U.S. firms have seen demand return as they reopen from the lockdowns imposed in the spring and early summer. The U.S. economy has so far managed to weather July’s sharp rise in new coronavirus infections and business closures that threatened to knock the recovery off course.
However, the unusual economic environment—a sharp and deep contraction in the spring caused by a global pandemic—has made it harder to interpret recent data. U.S. output fell at an annualized rate of about 32% in the second quarter, the worst contraction on record. Other indicators have suggested the U.S. economy remains vulnerable. New applications for jobless benefits rose in late August. Payroll gains slowed in July from June. More pain could be on the way as several companies have announced large job cuts. Risks persist around the world in the second half of 2020 depending upon what happens with the progression of the virus and possible additional restrictions.
Deconstructing GDP and matching that with the latest economic data would suggest real GDP will bounce back in the third quarter. The most stunning rebound has been consumer spending on goods, which has recovered its entire recession drop and is now about 5% ahead of its February pre-pandemic level. This summer’s resurgence in virus cases led to a lull in most measures of consumer activity during July. While this quarter should certainly be stronger than the last, the fourth quarter remains a bit of a mystery. Growth for Q4 GDP will be dependent on continued declines in new COVID-19 cases and a rebound in consumer engagement in August and September.
With the economy hitting speed bumps, the onus will be on policymakers to provide additional support to households and businesses that are struggling due to the pandemic. Congress has been deadlocked on the next set of fiscal measures. It is clear, however, that more aid will be needed to avoid deepening the economic crisis.
GDP: The second estimate of the second quarter real GDP showed a -31.7% annualized growth, slightly better than its advance estimate of 32.9%. While there were signs of slowing in activity through the summer months as the virus spread, the switching on of the economy in May and June will still show up in double-digit annualized growth in the third quarter.
It will likely be well into 2021, and quite possibly later before the level of economic activity recaptures its pre-crisis level. Much will depend on the speed of development and effectiveness of a vaccine as well as the continuation of fiscal supports to bridge incomes until activity can return to normal.
Consumer Spending: Personal spending rose for the third straight month in July, increasing by 1.9%. Personal income rose by 0.4% month-over-month in July. Income supplement programs provided in the CARES Act continued to support personal income. The personal saving rate remained elevated at 17.8%, slightly lower than where it was in June.
Spending has continued its upward trend and is now only 5% below where it was in February. The consumption recovery thus far would not have been possible without solid income gains. Specifically, the income supports provided in the CARES Act have enabled Americans to spend over these past three months, despite the struggling labor market.
However, with income now set to fall in August due to the expiration of the $600/week unemployment check, consumers will think more carefully about spending decisions in the coming months. Congress will need to provide more income support to avoid a setback in the economic recovery. However, with Democrats and Republicans still deadlocked, a stimulus bill does not appear imminent.
CPI Inflation: Consumer prices jumped 0.6% in July. The rise has reflected an unwinding of pandemic-induced price cuts this spring rather than the start of a sustained pickup in inflation.
Weak demand is likely to keep a lid on inflation in the coming months, as many households are unable or unwilling to spend amid the tenuous jobs situation, questions over the amount and duration of unemployment benefits, and continued risk of the virus.
Small Business: The NFIB's small business optimism index fell by 1.8 points to 98.8 in July. Five of the ten subcomponents fell on the month, four improved, and one remained unchanged. Leading the declines were expectations about an improvement in the economy and higher real sales. Labor market indicators meanwhile were mostly positive. The share of firms planning to increase employment continued to improve for the third consecutive month.
The pullback, led by tempered expectations regarding future economic conditions, has been consistent with a host of other indicators that point to slowing economic momentum as the surge in new COVID-19 cases in the June-July period caused many states to hit the pause button to their reopening plans.
With the spread of the virus still elevated, near-term risks have appeared tilted to the downside. The recent stimulus via executive action, while a net positive for economic activity, bypassed new direct aid to small businesses. With small businesses still on shaky footing, more support will be needed.
Labor Market: U.S. unemployment claims fell below a million in late August for the first time since the coronavirus pandemic struck in March, as the deeply wounded labor market continued to regain some footing. The number of people collecting unemployment benefits through regular state programs also decreased to about 15.5 million at the beginning of August. The decline in jobless claims indicates layoffs are easing and hiring is picking up. However, a new wave of layoffs is washing over the U.S. as several big companies have reassessed staffing plans and settled in for a long period of uncertainty with lower payrolls.
Housing Market: The housing market has been one of the brightest spots in the U.S. economy, now. Demand has remained resilient despite the devastating impact of the coronavirus. Behind this strength are millennials who, after many years of sitting on the sidelines, are leaping into homeownership due to rising affordability. However, this momentum appears likely to slow, in part as the initial thrust from falling mortgage rates dissipates, but also as the resurgence of COVID-19 weighs on the labor market recovery. While ongoing improvement appears likely, much like the overall economy, it will likely be well into 2021 before activity regains its pre-crisis level.
Beyond the near-term, challenges will remain for the housing market. The most notable risk surrounds the job market and the current rise in infection rates. Absent a continued rebound in jobs, which has remained 10% below pre-crisis levels, and income, which has to-date been highly dependent on increased government transfers, there could be a renewed setback in home sales and prices later this year.
US Dollar: The dollar has made a sharp U-turn this summer following a long rally, potentially adding fuel to this year’s surprising stock-market rebound. The fall extended a reversal that began in late March, spurred lately by ballooning worries that mounting coronavirus cases will stall the U.S. economic rebound, even as growth accelerates in countries from China to Germany.
It is not too difficult to explain recent dollar weakness. First, not only has the Fed provided massive liquidity to financial markets, but other central banks and foreign governments have now caught up with such stimulative policies, most notably the European recovery fund plan. Further, the turning of the tables between the U.S. and Eurozone in terms of increasing virus case counts also has likely played a role.
Fed’s Policy Shift: The Federal Reserve has decided to effectively set aside its three-decades-long practice of pre-emptively lifting interest rates to head off higher inflation. The practical impact has been that it may be a very long time before the Fed considers raising interest rates. The change has reflected lessons the Fed learned in recent years about how inflation did not rise as anticipated when unemployment fell to historically low levels. In other words, a robust job market can be sustained without causing an outbreak of inflation.
The Fed had been moving in this direction over the last two years, so, what is the rationale for this policy change?
The persistent undershoot of inflation from Fed’s 2% longer-run objective has been a cause for concern. While it might be counter-intuitive for the Fed to desire more inflation, particularly given rising costs for certain items like housing, the Fed has needed to avoid an adverse cycle of ever-lower inflation and inflation expectations.
The dynamic has been particularly troubling because expected inflation feeds directly into the general level of interest rates. Lower inflation deprives central banks with already-low interest rates of tools to counteract downturns. This adverse dynamic has played out in other major economies around the world and once it sets in, it can be very difficult to overcome. Fed wants to prevent such a dynamic from happening here.
Eurozone: In Europe, IHS Markit’s composite PMI for the eurozone fell to 51.6 in August from 54.9 in July, indicating its expansion slowed. This came as infections have again surged in Europe, hitting the services sector particularly hard.
In the second quarter, the eurozone’s GDP fell 40.3% on an annual basis contracting more sharply than the U.S., reflecting that the European lockdowns were more restrictive and longer-lasting. Eurozone policymakers had hoped that by getting a firmer grip on the virus, the currency area’s economy would see a stronger rebound during the remainder of the year and into 2021.
Those affected have been much younger on average than during the first wave of the pandemic, and hospitalizations have been much lower. That makes it less likely that governments will revert to widespread lockdowns, which would likely send the eurozone economy back into contraction.
In contrast with the services sector, some of Europe’s factories reported strong growth in August.
Europe still faces major challenges. It could take years before its economy returns to its 2019 size. Moreover, the region is highly dependent on exports and tourism, neither of which will recover fully until the virus is under control around the world. In Southern Europe, governments need to service massive debts that have been inflated by the mammoth costs of containing the pandemic. Borrowing costs have so far been kept in check by aggressive government-bond purchases by the ECB, but the support is temporary.
China: Chinese economic activity jumped sharply in Q2, and the latest economic figures would suggest a further, more moderate, gain could be in store for Q3. Manufacturing has continued to lead the way higher, with July industrial output growth steady at 4.8% year-over-year. In contrast, retail activity has continued to lag, although July retail sales did show a smaller 1.1% year-over-year decline. Meanwhile, the broader measure of service sector output has been somewhat firmer, rising 3.5% year-over-year in July. So far this year China’s GDP slumped 10% quarter-over-quarter in Q1, before surging back 11.5% in Q2. So long as China can register solid gains in activity in both Q3 and Q4, full-year 2020 GDP is on track for growth of 1.6%.
Outlook: Recent high-frequency data indicates at least a loss of momentum at the national level in August and in many regions a retrenchment. The national data will likely fall back in the coming weeks given the virus has yet to be contained in many areas of the country. How long a greater degree of caution will continue depends on the spread of the virus, but it presents a downside risk to a third-quarter growth forecast. The outcome is not set in stone, however.
The fourth quarter and beyond remain highly uncertain. Not only does it remain unclear if additional fiscal stimulus will come to pass, but the virus trajectory in the fall and winter months is unknown. Even if households do not receive an additional stimulus, they may be well-positioned to spend if the virus remains under control given the elevated savings built in recent months. Unfortunately, the broader recovery continues to remain highly dependent on the trajectory of the virus.
Looking ahead the housing market outlook depends on the labor market recovery. Prospective buyers will need the income to take the plunge into homeownership, but a wobbling labor market could delay their plans. Worryingly, the labor market recovery appears to be losing steam. Employment gains slowed in August compared to the previous three months.
The expectation that consumer spending might take a hit due to a reduction in household stimulus could weigh on the broader economic recovery. Since inflation is not a huge worry at present, the Fed can focus on employment and try to prevent spillovers from the labor market. But fiscal support is crucial for households and likely more effective at this stage rather than further monetary policy easing. Congress needs to act on another round of relief, particularly for state governments to forestall another round of layoffs at the state and local level which would weigh on growth over the medium term.
This Newsletter was produced for Middleburg Financial by Capital Market Consultants, Inc.
Sources: Department of Labor, Department of Commerce, Eurostat, Morningstar, Bloomberg.com, National Federation of Independent Business, IHS Markit, National Bureau of Statistics of China
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