August 25, 2020 – A lot of people – online and offline – have been asking about my opinion on the economy. When will the recession be over? Is the recession over already? How does the recession stack up with other events in the past? What are the risks going forward?
So many questions! Let’s take a look…
The recession is bad but not as bad as the headline numbers may suggest
I’ve made this point many times before, but just to get this on the record again: The 32.9% GDP plunge in the second quarter overstates the severity of the recession quite a bit. The quarter-over-quarter drop was about 9.5% but when you annualize this decline, effectively assuming that we’ll get three more quarters from hell like this, then you’ll reach the -32.9%. But quarter over quarter we saw “only” a 9.5% drop, which is actually surprisingly benign considering how bleak the economy looked in March and April. Add that to the Q1 GDP drop and you’ll get a 10.6% drop relative to the peak GDP figure in Q4 2019. By historical comparison, that’s a massive decline. Much worse than the Global Financial Crisis in 2007-2009, but not even close to the Great Depression or the recession around WWII.
In any case, the annualization is just the way GDP numbers are reported in the U.S. For example, in my “other home country” Germany the quarterly growth rates are reported as the simple Q/Q growth rate, not annualized. So, some people lamented that the U.S. with a 32.9% drop was hit much harder than Germany with a 10.5% quarterly decline. But when you annualize Germany’s decline it’s slightly worse than the one in the U.S.
Following the longest expansion on record, the 2020 recession was likely the shortest on record: only 2 months!
Even though the 2020 recession spanned two quarters, Q1 and Q2, if we look at the economy at a monthly frequency, the drop in economic activity was concentrated in March and April only. January and February still saw solid growth and thus were still considered part of the longest economic expansion on record. Likewise, May, June and July already saw very robust growth. Below are the time series for Payroll Employment, Industrial Production and Retail Sales. (Side note: quite intriguingly, GDP is never reported at a monthly frequency, though some private economic data providers have their proprietary monthly estimates. The NBER business cycle dating committee thus doesn’t use GDP but rather some alternative monthly data series, including payroll employment and industrial production)
So, it’s indeed possible that the recession really lasted for only 2 short months. By far the shortest ever on record! In comparison, the last five recessions were:
- 1980: 6 months long and the previously shortest recession in recorded history since the 1854.
- 1981-1982: 16 months,
- 1990-1991: 8 months,
- 2001: 8 months (and quite intriguingly, this recession spanned three quarters and we saw positive growth in the middle quarter, so the 2001 recession did not satisfy the naive recession definition of at least 2 consecutive quarters with negative GDP growth)
- and 18 months (2007-2009).
… but we don’t know for sure until more data come in!
So, why hasn’t the National Bureau of Economic Research (NBER) called the end end of the recession, effective 4/30/2020? Very simple: They are facing the exact same real-time data problem I outlined in a post a few months ago dealing with the timing of Bull vs. Bear markets. For a while after the trough you find yourself in a “limbo” state. If the economy continues to grow you’ll declare the end of the recession and, specifically, you’ll have to back-date(!) it at that past trough. But if the economy were to derail again after only a months of recovery, the NBER would likely call the entire event a recession, despite the temporary reprieve as in 2001, when GDP grew again half-way through the recession only to go down again the following quarter!
That’s analogous to the stock market world where you call the entire 2000-2002 market move a bear market instead of three bear markets straddling two bull markets in between, if you remember the chart from that May 11 post.
So, it all boils down to the two central questions…
Will the recovery continue? And will it continue long enough to qualify as a new economic expansion?
So far, things look pretty good for a continued recovery. And again, with recovery I’m talking in terms of growth rates, not levels of economic activity. For a while, the level of economic activity will likely remain below the peak levels in late 2019/early 2020. But as long as growth rates stay positive we should be in good shape. Likewise, we’ll have an elevated unemployment rate for a while. But as long the trend in the UER is downward, we’re in good shape. This is the part that a lot of non-economists (and maybe even economists) have a hard time to wrap their head around; it may still feel like a recession to a lot of people. But the level of the unemployment rate doesn’t matter, only the direction.
And there are some indicators that tell me the economy is on the right path:
1: The stock market has obviously recovered. The broad S&P 500 reached a new all-time-high and is now 50+% above the March 23 low. I could not find any past recession where the market recovered that strongly and the recession eventually continued. Normally, the recession ends within a few months after the stock market bottom. For example, in 2009, we saw the stock market trough in March and the economic trough in June. Actually, the 2020 recession was so short and abrupt, it looks like the stock market had its trough only about three weeks into the recession and a little over a month before the end of the recession.
2: I always like to look at high-yield bond spreads as a leading indicator. In the global financial crisis, the spread peaked in December 2008, even earlier than the stock market bottom. And spreads are also not just past their peak but even just about back to normal again, please see the chart below:
3: The TED spread (spread between the 3M LIBOR and the 3M T-Bill) is also not just below its peak, not just back to normal, but now even below the 2019 levels. See the St. Louis Fed FRED database for the time series chart.
4: Business climate indicators: I like to look at the Institute of Supply Management’s (ISM) Purchasing Managers Index (PMI) as a leading economic indicator. If you’ve read all of my blog posts (who hasn’t???) I’ve mentioned this indicator previously in other posts related to the connection between macroeconomics and finance. The ISM-PMI is normally a good indicator for timing the end of a recession. When it starts bouncing up from its recession low, you’re just at or just past the economic trough. When you’re back above 50 again as we have been since June, the economy is normally way past the economic trough.
And a whole slew of other indicators that all look pretty solid. Not all of them with their own chart for the sake of brevity:
- The ISM-PMI sub index “New Orders” (something of a leading indicator within the PMI leading indicator) is even stronger than the overall index.
- The PMI index for the services industry is above 50 again.
- Housing starts and housing permits (both very popular leading indicators) bounced back and are now above their year 2019 averages again (though still slightly below the early 2020 peak).
- Unemployment claims (again, one of my favorite indicators, as mentioned in several blog posts here) are still high, but declining at a rapid pace. And here again, it’s the direction, not so much the level, that correlates mostly with the direction of the economy.
- The Atlanta Fed real-time GDP tracking estimate: It stands at a whopping +25.6% for the third quarter as of August 18. And again, that’s an annualized number consistent with a Q/Q growth of about 6%, which means we’d recover more than half the drop during the recession in one single quarter. The fastest recovery out of a recession ever. Not bad!
Related to the last point, how is it possible for the economy to grow at such a fast pace again? I made that point in a post in April already and now’s a good time to rub in how accurate my guesstimate from back then has been. Mind you, this was my forecast from before the Q1 GDP number was released and I came to within a fraction of a percentage point of Q1 and about 2.6 percentage points of the the Q2 number. Not bad, ey?
In any case, if you assume that the drop in economic activity was concentrated in March and April and after that GDP slowly creeps back, you get a tremendous bump in Q3. Even though the growth rate in July through September is not even that large. You get this large base effect when comparing the average quarterly levels (not the quarter-end figures!) between Q3 and Q2. So, despite staying well below the 2019 GDP levels you get some really large GDP growth numbers in the second half.
Also, today’s post wouldn’t be complete without addressing the issue that started the whole economic mess. Which brings me to the next point…
The “you know what” situation is getting better as well!
I don’t even dare to use the exact phrase for fear of offending the search engine gods. So, instead of using the actual word for the “you know what” situation, I use a code word: “beer” – see what I did here?!
In any case, after the first wave of beer cases and beer deaths in the Spring, we saw a marked decline in May until early June only to see a resurgence again, of both cases and deaths starting in June. Will this derail the recovery? Well, so far it hasn’t. And it looks as though the second wave is now past its peak as well. Why wasn’t the second wave as damaging as the first? Well, most importantly, it was mostly the cases that went through the roof: about +100% relative to the first peak. But the “beer” situation only claimed about half the deaths during the second wave. Which means the fatalities divided by the cases was actually only a quarter of what it was during the first wave.
I’m not a medical expert, so I can’t say what’s the reason for the second wave to be less deadly…
- Maybe we’ve found treatments that finally work?
- Maybe the states that were hit the hardest in the second wave (FL, TX, GA, AZ) just had better procedures to protect the elderly?
- Related to the previous point, maybe younger folks are catching the beer virus now and their health is more resilient?
- Maybe all susceptible folks have already died in the first wave?
- Maybe we’re testing more and are more likely to find “light cases”?
It’s probably a combination of all. And related to the last point, see the chart below. It’s a scatter plot of tests (x-axis) vs. cases (y-axis), both in 7-day moving averages. There has been a surge in tests that coincided with the surge in positive tests. And the blue line looks like that despite the aggressive testing we’re now running out of folks testing positive. A very different picture compared to April when we probably had very limited testing capabilities and 22% positive results. I suspect that if we had tested 800,000 people every day back in April, we probably would have found close to 200,000 cases back then. So, don’t get too worked up about a resurgence in new cases now. There were a lot of unreported cases back in April!
So, in a nutshell, while I’m not happy with the resurgence in cases and deaths, and every death is a tragedy, I find the second wave of beer cases a lot less scary than the first one. And the stock market seems to feel the same!
Risk factors
As always, just to cover my behind so I can blame it on something or somebody if I’m wrong, here are some ways my rosy outlook could darken again:
End of the stimulus: Some people may claim that the end or at least the reduction of unemployment benefits will wreak havoc on the economy. Yeah, true, that’s a possibility. But it could also do the exact opposite. Previously, a lot of people were making more money staying at home and collecting UE benefits than working. Enticing workers to come back to work may actually help the economy. But I concede that economists are not in agreement on this one. The more “demand side” economists (old-fashioned Keynesians) will find the large transfer payments useful. The supply side economists (my personal camp) will prefer a slow phase-out of the payments that incentivize people not to work.
Inequality: This may not exactly derail the economy, but I like to point out the usual disclaimer when looking at aggregate economic and financial data; we tend to ignore that despite the aggregate recovery, a lot a people and businesses are still hurting. This is a very unequal recovery: corporations tend to do well, small/mom-and-pop businesses not so. The technology sector is doing well, brick and mortar companies not really. White collar employees do OK, blue collar workers not so. Multi-millionaire early retirees with a big stock portfolio are doing great, while single working parents are suffering. So, again, just a general disclaimer: I’m very much troubled about this recession being particularly damaging to lower-income Americans.
Politics: There is an election in November that will bring uncertainty. Obviously before the election and on election night. But even more damaging would be a contested election with lawsuits and uncertainty over who really won.
Inflation: Ever since the mid-1980s, the Fed has been blessed with mostly demand shocks: economic weakness coincides with low inflation. So, accommodative policy (low interest rates) always went together really well with low economic growth. Like milk and chocolate chip cookies.! In contrast, a stagflation scenario, high inflation and low growth, not seen since the 1970s and early 80s, would put the Fed in a real bad spot. Do you want to fight inflation and sink the economy? Or save the economy but let inflation get out of hands? So, an inflation shock could be a real spoiler here. And the inflation shock could come from many sources, including higher cost of running your business due to expensive health safety regulations, a new trade war with China, energy price spikes, etc.
More waves and more deadly “beer” strains, new waves during the 2021 flu season, etc.: Yeah, that’s a concern! I hope that doesn’t happen!
Other “black swan” (or not so “black swan”) events: Military conflicts and other unexpected stuff out of left field.
Conclusion
There you have it. I have a pretty optimistic outlook on the economy. But since I planned my safe withdrawal strategy well I can be assured that if the worst were to materialize again and we have another or a continued recession and bear market, I can handle that too. Hope for the best, prepare for the worst! Stay healthy and prosperous everybody!
Thanks for the information. I just am never trying to time the market so in a sense, it doesn’t matter to me?
On the other hand, it is very nice to have a general idea of where things are going for a bit in the near term. I guess that’s my human nature. I really do appreciate the analysis and I was scratching my head at the PMI earlier when I was looking (thanks for the tip on looking at that as a shortcut) but was like, data is data.
Well, as I wrote in the market timing/macro post:
https://earlyretirementnow.com/2018/02/21/market-timing-and-risk-management-part-1-macroeconomics/
… I view the macro picture not so much as a way to time the market, but more a tool to not lose your nerve. If the economy looks solid, there’s no point in taking off risk and reducing the equity portion of the portfolio.
Ah ha, I need to go back further into your trove of info! Fortunately I’ve not lost my nerve yet but then again, I have a lot more money than back in ’08 and human emotions can be tricky. 🙂
Yeah, I consider the 2001 and 2008 events good training for not losing my nerves! And 2020 turned out to be a lot less damaging! 🙂
“But the level of the unemployment rate doesn’t matter, only the direction.”
I understand that the direction of the UER indicates direction of the economy, but I would think that the level is very important in our consumer driven economy.
Hi Big Ern, thanks for sharing your thoughts on this, as always, very well laid out and easy to understand.
Same question here, would you mind explaining why “the level of the unemployment rate doesn’t matter, only the direction”?
I replied to the original question with a more mathematical explanation. An alternative way of thinking about this is to note that if you look at consumption and investment patterns of employed vs. unemployed folks, then obviously the employed consume and invest more. So, growth can come from 3 sources: growth in C+I of employed people, C+I of unemployed people and people moving from unemployed to employed. If 2 or 3 percent of the labor force move from unemployed to employed that tends to have a bigger impact than other 2 factors.
The level of the UER is important for the level of consumption. No doubt.
But for growth rates, only the direction of the UER matters. If you calculate the growth rate of consumption as C(t+1)/C(t)-1 and a high unemployment rate impedes BOTH C(t) and C(t+1) then the UER has no impact on the growth rate. In fact, if the UER is high in both t and t+1 but it’s LOWER in t+1, then you get a positive impact on the growth rate.
As always, you have delivered an excellent summary, backed with data. Thank you for sharing your intellectual economic insight.
Thanks! Glad you liked it! 🙂
Thank you as always for writing this.
One takeaway is I might have to get over being a permanent bear on housing. There was so little new inventory built for nearly a decade, maybe we don’t ever catch up? There should be some short-term bumps whenever the normal foreclosure process is allowed to start.
Also…I want more beer, but this article makes me want…less beer
Haha, yes, I only like the literal beer, not the figurative one! 🙂
Housing is peculiar right now. I thought that pre-beer there was a bit of bubble, so I can understand your slightly bearish view. But post-bubble, everyone wants to move to the suburbs. Very lean inventory here. Prices are holding up really well despite the recession.
Thank you. Your analysis is very helpful.
You bet! 🙂
One point about the death rates associated with covid cases. I think it’s important to remember that death by covid 19 is not particularly quick. The average time in a hospital for a person who does of covid complications is about 3 weeks. The average time it takes for a new case to develop complications requiring hospitalization in the first place is about a week. So you could be looking at a month or more between when a case is first determined via testing before it actually turns into a fatality. We’re less than a month out from the peak of the second wave, so it’s fundamentally premature to say that the second wave is less deadly than the first. We just don’t know how many of those early to mid August cases are going to end up hospitalized and then the predictable subset of those will hit the ICU and most of those will likely die of the disease…
The good news is, we’re theoretically more prepared now. Hospitals have had a chance to figure out what procedures keep staff from getting sick, and ventilator production seems to be (at least currently) ahead of where we need it to be.
Of course, deaths might not even be the key, maybe just hospitalizations. Even if the death rate keeps declining, localities are going to be unlikely to ease restrictions if hospitalization rates remain high.
Yeah, all good points. And I haven’t heard anything about hospitals being overwhelmed. Certainly not as badly as in NY City at the peak of the crisis.
Good point! There is a lag between deaths and cases. And remember, the cases are down about a third, falling pretty rapidly. This will hopefully translate into a big drop in fatalities coming soon.
But never underestimate the way people might cook the books. I wouldn’t be surprised if a lot deaths of uninsured people are falsely labeled “beer” to help the hospitals with the bills.
As a nurse who works in a major academic hospital in a major city, I’d like to share that our number of hospitalized COVID patients is a fraction of what it was at the peak. Our ICU isn’t overwhelmed. Treatment has changed and people aren’t as sick. Few are on ventilators. We tend to see our situation as hopeful, though we are still vigilant about prevention. Even quarantine times have been reduced for those who test positive. The general consensus among physicians I work with is that the virus has mutated into a less virulent form. I hope that’s true!
Thank you, Big ERN for this great analysis! I’ve been on the fence about hoarding cash versus investing because I wasn’t sure if we were waiting for the economy to topple. But I feel like I see demand for services everywhere and everyone aching to get back to life as usual.
Wow, thanks so much for confirming this. I had heard similar stories from people working at hospitals here, but it’s good to know that this is also true in other areas! Let’s hope we can beat that critter! 🙂
Excellent post, you explain all this in a way that is easy to digest and understand. I’m curious how concerned you are about the inflation / stagflation scenario? I’ve been listening to a lot of Ray Dalio recently and this comes up often. Do you think it is a low likelihood, or do you feel it is one of the more likely risk factors that could come into play?
I’ve been concerned about the inflation scenario for a long time, but it’s not materializing. One theory is that high debt levels – normally considered inflationary – are actually deflationary because they create uncertainty about future tax hikes and thus depress investment. See Japan: high debt levels, they WANT to create inflation but they can’t.
Karsten – what about a thought that USD is world’s currency and people/institutions in other parts of the world are actually using in their daily activities, thus creating a demand for the excess paper crated at home (US). Thus, inflation is muted.
I think for US inflation, what matters is the US currency in circulation in the US, not abroad. So, I don’t see foreign use of USD as muting inflation.
But I think that the US stock market and especially US bonds have a safe haven asset status. That helps us in the US.
I think a few contributing factors include: compared to the past, services make up a higher percentage of things we consume and most wages haven’t been increasing much except for a few fields. Also, high and low inflation is psychologically self fulfilling, once people think inflation will stay high/low its hard to break that cycle. Also a lot of the tech innovation has been from rethinking existing products/services to bring their costs down rather than creating entirely new products, some examples include Uber, Google, FB, or those startups that calls itself a “disrupter” such as the newer mattress companies.
Good point! I certainly hope that the tech revolution keeps inflation at bay. 🙂
Excellent write-up as always! With the election coming, I would love to see your analysis of how past elections have (or have not) affected the market.
Hah, I hope I can stay out of that mess. Remember last time when the prediction was: Trump won’t win and if he wins it will create another 1929 bear market.
Really appreciate your insight here. One thing that’s surprising about this recession is that the Shiller PE Ratio (CAPE) continues to climb without being reset to sane levels. According to your ultimate guide to SWR a CAPE > 30 is indicative of negative returns over the next 10 year period. Is the can just being kicked down the road here?
I’m surprised about that too. Corporate America has been much less impacted than main street America.
A CAPE above 30 doesn’t mean negative returns over the next 10 years. Actually the rough estimate is real return = 1/CAPE. So we’d be looking at about a 3% real return. Slim pickings! 🙂
Hi Karsten – Again, thank you.
This train of thought in this post works well by “strategically looking at market” through various indicators but actually not changing anything and enjoying the ride (and reallocating sometime later in time).
I am going to save these links and look at them to before reallocating funds.
Yes, exactly. I don’t want to do any short-term trading on this. Just reconfirming my asset allocation and making sure my SWR still makes sense! 🙂
Hi Big Ern,
Thanks for this excellent post. I appreciate your optimism which is supported by data. It’s nice to have an economist in the FIRE community to help calm the nerves.
Oh, thanks for the kind words! Glad you found this informative! 🙂
Really nice and interesting post.Keep posting. Thanks for sharing.
360DigiTMG
Thanks!
Optimism is wonderful – on a tangent, I’m curious what your views are on rate of increase in the S&P 500. Between 1986 and 96, it was fairly flat, and really picked pace 2009 onwards. Do you expect the momentum hold? Or will growth slow? I guess what I’m trying to understand is if the S&P 500 will always grow (with volatilities in phases)? I guess it boils down to what the US is doing today. What do you think? Is the US doing enough today that makes you believe that it’ll continue to do well in the future?
Goos question. A CAPE>30 would imply a real S&P 500 return of only 3% over the next 10 years (but then eventually going back to long-term averages, ~6.7% real).
I’m hopeful that the U.S. will remain the growth engine of the world and continue the old trend!
I too share this view. Still living In the Bay Area, I see so much innovation happening that isn’t happening anywhere else in the world. We will see more from AI and automation.
Yup, that next industrial revolution will come from the U.S.
Hi ERN, if the CAPE / future returns scenario you describe above indeed plays out this way going forward from here, do you think that a rising equity glide path for a traditional retiree turning age 65 now and retiring soon makes sense. Thanks.
Yup! See parts 19&20 of my SWR series. GPs make the most sense when the CAPE is elevated. 🙂
The challenge is adding more to equities when the CAPE right now is at 32x. I’ve been heavily influenced by Warren Buffet, Morningstar research, the folks at Tweedy Browne, and other value investors over the years that buying equity shares is buying shares in a business, and it’s important to value the business, using discounted cash flow, various multiples. I have a hard time paying 32x eps for a business. That’s why I didn’t buy Tesla pre-split at $300. Lol. Perhaps I’ll wait a year or two to see if the CAPE comes down, and if it doesn’t then I have no choice but to slowly glide path my equity allocation higher.
It’s a conundrum for sure. If it helps you, the PE of forward-looking expected earnings is not quite as crazy high. With the CAPE we’re still factoring 10–year-old earnings, which drags down the denominator. So, you can probably 20 to 25x. 4-5% yield is better than the bond market.
I’m waiting to pass judgement until January 1st to see if we are out of the woods or not. My wife worked in the airline industry and we were fortunate that she could take the early retirement package offered to her (free flights for life woohoo!). Once the artificial stimulus ends on October 1st there is going to be mass carnage, 50,000 people across the industry at a minimum gone instantly. Oh and for those lucky enough to stay, they are not able to get enough hours to remotely sustain their bills. Capacity is down 70%, business travel will be nonexistent for a year or two, it’s a very bleak picture, and this is just one sliver of an industry. Hopefully there’s a vaccine and stuff returns to normal, but you can only print money and have stimulus for so long. I figure 3 months after the music stops and we see what shakes out with the election will be a good indicator of what the future holds.
Fingers are crossed because we want to get back to jet setting around the world!
Yes, we will need more data to confirm this.
Also, remember that the recovery will not be even. Think back to 2001: The recession was over in November. But the airlines suffered for many more years.
How to you feel about TMF/UPRO/VXX going into the election that you blogged about a few months back? I am also interested in your take on swapping UPRO for TQQQ as it seems traditional businesses will continue getting hammered, but TQQQ has a massive run up and increased volatility. Would be interested in your thoughts.
I like that idea! Yes. that might be a good hedge either way.
About the TQQQ: Maybe reduce the equity share in that case to account for the higher vol!?
Great article and analyses. Curious if you foresee an impact on the rental market? I own a couple small multifamily properties in Central Texas, and personally did not see any impact on rental payments, etc even during March and April of “beer times”. But I’ve heard speculation on rents dropping, MF valuations going down, etc. I don’t really see it, but curious what your thoughts are 🙂 Thanks!
Well, in theory, low interest rates will drag down rental yields. But that’s a very slow process that will work out over years. But then again, if you refinance and get a lower mortgage rate on your properties it might be a wash.
But there’s also a plus for RE investments: lower yields will again create a rush to pump money into anything else with yield. Your properties will likely increase in value. 🙂
Karsten,
I came over from Justin’s recent post hoping for some good news. 🙂 I found a bit, and perhaps this recovery is on more stable footing. Still, there’s a lot out there that leaves it pretty shakey. Really solid, detailed analysis. Some food for thought.
By the way, were you joking a bit about said beer virus and search engine gods? Is there something I should know about saying the proper name(s) within an article about personal finance that might offend the algos?
Thanks!
Half joking, half serious. Both search engines and advertisers will penalize you for writing about the wrong code words. I noticed that with an earlier post in April.
Hi,
Seriously, this post was damn awesome, one thing that strikes me that most is your style of writing. i could understand the concept behind this very well just by reading at once.. thanks for sharing this wonderful article.
business standard
ERN,
Funny that you mention inequality. How do you feel about this emergent sentiment that followers of the FIRE movement are a “part of the problem” when it comes to inequality? My take is that, on the one hand, the FIRE movement is full of mostly frugal people who are self made millionaires. On the other hand, we generally support tax policy that is more favorable to haves rather than have-nots (right?) because our goal is to one day be one of the haves.
Would love to hear your thoughts on this matter, though probably too ideologically/politically charged for your blog.
Cheers!
Inequality is a problem that will be with us for a long time. A lot of populist policies will only make inequality worse.
I think the FIRE movement should stay out of politics. If the general public finds out that a lot well-meant policies that are designed to support the hard-working middle class are actually mostly benefiting the multi-millionaire FIRE bloggers, then some of those policies might be changed to cut us out.
e of beer cases a lot less scary than the first one. And the stock market seems to feel the same!
The Market is surely doing superb! 🙂