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How low can you go?

admin | March 20, 2020

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

The economic shutdown triggered by the coronavirus is unprecedented in modern history. The economic data over the next few months should be well outside the ranges seen in generations. Coming up with forecasts in this fluid environment is a struggle. Under one plausible scenario, US economic growth in the first quarter could sink to zero and in the second quarter to -11% with a 15% rebound in the third quarter. Unemployment in the next few months could spike to 5.5% before sliding lower.

A scenario for the evolution and response to coronavirus

As an economist, I have no special insight into how the spread of the coronavirus will evolve. Nonetheless, it is impossible to say much about the economy without making some assumptions about how widely the virus will spread and what steps government and the private sector will take to slow it down.

It seems reasonable to assume that economic activity fell sharply around the middle of March, remains severely depressed throughout April, and then begins to gradually ramp back up beginning sometime in May.

For now, it also seems reasonable to assume that most of the lost activity comes back, but that there is some degree of damage done that is not quickly recovered. My primary concern at this point is that businesses, especially small businesses, will be forced to shut down permanently and will be unable to participate in the bounceback. Layoffs can be reversed if the employer remains solvent. Business closures are not easily reversed. The makeup, size, and timing of fiscal support, especially for small businesses and industries most affected by the virus, will play a major role in determining how we get through this.

Admittedly, my scenario may prove overly optimistic. The longer the economic shutdown, the more persistent damage will ensue. Governments need to adopt fiscal policy in a timely and mostly effective manner, which may not come to fruition. Most importantly, if states and major cities are still in lockdown three months from now, then the economic scenario will be far different.

Real GDP growth

Economic activity is going to sink sharply in March and again in April. Of course, this straddles the first two quarters of the year, but the second quarter will bear the brunt of the weakness. Economic activity was close to normal right up until the middle of March, so the first quarter will show serious impact for roughly one-sixth of the period. This should be enough to drive Q1 real GDP growth down to something close to zero. The second quarter plunge may be steeper than 10% annualized, perhaps near 11%. The bounceback in Q3 would be similarly violent, possibly close to 15%.

The critical variable for GDP in this scenario will be consumer spending, which constitutes about two-thirds of overall output. One might imagine consumption falling by half, but several major components of spending should be relatively unaffected. Housing and utilities and health care services are two of the largest categories of consumption, and neither is likely to be affected much. Financial services is another large category unlikely to be affected much. Just running through the major categories and making rough assumptions about how severely they could drop, consumer spending could plunge by as much as 10%. If this were to take place all in one quarter, it would work out to around 40% annualized. But consumer spending should drop by less than 10% in Q2, presuming we see a substantial recovery beginning well before the end of the quarter. In any case, real consumer outlays look likely to fall slightly in Q1, down about 14% annualized in Q2, rebounding by around 18% in Q3, and back to relatively normal growth by Q4.

For investment spending, I may be overly optimistic, but I envision a lot of crosscurrents. There may be pockets of aggressive outlays to partially offset the pause that many industries will take in purchases of plant and equipment. Business fixed investment looks likely to sink by about 10% in Q2 and regain that lost ground in Q3.

I will continue to adjust and refine the outlook as the situation evolves, but risks to the forecast look skewed to the downside for the degree of economic contraction in Q2. Nonetheless, at the moment, I remain optimistic that whatever we lose in the near term will come back over the balance of the year. That sunny scenario could sour going forward.

Labor Market

I did a similar exercise for payroll employment, going category by category and making guesses about the possible magnitude of job losses. My initial guess is that in a worst case scenario, we could lose as many as 11 million jobs at the peak, with the retail and leisure categories hardest hit, and private and public sector education jobs also sinking by a few million. For the moment, I am assuming that firms will, in part with the help of fiscal support, not shed nearly that many workers.

For now, I have penciled in a loss of around 200,000 jobs for March, noting that the March survey reference period ended March 14, just as firms were beginning to contract. Then, the April payroll tally could be down 3 million, and May might be flat. Then jobs rebound in June, July, and August, recovering the bulk of the losses recorded in the spring.

That scenario would likely produce a spike in the unemployment rate in April to around 5½%. The jobless rate could then slide back down beginning in June, moving back below 4% by July or August.

As an aside, the next few initial jobless claims figures should be calamitous. The reading for the week ended March 21 is likely to be in the millions. Ohio alone reported 140,000 new claims from Sunday through Thursday.

Conclusion

Brace yourself. The economic data is going to be worse over the next few months than anything we have ever seen, even during the 2008 financial crisis. Hopefully, the economy will bounce back relatively quickly, but until it does, the contraction should be steep and severe.

admin
jkillian@apsec.com
john.killian@santander.us 1 (646) 776-7714

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