Upside surprises in 2021

| November 20, 2020

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

This year seemed to bring one surprise after another with generally bad news in the spring, better news in the summer and mixed news with the arrival of fall and the approach of winter. Next year promises surprises as well, most qualifying as good news for fans of growth and recovery. The US economy stands to see a near complete rebound from pandemic with upside as some sectors jump back to normal. The labor market should approach full employment by the end of 2021 with an unemployment rate near 4%. Inflation is a conundrum, however, with potential to go higher or lower. And none of this really shows up in consensus forecasts.

A nearly complete Covid recovery

News of successful vaccine candidates from Pfizer and BioNtech and from Moderna have raised hopes in financial markets for a substantial move back toward normality at some point next year. Even so, the consensus economic projection implicitly assumes a gradual and only incremental recovery next year, as economic growth is only modestly above trend while the unemployment rate only falls by a few tenths of a percentage point each quarter.

There is a substantial risk—or, perhaps more accurately, reward—that medical treatments such as antibody cocktails and vaccines will lower the threat of Covid by enough to allow state and local governments to lift the bulk of the restrictions on high-contact sectors of the economy and social gatherings. In that event, there could be an explosion in economic activity as restaurants, retailers, hair and nail salons and others are able to fully reopen. The 2021-2022 academic year could bring a return of in-person classes in the fall. And beaten-down sectors like travel and spectator events could begin to ramp back up.

As the economy continues to recover, the normal pattern would be to expect GDP growth to moderate as the level of activity gets closer to the pre-pandemic norm. However, there is risk of substantial but brief acceleration in activity as key sectors jump back to normal in an abrupt rather than a slow and gradual fashion, perhaps in the second or third quarter. These jumps to normality would market the clearest upside surprises for growth.

The labor market approaches full employment

The labor market has been a bit of an enigma in 2020. On one side, the payrolls figures through October have only retraced about 55% of the ground lost in March and April, a much lower percentage of recovery than we have seen for consumer spending, industrial production and even real GDP growth. However, the unemployment rate has consistently offered pleasant surprises virtually every month since April. In the early days of the lockdowns, there were fears that the reported unemployment rate would surge to 20% or even 25%, but the April reading just below 15% proved to be the peak. Since then, the descent has far exceeded most economists’ expectations. For example, the FOMC median projection for the fourth quarter of 2020 was forced down by almost two percentage points from June to September, and the September estimate of 7.6% was easily surpassed by October, when the jobless rate slid below 7%.

That trend has momentum going into 2021, and consensus projections, which call for the unemployment rate to inch down by a few tenths of a percentage point each quarter through 2021, may be too cautious. The pace of improvement in jobs may slow down over the next few months in response to the intensification of the virus, but, consistent with rapid Covid recovery, if vaccines and treatments help to bring the virus under control by around mid-2021, the labor market could enjoy something closer to a full recovery over the course of next year.

Of the 10 million jobs yet to be restored, three million are in sectors not particularly restrained by virus-specific restrictions, such as manufacturing and construction, and should gradually return. The other seven million are in sectors held down to varying degrees by government-imposed social distancing rules, including two million jobs at restaurants, 1.5 million jobs in education, about 750,000 jobs at hotels and another 750,000 mobs at amusement parks, spectator events and similar places. It is not difficult to envision a period of two or three months where these sectors come back to life, perhaps in the summer and into the fall.

Consensus forecasts call for the unemployment rate to range between 5.5% to 6% by the end of 2021, more than two percentage points above the February 2020 level. But it looks plausible the US could see a jobless rate as low as 4% by the end of 2021. Such a result would roughly match the FOMC’s estimate of full employment, which stood at 4.1% in their September projections.

Inflation could be up or down in 2021

The pandemic shuffled the economic deck in an unprecedented way in 2020. The economy clearly took a massive hit due to the lockdowns in the spring and will continue to work toward a full recovery in 2021. While that aspect of the pandemic effects has been fairly straightforward, the impact of the pandemic and the associated changes to the economy on inflation have been more ambiguous. The immediate effect on prices was mostly downward. Energy prices sank as transportation plunged globally, and economic activity generally declined. The prices of many services that were tightly limited, such as airfares and hotel rates, also fell. In contrast, for a limited number of items such as food commodities, the combination of heightened demand and the snags introduced into the supply chain led to temporary price hikes.

For other categories, the response was more complicated. For example, used vehicle prices initially sank as dealerships were forced to close, and demand fell sharply for a time. However, once the lockdowns loosened, demand for motor vehicles jumped as commuters looked to avoid public transit and used vehicle prices surged. Similarly, home prices, which do not show up directly in the consumer price gauges, rose sharply as demand exploded. Meanwhile, for certain categories, the changed state of the economy created difficult questions for government statisticians. People are driving less, and motor vehicle insurance companies saw a steep drop in claims as a result. A number of them rebated some of their savings back to policyholders. Is that a price drop or simply a decline in the usage of insurance? The Bureau of Labor Statistics called it the former, leading to unusually large declines in prices, which have had a noticeable impact on the core index. Similarly, some colleges dropped their tuition charges to reflect the more limited experience of remote classes. Again, the BLS chose to classify that as a price decline rather than a fall in the flow of education services being provided.

As the effects of the pandemic begin to unwind in 2021, a number of these special forces on inflation will dissipate or even reverse. Given the variety of unusual forces that will be in play, inflation could range over an unusually wide set of outcomes. Inflation could easily remain soft, which is the consensus view. Most Fed officials have expressed an extremely high level of confidence that inflation will remain soft in 2021 and likely for several years due to elevated unemployment for the foreseeable future.

While that argument is valid, it is unclear, as noted above, that there will be substantial labor market slack much beyond mid-to-late 2021. However, there are equally compelling arguments for an uptick in inflation. The unwind of social distancing restrictions are likely to produce a return to normal prices for a number of categories such as airfares, hotels, motor vehicle insurance and college tuition, to name a few. In addition, the challenges presented by the pandemic, such as creating more socially distanced factory floors, restaurants and so on, spending more on cleaning and other precautions, and potentially higher labor costs, could force firms to raise prices to recoup their expenses. Another tailwind for inflation in 2021 could be higher energy costs as a rebound in global economic activity pushes oil prices back toward pre-pandemic levels. While the direct effects of this will be clear and not affect the core inflation figures, the impacts could be broader as most firms have some exposure to energy costs and may feel compelled to try to recoup some portion of any increase in those expenses.

Unlike most Fed officials, I do not have a high degree of conviction on where inflation is headed in 2021, but a pickup to above pre-pandemic levels seems as at least as likely as a continuation of softer increases. In fact, it seems reasonable to expect year-over-year inflation rates to settle at or even modestly above 2% in the second half of next year.

A smooth consensus

Despite these potential surprises, the consensus economic forecast for 2021 looks for relatively steady economic growth over the course of the next year at a modestly above-trend pace. The most recent monthly Bloomberg survey of economists, for example, has a median forecast for real GDP growth of 3.1%, 3.3%, 3.2%, and 3.2% over the four quarters of 2021. Similarly, the unemployment rate slowly falls, to 6.7% in March, 6.4%% in June, 6.1% in September, and 5.7% in December. Finally, inflation is anticipated to run consistently below the Fed’s 2% target, with the year-over-year advances in the PCE indices, headline and core, both sitting in a 1.7% to 1.8% range in the second half of 2021. This is typically what consensus economic forecasts look like – a very smooth pattern over the course of the year — but actual outcomes are rarely so boring—2020 being a clear example.

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