Getting economic activity back to its pre-COVID levels

The US economy fell by 3.5% in 2020, in line with the decline in world GDP. The US performed better than its counterparts in the Eurozone, UK, Canada and Japan but worse than the average advanced economy. But, the rebound in US economic growth in 2021 is expected to be stronger than average despite high COVID 19 cases (although new cases and hospitalisations are now finally starting to trend down from recent peaks).

We expect GDP growth to surge by 6.4% in 2021, higher than our expectations for global growth (at 5.5%), because of the huge fiscal stimulus planned in the US this year which is likely to be worth at least 13% of GDP. GDP growth should have recovered its COVID 19 losses in the March quarter and be back to its pre-COVID trend level of GDP by the end of the year (see chart below).

This means that spare capacity in the economy will be reduced faster than anticipated which may put upward pressure on inflation.

Alongside the impact from lower overseas travel, domestic state border closures are restricting interstate tourism. These issues have all had a harder hit on tourism compared to other industries. Pre-COVID, around 4.9% of Australian jobs were in tourism-related areas like accommodation, cafes and takeaway food services. Employment in the tourism sector was down by around 12.8% over the year to September (the latest period for which the ABS gives data on tourist jobs). In comparison, total employment growth was down by 2.7% over the same time period. Job gains since September have been decent nationally so tourism jobs are also likely to have benefitted since September 2020.A rebound in US consumer spending is an important driver of the growth rebound. Fiscal stimulus has been targeted towards compensating consumers for lost incomes during the pandemic. Unlike a normal recession, income growth is holding up, although the majority of this strength is due to government distributions. While total income was 4.7% higher over the year to December, this was driven by government benefits. Excluding government benefits, income (which would be income received mainly from employment) rose by 0.9% over the year to December (see chart below).

But more stimulus is still on its way which will lift consumer incomes further. And the labour market is expected to keep recovering. So far, only 56% of jobs that were lost in the initial uncertain stages of the lockdown in March/April 2020 have now been recovered, which is low (in Australia by comparison nearly 93% of jobs have been recouped). While the US unemployment rate has come down from its peak of 14.8% in April to 6.3% in January, this masks a big fall in the participation rate (to 61.4% from its pre-pandemic level of 63.3%) which is a sign of discouraged job seekers. So, if this is allowed for the true level of the US unemployment is currently around 9.1%. There is also the problem of unemployment becoming permanent the longer it continues. The proportion of those unemployed not on temporary layoff is now at a higher share than those on temporary layoff (see chart below). The better performance of the Australian labour market shows the benefits of adopting a program to subsidise wages (JobKeeper) to keep people employed, rather than giving people cheques in the mail. However, the US COVID 19 outbreak has also been significantly worse than Australia’s which has helped Australia’s economic recovery.

An uncertain outlook for business investment is a downside risk to the US growth outlook. Small business confidence is still well below its pre-pandemic level but large business CEO confidence has recovered its COVID losses. And there are risks ahead for big business – the Biden administration plans to increase corporate tax rates (from 21% to 28% although it will probably end up lower at around 25%) which would hit business profits (but potentially be offset by the boost to revenue from extra fiscal stimulus).

An unexpected inflation breakout is becoming a bigger downside risk to the growth outlook, if fiscal stimulus overheats the economy. If our forecasts are correct that US fiscal stimulus pushes US economic activity back to its pre-COVID trend level (which was operating around full capacity) by the end of the year while the US Federal Reserve (Fed) keeps interest rates lower than pre-pandemic, there is a risk of an inflation breakout (price growth running steadily over 3% per annum). Signs of this risk are building with consumer inflation expectations (for the next year) reaching a 6½ year high in January. Investors should expect inflation to run at a higher level in the near-term compared to the past decade. The counter to this is if the US labour market continues to lag behind in the recovery then the pick up in inflation won’t be sustained.

The policy backdrop in 2021

Monetary policy will take a backseat in 2021. The Fed will continue its bond buying program (of $80bn/month Treasury securities and $40bn/month of mortgage backed securities) and interest rates will remain unchanged at 0-¼%. The US Fed is operating under a new “2% inflation averaging” monetary policy regime. Practically, this means that the Fed will tolerate inflation below and above 2% to make up for a past over or undershoot. So, an inflation breakout may not result in the Fed quickly increasing interest rates. But it would put pressure on the central bank to reduce its accommodative bond buying program and to reassess its rhetoric that interest rates will be unchanged until after 2023.

The policy focus in 2021 will be on fiscal spending. The first round of spending will be a COVID-19 relief package, passed in the current financial year. Biden initially proposed a $1.9trillion (9% of GDP) package (after Congress approved a 4% stimulus package in December) that contains: $1,400 cheques for low and middle income households, state aid and a boost in unemployment benefits, vaccine and testing spending. Other components include an increase in the minimum wage and school spending. The Democrats control in Congress gives them room to pass these policies through a process called “reconciliation”. Reconciliation requires a majority or 51 votes in the Senate which the Democrats hold. The reconciliation process also requires that expenditure outlays be matched with cost savings over a 10-year timeframe which the Democrats assume by modelling that the economy will be stronger with fiscal stimulus. Democrats recently passed 2021 Budget plans in Congress that include instructions for reconciliation which is the first step in this process.

Another spending package, likely to be passed in the 2022 financial year will focus on infrastructure and the environment, offset by higher top end personal and corporate taxes. Details on exact costs are unknown. In terms of other policies like trade, the hard stance on China is still being pursued and Democrats are pushing for US companies to use American products in the supply chain.

US debt issues

Extraordinary fiscal stimulus means that US government debt is soaring, as it is in most advanced economies that are supporting households and businesses in the pandemic. The budget deficit is expected to be around 17% in 2021 (see chart below) and in the medium-term budget deficits are likely to fall to around 4-5% of GDP. Total public debt (which is total accumulated debt) is likely to remain at a record high around 130% of GDP. High debt levels (as a share of income or GDP) are a vulnerability to the economy, if the cost of borrowing increases. For now, government bond yields are contained, hovering below 1.5% (for the 10-year bond) and are running at less than the nominal growth rate of the US economy (which will average around 2-3% over the medium-term) which means that debt servicing is sustainable for now. And without the increase in spending and debt to date, economic growth would have collapsed. However, with the current savings rate remaining high, mobility increasing and the vaccine being rolled out, the very generous plans for fiscal stimulus are questionable.

Implications

US equities performed exceptionally in 2020, with the S&P ending the year almost 16% higher than at the beginning of the year. Solid earnings growth, fiscal stimulus and low interest rates are positive for the US sharemarket in the next 6-12 months. But relative outperformance is likely to be in non-US sharemarkets in 2021 from the rebound in global growth, a lower $US, relative underperformance in these markets in 2020 (compared to the US) and a larger index tilt towards non-technology sectors (like financials, energy and materials) that underperformed in the COVID pandemic in 2020 and do better in an environment of higher inflation.