As the great American philosopher Yogi Berra once observed, “It’s tough to make predictions, especially about the future.” Investors are inherently betting on a future state of the world: a state in which financial markets recognize the fundamental value of a business, dividend and interest payments are made on time, tenants pay rent to landlords – all the things that create return on investment. Fundamental research and a keen attention to value help to identify specific opportunities for return, while at the same time mitigating the risk of something going wrong. Occasionally, something truly unique or rare happens that affects all asset classes, and Professor Berra is proved right once again. In March 2020, things went really wrong in the United States, as the societal, economic and financial consequences of the COVID-19 pandemic quickly became evident. In the same way that an earlier generation was forever influenced by coming of economic age during the Great Depression, so, too, will we be forever changed by the experience of the past year.

The good news is that there is good news. Daily diagnoses of COVID-19 peaked in mid-January and have fallen almost 80% since then, despite concerns that colder weather would lead to more infections at indoor gatherings, and despite the worrisome mutations of the coronavirus. New case diagnoses are declining in every state, and hospitals are no longer stretched to capacity. The Food and Drug Administration granted emergency use authorization to Johnson & Johnson’s ENSEMBLE vaccine in late February, so there are now three vaccines in distribution in the United States. As of mid-March, about 20% of the population has had at least one shot, and this figure will continue to rise rapidly throughout the spring.

There is light at the end of the tunnel, although it can sometimes be hard to make out through an N95 mask and fogged glasses.

Recovery

The economic price of COVID-19 pales in comparison to the human toll. Over 530,000 lives have been lost in the United States, on top of an additional 2 million deaths elsewhere throughout the world. The disruption to lives, families and loved ones will linger for years to come. The economic recovery, on the other hand, has unfolded rather quickly and easily, at least at the macroeconomic level. After an unthinkable contraction of 31.4% in second quarter 2020, gross domestic product (GDP) rebounded at a similarly startling pace of 33.4% in the third quarter, before ending the year at a more modest growth rate of 4.1%. By statistical convention, GDP growth is calculated on a quarter-over-quarter basis, and then reported at an annualized rate. The 31.4% drop in second quarter 2020 was therefore in reality a decline of around 7% quarter over quarter, which annualizes to the reported figure of 31.4%. Economic volatility in 2020 was unquestionably pronounced, but not as drastic as the headline figures would indicate.

However calculated, a drop of 31% followed by a gain of 33% still leaves the economy short of where it started. Absolute GDP, adjusted for inflation, remains 2.4%, or $470 billion, below the previous peak of fourth quarter 2019. We will undoubtedly close this gap by the summer of this year, but only after losing almost two years of economic growth.

The nearby graph of absolute economic output illustrates the unusual nature of this recession. The shape of this cycle is literally and graphically different from economic contractions of the last 60 years. Most recessions occur for one of two broad reasons: either the Federal Reserve raises interest rates and tightens monetary policy to prevent an economic expansion from overheating, or excesses on Wall Street lead to financial disruption that translates to Main Street. Either way, the economy gently rolls over (although it doesn’t feel gentle while it’s happening), finds a bottom when a combination of easier fiscal and monetary policy begins to work and gradually recovers to a previous peak. For example, during the 2007-2009 global financial crisis, economic output contracted by a total of 4% over a year and a half, and from that bottom took an additional two years to return to the prior peak level of output.

This time is different. Monetary policy was not tight at the onset of the pandemic, and no bubbles were bursting on Wall Street. Instead, this was a rare recession of our own making: Policymakers and politicians proactively chose to restrict certain economic activity to slow the spread of the coronavirus, thereby creating the shortest and sharpest economic cycle in history. In 2020, the pace of economic activity contracted by 10% in a mere two quarters (peak to trough) and will likely rebound to prior output levels within a year of last summer’s bottom. The difference in the two cycles highlighted in red on the graph is striking.

This time is different, though, only because it hasn’t happened in a long time, and now it’s happening to us. Although we don’t have robust economic data from the period of the 1918-1919 Spanish flu, contemporary news coverage implies that the economic toll was similar, as businesses, schools, restaurants and theaters closed while families quarantined at home to avoid contracting a disease for which there was no cure or vaccine. Fast forward to the so-called Asian flu of 1957-1958, and the pattern is similar. Here, the rapid development of a vaccine curtailed the human and economic toll. Nevertheless, at the height of the Asian flu pandemic, U.S. GDP (which was reported more robustly by this time) contracted at an annualized pace of 10.0% (first quarter 1958), a dubious record that stood unchallenged until a year ago.

Expansion

Massive government intervention has driven the first phase of the current economic recovery: The second phase of sustainable expansion must be led by a rise in consumer spending. At almost 70% of GDP, personal spending is the durable engine of economic growth that government spending can never be. Unfortunately, measures of consumer confidence remain depressed, and as of February stand even slightly lower than they were in summer 2020. This bodes ill for consumer spending, at least in the very near term, as worried people do not tend to spend a lot of money.

This is not surprising. It has been a long and dark winter, both literally and figuratively, with little to be confident about. In addition to the pandemic, we, our friends, neighbors and colleagues spent the last year wrestling with political drama, raw reminders of social and racial inequality, concerns about children and remote learning, uncertainty about the timing and availability of vaccines and the general ennui that accompanies the Groundhog Day existence that has become our daily lives. Here, too, there is light at the end of the tunnel. These issues will continue to weigh on confidence for some time, but as the fog of uncertainty lifts (and as spring springs), we expect to see an improvement in these confidence surveys.

Once confidence rebounds, there is fortunately plenty of money to be spent. One of the more dramatic developments in this economic cycle is the increase in personal savings. Personal income rose sharply in April 2020, due largely to elements of the March 2020 Coronavirus Aid, Relief, and Economic Security Act (CARES Act), while at the same time personal spending collapsed, as people sheltered at home and only bought necessities.

This combination of developments is a recipe for an accelerating economic rebound as 2021 progresses. Once vaccinations get us closer to herd immunity, open economies and restored confidence, then excess savings and pent-up demand will fuel an economic rebound, while the Federal Reserve has promised to keep the economic party going by refilling the punch bowl of low interest rates and continued monetary stimulus. What’s not to like?

The Price Tag

As the old saying goes, there are no free lunches, on Wall Street or elsewhere. At what price do we enjoy these economic tailwinds, and what risks accompany this otherwise favorable backdrop for the economy, corporate earnings and markets?

The first economic risk is that the colossal amount of fiscal support outlined above is simply not sustainable. Although precious few deficit hawks currently roam the halls of Congress, at some point stimulus checks, enhanced unemployment and payroll protection support will stop coming. Prior to the onset of the COVID-19 crisis, government transfer payments accounted for about 17% of household income. This includes, among other things, Social Security payments, Medicare, Medicaid, veterans’ benefits and the Supplemental Nutrition Assistance Program (formerly known as food stamps). This figure has risen gradually over time, averaging 13.4% in the 1990s, 14.5% in the 2000s and 17.2% in the 2010s.

The implementation of the CARES Act sent total government support soaring to over 31% of household income in April 2020, and this figure remains at 27% of total income as of January 2021. In other words, much of the excess savings discussed earlier is due to government programs that are not infinitely renewable. The economy – and the labor market in particular – needs to recover so that households are no longer reliant on extraordinary government support to function.

A second risk is that the pain of the recession and benefit of the rebound are not equally distributed. The inequality of wealth, income, education, access to technology, healthcare and affordable housing is a well-known problem plaguing this economy, and a deeply unfortunate side-effect of the COVID-19 crisis is that these gaps have widened further. Unemployment across the economy skyrocketed a year ago, and the subsequent recovery has been uneven. The unemployment rate for workers with a college degree or higher, and who are often employed in information, financial or technology jobs in which remote working is easier, has fallen back to 3.8% as of February 2021. The unemployment rate for workers with a high school degree has also recovered, but only to 7.2%, and workers without a high school degree face a job market where unemployment still stands at 10.1%. In fact, in February the unemployment rate for workers with at least some college education fell, while the unemployment rate for workers without a college education rose.

These patterns are reflected in racial inequity as well. Across all educational levels and age groups, the unemployment rate for white workers is 5.6% at present (February 2021), vs. 9.9% for Black workers. Asian unemployment, at 5.1%, is even lower. This is a subject for much deeper discussion in a different forum, but suffice it to note that a robust and durable recovery in the economy requires broader job creation and availability across the educational and racial spectrum.

A third economic risk arises from the potent combination of fiscal stimulus, monetary expansion and rising household savings. This is a textbook recipe for inflation, at least when consumer confidence improves and people start spending money again. There is at present little evidence that inflation is a problem in the American economy: The Consumer Price Index (CPI) rose a scant 1.7% year over year in February and hasn’t topped 2% at any point in the past year. Fixed income investors, however, are beginning to price future inflation into their buying decisions, driving up the yield on longer-dated government bonds in order to compensate for the risk of higher inflation in the future.

The move has been rather dramatic. Although the very short end of the U.S. Treasury yield curve remains close to zero, in line with monetary policy, the yields on longer-dated bonds have risen back to pre-pandemic levels. The 30-year government bond yields 2.27% as of mid-March, compared to 1.65% at the beginning of the year. This rise in yields is taking place despite the fact that the Federal Reserve continues to buy about $80 billion of Treasury securities each month (plus an additional $40 billion of mortgage-backed securities), exerting upward pressure on bond prices (and therefore downward pressure on yields).

We see these rising inflation expectations even more clearly in breakeven spreads. A breakeven spread is the difference in yield between a nominal U.S. Treasury bond and the Treasury Inflation-Protected Security (TIPS) with an equivalent maturity. The only difference between these two securities is who bears the risk of inflation: An investor in a nominal Treasury bond runs the risk of being repaid in dollars whose value has been reduced by inflation, whereas the principal of a TIPS is adjusted to reflect inflation, so the U.S. Treasury bears the inflation risk. The gap between these two yields – the “breakeven” at which they provide a comparable return to each other – is the aggregate market expectation of inflation over the life of the bond.
 

Investment Implications

Even a modest increase in inflation poses a risk to the objective of preserving wealth. After all, at the end of the day it’s not how much money you have that counts, but what you can buy with the money you have. Wealth is, in other words, an absolute concept. Money is simply a way of measuring wealth on any given day.

Readers are no doubt familiar with the miracle of compound interest – how a small amount of money, at even a modest interest rate, can compound into great wealth over time. No less an eminence than Albert Einstein referred to compounding as “the eighth wonder of the world,” and observed further that “he who understands it, earns it. He who doesn’t, pays it.” Einstein knew well the Newtonian principle that to every action there is an equal and opposite reaction. Inflation is the equal and opposite of compounding: It can cause great wealth, at even a modest rate of inflation, to diminish over time.