Q2 GDP: The Worst In 74 Years


Like Demobilizing From A World War

BEA’s quarterly GDP data only goes back to 1947, which is unfortunate, because 1946 is where we would find the closest analogy to what is happening right now.

During World War II, the entire US economy had become highly dependent on a single customer: the Federal government, and mostly the Department of War. Coming out of the Great Depression, the economy blew up as war bonds funded a huge industrial buildup, and there was plenty of labor demand both military and civilian.

The war in Europe ended in 1944, and demobilization began, slowly at first. 1945 was a poor year economically, and the Pacific war ended that August, accelerating demobilization.

Hundreds of thousands of military personnel were suddenly unemployed. Industry lost their best, and in many cases only customer. The economy tanked. Here’s what that looks like on a chart:

The US economy contracted by 12% in 1946. The worst on record is 1932, when the economy contracted by almost 13%. Since 1947 the worst quarter was Q2 2009 when the real economy contracted at 3.9% YoY. Q2 2020 blew that away:

In Q2, real GDP contracted by 9.5% YoY; almost one tenth of output vanished. Nominally, GDP declined 10% QoQ.

The only real historical analogy for what is going on is demobilizing from an all-consuming world war — a huge exogenous shock to employment and demand.

But I find it helpful to compare everything we’re experiencing to the GFC, because most everyone reading this is old enough to remember it well.

A long way.

Nominal Versus Real

I looked at real GDP in the intro, mostly to account for the extraordinarily high inflation rates in the 1940s, but that’s the last we will be looking at real numbers. In current circumstances, it’s hard enough to get the nominal numbers right, let alone figure out how to deflate them. Indeed, we are seeing very large revisions all over the data already, and there will be more to come. So we will look at prices separately.

But in general, for current numbers the same caveat applies to all of it: the data quality is unusually poor right now, and there will be unusually large revisions.

Also, all numbers are not annualized unless noted.

Finally, my apologies for the length of this article. History happens infrequently, and this is the first draft. To anyone who reads every word: I salute you.

How -10% QoQ Happens

There are three very large differences between 1946 and 2020

  1. 1946 involved a shock from reduced government spending, while in 2020 government spending is trying to fill the hole in consumption left by the pandemic.
  2. The Fed.
  3. Services were not nearly as important to the report as they are in 2020.

We’ll get to the other two later, but services are going to keep coming up, because they drive every report in some way, never more so than Q2.

So we see two trends:

  • Personal consumption has gone from under 60% of GDP in the late 1960s to almost 70% now.
  • Within that, services dominate, accounting for two-thirds of PCE, and almost half of all GDP, up from 25% in the late 1940s.

Part of the reason 1946 was so bad was because the goods economy had to shift from one customer to hundreds of millions of customers, few of whom wanted or could afford a tank or bomber. But the goods economy is not nearly as important now.

What we will see in 2020 is a group of services with high fixed costs that make up for it by packing them in at peak demand times — transportation, recreation, travel, food — that are down considerably. Some categories, like live sports and entertainment, are down 100%. So how does -10% QoQ happen?

61% of the decline in GDP came from services. Digging into the main subcategories:

So a few things here:

  • The good news is that almost a quarter of the loss in GDP came from health care, and it’s easy to see a recovery happening in that sector.
  • But the bad news is everywhere else. Housing is the other giant category that can move the whole report by itself, and as you can see, it increased modestly in Q2. But we are starting to see signs that this may have begun to roll over in July and August.
  • The really bad news is in the middle three boxes: transportation, food/accommodations and recreation. Together they accounted for 35% of the reduction in GDP growth, and it’s very hard to see a recovery in these areas absent a safe, effective vaccine.

So we see a grim landscape in a wide swath of the economy.

Let’s start at the top, with income.

Income and Saving

Income tables are conveniently monthly, so we can dial our analysis back to the beginning of March.

This is been the largest shift in household balance sheets in history. Benefits vastly exceeded income loss, and between that and reduced consumption and taxes, households have saved an additional $943 billion versus the February TTM average. The personal savings rate is at an all-time quarterly high:

Not even close anywhere. How does that happen?

So cumulatively versus the February TTM average, by the end of June:

  • Households earned $225 billion less,
  • But received an additional $693 billion in government benefits, exceeding income loss by $414 billion.
  • But households also consumed $473 billion less,
  • And paid $40 billion less in taxes.
  • Consequently, households saved an aggregate of $943 billion.
  • Of which, they paid off $99 billion in revolving debt through May (not in chart).

These are just stunningly large numbers. What happens to that savings bubble is the key issue for the economy going forward.

The biggest issue is how that savings is distributed, and we really don’t have a good answer to that yet. Most likely, this bubble is highly skewed towards high-earners who did not lose their jobs, but don’t have a lot to spend money on right now.

The reason that this is important is that while all that cash is just sitting in bank accounts, this is not a stimulus, just rescue. We need to see that savings bubble become more consumption in order for it to be stimulative. Whatever portion that savings bubble is held by low-earners, it will likely all go into consumption throughout the rest of the year to make up for income loss. That is stimulative in a deflationary environment like we are in now.

But if it is largely held by high-earners, that cash likely stays where it is in the short-term, and will not be stimulative. My fear is that the bubble is heavily weighted towards the top end, but we really don’t know.

Consumption

Remember, this is over two thirds of GDP, so it’s where most of the action is. In Q2, consumption was down over 10% in the QoQ and the YoY. But like with income, we get monthlies here, so we can dial back to the end of February.

But like so many charts, the Y-axis is destroyed in quarterly PCE QoQ.

We’ll start with goods, where all the good news is. In the QoQ, goods consumption was down 4.5%, but this is masking the rapid monthly changes.

As you can see, all the aggregates are now up from February levels. The recovery has come in some of the worst hit portions — household durables. Most of the subcategories are well up from February levels by June, as purchases delayed in March and April are made in May and June.

In fact, if we strip out the huge deficit in energy, the goods economy has almost taken out all the cumulative losses of April.

So there is a bit of good news being obscured by the monthly average. But still, with energy included, there is $52 billion in lost revenue in the goods economy, $44 billion of that just energy goods, and $43 billion of that just gas and diesel. The losses in energy were offset almost exactly by groceries, up cumulatively by $46 billion. The oil business has a long road back, but the rest of the goods economy came out of June in decent shape.

One dark spot in the silver lining is clothing, which is really still taking it on the chin. Though nowhere near the depths of April, clothing is still down almost 8% from February to June, with an accumulated revenue deficit of $39 billion. This is sort of piling on for the whole industry, which had been experiencing poor sales and high inventories through 2019. They were just beginning to get on top of it when COVID hit.

Like energy, they have a long road.

Turning to services, this is where most of the bad news in the report is. Looking at the accumulated losses, they are giant and continued to grow in June.

Housing and health care are the big dogs in services, so big they can move the entire report by themselves. In 2019, they were 35% of all consumption, and 24% of all GDP. They are going in opposite directions through June.

While housing PCE is growing just a little more slowly than usual, health care is way off, still down 13.5% from February, though up 42% since April, so it took out 65% of the monthly deficit by June. But the accumulated revenue deficit is $173 billion through June, 41% of the total services deficit. They have a long way to get back to zero.

But the good news is that it is easy to imagine that health care can rebound, even in the absence of a safe effective vaccine. A lot of that deficit is deferred checkups, and voluntary procedures that will eventually be performed.

Housing is a different story. Via deferrals and government benefits, both renters and mortgage holders have been able to keep up with payments. But when we look at the high frequency alternative data, that looks like it may be coming to an end in July and August.

But the biggest problems are in transportation, recreation, food, accommodations, and a bunch of smaller services grouped in “Other”. These are the high fixed-cost businesses that we discussed earlier. In 2019, these were 23% of all PCE and 15% of all GDP. Together, they had an accumulated revenue deficit from March to June of $350 billion through June, or 83% of the total services revenue deficit.

In the quarterly numbers, these services accounted for 46% of the total nominal QoQ reduction in Q2 GDP. These are the key business that will make or break the recovery

As bad as it is, we have seen a little recovery from the depths of April, but there is still a long way to zero.

Let’s dig into each one of these and see why recovery is going to be so difficult here.

Starting with transportation, which looks to be in real trouble absent a safe effective vaccine.

There are large deficits that have accumulated in these four subcategories. Moreover, with the exception of vehicle services, a robust recovery does not seem to be in the offing:

Citigroup (C.PK) CEO Mike Corbat framed this situation pretty well in their earnings call:

And when you get to… normalization, and simply put normalization to me is am I willing to get on the airliner? Am I willing to get in a subway? Am I willing to go into a crowded venue to watch a sporting event or a concert or what it may be?

He was speaking generally about the economy, but notice the first things he mentioned are transportation services. The other things he mentioned are recreation services, where there is a $92 accumulated billion revenue deficit.

This is where we see the hardest hit categories by percentage, with movie theaters and live sports still down 100% in June.

Sports clubs and casinos have had the best recoveries here, but still nothing to write home about. “Am I willing to go into a crowded venue to watch a sporting event or a concert or what it may be?” The answer for most people will be “no” until there is a safe effective vaccine.

Food services are hugely important for two reasons. In the first place, it was almost 4% of all GDP in 2019. But this Friday, we get July jobs, and the largest block of remaining unemployed in June was still restaurant and bar workers. So recovery here is not just important for the top line GDP number, but also how employment and host of other things work out.

What we are seeing is that by June, though there are still very large cumulative losses, fast food restaurants actually brought their deficit down in June.

If the lines at drive-thru in my neighborhood are any indication, the September quarter is going to be good for fast-food restaurants, as people tire of their own cooking, but still can’t go out for a full service meal.

But the big issue for both GDP and employment is those full service places, with $46 billion in accumulated revenue losses, and still growing. We’ll talk more about that when we look at the high-frequency alternative data.

A final thing on food services. Mostly what you pay for in food service is the service, not the food:

Accommodations look very similar to our recreation categories:

Hotels continue to pile up losses, and school housing, like meals, are up in the air right now. Another one with a long road back to zero:

Finally, the Other category is pretty large and contains lots of types of business, so let’s focus on just a few:

The two foreign travel categories will not be getting much better any time soon, especially with US residents banned from most countries right now.

Also seeing very large losses that will not be turning around significantly are personal care services — hairdressers, manicurists, etc. Many of these businesses are closed right now and may never reopen.

Education and professional services (to households, not businesses), have recovered more, but still have a lot of lost ground to make up.

In case you were wondering, the foreign students that the President wanted to kick out of the country stimulated the economy to the tune of $44 billion in 2019.

One service that has done well through this is delivery:

In services, the silver linings are in millions, not billions

So, to sum up:

  • The biggest story in goods is collapse of energy consumption, offset almost entirely by groceries.
  • Pulling out food and energy, goods finished June higher than February on the back of a surge in household durables demand.
  • But companies in the goods economy still have $52 billion in lost revenue to make up.
  • Services are where the real troubles are with $421 billion in accumulated losses
  • Health care is the single biggest contributor there, with $173 billion in accumulated revenue losses. It’s easy to see this sector recovering.
  • Housing remains the big dog that hasn’t barked yet.
  • But there are a group of services with high fixed costs that make up for them with density and volume at peak demand — transportation, recreation, food, accommodations, personal care and foreign travel — that are not recovering well. These services comprised 15% of GDP in 2019 and had a $350 billion revenue deficit that is growing larger every month. Almost half of the nominal QoQ GDP loss was these services. This will be the toughest part of the recovery.

Prices

The data quality is pretty poor all around these days, but I have less confidence in price data than the others. It’s hard enough to get the nominal numbers correct right now. This is where we are likely to see the largest revisions down the road, so treat it all as approximations.

Here we’re going to wind back to January, as prices started moving a month before consumption.

Starting with the major aggregates

Overall, prices were down slightly, but that is masking a lot of rapid changes in the splits.

Goods deflated rapidly, but less so in durables where the demand we saw up top combined with supply chain and inventory issues in some categories to start raising prices.

In nondurables, the net effect of food inflation and rapid energy deflation was slightly inflationary, but that could easily disappear in revisions.

Services, normally inflating at around 2.4% annually, are down to about 1% inflation in the annualized numbers.

Let’s dig in, starting with durables, where the shifts have been remarkable.

By far the largest goods category is vehicles, and we see a big split between new vehicles, where prices are stable, and used vehicles where they have cratered. This is the environment into which Hertz (HTZ) and their creditors are seeking to liquidate their fleet.

I also included three of the home durables categories so you can see some of the unusual price action there. The background is that all these businesses had limp demand and high inventories coming into all this. As you see, appliances and home tools were deflating before any of this started.

Then the initial COVID surge in China messed with their supply chains, and inventories plummeted in February.

Furniture demand collapsed at first, but appliance and hardware demand did not.

So this all gives us context for the inflating prices here. Inventories collapsed in February, but demand stayed pretty steady in appliances and home tools, so those prices rose. When demand rose in May, prices followed, with inventories still tight. But furniture had a tougher road in April, so prices collapsed at first. Look for prices to recover in July and August.

Even rapidly-deflating TVs are seeing their deflation rate come off

Most remarkable of all:

PCE price indexes account for quality improvements, so since it began in 1979, the PC price index is down 99.94%, deflating annually at 16.5%. The last month it registered a positive YoY rate was June 1979, 31 years ago.

After Apple’s (AAPL) blowout Mac and iPad quarter, Tim Cook had color on both sides on the equation:

We expected iPad and Mac growth to accelerate and we saw very strong double-digit growth for these devices this quarter. This remarkable performance came in spite of supply constraints on both products.

Supply constraints plus increased demand equals higher prices.

Moving to nondurables, this is where food and energy are:

Food and household supplies are in great demand as people stay home, and supply chains have been slow to react. Gas has seen decreased demand and bloated stocks. Clothing is the other large category in nondurables, and we already looked their issues with inventories and demand. Prices are reflecting that.

We’re going to skip a full discussion of services inflation, as we are seeing a lot of formula effects in the numbers. What this means as both supply and demand shift so rapidly, the composition of what people are buying is changing rapidly. PCE attempts to measure price shifts in what people are actually purchasing, and when the composition of these categories shifts rapidly, so too can the index, and not always in the expected direction.

The most extreme example here is live sports, down 99.996% since February, but with prices inflating at 7% YoY. What does that even mean? It will likely be a few months before we have a better idea of what is happening here.

Summing up:

  • Overall, prices are down.
  • The two biggest movers in goods were food, rising in prices, and energy, falling fast. They more or less offset each other.
  • Many household durables saw increased demand in May and June, and inventories are depleted from supply chain issues. Deflation is muting, or prices even rising.
  • Services prices were up only modestly, less than usual. There are too many unusual things happening in services to really get a good grip on what the price indexes mean.

Investment and Inventories

Here, we are back to quarterlies. In Q2, nominal investment was down 8.3%. It’s one of the few places matched by previous terrible quarters, like Q1 2009

All the categories outside of IP down were down by double-digits.

In nominal dollars, equipment and structures investment were both down by over $100 billion.

All together, it was responsible for 14% of the reduction in nominal GDP, 1.4 pp. That’s about as much as you will ever see fixed investment move the top line.

Starting with nonresidential structures, all the subcategories were down, but here again, the collapse of the US oil business shows up big

Less than $1 billion of that yellow box is mining, the rest is oil wells. Other big movers in the subcategories:

  • About 40% of the blue box is health care -8.8%
  • Almost all of the gray box is power: -6.4%
  • About half of that red box is lodging: -9.6%
  • Malls: -7.8%
  • Restaurants and bars: -8%

Residential investment was down 11.3%. Single family homes and improvements always drive this one.

I have been expecting this one to recover shortly, but we just got June construction data from the Census Bureau, and it was down 3.6% MoM, a -35% annualized rate. But still, that is better than April and May, both down over 7% MoM, a -62% annualized rate over the 2 months. Hopefully we got a pop in July; this one changes fast.

Equipment investment had a quarter equally as bad as residential investment, down 11.2%.

IT Investment never takes a quarter off, but the rest are down considerably, none more than transportation equipment.

Not much to say here except to highlight aircraft investment, now down 81% since Boeing’s (BA) troubles began in Q1 2019. Talk about long roads.

Finally, IP investment, the least worst. This is a category that typically grows over 5% a year, down 1.1% in Q2.

Again, the silver lining comes in millions.

The most difficult recovery absent a safe effective vaccine is entertainment. It’s pretty much impossible to shoot a movie or TV show with the current level of risk. This also had one of the highest unemployment rates in the last jobs report.

Turning to inventories, destocking took out 1.3 pp of GDP this quarter. The destocking began in February as supply chains in China got hit.

The background here is that in the summer of 2018, wholesalers built up inventories in advance of tariffs, some of which never came. They were anticipating a blockbuster Christmas season, which also never came. By the time demand collapsed in December 2018, it was too late to reverse it, and inventories continued to rise through the first half of 2019.

They were starting to get it together, but you see what happened beginning in February. It looks like there may be more to go. The data only goes through May, so given the GDP report, it looks like that line kept going down in June. It will likely go below the origin before restocking begins.

Summing up:

  • All categories, even the normally very strong IP investment were down in Q2.
  • Oil well construction drove nonresidential structures construction, down 33% QoQ.
  • Single family home construction down 13% QoQ drove the residential line.
  • All the transportation equipment categories got crushed. Aircraft investment is now down 81% since Boeing’s troubles began.

Government

BEA has two ways of measuring how big the economy is, Gross Domestic Product and Gross Domestic Income (GDI). They usually come out to about the same top line number, though the full GDI tables are a couple of months behind. The difference is that GDP counts who’s spending the money and what they are spending it on. GDI counts who’s getting the money. The personal income section of this article comes from GDI, but the rest comes from GDP.

The reason I bring this up is that GDP does not capture a huge swath of government spending. It only counts the things government buys, so it is missing salaries, benefits, and subsidies to industry. Those last two were huge in Q2, but they only get counted in GDP when the recipient either consumes or invests with it. As we have seen, there was not a lot of either going on.

So Federal government consumption and investment — the stuff they buy — was up quite a lot in Q2, by 16.5% QoQ, but that is only $57 billion and added 0.2 pp to GDP. This was offset by state and local consumption and investment, down 8.4%, or $52 billion. The later will remain a small drag on employment and GDP growth for a while.

So GDP and even GDI don’t capture the full extent of what the Federal government and the Fed are doing. Treasury produces a mountain of data and I am still combing through that. Article forthcoming!

But looking at the GDI tables, we see a couple of things. The first is the extraordinary explosion of benefits, subsidies and transfers to states in Q1 and especially Q2.

The transfers to states are mostly expanded unemployment benefits, so you can lump that in with benefits. As you can see, everything besides benefits and subsidies, the blue box, only rose modestly.

The other thing that pops up is that Steve Mnuchin is moving the composition of the debt to the short end to take advantage of the very low rates there.

At the end of Q2, Steve Mnuchin had 19% of the Federal debt in bills, up from 11% in Q1, with an average interest rate of 30 basis points. At the end of June, there was over $26 trillion in Federal debt, and over $5 trillion was bills. $2.9 trillion of those bills, 57%, were auctioned in Q2. The weighted average term is 69 days and the weighted average rate is only 16 basis points.

Despite adding $2.75 trillion in debt in the quarter, of course the all time record, the Federal government still managed to pay $6 billion less in interest. Pretty slick.

Trade

Net trade was basically a wash in the quarter with the decline in exports more or less offsetting the decline in imports. Exports were down 26% QoQ, or $160 billion, and imports down 20% or $148 billion.

Breaking it down a bit:

Mostly a lot of offsetting, but some things to note:

  • Petroleum exports down 54% and imports down 53%.
  • More Boeing: civilian aircraft exports down 56% QoQ and 64% since Boeing’s troubles began.
  • Combined auto trade down 55%.
  • The two travel categories down a combined 75%.
  • The two transport categories down a combined 53%.
  • Even with the increased QoQ agriculture sales to China, food exports are still down.

Pretty much a demolition of trade.

Alternative High Frequency Data

There are all sorts of new data sources, and they all come with big limitations. But they are all telling us the same thing: it looks like the recovery stalled out somewhere in the middle of June

We start with the Census Bureau’s brand new Household Pulse Survey. This is a weekly online survey. The limitation is right in that last sentence. Online surveys, even employing best practices, tend to be a little poor. Also, they only began it the week ending May 22. But still, it’s the Census Bureau, and some of the best survey economists in the world work there.

The employment part of the survey shows that employment peaked in mid June

Moreover, many of those who are counting themselves as employed have shifted from more traditional employment to self employment or working for a family business. It’s unclear how “employed” these people actually are.

What we see is that private, government and nonprofit employment is flat with May 22 again after rising by 5% though mid June. So as of the last report, it looks like about 2.5 million people are have moved from traditional employment to self employment or working for a family business.

The survey also asks about housing, and this is where we see that may be rolling over, maybe this month.

Starting with renters, we see that proportion of renters who did not pay rent is on the rise since mid-June

When asked about next month, renters are losing confidence in their ability to make rent.

Again, the peak here looks like mid June. As of the last survey, a third said they had no or slight confidence in making payment. Only 39% had high confidence they would make rent.

We see the same patterns with mortgage holders:

It looks like deferrals may have peaked.

We also see mortgage holders begin to lose confidence in their ability to pay, but not on the scale of renters:

Mid June is the peak of the recovery, all over this data.

Next up is the JPMorgan (JPM) credit card tracker:

Again, peaking in mid June.

Homebase provides payroll, billing and other services to small businesses. They have 60,000 customers with about a million employees, so it isn’t the biggest sample, but the patterns comport with what we see elsewhere:

Homebase

Stalled in mid June. Looking at some of the worst states of the pandemic, we see that economic activity is definitely coming off:

Homebase

Google and Apple have been releasing indexed mobility data from their maps apps. Google gives us more detail. Looking at their retail and recreation category, we can see, except for a little spike for the July 4 weekend, the growth in trips to retail and recreation has stalled nationally.

When we look at the COVID hotspots, we see a stronger drawdown after mid June

OpenTable has been releasing YoY restaurant reservation data. The limitation here is that we’re missing fast food and restaurants that don’t take reservations, so we’re only looking at the top slice of restaurants, and it’s unclear exactly what that means.

But this is also a key area for both GDP and jobs recovery, so let’s take a look.

So we see the same pattern of recovery in May, stalling in June, though we may be back on the upswing. Looking at our hotspots:

Nevada aside, we see bigger June dips in these states, as local areas shut down again.

The final look is possibly the most scary. Yelp just reported that 55% of the closings in their business listings are now permanent:

Yelp

Breaking it into business categories, we see that restaurants are even higher, at 60%.

Yelp

This is grim, especially for jobs. There are still many millions of restaurant workers unemployed, and it doesn’t look they will be going back to work any time soon.

Summing Up

  • Q2 2020 was the worst quarter since 1946. The only relevant comparison is world war demobilization.
  • The biggest story in goods is collapse of energy consumption, offset almost entirely by groceries.
  • Pulling out food and energy, goods finished June higher than February on the back of a surge in household durables demand.
  • But companies in the goods economy still have $52 billion in lost revenue to make up.
  • Services are where the real troubles are with $421 billion in accumulated losses
  • Health care is the single biggest contributor there, with $173 billion in accumulated revenue losses. It’s easy to see this sector recovering.
  • Housing remains the big dog that hasn’t barked yet.
  • But there are a group of services with high fixed costs that make up for them with density and volume at peak demand — transportation, recreation, food, accommodations, personal care and foreign travel — that are not recovering well. These services comprised 15% of GDP in 2019 and had a $350 billion revenue deficit that is growing larger every month. Almost half of the nominal QoQ GDP loss was these services. This will be the toughest part of the recovery.
  • Overall, prices are down.
  • The two biggest movers in goods were food, rising in prices, and energy, falling fast. They more or less offset each other.
  • Many household durables saw increased demand in May and June, and inventories are depleted from supply chain issues. Deflation is muting, or prices even rising.
  • Services prices were up only modestly, less than usual. There are too many unusual things happening in services to really get a good grip on what the price indexes mean.
  • All categories of investment, even the normally very strong IP investment were down in Q2.
  • Oil well construction drove nonresidential structures construction, down 33% QoQ.
  • Single family home construction down 13% QoQ drove the residential line.
  • All the transportation equipment categories got crushed. Aircraft investment is now down 81% since Boeing’s troubles began.
  • Since it does not cover benefits and subsidies, GDP does not have a lot to tell us about government.
  • But spending was up about a trillion dollars in the quarter.
  • Large declines in imports were offset by large declines in exports.
  • High frequency data is indicating the recovery stalled in mid-June

What Does It All Mean?

I quoted Citi CEO Mike Corbat above, but I want to return to his remarks more fully, because I think he framed the situation well. He finished up his scripted remarks with this:

We are in a completely unpredictable environment which no models, no cycles to point to. The pandemic has a grip on the economy and it doesn’t seem likely to loosen until vaccines are widely available.

When asked to elaborate later in the call:

I think of this going through four stages, containment, stabilization, normalization and ultimately a return to growth… I would describe right now that broadly in the world we are somewhere between containment and stabilization, right? Containment is that we can bend the curve in terms of the transmission of cases. Stabilization is that as we remove or start to take down some of the barriers or actions that were put in place…

And when you get to the third phase around normalization and simply put normalization to me is am I willing to get on the airliner? Am I willing to get in a subway? Am I willing to go into a crowded venue to watch a sporting event or a concert or what it may be? And I think realistically when we get to that third bucket, I just don’t see that coming and I would say many don’t see that coming until we feel like there’s an anti-virus vaccine that’s available for the mass population around that. And so I think one of the things that people struggle with today is the disconnect in some ways between where the market is in some ways and actually where we are in terms of this health pandemic… So I don’t want to be pessimistic in there. I want to be a realist and I just think that in order to truly normalize, that’s what’s necessary to do that. [emphasis added]

Let’s break down the key points:

  • The pandemic caused the recession, not the shutdowns. This is at root a public health problem, not a political or economic one.
  • We cannot get out of containment.
  • We will not get to normalization until there is a safe effective vaccine. The recession only begins to end then.
  • There is a huge disconnect between the market and economy right now.

One thing that comes across in the macro, and also my reviews of the major banks’ quarters, is how well economic policy worked. The point was to get all sectors flush with liquidity so they could weather the short term storm. All sectors — banks, corporations and households — are historically flush with cash. Since March, Treasury has increased the Federal debt by over $3 trillion, now at $26.5 trillion. Over half that $3 trillion is still sitting in Treasury’s checking account. Even Treasury is hoarding cash.

But liquidity does not buy solvency, it only buys time, about 5 months of it. The point was to use that time to learn about the virus, set up a national system of best practices, and ramp up testing and tracing so that turnaround was better than this:

Demand for testing has soared in recent weeks. And we are providing testing results in about two days for the highest priority patients, and the average turnaround time for non-priority patients is at least seven days.

-Quest Diagnostics (DGX) CEO Steve Rusckowski on their earnings call July 23

In seven days of not knowing, an infected patient can transmit to dozens of other people if they don’t self-quarantine. This is not best practices.

So we already spent over a trillion dollars, with more at the ready, and we were never able to get to containment. That money and the time it bought was wasted.

So the economy will do as well as we do with the virus. Which has not been good. Of countries with populations over 5 million, only Chile and Oman have higher case rates.

But I do have a bit of good news here, which is that it has stopped spiraling out of control, and is actually getting better. This has become very obvious from the top-down:

175 daily cases per million is still very high, but as you can see we pulled back from the brink. The 2-week growth rate is negative and going down.

Looking at the map of where it’s bad right now, what instantly pops out is still the sunbelt

Except for new Mexico, the entire sunbelt was dark red or orange just a few weeks. Still, right now it is pretty bad all over and the ugly harvest of deaths from all those cases in June and July is starting to come to fruition.

But this has been apparent for a few weeks now. What was equally as troubling is all those states around 100 cases per million in the midwest, mountain, mid-Atlantic and Pacific northwest. Even Rhode Island is having problems again. Pretty much all those states were seeing their case rates rise, but now several have learned the lessons of Florida and Texas, and cut it off before it got even worse.

A few weeks ago the “Getting Worse” map had very little blue and now it’s almost all blue. Some pockets of orange remain in those regions I mentioned.

But still, we may be seeing this turn around in most places:

The other data that has proved to be a good leading indicator is the positivity rate. That has been stickier than the case rate.

5% is the WHO guideline for reopening, and as you can see, large swaths of the country are not even close. But slowly, it’s started to get better.

There is way too much orange in these last two maps for me to be comfortable. The example of Israel is instructive. They really looked like they had the virus beat. But then they reopened the schools, all grades at once. Netanyahu told Israelis to go out and have some fun. If you know any young Israelis, you know they don’t exactly need the encouragement.

Worldometer

Israel went from 2 cases per million to 190 in 2 months. Progress can be fleeting.

Until there is a safe, effective vaccine.

Market Outlook and TINA

Citi CEO Corbat touched on the disconnect. I have been telling you for 5 months now that this is an economic calamity unlike we have ever seen. If you were alive in 1946, I apologize.

But in 4 of those months, the market has gone up. Earnings season is upon us, and with 75% of the S&P 500 reporting Q2, we see H1 2020 index EPS down 57% YoY. Very few companies are telling us it’s about to get better soon.

I’m frequently told this is because of TINA.

TINA is an acronym for There Is No Alternative. What the people who talk about it mean by it is that with rates so low, there is no option other than to extend risk into equities and the market will continue to rally in the face of the worst recession in 74 years.

TINA is just the latest version of TTID: This Time, It’s Different. An ahistorical argument as to why the market will never go down again. Spoiler: it never is different. The last three market crashes were preceded by similar arguments.

  • 2008: Through advanced math and extensive use of derivatives, banks had reduced their risk to almost zero. It says so right here in the model.
  • 2000: Cash flows don’t matter in the New Economy, number of customers and reach do. (Does that one sound familiar?)
  • 1990: Tax cuts solve all problems.

Of course, this is many people’s favorite milestone in the 2000 madness:

Amazon screenshot. Highlight added.

This was a best-seller in 1999 and 2000, and argued that the rally would keep going to Dow 36K. Twenty-one years later and still 9k short. Fun fact: one of the authors has been in and out of Trump’s White House Council of Economic Advisors.

There is an alternative. Treasuries and cash. Many are already choosing it. Heck, everyone is choosing it — every sector of the economy is more liquid than it has ever been.

Nothing strikes to the heart of this like the insane demand out there for the ample supply of Treasury bill auctions. Since the Fed lowered the IOER to 10 basis points, there has been a torrid pace of bill auctions, terms a year and under. Since March 16, a total of $8.2 trillion in bill auctions have taken place. There were $24 trillion in bids, 192% more. The weighted average term was 96 days, and the weighted average rate was 14 basis points. All that money, chasing 14 basis points for 3 months. Just looking at the 1 month bills, 1.4 trillion has been auctioned since March 16, with $4 trillion bid — 191% more. The weighted average rate is 11 basis points. For the $195 billion that has not matured yet, $609 billion was bid, 212% more. The weighted average rate is 10 basis points, the same as the IOER. There is an alternative.

More than that, banks have decided that even extending their risk horizons out that far is too much, and the result is skyrocketing reserves held at the Fed:

They have come way down from the peak, mostly as Treasury keeps drawing cash, $3 trillion so far in new debt. This quote from the Bank of America earnings call from CFO Paul Donofrio stood out to me:

We’ve added $284 billion in deposits since year-end. All of that has gone into cash earning 10 basis points.

So they popped it all in reserves, not even wanting to extend their risk out to 3 months to get another 4 basis points. That’s another alternative.

It’s never different.

Disclosure: I am/we are long AAPL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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