The economic outlook for Q2 is overwhelmingly optimistic, with consumers expected to shake off lingering pandemic-related uncertainty and go on a services spending spree. We look for a spike in inflation to complicate the interest rate outlook for investors. For markets, rising interest rates will remain a focus—it isn’t just how high rates can go, but how fast. Even strong equity market fundamentals may be jolted by volatility in interest rates.
Key takeaways
- Q2 growth is expected to surge, fueled by stimulus checks and pent-up services demand.
- Monetary policy is increasingly linked to employment. We break down other metrics we will use to monitor the state of the recovery in labor markets.
- In Q2, inflation, rising interest rates and policy are converging to challenge investors.
Economic optimism is in the air
Between stimulus checks, market performance, better weather and finally getting a vaccine appointment, the optimism is palpable. The outlook for 2021 growth continues to strengthen as tailwinds and supports align to serve up a blockbuster year for growth. The Fed issued a new set of economic projections at the March 17 FOMC meeting which sharply upgraded its 2021 GDP forecast to 6.5%, up from 4.2%. This would be the strongest year of growth since 1984. The market consensus has been catching up to policymakers, and forecasts of 2022 are also moving higher, currently at 4.0%.
FOMC GDP Projection
Source: Median Economic GDP Projections of the Federal Reserve Board, March 17, 2021.
There are numerous factors driving such a strong outlook. Consumption, first and foremost, is expected to surge. Households are launching into Q2 with more cash stockpiled than at any time on record. We expect the savings rate to surge back above 30% in April in the wake of the latest round of stimulus checks from the American Rescue Plan Act (ARP). Households have used some of this windfall to pay down debt, and household leverage at the macro level is at its lowest point since the early 1980s. Another support for household spending comes from a surge in wealth creation on the back of equity prices and real estate valuation in 2020.
In Q2, vaccine distribution is expected to sprint toward widespread availability. The Biden administration expects everyone to be eligible for vaccination by May 1, lifting the final hurdle to participating in, and spending on, services. If the pent-up demand for goods is any guide, then the beleaguered spending sector can be expected to add significantly to GDP in Q2. The ability to spend on travel, restaurants and events alone could add as much as 4.0% to GDP.
This frothy growth outlook is expected to pull the unemployment rate down sharply. Improvement in the labor market has slowed but been steady, with the jobless rate at 6.2% in February. The Fed’s forecast is for the unemployment rate to fall to 4.5% in 2021 and 3.9% in 2022, close to where we were pre-pandemic. But in recent speeches, Fed Chair Jerome Powell has given a lot of airtime to the idea that declaring “mission accomplished” on the employment front will take more than just a low unemployment rate. For this reason, traditional macro models that utilize output and employment gaps may be prematurely forecasting rate hikes in 2023. We dive into other ways to look at the labor market, and what we’ll be watching in Q2.
Payroll employment
Source: BLS, as of March 19, 2021.
The inflation and reflation narrative has been critical so far in 2021, and that will continue in Q2. Importantly, the slump in inflation that happened at the height of lockdowns will work its way out of the data around May, causing a jump in inflation due to the “base effect” calculation. We think consumer price inflation could briefly rise to over 3%, the highest level in a decade, although we think this would be transitory.
For 2021, we look for pandemic-driven price shifts to continue to muddy the picture. Business surveys are increasingly pointing to supply-side disruptions and higher commodity prices that are pushing up input prices. We have found that this typically correlates to higher energy prices but often has little pass-through to core CPI. Other factors are having a strong disinflationary impact. Owners’ equivalent rent (OER), a much-maligned subindex of CPI that makes up almost a quarter of the index, works to capture the cost of shelter. The downtrend in OER alone is a powerful disinflationary pull on core CPI.
The Fed targets the PCE deflator, which is a part of the GDP calculation. The PCE deflator captures more of the economy than the CPI and tends to run about 0.25% behind its inflation data cousin. This measure has run below 2%—the Fed’s inflation target—for most of the last 15 years. The Fed’s framework review, which began well before COVID-19 took hold, concluded with a shift to targeting average inflation of 2%. In other words, the new policy framework gives room for inflation to remain above 2% for years before the Fed would view inflation (in and of itself) as a reason to raise rates. The policy conclusion is a dovish one, but markets may have trouble hearing the message through the conflicting inflation data picture in Q2.
Monetary and fiscal policy pivot
After a busy 2020, the Fed is clearly hoping to keep its main policy levers—the Fed funds rate and monthly asset purchases—unchanged for 2021. Fed Chair Powell and numerous Fed speakers have flooded the airwaves to impress this upon markets. In the near term, Fed rate hike expectations are sneaking into the yield curve, with markets now expecting a rate hike by early 2023; we think this may prove too early. We look at what the Fed is focusing on, what would move the needle toward a rate hike, and where the Fed may yet face a challenge to credibility both in the near and long term.
U.S. government debt outstanding
Source: Flow of funds, BEA, as of March 26, 2021.
Fiscal stimulus will remain a driving force for the economy in 2021, putting policy proposals in the spotlight in Q2. So far, the fiscal response to the pandemic has dwarfed prior rescue packages by pumping approximately $5 trillion, or 25% of GDP, into the economy over the past year. This has caused a staggering increase in the deficit, sparking a debate of whether to reframe the deficit in terms of interest expense rather than government debt outstanding.
Looking ahead, households may need to be weaned off popular and generous programs like the stimulus checks and supplemental unemployment insurance. To make our economic recovery self-sustaining, the economy now needs business investment and infrastructure to be more active in driving growth. The Biden administration is in the process of rolling out plans for its next big policy priority, with a price tag of $2 trillion–$3 trillion, which includes traditional infrastructure, green energy and focused investment like 5G telecommunications. Through Q2, we will be watching closely to see how this next round of spending develops.
Equity and fixed income markets navigate rising yields
Rising interest rates have been the macro-market event of Q1. Supercharged growth, the renormalizing of inflation expectations, and further massive fiscal stimulus have all combined to accelerate the rise in yields. Despite the rosy economic backdrop, however, rising interest rates are often uncomfortable for markets.
10-year Treasury yield
Source: Bloomberg Finance, L.P., as of March 26, 2021.
Over the coming quarter, there are factors that support yields moving higher still: Surging growth (particularly in Q2), inflation that could surprise to the upside, and Treasury auctions that will be offering record amounts of debt to fund our deficit. But we also note the natural barriers to higher rates that materialize as yields near the 2.0%–2.5% range. Our expectation is that yields could readily continue their upward trajectory to and beyond 2%, but much beyond that could see more resistance.
For markets, rising yields have important implications. Traditional fixed income struggled for much of the first quarter amid the unrelenting climb in long-term rates; the downside of duration has become increasingly apparent this year. The Barclays Agg is down over -3% as of March 25, eroding nearly two years’ worth of yield in just the last few weeks. Within core fixed income, rates giveth and rates taketh away.
These benchmark rate spikes have sent ripple effects across financial markets, including in other fixed rate products like high yield bonds. History tells us, however, that credit should come out relatively unscathed. Investment grade debt carries a longer maturity, which aligns with poor performance periods of rising rates. High yield, however, is more impacted by the macro environment and individual company fundamentals and tends to be more duration‑agnostic over the medium term.
Equity market fundamentals, in some sense, bring us full circle to where we began our Q2 outlook: optimism. The consensus projects S&P 500 revenue to rise over 9% in 2021, 7% higher than the 2019 level. EPS is expected to surge 21%, also comfortably outpacing pre‑COVID performance.
For equities, the rise in long-term interest rates was also a key narrative of Q1. The Fed’s vow to keep rates low, plus an outlook for a supercharged economic recovery, has led to a steeper yield curve, a recipe for outperformance of value over growth. This is what we’ve seen; the large-cap FANG+ stocks have barely moved off late-August levels, which coincides with the inflection point for interest rates. More broadly, we expect earnings to continue to beat expectations in Q2 as surging revenues and operating leverage create a sort of perfect storm.
