Tug of war
The path of most economic metrics over the first half of the year have looked virtually identical. First, the economy enjoyed a strong January and February. Next, we suffered through a waterfall decline in March and April due to the coronavirus. Finally, we experienced a near-vertical rebound in May and June as the economy began to reopen and satisfy enormous pent-up demand.
But there’s a tug of war going on right now among Covid-19 metrics, economic fundamentals and financial-market performance. Witness, for example, that stocks and bonds have both rallied, suggesting very different fundamental interpretations of this data. After an 8% correction during June, the S&P 500 reversed course in July, rising 9% to a new cycle high just yesterday at nearly 3,280. Benchmark 10-year Treasury yields, in contrast, spiked to 95 basis points on June 5, but have since rallied hard to a low of 55 basis points earlier today, in a powerful flight-to-safety trade.
Claims soften What concerns bond investors? In our view, after sharp week-to-week gains during April and May, the pace of improvement in the labor market has plateaued since early June. For example, initial weekly jobless claims rose for the first time in 16 weeks in the week ended July 18, increasing 8.3% to 1.416 million claims. This also is the survey week for the July jobs report (to be released Aug. 7), suggesting the monthly improvement we’ve seen in labor-market conditions during May and June likely will moderate in July. Bond vigilantes may be trying to get ahead of this potential development by piling into Treasuries.
Earnings season better than expected On the other hand, there’s little question second-quarter GDP and corporate profits released during July will be dreadful. But the equity market appears to have already discounted that abysmal prospect, with the expectation that the second quarter will represent the trough of the recession cycle (which the NBER said began in February), and that we’ll be back in growth mode during the second half of this year and beyond. Also, consensus earnings expectations for the second quarter were for a 45% year-over-year (y/y) decline, versus a 13% y/y decrease in the first quarter. We’re about 30% of the way through the second-quarter earnings season as measured by market cap, and the results have been surprisingly positive: 79% of companies have beaten consensus earnings per share by an average of nearly 14%, the best beat rate in a decade.
Dreaded second wave Although we’ve clearly seen a second-wave spike in infections in the so-called FCAT states (Florida, Southern California, Arizona and Texas) over the past two months, the surge may be peaking, and mortalities have importantly diverged from this rising trend and remain relatively low. In addition, we’re making rapid progress on vaccine development, and we may have multiple vaccines available for emergency use as early as October. But bond investors may be anticipating an economic slowdown from this spike.
Commodities higher, inflation lower On the commodities front, oil prices have quadrupled over the past three months, and copper and gold prices have surged by about 45% and 30%, respectively, over the past four months, suggesting stronger economic growth and rising inflation. But inflation remains relatively benign, having declined sharply over the past six months due to the coronavirus. It may be bottoming, however, along with the economy this summer, and could grind higher over the balance of calendar 2020 and into 2021. Core CPI halved from 2.4% in February to 1.2% y/y in both May and June, while core PCE fell from 1.8% in February to 1% in both April and May, a 10-year low. Core inflation remains below the Fed’s oft-stated 2% target.
Buckle your seatbelts With a contentious presidential election, continuing social protests and negotiations in Congress regarding a Phase 4 fiscal stimulus package, this tug of war among numerous cross currents could result in heightened market volatility over the next several months.
Adjusting GDP estimates The equity, fixed-income and liquidity investment professionals who comprise Federated Hermes’s macroeconomic policy committee met on Wednesday to discuss the pace of recovery from the U.S. economic recession:
- The Commerce Department will flash second-quarter 2020 GDP on Thursday, July 30, along with its annual benchmark revisions. Although economic results for consumer spending and manufacturing were much worse than expected in April, shortly after the shutdown of the economy, they bounced back more quickly than expected in May and June. So we increased our second-quarter growth estimate from -27.8% to -24.3% versus a -5% first-quarter. The Blue Chip decreased its estimate from -32.1% to -33.6% (within a range of -38% to -28.6%). The Bloomberg consensus is at -32.8% and the Atlanta Fed’s GDPNow forecast is at -34.7%, up from -53.8% on June 4.
- We think the recession ended in the second quarter, and that enormous pent-up demand will spark strong economic growth in the third quarter as the economy slowly restarts. So we raised our third-quarter GDP growth estimate from 13.7% to 15.5%. The Blue Chip increased its estimate from a gain of 8.8% to 17.7% (within a range of 7.6% to 28.7%).
- We expect the availability of a vaccine and an elevated savings rate to drive strong economic growth in the fourth quarter, but we kept our growth estimate unchanged at an increase of 11.2%. The Blue Chip tweaked its estimate moderately higher from a gain of 6.8% to 7% (within a range of 2.5% to 11.7%).
- Due to a less-bad second quarter outlook and a stronger third-quarter rebound, we raised our full-year 2020 GDP growth estimate from -4.2% to -3.1%. The Blue Chip consensus raised its estimate from -5.8% to -5.5% (within a range of -7% to -4.1%).
- We believe the economy will accelerate into 2021, so we raised our full-year 2021 growth estimate from 4.1% to 4.5%. The Blue Chip consensus remains unchanged at 4% (within a range of 2.2% to 5.8%).