Economic Growth & Inflation
The longest-running United States economic expansion on record came to an abrupt end in March as the coronavirus pandemic forced a national shutdown. The contraction in U.S. economic activity was the sharpest on record, declining 31% during the second quarter. While the depth of the recession was extreme, the duration was short as the third-quarter gross domestic product rebounded with the largest increase on record, up 33%. While the current 2020 full-year growth estimate of negative 3-4% is difficult to label a win, fears of a repeat of a Great Depression scenario as the economy hit a wall in the spring failed to materialize.
Labor market conditions rapidly deteriorated as the lockdown went into effect. The April unemployment report registered more than 20 million job losses, with the unemployment rate reaching nearly 15%. The non-financial service sector bore the brunt of the shutdowns, representing more than 80% of total jobs lost.
Passage of the CARES Act in late March provided direct economic assistance to workers and families most impacted by COVID-19. The Paycheck Protection Program helped to preserve jobs in industries facing disruption as the pandemic spread across the globe. The labor market in the U.S. rebounded strongly as the economy reopened, exceeding even optimistic projections at the depth of the recession. 12 million new jobs have been added since May and the unemployment rate has been cut in half, now standing below 7%.
The pandemic created highly divergent outcomes for both individuals and businesses in the U.S. Service sectors, most notably hospitality, leisure and travel, suffered unprecedented damage and recovered more slowly relative to the goods-producing sectors. The concentration of low-wage jobs in the hospitality and retail sectors led to more job losses among the most vulnerable Americans.
Both old and new technology companies were among the beneficiaries of the reshaping of the American economy since the coronavirus outbreak. Increased reliance on technology as companies transitioned to remote work environments accelerated the rise of the digital economy. This shift to work-from-home combined with record-low interest rates also fueled demand for housing (especially in low-density markets) and boosted spending on household goods.
The pandemic-driven economic shutdown story played out similarly across the globe. The Asia-Pacific region was the first to enter the crisis and is now the first to show signs of near-full recovery as the measures to contain the virus have been successful. In contrast, Europe is facing a second wave of COVID-19 cases and is implementing new containment measures, which are facing resistance from businesses and citizens weary of the pandemic.
The pandemic also had an immediate impact on the inflation environment. An immediate deflationary impulse, especially among virus-sensitive goods and services (e.g., airlines, lodging and clothing), emerged as economies shut down. Oil prices plunged into negative territory in late April as demand plummeted and producers struggled to find storage capacity.
Inflation measures quickly recovered, as consumers continued to spend with the benefit of fiscal stimulus as the economy gradually reopened. Supply chain disruptions arose among virus-resilient sectors such as auto and home furnishing, creating shortages and boosting prices. Housing costs in the U.S. have been mixed this year, as the increase in home prices has been offset by a decline in rent payments.
Monetary Policy
Global capital markets sold off sharply and credit conditions tightened as investors understood the severity of the economic fallout from the coronavirus in March. The Federal Reserve (Fed) joined central banks across the globe in implementing unprecedented measures of monetary expansion to limit the damage.
Fed easing started with two emergency Fed rate cuts in March, bringing rates back to zero. These were followed immediately with new bond-buying or quantitative easing (QE) programs. The Fed reintroduced monetary policy tools used during the Great Financial Crisis of 2007-09, in addition to new measures supporting fixed-income sectors and securities facing extreme selling pressure.
The Fed’s commitment to using the “full range of tools to support the economy,” coupled with record fiscal stimulus, cushioned the devastating impact of the sudden economic stop. Fed policy will continue to err on the side of accommodation as long as the pandemic poses risks to the economic recovery in the U.S.
In August, the Fed announced a significant change to monetary policy, which will allow inflation to run above its 2% target following periods of persistently low inflation. The new framework is likely to change priorities in the Fed’s dual mandate, with price stability taking a back seat to full employment goals. The Fed is unlikely to tighten until labor markets return to pre-pandemic levels and inflation runs consistently above 2%.
Interest Rates and Credit
Treasury yields tumbled to historic low territory in early March as investors sought safety during the extreme market volatility and credit stress. Market dislocations arose for nearly all fixed-income assets as margin calls forced selling by levered investors, overwhelming broker-dealer balance sheets in the process. Market functioning for “off-the-run” Treasury bonds faced unprecedented distress.
Liquidity conditions also deteriorated precipitously across the corporate and securitized bond markets, with spreads hitting their widest levels since 2009. In a repeat of the Great Financial Crisis, only the Fed’s balance sheet was large enough to restore market confidence. The credit pipes reopened immediately when the Fed announced its new liquidity backstop for corporate bonds on March 23.
Credit markets continued to heal throughout the remainder of 2020, with spreads retracing nearly all of their first-quarter widening. Investment-grade and high-yield corporate borrowers are taking advantage of the credit market rebound, with new issue volume at a record-setting pace.
Despite range-bound trading for Treasury yields since March, real yields for Treasury Inflation-Protected Securities (TIPS) continued to move deeper into negative territory. 10-year yields on TIPS reached a historic low of -1.10% in early September. Investors have been increasingly willing to pay for the diversification benefits of TIPS, as the Fed extends its timeframe for zero interest rates and appears to remain willing to print money to finance additional fiscal stimulus and deficit spending.
Exhibit 1. Bond Market Performance (1-Yr as of 12/31/2020)
Equity Markets
Global equity markets plummeted with record-high volatility as the coronavirus spread from China across the world. Investors feared the worst when some of the best health care systems from China to Italy buckled under the strain of the pandemic. After hitting a new high on Feb. 19, the S&P 500 Index suffered a 34% decline in just over a month. The Fed’s announcement on March 23 to buy as many bonds as necessary to calm markets marked the bottom for nearly all risk assets.
In a year marked by a string of unprecedented events, one market trend that held steady was the outperformance of growth over value stocks. Technology companies have been insulated from the economic fallout during the pandemic and, in certain cases, benefited from the increased reliance on technology and acceleration of changing consumer habits. Record-low Treasury yields also boosted valuations for these consistently high earners and cash flow-generating tech companies in the low-inflation, low-growth environment.
Global equity markets have generally failed to keep pace with the size of the rebound for U.S. equities. Investors remain focused on divergences in the path of the pandemic among different countries. The coordinated injection of liquidity and fiscal stimulus in response to the pandemic (including a weaker U.S. dollar) should continue to be supportive of the recovery in emerging market equity valuations.
Exhibit 2. Financial Market Performance (1-Yr as of 12/31/2020)
Now that 2020 has come to an end, what can investors expect in 2021? Be sure to check back next week for our 2021 Capital Markets Outlook!
Index Definitions:
Bloomberg Barclays U.S. Aggregate Bond Index – An index that is a broad-based flagship benchmark that measures the investment-grade, U.S. dollar-denominated, fixed-rate taxable bond market. The index includes Treasuries, government-related and corporate securities, MBS (agency fixed-rate and hybrid ARM pass-throughs), ABS and CMBS (agency and non-agency).
Bloomberg Barclays U.S. Corp High Yield – An index that measures the USD-denominated, high yield, fixed-rate corporate bond market. Securities are classified as high yield if the middle rating of Moody’s, Fitch and S&P is Ba1/BB+/BB+ or below. Bonds from issuers with an emerging markets country of risk, based on Barclays EM country definition, are excluded.
S&P 500 Index – An index of 500 stocks chosen for market size, liquidity and industry grouping, among other factors. The S&P 500 is designed to be a leading indicator of U.S. equities and is meant to reflect the risk/return characteristics of the large cap universe.
MSCI EAFE Index – An index that is designed to measure the equity market performance of developed markets outside of the U.S. & Canada.
Russell 2000 Index – An index measuring the performance of approximately 2,000 small cap companies in the Russell 3000 Index, which is comprised of 3,000 of the largest U.S. stocks.
MSCI Emerging Markets Index – A free float-adjusted market capitalization index that is designed to measure equity market performance in the global emerging markets.
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Disclosures:
The views expressed in this material are the views of PMAM through the year ending December 31, 2020, and are subject to change based on market and other conditions. This material contains certain views that may be deemed forward-looking statements. The inclusion of projections or forecasts should not be regarded as an indication that PMAM considers the forecasts to be reliable predictors of future events. Any forecasts contained in this material are based on various estimates and assumptions, and there can be no assurance that such estimates or assumptions will prove accurate. Actual results may differ significantly.
Past performance is not indicative of future results. The views expressed do not constitute investment advice and should not be construed as a recommendation to purchase or sell securities. All information has been obtained from sources believed to be reliable, but accuracy is not guaranteed. There is no representation or warranty as to the accuracy of the information and PMAM shall have no liability for decisions based upon such information.
