Misleading Indicators

8/19/20

With economic data, we’re frequently looking in the rearview mirror, but we work with what we have. At this point, only limited data relating to the state of the economy are available, but what we have are showing remarkably strong indications. Specifically, by July, residential construction rebounded sharply from the recent lows in April, as did retail sales. Both are important indicators of broad economic activity; and in both cases, the July results were comparable to those posted in February before widespread lockdowns went into effect. The employment situation has also improved, with the civilian unemployment rate dropping for two consecutive month, falling to 10.2 percent in July, after a high of 14.7 percent in May. Meanwhile, these positive developments seem to be corroborated in the stock market, with the S&P500 index posting a historical high this week, fully recovering all of the losses that that occurred earlier this year.

The eagerness for a full-fledged recovery notwithstanding, it would be a mistake to infer from these data that the worst is over and that the light has been lit at the end of the tunnel. Don’t kid yourself.

An ever-present challenge for market observers is deciding whether an observed perturbation is the start of a trend or a temporary adjustment that will be shortly be reversed. This question is ubiquitous, affecting prices of all manner of goods including stocks, securities, interest rate, and commodities, as well as macroeconomic data like components of GDP and related economic indicators. Understandably, different analysts will likely look at the same data and make different judgments. That’s precisely what’s going on today, as we try to discern the direction of the economy.

In hindsight, it’s easy to attribute the sharp declines in economic activity in March and April to the forced shutdowns in connection with efforts to contain the Coronavirus. Rebounds in May and June have been attributed, in part, to the relaxation of some of the closures across the country, as well as to some measure of pent up demand being satisfied, as consumers acted to catch up on purchases that they had been forced to postpone. These explanations, however, don’t tell the real story. In fact, the observed rebounds were predicated on government transfer payments that surged during the second quarter.

These transfer payments include social security benefits as well as two new programs under the CARES Act: the supplemental unemployment insurance and the economic impact payments to individuals. Taken together, transfer payments rose from $2.4 trillion in Q1 (seasonally adjusted, annual rate) to $4.8 Trillion in Q2 — almost doubling! Unquestionably, the reason the July numbers are as healthy as they seem to be is largely due to the size of these transfer payments, which amounted to almost a quarter of the GDP.

Critically, transfer payments don’t show up directly as a GDP line item. Rather, they have their effect largely by affecting disposable income of households, thereby influencing the level of consumer spending. The unprecedented level of support from the CARES Act served to limit the decline in consumer spending to about 4.5 percent in Q2.

So… should we take heart in the latest economic statistics, thinking that the recent improvements that we’ve noted are the beginning of a trend? Not likely — not with the current stalemate about the next round of economic stimulus. Given the fact that Democrats have already lowered their aid proposal to something on the order of $2.0 trillion, we’re looking at a drop in the value of transfer payments in Q2 in the range of $2.8 trillion and, in all likelihood when all is said and done, more. To expect a recovery to take hold in the face of this kind of a reduction of federal assistance is delusional. Instead, as we head into the fall, we should anticipate seeing a reversal of the recent improvements, with little reason to expect a recovery phase to begin anytime soon.

Sadly, I make this prediction without differentiating how the coming election ends up. That said, it appears that the Democrats at least have a plan. The Republicans got nothing.