Stuart's Breakfast Orange; News Flash for Fed; Seasonally Adjusted there are no Pandemics in April

"you cannot predict inflation or deflation until you understand the extent of the virus over the next six months". John Mauldin's precise words show why the Fed's January meeting is a holding meeting. The central bank added progress on vaccines to its list of uncertainties but maintained confidence in the economy's outlook. However, as my friend and former colleague Meghan Greene wrote in the FT last week, Murphy's law suggests that the risks remain on the downside. Therefore it's not surprising that the Fed maintained, that they're not even thinking about thinking about raising rates or even tapering its bond purchase program. Treasury market bulls have come to view FOMC press conferences as a reliable source of profit and last week's meeting was no exception.

Major western industrialised economies, don't have a good pandemic record and as a result, the Antipodes are increasingly being viewed as the role model for the initial post-pandemic period. Vaccine nationalism and the threat of viral mutations means that governments will seek travel restrictions for most of the year, continuing to dampen tourism. At the same time, entertainment venues are likely to maintain limitations on crowds. Nevertheless, the return to a semblance of normality will enable domestic services to rebound sharply.

Despite the downside risks from slow vaccine rollouts and viral mutations, I continue to believe that the recovery will be front-loaded. The second quarter will be the strongest quarter of the year. Several factors justify this assertion. First, growth is being suppressed by the second wave of the virus and lockdowns. Fourth-quarter data from the major industrialised economies have been mixed, some above zero, some below, but most marginally better than expected. The US economy expanded at a seasonally adjusted, real annualised rate of 4% during the period. However, this was driven by carry over from the third quarter, at the end of the third quarter, real activity was 6% higher than the third quarter average. There will be no positive carry over for the first quarter, and I expect modest contractions amongst the major industrialised economies, but strengthening manufacturing activity will alleviate first-quarter gloom.

The constraints on the first-quarter will lead to a corresponding rebound in Q2. I expect an initial easing of lockdown restrictions by mid-March and other domestic constraints lifted by May. The economy will also receive a shot in the arm from, sorry, the shots in the arms. The spring in second-quarter GDP is likely to be multiples of the modest decline in the first quarter. This jump will also be turbocharged by seasonal adjustment. Seasonally adjusted there are no pandemics in April, but there was in 2020, and the adjustment mechanism will try to compensate for the discontinuity break last year by adding a strong kicker this year. I still expect overall growth amongst the major industrialised economies to recover to pre-pandemic levels by the end of the year, but to the extent that second-quarter growth is exaggerated, there will have to be some payback.

The most obvious payback period is in the third quarter, but the second quarter's significant rise will provide a strong carry over into the third quarter. Moreover, there will be an additional economic stimulus for the US and most likely other major economies. Congress has already agreed on additional spending of $900bn, and President Biden is seeking another $1.9tr. Biden has gone in high to provide room for a compromise; markets have discounted $1.0-1.2tr, I'm more optimistic. Although seeking reconciliation, the President has sufficient votes to push it through. Importantly, this funding is likely to be available in the third quarter. However, the resilient third-quarter performance represents displacement activity. It pushes the disappointment into the fourth quarter where the post sugar rush is likely to meet atavist concerns over a new virus variant.  

This fizz then fizzle is important as to how 2021 plays out in the financial markets. Second-quarter activity is likely to be exaggerated, but the media does not seek granularity in economic data. The conclusions of statistical models and statistical adjustment are presented as fact (Chinese data being the most notorious example). The consensus already incorporates estimation that the recoveries will be stronger than official forecasts (although new virus variants have tempered some of this optimism), but I think there will be a renewed surge in risk appetite as the economies reopen before these give way to concerns over a possible taper.

The Fed has a better understanding of the seasonal adjustment quirks, but its actions are not independent of the media or markets. A similar seasonal adjustment pattern occurred in the wake of the Great Financial Crisis. The seasonal adjustments were on a smaller scale, but the deep contraction in GDP in the fourth quarter of 2008 and the first quarter of 2009 set in motion a clear pattern over the following four years in which seasonal adjustment boosted activity in the opening and finishing quarters while dampening down the middle quarters. The Fed's response was to end QE in response to the stronger momentum and restart it after the slowdown. This period encompassed the infamous taper tantrum and the subsequent move to QE Infinity.

To paraphrase The Who, the Fed won't get fooled again. It will resist the siren calls of higher interest rates initially, but like King Canute, it cannot hold back the tide of higher government bond yields indefinitely. 

Next up a closer look at Australia as a model post-pandemic economy. 

Stuart Thomson is an independent economic and strategist. His writings reflect his personal views and are intended for the reader's entertainment and to elicit debate. They are not intended to constitute investment advice.