Patterns Of Recession
In the early days of her marriage, my mother tried to achieve the almost impossible goals established by society for a 1960s wife. Apart from tending to the needs of my somewhat Victorian father, she did her best, on an inadequate allowance, to keep herself and a growing family fed and clothed. Dutifully following the dubious home economics doctrine of the time, she would stew up great vats of jam and made some attempts at growing vegetables in the back garden. In addition, rather than buying a new dress, she would often make one herself, picking up a pattern and fabric at some store in town. The pattern was printed on tracing paper, and she would lay it out on the carpet, and then set to work with scissors and pins.

The whole process was very mysterious to me as a child, (as it still is now), but I remember vaguely thinking that the dress-pattern business was a bit of a racket. After all, my mother was a certain shape. Why would you need all these different patterns to fit her? But different they all were, and each dress presented a new challenge to my mother, which she met with youthful energy and her characteristic enthusiasm. 

Since the onset of the COVID-19 crisis, one of the most frequent questions I have been asked is about the pattern of this recession. Most typically, I’m asked to pick a letter.  Is it “V-shaped,” “U-shaped” or “L-shaped”? Given these crude choices, the answer is pretty straightforward—it is “U-shaped.” That is to say, the economy has fallen into a deep recession, will remain in very bad shape until the distribution of a vaccine, and should then see a surge in activity.

However, it is becoming increasingly clear that none of these letters does an adequate job of characterizing the likely shape of this experience. Because of the severity of the initial shutdown and the attempts to partially reopen, a more accurate description would include a slump, a bump, a crawl and a surge. Moreover, while this pattern is likely to be repeated across output, employment, profits and inflation, it will look a little different across each of these variables. For financial assets, as with my mother’s dresses, it is these differences in patterns that will make all the difference in outcomes.

A Pattern For Growth
The extent of the initial GDP slump should be further clarified by data due out this week. First quarter real GDP may be revised to show a slightly milder loss than originally reported. However, the second quarter will be epically bad.

Consumer spending may have fallen even more in April than in March, with widespread losses across discretionary goods, restaurants and a host of leisure, entertainment, travel and personal services. That being said, the last few weeks have seen a partial reopening and this, combined with the impact of stimulus checks distributed in April and May, should allow for a substantial bump in consumer spending in the third quarter. Thereafter, however, recovery should slow due both to the difficulty in supplying consumer services while observing social-distancing protocols and a lack of demand caused by health fears, cancelled events and the uncertainty caused by a deep recession. It will only be in the aftermath of the widespread distribution of a vaccine, hopefully in the first half of 2021, that consumer spending can begin to surge back to pre-recession levels.

Home building, likewise, will probably rebound in the third quarter following a second-quarter slide, as most construction workers resume activity with some social distancing rules in place. However, the housing market is likely to be soft throughout the recession due to economic uncertainty, health fears among buyers and sellers and weak demographics.

Business fixed investment is also taking a hit, as will be evidenced by Thursday’s durable goods report. As with consumer spending, this partly reflects supply difficulties. However, beyond this, investment spending will be battered by falling global trade, low oil prices (reducing the demand for energy infrastructure), weak demand for transportation equipment and economic uncertainty. While this recession didn’t start with a capital spending slump, the weakness in investment spending could take a long time to dissipate.

The health-related shutdown and reopening of manufacturing, both in the U.S. and overseas, could also accentuate the slump and the bump in the forecast, with inventories falling very sharply in the second quarter and then bouncing higher in the third.

Government spending looks like it will be weak throughout the next two years. The CAREs Act included $150 billion for state and local governments, though earmarked for spending incurred due to the COVID-19 emergency. However, even if this money were used to fill general budget shortfalls, it would still fall woefully short of their needs. In the recession of 2007-2009, which was less than half as deep as the current one, state and local government revenues, excluding federal grants, fell by 6.8%. A proportionate decline in revenues this time around, combined with higher social spending, would leave state and local governments hundreds of billions of dollars in deficit, requiring massive layoffs. Even if state and local governments receive some further help from additional federal relief, it is unlikely to prevent massive cutbacks and layoffs throughout the rest of 2020 and 2021.

Finally, both exports and imports of goods have been hit by the pandemic, as should be made clear by the advance economic indicators report, due out on Friday. However, trade may well prove to be a drag on the U.S. economy throughout this recession since travel and transport services, in which the U.S. traditionally runs a surplus, will likely remain moribund until a vaccine is distributed globally. The facts that the U.S. recession is being accompanied by a global recession and that “safe haven” status has boosted an already over-valued dollar by another 3.5% year-to-date, should further squash trade as a source of demand growth.

So how does this all add up? While acknowledging the heightened uncertainty of any projection at this time, one possible path could have real GDP fall by roughly 35% annualized in the second quarter following a nearly 5% decline in the first, then bounce by about 15% in the third quarter and climb 5% in each of the next two quarters before rising by 8% in the second quarter of 2021 and roughly 10% annualized in the subsequent two quarters and at a similar pace in early 2022.

A Pattern For Employment
In this scenario, and looking at the numbers in absolute rather than annualized terms, real GDP falls by 11.4% between the fourth quarter of 2019 and the second quarter of 2020. This would far eclipse the 4% drop in real GDP seen in the Great Financial Crisis. Even with this, the employment collapse is likely to be greater. 

The May employment report, due out on Friday, June 5^th, could show a further roughly 3 million job loss on top of the 21 million jobs shed between February and April. If this transpires, and May proves to be the low point for employment in this recession, then the peak-to-trough job loss would be roughly 16%. 

Thereafter, however, job growth could turn positive. 

The monthly employment report always refers to the week that contains the 12^th of the month and, in early May, many businesses were just beginning to reopen. This, on its own, would trigger an employment bounce in June. However, these gains could be suppressed by state and local layoffs and the expiration of incentives for small businesses to hang onto workers even as enhanced unemployment benefits discourage many from trying to return to work. We assume that the next federal aid package will continue some form of unemployment bonus payments and will not provide nearly enough funds to help states and localities avoid further cutbacks. 

If this is the case, then while payroll employment could fall by 15% in absolute terms in the second quarter from its first-quarter peak, its third-quarter rebound would be a much more modest 1% and employment growth would only average 2% per quarter in the following three quarters followed by 3% quarterly gains in the second half of 2021. 

The data will likely look even worse when it comes to the unemployment rate. The 14.7% reading for April, while the worst since 1940, still severely undercounted unemployment because of former workers who misclassified themselves as being either still employed or out of the labor force entirely. We expect this to be partly rectified in employment reports over the next few months, which could push the unemployment rate above 20%. Thereafter, the same forces slowing a rebound in employment should keep the unemployment rate high and it is possible that it will still be in the mid-teens by the end of 2020 and above 10% by the end of 2021.  

A Pattern For Profits
At first glance, the outlook for corporate profits should be absolutely dire. On average, in the 11 recessions since 1947, real output has logged a peak-to-trough decline of 2.2%. However, profits are much more cyclical than the economy overall and nominal adjusted after-tax profits have fallen by an average of 17.1% in the associated profit recessions. (It should be noted, however, that the dates of the profit recessions and output recessions don’t line up exactly, with profits tending to peak an average of two quarters before and trough one quarter before the associated economic recessions.)  Given this relationship, and a possible greater than 11% peak-to-trough fall in real GDP, it would seem possible for profits to turn negative for one or more of the upcoming quarters.

However, it is likely that profits will avoid this fate for a number of reasons. 

First, a bigger fall in employment than output should lead to productivity gains that could mostly accrue to corporations.

Second, losses in the financial sector, which accounted for much of the 2007-2009 profit slide, should be much milder this time around. Home prices are holding up, as should be confirmed by the Case-Shiller data due out on Tuesday, while a high personal savings rate, low interest costs and the cash infusion from the federal government should mitigate consumer distress.

Third, the most important sectors for corporate profits are different from the most important sectors for output and employment. In particular, in the fourth quarter of 2019, consumer staples, health care, financials, technology and communication services accounted for over 76% of S&P500 operating earnings. These sectors, with the exception of financials, should be able to ride out the social distancing recession without significant profit declines.

This being said, profits will likely fall much more than real GDP in the second quarter before rebounding more sharply in the third. Thereafter, assuming that high unemployment limits wage gains and interest rate hikes in 2021 and 2022 and that the dollar slips even as oil prices recover, profits should recover at a rapid pace, potentially setting a new, all-time high in 2022. However, it should be noted that this projection depends, not just on these hard-to-predict economic variables but also on politics. At some stage, the federal government will have to grapple with the extra debt it has incurred in recent months and, if part of the answer is increasing corporate taxes or reducing tax breaks, profits would clearly be vulnerable.

A Pattern For Inflation
Finally, there is a pattern for inflation. Inflation is a lagging economic variable and normally hits its lowest point well after a recession is over. It is also worth noting that, in the aftermath of each of the four recessions since 1982, year-over-year core CPI inflation has hit a lower trough, reaching just 0.6% year-over-year in October of 2010.

However, inflation may prove a little more recession-proof this time around for a few reasons. First, the pandemic recession has caused some goods and services to be in limited supply and shortages of various food items and household goods have caused some bidding up of prices in these sectors. Second, big price declines in areas such as lodging, restaurant meals and air travel may not stick, since companies have to incorporate the extra costs of doing business in a socially-distant way. Third, direct payments and enhanced unemployment benefits for consumers could allow many sellers to maintain or raise their prices more than would normally be the case in a recession. Finally, surging money supply indicates that both consumers and corporations have significantly more liquidity available than would be expected in a recession of this magnitude.

Consequently, while core consumer prices fell by 0.4% in April and could well be flat in May, they should stabilize in coming months, even as the economy continues to grapple with a deep recession. Headline inflation, which is dipping more in the short run due to low oil prices, could rebound a little more strongly in the months ahead. In summary, inflation will likely see the least accentuated pattern of the key economic variables in this recession and recovery and could begin to heat up as the economy accelerates later in 2021.

Investment Implications
For investors, perhaps the biggest surprise of this extraordinary recession is that equities are not down more. As we’ve noted before, this is, to some extent justified by the sectoral concentration of U.S. equities, the potential for a sharp profit bounce following the distribution of a vaccine and a very easy monetary policy which has left long-term interest rates at unattractively low levels. 

This being said, markets may still anticipate a sharper near-term recovery in output than seems likely to occur and analyst earnings estimates for 2020 and 2021 still look too optimistic. Because of this, and because of the extraordinary medical, economic and political uncertainty caused by this pandemic, investors should still probably maintain a relatively defensive and very diversified posture until the many patterns of this recession become a little easier to discern.

David Kelly is chief global strategist at JPMorgan Funds.