Depressing Recession
That this time is different is without a doubt. The question is, how different? While the depth of the contraction may have a parallel with the Great Depression, the speed of the collapse of employment is unrivaled in US history. Thus, the comparison to past economic cycles is fraught with imperfect analogs. The center of the debate is the recovery phase: a sharp rebound that matches the decline? A U-shaped recovery that endures a few quarters before returning to trend? Or the dreaded L-shaped recovery that echoes the Great Depression? Our argument is a bit of each. Some sectors/regions will rebound sharply, some will endure a prolonged contraction, while others will face enduring impairment.
Photo: Edwin Hooper on Unsplash
The economic impact of the Pandemic will most assuredly resemble the Great Depression in depth. The critical question is the length of the recession. Monetary and fiscal policies are unprecedented in their scale and scope. These measures will limit the risk that an economic recession doesn’t become a depression era. The threat still exists. The recessions that occurred, which bookend the 2010s, transpired as the Millennial generation became the dominant proportion of the workforce. These economic setbacks are preventing them from forming new households that would drive an increase in consumer spending for the next decade. A prolonged recession would only augment the effect as they spend less and save more.
Placing the current economic situation in this context enables a better understanding of where the economy goes from here. The first quarter saw a material drop of consumption of $260 billion and investment of $48 billion (exhibit 1). These amounts would annualize into a 6% rate of decline. This quick calculation materially understates the damage. Why? Social distancing was only in place for two weeks during the quarter, and most states didn’t adopt the measures until after the end of the quarter.
Exhibit 1. GDP Contribution by Component
Source: Federal Reserve Economic Database
The States will maintain mitigation measures until at least the end of April. Most States will go further and keep the mitigation measures in place until at least the end of May. The implication is that the economic impact will be a multiple of the previous quarter.
The drop that materialized in the first quarter has not existed in the GDP data from 1947 (exhibit 2). The Great Recession did not approach that peak rate of year-over-year decline, and it was the most significant decline in the data. Neither the stagflation of the Seventies nor the war-induced fiscal expansions of the Fifties or Sixties were as deep as what the economy recently experienced in just two weeks.
Exhibit 2. Real GDP Change (Year/Year, %)
Source: Federal Reserve Economic Database, CRM Calculations.
This outcome leaves a challenge of epic proportions in front of the US economy. A conservative estimate for the second quarter would double the magnitude of the impact from the first quarter. This calculation would result in an estimated decline of $600 billion (12% annualized). The carnage will be much worse than this amount because most States are not lifting their social distancing measures on May 1st. Even for those that are removing restrictions, they are not a complete reversal of prior rules.
The economic output lost in the second quarter will fall north of $1.2 trillion (25% annualized). The decline in the first quarter is known. Extend the prior number by a multiple of four to reflect eight weeks of social distancing rather than only two weeks to derive the fall for the current quarter. The optimism in that number does not consider that social distancing measures could extend for twelve weeks (the whole quarter). Regardless of the time frame, the impact is unfathomable.
A similar number materializes when estimating the impact of the individual components. Assessing the six sectors that are most directly affected by the economic shutdown enables a clearer understanding of the significance (exhibit 3). The leisure sectors will bear the burden of the economic calamity with dining & hotels falling an estimated $400 billion and recreation declining $235 billion. These declines are devastating for these sectors.
Exhibit 3. Economic Impact by GDP Component
Source: Federal Reserve Economic Database, CRM Calculations.
Investment also will fall over $200 billion as equipment and structures continue their prior decline. Without a clear picture of when removing the economic straitjacket, these numbers will not return. Currently, no clarity exists. Thus, regardless of the measurement, the result is grim.
The question arises as to the length of the recovery. While the uniqueness of the current situation fails to find a parallel in economic history, the prior data helps frame a possible trajectory. The debate on how long the exit centers on three types:
The hopeful “V” recovery that rebounds as fast as it fell (e.g., 2001).
The “U” recovery rebounds after a few challenging quarters (e.g., 2008).
The dreaded “L” recovery has growth permanently impaired (e.g., the Great Depression
While we all want a V-recovery, it is improbable. With a robust fiscal response, an extended U-recovery is possible. With an inadequate fiscal response, the likelihood is of an L-recovery.
Exhibit 4. US Recession Time Until Return to Prior Peak
Source: Federal Reserve Economic Database, CRM Calculations.
A quick rebound is dubious, given the history of recessions in the US. The average duration is six quarters, and the Great Recession took 14 quarters to achieve its prior peak (exhibit 4). The interesting artifact of US recessions is that they are usually the result of changes in Government expenditures (e.g., war) or investment (e.g., real estate). The one instance where consumption led the decline was the result of monetary policy in the 1980’s lifting interest rates to fight inflation. The high rates led to a double-dip recession only a quarter after recovery. This data highlights the uniqueness of the current situation: consumer-led demand destruction is unprecedented in the data reaching to the 1940s. This place is uncharted territory.
Exhibit 5. Real Consumption Growth per Capita.
Source: Federal Reserve Economic Database
The only parallel for demand-led contraction is the Great Depression. The effects on consumption lingered until the mid-1960s as real consumption growth per capita was constrained (exhibit 5). The Millennial generation is in their household-formation period. Yet, consumption after the Great Recession only peaked at the average for the prior four decades. This situation alone portends slow consumption growth.
The addition of the Pandemic will depress the prior trend on consumption growth further as savings rates expand. While the Millennial generation will enable modestly higher productivity growth over the next decades, a reduction in consumer spending may outweigh the benefit. Thus, the Japanification of the US is the greatest threat from the Pandemic: increased savings, lower consumption, and increased productivity.
The outlook reflects an optimistic outlook with a duration of six quarters until returning to the prior peak. Our expectations for the second quarter include declines of $1.2 trillion for consumption and $240 billion for investments (exhibit 6). The result is a 6.5% decline in GDP ($1.2 trillion at an annualized rate.) This decline is four times the most significant quarterly decline seen during the Great Recession.
Exhibit 6. Forecast for US GDP Growth
Source: CRM estimates. Amounts are annualized rates.
Return to year-over-year growth occurs in the second quarter of 2021, while the prior peak takes two years to achieve. The current estimate for the calendar year is a 3.5% decline. There is material risk to the forecast. An anti-viral/vaccine/testing program is assumed to arrive in the fourth quarter. This outcome permits the dynamism of the US to jump the economy back to normal. Inadequate fiscal policy and poor pandemic management would place this outcome at risk. The belief is that the stakes are too high not to get it right. Only time will tell whether this faith was properly directed.
This is Capital Risk's US Economic Outlook for the first quarter 2020. The full report is found here.