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.