The backdrop to this is that the impact of COVID-19 was on full display in economic data released in May. Consumer sentiment has hovered near the lowest level in nearly a decade reflecting the wave of challenges unleashed by the pandemic. Almost overnight, the economy swung from an expansion into a deep contraction with real GDP in the first quarter declining at an annualized rate of 5.0%. Personal incomes in March and April suffered the steepest drop since 2013, and consumer spending fell at the fastest rate since 1959.
Nearly 2.1 million Americans filed initial unemployment claims the week ending May 23, bringing the cumulative total from the past nine weeks to more than 40 million. The continuing claims data indicated more than 21 million were out of work the week ending May 16. Retail sales plummeted by more than 16%, a decline never seen before in the history of the series. Closures of nonessential businesses all around the country coupled with price declines and mounting job losses would explain the sharp drop in sales in the month.
Concerning prices, the consumer price index (CPI) in April fell by 0.8% month-on-month, the largest monthly decline since December 2008. Business sentiment also worsened as the NFIB small business optimism index fell by 5.5 points to 90.9 in April.
While aggregate demand has fallen more abruptly, the supply side has also contracted. Industrial production fell 11.2% in April, and manufacturing output dropped 13.7%. Output in the mining sector, which includes oil & gas, declined 6.1% in April. Orders for durable goods fell by more than 17.0% during the same month.
Housing has been the only example where activity has remained fairly strong even without comparison to its March and April low points. Whether other sectors can follow housing’s trajectory will come down to the public health situation.
China, the country furthest ahead in the battle against COVID-19, saw industrial production and investment bounce back into positive territory for the first time this year in April. If this is any indication for the future path of the U.S. economy, recovery is coming. For now, it is wait and see.
Labor Market: The U.S. labor market has taken a body blow from the COVID-19 pandemic with millions of individuals being displaced and unemployment spiking to its highest rate since the Great Depression. But many states have slowly started to relax shelter-in-place restrictions and federal authorities have offered financial support (e.g., PPP lending and the Federal Reserve’s Main Street Lending Program) that should help keep many businesses viable. Therefore, payrolls should start to recover in the coming months as temporarily shuttered businesses re-open. Of course, any rebound in employment could be reversed if the pandemic flares again, and states return to lockdown mode.
But employment will not return to its February 2020 high anytime soon. Payrolls in some sectors have been slow to recover due to continued social distancing practices (e.g., leisure & hospitality) and/or acceleration of secular change that was already underway (e.g., online retail). Moreover, some businesses have already closed permanently and will not be recalling displaced employees. Under the assumption that states would not need to lock down again, the month of May should set the highwater mark for the unemployment rate near 20%. But the unemployment rate is expected to recover only to 8% or so by the end of this year, and it will likely still exceed 6% at the end of 2021. In other words, it likely will take several years for the labor market to fully recover from its pandemic-induced meltdown.
Inflation: The fallout from the coronavirus has had a sizable disinflationary effect on prices due to the large demand shock, plunge in oil prices, and strong dollar. U.S. consumer prices in April posted their largest monthly decline since the last recession after energy prices collapsed and efforts to contain the coronavirus disrupted demand for an array of goods and services. The consumer price index fell by 0.8% in April, the second month in a row that prices had eased since the pandemic reached the U.S. and the biggest drop since 2008. Business closures and stay-at-home orders aimed at containing the virus have created cheap oil, and falling prices for airfares, clothing, car insurance, and other goods and services.
Overall prices were up 0.3% from a year earlier, the smallest 12-month increase since October 2015. Core prices were 1.4% higher from a year ago, the smallest gain since April 2012. One area where the pandemic has pushed prices higher is food. The price index for food posted its largest monthly increase since February 1974. Americans stocked up from the pandemic’s outset.
A near-term worst-case scenario would be an extended period of deflation. That seems unlikely with the Federal Reserve and U.S. Treasury pumping trillions of dollars into the economy and a consensus-building around a sharp but relatively short downturn.
Another longer-term concern has been that large amounts of government borrowing and rising costs of doing business could push inflation uncomfortably high. But with the loss of tens of millions of jobs and unemployment hitting a post-World War II high in May, the focus has been more immediately on building a fiscal and monetary bridge until the coronavirus is contained.
Manufacturing: U.S. manufacturing contracted at the sharpest rate since the last recession as companies pulled back following lockdowns to halt the spread of the coronavirus. With orders collapsing at a rate not seen for over a decade, supply chains have disrupted to a record degree, and pessimism about the outlook hitting a new survey high has led to a rising number of firms culling payroll numbers.
Federal Policy Responses: To date, Congress has provided roughly $2.9 trillion in fiscal support for households, businesses, health-care providers, and state and local governments—about 14.0% of GDP. The fiscal response has been the fastest and largest response for any postwar economic downturn.
The Federal Reserve has also acted with unprecedented speed and force. After rapidly cutting the federal funds rate to close to zero, the Fed took a wide array of additional measures to facilitate the flow of credit in the economy.
While the economic response has been both timely and appropriately large, it may not be the final chapter, given that the path ahead is both highly uncertain and subject to significant downside risks.
Negative Interest Rates: Negative interest rates in the U.S. seem likely as a very last resort—and a remote one, still. Negative interest rates would have harmful effects on financial markets and the banking industry as it would create downward pressure on bank profitability which, in turn, would limit credit expansion offered by banks. Introducing negative rates in the U.S., where short-term funding markets have relied more heavily than in other countries on money-market mutual funds, would create significant complexity or distortions to the financial system.
The Fed would be more likely to stimulate growth with tools used after the 2008 financial crisis, including purchases of long-term securities and explicit guidance about how long they plan to buy assets and keep rates low.
The Shape of the Recovery: The large drop in economic activity followed by a painfully slow recovery is expected. The U.S. economy is not likely to get back to 2019 levels of output until late 2021 - or beyond. This is not likely to be a quick recovery.
This would reflect the depth of the contraction now being recorded for the spring, as well as more evidence that soaring joblessness and months or years of social distancing will depress economic activity well into next year.
Shoppers are anticipated to switch to cheaper items and forgo consumption splurges, likely remaining tightfisted long after lockdowns end. Some corporations have already announced fresh layoffs for the fall, prolonging the joblessness surge that has already left tens of millions of Americans unemployed.
Among the reasons for the darker outlook has been that lockdowns are easing more slowly than originally expected in some states, and some large-scale social gathering activities will not be possible again for months. Retailers and restaurants that have reopened are allowing fewer customers at a time due to social distancing. And consumers worried about infection risks may take a long time to return to their old habits.
The possibility of the virus resurging in the fall or next winter could lead to potential setbacks, which could make the recovery look even more jagged rather than smooth. There is also a risk that the increase in unemployment could have follow-on effects in the form of lower consumer spending. That could cause an acceleration in job losses again later this year or turn temporary furloughs into permanent layoffs.
Eurozone: The euro area is facing an economic contraction of a magnitude and speed that are unprecedented in peacetime. The eurozone’s gross domestic product fell 3.8% versus the final three months of 2019 as measures imposed to limit the pandemic’s spread stalled economic activity. The economy shrank by 14.4% on an annual basis, far exceeding the 5.0% contraction in the U.S. economy over the same period. That has largely reflected Europe’s earlier and broader lockdown.
An even sharper fall in the eurozone during the second quarter will occur. With restrictions in some countries only starting to ease in May, a larger chunk of second-quarter output will be lost than in the first quarter.
The European Central Bank signaled its willingness to expand its efforts to buffer the impact of the economic crisis, including a €750 billion program to buy the bonds of governments that are themselves spending huge sums to support their economies. The European Commission proposed a $2 trillion coronavirus response plan, including a massive pooling of national financial resources that, if approved, would deepen the bloc’s economic union in a way that even the eurozone debt crisis failed to achieve.
Some rebound in activity in the eurozone is expected in the second half of the year, but the lost output is not expected to recover quickly. The eurozone could shrink by at least 8% this year.
The eurozone’s northern members appear to have suffered more modest declines than their southern counterparts. This widening divide has posed a challenge to the long-term viability of the euro as a currency since it feeds political tensions over how and whether to share the burden of the coronavirus pandemic.
Outlook: Economic activity around the world is unlikely to rebound as quickly as it declined, in part because social distancing, restricted activities, and other virus responses are likely to continue in some form for many months, whether by individual choice or government edict.
Though still early, Q2 real GDP looks likely to contract at a 30%-40% annualized pace in the Eurozone, the United Kingdom, Canada, and elsewhere. Worse yet, some major emerging market economies like Russia and Brazil appear to be in the early stages of their COVID-19 outbreaks. Global growth in 2020 is expected to decline by about 4.0%.
Under the assumption that states slowly start to re-open and that the virus does not return in a meaningful way in the coming months, U.S. real GDP growth should turn positive again beginning in Q4-2020. Real personal consumption expenditures should grow strongly in the next few quarters due, at least in part, to pent-up demand for services. That said, many service providers likely will be operating at reduced capacity for some time. Furthermore, some businesses have closed permanently. Although the unemployment rate should begin receding this summer, it is likely to be above 6% at the end of 2021.
In case the Congress fails to pass legislation that would provide additional support to state and local government, the associated cutback at the state and local level should exert some additional headwinds on overall growth in 2021. But real GDP growth could be a bit stronger next year if lawmakers indeed grant additional financial support to states and municipalities reeling from the costs of the pandemic.
Sources: Department of Labor, Department of Commerce, National Federation of Independent Business, Eurostat, Morningstar, Bloomberg, Institute for Supply Management
This Newsletter was produced for Middleburg Financial by Capital Market Consultants, Inc.
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