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.