Business cycle analysis can seem theoretical, full of graphs and equations, but in reality the models are just an aggregation of the collective experiences of past cycles. 1 1 Close When new data come in that don’t fit the models, the models are adjusted. Sometimes it reminds me of the alien trying to fit into Vince D’Onofrio’s body at the beginning of the first Men in Black movie. Post-recession forecasting is the art of applying the patterns of past recoveries to the current one. A typical post-recession trade recommendation might be something like “this sector has outperformed at this stage during five of the past six recoveries.” Such analogies are useful in guiding tactical decisions, but they do require some caution. Each cycle is unique. And some cycles are more unique than others.
The 2020 recession stands out as very different from others in recent memory. Each of the past few recessions featured excesses in the financial system followed by the unwinding of those excesses. The recessions were often preceded by rises in oil prices and small upticks in consumer prices which triggered tighter monetary policy from the Fed. The recoveries from these recessions were slow, but the periods of expansion grew longer each time. A simple model of credit cost could go a long way toward explaining the cycles. 2 2 Close I would argue that many of the models oversimplified what happened, but no one would listen anyway. However, unlike those recessions, the 2020 pullback had nothing to do with imbalances in the financial system. It was caused by the health crisis, which brought the economy to a sudden and almost complete halt. The unusual characteristics of this recession are the result of this difference.
The pandemic led to an extraordinary drop in activity. The losses in jobs and growth dwarfed those of previous recessions. While contractions usually play out over several quarters, this one lasted barely two months. In some ways, it was a throwback to recessions of the 1970s which were caused by the sudden shock of oil embargos. But the 2020 recession was not the result of monetary tightening in response to higher prices as those were. As bad as those recessions felt, none had anywhere near a 30% drop in GDP nor unemployment rates over 14%. This was a much deeper recession than we have seen, even when compared with the Great Financial crisis.
Fortunately, the differences aren’t all on the downside: the recovery has been much faster and stronger than any we’ve seen in the past three decades. Growth returned much more quickly than most forecasters had anticipated. This is partly because some of the most binding COVID restrictions were temporary, and people became more comfortable resuming some of their activities after the initial lockdown. But perhaps more importantly, the policy response was more aggressive than during previous recessions. There was strong bipartisan support for immediate fiscal measures, and monetary policy went well beyond what it did during the previous financial crisis. 3 3 Close The measures were aggressive in 2008, but they were not nearly as fast or as large as in March and April of this year. Policy makers were more willing to add support in the face of a health crisis than one thought to be caused by excesses in the housing or equity market. 4 4 Close Policymakers don’t worry about encouraging bad behavior from viruses. They’re not included in the moral hazard list. The stimulus has been so big that household disposable income increased this year as the fiscal transfers have outweighed losses in pay. That is very unusual for a recession year.
The recovery has not only been faster than in past episodes, but it has also been different in its composition. Normally during recessions, service providers hold up better than goods producers because manufacturers are stuck with unsold inventories. This year services were hit very hard and have been slower to rebound. Restaurants, travel and other services are more directly affected by COVID fears. People have shown more willingness to buy things that they can have delivered. The restrictions have had less effect on the technology industry and has helped companies that cater to folks who stay at home.
In past recoveries investors and economists examined every little piece of newly released data to determine how quickly the economy would recover. They wanted to know if the tea leaves suggested a second dip or a coming boom. This time, the current data is less important in determining the medium-term outlook. That is because the health crisis is temporary (we hope anyway), and any short-term weakness tells us little about the outlook for next year. Next year’s GDP will depend more on the effectiveness and distribution of the vaccine than this month’s industrial production. Investors can still look in the data for some indication of what the post-COVID economy will look like. For example, in unemployment data, the number of “permanent job losers” is probably more important than the headline number as it gives more indication about what to expect from the job market next year.
As we head into to year end, the financial news will be filled with recommendations about what to invest in based on comparisons with past recessions and recoveries. When considering these tilts, it is probably best to be aware of how this recession has been different. It has been a much faster cycle, so calendar analogies probably won’t hold up. What happened six months to one year after the last recession has probably already happened this time. Traditional sector bets are also unlikely to follow the same patterns. The sectors that were once considered cyclical may not be so this time. The next year will offer plenty of opportunities in macro markets, but they will probably be as unique as the recession that preceded them.
What We Are Watching
Bank of Canada Meeting (Wednesday)
At its last meeting in October, the Bank of Canada announced a reduction in the size of its government bond purchases but a tilt towards longer-duration bonds aimed at maintaining downward pressure on borrowing rates. Since October, there have been several favorable developments for the Canadian growth outlook. Positive vaccine trial results have led to improved prospects for economic normalization in 2021 in Canada and elsewhere. Oil prices have risen in recent weeks, which may benefit Canada’s large energy sector, and the Canadian government has signaled a willingness to introduce additional fiscal stimulus. 5 5 Close Reuters: “Canada deficit seen higher, government eyes up to C$100 billion in stimulus spending,” 11/30/2020. At the same time, however, domestic COVID cases have risen to new highs, and the most recent GDP release fell short of economist forecasts. Market participants will be eying this month’s Bank of Canada meeting to see how the central bank weighs these conflicting developments. If policymakers strike a positive tone, it could imply that additional monetary easing is unlikely, potentially boosting the Canadian dollar and weighing on domestic fixed income.
U.S. CPI (Thursday)
After rebounding strongly during the reopening period, core inflation slowed down in the past two months as upward adjustments to goods prices lost momentum. Indeed, goods prices excluding food and energy (“core goods”) declined in October, the first negative print since May. Ex-energy service prices (“core services”) have slowed sharply since the COVID-19 pandemic began, with large declines in hotel and airline prices, as well as deceleration in larger (and traditionally more stable) components such as Rents and Owners’ Equivalent Rents. This has led services inflation to stand at a 9-year low on a year-over-year basis. Historically, trends in core services have been more persistent than trends in core goods. If this tendency continues, it would suggest that overall inflation will remain soft moving forward, reinforcing the Fed’s view that rate hikes (or any form of tightening for that matter) are not even a remote consideration at this point. Next week’s data will help ascertain the extent to which this guidance remains unthreatened by inflation.
ECB Meeting (Thursday)
In recent months, most European countries have responded to a severe COVID-19 second wave by reintroducing various types of lockdown measures. While these actions appear to be gaining traction in terms of restraining the pandemic, they have also taken a toll on economic activity, with data pointing to a sharp slowdown in services in recent months. In October, European Central Bank (ECB) President Lagarde noted that “in the current environment of risks clearly tilted to the downside,” the central bank would “recalibrate its instruments, as appropriate” at its December meeting. 6 6 Close ECB: “Introductory Statement, Press Conference,” 10/29/2020. As a result, forecasters expect that the ECB will announce changes to its asset purchase programs 7 7 Close There are currently two separate purchase programs, the longstanding asset purchase programme (APP) and the more aggressive pandemic emergency purchase programme (PEPP) launched in March. and/or its targeted long-term refinancing operations which supply liquidity to banks on attractive terms. Market participants will also be watching for any new commentary around the level of the euro exchange rate, which has traded near record highs on a trade-weighted basis in recent months. If President Lagarde takes a hands-off approach to questions related to the exchange rate, the euro could receive a further boost.