The economy is experiencing the first effects of a powerful double-dose vaccine of broad inoculation and fiscal stimulus. The reality is that forecasts remain very uncertain. The pandemic recession had no modern precedent and so we have no good road map on the speed at which the economy might naturally recover. In addition to this, we have no example of the impact of fiscal stimulus of this scale, aimed primarily at low and middle-income consumers. What we can say is that early signs show the recovery is accelerating, suggesting a faster return to “normal” than many had dared to hope a few months ago. While this is very good news in general, it brings with it challenges for investors in making sure their portfolios are positioned for the very different financial landscape of a post-pandemic world.

Progress On Vaccination
On the pandemic itself, the strong improvement in case numbers in January and February has recently stalled out. However, the pace of vaccination continues to accelerate from an average of 1.3 million doses a day at the end of January to over 3 million doses per day over the last week. That being said, most of the impact of vaccination is ahead of us, since full protection for a two-dose vaccine doesn’t kick in for two weeks after the second dose and that, as of two weeks ago, just over 13% of the population had been fully vaccinated. A recent Gallup poll showed that 74% of Americans are now willing to be vaccinated, up sharply from 50% last September. Assuming vaccines remain effective against emerging variants of Covid-19, an ever-growing share of the population should achieve some immunity from the disease in the months ahead, allowing the nation to transition back to some form of “normal” this summer.

Economic Data Heating Up
While we still have some distance to travel in overcoming the pandemic, economic data for March suggest that a robust recovery is already underway. 

• The ISM manufacturing index for March came in at a 37-year record high of 64.7, blowing past a consensus expectation of 61.5.

• March light-vehicle sales came in at 17.7 million units annualized, their strongest monthly reading since 2017.

• Most importantly, non-farm payroll employment rose by 916,000 in March with upward revisions adding a further 156,000 to combined job gains in January and February.  With these increases, the economy has now recovered 14 million, or 62%, of the 22.4 million jobs lost in the pandemic.  The unemployment rate fell a further 0.2% to 6.0%.

• The week ahead should provide further evidence of this acceleration in economic activity with service sector PMIs showing solid gains for March and the February JOLTs survey showing a marked uptick in job openings.

It should be noted that the March employment report referred to the survey week that ended on Saturday, March 13 and thus was not directly impacted by the provisions of the American Rescue Plan, signed into law on March 11. This legislation is set to pump $1.16 trillion, or more than 5% of GDP, into the economy before the end of September. Stimulus checks should now be fueling a surge in consumer spending as corroborated by recent strength in airport traffic, restaurant reservations and credit card transactions.  In addition, the Rescue Plan should directly lead to greater hiring of health care workers as well as all those involved in the refurbishment of schools and colleges to meet health protocols.

The Prospects For Further Stimulus
We also need to factor in the impact of further legislation. Last week, President Biden outlined his infrastructure plan in which $2 trillion in additional spending over the next 8 years would be paid for by higher corporate taxes over the next 15 years. These tax increases would include raising the corporate tax rate from 21% to 28% and instituting a 21% tax on overseas corporate profits. While the White House did not provide detailed analysis on how the spending or taxes would be spaced out over time, allowing for the effects of economic growth and inflation, $2 trillion over 15 years would imply about $100 billion in 2022, or roughly 5% of the $2.1 trillion in after-tax corporate profits that we expect for next year.

As a practical matter, if this is passed it will be via the reconciliation process, and due to Senate rules, the legislation can’t pass as proposed since the bill would not be allowed to add to the deficit beyond a 10-year window. However, there is a good chance that trimmed down infrastructure provisions could pass if combined with a multi-year extension of the enhancements to the Child, Dependent Care and Earned Income Tax Credits in the American Rescue Plan. These provisions, which will likely turn out to be very popular, cost $130 billion for a single year and a multi-year extension of them would likely be financed by higher income and capital gains taxes on upper-income individuals.  There is probably at least a 50/50 chance that all of this will go through in a reconciliation bill before the end of the year, and by front-loading benefits and back-loading costs, could, on net, add to economic stimulus going into 2022,

Beating The Fed’s Forecasts
The implications of all of this for growth, jobs and inflation are extremely difficult to estimate with any precision. There simply is no modern blueprint for how fast the economy could recover from a pandemic as the pandemic winds down. In addition, we have no historical experience of what happens when, over a six-month period, stimulus aimed at lower- and middle-income households, equivalent to over 5% of GDP is dispersed into an economy that is already recovering.

What does seem likely, however, is that economic numbers this year will be even stronger than the Federal Reserve’s March projections. At that time, they envisioned real GDP rising 6.5% year-over-year in the fourth quarter with an unemployment rate averaging 4.5% and consumption deflator inflation projected at 2.2% year-over-year.

If, over the next few months, it becomes apparent that the economy will indeed beat these numbers, markets will likely begin to price in a tapering of bond purchases starting in early 2022 and a first increase in the federal funds rate in early 2023 or even late 2022.  This could easily push 10-year Treasury yields above 2% in the months ahead.

Adjusting To Higher Interest Rates
Such a scenario presents challenges for investors in fixed income and equities. On the fixed income side, higher Treasury rates could lead to losses for many long-duration and high-quality bonds as there is limited room for spread compression. One potential exception to this is emerging market debt, although, as always, investors will need to be wary of the many potential regional problems in this space.

On the equity side, this scenario also poses some challenges. Following a 22% drop in S&P500 operating earnings in 2020, analysts expect a 40% rise in 2021 to roughly $172.50. While this is possible in a faster-than-expected recovery, further gains in 2022 could be very limited, given higher interest rates, higher wage costs, slowing economic growth and, potentially, a hit from higher corporate taxes. This makes today’s overall market valuations, at over 22 times forward earnings, look pretty rich, while frothier areas of financial markets remain are particularly vulnerable to higher interest rates.

However, it is also important for investors not to neglect opportunities as we transition to a post-pandemic economy. Even after a rotation towards value and small cap stocks in recent months, relative to history, they still look cheap compared to large-cap growth stocks and should benefit from a very strong economic surge. International stocks also look less expensive than U.S. equities with higher dividend yields and have the potential to outperform once the global pandemic subsides. A higher-than-average dispersion of valuations within the S&P500 points to a potential opportunity for active managers. Finally, longer-term themes such as greater R&D investment in green technology and biotech and the growing importance of China in global fixed income and equity markets could all provide opportunities for better returns in the years ahead.

A double-dose of vaccines and fiscal stimulus should make 2021 a spectacular year for economic recovery. However, high valuations and rising interest rates could also make it a challenging one for investors, underscoring the importance of making adjustments to help portfolios meet the challenges of a fast recovery and the financial landscape of a post-pandemic world.

David Kelly is chief global strategist at JPMorgan Funds.