A Year of Division and Promise

Strategas' Economic Outlook for 2021

Many of us are happy to leave 2020 in the rearview mirror. Last year, the COVID–19 pandemic touched nearly every facet of our lives, roiling societies across the globe, devastating economies, and challenging us in ways we have not experienced before.

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Intertwined with the pandemic, politics affected nearly everything related to investing and the economy in 2020. Not only did the year feature one of the more contentious elections in modern history, but Congress passed one of the most important pieces of legislation in recent memory (the CARES Act), which was both historic in size and scope and will have ripple effects for years to come.

What awaits us in 2021? Here's how we expect the economy and the political scene to unfold in the year ahead:

Economic Outlook

The economic impact of the COVID–19 recession was severe in 2020, and the ramifications will linger for years to come. As we reflect on the past year and the months ahead, we've found it useful to key in on three themes by which to examine the state of our economy:

Growth Rates vs. Levels

Given the fast and dramatic changes in economic activity this year as the economy shut down and reopened, the rates of change for key data series have become warped. To get a better sense of the economy, we need to look at the actual levels for the data, particularly GDP, which broadly measures the country's output. In the second quarter, GDP fell at an annual pace of 31%, a record for any quarter since these figures have been kept. But it went on to rally 33% the very next quarter, another record-setting number.

However, though the growth rate recovered, the levels of nominal GDP were still well off pre–pandemic figures. GDP declined by $2.0 trillion in the second quarter, but rebounded to add only $1.7 trillion in the third quarter.

The same can be said of many labor market data sets. Growth rates have been strong, but we need to continue on that pace for several more months to return us to pre–COVID trend (or better). This seems likely, as we are forecasting strong GDP growth in both 2021 and 2022, based on pent-up demand and the progression of the vaccine rollout.

Manufacturing vs. Services

This has been a unique recession. Business cycles are usually driven by volatility in goods sectors (cars, home appliances, factory equipment, etc.). These areas tend to be more cyclical, featuring inventory build–ups in times of expansion and drawdown in contractions. On occasion, this weakness spreads and generates a financial crisis, like the spread of the housing crash into a full–blown economic crisis in 2008.

This cycle was different because the weakness in the economy has been from the usually stable services sector. Though this is no surprise given the nature of the pandemic and recession, it goes to show that we needed a medical solution to begin economic healing. Now that several highly effective vaccine candidates have us on a path to widespread inoculation in 2021, we expect the services sector to rebound strongly on the back of pent-up demand (particularly from higher income households, which felt less pain from the COVID–19 recession and also represent a higher percentage of discretionary spending). Because this cycle was unique, the recovery will likely be as well.

Short Run vs. Long Run

As with anything in investing, time horizon matters greatly. In the short run, the pandemic has been deflationary, forcing prices down as demand dried up. High unemployment and falling output reinforce these disinflationary and anti–growth forces. As the virus continues to challenge our society, these factors are likely to remain the dominant players, even with multiple vaccines imminent.

The longer run, however, paints a much different picture. First, though there may be lingering scars from the recession, the vaccine rollout should return us to pre–pandemic levels of growth, bolstered by pent–up demand in service sectors and continued policy boost from both Congress and the Fed. Though this would seem inflationary (and still may be over time), we think the inflation discussion remains a little premature – we need to see a strong recovery in labor markets first, where wage inflation may lead to some price inflation down the road. That will be difficult with unemployment still quite high and the output gap so large.

Additionally, the monetary policy tailwind should, in theory, pull back as the recovery strengthens. Monetary policy is meant to be symmetrical – easing now to battle a recession should lead to tightening later. Though the Fed does not seem to be in any hurry to raise rates (and recently changed their mandate with regards to inflation), an exit ramp is still required. Though these are longer–term concerns, we must manage for both the short– and long–term time horizons.

Political Outlook

Economic Volatility Begets Political Volatility

One theme we've noticed since the financial crisis began is that economic volatility tends to lead to political volatility. With an uneven recovery following 2008’s financial crisis, the U.S. is experiencing the most political volatility we can find over the past 100 years. November’s election marked the eighth federal election since that financial crisis began unfolding, and voters have now removed the party in power in seven of those eight elections. This instability has led to more contentious rhetoric and more bifurcated party platforms. Heading into the 2020s, this theme should remain dominant. The recovery from the COVID–19 recession has been choppy, with some sectors recovering quickly and others still in the depths of a recession. Should the COVID–19 recession amplify the trend of economic inequality across the country, we expect political volatility to persist.

Narrow Majority Will Limit Policy Options

Though Joe Biden won the election, the Blue Wave did not materialize in the way that polling had suggested it might, limiting the gains for Democrats in the House and Senate races. In fact, Democrats lost 12 seats in the House and will hold their smallest House majority over the past 140 years. Similarly, the Democrats will hold their smallest Senate majority with a new Democratic president since 1884. Currently, the Senate is divided 50–50 between Republicans and Democrats with Vice President Harris breaking any tie, giving Democrats the slimmest of majorities. The 2020 election continues the trend since the 2000 election of a narrowly divided country that swings slightly center left or center right depending on the dynamics of the current election.

This outcome will limit the actions that President Biden can take on key policy initiatives, particularly since there does not seem to be much appetite to eliminate the filibuster in the Senate. However, the Democrats do hold a majority and winning two seats in January's Georgia special election boosts the odds of some near–term spending initiatives, particularly on coronavirus relief, additional income support, and infrastructure. The Democrats' majority in the Senate also increases the probability of some tax changes to individual and corporate income, though that’s likely not to be debated until later this year. We further expect Democrats to push for new health care legislation later in 2021 and into 2022.

With legislation restricted to largely fiscal policy issues, we expect President Biden to lean more heavily on areas where executive authority can be wielded – trade and tariff policy, climate change, global relations, and geopolitics, to name a few.

Overall, the introduction of the coronavirus vaccine is exactly the shot in the arm our economy needed and limits the need for the most aggressive Congressional actions in 2021. With the acknowledgment that the economy is still suffering from serious problems that will take a long time to heal, we are optimistic about the prospects for 2021 – and beyond.