US stocks are rebounding sharply from the steep losses incurred in the early days of the pandemic. After a brutal 34 percent decline in the S&P 500 in the span of about a month, stocks have staged an impressive rally that has left the S&P 500 only about 9% below its all-time high set on February 19. Both the speed and the severity of the decline and its subsequent recovery are unprecedented in stock market history.

The market’s rise from the ashes comes against a backdrop of the worst economic environment since the Great Depression. More than 60,000 people have died, and more than 30 million people have filed for unemployment in the last six weeks, representing nearly 20 percent of the entire US workforce. Due to processing delays, most economists believe the actual number of unemployed may be significantly higher. Forecasts for second quarter GDP (annualized) are in the -30 to -40 percent range, a number consistent with the 1929-33 experience. A recent report released by the nonpartisan Congressional Budget Office (CBO) forecasted the US unemployment rate to average 10 percent in 2021 with economic activity not returning to 2019 levels until sometime in 2022. Corporate earnings, the fuel that drives stock prices, are expected to crash by 30 percent or more in 2020, with a gradual recovery beginning in 2021. Yet the stock market powers higher. What gives?

Cue the Federal Reserve and the US government. Through an alphabet soup of monetary policies designed to reduce borrowing rates and shore up weakening corporate balance sheets, the Fed has delivered an unequalled flow of liquidity to the US economy, nearly four times dispensed during the Great Financial Crisis of 2007-09. That, coupled with approximately $2.7 trillion in fiscal stimulus from the Congress to support ailing small businesses and those workers displaced by the coronavirus, is being viewed by investors as necessary and sufficient support until the US economic heart is once again beating on its own. On a smaller scale, central banks around the world are following a similar path.

But is it really that easy? Once the economy recovers, what are the longer-term implications of a federal deficit swelling to nearly 18% of GDP, and total federal debt exceeding the size of the entire US economy? Here are a few possible outcomes:

  • Higher interest rates if the appetite for US government debt wanes due to changing geopolitical forces;
  • Higher inflation if the government pursues a strategy to erode the real value of the debt;
  • Loss of investor confidence in the government’s ability or willingness to honor its debt obligations;
  • Assuming the statutory debt limit remains in place, higher interest outlays for debt service that would reduce the share of discretionary government spending available for other productivity-enhancing investments;
  • A sharp decline in the value of the dollar relative to our trading partners;
  • Higher taxes as a way to increase revenues and reduce the size of the deficit;
  • Potential downgrade in the credit quality of US government debt, resulting in higher interest costs; and
  • Less government flexibility to respond to future crises.


Although these potential outcomes are universally negative, recent experience argues that none are especially likely. Despite dire warnings from deficit hawks about soaring inflation after the stimulus measures were enacted in 2009, US inflation remained muted, the dollar rose, and interest rates continued their long steady decline that began in 1982. Overseas, the Bank of Japan’s multi-year effort to acquire more than half of the entire Japanese government bond market and push interest rates below zero have so far failed to raise inflation and growth rates to government targets.

Setting aside the high degree of uncertainty surrounding when the coronavirus may finally be subdued, a few questions hold the key as to whether April’s head-spinning rally in US equities is justified: 1) will the economy return to a level of normalcy by late 2020 or early 2021 as is expected by some forecasters; 2) does the political will exist to increase the size of the stimulus if it is determined that more is needed to avert economic catastrophe; and 3) once the economy  recovers, will the explosion in debt jeopardize the status of the United States as the poster child of global capitalism. The next few months should provide the answers to these critical questions.

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Learn more about Bruce Simon, our Director of Research.

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