- It's highly likely the US GDP for all of 2020 will print below negative 10%, meeting the technical definition of a depression.
- COVID-19 could be obfuscating other unknown weaknesses in the economy that are indiscernible for now but are not being addressed by policymakers.
- Consumer spending - 70% of the economy - will likely be constrained even into 2020Q4 because of back rent and mortgage debt and a decline in consumer confidence.
- There are significant geopolitical risks, including potentially disastrous torrential rains in the Yangtze River Valley that could be threatening the Three Gorges Dam, the largest dam in the world.
NEW YORK (July 3) - Gross Domestic Product for the Second Quarter of 2020, or "2020Q2 GDP", declined a record 32.9%, slightly above the consensus estimate of a 34.1% decline. It came in 90 bps above the lower end of our estimated range of decline of 25% to 35%, as set forth in our June jobs report.
The decline was led by a chart-busting 25.05% decline in Personal Consumption Expenditures ("PCE"). That, in turn, was led by a decline of 22.93% decline in Services, together with an additional decline in Nondurable Goods ("NDG") of 2.16%. The services decline was led by healthcare, food services, and recreation as people feared in-person doctors' appointments, indoor dining was mostly banned, and vacation locales were abandoned by a fearful public.
Consumers Have Left The Field
We had mentioned in our reportage of 2020Q1 GDP that the COVID-19 virus had only started to have significant effect in the United States after the first week or two of March, and thus, only reflected about 2 to 3 weeks of March PCE data. We called those PCE numbers "disastrous". We have no adequate superlatives for the 2020Q2 results. Moreover, if we can torture Paul Krugman's analogy that the economy is in an "induced coma" because of COVID-19, we don't really know if there are other underlying "pathologies" affecting the patient, the American economy. The tremendous drop may be attributable to other weaknesses in the economy, beyond which so many easily attributable to COVID-19.
Source: FRED data from the St. Louis Federal Reserve
This view is supported by the continuing burn off of inventories that we have seen for several quarters. We had presumed in our 2019 GDP reports that the drop in inventories was attributable largely to the difficulties at Boeing (NYSE:BA) (i.e., stopping production of the 737 Max jet in December) and the GM (NYSE:GM) strike that ran through most of October. We had anticipated that there would be buildup in 2020Q1, but the inventory decline actually started in 2019 and accelerated through February before its sharp downturn in March. While some of this pre-COVID-19 business inventory decline may have been attributable to a decline in China production in December, or the foresight of managers, it seems to us there may be something more in the economy, as yet obfuscated by COVID-19, that may have affected these inventory drawdowns in the first three months of the year, before the pandemic's serious effect in the USA. The IBD/TIPP Economic Optimism Index fell sharply in the reading earlier this month to 44, down more than 6 percentage points and indicating pessimism. That number correlates to performance in important sectors of the economy, including, notably, the Revenue Per Average Room in the hospitality sector, as we related here.
A Technical Depression...
2020Q2 GDP came in at the lower end of the range of down 25% to 35% that we anticipated in our June jobs report.
July, and, likely, August and September GDP are also likely to continue showing the devastating economic effects of COVID-19. We expect movement along a mostly flat line, likely no more than just a +/- 2 percentage points change from the total aggregate GDP that printed today. With more than 25% of the population behind, or fearing they'll be behind, in rent and mortgage payments, we believe consumer spending is unlikely to return with much vigor even in 2020Q4; people will apply any earnings they might receive to their housing or, given that economic declines tend to snowball, to their savings.
Thus, we are now entirely comfortable declaring the USA in a technical economic depression, defined as an average GDP of negative 10% for the year. Regular followers will recollect we called the depression signal back in April, with our March jobs report.
Our hope that we would avoid the horrible economic consequences of COVID-19, based on CDC pandemic experts speaking in late January, specifically that "The American people should not be worried or frightened by this" proved catastrophically wrong. That hope has, obviously, been crushed and we see no "V-shaped" recovery. With weekly initial jobless claims at more than 1.4 million for another week, we are likely to see a further devastating jobs report when July jobs prints a week from tomorrow.
...Amid enhanced geopolitical risk
Today's GDP prints into a global economy that is at higher geopolitical risk:
- The Three Gorges Dam is dangerously close to overflowing and perhaps even bursting. The dam, completed in 2006, is under the greatest pressure since it was built. A failure would send a tsunami-like wave downriver in a flood that would kill millions, cripple Chinese food production, and plunge the nation into blackouts. While China's Chinese Communist Party-controlled propaganda sites portray concerns by foreign observers as overwrought and panicky, it is worth noting that even Xinhua, China's state news agency, reportedly said there was a "'slight deformation' on some peripheral parts of the structure". China rulers, always opaque, could be sitting on a Chinese Chernobyl.
- The India-China border dispute in the Himalayas, along with Nepal, from last month, has quietened but remains a flashpoint between nuclear-armed nations. India announced yesterday that it is sending 35,000 troops to the area as tensions simmer and India has been rushing to build infrastructure on the China-India border.
- On the Korean peninsula, the Inter-Korean Liaison Office in the border city of Kaesong was blown up on June 16th, allegedly on the orders of Kim Yo-jong, the younger sister of North Korean leader Kim Jong-un in retaliation for some North Korean defectors to South Korea dropping propaganda leaflets over their communist neighbor.
- In Turkey, President Erdogan's decision to convert Hagia Sofia from a museum to a mosque is yet another move to reverse nearly 90 years of Turkish secularization by Ataturk. The 1500-year-old building, built by Greek architects under Roman Emperor Justinian as a Christian church, became a Mosque when Constantinople fell to the Ottomans in 1453. It is considered a holy site by Orthodox Christians of the Eastern Rite ("Greek Orthodox"). Politicians in Turkey's NATO ally, Greece, which is overwhelmingly Greek Orthodox, were vociferous in their condemnation of the move and Greek businesses have boycotted trade with Turkey. The conversion will doubtlessly boost tensions in the region and complicate relations between NATO members Greece and Turkey and leave the United States, as well as the rest of NATO, in an awkward position in a critically important region of the alliance. Meanwhile, Russia, to solidify its ties to Syria, has promised to build a replica of the Hagia Sofia structure there.
- There are reasonable concerns about the deep political divisions we see in the USA in the aftermath of the death of George Floyd.
We think, at best, Congress will come to just a "patch" for their widely disparate current differences on coronavirus aid. And with it being an election year, with both the White House and the House up for reelection, politics - not pragmatism - will dictate the outcome. The failure of Congress to come to an agreement will likely further weaken the USD as the EUR benefits from the aid package passed by the EU last week. The 3Mo/10Yr yield curve, which has been narrowing, on-and-off, since the end of 2017 and inverting in 2019, is improving. Today, the two are separated by 48 bps, but with a 10-year note at just 59 bps as of yesterday, we're likely to see increasing pressure on borrowings so that only the highest quality borrowers will find reasonable borrowing rates. We see this as particularly affecting state and city governments, which have, in the majority of cases, papered over their defined benefit pension liabilities with actuarial sophistry worthy of Bernie Madoff. We anticipate that there will be municipal defaults that will affect the markets as well as defaults on other sectors. China's contagion from its need to refinance debt in a depressed economy and the risk at the Three Gorges Dam (discussed above) deeply concern us. We're also concerned about deflation and disinflation, which are arising in Australia and which the ECB has warned could affect Europe. Fed Chair Powell discussed low consumer inflation in his remarks yesterday. Barring a vaccine and its wide distribution and effectiveness, we repeat our concerns that we are in an "L"-shaped non-recovery. But watch for our monthly jobs reports, where we go through multiple data points, for revisions up or down on that number.
Our medium-term outlook, out to the end of 2022, mostly mirrors our short-term view, with some additional consumer spending on consumer durables, but little much else. We think the "L" will have a tail well into 2022.
Our long-term view of the economy, into 2023Q2, is more optimistic, provided that the challenges of the current situation and political stress in the USA, and increasing tensions with China, do not fundamentally alter the economy as we know it.
AI, 5G, and electric cars will likely be on the brink of being fully "ripe" by then and could make a significant impact on the economy. 5G should boost the GDI segment of GDP by as much as 200bps over four quarters (i.e., 50 bps/quarter) when it starts up. A similar, but lower, boost to PCE could be anticipated as consumers migrate to the new, better, 5G system.
More growth is coming from what we call soft-sectors and all have benefitted from the pandemic: personal services, like food and product delivery and on-demand taxi and cable TV services; social media; remote conferencing technology; and consumer items have all had tremendous growth during the pandemic and are likely to become permanent aspects of the US economy.
Meanwhile, big industrial firms like Boeing and Caterpillar (NYSE:CAT) - where thousands of people are employed and wages tend to be high - will struggle; Boeing with its myriad technological issues and Caterpillar with competitive challenges from foreign heavy equipment manufacturers.
President Trump's more protectionist trade rhetoric, and the new USMCA, could add foreign-owned domestic production to drive GDI to GDP growth, particularly in the GDI category if he is reelected. We're beginning to see some of that, as with the Mitsubishi plant in Alabama.
A new UK/US or UK/North American trade deal should be a substantial boost to future GDP as well.
Nevertheless, we anticipate managers will look for growth in certain low-margin industries and to acquire and consolidate competitors to realize cost savings from economies of scale. We also expect internet retailers, like Amazon (NASDAQ:AMZN), to realize enhanced growth by adding to their business of selling "stuff" to their nascent business of selling "experiences" - concert tickets, airlines, cruise lines, car rentals, theme parks, hotel chains, etc. once we are beyond COVID-19.
- Outperform: Trucking and delivery services on speculation of consolidation and acquisition as well as pandemic market growth that will likely continue thereafter, and consumer discretionary and retail in the higher- and luxury-end segment. Longer-term investors might leg into well-capitalized higher-end QSRs and casual dining; REITs that own real estate in sectors identified as "opportunity zones" under the Tax Cut and Jobs Creation Act of 2017. We continue to believe CHF is a safe-haven from domestic and geopolitical uncertainty we discussed above and may likely be a better alternative than gold.
- Perform: consumer discretionary and retail across middle-market and low-end sectors; consumer staples, energy, utilities, telecom, and materials and industrials; healthcare; and currencies of developing nations such as INR, GBP, and EUR.
- Underperform: Financials; heavily-leveraged REITs, the asset-light hospitality sector on speculation of declining GDP and COVID-19, especially lower end hospitality as US consumer confidence and lower fuel costs allow domestic travelers to "trade up" to the lower end of luxury brands (for example, lower-end Marriott (MAR) brands, like Fairfield, from a Choice Hotels (CHH) brand); airlines, again on COVID-19; and technology; lower-end, lower-quality QSRs (e.g., MCD, DPZ, YUM, etc.) on greater US delivery competition by their higher-end counterparts.
Source: Seeking Alpha