Three Key Transitions for U.S. Economic Recovery | Lord Abbett
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Institutional Perspectives

The tradeoff between GDP and the risk of COVID-19 transmission is shifting in favor of reopening the economy, but the transition for investors is unlikely to be smooth.

Read time: 3 minutes

The United States is moving toward a new regime in which the tradeoff between gross domestic product (GDP) and the risk of COVID-19 transmission is shifting in favor of reopening the economy. This is now possible because the healthcare system was never overwhelmed by the surge in cases, and newly infected people have a better chance of receiving the care they need.

As this shift takes place, many of the key scientific questions that would help in the design of optimal reopening strategies—conditions that govern viral transmission, development of effective therapeutic treatments, and progress towards a vaccine, if possible—are still subject to massive uncertainty.

Still, there are three key, imminent transitions that will interact with each other in ways that are critically important for investment returns:

Transition #1: From shutdown to gradual re-entry.

While public policy may determine the boundaries, businesses and households will have to decide how aggressively to re-open without a full understanding of the risks they are facing. This suggests that the resumption of activity will be gradual and characterized by a great deal of caution.

When consumers are reluctant to spend, businesses normally provide incentives to buy. This hints at a highly promotional environment in which households are offered incentives to engage in consumption that may seem relatively risky. Other businesses may choose to restrict supply to ensure safety while raising prices to maintain revenue. Weak aggregate demand would make the former strategy more attractive while stronger aggregate demand would favor the latter.

There may also be an increased emphasis on consumer segmentation, with offers specifically targeted at households that have been less affected by limitations on their incomes. As different tactics are taken to reach consumers, it seems unlikely that capital spending will be very strong. This could potentially depress aggregate demand and bias the overall economy toward very low inflation.

Transition #2: Monetary policy to support economic recovery.

With interest rates at the effective lower bound (ELB) and the short-term “natural” interest rate way below zero, the U.S. Federal Reserve (Fed) must use other tools to provide monetary stimulus:

  • The most effective tool would be to implement measures that raise inflation expectations in the medium-term, thereby lowering real interest rates. The Fed may attempt this by rolling out more aggressive forms of forward guidance. This would involve making a commitment to keep short-term rates at the ELB until inflation rises above the 2% target and/or unemployment falls low enough for the economy to be back at full-employment.
  • The Fed could supplement forward guidance with some form of yield curve control; extending very low rates from the overnight rate it usually sets to longer maturities of up to three years in the Treasury market.
  • The Fed could also commit to an aggressive program of balance sheet expansion, putting the markets on notice that it will absorb large portions of the increase in federal debt to be issued over the next two to three years, and also make balance sheet policy conditional on the achievement of its targets for unemployment and inflation.
  • The Fed could even implement negative short term interest rates, although it has expressed a desire to avoid doing so, if it judges the threat of deflation to be significant enough. This is a risky transition to negotiate in an environment of weak aggregate demand as it depends on influencing expectations.

Transition #3: Fiscal policy for stimulating recovery.

The shutdown of the economy may have resulted in a fall in GDP of 10% or more, or $2-3 trillion dollars. That’s about the same amount as the federal government’s three stimulus packages, including the CARES Act. It is already clear, however, that more support will be needed in the form of aid to state and local governments (especially those in which the incidence of the virus has been highest), income replacement for unemployed workers, and support for viable businesses that can’t reopen until much later.

Without additional support, we believe aggregate demand will remain feeble and a wave of bankruptcies will overwhelm the courts. If worries about large deficits and debt overwhelm the exigencies of the moment, the economy could be saddled with fiscal drag even as it is struggling to get out of the hole it has fallen into, as was the case in 2010-2014.

Risk between Transitions

Two potential risks to monitor between transitions include:

  • If reopening goes badly and policy is insufficiently stimulative, a deflationary outcome becomes more likely, in our view.
  • If everything goes right in reopening and there is significant progress on the scientific front on top of aggressive monetary and fiscal stimulus, we think the risk of an inflationary outcome is also in play.

However, unless unemployment falls very sharply in the near-term, it’s our view that the risk of inflation would likely play out in 2022 or beyond while the risk of deflation in the near-term is greater since the economy is currently very far below potential output.

Since each of these transitions could go favorably or unfavorably, there can be no clear conclusions in terms of investment implications other than to say we believe that risk and volatility is likely to remain high, and that’s due to the potential for two-sided outcomes at each stage.

 

Forecasts and projections are based on current market conditions and are subject to change without notice. Projections should not be considered a guarantee.

This article may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.

Glossary of Terms

In monetary policy, reference to a zero lower bound (ZLB) on interest rates means that the central bank can no longer reduce the interest rate to encourage economic growth. As the interest rate approaches the zero bound, the effectiveness of monetary policy as a tool is assumed to be reduced.

The “natural” interest rate, sometimes called the neutral rate of interest, is the interest rate that supports the economy at full employment/maximum output while keeping inflation constant. It cannot be observed directly.

The information provided herein is not directed at any investor or category of investors and is provided solely as general information about our products and services and to otherwise provide general investment education.  No information contained herein should be regarded as a suggestion to engage in or refrain from any investment-related course of action as Lord, Abbett & Co LLC (and its affiliates, “Lord Abbett”) is not undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity with respect to the materials presented herein.   If you are an individual retirement investor, contact your financial advisor or other non-Lord Abbett fiduciary about whether any given investment idea, strategy, product, or service described herein may be appropriate for your circumstances.

The opinions in the preceding commentary are as of the date of publication and are subject to change. Additionally, the opinions may not represent the opinions of the firm as a whole. The document is not intended for use as forecast, research or investment advice concerning any particular investment or the markets in general, and it is not intended to be legal advice or tax advice. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information.

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