June 1, 2020
Forecasters are calling for a second-quarter GDP contraction of at least 30%, according to the Blue Chip survey, while the model from the Federal Reserve Bank of Atlanta (GDPNow) calls for an much steeper 52% retrenchment. Yet, the S&P 500 index is down less than 7% this year after rallying more than 35% from its low point of March 23. There seems to be a huge disparity between the economy and the stock market.
There is a way to reconcile both numbers, however, if the economy turns around quickly and ends up the year nearly unchanged. In that case, the stock market rally would be justified and could even have some more room to go. Admittedly, this seems hard to believe right now. But is it possible?
Current economic numbers look decidedly dismal. As I showed in my previous post, some have shattered records by huge margins. Second-quarter GDP forecasts are correspondingly bleak. The contraction estimated by the GDPNow model is much worse than the Blue Chip average, but with numbers that large, the margin of error is certainly huge.
The economic shutdown is unprecedented because it was engineered on purpose. This makes it virtually impossible to make any reliable forecasts, especially at a time when everything is changing at blazing speed. Still, a useful paper just released by the Federal Reserve Bank of San Francisco tries anyway, by looking at the economic response that government stimulus spending achieved in the past and estimating what it might accomplish this time. The effect of the current program, it concludes, “is likely to be large.”
How large? They focus on a “fiscal multiplier” which is simply the factor by which GDP grows per dollar of government spending. “A multiplier of 1 would suggest that the COVID-19 stimulus to date—about 11% of GDP expected to be spent mostly over the next year—could increase GDP 11% or more over the next two to three years” compared to a scenario with no stimulus, according to the paper. What’s more, “the fiscal multiplier on government spending when monetary policy is by the zero lower bound is around 1.5.”
If this turns out to be the case, the economy could grow very strongly in the second half of the year and beyond – anywhere between 10% and 15%. Adding to that the growth that will be naturally come from the reopening of businesses could result in one of the fastest economic growth periods in U.S. history.
Breaking down GDP changes on a monthly basis allows us to take a stab at the numbers and estimate a possible path. As the table at the end shows, there are ways for the economy to end up almost unchanged for the year if it reopens quickly and the economists at the San Francisco Fed are right about the fiscal multiplier. The stock market rally would then make sense and may even have more room to go.
What could get in the way?
The path of the economy will be closely linked to the spread of COVID-19. While the total number of cases in the U.S. is going down, this is mostly due to the sharp decrease in New York cases. Stripping out New York, the number of new daily cases has barely budged in the last two months, and might in fact be going up in some states. Deaths, however, are coming down everywhere, suggesting that treatments are yielding better results. Both the degree of infection and the mortality rate may improve even further in the months to come as better treatments or a vaccine could become available.
The worst-case scenario is a second wave of contagion caused by abandoning safety protocols too soon. Unfortunately, authorities are delivering conflicting guidance about the use of masks, the kind of businesses that can reopen or the advisability of resuming activities in churches, restaurants or sports venues. Some medical experts have warned that caution is still needed to avoid a new wave of COVID-19 cases. On the positive side, a significant portion of the population seems determined to continue self-isolating, wearing masks and avoiding groups. Hopefully, this may help contain or prevent a second wave.
Three important components of GDP that will strongly influence third- and fourth-quarter numbers are consumer spending, business investment and government spending. The latter is likely to be large. Consumer spending is harder to predict, and it will depend partially on how people feel about spending on things that were not available during the shutdown, such as restaurants or travel. This will in turn depend on whether public attitudes about social interactions have changed, or simply on whether people miss restaurants and bars too much, or instead discovered the pleasures of cooking and drinking at home. Families and friends may be anxious to reunite, or may have found that video-conferencing is a good alternative.
While spending is likely to improve as businesses reopen, the chance that everyone who was laid off is re-employed before the end of the year is slim and this could keep consumption low, although recent numbers show that the labor market has started to improve. Business investment, on the other hand, may take a while to recover: uncertainty will be slow to dissipate, and earnings may be soft for a while.
It is impossible to have a good grasp of where the economy is heading given the broad range of possible outcomes, the lack of precedent and the speed at which the environment changes, day by day. The riots that have spread like wildfire across major U.S. cities is proof that unpredictable events can materialize quickly and change the outlook in unexpected ways.
But the stock market has made a simple bet: the economy is likely to recover quickly and GDP has a shot at ending the year nearly unchanged. Looking at the numbers, this may not be a crazy bet.