The Audacity of Slope: The Economy in 2020 and Beyond
Despite a strong start to 2020, including a record low unemployment rate and surprisingly strong job growth in both January and February, the longest expansion in US history came to a screeching halt the week of March 9th when over three million persons filed first-time claims for unemployment in the face of the first state lockdowns in response to Covid-19. As each week brought progressively more states into economic suspension, close to 40 million first-time claims have now been filed and the unemployment rate is expected to soon exceed 20%, a level only surpassed during the Great Depression.
Were it not for the ongoing, massively expansionary and profoundly expeditious monetary and fiscal policies pursued on a bipartisan basis in Washington, DC, designed solely to prop up the US economy during its forced health shutdown, a recession the magnitude of the Great Depression would not be out of the question. As it is, the current recession is likely to be very deep but hopefully short lived. To that end, the key question on the minds of everyone is how quickly a return to some semblance of normal is possible without an attendant rise in Covid-19 cases.
With a vaccine unlikely until 2021, continued shortages of testing supplies, limited contact tracing capabilities, and limited therapies to help the ill, reopening the economy will be a slow, staged process, with the potential for periodic setbacks quite high. 20Q1 GDP contracted at an annual rate of -4.8%. In 20Q2 the contraction will worsen to at least -30% and maybe even -35%, rates never seen in US economic history.
The Shape of the Recovery
In 20Q3, and possibly as early as late 20Q2, the recovery begins. That begs the question what shape will the coming recovery look like? Initially, there were hopes that the recovery would be quick and strong and thus the recession and subsequent recovery would be somewhat V-shaped. Regrettably, the magnitude of ongoing job losses, the unparalleled decline in consumer spending, sharp deterioration in factory utilization rates, deep damage to the energy industry, and steep drops in many other economic variables suggest that a meaningfully slower recover is most likely.
This presents the scenario that the recovery may well be U-shaped, where we spend the months of June and July bottoming out before returning to growth in August, but it takes till September or 20Q4 before growth meaningfully picks up. I strongly suspect that the recovery is check mark-shaped, where we bottom in June and then start to recover meaningfully in July. In either of these cases, it will take until mid- to late-2022 before GDP returns to where it was prior to the Coronavirus coming ashore. With some luck, 20Q3 growth is a strong 6% and 20Q4 comes in about the same, with growth slowing to about 2.3% in 2021.
Some expect a W-shaped recovery and base their prediction on SARS-CoV-2 returning in late fall or early winter and forcing another nationwide lockdown. While that may happen, hopefully we will be ready with a combination of ample personal protective equipment and proven protocols for testing and tracing such that stay-at-home restrictions can be largely avoided. That said, periodic outbreaks of the virus across the nation that require localized lockdowns are highly likely and must be factored into any recovery scenario. Lastly, some economists are predicting an L-shaped recovery, where we never make up any of the lost economic output but instead return to normal 2% growth in 20Q3 or 20Q4. This outcome is quite unlikely given the massive support our economy has received from the Congress, the Treasury, and the Federal Reserve.
With so many trillions of dollars coursing through the economy, there is concern that inflation will soon rise and become a problem, forcing the Fed to prematurely raise rates and thus quash the recovery. While this is clearly possible, it is highly unlikely. We entered the recession with inflation consistently running below the Fed’s 2% target despite 3.5% unemployment: the lowest in 50 years. Moreover, inflation rates in Europe, Japan and China could best be described profoundly quiescent. While the money supply is growing, absent a desire to borrow and invest by firms and subsequent lending by private banks, it is unlikely we will see inflation. Rather, the new money will likely wind up sitting at the central bank in the form of excess reserves and not in the hands of growing business. In fact, this is precisely what is happening, and we see evidence of it in the declining velocity of money. Until this process reverses, inflation is not a concern.
As for new residential construction activity, in December 2019 and the first two months of 2020, housing starts were running at an annualized rate of 1.6 million, by far the best rate since summer of 2006. As a result, housing was expected to strongly boost GDP in 2020. Regrettably, that was not to be, and in March 2020 starts fell 25%, reducing activity in all 20Q1 to a rate of 1.47 million. In 20Q2 starts will fall further to a rate of about 1.2 million and to 960,000 in Q2Q3 as builders ratchet down activity. The pullback is the result of productivity declines from having to reengineer job sites to ensure social distancing, the inability of buyers to physically walk through homes, the impact of higher borrowing costs for builders, as interest rate spreads widen on risky loans, and so on. That said, by 20Q4, starts should rise to 1.1 million as the chronic shortage of housing that we have been experiencing for a prolonged period of time, along with favorable demographics as Millennials hit peak home buying age, low interest rates, falling unemployment and generally reduced fears of Covid-19 combine to help homebuilders begin to return starts to their appropriate level.
In the commercial construction sector, while it started out the year relatively well, that was derailed and now it too is falling due to the uncertainty stemming from the virus, although there are wide variations in expected activity across categories. New lodging construction has come to a virtual halt due to the sharp decline in travel and leisure and hospitality activity due to Covid-19. While retail had been struggling for some time, the novel coronavirus has hastened its decline as it simultaneously helps Amazon gain market share.
As for office construction, with so many employees suddenly and successfully working from home, employers will, at a minimum, rethink their office space needs. It is hard to imagine a return to the way things were. Similarly, it is highly unlikely there will be big demand for new manufacturing facilities in the near future; manufacturers must first wrestle with resurrecting supply chains, reduced global trade, and excess manufacturing capacity, not to mention the redesign of the factory floor to encompass social distancing before seriously thinking about building new facilities.
Lastly, new school construction, be it K-12 or higher education, seems unlikely due to declining state revenues, falling enrollment and increases in distance learning. As for growth areas, warehouses, cold-storage facilities, and datacenters continue to be in great demand due to the inexorable rise in online shopping, the need for faster internet speeds and the rise of 5G.
In summary, the present recession is likely to be deep but brief, with the economy bottoming in late 20Q2 and beginning to meaningfully improve in early 20Q3, if the Coronavirus does not forcefully reappear. Inflation is not a concern and residential construction should bottom no later than 20Q3. Much can still go wrong, but a checkmark shaped recovery starting no later than July is what I expect.