It doesn’t happen often, but every now and then, when I get into my car in the morning, the tire pressure warning light comes on. My normal procedure when this happens is to stop by the gas station, fill the tires to regulation pressure, and go about my day. If, however, the warning light comes on again the next morning, it’s a job for the dealership not the gas station. There’s no point in pumping air into a leaky tire.

Economic data over the next few weeks will likely underscore the depth of the recession and provide a warning that a full recovery is still far from being achieved. Negotiators from the White House, Senate and House of Representatives will debate the next round of federal relief, commonly referred to as “stimulus.” However, for investors, it will be important to keep an eye on the pandemic itself. It is the pandemic, rather than any lack of stimulus, that is holding the economy back. While the stock market has remained remarkably resilient in recent months, it may be vulnerable to a correction, given the short-term risk that the recovery will peter out and the long-term consequences of all the stimulus being pumped into the economy in a rather inefficient effort to prevent this. However, while this suggests caution with regard to a simple long-only U.S. equity strategy, valuation anomalies created by the global pandemic also provide opportunities for long-term investors.

V Interrupted
The most widely followed data over the next week should provide little additional clarity to the economic picture, although they should show some continued recovery in existing and new home sales and a potential further small decline in initial unemployment claims. However, data from last week give a better read on economic momentum in the middle of 2020. 

In particular, the retail sales report for June showed considerable strength, with total sales rising by 9% following an 18% surge in May. Remarkably, retail sales have almost entirely recovered from the pandemic slump, going on a round-trip from up 5% year-over-year in February, to down 20% year-over-year in April, to up 1% year-over-year in June. 

However, the details of the report highlight the distorting impacts of both the pandemic and government stimulus. In June, year-over-year sales at restaurants and bars and at clothing stores were still down more than 20% while sales at food and beverage stores, hardware and garden stores and on-line were up by 12%, 17% and 24% respectively. This does suggest, to some extent, that if you put money into consumers’ pockets, they will spend it, albeit on a different basket of goods and services than in a pre-pandemic economy. 

That being said, in a pandemic economy, stimulus alone cannot trigger a full recovery. Even with the retail sales rebound, we believe overall real consumer spending was likely down by more than 5% year-over-year in June, as leisure, entertainment and travel services remain very hard-hit by the pandemic. In addition, we expect an economic drag in the months ahead from lower investment spending. As we show on page 27 of our Guide to the Markets, there is a very strong relationship between economic uncertainty and capital spending. To state the obvious, economic uncertainty is extraordinarily high right now, even eclipsing levels at the worst of the financial crisis. Government spending will also likely drag on the economy as many state and local governments will be forced to cut payrolls to balance budgets in reaction to the deep recession and lack of sufficient federal government aid. Consequently, while we anticipate a roughly 20% annualized bounce-back in real GDP in the third quarter, following a mammoth 35% annualized slide in the second, this would still leave real GDP down 7.5% year over year in the third quarter, with much slower future progress in advance of the widespread distribution of a vaccine.

This “V-interrupted” pattern should be evident in employment and profits also. The July jobs report, due out on Friday, August 7, should see much slower job gains than in June as some continued reopening is offset by the layoff of workers temporarily retained by small businesses as a condition of PPP funding. Moreover, the unemployment rate itself could rise due to a gradual fading of classification issues that have suppressed measured unemployment in recent months. If this transpires, the unemployment rate will remain well above 10%, with no easy way for restaurant, hotel, travel and entertainment workers to find new jobs. Unemployment claims, due out on Thursday, should provide further clues on this.

Through last Thursday, 42 of the S&P 500 companies had reported second-quarter earnings. While 76% of these have surprised on the upside with regard to earnings (which is a fairly normal percentage), blending actual numbers on those that have already reported with analyst estimates for the rest suggest a very sharp 44% year-over-year decline in operating earnings per share. Perhaps more importantly for markets, as the earnings season continues, more firms should provide guidance on future earnings, which is likely to be pretty negative. If this happens, it should become evident in the week ahead, as another 92 S&P 500 companies are expected to report their numbers.

The Washington Stimulus Game
Clearly, the next round of coronavirus aid should have an impact on both economic activity and corporate profits, and negotiations should begin in earnest this week as the Senate returns from its July 4^th recess. Even in a highly polarized environment, it is likely that a bill will be passed as neither political party will want to be blamed for sinking a bill containing much-needed relief. That being said, negotiations are likely to stretch into early August rather than be wrapped up in July.

Considering what appear to be the true priorities of the Administration, Senate Republicans and House Democrats, the final legislation could include:

• Further one-time checks to individuals, although likely phased out at a lower income threshold than in the first go-round. 

• An extension of enhanced unemployment benefits into early 2021, but at a significantly lower level than the extra $600 per week in the CARES Act.

• Some redirection of unused PPP money to a revised program generally targeting companies that have seen a substantial revenue decline.

• Some additional aid to state and local governments, although far less than the $1 trillion+ included in the House’s version of the next stimulus package, passed in May.

• Some additional aid for school reopening.

• Some liability protection for businesses making good faith efforts to follow public health protocols to avoid the spread of the virus.

The price tag for the overall bill would could come in between $1 and $1.5 trillion, added to a national debt that has already grown by over $3.3 trillion this year. Moreover, realistically a further bill will likely be needed after the November election.

The Leak In The Tire
Of course, both the potential fading of the economic recovery and the need for further massive stimulus springs from the growing spread of Covid-19. In just the six weeks, as we show on page 20 of the Guide to the Markets, the seven-day moving average of new confirmed cases has jumped from just over 20,000 to just over 60,000. Mortality rates have fallen, largely due to the changing demographics among those getting infected. However, sadly given the surge in cases, the daily death rate now looks likely to return to 1,000 or more within the next few weeks.

This resurgence of the disease is slowing, stalling and, in some cases, reversing, the staged reopening of the economy and will likely continue to hobble the restaurant, hotel, travel, entertainment and retail industries. Moreover, the uncertainty about when the pandemic will finally subside will slow investment, hiring and lending decisions across the economy. In addition, investors are aware that the money being spent to pump stimulus into the economy today must inevitably lead to higher taxes in the future.

This outlook contrasts with the still buoyant U.S. stock market, with the S&P 500 nearly unchanged for the year and it does suggest a risk of a correction. However, there clearly are still opportunities for long-term investors.

• First, as has been the case since the start of the pandemic, it still looks like 2021 will be a year of recovery for the economy and corporate earnings. This suggests the need to hedge against equity volatility in the short run while maintaining equity exposure to take advantage of an economic surge once Covid-19 has been tamed.

• Second, there are growing divergences within equity valuations and dividend-paying stocks in sectors that are less exposed to the pandemic look attractive for income-focused investors, particularly in an environment of still very-easy monetary policy.

• Finally, there are many countries around the world, particularly in East Asia, and more recently in Europe, that have done a better job in corralling the virus. This should allow their economies to continue with a phased reopening, with less damage done to their economies and public finances. For those who are underweight international equities, this may be a good time to consider increasing exposure to companies than can benefit from economic revival in these countries. 

David Kelly is chief global strategist at JPMorgan Funds.