'Full return to normal in 2021'

-- | 23/02/2021

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Lex Hall: The end of the pandemic in the US is coming soon and after massive vaccination, the US economy will be ready for lift-off. They're just two of the predictions contained in a new report by Morningstar's senior equity analyst, Preston Caldwell, and I thought I'd catch up with him today to explain some of that.

Preston, welcome to Morningstar Australia.

Preston Caldwell: Thanks, Lex. Glad to be here.

Hall: Now, you predicted the US economy will not only recover from the pandemic, but you say that it will test its limits in a way that hasn't been done since before the Global Financial Crisis. Can you expand on why you're optimistic on that front?

Caldwell: Yeah, sure. So, we're projecting that US real GDP posts 5.3 per cent growth in 2021 and 4 per cent growth in 2022. And actually, this isn't too far out ahead of consensus. I would say that the leading edge of consensus is very close within the range of this forecast now. And for us at least, this optimism is centered around the fact that the US is likely to reach herd immunity in the middle of this year. We're thinking it could happen by May, and we don't think it will happen any later than July. And this is a combination of both vaccination on a massive scale as well as the large prevalence of natural immunity via prior infection in the US So, once this happens, herd immunity is defined as the level at which the virus is no longer growing, even with behavior at totally normal levels. So, theoretically, that enables a full return to normal, and we think that will largely take place in the middle of 2021. We think there will be a steady normalisation of consumer behavior and that includes a recovery in the consumer services sector.

So, the main drag on US GDP as of the fourth quarter 2020 is the consumer services sector. The rest of the economy has gotten back to its pre-pandemic levels by and large. But consumer services is huge at 70 per cent of overall consumption, 50 per cent roughly of GDP. And so, for it to have a full recovery we need a recovery in consumer services. So, that should proceed with the threat of the pandemic being removed and that will not only enable a GDP recovery, but an employment recovery. And we think that consumers are eager to spend, that really, they're just being held back by the continued need to social distance. So, once that's alleviated then the US economy really should be ready to take off and move quite aggressively.

Hall: We've seen this morning, for example, the mass vaccination program. I saw a stadium in Texas, I think, where they're rushing people through, driving up, getting jabs in the arm. That's great. What do you think about eliminating the sort of psychological factor of the virus? You say that consumer services will pick up and people will want to spend again. The mood on the ground—are people sort of losing their fear of the virus, do you think?

Caldwell: Well, I think so. I mean, if we look back during late spring, early in summer, we saw a normalisation of activity then which was somewhat interrupted by the second wave. And then, once the second wave started pulling back that—the second wave in the US was kind of in June and July. After that, then we saw another increase in services activity. Also, we've done a lot of research looking at certain historical analogies for this episode. We tried to find historical events where there was large scale disruption on par with what we've seen from the virus, and we didn't just look at pandemics because it's hard to find a good pandemic that's an exact analogy to what we're facing today. But we looked at things like wars. So, for example, the rationing of many food items and gasoline in the UK for the better part of the 1940s while they were dealing with World War II. And what we found was, in that event and in events like it that that disruption didn't cause a long-term change in consumer behaviour. So, in the UK example, for example, consumers returned to their pre-rationing level of consumption of the rationed goods even after being deprived of them by a great degree for the better part of the 1940s. So, by that historical guide that would suggest that people will return to normal eventually.

Hall: And I suppose that's—I sort of put you on the spot there, because that's a pretty hard question to answer given just the sheer vastness of the states. I mean, it's 330 million people. Attitudes differ whether you're on the East Coast or the West, you're in the middle of America. So, it's hard to answer. Let's talk about stimulus, because that's another psychological fact that Joe Biden's $1.9 trillion stimulus, $2.5 trillion in Australian terms. This is crucial. And you say this will have a massive effect on household finances. What sort of effects are you seeing there? People will spend more in particular sectors, I imagine.

Caldwell: Well, I think what's really important is the stimulus that we've already had back in March 2020. There's a $2 trillion stimulus bill and another roughly $900 billion stimulus bill was enacted in December 2020. And so, that was sufficient to cause a huge boost to US incomes in 2020. And if we compare the size of that stimulus, we reached a US Federal deficit to GDP of roughly 16 per cent in 2020, which surpasses any peacetime year in US history. So, we've never had that kind of response to an economic downturn. And so, private after-tax incomes soared in 2020, even with economic activity being down, and that was a result of that stimulus propping up private incomes. And of course, that will happen again in 2021 with another round of stimulus. But going forward, though, I do think there will be diminishing returns somewhat, both on the demand side where people are not going to respond as much to additional stimulus dollars in terms of increasing their spending, but more importantly, in the long run, stimulus is really constrained by the supply side of the economy where the stimulus can only really increase the level of economic activity if there is an output gap, which is a technical term for slack in the economy. So, if the economy is operating below its potential level, then there's an opportunity for stimulus to close that output gap. But we think there's a good chance the US economy reaches its potential level by roughly 2023. And it could be a little sooner a little bit later, but at that point the ability of stimulus to sustainably lift up economic activity is quite limited, because the economy begins heating up at that point once you reach potential and inflation starts moving upward. So, the additional stimulus probably isn't going to have that big of an impact on the long-term path of GDP, although it might help us get to our potential a little bit sooner.

Hall: Okay. I'll ask you to put your equity analyst hat on for a second. We're going to get a vaccine-induced economic recovery, that's number one. But on the flip side, markets have largely priced that in and driven themselves into overvalued territory. We saw a bit of a tech sell-off overnight. Are there any particular sectors that you think retail investors should keep an eye out for?

Caldwell: Well, that's correct that we do think the markets are slightly overvalued now. So, our median US stock is about 10 per cent overvalued currently compared to our Morningstar fair values that are derived from our Analyst Ratings for each company. So, the market as a whole is fully pricing in this economic recovery that we're seeing, at least when it comes to equities. There are still some pockets of value. So, energy is probably the biggest example for us, although even there we've had a pretty substantial rally in recent months. But, yeah, you have to look at the sector and the company-specific level in order to find pockets of value at this point.

Hall: Okay. Preston Caldwell, thanks very much for your insights today.

Caldwell: Well, thanks a lot. Glad to talk with you.

This report appeared on www.morningstar.com.au 2021 Morningstar Australasia Pty Limited

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