When the economic damage to China from the novel coronavirus was evident in February (our last publication of this series), we had assumed the damage would be contained regionally (like SARS). Our initial impression was of some supply-chain related production disruptions, and the indicators of near-term growth we closely follow had shown improvement. In fact, we would have likely lowered the probability of recession in the U.S. had it not been for the uncertainty surrounding the coronavirus outbreak.

However, since our publication, the epidemic in China became a pandemic, with shocks to both the supply and demand sides of the U.S. economy, which has brought on unprecedented loss in production, income, spending, and jobs in the U.S. (1).

Chart 1

Leading Indicators Of Economic Activity Show A Steep Climb Ahead

Just as coincident economic indicators plunged in spring, most of the leading indicators of near-term growth have only barely begun to climb out of the deep hole. Out of 10 leading indicators of near-term U.S. economic growth that we like to look at, eight indicators are negative for growth (was two), one is neutral (was three), and one is positive (was five) (see table 1).

Table 1

That said, there are green shoots appearing even on indicators that we have assigned a negative signal on the dashboard. Credit spread on high-yield bonds, while still above the 10-year average, has come down steadily since its peak in the later part of March (see chart 2). The plunge in data (on the "real economy") bottomed out in mid-May as lockdowns loosened, and now the only way is up (see "U.S. Real-Time Economic Data Hints At Signs Of Improvement From Recent Lows," published May 21, 2020). Still, we have to see a sustained and meaningful rebound before we move them to a neutral or positive growth signal.

Chart 2

Consumer sentiment fell, but not as much as in the Great Recession, and the most recent data in May showed an uptick from April (see chart 3). On the manufacturing side, the Institute for Supply Management (ISM) manufacturing index turned contractionary (below 50) in March and fell further in April to 41.5 as mandatory closures took hold, but April was still not as bad as the historical low of 33.1 in 2008. With reopening underway, the regional manufacturing indexes that have data available for May show improvement, though it's still weak (see table 2).

Chart 3

Table 2

The economy's fate typically follows housing, and it is encouraging to see that the magnitude of slowdown in this sector has been much less compared with other sectors. Housing starts fell 30% in April to 891,000 (SAAR) and permits--a forward-looking gauge--fell 20.8% to a six-year low of 1.074 million as social-distancing measures took hold (see chart 4). Still, starts under construction, which drives the residential investment component of GDP, fell by just 1.7%, proving to be notably resilient, as did completions, helped by the classification of construction sites as "essential." We expect this to provide a floor for new home sales, though existing home sales will face a big second-quarter hit. Indeed, new home sales were up in April to 623,000, gaining 0.6% compared with consensus expectations for a 23.4% drop (see chart 5).

Chart 4

Chart 5

Leading Indicator Of The Labor Market Hints At First Phase Of Employment Recovery

Meanwhile, jobless claims remain high but are ebbing. In the past, weekly claims have been the best indicator of normalization, and the most recent level of continuing jobless claims (i.e., the stock of unemployed on unemployment insurance, which adjusts for some folks that may have gone back to work after some measures of lockdown were lifted) reflects the labor market has finally turned the corner after the shakeout that it went through.

For the May Bureau of Labor Statistics (BLS) survey week (which includes the 12th of the month), continuing claims as a percent of the insured workforce fell to 14.5% from 17.1% the week before, versus 12.4% in the April BLS survey and a 1.2% cycle low for nearly two-year cycle ending in mid-March (see chart 6). Continuing jobless claims should recede in coming weeks as economic activity rises with a loosening of social-distancing restrictions and as portions of the Paycheck Protection Program (PPP) program's loans used by businesses for payrolls are forgiven if businesses rehire workers by June 30.

Chart 6

Historically, the high prevalence of temporary layoffs--like in the early '80s recession, which was engineered by the Volker Rule through a rapid rise in interest rates-- has led the unemployment rate to fall sharply within the following 12 months of the start of a recovery. But this time around, given the uncertainty surrounding the pandemic and mitigation policies, we foresee an initial burst of recovery in employment in tandem with wider reopening of the economy this summer, followed by a more gradual pace of rebound as lingering fears and capacity restrictions likely mean a higher chance that a good chunk of the 78% of temporary layoffs (in the April BLS report) become permanent.

Financial Fragility Also Means Risks Are Tilted To The Downside

Households' balance sheets--which were in a relatively better shape compared with past recessions (see chart 7) heading into the labor shakeout--will likely deteriorate, although PPP's income replacement provisions certainly has helped cushion the blow (2). Moreover, if the federal government fails to extend current unemployment benefits past June, or doesn't provide much needed support to state and local governments--which operate under a balance budget framework--income loss and layoffs will subsequently pose severe headwinds to demand growth. Even if we didn't have big imbalances before, the slump may be creating them now.

Chart 7

Chart 8

There are also potential solvency concerns in the private business sector. Think of business closures, which will require time to reverse. Heading into the current crisis, our nonfinancial corporates financial fragility index was already meaningfully above its historical average (see chart 8 and "What Key Macrofinancial Indicators Tell Us About The U.S. Nonfinancial Private Sector's Vulnerability To Shocks," Oct. 17 2019)(3).

From a sector-level perspective, a number of sectors currently see a combination of low ratings (which are more vulnerable to downgrades or defaults in times of economic or credit stress) and high leverage compared with the period just before the 2008-2009 recession (see chart 9). Together, this means that some sectors will see significant downgrades in the current COVID-19 recession with comparatively limited financing options, compared with their higher rated investment-grade peers that typically (though there are exceptions) operate with lower leverage. Companies with less aggressive financial profiles, generally employing lower leverage, can raise capital even during stressed times provided that business and financial risk is still palatable to relatively risk-averse investors. This is not the case for the majority of nonfinancial corporate entities, however, where higher risk, speculative-grade issuers have dominated before the current crisis transpired (see "Historically Low Ratings in the Run-Up to 2020 Increases Vulnerability to the COVID-19 Crisis," May 28, 2020).

Chart 9

There are certainly exceptions, namely the telecommunications sector, which includes companies with high leverage and low median ratings, but also includes companies like AT&T, Verizon, and many cable operators, which also operate with higher leverage in general and see comparatively lower business and financial risk, and are less likely to face obstacles with raising capital in debt markets, especially now with higher demand for these services.

Other sectors saw structural deterioration, which will hurt business and financial risk, and thus demand for new capital. Examples include changing consumer preferences for online sales hurting retailers. Global demand has slowed for the automotive sector and it continues to bear a high cost of compliance for new environmental regulatory frameworks, as well as research and development expenditures for changing consumer preference for higher-fuel-economy vehicles and lower demand for vehicles in general. Others, like the media and entertainment, lodging, and transportation sectors, saw an abrupt drop in demand due to social distancing measures.

What About That Lone Shining Star Of All The Leading Indicators--The S&P 500?

It is remarkable that all the indicators representing the "real economy" in our dashboard of leading indicators are negative for near-term growth while the broad equity market indicator the S&P 500 index has a positive growth signal. Although it's still more than 10% below its pre-COVID-19 peak, the S&P 500 continues to make steady recovery (see chart 10).

Chart 10

There are at least three explanations worth mentioning on what the equity market's steady recovery must be reflecting.

First, traditional data on real economy lag and are reflective of April when the stay-at-home policies were the strictest, while financial market data are more current to reflect the start of reopening in May.

Second, the equity market is forward looking--it shows recovery before the real economy data show it because people are setting prices based on what they expect to happen, not what is actually happening. Currently, equity markets continue to make headway on expectations that the worst is behind the economy now that the gradual easing of lockdowns is underway (real-time economic data support this), together with encouraging news on the development of a vaccine.

Third, the underlying backstop of monetary and fiscal authorities doing "whatever it takes" has been a key stabilization force for the financial markets. Corporate profits are a function of investment, dividend and buybacks, savings of households, savings of government, and the rest of the world (also known as the Kalecki Profits equation). The unprecedented government spending and transfers is making up for a substantial portion of investment collapse, a spike in household saving, and a decline in dividend and buybacks. If the government hadn't stepped up as it did, the story would have been different.

It then follows that the current positive stock market, as well as the emerging recovery, could easily fall flat if:

• There is a resurgence in pandemic spread with another round of stay-at-home directives, or
• There is policy fatigue before an effective treatment is available.

Add to that, global uncertainty just picked up as relations between China and the U.S. soured even more. With uncertainty still elevated, yields on Treasury have only seen a mild rise even amid the climb in stocks and increase in supply.

The ability to restart additional sectors of the economy without a surge in virus cases will be a crucial test for stock markets in June and beyond.

A Note On Our Probability Of A Recession Measure

Regular readers of this series will notice the omission of our model-based measure for recession probability. The reasons for intentional omission are twofold:

• First, the economy is already in a recession--since March, when the economy was deliberately closed down in response to coronavirus shock (a textbook exogenous shock).
• Second, the current recession and the path of the economy in the next 12 months will be largely dictated by the pandemic spread, actions of mitigations, and policy fatigue. This recession is not your regular business cycle recession, and as such, our recession probability model--which is based on traditional business cycle experience--is not applicable.

Thus we are temporarily shelving our probability of a recession projection model.

Related Research

• Historically Low Ratings in the Run-Up to 2020 Increases Vulnerability to the COVID-19 Crisis, May 28, 2020
• U.S. Real-Time Economic Data Hints At Signs Of Improvement From Recent Lows, May 21, 2020
• U.S. Business Cycle Barometer: Uneasy Street, Feb. 27, 2020

Endnotes

(1) A supply shock is anything that reduces the economy's capacity to produce goods and services, at given prices. Lockdown measures preventing workers from doing their jobs can be seen as a supply shock. A demand shock, on the other hand, reduces consumers' ability or willingness to purchase goods and services, at given prices. People avoiding restaurants for fear of contagion is an example of a demand shock.

(2) Financial cycles matter for real economic activity. As part of our business cycle surveillance, we use a principal component analysis technique to track and assess overall "balance-sheet" vulnerability of the U.S. nonfinancial private sector. We developed a Financial Fragility Index for Households (HH) and Nonfinancial Corporates (NFC) separately, each capturing seven key macrofinancial metrics (from the Federal Reserve's Financial Accounts of the U.S.) deemed important determinants of the respective sectors' health. For the NFC sector, our financial fragility index captures principal components derived from metrics that together represent three major sources of macrofinancial imbalances (which often interact with each other): (1) high leverage (systemic default risk), (2) inflated asset valuations relative to underlying cash flows (bubble risk), and (3) high dependence on short-term financing (liquidity risk). The HH sector index is derived from similar metrics that can be bucketed in (1) and (3) above. In place of (2), we incorporate a measure that reflects the wealth effect, or the theory that consumers spend more as the value of their assets rise, even if their income and fixed costs remain the same.

(3) The vulnerability of the NFC sector has increased steadily over the past several years. Debt in the sector has grown faster than underlying economic growth, its reliance on short-term debt has increased, and profit margins are well past their peak (and stagnated since 2015).