This year will be best recalled as one where the economy went down, and the stock market went up. After suffering a 30 percent contraction in March and April, the GDP came back forcefully in the summer, only to fade out in the closing months of the year. The stock market continued to hit new highs as the year progressed.
The most harmed parts of the economy were also uniquely different this time around. Usually, an economic contraction occurs most in cyclical manufacturing industries, while services are less affected. This time around, the vortex of the economy’s collapse centered on the travel and hospitality industries. Initially, this was not so much the result of reduced demand as constrained access to supply. In the lockdowns to slow the spread of Coronavirus-19, businesses found themselves oftentimes at a disadvantage to serving the customer, if government edict permitted the customer to be served at all. State and municipal governments, with income in a free fall, are being forced to retrench and lay off. Even now, the most recent applications for unemployment benefits are running three times their number before the pandemic hit.
The second difference in this economic downturn is the representation of small businesses, which are being disproportionately taken down relative to their larger competitors who have better access to capital to tie them over. Independent restaurants are over-represented on this list, as are clothing stores, retail, gyms, spas, and salons. Bars, entertainment venues like theaters, and firms catering to business or vacation travel have been decimated. For many non-profits, it has been a nuclear winter, as exposure to both donors and the public is drastically reduced.
Now that we have two vaccines, with more to come, it is expected that we will see an eventual end to this pandemic. However, the country and the world will be a different place going forward. The vaccination campaign is expected to show positive economic results by the second quarter of 2021, with more momentum for gains coming in the second half of the year. Still, many firms have borrowed heavily, mortgaging their recoveries in the process. Many smaller businesses will not get help in time to survive.
There is also the matter in 2021 of a new president and a divided congress – subject to the vote in Georgia over their two Senate positions on January 5. Whether this will be a repeat of the gridlock seen when Obama was president is at this point unknown. The Biden administration is expected to be more centrist. If so, some Republicans may want to join them in passing legislation. This assumes administration-desired legislation gets to a vote, which does not always happen in a divided government.
Finally, there is the matter of the rest of the world. For whatever reason, many parts of the world have coped with the coronavirus better than the United States. With five percent of the world’s population, the US recorded seventeen percent of the covid-19 cases and deaths. This has led to far greater economic growth in 2020 being recorded in Asia and elsewhere than in the US. We may have reached a point where the world does not depend on US growth to prosper. This has implications for everything from the centrality of the US dollar in international trade to our ability to influence foreign conduct to our advantage. In fact, the dollar is now down thirteen percent in value from last March 1 relative to other currencies.
The decline in the US dollar has a number of adverse implications. If foreign investors’ portfolio investments in US dollar assets lose value due to the dollar’s depreciation against their home currency, then investments in dollar assets become less attractive. This could lead to a demand for higher interest rates to compensate for the currency’s decline. Higher interest rates would blow a hole in the US budget, as the US government is the largest issuer of US dollar debt in the world. It would also reprice interest rates for other assets higher as well, complicating the efforts of businesses to increase profits without a price increase of some magnitude to compensate for higher interest expense.
Higher interest rates would also cut the ground out of one of the tenants of Modern Monetary Theory (MMT). This theory, which has largely been used to explain and justify the expansion of stock prices for the past decade, rests in part on the assumption that there are so many investors looking for returns, the trend was and will continue to be one of low and falling interest rates, high market valuations, etc. Those of us who have been around a while have seen this movie before. It does not end well.
While not all the stock market is generously valued, there is sufficient euphoria to drive the indexes up. When a car company that did not exist a decade ago has more value than one that has been around for a hundred years, you have to wonder. This car company, Tesla, joined the Standard & Poors 500 last Monday as the fifth largest position in the index. Buckle up and enjoy the ride.
The $900 billion stimulus bill passed on Sunday has not been signed into law as of this writing. Assuming it is approved, distribution of the funds is not expected to impact the economy in December 2020 and only marginally in January 2021. They will, with the progress on the vaccinations, help to provide a better year-over-year progress in the second quarter and the second half of 2021.
The strongest recoveries will be staged by the industries most adversely impacted in 2020. Recovery will be constrained by the amount of debt assumed by some firms during the pandemic, as well as their domestic versus international orientation.
As mentioned earlier, a weaker dollar at some point will require higher interest rates to compensate for the risk of it falling further. This would seem to imply an ongoing slide, which, hopefully, will be orderly enough not to induce panic selling.
At this point, look for a ten-year US Treasury yield of 1.25-2.00 percent before year-end 2021, with the 30-year treasury to be around twice the ten-year quote.
Such a shift will affect bank lending rates, as well. This could impair ventures that depend on the low cost of funds to become viable investments.
A falling dollar makes imported goods more expensive in dollar terms. Thus, commodities like copper, iron, oil, and the like would be priced higher in dollars even if they are constant in foreign currencies.
The second source of inflation is the commitment to a $15 per hour minimum wage made by the Biden administration. While to be implemented over a number of years, it could start a wage spiral that will result in higher prices.
Depending on who is doing the counting, inflation is now around two percent. Expect that to be up to four percent by year-end 2021.
The Stock Market
Stocks have recently shown an expansion of the number of issues participating in the rally, which is a healthy development. Still, through December 18, the Standard and Poors 500 is up 14.3 percent, mainly on the backs of a handful of issues (Amazon, Facebook, Netflix, Apple, Google, and Microsoft) that make up about 22 percent of the index. The addition of Tesla will concentrate performance further still. The Nasdaq Index, where these issues make up 46 percent of the value of the index, is up 45 percent.
The issue is whether the past will be prologue. Of the seven companies mentioned above, three (Amazon, Facebook, and Google) face antitrust issues both here and in Europe. Netflix is confronting competition from the likes of AT&T’s Warner Media as well as Disney. Tesla, which made about 400,000 electric cars last year, now has competition from the like of General Motors, Mercedes, BMW, and others. 2021 will be a very interesting year for investing indeed.
Warren M. Barnett, CFA
December 23, 2020