later in October, the Atlanta Federal Reserve GDP Now tracker (a running, real-time estimate of GDP) provides a glimpse of where growth will clock in. As of Oct. 7 the tracker forecasts Q3 GDP coming in around 35 percent quarter-over-quarter at a seasonally adjusted, annualized pace. This 35.3 percent increase would leave the U.S. economy just 3 percent smaller than what it was when the calendar flipped to 2020.
The shift to growth can be seen vividly in overall U.S. consumer spending. U.S. Personal Consumption Expenditures (PCE) accounts for nearly 70 percent of overall U.S. economic growth (GDP). While data are available only through August, an overall tally of nominal spending is only 3.4 percent below its pre-pandemic high. Digging a level deeper, we can see that overall spending comprises three segments:
- Durables: home furnishings, durable household equipment and automobiles
- Non-durables: food and beverages for off-premise consumption, clothing, footwear and gasoline
- Services: housing and utilities but, more importantly, the most aggrieved segments of recreation, transportation and food services, plus health care
Since the pandemic struck, durables have been extremely strong, now 12 percent above their pre-pandemic highs. Non-durables spiked in March as Americans front-loaded shopping and stockpiled goods. While there was an initial decline in the months that followed, non-durables are now 2 percent above their February levels. Services remain 7.5 percent below February highs, but this segment of the economy depends on people venturing out and being around other people at a restaurant, a movie or traveling.
It would’ve seemed unlikely in April, but many segments of the U.S. economy have now completely recovered pandemic-driven economic losses.
We’d be remiss to not mention the role fiscal stimulus has played in keeping consumer spending afloat as an additional 17 million Americans were reported as unemployed from February (5.7 million) to April (23 million) as a result of COVID-19. Fortunately, since then payrolls have grown rapidly, pushing the number of unemployed down to 12.5 million total. If stimulus doesn’t materialize in the coming weeks, we don’t believe it would be an absolute market-breaker given many Americans have already emerged from the economic valley. Of course, additional stimulus would help pull more Americans out of the valley, and we still think it's likely to come after the election no matter who is in office. And if we do get a vaccine in the coming months, that certainly would speed up the healing.
The Market Is Reflective of the Economy
We continue to hear chatter that the market does not reflect the economy. Well, we disagree. Overall, U.S. economic data have formed a V-shaped recovery, and so have U.S. markets. Yes, the U.S. economy is 3 percent smaller than it was at the beginning of the year; however, one must remember that the market is a discounting mechanism, and currently it is pricing in optimism for the future and a complete recovery in 2021. We must also remember that the index that everyone quotes, the S&P 500, is neither the entirety of the U.S. market nor equal-weighted. Let’s break these two statements apart:
- While the S&P 500 is up nearly 6 percent year to date as of Sept. 30, U.S. Mid-Cap and U.S. Small-Cap stock indices are lower by 9 percent and 15 percent, respectively.
- Because it is market-cap-weighted as opposed to equal-weighted, the S&P 500 is concentrated in names that have benefitted from our current at-home working and shopping lifestyle. These large names have helped power the index higher, while other parts of the index have languished. The equal-weighted S&P 500 index, for context, is down 4.75 percent year to date.
This bifurcated market becomes clearer when you examine sector performance. Indeed, through Sept. 30, six sectors in the S&P 500 are positive. Information Technology is up 28.7 percent, driven by Apple and Microsoft; Consumer Discretionary is up 23 percent, driven by Amazon and Home Depot; Communication Services are up 9 percent, pulled higher by Facebook and Alphabet; while Energy has fallen 48 percent; REITs are down 6.8 percent; and Financials are down 20.2 percent.
While 2020 wasn’t a typical recession, whomever takes office following the next election will inherit an economy likely early in the business cycle or, at a minimum, mid cycle.
Performance in many sectors is being driven positively by companies that are helping us live our lives during COVID-19. Meanwhile, segments of the U.S. economy where the virus is a significant headwind have been a drag. However, we think there may be opportunities in asset classes and sectors currently facing headwinds as we continue to inch back to what was “normal” pre-COVID-19.
Looking forward, we believe economic growth will continue to recover as the economy adapts and the prospect of a vaccine rises. Given that backdrop, we believe there are opportunities for the market to push higher. However, the next leg up will likely be driven by different leadership.
The World Is Uncertain … Except for the Fed
There are still myriad worries for investors to ponder going into Q4. Currently topping the list is a spike in COVID-19 cases and, of course, the U.S. presidential election. While COVID-19 cases are on the rise, the economy is adapting, stimulus is likely — if not now, then after the election — and a trove of data from late-stage vaccine trials is expected in Q4. Any positive vaccine news would likely allow the market to discount the impacts of an unfortunate spike in cases this fall and winter.
We think there may be opportunities in asset classes and sectors currently facing headwinds as we continue to inch back to what was “normal” pre-COVID-19.
Regarding the election, we acknowledge that a contested election and a Democratic sweep could produce knee-jerk market reactions. However, our research would suggest that the president isn’t a primary driver of growth or market returns, regardless of party affiliation. Instead, where the U.S. economy resides in the business cycle when a president takes office is a better indicator of market returns than an administration’s policies. A president can certainly be an incremental positive or negative to economic growth and market returns but not an absolute positive or negative. We think of the U.S. economy as a large tanker that, once in motion, is incredibly hard to knock off course. Presidential policies can push against it or with it, but they can’t entirely impede the economy’s natural, long-term momentum.
This is where there’s good news for whomever takes office next. While the U.S. economy has recaptured some of its lost growth, there’s still significant slack. In other words, there’s more room for growth.
Presidents and the Business Cycle
The U.S. economy is now exiting a recession and is early in a new business cycle. Our research tracing back to 1960 indicates that presidents who were elected early in a business cycle see a 14.2 percent annualized market return during their tenure in office. Similarly, presidents who inherited an economy midway through the business cycle saw markets produce a 10.6 percent average, annualized return. Nine of 10 presidents who inherited an economy early- or mid-cycle witnessed double-digit returns. Only one, George W. Bush in 2004, witnessed a negative return due to the Great Recession.
Contrast this with presidents who took the reins of an economy late in the business cycle or when the economy was out of slack. Returns dipped to single digits, with average annualized returns of 6.7 percent. Notice, in all cases market returns were positive — regardless of administration.
For the past 40 years, the Fed has followed the Paul Volcker blueprint that emphasized keeping inflation at bay and moral hazard to a minimum. Today, the Powell blueprint emphasizes enhancing inflation and letting the economy and markets run hot.
While 2020 wasn’t a typical recession, whomever takes office following the next election will inherit an economy likely early in the business cycle or, at a minimum, mid-cycle.
The New Fed
This business cycle conversation leads to a final, and important, point about the role the Federal Reserve plays in charting the path of economies and markets. The Fed typically eases rates early in the business cycle and gradually shifts to a slow and steady process of tightening as the business cycle enters advanced stages. Looking forward, no matter who wins the election, the Fed will remain an economic and market "ally" and will wait until the economic cycle is firmly in its final stage before even contemplating tightening. We don’t anticipate the traditional, gradual tightening cycle as we’ve seen in the past.
For the past 40 years, the Fed has followed the Paul Volcker blueprint that emphasized keeping inflation at bay and moral hazard to a minimum. Today, the Powell blueprint emphasizes enhancing inflation and letting the economy and markets run hot.
The Fed recently said it won’t tighten interest rates until the economy has reached maximum employment and inflation has not only risen to 2 percent but is on track to moderately exceed 2 percent for some time. That last italicized bit is admittedly open-ended. But it's safe to say the Fed won’t be in any hurry to raise interest rates or tighten policy, which typically marks the beginning of a recession.
The Fed has the market’s back, and that isn’t going to change whether it’s Donald Trump or Joe Biden in the White House. This is a truly fundamental shift for the Fed, and it’s a shift we’ve forecasted and written about heavily. While the “new” Fed doesn’t mean we won’t experience market downturns, we believe the “Fed put” means future downturns will likely be shorter — kind of like what we have now. Regardless, one of the best ways to build wealth and financial security through every presidency and business cycle is to work with a financial advisor who can help you build a long-term plan that’s resilient in any economic season.
Related: The U.S. Election Is the Biggest Political Risk We Have Seen in Several Decades