Jon Manchester, CFA, CFP®, Senior Vice President and Portfolio Manager – Sustainable, Responsible and Impact Investing

June 30, 2020

COVID ContractionThe longest U.S. economic expansion on record came to a rather sudden end in February, undone by the hard frost of stay-at-home directives. The National Bureau of Economic Research (NBER) declared the expansion over after a gaudy 128 months: eight months longer than the prior record dating back to 1854 and double the average length of economic expansions since World War II.

It didn’t appear to be a particularly challenging call for NBER due to the severity of the downturn. Consumer spending—the domestic economy’s growth engine— sputtered in March (-6.9%) and wouldn’t start in April (-13.6%). The official U.S. unemployment rate spiked from 3.5% in February to 14.7% in April, its highest level since the Great Depression, and even that may have understated the payrolls problem. Millions of workers had their hours reduced, taking the “under-employment” rate up to 22.8%. At the aggregate level, U.S. Real Gross Domestic Product (GDP) sank 5% annualized in Q1, and will no doubt confirm the recession declaration when the second quarter numbers roll in. Although steadily improving, the New York Federal Reserve’s estimate for Q2 U.S. GDP “growth” stood at -15% as the third quarter got underway.

COVID-19 has left its crown prints all over the globe, of course. The employment picture appears brighter in other developed economies, although various structural and cultural impediments to layoffs arguably casts that picture in artificial light. In the eurozone, the un- employment rate edged up to 7.3% in April. This was helped considerably by the fact that France, Germany, and other countries have subsidized the furlough of millions of workers. In April, for example, about 2.6 million Germans were officially unemployed, but another 10 million were furloughed and didn’t count as unemployed.(1)

Somewhat flattering job statistics aside, the eurozone suffered a 3.6% Q1 GDP decline, and the International Monetary Fund (IMF) is projecting a 10.2% contraction for 2020 in full. The European Central Bank (ECB) has responded aggressively, including offering a borrowing rate of -1% to commercial banks if passed along to businesses and consumers, or -0.25% with no strings attached.

Consumer spending—the domestic economy’s growth engine—sputtered in March and wouldn’t start in April.

Meanwhile, in Japan, the unemployment rate in April shot up to… 2.6%? This despite a 2.2% annualized Q1 GDP decline, which followed a steeper 7.1% slump in the fourth quarter of 2019. The discrepancy between Japan’s rather rosy employment data and other major economies can be partly explained by the “social contract” whereby Japanese companies are more or less expected to retain workers permanently. Social media in Japan reportedly erupted in March following the evidently controversial news that companies had rescinded job offers to 21 recent graduates because of the pandemic.(2) Demographics certainly play a role as well, with a fairly tight labor force resulting from the world’s oldest population. Although Japan’s employment outlook may remain relatively sanguine due to these factors, generating economic growth may continue to prove elusive. Japan has only managed >2% annual Real GDP growth once since 2010, with three of the last four years at sub-1%. The Japanese government is throwing yen at the problem: roughly the equivalent of $2.2 trillion in stimulus spending to combat the recession and pandemic, or a staggering 20% of GDP.

Indebted to the FedWith large swaths of the global economy on ice, policymakers have been exceedingly busy attempting to bridge the numerous fissures opened up by this pandemic. In total, fiscal stimulus measures of around $11 trillion have been announced worldwide.(3) COVID-19 appears to have arrived at a fairly inconvenient time— not that there is a convenient time for a global health crisis—given that a number of government balance sheets were already stretched. In the U.S., federal debt held by the public soared during the credit crisis and its aftermath, and has only drifted upward since, moving north of $17 trillion or approximately 80% of GDP in the first quarter of 2020. Those numbers will clearly continue higher this year, and it is worth noting that when intra-governmental debt (i.e., Social Security) is included then federal IOUs already exceed GDP.

Before we press the panic button, there are a couple of interesting twists to the federal debt story. The Federal Reserve (the Fed) has committed to buying essentially an unlimited amount of Treasury bonds, and Morgan Stanley estimates the central bank may purchase $2.5 trillion worth in 2020 alone.(4) When Congress approved the $2 trillion CARES Act in late March, therefore, it already had a ready buyer to fund the spending. Further, by law, the Fed has to pay its profits to the Treasury. You can see where this is going: the Treasury pays the Fed interest on the bonds, but eventually nearly all the money ends up back with the Treasury. As Stony Brook University economics professor Stephanie Kelton puts it: “Once the central bank buys them, it’s as if the Treasury never issued them in the first place. For all intents and purposes, they’re retired.”(4) A bit of accounting magic, perhaps, but also a pretty big advantage of being able to print your own money – as long as inflation remains contained.

The second twist is simply that borrowing rates are astoundingly low. In May, the U.S. Treasury issued 2-year notes at 0.178%. It borrowed $32 billion at 0.70% for ten years. The Treasury even issued 20-year bonds for the first time, and is paying 1.22% on that debt. Needless to say, it’s an extremely undemanding interest rate environment for the government; meaning that this fairly compelling affordability story may encourage borrowers across the world to continue extending credit to Uncle Sam.

Buying TimeThe massive fiscal and monetary fireworks show around the globe is meant to bend the economic curve, in a sense. Similar to the concept of flattening the COVID-19 curve via social distancing, policymakers are trying to buy time for economies to recover and normalize. There are some signs it’s working. Domestically, the employment report indicated 2.5 million jobs were added in May, and another 4.8 million in June, taking the official unemployment rate to a still elevated 11.1%. Retail sales jumped nearly 18% in May, and durable goods orders rose more than expected. These reports have buoyed the “V recovery” crowd that argues for a quick reversion once the economy reopens. Goldman Sachs analyst Jan Hatzius speculates this could be the shortest U.S. recession ever, envisioning a strong Q3 rebound; but he does express concern that we are now a clear under-performer on virus control.

Others are more skeptical, believing a “U” or maybe “W” shaped recovery is more likely. The Fed itself is cautious and expects to maintain the Fed Funds target rate near zero through at least 2022. That should be supportive for markets, but the economic impactis less clear given we’ve been in a low interest rate environment for most of the past decade. The best bet might be that economic growth will experience fits and starts until we have an effective vaccine or at least a proven therapeutic drug that definitively short circuits the most adverse outcomes. Until then, economic activity may misfire for stretches, running below potential. A certain portion of business is able to shift online, but U.S. retail e-commerce sales still only accounted for ~12% of total sales in the first quarter, according to the Commerce Department. In the meantime, some companies have fallen by the wayside: Hertz, J. Crew, Neiman Marcus, Chesapeake Energy, and others have filed for bankruptcy.

The IMF estimates the “Great Lockdown” will inflict a cumulative loss of over $12 trillion to the global economy during 2020 and 2021. A big question is how long it will take to fully recover. The Congressional Budget Office (CBO) projected it will be 2030 before the U.S. economy returns to its inflation-adjusted, pre-pandemic level. Following the Credit Crisis, it wasn’t until 2017 that the U.S. unemployment rate declined to pre-crisis levels. In other words, patience may be required for those expecting a near immediate return to normalcy.

The U.S. economy is innovative and resilient but faces additional challenges, including our own demographic headwinds and widening wealth disparities. This health crisis has exacerbated some of these structural economic deficiencies. According to a recent Barron’s cover story, around 40% of the people who have lost their job during the pandemic were earning less than $40k per year, compared with 13% of those earning $100k or more.(5) Fed Chairman Jerome Powell acknowledged the downturn “has not fallen equally on all Americans.”(6)

Further fiscal support is likely—targeted to those most in need—with the hope that we can buy enough time to navigate this latest “new normal” iteration and emerge stronger on the other side. Until then, thank the nearest health scientist and/or epidemiologist, for it’s their work that will ultimately allow the global economy to shift into a higher gear.

1 “European Slump Is Worst Since World War II, Reports Show,” www.nytimes.com, 4/30/202 “Why Japan’s Jobless Rate Is Just 2.6% While the U.S.’s Has Soared,” www.nytimes.com, 6/20/203 “IMF Projects Deeper Global Recession on Growing Virus Threat,” www.bloomberg.com, 6/24/204 “How the Government Pulls Coronavirus Relief Money Out of Thin Air,” www.nytimes.com, 4/15/20

5 “Why the Widening Wealth Gap Is Bad News for Everyone,” www.barrons.com, 6/19/206 “Semiannual Monetary Policy Report to the Congress,” www.federalreserve.gov, 6/16/20