Looking at the rebound in many financial assets and some of the key data series such as the US ISM, we could be forgiven for thinking that the economy is quickly recovering from the global recession that has plagued the economy in recent months.
The Nasdaq 100 and LQD, US Investment Grade Bond ETF, have recovered to well beyond their pre-pandemic levels.
There is, however, an enormous bias in financial markets toward assuming that the US equities equate to the US economy and that the US economy equates to the global economy.
The US equity market, however, is perhaps the worst indicator of real economic performance. As we’ve covered in our last Macro print, in today’s markets distorted by intervention, the rebound in the US equity market may actually be a harbinger of weaker long-term growth.
There is a huge difference between a rebound and a recovery. Economies can rebound from the depths of the economic data that were registered in Q2 2020, without necessarily making a full recovery.
The speed and depth of the decline in the economy as a result of the COVID pandemic was shocking, but the policy response that followed was emphatic.
To put the March move in the US equity market into perspective, we can compare it to Black Monday of 1987, the dot com bust of 2000-2002 and the global financial crisis of 2007-2008. On an annualized basis, the decline in March was 98.5%, eclipsing the 1987 crash which was 94.5%. The dot com bust was only 16%, whilst the GFC was 41% on an annualized basis (according to research by Refinitiv).
There has never been a recession in history that was so unexpected or a response that has been so rapid. The US Federal Reserve expanded its balance sheet at an astonishing rate, one that dwarfs the experience of 2008-2009.
Additionally, the US government implemented fiscal support packages in excess of $2 trillion.
This year’s sell off was indeed exceptional and its rebound spectacular. There is, however, a profound difference between a V-shaped recovery in a few selected assets and a V-shaped recovery in the real economy. We can go even further and say there is also a huge difference between a V-shaped recovery in certain economic data points and a V-shaped recovery in the real economy.
Today’s macro-economic signals are distorted by policies that support risk assets at the expense of real growth. Today’s investment and capex decisions are also being distorted, as businesses prefer to allocate capital on buybacks. The recession and its response have happened so quickly that the effects are still to be felt.
The global pandemic recession has (so far) taken place at such speed that it is almost too hard to comprehend. All the usual recessionary signals were missing, because this was a true exogenous shock. We reversed from an all-time high in US equity markets to a 35% decline in 3 weeks. This has never happened before.
Most recessions start slowly. The warning signs begin to build months in advance, whilst the macro data deteriorates over a long period of time. The yield curve also normally provides an early warning by inverting and then re-steepening in advance of the recession. On this occasion there was a very slight inversion last year, but the dynamics were completely different from the previous four recessions. This is then followed by an exogenous shock (like the Lehman insolvency) which leads to a full escalation of the recession.
Case in point: 2008. The Global Financial Crisis of 2008 was at least two years in the making, with cracks first starting to appear in parts of the housing market in 2006. The central bank response at the time (i.e. the US Federal Reserve) then allowed huge imbalances to build up in other areas of the economy, before the final phases took shape around the time of the Lehman insolvency (exogenous shock) in September of 2008. The warning signs were there for those wishing to heed them. In fact, the problem was not so much spotting the signs, but being able to hold onto a bearish position for long enough, whilst the crisis played out over an extended period of time. The 2020 crash was a different story. The decline in many data points during the COVID-19 crisis was on a completely different scale and speed that had not been seen during previous economic dislocations such as deflation (1930’s), war (1940’s) or inflation (1970’s).
Never in history had so many economies been simultaneously placed into a self-induced coma. All countries on earth have been dealing with COVID-19 in one form or another and many of them have chosen aggressive measures in order to deal with the pandemic.
On a month-on-month basis, both manufacturing and service macro data fell to levels that will probably never be seen again (we hope). The magnitude of the declines in 2020 have obscured all previous data points.
Just look at US Industrial Production on a month-on-month basis.
These cliff-like patterns have been experienced across all sectors and geographies.
Not only were the month on month data points bludgeoned down to new lows, but we also saw dramatic declines in many of the year-on-year data points. US Industrial Production collapsed to levels that exceeded the levels reached during the financial crisis.
These rebounds can be even more dramatic in the survey data such as the US ISM (or global PMIs), where the survey’s questions can be as simple as ‘do you expect activity this month to be better or worse than last month”.
In April, almost every respondent would have said that the month was worse than March. In May, it couldn’t possibly be worse than April, therefore the majority of correspondents would have indicated that activity was improved.
Unfortunately, this is only sentiment and not volume. Purchasing Managers (i.e. the ones who answer the “sentiment” survey) can feel far happier about their prospects without any uptick in volume. During periods of dislocation such as Q1 to Q2 2020, there were not only distortions in the data, but in the process of data collection.
One of the key questions about these recoveries will be its sustainability. Are we seeing an organic rebound or one that has been entirely fueled by government and central bank handouts? Can the handouts be taken away and the recovery continue? There may be some clues in the employment data.
The US employment data has been some of the most controversial of the recent economic releases. US Non-Farm payrolls kicked-off a renewed surge in hope when in May it showed a gain of nearly 2.7 million jobs, when additional losses had been expected by everyone. These job gains then extended to 4.8 million in the following month, again ahead of expectations.
The consensus for May had been for a huge decline that was expected to take the unemployment rate to 25% (from around 15%). Instead, the May payrolls data saw jobs being added to the economy and the unemployment rate fell.
It has now moved back to an unemployment rate of 11.1%. This is still higher than the unemployment level during the Global Financial Crisis of 2008, but the trajectory is expected to continue the steep decline.
For that to occur, it would require the weekly initial jobless claims to continue its precipitous decline. Unfortunately, that has recently ticked up for the first time since April. This uptick has taken place from a level that is still significantly higher than all the previous increases in initial jobless claims during previous recessions (and by some margin).
This shouldn’t be ticking higher in a ‘recovery’…
…especially not from a level that equates to a pre-COVID 40-year high.
What has been happening in the jobs market is an extreme distortion based on government intervention and data chicanery.
This is particularly evident in the UK where the official unemployment rate remains rooted close to the all-time lows…
…even though the April unemployment claimant count shot through the roof.
It all comes down to a definition of who is unemployed and who is merely collecting a ‘temporary’ support check. These definitions are often provided by government agencies. Further distortions are also created by seasonal adjustment factors that were not designed to cope with the extremities of this period.
The distortion in the numbers mainly comes from the fact that furloughed workers have not been counted as unemployed, even though they are not working and are collecting benefits. This is evident in the UK.
In the US, the unexpected rise in employment (non-farm payrolls) was apparently because employers needed to shift workers back onto payrolls to capture the next round of government support benefits i.e. people were re-employed, in order to stay furloughed.
All of these mechanisms really affect the final number, and hence, our interpretation of the real state of the economy. Jobs are absolutely key, especially at a time where the US households have very high expectation about future job opportunities.
Sentiment could reverse sharply if the jobs do not materialize, which is why governments are already preparing for that eventuality. We should expect some of the UK government schemes will be extended into 2021. It is highly unlikely that the US government will allow unemployment to explode higher as the furlough schemes roll-off in July ahead of the November election. Leaders are already planning on extending support, which will cost anywhere between $1 trillion and $3 trillion.
If households expectations about an economic recovery are not met by the rules of competition and free markets, governments will likely ensure that that will be the case anyways.
The ongoing assumption that fuels those hopeful expectations about the future of the job market is that most individuals on temporary support will eventually rotate back to the real economy and take up their former posts, thus helping to fuel a full economic recovery, rather than merely representing a partial rebound.
This assumption is dependent on two critical factors:
Pre-COVID: The Ailing Economy
We’ve written on this at length in previous Macro prints. The S&P500, near the all-time highs, is not a sign of a healthy economy. We have actually argued that it is, in fact, a sign of an unhealthy one. The S&P500 has had little to do with economic fundamentals or earnings for most of the last decade. The market has soared even as earnings flat-lined.
The S&P 500 has largely followed the expansion of global central bank balance sheets for the last 10 years. This means that. liquidity and not fundamentals have been the core driver of performance. (See our “Mike Green on Passive Flows Dominating Market ‘Fundamentals’” where we cover this concept in excruciating detail).
Growth in productivity has been replaced by growth in debt in order to maintain the mirage of growth. Government debt-to-GDP was already extended in many regions prior to the COVID crisis. It has now exploded higher in response. Although there is no obvious level at which government debt-to-GDP becomes terminal, Reinhart and Rogoff in their book ‘Growth in a Time of Debt’ (2010) suggested that anywhere in excess of 90% becomes a problem. The US and the UK are beyond that level already.
Can countries carry higher levels of debt if interest rates are falling? The answer to this is of course yes, but only up to a point. Many countries have seen their interest payments increase even as interest rates have fallen because they have used the opportunity to raise even greater levels of debt.
This argument has also been extended to equities. “Equities are not overvalued, because interest rates have been falling and therefore equities, with a higher dividend yield and a low discount rate, look attractive”. This is an argument that watches the theory pass beyond the wall of common sense. If interest rates and yields across the yield curve (i.e. from overnight rates to 10-year yields) are close to zero, therefore reflecting future growth expectations that are close to zero, then why would anyone buy equities that are supposed to be the riskiest play on growth? Equities should fall when expectations for growth are so low.
There comes a point where declining interest rates cease to be supportive of corporate earnings. It is probably around the same level where consumers shift from saving less to saving more.
High levels of debt and low levels of interest rates start to change the behavior of households and businesses in a way which undermines future growth prospects. We seem to be at that stage of the cycle, and that was evident prior to the pandemic.
Have economic habits been changed by the COVID crisis?
Over the long term, habits will probably change far less than currently forecasted. In the midst of dislocations, we often think that we are undergoing profound change, but as Tony Crabbe, The Business Psychologist (author of ‘Busy: How to thrive in a world of too much) argued in a recent interview:
“Habits are massively context dependent. When we snap back to a post-covid world, the habits that we think of, that we’ve developed now, that seem super important, are very likely just to disappear. And so certain things will stick because of economic realities, but relying on human behavior to shift radically and our habits to shift radically……….is a bit overblown at the moment.”
There will clearly be some changes in our patterns of consumption and working behavior due to the COVID crisis, but these are mainly an acceleration and concentration of existing trends, such as the move to online shopping and toward greater flexibility in the workplace, that technology is already enabling.
Many corporates have already adjusted to this new reality, realizing that they need less staff to fulfil roughly the same orders as before. Large corporates have acknowledged that they don’t need as many layers of management to remain productive. Temporary layoffs will become permanent redundancies. The leisure and entertainment sectors bore the brunt of the initial culls. Management layers within the service sector are likely to experience the next wave of cuts.
Policymakers have learned how to deal with a liquidity crisis, and they moved aggressively to deal with this one. The financial system did briefly break in mid-March when US 10-year government bond yields surged from 40 to 120 bps whilst the equity market was still in free fall.
Recognizing the risks, the US federal reserve announced QE infinity. The Royal Bank of Canada and the Reserve Bank of Australia announced Quantitative Easing programs for the first time. Almost all central banks, it seems, are currently playing the same game.
This was all topped with fiscal packages as well. Income support directly from the government has helped consumption remain relatively robust, albeit with shifting consumption patterns.
If economies were already in a poor state before the crisis began, then it’s safe to assume that they are in a much worse state today. Raising the levels of debt today must come at the expense of future consumption. But who will pay for this and how?
Today, the fiscal authorities are embarking on spending programs to complement the ongoing and accelerated levels of QE. Past attempts at stimulus, despite helping contain chaos in the short-term, have only managed to lower expectations of growth and inflation, distorting the value of capital so that it flowed away from productive means, such as capex, into non-productive means such as buybacks. They have helped increase social inequality, and the concentration of the ownership of capital.
Paying the bills for the current recovery will be the biggest question for the current generation and perhaps, also, the generation after that. Baby Boomers and to a lesser extent, Generation-X, have all the assets. Millennials and Generation-Z have almost nothing, but they will inherit governments with high levels of debt.
It’s easy to highlight the problems as they have been building for decades. But what about the solutions? Is it all gloom and doom or do the proponents of Modern Monetary Theory have something that is workable?
Can central banks finally get the right type of inflation (wage and economic), or will they be destined to forever increase income inequality by backstopping the financial assets that are only held by the few?
Perhaps austerity is still the option – taking our medicine over a longer period of time in order to pay for our recent excesses.
In the next editions of The Lykeion, we will look at the proposals that are being touted as the solution to the current predicament, a predicament that has been building for years and has increased the burden for future generations.
We’ll be writing about Austerity and Taxation in the next Macro print, and about Inflation and Modern Monetary Theory in the one after that.