We all wish we could go to the movies again, but there’s one thing we don’t miss: the guy who always complains about inconsistencies in the films’ plots. “How did he hang the poster back up from inside the tunnel?” “If he traveled back in time, how come she doesn’t remember him?” “If he’s being hidden from the Empire, how come his name is still Skywalker?????” 1 1 Close The Shawshank Redemption, Back to the Future and Star Wars. I’ll admit that I may have yelled out “WHY DO THE ZOMBIES ONLY LIVE UPTOWN???” when watching I Am Legend. While these kinds of questions may seem pedantic at the theater, they are an important part of how macro investors understand markets. We have to ask things like “how can stocks be up when bonds are pricing a recession?” if we are to make informed decisions. 2 2 Close Though maybe not the twenty times a day that I hear it.
This is a good year to think of markets as cinema. It started like a romantic comedy in January, then in March there was non-stop action. Now the action has slowed, giving way to some dramatic tension and suspense. The economy has partially recovered, but we don’t know how long it will take for different parts of the economy to return to previous levels. We don’t know when things will return to normal or if there will be any permanent changes to how we do business.
The consensus forecasts provide some answers, though not without a few plot holes to complain about. For example, the 2022 budget deficit is pegged at 7% of GDP while the government debt as a % of GDP is seen falling by a few percent in the same year. 3 3 Close This would require very high nominal growth, well above the expected level. Data from Bloomberg Consensus Forecasts. These types of inconsistencies occur because different economists submit estimates for each indicator, and they don’t always share each other’s outlooks. The debt forecaster may have a completely different view from the deficit guy. It’s sort of like having a different screenwriter for each scene in a movie.
On a higher level, however, the forecasters are mostly telling the same story. They expect a sharp recovery into next year after the worst quarter on record. Growth is expected to rise for the next few years. If they’re right, GDP will have recovered all the pandemic losses some time in 2022. Private investment is expected to take a little longer to reach pre-crisis level, but forecasters see consumption returning quickly. 4 4 Close Data from Bloomberg Consensus Forecasts.
A couple of areas have remained steady through the crisis and will potentially remain so into the future. The current account deficit has stayed between 2 and 2.5%, hiding the extreme moves in both imports and exports. Inflation is expected to fall a little this year but return to around 2% next year. Housing numbers have had a similar small drop but by next year some are expected to be stronger than they were in 2019. You may have noticed that despite the massive stimulus programs enacted this year, government spending has hardly changed. This is not an error: government spending measures do not include transfer payments or loans such as the PPP. The program shows up in the budget deficit estimates which stay wide despite the expected return to growth.
Economists are saying that from a macro perspective, the economy can withstand the health crisis. There isn’t much fear of a double dip or high inflation. These forecasts are like Rogue One – they fill in a key plot hole and awkwardly explain why stocks and bonds have both been rallying. 5 5 Close Rogue One explained why there was a design flaw in the Death Star. It was a surprisingly entertaining movie. Forecasters are expecting the most benign scenario for those assets: low inflation and interest rates combined with solid growth. Consumers will spend, houses will be built. A few more people will be out of work than there were in 2019, but this slack will keep prices in check. This optimistic outlook may be hard to imagine when so many people are unemployed, many areas still have restrictions on movement and activity, and shortages of basic goods are a recent memory. It can be unsettling when markets are more forward looking than we are.
One peculiar aspect of current pricing is how relaxed the markets are about debt. This movie could have a warning that it is not appropriate for deficit hawks who believe that higher debt levels would mean that investors would demand higher yields and would result in lower earnings and declining equity prices. 6 6 Close This market is rated DH-13. Some material may not be appropriate for people who believe in Ricardian Equivalence This is more evidence that investors have changed their views on this.
Perhaps the biggest reveal from the forecasts is that despite what people think, equities aren’t pricing something totally detached from the economy in absolute terms. (The spreads among stocks are a different story 7 7 Close Those seem kind of crazy ). This doesn’t mean that stocks and bonds are right in their implied views. Rather it means that if you object to the pricing, you either disagree with how stocks were valued pre-crisis or you think that the pandemic will make companies less profitable when growth returns. 8 8 Close You may also think stocks are riskier and deserve a higher risk premium. Then your favorite movie is probably Chariots of Fire. Or you could just think that the economic forecasters are wrong. For example, in a plot twist, inflation could surprise to the upside or growth to the downside. But for now, forecasters are saying this movie will have a happy Hollywood ending and markets agree. And nobody likes spoilers.
What We Are Watching
U.S. Fiscal Policy
Policymakers in the U.S. moved aggressively in March and April to provide support to households and businesses impacted by the coronavirus pandemic. However, some key provisions of those relief efforts are set to expire shortly, most notably additional unemployment benefits of up to $600 per week which cut off at the end of July. Congress and the Trump administration are now attempting to reach consensus on a new fiscal package to extend support in the months ahead. However, as of this writing, meaningful differences remain between the Trump administration, Senate Republicans, and House Democrats on key issues. Republican leaders are pushing for reducing the $600 per week unemployment benefits, arguing that current payments are generous to the point of disincentivizing work for people with lower incomes. Democratic leaders would like to preserve all or most of the current unemployment benefits, and in addition are advocating significant support to state and local governments, which have seen their revenues plunge in recent months. If politicians are able to reach a deal this week, it would remove some downside risk to the near-term outlook for the U.S. economy, potentially providing a boost to risk sentiment.
U.S. GDP (Thursday) and Eurozone GDP (Friday)
This week, the U.S. Bureau of Economic Analysis (BEA) and Eurostat will publish their initial estimates of second quarter GDP growth in the U.S. and the Eurozone respectively. These releases will almost certainly show the most rapid contractions in economic activity in either region on record. The second quarter began with the U.S. and Europe in full lockdown mode, resulting in extremely depressed levels of consumer spending, industrial production, and capex activity. Monthly data for May and June has generally shown some degree of recovery, but average levels of activity for the quarter may be around 10% below pre-pandemic levels. 9 9 Close In the U.S., the convention is to report quarterly GDP growth in annualized terms, resulting in an eye-catching consensus forecast among economists surveyed by Bloomberg of -34% GDP growth in the second quarter. In the Eurozone, forecasters are looking for -11%, not annualized, which is actually somewhat worse but doesn’t look quite as bad. In some sense, the weakness of second quarter GDP may already be “old news,” and economists and market participants may focus on what information can be gleaned about the prospects for recovery in the third quarter. In the U.S., the data will embed the BEA’s initial estimate of overall consumer spending growth in June, with a strong result potentially boosting optimism for the outlook. 10 10 Close Retail sales data for June, published earlier this month by the Census Bureau, was quite strong. However, retail sales are only a subset of consumer spending, and areas such as healthcare, education, and travel have also been heavily disrupted in recent months. In the Eurozone, additional detail on second quarter growth will not be published for a few more weeks, leaving markets to respond solely to the headline growth rate.
Market focus for the upcoming FOMC meeting rests largely on potential changes to the Fed’s forward guidance. Possible innovations include explicitly linking monetary policy to economic outcomes such as reaching a specific PCE inflation rate or seeing the unemployment rate fall below a certain threshold. With yield curve targeting challenged and losing traction according to the last FOMC minutes, the yield targeting option appears to be less likely now. Any substantial changes to forward guidance will, in any case, be geared toward reinforcing the Fed’s dovish stance. Thus, the introduction of strong guidance should be positive for risky assets and bonds, as well as negative for the U.S. dollar.