5-Minute Huddle: The Recovery Begins

May 11, 2020

By Justin Pawl, CFA, CAIA, CFP®

In this week’s edition:

  • Last Week Today.  Economic, market, and other events that moved markets.
  • The Recovery Begins.  Economic activity has bottomed.


Last Week Today.
  After eight weeks of astounding monetary response, the Federal Reserve’s balance sheet rocketed to $6.7 trillion. The tidal wave of liquidity totaled $2.4 trillion in additional capital, averaging $300 billion a week.  The Fed is doing all it can to “paper over” the pandemic pothole in the economy, but the Fed can’t solve this issue alone.  This leaves governors and mayors in the awkward position of weighing the value of individual lives vs. financial survival of the whole as they decide when and how to open up local economies.  |   The headline U.S. unemployment rate rose to 14.78% as 20.5 million jobs were lost in April.  Sadly, the shockingly bad numbers understate the actual level of unemployment: 1) the timing of the survey didn’t include 7.1 million people that filed for unemployment after April 18th, and 2) the Bureau of Labor Statistics admitted the rate would have been five percentage points higher had they not mistakenly counted furloughed workers as employed.

Despite negative economic data and falling earnings, global equities rallied for the second week in a row. Domestic stocks outperformed international, with the Nasdaq leading the way to punch into positive territory on the year after gaining +6% last week (+2% YTD).  The stock market’s rally seems incompatible with the horrendous economic data, but less so when one considers the amount of monetary and fiscal stimulus applied by central banks globally.  Moreover, investors are clearly pricing in a relatively quick earnings recovery and, thus, giving corporations a pass on 2020.  Bond investors are less sanguine about the outlook.  The yield curve is no longer inverted, but the 10-year bond is yielding just above 0.5% and loaning your money to the government for 30 years will earn you a scant 1.4% annually.  Of course, the government’s hand can be seen in the yield pricing as well, as the Fed’s bond purchases are intended to hold down rates to make borrowing more affordable and stimulate economic activity via credit growth.

For detailed weekly, month-to-date, and year-to-date asset class performance, please click here.

The Recovery Begins.  April marked the peak lockdown in the U.S. and globally, and history will likely show that technically the U.S. recession is over.  I use the term “technically” because recessions, by definition, end in the month when GDP is at its lowest point.  With states beginning to allow businesses to open, economic activity in May should be higher than it was in April. Even if the recession is technically over, it doesn’t and won’t feel like it for a while.  The economic destruction from the Great Lockdown is significant, and the effects from forced closures will reverberate in the economy for years, if not longer, as businesses and consumers confront the new normal required to live in a pandemic world.  A vaccine will go a long way to bringing us back to something that resembles the pre-Virus normal. Still, even if one arrives tomorrow, the inertia from the lockdown will be slow to reverse following a quarter in which GDP declined somewhere between -25% and -40%.

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Source: Federal Reserve Bank of Atlanta.

Consider a recent National Bureau of Economic Research (NBER) survey.  The survey found that 43% of small businesses were closed in April, and 25% had less than a single month of cash on hand. Nearly all of the owners of the closed-businesses were skeptical they would be able to re-open if the recession dragged on for six months, and one-third don’t expect to re-open at all.  According to the Small Business Administration, small businesses employ approximately 50% of the labor force and are responsible for nearly two-thirds of new job creation.  Evidencing the lack of economic activity at small businesses, credit card data shows that one-third of small businesses are still closed, and there are no transactions at 98% of travel agencies, 88% of photography studios, 75% of daycare centers, and 60% of advertising agencies.

For those businesses that do survive, many (if not most) will look very different in the post-Virus world. Bloomberg News reported that the New York Museum of Art is permanently cutting 17% of its workforce and 44% of its exhibit budget.  Like the iconic museum, business owners and management teams are making difficult budgeting decisions, and most will come back as smaller versions of their former selves.  This means that out of necessity, many of the “temporary” job losses from March and April are destined for permanency.  Meanwhile, 78% of people furloughed in March are under the impression their same jobs will be available when the lockdown ends. Thus there is a disconnect brewing between employers and employees.  As the chart below highlights, depending on the post-pandemic growth rate, an optimistic scenario would see the U.S. reach full employment in about four years.  A pessimistic scenario doesn’t project full employment in more than ten years (full employment is defined as an unemployment rate of 4.5%).

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The relatively slow recovery in employment is one reason we don’t hold high hopes for a V-shaped recovery; other reasons include changing consumer preferences and demand destruction.  Hence, a substantial bounce in Q3 GDP is likely following the deep economic contraction in Q2, but not one that gets the economy back to its pre-pandemic level.  Following the Q3 rebound, we expect the economy to settle into a sustained level of growth that resembles our Good, But Not Great theme of 2% – 3% per annum.  This scenario is illustrated in the chart below, and, no, Nike is not sponsoring the recovery, but the projected shape of the recovery sure looks like their famous logo.

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Of course, financial markets and the economy are two different animals. Financial markets are forward-looking and already pricing in a recovery.  Jeremy Siegel, market commentator and Professor of Finance at the Wharton School, stated the other day that 90% of the value of a stock is based on earnings beyond the next twelve months.  Hence the stock market rally, when viewed through this lens, makes sense despite the awful economic data that has been released and will continue to trickle in over the next few months. Yet, markets do not move in straight lines, and setbacks are inevitable.  Ultimately, we believe U.S. stock markets will move higher.  But the path to new highs will be filled with fits and starts, just as they have following every other financial or existential crisis in history.

The good news is that we’ve made it through the worst of the economic slowdown.  Now comes the recovery.  Opening the economy will be more challenging than closing it, just as cleaning-up a completed jigsaw puzzle and throwing it in the box, is easier than putting it together.  Moreover, the true toll of the pandemic in terms of the human tragedy and economic destruction won’t be evident for years.

Yet, there is reason to be optimistic.  Science is learning more about the virus every day and getting closer to developing an effective vaccine.  A vaccine would remove a lot of uncertainty and allow everyone to get back to normal sooner.  Yet, as the timing for a vaccine is uncertain, America cannot sit idly at home, waiting for it to arrive.  Instead, we need to use common sense and embrace social distancing, greater use of masks in our daily lives, and frequent handwashing to get back to work in the new normal and spur this fledgling recovery along.  We all have a role to play in this economic recovery, so whether you do yours out of patriotism or to help people get back on their feet economically, please embrace the new normal to keep you and your loved ones safe.

Be well,

Justin