Alphabet checklist

| September 18, 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.

It has been roughly six months since the Covid lockdowns began. The economy contracted by an unprecedented amount but has been moving back toward normal since the beginning of May. It still has far to go, but some sectors have fared better than others. In the early days of the pandemic, there was a fascination with describing the prospective economic recovery with letters. A surprisingly large proportion of the economy has enjoyed a “V-shaped” recovery, even as some areas more impacted by the virus continue to languish.

Letters and shapes

It seems reasonable to limit the letter choices for different sectors to three. A ‘V’ can denote a sharp drop followed by an equally vigorous bounce, a ‘U’ can describe a sharp drop followed by some time at the bottom and a gradual pickup, and an ‘L’ can trace a sharp drop followed by little or no rebound at all. There is a virtually infinite list of descriptors used analysts, but ‘V’, ‘U’ and ‘L’ should cover the territory.

Roll call

A few components of GDP fall into each category.

V-shaped sectors:

  • Consumption of goods. Consumer spending on goods sank by 15% in March and April, but rebounded sharply in May, June, and July. By July, just three months after the lockdowns eased, spending was more than 6% higher than the February level.
  • Business investment in equipment. Core capital goods orders and shipments dropped by about 8% in March and April but recovered that ground in May, June, and July. As of July, these gauges were within ½% of the February level.
  • Housing. The housing sector has probably been the strongest in the entire economy since the lockdowns ended. After a brief dip, activity surged. Housing starts in July and August were well above the 2019 average, while new and existing home sales in July were at the fastest pace since 2006.

Each of these performances represents a major surprise relative to expectations back in the spring. Consumer spending has benefited greatly from the massive fiscal support, which has left households with more income than they would have had in the absence of the pandemic. The Fed was convinced that business investment would languish for a sustained period of time, and in fact Chairman Powell and other officials have argued recently that business investment in broad terms is dragging along the bottom, a view directly contradicted by the data cited above. Finally, housing demand has been explosive, as households look to move to larger homes with more space and social distance.

U-shaped sectors:

  • Consumer spending on most services. For some services, the pandemic has been largely irrelevant. Spending on financial services, for example, have been steady throughout the year. However, the lockdown restrictions, some of which remain in place, sharply curtailed consumer outlays for a variety of services, such as restaurants and personal care services. Services expenditures dropped by about 20% in March and April. Since then, we have seen significant progress, but the July level remained almost 11% below the February level. Put differently, services spending through July had recovered roughly 55% of the lockdown drop. The August retail sales data showed that restaurant spending continued to recover (up almost 5%) last month, so we continue to make steady progress, but it will be difficult to get back to the pre-pandemic norm until the virus is under much firmer control.
  • Foreign trade. Both exports and imports of goods plunged for three months through May. Both sides of the ledger rebounded in June and July. Exports in July were still down by more than 15% on a year-over-year basis, while imports were down by less than 10%. Anecdotal reports and data indicate that trade activity, particularly imports, surged in August and is continuing to increase sharply this month. Interestingly, I thought a sharp drop-off in trade activity would have narrowed the trade gap (because imports are so much larger than exports), but in fact, the trade deficit increased sharply in July and probably has widened further through the rest of Q3, as imports revive somewhat faster than exports.
  • Inventories. The liquidation in inventories in Q2 was massive, subtracting over 3 full percentage points from GDP. While we do not yet have much hard data to confirm a bounceback, there are ample anecdotal indications that factories are at least trying to replenish depleted store shelves and warehouses. The auto industry offers the clearest example. Vehicle sales held up much better than expected during and after the lockdowns, while closure of assembly plants for two months led to historically lean stocks. Production has rebounded strongly, and inventories should at least stabilize in Q3 and will likely increase back to normal going forward to the extent that firms figure out how to produce fast enough to outpace consumer and business demand.

L-shaped sectors:

  • Specific consumer services. There are at least a handful of services that have yet to bounce back meaningfully due to the virus and attendant lockdowns. Consumer outlays for air travel were barely more than half of the February level in July. TSA data on travelers going through security checkpoints suggest that air traffic is barely one-third of year-ago levels. Other similarly depressed areas include admissions to spectator sports, concerts, and movie theaters, hotels, and hair salons. Expenditures in these categories should rise going forward, but they will not get close to normal until the virus situation has improved dramatically, perhaps until a vaccine has been widely disseminated.
  • Business investment in structures. Nonresidential construction has been hampered to some degree by lockdown restrictions, but the main issue is that the demand for office space, hotels, retail, and a variety of other facilities is highly uncertain until the medium- to long-term economic outlook is clearer. Even so, the main source of drag in this sector has been the dive in oil and gas drilling, reflecting soft global demand and the attendant fall in prices. The domestic energy sector is unlikely to bounce back in a meaningful way until the global economy revives further.

Grading the overall economy

Netting this all out, where is the overall economy? Real GDP contracted by close to 10%, not annualized, in the first half of the year. The Q3 rebound is likely to be much stronger than imagined a few months ago. The consensus has been revised up to around a 25% annualized gain, which would retrace just over half of the decline. The consensus projection for a 5% annualized rise in Q4 would take the cumulative retracement over 60%. I would certainly label that a U-shaped recovery.

My outlook is more positive than that. I expect Q3 real GDP growth to snap back at around a 37% annualized pace, which would retrace close to three-quarters of the lockdown-induced drop, and a 7% annualized rise in Q4 would erase over half of the remaining shortfall. I foresee real GDP regaining its Q4 2019 level by Q1 of 2021, or Q2 at the latest. However, even that outlook, much more optimistic than either the private consensus or the Fed’s projections, would still be closer to a U-shaped recovery than a ‘V’ in my view, since it would have taken close to a year to make up for the drop that took place over just two months. Perhaps my outlook would more accurately be labeled a Nike swoosh or checkmark.

Nevertheless, the performance of the economy over the first three or four months since the lockdowns has been remarkably strong. The goods sector of the economy has broadly enjoyed a V-shaped recovery, surpassing all expectations. Services spending is taking longer to bounce back, reflecting the restrictions imposed due to the virus. How the portions of the economy that are still depressed respond from here will depend in large part, as the FOMC has said, on how the virus evolves and how the timing and magnitude of improvement in labor markets compares to the withdrawal of fiscal support.

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