KEY DATA: GDP: -4.8%; Consumption: -7.6%; Durables: -16.1%; Imports: -15.3%; Equipment Spending: -15.2%/ Pending Home Sales: -20.8%
IN A NUTSHELL: “Even though the business closings did not start in earnest until late in the quarter, the economy still contracted dramatically.”
WHAT IT MEANS: The economy started shutting down in the middle of March, yet the decline in economic activity in the first quarter of 2020 was greatest since the collapse of the financial system at the end of 2008. Even in the first quarter of 2009, when payrolls were being cut by 700,000 or more a month, the decline was not as steep. That shows how massive the impact on the economy Covid-19 has had already, and the second quarter should be a lot worse. The report, to some extent, is indicative of what is going on. Consumer spending tanked, led by a huge drop in durable goods demand. Vehicle sales fell off the cliff in the latter part of March and while it may be slowly improving, the average for the second quarter should not be very good. With the economy shut down, imports fell to their lowest level in three years. Exports also declined, but at half the pace of imports. That caused a significant narrowing of the trade deficit, which limited the drop in growth. Business investment, led by a huge fall in equipment spending, was off sharply. That was hardly a surprise since firms weren’t doing a lot of spending on capital goods for almost a year. What did surprise was the modest rise in government spending, especially at the state and local level where all the action is occurring. The federal government has been doing some buying, but is providing a lot less support than the state and local governments. Also, residential activity posted a double-digit rise. Given the sharp drop in the National Association of Realtors Pending Home Sale Index in March, that is likely to turn around sharply in the second quarter GDP report. A note of warning: This is an advanced estimate and given the huge nature of the changes, don’t be surprised if the revised data look a lot different.
MARKETS AND FED POLICY IMPLICATIONS: The first quarter economic declinewasclose to consensus but greater than I expected. I had assumed government spending, coupled with a major narrowing of the trade deficit would restrain the drop. But a surprisingly large decline in business investment really did the economy in. Regardless of what we saw in the first quarter, all eyes are on the second quarter, where we could see the largest drop since the Great Depression. But forecasting that number with any accuracy is largely impossible. We have no idea how fast the economy will start opening back up. We don’t know how consumers will react to the opening, in terms of spending. We don’t know the capacity of businesses to safely bring back workers and ramp up production. We don’t know how much more money the federal government will pour into the economy, especially with an election coming up. We don’t know how other countries will reopen and their appetite for our goods. And we know very little about the course of the virus and how quickly drugs will become available on a widespread basis. In other words, we know almost nothing. That is why the estimates for the second quarter currently range from about -20% to -40%!It will be bad, but how bad we just don’t know. But the real test will come not in the second or third quarter. It is the fourth quarter and the first half of 2021 that will tell the tale. That is when governments will have exhausted their funding and will be reducing support for the economy dramatically. Businesses and households will have to be standing on their own or they will sink quickly. It is important to recognize that even if we get just a 20% annualized decline in growth in the second quarter the level of economic activity will have fallen back to where we were in the first quarter of 2017. In other words, we will have wiped out over three years of growth! A 40% annualized decline would bring us back to the end of 2014. Very simply, it is could easily take two years or more just to get back to the level of economic activity we had at the end of 2019. And that does not factor in any lasting effects of the virus on consumer and business spending as well as the possibility of a resurgence of the virus in some form next winter. Meanwhile, the equity markets keep rising as if nothing happened. The S&P 500, as I write this piece, is back to where it traded on March 6th – of this year.Can we really say that the outlook for the economy over the next 12-18 months is the same as it was in early March, which is what the markets are implying? That makes no sense to me, as an economist. But then again, the markets had been soaring despite mediocre growth for over a year, so why should I believe that economic fundamentals would drive equity prices now? Is it time to ask, once again, the question posed by former Fed Chair Alan Greenspan on December 5, 1996: “… how do we know when irrational exuberance has unduly escalated asset values…?” Keep in mind, it took another 3½ years for the tech bubble to finally start to burst, so things could keep going for a while.