Key takeaways

• Major economies have moved past the recessionary trough seen earlier in 2020, with many achieving a solid rebound in manufacturing and a slower recovery in service activity and employment conditions.
• With GDP activity levels still well below normal, accommodative policy has become—and likely will remain—critical to the outlook both for the global economy and for financial markets.
• Extraordinary monetary policies have boosted liquidity and supported asset prices, although they have been less successful in generating economic growth.
• Fiscal spending provided critical support during the recession, but fiscal drag is a risk to the economic outlook if stimulus is wound down too quickly in 2021.
• The Asset Allocation Research Team believes the potential for elevated financial market volatility remains high due to high asset valuations and the potential for surprises in policies, the election, the virus, and the economy.

Economic policy historically has had an important influence on the business cycle. Policymakers often seek to provide some countercyclical balance to economic trends—easing monetary and fiscal policies when economic conditions worsen, tightening when growth-momentum accelerates.

Lately, the policy response has become an even more critical driver of the outlook for the economy and financial markets. Due to the continued pandemic and related restrictions on mobility and activity, greater sustained policy support has been required in the face of an incomplete reopening of the economy. In addition, the massive monetary and fiscal stimulus implemented during the first half of 2020 implies that any move toward policy normalization will be even more challenging and consequential than during past expansions.

Business cycle: The world emerges from a short but historically sharp contraction

• In the United States, the early-cycle recovery gained steam as economic activity continued to bounce back from extremely low levels.
• The manufacturing sector has rebounded strongly and continues to claw its way back toward pre-virus levels, boosted by sharp recoveries in consumer durables such as housing and autos.

After a strong post-lockdown rebound through June, the rate of improvement in service-based industries has slowed. This trend represents ongoing reopening challenges for segments such as travel and restaurants, shown in the chart "The rate of improvement has slowed amid challenges to reopening."

• Labor markets extended their incremental improvement, but new initial weekly unemployment claims still finished above pre-COVID highs. Roughly 29 million Americans remain on some sort of unemployment insurance.
• We expect the consumer outlook to remain heavily dependent on the level of fiscal-policy accommodation in the coming months.

Global activity continues to improve, shown in the chart "Many major economies have entered the early-cycle recovery phase," led by a recovery in manufacturing.

• Most major countries have successfully reopened large swaths of their economies and moved past their recession troughs, although activity levels remain well below historical norms.
• China's recovery is the most advanced, bolstered by fiscal spending on infrastructure, a recovery in the property sector, and a broad-based industrial rebound.

The eurozone and UK expanded their early-cycle recoveries, with Germany and France enjoying the brightest outlooks.

• Rising COVID cases likely will slow the pace of improvement, but governments’ reluctance to reimpose lockdowns, plus accommodative monetary and fiscal policies, continue to support the recovery.
• While the US confronted soaring job losses with a substantial increase in unemployment benefits, major economies in Europe enacted work schemes that subsidized wage costs.
• These programs incentivized businesses to avoid layoffs, kept unemployment from spiking, and generally support the consumer outlook. See the chart, "Europe and US: Decidedly different responses to labor-market stress."

Monetary policy: Tremendously accommodative, supportive of asset prices

Massive injections of liquidity—and promises to maintain easier policies for longer—have provided a significant boost to asset prices.

• Since March, the US Federal Reserve has expanded its balance sheet by nearly $3 trillion. Along with extraordinary programs implemented by other central banks, financial markets have benefited from a more than $6 trillion injection of global liquidity over the past 12 months, shown in the chart "Major central banks' balance sheets have expanded to unprecedented levels."

• Quantitative easing (QE) has directly pushed up prices on Treasurys and mortgage-backed securities; low yields have boosted valuations for equities and corporate bonds; and negative real (inflation-adjusted) yields boosted gold prices to record highs.
• Recent changes to the Fed's monetary framework, announced at August’s Jackson Hole Economic Policy Symposium, reinforce the notion that extraordinary accommodation will continue well into the recovery.
• Average inflation targeting (AIT), wherein a central bank adjusts its next-period target to account for prior results, allows for the Fed to tolerate higher inflation in an attempt to make up for past below-target misses.
• Additionally, an emphasis on more broad-based and inclusive employment objectives implies unemployment rates may need to drop lower than during previous cycles before the Fed would tighten policy.
• Eurodollar futures suggest an expectation that the Federal Reserve will maintain interest rates close to the zero lower bound for the next 3 years.

The Fed possesses plenty of tools to further support financial conditions, but the impact of those tools on the real economy may be somewhat limited.

• Low interest rates have supported housing-market activity and spending on consumer durables.
• The creation and launch of extraordinary facilities—such as the Main Street Lending Program, Municipal Liquidity Facility, and Corporate Credit Facility—restored calm in the financial markets.
• However, the total use of these facilities has been relatively small in scope—less than $100 billion—and the economic impact has been limited.
• Were financial conditions to deteriorate, the Fed could deploy further reinforcements. Issuing more debt, however, is not a panacea for resolving pandemic-related problems for small businesses, unemployed workers, and other entities.

We expect the extraordinarily high level of monetary accommodation to continue, although the outlook is not without risks.

• Balance sheet expansion has slowed over the past 2 months and may presage slower liquidity growth ahead.
• The Fed does not appear to be deliberately targeting higher stock prices, implying an equity-market drawdown would be viewed as normal and not necessarily a reason to ramp up its balance sheet expansion even further.
• Over the intermediate term, extending such massive monetary stimulus well into the economic expansion could raise inflationary pressure to a greater degree than the Fed intends.

Fiscal policy: Fiscal drag is a risk to the economic outlook if stimulus is wound down too quickly

• Federal government support will remain critical to the economic outlook.
• The government provided more than $3 trillion of fiscal support through the Coronavirus Aid, Relief, and Economic Security (CARES) Act and other legislation in the first few months of 2020, boosting consumer spending at a time when the shutdown in economic activity was most acute.
• However, the level of support will wane in the coming months. For instance, extra unemployment benefits provided high levels of income replacement to low- and middle-income workers, but for the most part these benefits expired in July.
• Congress continues to debate legislation to provide additional federal support. The result will influence the economic outlook over the next several months Fiscal drag—particularly from state and local government (SLG) retrenchment—could weigh on the economic recovery.
• Because SLGs need to balance their budgets—and tax shortfalls have a lagged impact on those budgets—cash-strapped SLGs can generate major fiscal drag long after a recession ends.
• In 2010, strained budgets led to SLG retrenchment that detracted from GDP and blunted federal stimulus. The overall contribution from government spending dragged on GDP from 2011–14, despite still sizable federal fiscal deficits, shown in the chart "State and local budget cuts could drag on US economic growth."
• Independent estimates of SLG budget shortfalls are in the $400 billion to $600 billion range over the next two years, implying greater federal support will likely be needed to prevent fiscal drag.
• The outcome of the November elections is likely to have an impact on fiscal policy and the economic outlook for 2021.
• In early 2021, we think it’s quite possible that the economy will not be fully reopened, that GDP activity will remain far below 2019 levels, and that unemployment will still be elevated. In this scenario, additional fiscal support will likely be needed.
• The contentious debate over fiscal policy is likely to continue if we have a divided-government result—where Democrats retain the House of Representatives and Republicans hold on to power in either the Senate or the White House.

• If the Democrats sweep the White House and both houses of Congress, they would presumably be more inclined to raise spending levels and fiscal support. This scenario likely would reduce the risk of economic weakness in 2021, but it’s also possible that, as the year progressed, higher spending could increase inflationary pressures were the economy to close in on a full reopening.

Fiscal multipliers (the "bang for the buck" of fiscal easing) tend to be stronger when focused on spending as opposed to tax cuts, and also when a weak economy is coupled with accommodative monetary policy. See the chart, "Fiscal stimulus, spending trends to have greater economic effect than tax cuts."

A shift in policy focus to higher-multiplier spending could potentially deliver greater near-term economic effects than did the tax cuts enacted during the period of low unemployment in 2017.

Asset allocation outlook: Early cycle with tempered optimism

The sharp recovery in prices for riskier assets has been underpinned by abundant liquidity. Asset returns are likely to be increasingly influenced by both fiscal and monetary policy decisions.

• The emergence from recession suggests a more constructive business cycle backdrop; however, stocks have recovered so much ground since March that they might have pulled forward some of the gains that typically would have been earned during the early-cycle phase.
• The potential for outsized bouts of volatility is likely to remain high, and thus a relatively neutral near-term asset allocation positioning may be warranted.
• Portfolio diversification remains as important as ever, with the valuations of non-US and inflation-resistant assets appearing relatively favorable.