Time is of the essence

| July 17, 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. This material does not constitute research.

At the moment, the economic picture varies drastically depending on the timeframe. The rear-view mirror reflects strong data in May and June, as the early stages of the economic rebound were robust. The current situation is less upbeat, as a resurgent virus has stalled the return to normal activity. The outlook depends very much on the how far forward you look. Market participants and policymakers have wildly varying views, in part due to focusing on different time horizons and varying scenarios for how Covid-19 plays out.

Out of phase

 In the early stages of the Covid-19 crisis, the major economic data were clearly out of phase.  When the economy first locked down in March and early April, data still reflected an open economy.  Then in May, as the economy was ramping back up, the major releases from April showed massive declines in activity and employment.

That dissonance has recurred in July.  Major economic releases for May and June, especially consumer spending and employment, surged.  The first phases of the reopening went surprisingly well.  In fact, retail sales in June recovered essentially all the way back to pre-Covid February levels.  Some other indicators showed a similar vigorous bounce, most notably housing sector indicators like new home sales.

However, the economic strength in the recent past is not especially relevant because we know that the economy has lost momentum in late June and early July as a resurgence of the virus in the South and Southwest has led to some reversals in business openings and in economic activity, especially for bars and restaurants.  There is a widespread expectation that indicators like employment and consumer spending that were so strong in May and June may cool or even decline outright this month and possibly in August.

Economic outlook(s)

Economists and market participants continue to debate the economic outlook.  There are massive ranges for growth expectations over the next few months and the next few years.  The relevant questions for the economic outlook depend very much on the time horizon.

Near-term.  The most immediate question is how long the current surge in the virus will last and how much damage it will wreak on the economy.  This is the most important question for the July and August performance of the economy as well as third quarter GDP.

The other critical economic uncertainty in the short run is what happens with fiscal policy.  With the PPP and extra unemployment benefits deadline approaching, what Congress chooses to do with the next round of support will have important implications over the next several months for employment and consumer spending.

Medium-term.  Looking ahead to late 2020 and early 2021, the most important questions are:

  • Will there be a second wave of the virus in the fall? and
  • Will there be an effective vaccine within the next six months to nine months?

On the second wave, the evolution of Covid has confounded experts consistently from the beginning, so predictions about the course of the virus are problematic.  However, the second wave hypothesis presumed that hot weather during the summer would tamp the virus down in the summer, as is usually the case with the common cold and flu strains, and then there would be a rebound in cases in the fall.  Of course, sadly, the first part of that logic did not hold, as the virus has actually gathered speed in the hottest parts of the country in June and July.  A Covid resurgence in the fall looks less of an issue because the virus never lost much ground in the summer.  Rather, the most likely risk is somewhat different: that the beginning of flu season will add to the burden on the health care system.  If Covid is stretching hospital systems to the brink in major cities in October and November, the return of the seasonal flu could push some areas past the breaking point.  In addition, cases of the flu and Covid will not be easily and neatly divided, which could put additional stress on the testing infrastructure as well as forcing more people to quarantine at the first sign of cough and fever.

At times, it seems that the stock market is focused more than anything else on whether we will get a Covid vaccine. This is undoubtedly a massive source of uncertainty for the outlook.  Let’s assume that at least one drugmaker successfully runs the testing gauntlet and offers a vaccine for mass distribution in the U.S. by early 2021.  Does that knock the virus out?  Not necessarily.  It remains to be seen how many will take the shot(s), as many worry that the process has been rushed and that the vaccine will not be safe.  And we have no idea how long the protection from a vaccine would last.  Nonetheless, a reasonably effective vaccine would presumably go a long way toward allowing areas of economic activity that are currently limited to get back to normal.

Longer-term.  The longer-term outlook is, as always, the least foreseeable, but in some ways it is also the simplest.  Looking out, say, two or three years, the question is, will the economy be more or less back to a pre-Covid normal or will we be wearing masks and social distancing forever?  I have a fairly high degree of confidence that Covid will eventually fade as an economic drag.  Even massive epidemics in the past, like the 1918 Spanish Flu, eventually waned.  One way or the other, I expect that Covid will also diminish.

While a vaccine is likely to be a key force for defeating Covid, society would likely eventually develop a form of herd immunity.  Dr. Scott Gottlieb has argued that the worst of the virus will be over by around January, one way or the other, either because we have a vaccine or because six more months of community spread has resulted in the beginnings of herd immunity.  There remain many questions around the duration of antibodies, but the stimulation of T-cells in most victims, which creates a memory of how to fight the virus, should mean that anyone contracting Covid for a second or third time in the future should be able to fend it off more effectively.  While achieving herd immunity is not the ideal way to defeat Covid, since it means that a large percentage of the population would have to contract the virus, it is in essence a failsafe for an end date to the economic drag.

Markets and economic policy

There is an interesting dissonance regarding the longer-term time horizon.  Stock investors appear to be handicapping the timeframe of a vaccine and may be mostly thinking that the world will return to something resembling a pre-Covid norm once a vaccine is broadly disseminated.

In contrast, Fed policymakers are talking and behaving as if the world will be stuck with Covid for years and years and have, in effect, dragged the Treasury market along for the ride.  The June SEP projections show that the FOMC thinks that it will need to keep rates near zero through at least the end of 2022, and that the level of economic activity will not return to its pre-Covid level until at least late 2022.  While this gloomy perspective is certainly possible, it would seem to require that we do not get an effective vaccine in late 2020 or early 2021.  If that does happen, it is hard to see how restaurants, hair salons, and air travel will remain at a fraction of their normal activity 18 months later.

I would argue that one reason for the Fed’s gloom, in addition to a very pessimistic outlook for our ability to control the virus, is that most Fed officials have always hewed to economic models where the demand side of the economy dominates.  Thus, policymakers see a spike in unemployment as a demand shock, regardless of its cause.  Households lose income, their demand falls off, and there are disinflationary pressures. As an aside, it interesting how the Federal Reserve system declared that the Phillips curve was dead when unemployment was low but suddenly revived it as soon as the unemployment rate surged.

While it is easy to acknowledge that there will be demand-side and supply-side effects from the Covid-induced economic downturn, it is clear that the latter are more potent.  The consumer has shown ample appetite to spend, and federal government largesse has kept household coffers full, at least so far.  So, spending has bounced back rapidly for activities not directly impacted by social distancing concerns.  As a result, this downturn does not look anything like a garden-variety recession.  The unemployment rate is still high because many businesses are unable to operate normally, not because consumers are unwilling or unable to spend.  There are not imbalances that need to be slowly unwound (aside perhaps from the federal debt burden).  If or when a vaccine or herd immunity knocks out Covid, there does not need to be a long-lasting demand-side drag, as animal spirits could snap back rapidly.  What has happened and is happening this year seems more of an economic interruption than a recession.  There are not many examples of this type of cycle.  Perhaps the closest one in modern times was the brief 1980 recession that occurred when the Carter Administration imposed credit controls.  The downturn ended quickly when that ill-considered policy was reversed later in the year.

Imagine this: Rip van Winkle fell asleep in 2019.  He wakes up in 2023 to a world where Covid has been largely defeated or, at a minimum, kept in check with annual vaccines.  Will Rip see an economy that looks mostly like the one that existed when he fell asleep or one that is still struggling to climb out of the 2020 recession?  I would argue strenuously the former.  Then why would the Fed still need to be at zero rates, perhaps governed by a forward guidance commitment or even a yield curve control lockdown of part of the yield curve, and maybe even still in the midst of QE?

In any case, the dichotomy between a relatively upbeat outlook embodied in the stock market and a near-permanent malaise expected by the Fed and priced into the Treasury market will eventually have to be resolved one way or the other.  If not, then both markets are priced for “perfection” mainly due to the overwhelming liquidity on offer from the Fed, which would probably present its own set of problems at some point down the line.

john.killian@santander.us 1 (646) 776-7714

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