Will Peak Economic Growth Suppress the Stock Market?

It’s no secret that the U.S. economy has surged from the global pandemic doldrums. With more and more businesses across the country reopening their doors, business is starting to return to normal, which has boosted many Americans’ confidence.

One needs to look no further than recent retail sales data to discover how optimistic the American consumer’s attitude is these days. As we discussed in the April 20 “A First Quarter to Remember” article, retail sales soared 9.8% in March, exceeding expectations for a 5.5% rise. Remember, U.S. economic growth is largely dependent on a confident consumer, as consumer spending accounts for nearly three-quarters of total GDP growth.

So, with more Americans reopening their wallets, U.S. economic growth expanded at a 6.4% annualized pace in the first quarter. That’s the second-fastest economic growth rate since the third quarter of 2003, and it crushed economists’ estimates for a 6.1% annualized rate. I should also add that the U.S. economy raced to a record 33.4% annualized rate in the third quarter of 2020 and a 4.3% annualized rate in the fourth quarter of 2020, according to Reuters.

Many economists are currently looking for full-year 2021 GDP growth to exceed 7%, or the fastest pace in nearly four decades. The International Monetary Fund (IMF) expects U.S. GDP growth of 6% this year, compared to previous estimates for a 5.5% expansion back in January.[1]

The optimism surrounding the U.S. economic recovery has undoubtedly spread to Wall Street over the past year, as the broader stock indices have rebounded from the March 2020 lows. The S&P 500, Dow, and Nasdaq have surged 87%, 82%, and 106%, respectively, in the past 13 months; all three are sitting at or near all-time highs.

The stock market surge has ignited some skepticism about whether the run higher is sustainable, especially when considering that the second quarter could represent peak economic growth.Goldman Sachs (shown in the chart below[2]) expects U.S. economic growth to peak at 10.5% in the second quarter and then decelerate in the following quarters.

Goldman Sachs isn’t alone. The Federal Reserve also anticipates that U.S. economic growth will slow down dramatically in the upcoming quarters and years. Following the March Federal Open Market Committee (FOMC) meeting, the Fed released its summary of economic projections. This report showed that our central bank expects 6.5% GDP growth in 2021, 3.3% GDP growth in 2022, and 2.2% GDP growth in 2023. And after that, GDP growth is forecast to slow to about a 1.8% annual pace.[3]

So, the question is: After bouts of accelerating economic growth, how does the stock market perform as economic growth eases off the gas pedal?

Some market pundits are indeed declaring that the “easy money” was made and that the path to profits may grow bumpier as U.S. economic growth remains positive but slows dramatically. Goldman Sachs pointed out that the S&P 500 has averaged 1.2% gains per month when GDP growth is positive and growing in the past four decades. The index has only achieved average gains of 0.6% when economic growth is positive, albeit slowing.

Other strategists consider the performance of small-cap stocks as a barometer for where the stock market is headed in the wake of slowing economic growth. A Wells Fargo analyst recently pointed out that when small-caps outperform their larger-cap peers, it’s often a sign that we’re in the early stages of a bull market. And, on the flip side, when large caps outperform, the bull market is starting to age.[4]

Well, the small-cap Russell 2000 has soared more than 130% from the March 2020 lows, vastly outperforming the larger-cap indices. Most recently, though, the gap between the indices has narrowed. The Russell 2000 rallied about 3.6% in April, versus the S&P 500’s 5.3% gain and the Dow’s 3% rise.

Still, none of these analysts are expecting a correction in the near term. History tells us that bull markets last nearly three years on average—and the current bull market just got underway in late March 2020. But what they are cautioning is that significant market gains could be harder to come by in the upcoming months, given that economic growth is moderating. Wall Street has already “baked” the economic gains into the “cake.”

Now, with that said, one thing that we need to remember is that the economic reboot has been a bit slower across the pond in Europe. Goldman Sachs doesn’t expect GDP growth to peak in other parts of the world, specifically in Europe, Japan, and other emerging markets, until the third quarter of this year.

The IMF anticipates that the Eurozone will grow at a 4.4% annual pace in 2021, and the United Kingdom will expand at a 5.3% yearly rate. China and India will lead global growth, with forecasted GDP of 8.4% and 12.5%, respectively, this year. Overall global GDP growth is forecast to be about 6% this year, up from forecasts for 5.5%.[5]

The path to economic recovery has varied worldwide, and how the stock market will react to positive financial data here in the U.S. and abroad is anyone’s guess. Certainly, no one anticipated that the stock market would surge amidst the global pandemic and recession—yet it did!

That’s why it’s crucial to develop a financial plan and stick to it, no matter what the market and economy throw at us in the near term. Easier said than done some days, which is why the financial advisers at Nicollet Investment Management are standing by to help you navigate the uncertain waters. Give us a call today, and we would be happy to help you create an investment roadmap.

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[1] https://www.cnbc.com/2021/04/06/imf-world-economic-outlook-april-2021-global-gdp-to-hit-6percent.html

[2] https://www.marketwatch.com/story/goldman-sachs-says-s-p-500-returns-may-tumble-as-u-s-economic-growth-peaks-buy-these-stocks-11619090474?siteid=yhoof2

[3] https://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20210317.pdf

[4] https://www.reuters.com/business/small-cap-stocks-lag-wall-street-worries-about-broad-slowdown-2021-04-26/

[5] https://www.marketwatch.com/story/imf-lifts-outlook-for-global-and-u-s-growth-11617712232