by Dr. Charles Lieberman
Chief Investment Officer

Second quarter GDP collapsed at a 32.9% annual rate, as was widely expected. Nonetheless, more timely data shows that the economy is bouncing back. It has a long ways to go and the path back will not be smooth or easy. But the recovery process is clearly underway.

Let’s start with Q2 GDP. It actually declined by 9.5% during the quarter, which was annualized to a 32.9% annual rate, a massive decline by either measure. Consumers lead the way, with such outlays falling at a 34.6% annual rate. Household spending includes durables, nondurables and services, and services were especially weak. Durables fell modestly at a 1.4% annual rate and nondurables fell by 15.9%. In contrast, services collapsed at a 43.5% annual rate. Services include everything from haircuts, banking services, entertainment, housing costs, hotel room rentals, health care services and utility consumption. Most people would probably be surprised to discover that spending on health care accounted for nearly 30% of the entire decline in household spending, while recreation accounted for only 14% of the total decline and transportation services accounted for less than 9% of the total. In contrast, housing and utility consumption actually contributed modestly to growth in household spending. Some of the fall in spending is likely to recover fairly quickly, as people are able to revert to more normal levels of activity, with health care being a prime example. Other forms of spending, such as subway, bus or airline travel will take longer, no doubt, and may require a vaccine to recover more fully.

It is also rather important for the recovery that household income rose sharply during the quarter. Wages and other forms of worker compensation fell by almost $800 billion at an annual rate, reflecting the enormous job loss reported for April. But second quarter government support payments, including unemployment insurance plus payments to individuals, increased by three times as much, more than $2.4 trillion at an annual rate. With spending down and income up, the savings rate for U.S. households exploded from 9.5% in Q1 to 25.7% in Q2. So households have the financial firepower to boost spending when they are ready. Moreover, instead of defaults rising during the recession, as would normally occur, consumers have been paying down debt, instead.

Another very significant divergence occurred between spending on goods and the production of goods. Household spending on durables and nondurables declined far more moderately than production levels. How did business supply those goods? From inventories. Normally, inventories grow by $60 to $75 billion annually to keep pace with a growing economy. But with production declining so sharply relative to demand, inventories were destocked at a $236 billion annual rate, accounting for more than 12% of the decline in Q2 GDP. That’s simply unsustainable. Moreover, inventories will need to be replenished, which will provide a solid tailwind to future production as firms rehire or call workers back to resume production.

A similar dynamic affected capital investment. Spending on computer equipment actually rose at a $24.6 billion rate in Q2. Despite that increase, total real capital investment on equipment, including computers, fell at a $134.5 billion pace. So capital investment is also likely to become a tailwind for the economy in the near future.

High frequency data suggests that the recovery is already underway. Gasoline consumption, an indication of car miles being drive, people moving through TSA checkpoints, and measures of population mobility all show marked improvement, even when they still clearly have far to go. A weekly economic index constructed by the New York Fed to track GDP shows significant improvement from its lows in late April. The pace of improvement of that measure has slowed a bit recently, suggesting that the rise in Covid cases in recent weeks is exerting some drag on the recovery. This isn’t entirely surprising. No one should expect a smooth or quick rebound to January/February levels of economic activity, especially before a vaccine becomes available. Nonetheless, it is clear that a recovery is underway. I’d ballpark Q3 GDP growth in the 15% to 20% range.

Earnings reports for Q2 have come in dramatically higher than expected by the stock analysts. Some of this may well be the result of most companies suspending earnings guidance and analysts having had good reason to be very fearful that companies performed very badly during the quarter. In fact, companies did perform poorly, just nowhere near as badly as had been expected. Everyone will now have a chance to recalibrate.

Full economic recovery will take some time, and a vaccine is really necessary to unleash the economy’s full potential. Fed Chair Powell didn’t want to speculate on that possibility during his press conference after last week’s FOMC meeting. As he noted, the Fed needs to plan for bad developments, not good things. But Drs. Fauci and Gottlieb believe we will have a vaccine before the end of the year, quite possibly multiple vaccines, and widespread availability would then be likely to follow in 2021. Several are already in Phase 3 trials. Until those results are known, the recovery should continue, but at a moderate pace that may be subject to periodic ebbs and flows in response to new Covid cases and the willingness of the government to continue to help households bridge the gap through further support packages. We are investing accordingly.

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