It should come as no surprise that the U.S. economy, largely locked down by the global coronavirus pandemic, turned in its worst performance in more than a decade in the first quarter of 2020. Worse, that dismal showing likely offers just an inkling of the damage yet to come as this plagued year continues.
Gross domestic product (GDP)—the value of all goods and services produced in the U.S.—contracted in the first quarter. Meanwhile, GDP growth forecasts for the second quarter are ugly, and even if a restart goes smoothly, the actual numbers are still going to be dismal. Too much damage has been done and it seems inevitable the second quarter will confirm that the U.S. is already in a severe recession.
Worrying Numbers
The nation’s GDP contracted at a seasonally adjusted annual rate of 4.8% in the January-through-March period, as both consumer and business spending fell sharply. Estimates had been for a decline of 3.8%. The actual 4.8% slump marked the first drop in output since early 2014 and the steepest decline since late 2008 during the depths of the Great Recession.
As noted, the grim first-quarter report reflected the early fallout from the pandemic, with worse damage expected in the second quarter. Since there needs to be at least two quarters of negative GDP for there to be an official recession, most likely the country is already there.
Consumer spending tumbled 7.6%—the biggest drop in 40 years—after rising 1.8% in the fourth quarter. The sudden shutdown of most consumer-service businesses, combined with millions of layoffs, has abruptly shriveled purchases. Consumer confidence, which can foreshadow spending, fell sharply in April to the lowest level since 2014.
Business investment fell 8.6% after a 2.4% decline in the fourth quarter, marking the first time since 2009 such outlays have fallen for four straight quarters. Companies had already restrained spending amid the Trump administration’s trade war with China last year. Any increased optimism following January’s Phase 1 trade deal between the U.S. and China has been dimmed by the pandemic. If consumers are not spending, there is no reason for businesses to buy new equipment to ramp up production. Purchases of factory equipment and computers plummeted 15.2% while spending on structures dropped 9.7%. This, in part, was also driven by the crash in oil prices, which prompted producers to shut down drilling rigs.
Congress passed about $3 trillion in programs to minimize the damage. Among other measures, lawmakers boosted unemployment benefits and eligibility and offered forgivable “paycheck protection” loans for businesses with fewer than 500 employees, aimed to cover eight weeks of payroll and other expenses with the loans forgiven if they retain workers during the pandemic lockdown. The Federal Reserve also rolled out a batch of programs to support lending to businesses and households.
Federal Reserve Chairman Jerome Powell said on May 13 that 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.” He also said that the economy should recover once the virus is under control. But he cautioned that without more help, many small businesses may not survive that long. And he warned that a wave of business and household bankruptcies could do lasting damage to the nation’s economic output. Powell indicated that, while the Fed will continue to bring all its power to bear on stabilizing the economy and financial markets, the biggest future response may have to come from Congress.
Equity markets have rallied since they reached a bottom in late March, driven by liquidity from global stimulus; however, earnings expectations for companies are dropping rapidly. There has been $10 trillion and counting in stimulus globally—both fiscal and monetary—in about eight weeks. That is a lot of money flooding the market and has fueled the rally. Earnings expectations are dropping like a stone. Most economists expect -4% in global GDP for 2020.
The coronavirus has stifled global economic activity in a remarkably short period of time. In contrast to downturns of the recent past, where misallocated capital or asset bubbles were to blame, the current crisis is unique in that it pits man against pathogen in a global pandemic where the best defense for now—social distancing—is the very thing inhibiting a larger scale economic recovery. Adding to this uncertainty is the fact that there is no credible timeline for when the virus will be contained or eradicated. In a 60 Minutes interview aired on May 17, Powell said that while he expects steady economic growth in the second half of the year barring no second wave of the virus, getting back to full-strength will likely require an effective vaccine.
Will Banks Survive the Virus?
Banks appear to have passed the first test: a short but pronounced period of market mayhem, combined with a simultaneous corporate drawdown of hundreds of billions in credit. Whether banks can maintain this new-found trust depends in large part on their ability to withstand coronavirus and its aftershocks. That in turn rests on whether post-financial crisis reforms—some of which the banks are lobbying furiously to relax—have left the system strong enough to survive.
The banking system has changed dramatically since 2006. There are fewer banks holding more assets, and the makeup of those assets is quite different. Banks are less reliant on loans, and the industry, in search of yield, has shifted its focus away from home mortgages to riskier commercial loans. The good news is that the banks have the Great Recession to learn from as an example, as well more capital to stomach loan losses.
After the Great Recession, lawmakers enacted the Dodd-Frank Act, sweeping financial legislation intended to ensure that a Great Recession never happens again. A big part of the act was the requirement that every bank in the country hold more capital to act as a cushion should the economy take a nosedive and many loans default simultaneously. As banks built up these buffers, regulators insisted that each bank be subject to an annual stress test to see if they could survive a worst-case economic scenario. The banks have indeed raised their capital levels. The combined tier 1 capital ratio, a measure of a bank’s core equity capital to its total risk-weighted assets, is more than 2.5 percentage points higher now than in 2006. The total risk-based capital ratio, which measures a bank’s core equity capital (tier 1) and less secure supplementary capital (tier 2) together as a percentage of risk-weighted assets, was 1.59 percentage points higher.
The real test of the resilience of banks and the financial system is yet to come. Large parts of the global economy, from airlines to retailers to shale companies, have seen revenues evaporate. At the height of the virus, we expect over 25 million people to be out of work.
When U.S. banks announced their first-quarter earnings in mid-April, they made it clear that they were increasing reserves to deal with anticipated loan problems among their clients.
Previously, banks had to ensure reserves were enough to cover “incurred losses,” which meant they made provisions for loan losses only when customers actually missed payments. Under the new accounting standard, which began this year, banks must make provisions based on a loan’s lifetime value. Basically, this amounts to predicting the future, which bank executives describe as the most uncertain they have ever seen. But this change makes banks prepare for the losses before it’s too late.
Banks’ profitability could be threatened in the near term as they are forced to tighten lending standards. Most banks reported that they began implementing stricter lending standards for borrowers in late March “as the economic outlook shifted” on news about the spread of the virus. A historic drop in bond yields recently could pressure banks further because it tends to hurt their profitability.
Light at the End of the Tunnel?
One of our sources, a highly regarded analyst and physician, feels that there has been significant progress made on understanding how the virus behaves, tools that can detect it, its mode of transmission, how it affects various organ systems, preventive and therapeutic strategies, and a potential cure.
Diagnostic testing development has been encouraging, he says, despite concerns about the effectiveness of some tests. The percentage of tests that are coming back positive has now dipped under 10% for the U.S. as a whole; once that number dips into low single digits, it may indicate that a sufficient part of the population is being tested. The doctor stresses that, given that asymptomatic carriers are those most likely to spread the virus, the only preventive strategy that has been proven successful so far has been social distancing, hygiene education (wash your hands!), wearing masks, and self-quarantining.
On the vaccine front, he sees several promising efforts and has some confidence that a successful drug could be developed by October or November of 2020 (though that optimistic result would still require a months-long rollout, meaning we could still be a year or more away from general inoculations).
Our view is that while the U.S. economy will slowly begin to reopen in May, it is likely going to take at least a year before we get back to normal (or whatever the “new normal” will be). If the process takes a year or more, the question becomes how companies will do when they are running below capacity at 20%, 30%, or 50% during that time.
The recovery will not be the same across every sector and for every business. For some, it will be slower than others, and it is possible that not everyone will return to the same levels of pre-pandemic economic activity, given the likely changes in consumption patterns and restructuring of production. The stimulus money will help, but we expect to see a long recovery period ahead for the economy, with volatility persisting, and perhaps even intensifying, until the full impact of the pandemic is clarified.
Key Indicators to Watch
- The effectiveness of fiscal and monetary policy in providing liquidity and stemming the economic downturn.
- The point at which new COVID-19 cases plateau and start to decline, signaling an inflection point for the global pandemic as well as global capital markets.
- Downward U.S. dollar index movements, as U.S. dollar demand tends to rise during periods of crisis and fall during periods of global economic recovery.
- Downward volatility movements, as downward migration would suggest a movement toward calmer markets and investor sentiment.
- A healthy commercial paper market supportive of broader capital market activity.
There should be data points over the next few months that provide hints as to how well the restart is going, including third-quarter forecasts. Markets are probably going to be choppy through this, but if there are incremental signs of a recovery in some of the data, then it’s likely there will be solid support for stocks and a continued rotation away from some of the “stay-at-home” names that did well early in the selloff towards those that could benefit in a back-to-work scenario. Of course, all bets are off if the restart coincides with a resurgence in new cases of the virus.
It is also important to recognize how much has been learned about this initial wave of the virus, which should help us deal with a second wave more effectively if it happens. But this is obviously a big risk and the reason why there is so much debate about re-opening the economy. Governments have a responsibility to keep people safe from the virus as best they can (and avoid overwhelming the medical facilities); but this is being weighed against the economic and psychological damage being inflicted on society by the lockdown. It is a very difficult situation that will create volatility as virus data is scrutinized for signs of a new outbreak. At the same time, positive news regarding potential therapies and/or promising vaccine candidates may cause upward spikes in equities on the expectation they could result in a quicker return to normal.
Although not the main scenario economists are forecasting, they do not discard an economic relapse in the coming months should there be another outbreak of the pandemic. This would result in a W-shaped recovery. In the most positive of scenarios, the recovery will be V-shaped with a rapid return to normality and the GDP seeing a vigorous recovery starting at the end of the second quarter. Ultimately it all depends on how the pandemic progresses and how long the world takes to return to a degree of normality.
Things to Come
Though the economic response has been extensive and timely, the path ahead is very uncertain, and, as we know, the market does not like uncertainty.
The overall policy response has provided a measure of relief and stability. But the pandemic raises longer-term concerns as well. How quickly and sustainably can the virus be brought under control? Can new outbreaks be avoided? How long will it take for confidence and normal spending, both from consumers as well as businesses to return? What will be the scope and timing of new therapies, testing, or a vaccine?
The answers to these questions will help us try to figure out where the economy is going for the rest of the year. Meanwhile, the market is trading as though everything is going to be OK. That may be true long term, but over the short term, we are not so certain it will continue while we lack definitive answers on treatment. We would still be invested but cautious going forward.