Submitted by Joseph Carson, former chief economist at Alliance Bernstein
The Bureau of Economic Analysis (BEA) estimated that Q2 Nominal GDP declined 34.3% annualized, the largest quarterly drop in our lifetime. On March 12, I penned the article “Investors Should Brace for a Record Decline in GDP”. Never did I imagine that the Q2 GDP decline would be nearly 5X times the previous record drop of 7.2% in Nominal GDP in Q4 2008.
Here’s a few observations.
First, Q2 Nominal GDP was estimated at $19.4 trillion annualized, a drop of over $2 trillion from Q1 level of $21.5 trillion. BEA reports the GDP figures on an annualized basis. So the quarterly rate for Q2 Nominal GDP was $4.85 trillion, a figure that roughly matches the aggregate amount of fiscal and monetary stimulus injected in Q2.
According to my estimates, the combination of federal stimulus payments to individuals plus the expansion of the Federal Reserve Balance sheet amounted to an increase of approximately $5 trillion in aggregate fiscal and monetary stimulus over the three months ending in June. Never before has the scale of fiscal and monetary stimulus matched the nation’s nominal output in a single quarter.
Second, Q2 nominal consumer spending declined at an annualized rate of 35.8%. But the actual decline is much worse. BEA estimated that people’s rent payments in Q2 increased $ 2 billion to a record $641 billion. BEA estimates consumer spending for rent based on an accrual basis. In other words, BEA methodology assumes people made their rent payments on time and in full. Yet, reports show that more than one-third of renters skipped paying part or all of their rent in Q2.
Third, Q2 saw a record decline in Nominal output and a record increase in financial (equity) wealth. Based on preliminary data the market capitalization of domestic companies increased by $7 trillion in Q2 while nominal GDP, measured quarterly, declined by approximately $500 billion.
Critics argue that macro valuations of equity markets are less important nowadays. I disagree. Based on my calculations, the ratio of the market capitalization to Nominal GDP stood at 2x times at the end of Q2, surpassing the prior record high of 1.87x times at the end of the tech bubble in Q1 2000.
In other words, the 2020 equity market is the most expensive (or over-valued) in our lifetime. Current record market valuations indicate an extremely poor risk-reward ratio, even worse than what followed the tech bubble of 2000.
What happens next? The recessionary conditions from the pandemic are not over. And the prospect of reduced or an interruption in federal stimulus will make it worse.
Investors need to realize that the spending impulse from federal stimulus operates like the flow of new credit. That is, reducing or lowering the flow of stimulus payments to individuals will trigger a sharp drop in spending, especially when so many remain unemployed. Also, people face unpaid credit, rent, and mortgage bills.
The pandemic crisis is unique in that involves public health, finance, and the economy. An all-out policy package pushed finance and the economy far ahead of the public health crisis. Unfortunately, the public health crisis lives on. So the rebound in finance and the partial recovery in employment are fragile, especially if Congress fails to provide additional financial support until medical science finds a cure for the virus.