FORWARD OUTLOOK FOR THE U.S. ECONOMY

In spite of the ongoing Covid 19 pandemic, there’s good news and bad news regarding the U.S. economy.  The good news is, the economy grew by an annualized rate of 33% in the third quarter of 2020.  That bad news is, that’s still about 3.5% smaller than it was at the end of 2019.  Most forecasters believe that it will be late in 2021 or early in 2022 before the economy is able to return to full growth mode.  That said, what does it all mean for investors?

Are the numbers fooling us:  The huge third quarter bounce was welcome news, but it only points to the very sharp drop the economy took and the end of the first quarter and the beginning of the second.  The surprise on the upside might further be attributed to lower expectations in the first place.  During this same period many U.S. companies improved their net incomes by cutting costs rather than increasing revenues.  Cutting costs is usually good for investors in the short run, but the growth that most investors seek needs to come from increased revenues.

Growth is uneven and concentrated in a few areas:  Jonathan Golub of Credit Suisse estimates that all the companies in the S&P 500 reported a composite across the board fall of net income by about 10.2%.  But of this total, those companies with a major export business experienced a fall in net income by over 14%.  On the other hand, those companies with their net incomes derived primarily from domestic markets showed a decrease less than 9%.

The five biggest tech firms (Amazon, Apple, Facebook, Alphabet, and Microsoft) have seen their market capitalization decline by nearly ¼ of the entire S&P 500.  But at the same time these five companies have generated shareholder returns of about 39%, dwarfing the other 495 index members whose aggregate shareholder returns were -1%.  This points to smaller and medium sized companies that are struggling the most.  They are nearly four times as likely to be losing money than large companies.  The sentiment among small and medium size companies is that nearly half of them believe that they will run out of cash in six months.  This picture was beginning to worsen before the pandemic.  Now it appears to be worse overall than either the Dot Com Bust recession or the Financial Crisis.

Massive increases in debt:  In times of financial pullbacks, the most common remedy for companies that face cash flow shortfalls is turning to the debt markets.  As a company’s financial fortunes worsen, so does its credit ratings and its ability to borrow money more cheaply.  This has led to a major increase in high-yield debt or junk bonds.  The default rate for high-yield was 1-2% for a number of years.  Recent estimates show that this rate could climb up to 7% by the end of 2020.  The number of CCC+ or lower rated companies has increased by 50 % since the end of 2019.

The impact of ultra-low interest rates and increased liquidity could have an adverse effect if it serves to help support some companies by postponing their inevitable demise.  The impact of further fiscal stimulus is not clear at this point as the government is in the process of transition and will likely wind up with divided politics similar to what it was for the last two years.  The premise might be that the government will attempt to prevent companies from being pushed out of business owing to market forces for the short run.  What effect will this have on the debt markets over the long run is also not yet clear.

There still remains the pandemic:  The overarching concern for the economy is still the pandemic.  Infections are rising pointing to the probability of a widespread second wave.  As this happen, state and local governments might be forced to return to some form of lockdown status to protect the population.  Too many times these lockdowns take place in densely populated areas which could end up hurting the economy across the board, and perhaps wipe out some of the recovery that had been taking place.  Although vaccines are starting to rollout, this might not present enough of a positive impact on the economy until the end of second quarter of 2021.  To make public places safe again, the U.S. might need to have as much as 70 – 80% of the entire population vaccinated.  Reaching this benchmark might take until July, 2021, or later.

Conclusions:  Although numbers look rosy in some aspects, the future still looks rough, at least for the near term.  The timeline of the vaccine rollout will have the greatest impact on the economy returning to full force.  In the meantime, investors need to be wary as there still are some bona fide bargains out there, but expectations for growth should not be overly optimistic.

Sources: “Still Ailing,” The Economist, November 7^th, 2020.