Monday 1 June 2020
The Congressional Budget Office in its latest forecast estimates US unemployment will still be as high as 8.6% in Q4 of 2021. Released in May, the CBO’s Interim Economic Projection 2020/2021 also indicated GDP in the same quarter will be just 1.6% below the level seen in Q4 of 2019. There seems to be a conflict between the two projections. Unemployment in the US hasn’t been as high as 8.6% since 2011. How will the US economy achieve real output in Q4 of 2021 that’s just 1.6% below the comparable quarter in 2019, with the highest unemployment rate we’ve seen in a decade? By the way, the CBO’s full year unemployment forecast for next year is 9.3%. Is the CBO expecting a productivity miracle? Both the rate, and the levels, of GDP recovery appear to be quite optimistic in the CBO outlook; whereas the unemployment projection looks far more reasonable.
Analyst consensus for SP500 earnings in 2021 is currently $164, compared to $126 this year. This too seems rather ambitious given that SP500 earnings last year came in at $163. Moreover, given the closing level of the SP500 last week, at 3044, the market is now trading at 18.5 times earnings—potentially justifiable in a stable environment, but less so now. As some observers have noted recently, the market seems to be trading not on 2021 earnings, but on 2022 earnings. Indeed, when you combine projections from the CBO, and other economic forecasters, the US market is priced as though monetary and fiscal policy will sustainably shoulder the current price level—like the portage of a heavy canoe—across this year and next, without much risk of interruption. The analyst consensus data comes from the weekly market PDF released by Yardeni Research. N.B., Yardeni forecasts not $164 in SP500 earnings for next year, but $150.
Markets can be expected to trade against bad news by rising strongly if they see improvement in the future, especially if they discern a low in economic activity in the recent past. That describes the current shape of the US market and, given monetary policy, it’s not crazy at all that prices have rebounded so strongly. The concern however seems to be in the price levels themselves. Had the SP500 fallen to 1500, and then rebounded to 2500, for example, the very same shape currently traced out by the market might seem more sustainable. Clearly the market sees a V bottom in economic activity, wants to trade off that low, and may very well be right in forming such a reaction. Where the market may be quite wrong, however, is in the length of time required to return to 2019 levels of GDP, earnings, and employment. This is especially true given that market resilience the past several years has clearly been sourced from the steady drip of retirement contributions from workers into passive investment vehicles.
A recent tweet thread by Schwab’s chief market strategist, Liz Ann Sonders, tried to address this subject: the dramatic disconnect between market prices and earnings estimates.
Both now, and in 1999, the price level of the SP500 in the immediate aftermath of the most acute phase of each market decline traded at rising levels that seemed “crazy.” Again, that’s to be expected. But there’s a big difference between now and then. During the great recession, the decline of the SP500 took nearly 18 months to play out, from late 2007 to early 2009. And the total decline, of 53%, was far more severe. Today, we are only 90 days past the market crash and the initial wave of closures and job losses. Economic conditions will surely get better. But, at what rate, and to what level?
The Gregor Letter base case for economic recovery remains unchanged. The common missing link in most forecasts appears to be the lack of acknowledgement that pandemics take several years to resolve. The culture, for example, is worried about a second wave when the actual concern is multiple waves or oscillations of lower intensity, traveling outward for 2-3 years. Indeed, it’s becoming clearer why the field of epidemiology, when projecting pandemic outcomes, typically models a succession of many smaller waves—waves that reflect the back-and-forth of easing and hardening of preventive behavior.
Consider for example where we are in the current pandemic cycle. The world enacted a historic shutdown as the first big wave of cases (formed in silence before any shutdowns took place) rolled through societies. That historic shutdown very effectively broke virus growth—but, on a global basis, did not trigger declines. Subsequently, societies began to ease preventative behavior and now in a number of US states and other countries, case counts are growing again. Enough so that the global case count, after plateauing, is starting to rise. In the chart below, from The New York Times, it appears the global shutdown was quite effective at halting growth until the end of April. The hardening of behavior worked. Then the easing of behavior started.
Readers of the Gregor Letter will recognize the dynamic at play here. It’s quite similar to watching the collapse of gasoline demand growth during a classic oil price shock. In such a shock, the initial oil price spike catalyzes a dramatic pullback in consumption behavior, which then eventually feeds through to lower prices. The only cure for high prices, is high prices! Then, upon seeing lower prices, consumption returns and, whoops, prices start drifting upward again.
Remember, your average layperson continues to regard the virus as a form of flu, that will naturally dissipate in summer and may only return again in the Fall. I warned, in the last letter, about allowing one’s assumptions to lapse in this direction. The virus is not the flu. Not even close. It’s not even in the same family. The only seasonality associated with the virus will come through behavior—people getting outside into open spaces, and avoiding enclosed spaces. In high contrast to the very obvious hopes and wishes of the culture, the virus does not contain some magically self-extinguishing property that makes it “go away on its own” in the summer.
The Federal Reserve released its Beige Book last week, and the story it told was depressing. Much of the detailed and anecdotal reporting from the 12 Federal Reserve Districts was to be expected as the recession deepened further into May. But I would draw your attention to the reports from the Cleveland and Dallas districts in particular. When it comes to oil and gas, the two regions are closer than many would suppose. Indeed, back in 2014 and 2015, I did some research and wrote a story or two about the US capex revival, and discovered that the great expansion of US oil production relied heavily on the manufacturing, steelmaking, and electronics industries in the upper Midwest. As you know, both the Cleveland and Chicago districts were already feeling the effects of the trade war policies which impacted steel and the automobile industry starting two years ago. Excerpts from the Cleveland district:
Manufacturing orders continued to slide. Several contacts noted that the shutdown of automotive production was particularly painful; others reported that they anticipated long-lasting and adverse impacts to the aerospace and energy sectors. More than two-thirds of contacts indicated that capacity utilization is below its normal range, citing lack of demand, inefficiency brought on by social distancing, and difficulty convincing employees that it is safe to come to work…
Weaknesses in the manufacturing, construction, retail, and energy sectors resulted in weaker cargo volumes for freight companies. Contacts highlighted reduced auto and metal production as particular pain points. The difficulty for transportation firms is exacerbated by the fact that freight volumes were already soft going into the pandemic. The few bright spots in the sector are limited to cargo for groceries and local and short-haul transportation.
Paul Krugman was interviewed by Noah Smith of Bloomberg, and the conversation they had is important and necessary to understand. In recent remarks on Twitter, Krugman voiced the opinion that the pandemic shock was “more like” a standard recession typically brought on by higher interest rates—with a quicker recovery—and “less like” a balance sheet recession, with a more drawn out recovery. But in the conversation with Noah Smith, Paul added more detail to his view, and noted that if the pandemic was stubborn and lasted for a while, then balance sheets could indeed fall into disrepair, compounding and lengthening the recovery time:
My take is that the Covid slump is more like 1979-82 than 2007-09: it wasn’t caused by imbalances that will take years to correct. So that would suggest fast recovery once the virus is contained. But some big caveats. One is that we don’t know how long the pandemic will last. Right now, we’re probably opening too soon, which will actually extend the period of economic weakness. Another is that even if we didn’t have big imbalances before, the slump may be creating them now. Think of business closures, which will require time to reverse.
Nevertheless, Krugman remains moderately upbeat on the prospect for recovery when it arrives, but, has not yet tied himself down to a date, or time period. I would characterize his position as one that forcefully pushes back on the prospect of a multi-year depression, but is without a commitment to a visible outcome.
I will also make a prediction: when Paul more fully absorbs the long series of waves that tend to characterize pandemics, he will update his view to reflect how hard it can be to recover when imbalances are given room to become damaging.
In the Spring of 1992, Los Angeles erupted in riots in the wake of the Rodney King trial, and its acquittal of the police. While the trial outcome was the trigger, those of us living in Los Angeles at the time were quite aware the city was already on tenterhooks. A deep recession, exacerbated by large cuts in the defense and aerospace industries, had hit local real estate and job markets quite hard. Unemployment in LA County began the year at 9.5%, and would eventually rise, peaking around 10.7%. Worse, the LAPD as headed up by Chief Daryl Gates was outrageous by any standard, and extremely controversial in its paramilitary tactics. The riots began as a reaction to the King verdict, but soon degenerated into looting. For those of us who saw everything up close—from fires lapping at buildings in Mid Wilshire, to the daytime looting events on the La Brea and Melrose corridors, to the eventual arrival of the National Guard—it was as though the painful recession and the accumulated excesses of the LAPD all came together in a single week. That historical flashpoint, in my view, offers the best context to understand what’s happening right now. With one difference. This time, the dynamics are more fully national, on a much larger scale.
—Gregor Macdonald, editor of The Gregor Letter, and Gregor.us
Photos: 1. Greenwich Village looking south to the World Trade Center, New York, 2015, Gregor Macdonald. 2. Sixth Street Viaduct Replacement Project, Los Angeles, 2018, Gregor Macdonald.
The Gregor Letter is a companion to TerraJoule Publishing, whose current release is Oil Fall. If you've not had a chance to read the Oil Fall series, the single title just published in December and you are strongly encouraged to read it. Just hit the picture below.