Here’s how variations and labor shortages will impact the economic outlook
At the start of the year, our economic theme was âLight at the end of the tunnelâ. The promise of vaccination deployments, reopening of economies, and the combination of pro-cyclical fiscal and monetary policies have indicated that there is light at the end of the COVID tunnel. Our expectations at the start of the year were for robust economic activity in 2021, with an estimate of real GDP growth of 4-5%.
Now, at the end of the year, our theme has played. However, a new question has arisen. With the Delta variant, labor and supply shortages, and the expiration of some stimulus programs, will economic activity pick up again in the tunnel? We do not think so. There may be a break, but nothing like the tunnel experienced last year with the closure of economies.
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We anticipate a significant recovery; we now expect GDP to be between 5.75 and 6.50% in 2021. We do not expect the economy to return to the tunnel, but we do expect growth in the second half of the year to be slower than in the first half . COVID Delta variant disrupts business and school reopenings, supply chains and back-to-office plans. These problems, along with the decline in stimulus measures, are expected to slow economic growth.
Many variables continue to suggest that we are out of the tunnel:
Economic activity. Since the third quarter of 2020, the US economy has experienced the Great Recovery, robust GDP growth, well above the 10-year average. Naturally, after a severe contraction followed by a Great Recovery, economic growth will eventually slow down. The last cycle is a good example; after the Great Recession of 2008-09, we never experienced the Great Recovery, but economic activity rebounded early in the cycle before slowing down.
Labor market. The non-farm payroll increased by 3.6 million in the first half of the year. Today there are 10.9 million vacancies and the unemployment rate stands at 5.2%. By the end of the year, we expect the unemployment rate to be below 5.0%. There is clearly a dynamic in the labor market and jobs are available.
This year, monthly employment growth has averaged 586,000. In August, payroll growth only increased by 235,000, possibly due to concerns about the Delta variant. Today, 50% of small business owners say filling open positions is their number one concern. We may not return to the tunnel, but COVID concerns could hamper wage bill growth for the rest of the year and start to weigh on the economy. Long-lasting labor shortages could negatively impact economic activity, but we believe this will be temporary as vaccinations increase.
Finally, the expiration of improved unemployment benefits could stimulate labor supply and hiring. At the beginning of September, around 7.5 million people lost their subsidized unemployment benefits. We do not believe that this alone will constitute a radical change for the labor market. Half of the states ended increased unemployment over the summer, but there was little evidence of a significant change in the job market.
Some variables send mixed messages, suggesting a pause in GDP growth:
Consumer confidence. The University of Michigan consumer sentiment index plunged in August to its lowest level since December 2011. The spread of the Delta variant is clearly hurting confidence. The significant drop of 10.9 points is worrying because historically similar declines have been associated with recessions. If concern over COVID slows down future spending plans, GDP growth could pause.
â¢ As of July, personal consumption data is showing signs of weakness. July retail sales were lower than expected, falling 1.1% month over month. At the time, it seemed that consumers were spending more on services and less on goods. The resurgence of COVID poses a risk to spending on services. Many companies in the hospitality and leisure sector have announced a reduction in services due to lack of demand.
The aforementioned improved unemployment benefits provided consumers with $ 30 billion per month. Today, unemployment benefits amount to around $ 3.5 billion. No doubt this money was spent to support consumption. We expect wages to eventually replace the loss of these stimulus payments.
â¢ Supply chain disruptions will continue to deplete stocks. It can have an impact on consumption, consumers who are willing and able to spend cannot if the items are not on the shelf. This will have an impact on Q3 and Q4 GDP, but the issue is clearly transitory. As bottlenecks are resolved and stocks are restored, spending will pick up in the near future.
â¢ Stock Exchange. The stock market is a leading indicator. From the start of the year through August, the S&P 500 is up 21.5%, suggesting that we are out of the tunnel. Keep in mind that last year, in the midst of a global pandemic, the S&P 500 posted an 18.4% return. Send a signal that there was light at the end of the tunnel.
We expect the S&P 500 to produce returns in the range of 16-22% in 2021 and 7-10% in 2022. We expect a correction, which is normal and healthy.
â¢ Business profits. Corporate profits jumped more than 40% year-on-year, the fastest pace since the fourth quarter of 2009. A significant increase was expected given that a year ago, profits contracted by 20% . Easier financial conditions and pent-up demand should continue to support earnings growth.
â¢ Federal Reserve. The Federal Reserve has repeatedly suggested that patience is warranted in changing monetary policy. Slow job creation and the recent moderation in inflation support the Fed’s position. We expect the Fed to announce a reduction plan later this year. It is important to note that the tapering is not the tightening. Short-term interest rates are expected to increase in early 2023, and long-term rates are expected to increase slightly throughout the year.
â¢ The Fed and the markets seem to be averting the threat of inflation. Some inflation will be transitory, timber and corn are prime examples of transitory inflation. Wage inflation could be less and pose a threat to corporate margins.
â¢ Labor and input shortages could weigh on GDP growth in the second half of the year. Shortages could keep inflation above the Fed’s target until 2022 and possibly 2023.
We come out of the tunnel, economic activity will naturally moderate with the maturity of the cycle. We believe GDP will end the year around 6% and slow to 4% in 2022.
Historical cycles can give us some clues for the future. While this cycle is somewhat unique due to the pandemic, nonetheless, since World War II, the average cycle has lasted 54 months. With that in mind, the current cycle could enter its final two-thirds. History tells us that stock performance moderates in the last two-thirds of the cycle, but returns have outperformed bonds and cash well.
We can see some slowdown in the data as the economy grapples with the Delta variant, shortages and inflation. Counterbalance these issues: Continued strong demand for goods, low inventories and low borrowing costs will support GDP growth. We are in the Great Recovery phase and the phase will continue until 2022.
KC Mathews is Director of Investments at UMB Bank.