Looking Beyond Near-Term Recovery: The Sustainability of U.S. Economic Expansion
April 30, 2021
By Joseph Rubin
The Bureau of Economic Analysis has released its first estimate of growth in U.S. Gross Domestic Product (GDP) for the first quarter of 2021. The robust 6.4% projected annual growth rate, significantly higher than the revised 4.3% annual growth rate in the fourth quarter of 2020, demonstrates that the consumer and business disruption caused by the COVID-19 pandemic may be receding. The pandemic put the economy on a nightmarish roller coaster ride, with GDP rising and falling more than 30% in consecutive quarters, businesses closing, and millions of people losing their jobs. A primary consideration for politicians, economists, business leaders, and every American concerned about recovering their quality of life, is the trajectory of COVID-19 and the pace and sustainability of economic recovery.
The first quarter results confirm that the economic recovery appears to be happening faster than expected only a couple of months ago. Despite an uptick in new cases of COVID-19 in certain regions of the country, hospitalizations and deaths are trending downward. Half of American adults have had at least one vaccination. The pace of new jobs accelerated in March, as did consumer spending, manufacturing, and housing starts. All of this is being supporting by historically unprecedented government stimulus, both monetary and fiscal. Given these strong tailwinds, some rational exuberance is justified. The equity markets have responded with record highs.
The recovery for the remainder of 2021 looks very promising but what about the next few years? Some are wondering whether the sugar rush of rapid short-term growth will leave us feeling down and out in 2022. A major concern is that ramped-up spending in all sectors of the economy combined with rapid job growth will unleash inflation, virtually locked away for the past forty years. The roller coaster ride may continue for a while, and only time will tell whether the dosage of stimulus was appropriate for the severity of the economic impact of the disease. Hopefully the government’s well-intended efforts are not creating a gap between expectations of continued economic growth and the reality that booster shots only last so long.
Let’s review the activity in each component of the economy in an effort to assess the likely longevity of the recovery.
Economic Growth Engines
Until the onset of the pandemic, the U.S. economy had enjoyed a long-term recovery from the Great Recession more than a decade ago. Growth of GDP was steady at around 2.5% annually; very respectable considering historical trends and an economy of about $22 trillion. However, that moderate growth was bolstered by an extraordinarily lengthy period of low interest rates engineered by the Federal Reserve. Those low interest rates enabled corporations to borrow and invest, boosted private investment returns, and enabled families to buy homes more cheaply. Indeed, the U.S. economy was being propped up well before the pandemic struck.
Starting in March 2020, the government’s response to the pandemic’s potential impact on the economy was swift and ambitious. The Fed set the Federal Funds rate at rock bottom and supported the prices of securities; it is still purchasing $120 billion per month of Treasuries and mortgage-backed securities, ballooning its balance sheet to almost $8 trillion. These purchases have given confidence to issuers and investors that the market will be liquid and trading should continue. Fiscal stimulus was added, pumping trillions more into the economy. By March of 2021, the economy appeared to be booming. The most recent Federal Reserve Board forecast for full-year 2021 GDP growth is 6.5%, slightly higher than the 6.4% median forecast of The Wall Street Journal’s April survey of 77 prognosticators. These growth projections have been pushed upward with each new stimulus bill and higher-than-expected reports of economic indicators (the Fed’s forecast for 2021 growth was 4.2% in December). However, both the Fed and the Journal surveys drop to normal growth levels quickly in the next two years: 3.3% and 2.2% for 2022 and 2023, respectively, for the Fed, and 3.2% and 2.4% for The Wall Street Journal. The Fed projects longer term growth at just 1.8%. This suggests they believe the stimulus-induced rebound will take us into part of next year and then possibly run out of steam.
The extraordinary 2021 forecasted GDP growth rates must also be looked at in the proper context. We are used to comparing a current or upcoming quarter vis a vis the same quarter the previous year, which typically has similar characteristics as the current quarter. Given the massive disruption of the pandemic, those comparisons are distorted. First quarter growth of 6.4% beat The Wall Street Journal survey projection of 5.5% (which was only 2.2% in January). The survey report anticipates just over 8% growth in the second quarter of 2021, and in the last few weeks some economists have even projected 10% second-quarter growth. While these growth estimates are truly remarkable, they represent a rebound of a short-lived yet extreme economic shut down and therefore are not likely to be sustainable. Accordingly, while the temporary boom should be celebrated, we must be watchful for its longer-term side effects. Here are the major components of GDP:
The government has passed six stimulus bills, the three largest being the CARES Act in March 2020, the Consolidated Appropriations Act in December 2020, and the American Rescue Plan in March 2021. Together these bills have infused $5.7 trillion into the economy, including direct payments to individuals and loans and grants to businesses and local governments. These funds do not include the proposed $2 trillion infrastructure bill. The fiscal response is three times larger than the American Recovery and Reinvestment Act passed during the Great Recession. How this massive stimulus will impact economic performance over the next several years is almost impossible to predict.
We are a consumer-oriented society, and over the last few years consumption has represented about 68% of GDP. But the lockdowns in the early months of the pandemic curtailed spending and forced Americans to save. The savings rate, which averaged just under 7.5% in the decade leading up to the pandemic, rose to 26% in the second quarter of 2020 and averaged 17.5% in the year ended February 2021. According to the Bureau of Economic Analysis, personal savings rose to $4.1 trillion in the first quarter of 2021, up from $2.3 trillion in the fourth quarter of last year. For those lucky enough to have retained their jobs, and for all the Millennials and Gen Zers who moved in with their parents and saved on rent, that savings and the urge to spend is translating into rapidly growing consumption that will fuel short-term GDP growth. Add in the relief checks received by most Americans last spring, in January and in the last few weeks, and consumption is poised to soar. The Conference Board Consumer Confidence Index rose a whopping 19.3 points in March, while the University of Michigan’s Consumer Sentiment Index rose 10.5 points. The result: Bank of America reported a 67% surge in credit card usage in late March and early April. March retail sales were up almost 10% from last year and that trend is likely to continue as retail outlets open and the summer months and vaccinations lure more people out of their homes.
The third leg of the GDP stool is business output. Naturally, the uncertainty brought by the pandemic caused businesses to be conservative in their investments. This was particularly true when lower sales created illiquidity, reducing capacity for both production and capital expenditures. This situation has also started to turn around. The IHS Markit U.S. Manufacturing Index reached 59.1 in March, its second highest level on record, fueled by a rise in new orders. Moreover, this growth is being held back by supply chain shortages.
The Institute for Supply Management Manufacturing PMI rose to 64.7% in March, continuing ten months of expansion since a dramatic fall in the second quarter of 2020. New orders, production, and order backlogs all rose while customer inventories fell. The report also noted the supply shortages: “companies and suppliers continue to struggle to meet increasing rates of demand due to COVID-19 impacts limiting availability of parts and materials.” Growth in manufacturing appears to be mitigated by these supply shortages as well as labor shortages in some industries, both resulting in longer delivery cycles.
Economic Growth Mitigators
Not all Americans have been able to enjoy the economic recovery underway. The pandemic has had a more devastating impact on employment than the Great Recession. According to the U.S. Bureau of Labor Statistics, 9.7 million people remained unemployed in March and total employment is down 8.5 million jobs since February 2020. Long-term unemployment (unemployment greater than 27 weeks) represents about 44% of that total, meaning many have struggled to find work for more than half a year. Great strides have been recently made in getting people back to work, and the 916,000 new jobs in March were spread widely across industries; however, it will take some time to once again achieve full employment.
The Wall Street Journal survey is predicting a pickup of over 7 million jobs in 2021 to get unemployment back down below 5%. However, some companies may wait before hiring to make sure the recovery sticks. Moreover, the current employment rate of 6.0% doesn’t take into consideration those millions of people who were forced to leave the work force to care for children who were home from school, or because they gave up looking for work in a difficult job market. Counting that “underemployed” population, the unemployment rate rises to over 10%. As such, Americans are not equally benefitting from the recent economic recovery. Additionally, despite millions of job postings, gaps remain between the education and skill sets required and the existing skill sets of available workers.
Ask a Millennial what inflation is, and you might get a blank stare. Some of us remember a time when you bought extra today because the price would be higher the next time you visited the store. In the early 1980s, when inflation hit 10%, then Fed Chairman Paul Volcker squashed it through a draconian increase in interest rates. It flattened the economy for a couple of years but no one has worried about inflation since then. Even in the last few years when we reached full employment and all the text books said wage inflation would result in higher prices, the nation managed (somewhat inexplicably) to avoid it. Inflation has remained below the Fed’s 2% target.
Now the question is whether the onslaught of extraordinary stimulus and ravenous consumption will trigger a short-lived pop in inflation or be the catalyst for another generation of steadily rising prices. We got a preview in March when the Labor Department’s Consumer Price Index (CPI) rose to an annual rate of 2.6%, up from just 1.7% in February. However, a big portion of the March result was a 22% jump in gas prices. Nonetheless, with all that built-up savings and pent-up demand, we are seeing a shift in pricing power to sellers of goods, services, and experiences. Additionally, the cost of raw materials like metals, commodities, chemicals, lumber, and steel are already on the rise and will ultimately influence the prices of finished goods. A recent survey of the Federal Reserve Bank of Philadelphia found that 77% of respondents experienced an increase in input prices in February, raising the Prices Paid Index to its highest level since 1980.
Fed Chairman Jerome Powell remains calm, saying last month that “what happens in the next year or so is going to amount to prices moving up but not staying up.” The midpoint of the Fed Board’s current inflation projections is 2.3% in 2021 and just over 2% in 2022. Note that the Fed uses the Personal Consumption Expenditures price index (PCE), which tracks a different basket of goods and typically runs 0.5% lower than CPI. The Wall Street Journal survey suggests CPI will reach 3% by June and then fall back to 2.6% by December and 2.3% in December 2022. These projections suggest that despite the current economic jolt, inflation is anticipated to stay in check.
Beyond inflation, the other wild card the business world tries to predict is interest rates. The Fed is keeping short-term rates low but the market is pushing longer rates higher. Part of that push is the realization that the economy is heating up and part is the added supply of Treasury securities to fund the fiscal stimulus on top of the nation’s existing budget deficits. The ten-year Treasury rate, a key benchmark for pricing corporate and commercial mortgage debt, began 2021 at 0.93% and by the middle of February started rising to peak at just under 1.75% at the end of March. The rate has since backed off about ten basis points. The 30-year Treasury rate started the year at 1.66% and broke 2.4% before falling back to around 2.3%. That has driven demand for home mortgages down and then back up in recent weeks.
Economists are projecting that Treasury rates will increase steadily through the next year or two. The Journal survey projections average 1.93% for the ten-year Treasury at the end of this year and 2.22% by the end of 2022. It should be noted that those forecasts have risen each month as the economy regained its steam. Economists at the Mortgage Bankers Association (MBA) project the ten-year Treasury at 2.7% and the 30-year Treasury at 4.5% by the end of 2022. So there is wide variability in the projections but they have one thing in common: Longer rates will continue to rise making debt more expensive and potentially lowering profit margins and investment returns.
With so many data points and variables, how do we know if recent forecasts of economic expansion should be greeted with rational or irrational exuberance? There is a lot of great news: The economy is clearly opening up following an extraordinarily successful distribution of vaccines that hopefully will protect the nation against further surges of COVID-19. The incredible stimulus, accumulated savings, and pent-up demand are already driving increased consumption, the largest component of GDP. Employment is finally also improving. Interest rates, though higher than last year, remain historically low. The Fed declared again in April that it will remain accommodative.
Yet the economy still appears fragile. The pandemic isn’t over. The U.S. death toll is approaching 600,000 and there are flare ups in several regions. Globally, the virus is still spreading and new variants are emerging; as I write this record numbers of new cases are being reported in parts of the world.
Low interest rates have resulted in a more highly leveraged economy. Household debt has risen significantly, primarily though increases in home mortgages but also credit card and student debt. Corporations have been issuing bonds to preserve liquidity and take advantage of lower rates. The government is funding whopping budget deficits. And equity investors are borrowing record amounts against their holdings as the stock market hits new highs. This leverage leaves the nation vulnerable if the economy slows down, interest rates rise, or valuations fall.
Finally, perhaps the biggest risk to the economy is the method and pace of stimulus reduction. The federal government will ultimately have to recoup the cost of its short-term spending spree through tax revenue, possibly reducing corporate and household net income. A number of proposals have been made this month that could slow consumption and investment. The Fed faces the extremely delicate task of withdrawing from quantitative easing and raising short-term interest rates to their target range in a way that doesn’t shock the markets, prevent employment gains, or diminish the competitiveness of American companies around the world. Time will tell if the economic recovery is sustainable. Many projected variables need to fall into place for this to happen. EisnerAmper will continue to provide updates on the economic outlook as time progresses.
This content does not constitute accounting, tax, or legal advice, nor is it intended to convey a thorough treatment of the subject matter. The best way to use this content is as a catalyst for discussion with your colleagues and advisors.