Dec 21 2020
Following a steep economic contraction in Q2 as a result of the COVID-19 (coronavirus) pandemic, US GDP is expected to have increased 33.1% in Q3. With large swaths of the economy still affected by social distancing regulations, supply chain disruptions and decreased demand for services, this overall economic improvement in Q3 represented a source of optimism for consumers and businesses alike. Additionally, with certainty regarding the 2020 Presidential Election, the odds of some fiscal support prior to the end of the year are nearly certain, while potentially further may be on the horizon upon the start of the next administration.
Recent news and emergency authorization regarding the Pfizer and Moderna vaccines have driven financial markets further upward. Overall, it appears the most detrimental economic effects stemming from the pandemic have already occurred in Q2. Unfortunately, the worst is likely not yet upon us medically, with daily deaths and cases continuing to climb and hospital capacity beginning to be seriously challenged. Such developments have raised the specter of new lockdowns, which would be unequivocally bad for the economy but potentially necessary to prevent hospital systems from being overwhelmed throughout the country.
Labor market recovery cut short
While total employment is still below pre-pandemic levels, total nonfarm payroll employment increased by nearly 4.0 million jobs in Q3. This increase contributed to a decline in the unemployment rate, which reached 6.9% in October. This represents an improvement that has exceeded expectations given the economic downturn and future uncertainty. Additionally, the largest gains in employment stem from rebounds in Accommodation and Food Services, as well as Retail Trade sectors. This coincides with a decline in temporary layoffs and stable permanent job loss. However, the labor force participation rate, which represents the percentage of the population that is working or actively looking for a job, still only reached 61.7% in Q3.
Despite the significant rebound in Q3, the job market recovery slowed significantly in November. Employment increased by just 245,000 jobs, resulting in a marginal decline in the unemployment rate to 6.7%, while labor force participation actually receded from its upward trajectory. With regions beginning to impose restrictions once again to slow the surge in cases and economic conditions deteriorating since the latest payrolls report, it is likely that total employment will actually decline to end the year. While lame duck fiscal support will be a boon to the nation and its labor market, expectations support should be tempered, as there likely will not be any funding for state and local governments. This would places significant downward pressure over the next several months, with hundreds of thousands of additional job cuts in early 2021 likely due to states’ needs to balance their budgets.
Consumer spending levels off
Consumer spending, which is represented by Personal Consumption Expenditure (PCE), returned to its upward trajectory in Q3. Overall, PCE increased 8.9% in Q3, while still down 2.9% year-over-year. Consumer spending has benefitted from an accommodative borrowing environment via low interest rates, as well as stimulus. To no surprise though, PCE has been dragged down by a decline in spending on services, including food, accommodation and transportation. However, growth in durable goods in Q3 and year-over-year represents a source of optimism. Additionally, holiday spending in Q4 represents a potential opportunity for consumption to increase further, though retail spending has been weak in recent months, mirroring the slowdown in the labor market. Still, fiscal support in the form of PPP funding and enhanced unemployment benefits, there will likely be a floor to PCE despite spikes in the virus potentially resulting in new lockdowns. Until there is deployment of a coronavirus vaccine to a significant portion of the population, future PCE growth will likely remain muted.
As consumption rebounded in Q3 following a steep decline in Q2, consumer prices similarly rose to more acceptable levels. After consistently remaining well below the Federal Reserve’s average 2.0% inflation target, an uptick in inflation presents a source of optimism. Still, this growth in consumer prices was primarily a result of stimulus and unemployment benefits providing upward pressure.
As economic uncertainty persists, expectations regarding future price movement are difficult to project. While consumer prices will likely continue its upward trajectory, potential new lockdowns as coronavirus cases increase and no future stimulus may limit inflation growth in the short-term. However, once a vaccine is deployed, potential risks stemming from the Federal Reserve’s new management of inflation may continue to be present over the next few years. With the Federal Reserve now choosing to target an average annual inflation rate of 2.0%, there is a real possibility of inflation running above this 2.0% target once the threshold is passed. Additionally, higher consumer spending with interest rates expected to remain near-zero until 2024 may continue to push inflation higher. As a result, there is a real potential for inflation to run above the Federal Reserve’s 2.0% once a coronavirus vaccine is deployed, without much wiggle room to combat it.
Construction activity divergence
In Q3, the Construction Sector largely benefitted from the aforementioned low interest rate environment. However, structural differences between demand for residential and nonresidential construction activity contributed to diverging trends. For instance, residential construction activity rebounded strongly in Q3 from the decline in Q2, while nonresidential construction activity continued to lag behind. Growth for residential construction activity comes primarily as a result of a relatively low housing stock, while an oversupply of existing commercial real estate following the onset of the coronavirus pandemic has deterred investment for nonresidential construction projects.
As a result of relatively low interest rates, consumers benefitted from an accommodative borrowing environment in Q3, which fueled significant demand for new housing construction. The rapid rate of growth in Q3 is a stark comparison with Q2, where residential construction was hit the hardest by the coronavirus-induced slowdown. Due to the economic uncertainty in Q2, homebuilders backed away from new projects and consumers reevaluated their financial positions. However, a relatively low housing stock continues to push home prices higher, as demand for new homes persists. Accordingly, the low interest rate environment enticed consumers to finance new home purchases through mortgage debt in Q3, which saw housing starts return to pre-pandemic levels.
These trends are not the same for nonresidential construction activity, however, as social distancing guidelines and low business activity continue to hinder demand for retail and service operators. Accordingly, business bankruptcies have increased dramatically, leading to an oversupply of existing commercial real estate and derailment of investment in nonresidential construction. Furthermore, the economic uncertainty and long-term structural changes as a result of the coronavirus pandemic have deterred future investment in new commercial spaces. As a result, the value of private nonresidential construction is not expected to return to growth until a complete economic recovery is made and will likely continue to lag behind residential construction.
While the economy rebounded strongly in Q3, the economy still is a long way from reaching pre-pandemic levels. The Federal Reserve is not expected to increase interest rates and keep them near-zero until 2024, which will continue to provide an accommodative borrowing environment for consumers and businesses. So long as interest rates remain low, consumer spending and consumer prices will benefit from this upward pressure. However, as unemployment benefits and stimulus assistance wanes, the economy will continue to struggle to reach pre-pandemic output. Service industries are expected to continue to weigh down on the economy, as well as the labor market. Until a vaccine is deployed and the economy can operate at full capacity without limitations, a true economic recovery will likely be unfeasible.
Aside from the deployment of a coronavirus vaccine, the greatest challenge to economic recovery involves the passing of more stimulus assistance and support for state and local governments. While lame duck fiscal support will likely prevent worst case scenarios from occurring, partisan fighting on aid to state and local governments will likely lead to austere spending cuts, of which jobs will undoubtedly be cut in the months ahead. Regardless, the winter months will likely be characterized by a regression in the recovery story. Consumer and business bankruptcies will likely increase, in addition to credit lending standards that are likely to tighten further. These trends are expected to weigh on the recovery over the next few months, representing the economy’s worst position since early in Q2.
While there being clear risks that can result in a second economic dip and hinder the long-term recovery outlook, there are also several sources of optimism. The American economy has likely already experienced the most detrimental economic effects of the pandemic already. The country has adapted to obstacles along the way, rebounding more rapidly than was thought possible despite the current slowdown to the recovery. Since we know more about COVID-19 than we did at the start of the pandemic, with treatment options being vastly improved and personal and protective equipment supply issues less of a concern, the shock of any further lockdowns will be less severe than earlier in the year. Regardless, it is always darkest before the dawn unfortunately, as the winter surge in cases and deaths has been grim and is likely to get worse before it gets better. However, with vaccine deployment already underway and expected to accelerate in the coming months, in addition to some fiscal support measures for the American people coming before the end of the year and further possible in the first quarter of 2021, there is light at the end of the tunnel.
By: Ryan Roth, Lead Analyst; Mario Ismailanji, Senior Technical Analyst