Having read the forecast given last night by Goldman Sachs which explains that the U.S.’ Gross Domestic Product (GDP) will contract in the second quarter of 2020 by 25%, I thought it will be good to communicate with you some of my thoughts. I have spent over 5 hours of reading and I will try to condense this in 2,000 words.
The Pandemic
The pandemic itself is expected to last up to three months. In China it lasted a bit less than two months, but there were special measures in force (full lockdown in the Hubei province) and immediate reaction, plus unlimited supply of masks, and other protective gear.
In Europe and the U.S. most likely it will last up to three months, so we could expect it ends by 10 June, and ‘normal’ activity could be restored afterwards. President Trump speaks of July, but I think it could end up a bit earlier than that.
We have no proof so far that people who had the virus will develop immunity. This opens the possibility to have another pandemic lockdown in November 2020.
A lot of effort is put by many countries to get a vaccine going, but many specialists agree this is not possible before 18 months. A vaccine that works for most of the population would be a saviour, as once vaccinated people could restart the economic activity and would not worry about the illness anymore.
How much the US economy will contract in the second quarter?
Goldman Sachs forecasts that the impact of the coronavirus will be brutal. They forecasted a 6% reduction in GDP for the first quarter, and 25% for the second, followed by increases of 12% in Q3, and 10% in Q4. It is important explain, this are annual figures quarter on quarter. The figures would be better presented as a reduction of 1.5% in Q1, a reduction of 6.6% of Q2, followed by an increase 2.9% in Q3, and 2.4% in Q4. In total, Goldman Sachs expects a 3.1% contraction for the US GDP in 2020, Bloomberg has the pessimistic scenario at 3.5% contraction for the year.
To put things in context, the GDP in 2019 Q2 was worth $5.2 trillion. A 8% reduction will mean a loss of $416 billion in GDP in the second quarter.
The US has a 126 million full-time workers. Each added about $10,300 value in the second quarter of 2019. A 8% reduction would mean that 10 million full-time workers will be idle during the quarter. You could even argue that low productivity activities may be hit more: tourism, manufacture, and there could be even more employees affected.
Unemployed people in the US increased by 70,000 in the week ending 13th of March to 281,000, and Goldman Sachs estimates this will increase to 2.25 million for the week ending on 20th of March, an increase of 2 million in a week. All forecasts I saw indicate for more than 1 million of initial jobless claims for the week that passed.
It is impossible to say if Goldman Sachs forecast is right or wrong, but even a 20% reduction in GDP for the second quarter would be a huge problem for the US economy, but also for the Global economy. There would not be a high difference between the US and Europe when it comes to GDP reduction.
Economic activity after pandemic
There was clear slowdown of economic activity in China in the first quarter. The information available suggest that after the pandemic ended, people have gone back to work, they spent a bit of money in cafes, convenience stores, fast-food, and supermarkets, but not on white goods, cars, or real estate.
I would think that it will be similar in Europe and the U.S after the risk of infection will end and people could go back to work. Although economic activity will restart, the demand for many goods and services would be very, very low from July onwards. Ray Dalio estimates that corporations will lose as much as $4 trillion this year due to the economic damage; he also estimates that Global corporate losses will amount to $12 trillion this year.
We are now in one of those times in which the realities of the situation about the health, economic, and market impacts are so bad that conveying them accurately could provoke panic. The downside of withholding the facts is that it will undermine those Governments and companies’ credibility at a time when them having that credibility is most important.
Central banks and Government help
Both Governments and Central Banks have done all their best so far to offer help. The UK Government has made promises in excess of 10% of GDP, but it will need to borrow for this. The Central Bank could issue the money for this.
However, both Central Banks and Governments will need to act with care and the risk of a policy mistake will remain high. Printing too much money and the use of ‘helicopter money’ could undermine the trust in the Sterling Pound. When confronted with ‘helicopter money’, shopkeepers will start to think if to close the shops, because they do not know the value of those money sent from above. The UK needs to be exceptionally careful, as it imports a lot of food and essentials, and the exchange rates are important. So far, the Sterling Pound has devalued by 10% against the USD and 9% against the EUR.
There is however another problem, interest rates have reached 0% per annum, and from here onwards, the monetary policy of reducing the interest rate does not have much effect. It is hard for the Central Banks to push the interest rate into negative territory, but special time may need special measures and they may try this as well.
Markets
It is not easy to make prognosis about markets. GDP declines of these magnitudes did not happen that quickly even in the Great Depression.
I have read the UK Government is negotiating to take British Airways into public ownership. It seems the Government decided to not lend public money to a near bankrupt company with no revenue, so it needs to take it in public ownership. No clear idea how the agreement may look like, if only shareholders are going to be diluted, or bondholders will be asked to take a haircut too. I expect that many other companies would need to be taken into public ownership.
As a result, markets will continue to be under pressure, both equities and bonds may fall in value, probably with the exemption of the German, UK, and US Government bonds. Central banks will continue to purchase Government bonds, and probably corporate bonds too for certain companies with the highest ratings as investment grades. I expect Sterling to continue to devalue and this somehow will hide some of the equity loses.
For our clients, we could continue to do what we have already started. We prefer a small number of companies as equity investments. These companies have high cash reserves on the balance sheet, are defensive, and many produce essential products. We would continue to prefer Government bonds and cash, and some exposure to the US Dollar.
For an explanation of our equity selection, please read: https://www.n2-am.com/post/why-quality-investing
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