The coronavirus has imposed both a supply shock and a demand shock to the global economy. The supply shock was in the form of disruption to supply chains as factories were shuttered. The supply shock has largely been corrected.
The demand shock was in the form of a loss of demand as lockdown and stay-at-home orders cratered demand. Governments around the world acted to cushion some of the demand shock by way of fiscal support. In the US, a significant part of the fiscal cushion is expiring, which is the risk of a double-dip slowdown.
One puzzle of the stock market rally since the March lows is how stocks can strengthen in the face of the worst economic slowdown since the Great Depression. Sure, central bankers took steps to mitigate the worst of the damage. While they can print money, they cannot print sales or customers for businesses, nor can they print equity.
While some of the risk-on tone could be attributable to central bank action, the real reason for the market’s strength is fiscal policy. While the stock market isn’t the economy, and the economy isn’t the stock market, the two are nevertheless connected. I pointed out last week (see Analyzing the bull case) that US fiscal support had strengthened household incomes to pre-pandemic levels. Retail sales were therefore recovering strongly as a consequence.
All that is about to end as the $600 per week supplemental unemployment insurance payments expire at the end of July. Congress has failed to act to extend the benefits, and the economy is going over a cliff. Brace for the double-dip recession.
Differences in policy time horizon
The differences in monetary and fiscal policy response to the pandemic represent a stark contrast in time horizons. The Federal Reserve believes the effects of the COVID Crash are medium to long term in nature. The most recent July FOMC statement shows the Fed’s believes the pandemic will be a key driver of the medium term growth outlook.
The path of the economy will depend significantly on the course of the virus. The ongoing public health crisis will weigh heavily on economic activity, employment, and inflation in the near term, and poses considerable risks to the economic outlook over the medium term.
The economic recovery will be long and drawn out. Interest rates are going to be on hold for a very long time.
When asked about the triggers to raising rates during the press conference, Jerome Powell replied that they were not even thinking about raising rates. He also pleaded with Congress to enact another stimulus bill to keep the economy from going off a cliff as the Fed cannot do the heavy lifting all by itself [emphasis added].
It will take a while to get back to the levels of economic activity and employment that prevailed at the beginning of this year, and it will take continued support from both monetary and fiscal policy to achieve that.
By contrast, the fiscal response has been short-term in nature. Congress viewed the pandemic as a short-term shock to the economy. A short-term shock meant a short-term response. It was therefore no surprise that the extended $600 per week unemployment insurance benefits in the CARES Act expired at the end of July.
The short-term view was wrong. After raging through Washington State, northern California, New York, and New Jersey, the pandemic went on a rampage through the Sun Belt states. Setting aside the uneven stay-at-home responses of state governors, the populace did not feel safe enough to return to normalcy in the face of infection risks. So much for the reopening and the V-shaped recovery.
Assessing the damage
The main damage of the fiscal response can be seen in the expiry of the $600 per week supplemental unemployment insurance that expired July 31. The deadline was no surprise. House Democrats had passed a $3 trillion relief bill in May. No one expected that the Republican controlled Senate would pass the bill in its entirety. The bill represented the Democrats’ opening gambit in bargaining and it was a signal of its priorities, which were especially important in an election year. The Republican controlled White House and Senate did not take up the relief issue until mid to late July. When it did, it was unclear whether the resulting $1 trillion bill could muster sufficient Republican support in the Senate to pass.
While all sides are continuing to negotiate, there will be a discontinuous break in disaster relief, which could be catastrophic for some of the population. If we were to continue the cliff and precipice metaphor, it’s easier to limit the damage by preventing people from going off the cliff, than to try and rescue them after they’ve fallen.
For some perspective of the economic cliff, over 30 million Americans will see a sudden income cut of 50% to 75% if the $600 weekly benefits disappear. The Republican bill proposed a temporary supplement of $200 per week, to be replaced by two-thirds of the worker’s previous wages, which would be implemented later so that state governments could re-program their computer systems. George Pearkes of Bespoke Investment Group estimated that the Republican proposal represents a -3.2% reduction in GDP.
The economic damage is not just limited to household incomes. Depending on the jurisdiction, hastily enacted eviction moratoriums are either expiring, or have expired. The Intelligencer reported:
At midnight on Friday [July 31], a federal moratorium on evictions will end. Similar bans by state and local governments have already passed or will soon expire. With tens of millions of Americans seeking jobless benefits, and the federal unemployment-insurance bonus set to expire, many American renters will soon be at risk of losing their homes…
[The CARE Act] protected people from eviction if they live in homes or apartments with a federally backed mortgage. According to one estimate, that amounted to roughly 12.3 million units, home to just over a quarter of the country’s renters. There were problems with the law, though. Apart from leaving three-quarters of the country’s renters exposed to evictions, there was also no enforcement mechanism or penalty for landlords who attempt illegal evictions.
Even if Congress were to agree to a rescue package later in August, the discontinuous loss of unemployment benefits has the potential to become a homelessness crisis with dire consequences. Over 40% of renters are at risk of eviction.
The lack of a rescue package has other repercussions. One glaring problem is the hole that the pandemic has blown in state and local budgets.
Without federal aid, state and local governments will have no choice but to cut employment. Despite the improvement in Nonfarm Payroll (NFP) for the past few months, government employment has not recovered. Expect it to drop in the coming weeks and months.
If you thought that employment rebound was a bright spot in the recovery, be prepared for a negative surprise. Former Treasury official Ernie Tedeschi observed that high frequency Census data shows a softening in the jobs market. The market consensus for the July NFP to be released this coming Friday is a gain of about 2.3 million jobs. Tedeschi estimated that, after adjusting for definition differences, timing, and seasonality effects, July NFP is likely to come in at a loss of -2.2 to -4.7 million jobs. Prepare for a jobs report shocker.
Economic data reports are turning sour. Initial jobless claims rose last week for a second consecutive week, indicating a stall in the recovery. The preliminary Q2 GDP fell -9.5% quarter/quarter, or at an annualized rate of -32.9%, which was ahead of expectations but still deeply negative.
The stock market had been rallying on positive economic surprises. The Citigroup Economic Surprise Index, which measures whether top-down data is beating or missing expectations, appears to be peaking out and turning down. To be sure, there is some good news on the horizon, as it appears that the new infection counts are topping out in the Sun Belt. Fatality rates will stop rising and begin to decline in about a week.
Nevertheless, the economic damage is becoming apparent. How will the market behave in the face of the economic cliff and disappointing macro releases?
In addition to the economic risks that have been mentioned, there are also other risks that the markets could interpret to be unfriendly.
First, assuming that Congress does cobble a rescue deal together at some point in the future, the economy will need fiscal support after the November election. If the support period of the new package does not last until late January, it may be virtually impossible to pass any legislation between Election Day and Inauguration Day. This raises the risk of another fiscal cliff and sudden stop in economic growth.
In addition, the effects of this economic cliff could affect the election. CNBC reported that 62% of swing state voters support the extension of the $600 per week unemployment insurance. Since this is contrary to the Republican position, it could degrade the Republicans’ electoral odds. As well, the Washington Post reported that Wall Street is showering the Democrats with campaign contributions. Such a level of defection is unusual considering how the Democratic agenda is unfriendly to financiers. A Biden and Democrat victory is likely to translate into higher corporate taxes and a reduced earnings outlook for 2021 and beyond.
There is an electoral silver lining for Trump and the Republicans. Despite the steady drumbeat of polls showing Biden leading Trump, the odds of a Biden victory have been trading sideways at PredictIt for about a month. Biden is not gaining ground in the betting markets, and Trump is not losing ground.
The risk of electoral chaos is also rising. Remember the Florida hanging chad controversy? The US could see a similar episode, but at a higher order of magnitude. President Trump has already questioned the possible legitimacy of the election and raised the possibility of a delay, which is legally questionable and rejected by his Republican allies.
Trump can’t legally delay the election, but he can take steps to question the legitimacy of the results. Business Insider reported that cybersecurity experts believe it could take weeks to determine the winner after November 3.
- Election cybersecurity experts said Tuesday that “the electorate may not be prepared for how long it’s going to take” for winners to be declared after the general election on November 3rd.
- A panel that included two cybersecurity experts who served in the White House agreed that simply counting ballots may take a week or two.
- Any litigation that follows that counting could postpone results for much longer in a scene reminiscent of the 2000 election, when results were delayed until January.
- The experts also said voters’ loss of trust in the system may be the biggest risk in the upcoming election.
- Despite fears of foreign interference, hacked voting machines, and disinformation campaigns, there is some optimism that the country is better prepared than in 2016.
Max Boot wrote in the Washington Post that he participated in a “war game” that postulated different electoral scenarios. Most of the time, it resulted in chaos and “near civil war in the streets”.
The danger of an undemocratic outcome only grows in other scenarios that were “war gamed” by other participants. For instance, what if there is no clear-cut winner on election night, with Biden narrowly ahead in the electoral college but with Michigan, North Carolina and Florida still too close to call? The participants in that war game concluded the result would be “near civil war in the streets.” Far-fetched rumors are enough to bring out armed right-wing militias today; imagine how they would respond if they imagined that there was an actual plot afoot to steal the election from their hero.
Such an outcome would create uncertainty, both politically and in the financial markets. Risk premiums would rise substantially under such a scenario and markets would tank.
A second demand shock
In conclusion, the pandemic has imposed both a supply and a demand shock to the global economy. The supply shock was in the form of disruption to supply chains as factories were shuttered – this has largely been corrected.
The demand shock was in the form of a loss of demand as lockdown and stay-at-home orders cratered demand. Governments around the world acted to cushion some of the demand shock by way of fiscal support. In the US, a significant part of the fiscal cushion is expiring, which is sparking dire consequences in the following forms:
- Over 30 million Americans will see an immediate 50% to 75% loss of income. A moderate scenario, based on the Republican proposal of a reduction of the $600 per week unemployment insurance to $200 per week, would result in a -3.2% fall in GDP. Even if Congress were to come to an agreement on a rescue package at a later date, the fiscal cliff damage will be difficult to undo.
- The expiry of eviction moratoriums has the potential to spark a homelessness crisis.
- Without federal aid, state and local governments are poised to start mass layoffs.
Even without the fiscal cliff, what reopening recovery was already flattening out, and the July Employment Report has the potential to see a large negative surprise. In addition, the economy is likely to need further support between Election Day and Inauguration Day, which will be virtually impossible to achieve.
Say goodbye to the V-shaped recovery. Wall Street has penciled in a steep earnings recovery for the rest of 2020. Get ready for downward estimate revisions as the prospect of a double dip recession gets factored into analysts’ models.