March 19, 2020

The Fed recently boosted its estimate of GDP growth for the year.  It believes that the $1.9 trillion fiscal stimulus package is a sorely-needed tonic for the economy’s woes.  It will presumably entice consumers to spend, businesses to start hiring rapidly, and raise the inflation rate to the desired 2.0% pace.  But is it right?  Could the Fed still be underestimating the degree of strength in the economy?  If the unemployment rate falls below the full employment threshold, won’t the inflation rate climb above target?   Might the Fed need to tighten prior to 2024?  Perhaps.  But those potential problems are still far into the future.  For now it is a Goldilocks scenario with turbo-charged GDP growth, a rapidly declining unemployment rate, and a somewhat faster – but still very low – inflation rate. That is a dynamite scenario for the stock market.

Last year the Fed grossly underestimated the degree and speed of the economic rebound.  For example, in June the Fed believed GDP would decline 6.5% in 2020.  In September it revised that to a drop of 3.7%.  By December they expected a decline of just 2.4%.  With that kind of a track record it is clear that the Fed did not have a good grasp on the willingness of consumers to spend and businesses to hire even though the government had provided the economy with $3.0 trillion of fiscal medicine in April.  The Fed should have known better.  Why did the Fed miss the mark so badly?  And with another $1.9 trillion of fiscal stimulus working its way into the economy isn’t it possible that the Fed is still underestimating the economy’s ability to grow?

What is likely to happen this year depends largely upon the rate of spread of the virus and the vaccine’s ability to corral it.  We are optimistic.  The number of new cases daily is falling quickly.  It has dropped 78% from a peak of 245 thousand in early January to 54,000 and a vaccine is being distributed rapidly.  That is a game-changer.  As of today 116 million Americans have received at last one dose of the vaccine.  It is being distributed at a rate of 2.0 million per day.  That means that by the end of April another 82 million people will be vaccinated.  That will bring the total number of vaccinated people to 198 million or 60% of the population.  Another 29 million people have already had the virus and are presumably immune.  And the CDC estimates that for every person who has been officially counted as having had COVID, there are three others that never went to the hospital or a doctor’s office and who, presumably, are also immune.  It is easy to see how a number of epidemiologists expect the country to achieve herd immunity of 60-70% of the population by the end of April.

As this process continues, won’t we now feel safe going out to a restaurant, getting on an airplane, staying in a hotel, going on a cruise?  It seems to us that the vast majority of Americans are anxiously awaiting the re-opening of indoor dining at their favorite restaurants and are booking their travel plans for the summer, fall, and 2022.  We keep thinking back to the end of the Spanish Flu which was the pandemic most similar to COVID.  That pandemic lasted from 1918 to 1920.  It was followed by the “Roaring Twenties” for exactly the same reasons that exist today.  People were tired of being cooped up and wanted life to return to normal.  And if that is not enough, our federal government has just given every family of four a $3,400 cash injection to pay for that trip to the Grand Canyon or Disney World!

Some economists look at today’s 20.5% savings rate and conclude that consumers remain fearful of the virus and may not spend much of their newfound cash.  We disagree.  With the savings rate at 20.5% there is currently $4.4 trillion of savings.  If the savings rate were more normal at 6.0%, there would be $1.3 trillion of savings.  This means that today consumers have $3.1 trillion more cash in their checking accounts and under their mattresses than they need.  And more cash is on the way.  Following the injection from the latest tax refund checks, the amount of surplus savings is likely to climb to $4.0-5.0 trillion.  But keep in mind two things.  First, the $3.1 trillion estimate of surplus savings was based on January data.  The world is totally different today as the virus is slowing rapidly and vaccines are being distributed.  If herd immunity is achieved by the end of April won’t our willingness to spend rise dramatically?  Second, in 2019, prior to all of last year’s dramatic swings in the pace of economic activity, consumer spending increased $0.7 trillion.  With $3.1 of surplus savings now and perhaps $4.0-5.0 trillion within a month, isn’t it possible that consumer spending this year climbs far more rapidly than anybody expects?  Our 7.5% GDP growth forecast for the year includes an increase in consumer spending of $1.1 trillion.  We feel we are being very conservative.

The Fed expects the unemployment rate to fall from 6.2% currently to 4.5% by yearend.  That implies that going forward employment will rise by 600 thousand per month.  Given that employment in the first two months of 2021 rose by 272 thousand per month, the Fed expects a dramatic quickening of the pace.  But is it really all that dramatic?  After falling 22 million in March and April, employment rose on average by 1,500 thousand workers per month for the remainder of 2020 for a total increase of 12.2 million.  If that is the case, isn’t an increase of 600 thousand per month for a total of 6.0 million between now and the end of the year conservative?  One might argue that 22 million people lost their jobs in March and April so it was easy to re-hire 1,500 thousand per month for a while.  True.  But today employment is still 9.4 million below where it was prior to the recession.  Of those missing jobs 3.5 million are in the leisure and hospitality industry and another 1.0 million are state and local government teachers who are unwilling to go back to work until they have received the vaccine.  Rehiring workers in just those two categories could boost employment this year by 4.5 million, and employment in those two categories represents just 16% of the total.  So a projected increase in employment between now and yearend of 6.0 million may be conservative.

Finally, the Fed expects the core personal consumption expenditures deflator to level off at 2.0% for the next couple of years.  But it also expects the unemployment rate to dip to 3.5% in 2022 which is below the full employment threshold of 4.0%.  If that is the case, isn’t it likely that the inflation rate will rise more quickly than the Fed expects during the next couple of years?  That is what the bond market is worried about.  Inflation expectations for the next 10 years have risen quickly to 2.3%, and the yield on the Treasury’s 10-year note has jumped from 0.6% last summer to 1.7% currently.  The bond market is worried about the combination of a rising inflation rate and the Fed’s refusal to even entertain the notion of a rate hike.

Even if the economy grows more quickly than expected this year and the unemployment rate declines rapidly, there is still slack remaining in the economy so it is unlikely to overheat this year.  But by yearend any remaining slack in the economy is likely to disappear.  That is when the market’s fears may become more exaggerated.  But for now a turbo-charged pace of economic activity, a modest pickup in the inflation rate, and a pledge by the Fed to keep rates low for the foreseeable future, represents a dynamite scenario for the stock market.

Stephen Slifer


Charleston, S.C,