United States / Analyst Insights
US Macro Update: Fork in the Road to Economic Recovery

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by Mario Ismailanji, Senior Technical Analyst
Sep 01 2020

The release of Q2 economic figures confirmed what was already clear, the economy contracted at its sharpest quarterly rate on record with a decline of 31.7%. This is in contrast to the decline of 5.0% seen in the first quarter. The effects of the COVID-19 outbreak have been all-encompassing, with nearly every measures of activity showing significant declines. Conditions were particularly poor in April before rebounding in the ensuing months alongside regional reopenings. While improvement continued into the third quarter, the recovery has stagnated as coronavirus hot spots have inhibited the full reopening of the national economy and fiscal support has waned.

Partial labor recovery

While the labor market suffered its sharpest employment decline in April, the next few months set the stage for a surprising, though incomplete, rebound. Aside from one week in the middle of the third quarter, weekly jobless claims have been over a million since late in Q1, significantly higher than at any point since weekly job claims were first recorded in the mid-1960s. Nonetheless, the number of individuals receiving unemployment benefits has continued its slow trend downward as of the week ending August 15, though it remains significantly high at 14.5 million.

Just as these job losses disproportionately hurt sectors that rely on interactions between people and other nonessential activity, job gains have disproportionately occurred in those sectors. For instance, retail trade and other personal and miscellaneous services have regained 61.7% and 54.2% of jobs lost from February through April, respectively, by July. Conversely, despite regaining nearly 4.0 million jobs during that same period, the most job gains of any sector and 47.8% of its lost jobs, the leisure and hospitality super-sector continues to face restrictions, particularly in the indoor dining and entertainment spaces. They will likely continue to face extreme difficulties until the successful deployment of a vaccine, therefore full job recoveries in this super-sector are expected to lag other areas of the economy.

Since the spike in April stemming from the initial enhancement of unemployment benefits and stimulus checks, real average hourly earnings have declined significantly; real average hourly earnings in July were 3.2% lower than in April. This was to be expected, as the jobs restored have been disproportionately low-skill and low-wage, leading to hourly earnings reverting lower as the composition of employed workers continues to normalize.

Consumption roller coaster

Like many indicators, real personal consumption expenditure growth has varied wildly in Q2. After a decline of 12.4% in April, consumer spending grew 8.4%, 5.2% and 1.6%, respectively, in May, June and July. In contrast to other recessions, services spending has weighed overall consumption down, with particularly sharp declines occurring in recreation, transportation, food services and accommodations, and healthcare.

The disproportionately sharp decline in these categories coincides with activities that remain restricted. Therefore, spending on services such as recreation and food services are expected to lag other services, particularly as colder months arrive and outdoor dining and activities become less viable.

Consumption trends have largely tracked changes in the personal savings rate; consumer spending declined to its lowest level in April, while personal savings rate rose to a historic high of 33.7%. Since then, the savings rate has declined significantly to 17.8% in July, yet this remains higher than any level measured since at least 1959. Declines in the savings rate have begun to plateau, which has mirrored the deceleration of consumption growth. With household saving expected to remain high for years to come and a labor market that will likely take until the mid-2020's to reach near-full employment, a return to pre-pandemic levels of consumer spending is expected to remain years away.

Inflationary bounce back

The rebound in consumption has boosted price levels from its early-Q2 lows to reach new heights by July. Much of this was enabled by the unprecedented level of stimulus from both monetary and fiscal policy, as measures such as enhanced unemployment benefits functionally increased income levels of low-wage workers who were unemployed. These individuals disproportionately tend to spend their money as opposed to saving it, fueling the quick bounce back.

Moving forward, the direction of price levels is uncertain due to the expiration of enhanced unemployment benefits and the ripple effect that can have. If they are successfully renewed in some manner, inflation would likely continue, albeit at a slower pace than seen in June and July. Failure to renew unemployment benefit enhancements and provide state and local governments with funding to cover revenue shortfalls would likely lead to added weakness in the economy. In such a scenario, disinflation or brief deflation would be more likely outcomes than moderate to strong inflation.

This all is occurring against the backdrop of a stated shift in how the Federal Reserve will manage inflation in the economy. Instead of targeting annual inflation of 2.0%, the Fed will employ average inflation targeting; to offset periods of lower than 2.0% inflation, the Fed will attempt to allow inflation to run slightly above 2.0% to make up for misses on the downside. How exactly this will manifest itself remains to be seen, though it appears to reinforce the idea of a near-zero federal funds rate target until 2023 at the earliest and potential for higher inflation once a vaccine is deployed.

Constructing the recovery

As anticipated, there were similar pullbacks in construction spending in Q2, particularly during the first half of the quarter amid stringent shelter-in-place orders. Residential construction fared worse than nonresidential construction, as unprecedented job losses lowered potential homeowners’ willingness and ability to pay for mortgages. The demand crunch weighed on homebuilders, as private home building permits declined below 1.1 million, the lowest since the first quarter of 2015. However, the end of Q2 and thus far in Q3 has been a recovery story for the residential market, as regional reopenings and government transfer payments supported consumers. Moreover, low existing housing stock and historically low mortgage rates are serving as two significant tailwinds for the residential market.

Similar to residential construction, weakness in the economy weighed on nonresidential construction. However, while the outlook for residential construction is bright, the past few months have not done much to alleviate uncertainty on the nonresidential side. In fact, changes in behavior in response to the pandemic pose difficult questions related to the working environment for services-industries. With many of these industries having work-from-home capabilities, demand for structures such as office buildings is likely to be structurally lower than in previous years. Furthermore, recovery in nonresidential construction tends to lag broader economic recovery. With an incomplete economic recovery likely until a vaccine is successfully deployed, an event unlikely to occur until mid-2021, nonresidential growth is expected to lag behind residential growth considerably.

Understated double-dip risk

Months into the restart of the American economy, certain things have become clear. Despite an initially strong pace of recovery, the economy is a long way from pre-pandemic levels. Additionally, the contraction would have been much worse if not for the federal government passing massive and swift fiscal stimulus in April. Enhanced unemployment benefits and stimulus checks supported the incomes of tens of millions who were either laid off or saw their hours cut. However, the recovery has lost some steam in the third quarter. The lapsing of unemployment benefit enhancements looms large, as the federal government was unable to come to bipartisan agreement on further stimulus.

Barring an overwhelming surge in cases, the greatest risk to the economy is likely no longer the coronavirus itself, but the growing possibility that there is no stimulus coming. The country has adapted reasonably well to the realities of living through a pandemic, and while certain activities are unlikely to fully resume until a sufficient portion of the population is inoculated from the virus, the novelty of the population’s changed behavior has morphed into a certainly bizarre sense of normalcy. Yet, much of this was made possible by the government’s intervention to keep the economy in stasis and plug in the gaps caused by the shutdowns in Q2.

Without any addition stimulus, disposable income will decline significantly as those unemployed lose more than half of their weekly earnings. Since those currently unemployed are disproportionately lower-wage workers, the effect of such an income decline would likely result in lower consumption shortly thereafter, though elevated personal savings would somewhat mitigate the decline. A decline in consumer spending would likely strain businesses fairly quickly in such an environment, as lower demand would almost certainly lead to increased unemployment as businesses lay off workers. Increases in business and consumer bankruptcies would likely follow shortly thereafter. While financial institutions have already taken large loan loss provisions thus far in 2020, they may have to revise their assumptions to account for further losses. Despite the fact that lending standards for businesses and consumers have already tightened significantly, access to credit would likely decline further in such a scenario. With less money moving around in the economy, the economy would be at a heightened risk of sliding back into contraction.

This does not even consider the impact of no additional stimulus for local and state government budgets. Without federal funding to address the shortfalls, states have already begun cutting funding to education, healthcare and other social services, as their rainy-day funds pale in comparison to the size of the revenue shortfall. A significant portion of these cuts will be accomplished by laying off workers, which would only further weigh on both the short- and long-term recovery. With the election roughly two months away, there is little time remaining for the federal government to agree on a deal for further stimulus, as most politicians will likely be spending their energy on campaigning for much of October. Overall, the risk of a double-dip recession in Q4 is understated, as a potential lack of sufficient federal support and winter surge of the virus may stand in the way of continued economic recovery.