U.S. Fiscal Stimulus Set To Supercharge Economic Recovery

Summary

• We've been consistently positive on the early cycle recovery since last April.
• In short, 2021 has already been coming together as a year of very strong economic growth.
• The American Rescue Plan was executed under budget reconciliation rules, which allowed it to pass with thinnest of majorities in the Senate.
• Vaccines, fiscal stimulus and expectations for a supercharged economic recovery have caused the cheaper and more cyclical areas of the equity market to outperform in recent months.

The American Rescue Plan, valued at $1.9 trillion, was passed by the Senate over the weekend and is set to be approved by the House of Representatives tomorrow. The bill will, in every likelihood, get some ink from President Joe Biden's pen later this week. We've been consistently positive on the early cycle recovery since last April. But the imminent passage of the bill capstones what has been a series of material, positive surprises for the U.S. economic outlook.

Take yourself back to what we knew on Nov. 4, 2020:

• A partial reopening of economies had lifted global economic growth in the third quarter

• However, COVID-19 infections were reaccelerating again in the United States and Europe

• The U.S. general election pointed to a gridlocked Congress, stifling hopes of further stimulus

We were still positive on the outlook late last year but thought a meager 5% real GDP (gross domestic product) growth rate seemed reasonable. Since then, the Pfizer (PFE) and Moderna (MRNA) vaccines (among others) were demonstrated to be highly effective, the lame-duck Congress passed a $900 billion stimulus package in late December (4% of 2019 GDP), Democrats won both Georgia Senate runoff races in early January - securing full control of the legislature - and the U.S. vaccine rollout has progressed at a reasonable clip. In fact, at the time of this writing, almost 20% of Americans have received their first dose, and the U.S. administration has indicated that there will be enough supply to inoculate the entire adult population in May. In addition, infections, hospitalizations and deaths from the virus are all trending lower.

In short, 2021 has already been coming together as a year of very strong economic growth. Adding an additional $1.9 trillion of fiscal stimulus (9% of 2019 GDP) WILL supercharge the recovery. We now think U.S. real GDP growth might log in close to 7% in 2021, which would be the best calendar year result since 1984.

Here are the major provisions of the deal:

• An extension of the $300-per-week enhanced federal unemployment benefits into September

• $1,400 stimulus checks to all taxpayers making less than $75,000 per year

• $350 billion of support to state and local governments

• Support for severely impacted businesses - e.g., restaurants and concert venues

• Additional funding for vaccine distribution, testing and tracing

Extended unemployment benefits and stimulus checks are likely to provide another shot in the arm for the U.S. consumer which - in the aggregate - was in outstanding shape already. Nominal personal income grew 6% in 2020 - a very strong outcome under normal economic circumstances and, frankly, a bizarro-world number for a recession year. Personal income spiked in January 2021 on the $600 stimulus checks, and is going to spike again in March and April on the $1,400 stimulus checks. The state and local government support is also meaningful, particularly for the labor market, where cash-strapped state and local governments with balanced budget rules have been forced to lay off workers.

What's next?

The American Rescue Plan was executed under budget reconciliation rules, which allowed it to pass with thinnest of majorities in the Senate. A little-known wrinkle of this reconciliation procedure is that it can only be used once per fiscal year. That means future Biden budgetary ambitions - such as an infrastructure or a tax reform bill - will either require the votes of 10 Republicans (cue Liam Neeson from the movie Taken: "Good luck") or it must wait until at least Oct. 1, 2021, when the next fiscal year begins (more likely).

Will all of this stimulus cause runaway inflation (part deux)?

I wrote about this issue last April after the historic fiscal and monetary response to the COVID crisis. The answer then was no, not yet. And so far, so good. U.S. core PCE (personal consumption expenditures) inflation is still below the Fed's target, running at just 1.5% as of January 2021. In short, I still think not yet is the right answer today. But that answer is getting more nuanced.

For one, core PCE inflation will spike to around 2.5% in the next few months due to what economists call base effects. Basically, as we replace the deflationary data from March and April of 2020 with more normal inflation data in March and April of 2021, the growth rates will look big for a period of time. That's just math and not something the Fed or markets should get very excited about.

Second, the uneven pattern of this recovery - which has been characterized by short-term bursts and pull-backs in key economic data points - could also create some more fundamental inflationary pressures in the short term. Remember, inflation is a consequence of there being too much demand relative to the available supply of a good or service. Right now, many of us are still stuck at home and bored, which has caused demand for goods like furniture and electronics to go through the roof. Goods producers (manufacturers) are having a hard time keeping up with that demand, particularly with COVID-related supply chain disruptions and labor shortages. That's inflation in a nutshell, but it should subside as demand shifts back toward services as life gets back to normal and supply chains and labor markets heal. The same thing could happen to airfare and hotel prices if everyone tries to go on vacation at the same time later this year. I could be wrong, of course, but this kind of inflation seems unlikely to be long-lasting.

The Fed and markets

Remember, the U.S. Federal Reserve (the Fed) wants to engineer an inflation overshoot and should tolerate these transitory effects. We still think Fed liftoff in early 2024 is an appropriate baseline. In a best-case scenario, we believe the central bank could begin raising rates at the end of 2022 if everything goes right and inflation surges sooner than expected.

Right now, Fed fund futures are pricing in a high probability of that best-case outcome. And 10-year breakeven inflation at 2.2% is now also within a few basis points of where the Fed wants it to be. Clearly, yields are higher for a reason, but we think there's already a healthy dose of optimism baked into the 1.6% 10-year Treasury yield. We look for yields to be more range-bound in the months ahead.

Key takeaways for investors

Vaccines, fiscal stimulus and expectations for a supercharged economic recovery have caused the cheaper and more cyclical areas of the equity market to outperform in recent months. Focusing in on our Russell Investments factor portfolios for the MSCI All Country World Index, for instance, we note that the value style has outperformed the growth style by 1,760 basis points since Sept. 30, 2020.

We think there is still further upside for the value style going forward as the earnings of companies most impacted by the COVID crisis are likely to outperform in the reopening phase. Notably, some tech products (e.g., webcams) could even face a hangover in demand as we all (hopefully) go back to a way of life in the next few months that looks a little more like 2019 than 2020.

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