The fact that the economic data is starting to turn down surprises no one. As Bank Credit Analyst notes:
“One thing is certain. Economic activity around the world faces its biggest contraction in modern times. Declines in second quarter GDP will be mind-numbingly bad in a wide range of countries, especially those that have instituted lockdowns and the closure of non-essential businesses. According to the OECD, the median economy faces an initial output decline of around 25% as a result of shutdowns and restrictions.”
Estimates for the drop in US real GDP in the second quarter range as high as 40% at an annual rate, as you can see below. To put this into perspective, the peak-to-trough decline in US real GDP in the 2007-09 recession was a mere 4% over six quarters.
But all these projections must be taken with a grain of salt. All the models in the world don’t know how to process what we are going through.
What is clear is the job market is bad. A couple reports this week highlight this fact:
– Initial jobless claims rose by 3,341k to 6,648k, the highest on record.
– Nonfarm employment declined by 701,000 jobs in March and the unemployment rate jumped from 3.5% to 4.4%. These two numbers are going to get much worse because both are based on the week running from March 8th to March 14th. Widespread shut-downs didn’t start until the second half of the month.
For what it is worth, the tea leaves are pointing towards a national unemployment rate that will at least hit the high seen during the financial crisis. As The Economist notes:
“GDP growth and the unemployment rate tend to move in opposite directions. Unemployment hit an all-time high of around 25% during the Great Depression (see chart). The coronavirus-induced shutdowns are expected to lead to a year-on-year GDP decline of about 10% in the second quarter of this year. Such a steep fall in economic output implies an unemployment rate of about 9% in that quarter, based on past relationships, which would be roughly in line with the peak reached during the financial crisis of 2007-09.”
A higher number is probable. After all, the economic hit we are going through is particularly concentrated in labor-intensive industries such as leisure and hospitality – sectors that employ more than 30m Americans. Were they all to disappear, unemployment would probably rise above 20%. Most people we follow think we see 15%.
Of course, this is why expanded unemployment benefits were recently rolled out. The CARES Act will allow impacted employees to receive an additional $600 per week in unemployment benefits in addition to their state unemployment benefits. This additional benefit will last for approximately four months and will expire on July 31, 2020. For example:
– A worker in California who recently lost their job due to COVID-19 is eligible for a maximum of $450 in California state unemployment.
– This individual will also receive an additional $600 in federal unemployment for a total weekly amount of $1,050 (for 13 weeks or through July 31,whichever comes first).
– The CARES Act expanded the categories of eligible individuals to include self-employed, freelancers, independent contractors and part-time workers.
QE to infinity
While this all plays out the Fed continues to buy assets furiously. As of Thursday, their balance sheet was up to$5.81tn as they buy Treasuries, mortgages, and some corporate bonds.
From what we can tell they haven’t started lending directly to corporations yet, but there is roughly $4tn committed to corporate loans over the coming months. It’s not a stretch to think the balance sheet hits $10tn at some point late in the second quarter or early in the third quarter.
And so far, the prospect of a $2-3tn budget deficit this year has done nothing to phase the government bond market (in part, of course, because the Fed is buying so much). Looking at the chart below you might even think the yield on the 10-year could hit 0% sooner than later.
What’s Priced In?
The question for investors is what has the market discounted? We are almost certainly pricing in a bad recession. The fact that analysts are talking about -25% GDP growth and 15% unemployment means those numbers are probably in the price today. Also, investors are generally very bearish, as you can see below.
The ratio of stock-to-bond returns is also at historically low levels.
But there are two challenges:
– While you never know, the consensus is probably that infection rates in the U.S. peak sometime in the next three-to-four weeks as we follow Italy’s path. To the extent they don’t then that will be a problem.
– Furthermore, bear market lows are a process, not a single point in time. It wouldn’t be unusual for the bear market to end with a retest, or even a breach, of the March 23rd lows at some point in the coming weeks. That was the case in 1974, for example….
In terms of strategy it implies:
– You don’t need to chase rallies,
– There is no rush to rebalance portfolios (a typical 60/40 allocation might be closer to a 50/50 allocation today).
– But critically, the markets turn way before the data turns. In 2009 for example, bankruptcies and bank failures continued to growth throughout 2009. However, the markets bottomed in March and ignored the bad fundamental news going forward.
Some Charts We Are Watching
– The growth in testing is stagnating. Blue bars are number of tests per day in the U.S. Red line is percent positive.
– Is it too much to hope that Italy may see some modest improvements next week?
– The Milken Institute is monitoring 89 treatments and 50 vaccines in development to prevent and treat COVID-19.
– China is returning to work slowly.
– And manufacturing is actually starting to grow again. Is the U.S. three months or six months behind China?
– If we are following the Italian experience, within the next 10 days or so we should see signs of stabilization in the daily increase in new US cases. If not, we are on our own uncharted path.
On this last chart Bank Credit Analyst notes:
“…Investors should continue to monitor this chart over the coming days and weeks, as it is likely to strongly influence consensus expectations of the duration of time that aggressive containment measures will be warranted in the world’s largest economy, which has now become the clear epicenter of the COVID-19 pandemic.”
Have a good weekend.
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