For the past month, there has been an obsession by traders and strategists to "package" this cycle into one of the typical "letters" - V, U or L; perhaps W or even a "Nike swoosh." Mocking the armchair "letterists", Investing legend Paul Singer said to go ahead and call it a "Q-shaped recovery":
Clearly this is a ridiculous exercise, and trying to boil down a global economy, with quadrillions in fund flows, into a simplistic 'shape' that even a central banker can understand, is an exercise fit for an idiot or any other full-time central bank employee.
Which is why Bank of America has taken a different approach, and instead of letters, its economists are thinking about the trajectory in phases. According to them, we are now past the first phase - the shutdown - and squarely in the second phase, which is one of a transitioning economy. The last stage is the recovery which will be driven by three factors: path of the virus, degree of offsetting stimulus and residual economic damage.
So instead of letters, here are the 3 phases of the shutdown as defined by BofA:
- Phase 1: The shutdown. This started in mid-March as lockdown orders were put in place, resulting in a dramatic decline in economic activity. Over the month of March, $1.1 trillion dollars were lost from a pullback in consumer spending. The unemployment rate jumped to 14.7% with more than 20 million jobs lost between March and April. This phase was completed in April as suggested by the stabilization in aggregated BAC card data, leveling off in small business closures according to Homebase, and a peak in initial jobless claims.
- Phase 2: The transition. This phase started in May and will be a story of a transition with the weakness spilling from consumer spreading to the broader economy. The BAC aggregated card data show that consumer spending inflected higher as stimulus was delivered and businesses shifted online. However, there likely will be spillover effects as the pain in the household sector leads to a downturn in housing construction. Investment likely will also weaken as businesses pull back on capex and energy investment turns down. Re-escalation of the trade war looms in the background as an additional risk. There is also a risk that state & local governments fall under stress and begin to cut back. In this phase, the unemployment rate comes off the peak but remains uncomfortably elevated. This phase goes from mid 2Q to 3Q.
- Phase 3: The recovery. In this last phase the economy reopens and businesses come back to life, bringing back workers. The strength of the recovery will depend highly on three factors: the path of the virus, the degree of stimulus and the extent of residual damage on the economy. The greatest uncertainty surrounds this phase.
Phase 3: looks like a recovery, feels like a recession
The bank's economists are most concerned about the third phase. After the initial bounce from the bottom upon reopening, the economy needs to find a sounder footing to progress further. The risk is that it plateaus thereafter for a period of time, entering a recovery period of fits and starts; Ultimately, it will boil down to three factors, explained below:
Phase 3: looks like a recovery, feels like a recession
The third phase leaves us the most concerned. After the initial bounce from the bottom upon reopening, the economy needs to find a sounder footing to progress further. We think the risk is that it plateaus thereafter for a period of time, entering a recovery period of fits and starts. We think it will boil down to three factors, explained below:
Path of the virus:
The path of COVID-19 will be the most critical part of the equation to understand the path of the recovery. Health experts are warning that the COVID-19 curve - either measured by the number of cases or deaths - will naturally increase as the lockdown measures are eased; the question is whether this leads to renewed lockdowns based on either data or political interference. The slope of the curve matters. A rapid steepening of the virus, similar to the second phase of the Spanish Flu, could lead to another round of lockdowns, forcing businesses to close once again and crushing what is left of animal spirits.
The goal is clearly to avoid such a negative outcome. The White House Coronavirus Task Force along with numerous health experts have outlined steps to a successful reopening, which include meeting a low enough level of COVID cases and implementing sufficient virus testing and contact tracing. Roughly 24 states have already eased social distancing policies in some form, kicking off the reopening process. Unfortunately many states have not met the criteria to reopen, which could put people in a place of having to weigh the tradeoffs between health and personal finances. Indeed, survey data suggests that even as states open up, activity will be slow to resume. According to CivicScience, while more than a third of workers feel comfortable returning to work now, consumers are hesitant to resume many typical activities such as traveling, eating out or going to a major sporting event for some time (Chart 3).
While BofA thinks it is unlikely that we will return to a blanket shelter-in-place policy, we could see "two steps forward, one step back" when it comes to the reopening. There will be some form of social distancing in place until there is a vaccine which could take 2 years, if not more. This will lead to cautious behavior including greater savings and therefore a slow and rocky recovery.
Degree of stimulus:
The policy response has been forceful thus far with around $2.8tn of stimulus on the fiscal front and a $2.4tn expansion of the Fed's balance sheet. The stimulus put in place has been aimed at stabilizing the economy - to offset the loss of income from the private sector and get credit to flow through the financial system.
The job is not over. The fiscal stimulus will fade in the summer and will likely need to be ramped up again. The expanded unemployment insurance of $600/week expires at the end of July while the expanded eligibility runs through the end of the year. However, that may not be sufficient on either metric, and these benefits will be extended, but perhaps adjusted to taper the $600/week added benefit until it is phased out. Also, the Payroll Protection Program (PPP) may need to extend the June 30th deadline to support small businesses with payroll and operating costs during the initial reopening phase. There will also need to be support for state & local governments to avoid coming cuts.
The Fed has also been active in capital markets and will soon be kicking off the Main Street Lending Facility, but BofA expects even more intervention by the central bank. Recent comments suggest the Fed is considering ways to support nonprofit organization as well as universities and colleges.
Residual damage to the economy:
One of the ways that the shock ripples through the economy is through bankruptcies. Given the extreme degree of dislocation, the economy needs to prepare for the failure of many businesses, resulting in permanent damage to real activity. Looking to corporate bond markets, BofA believes that the credit cycle should be at least as damaging as recent recessions, which means a 21% cumulative default rate and 8-10% of fallen angel downgrades from Investment Grade BBBs per year. With every passing day, the risks are growing that credit losses will exceed those estimates.
Meanwhile, we are likely to see even more destruction at the small business level. A recent CNBC survey found that 13% of small businesses would fold in less than a month under current lockdown conditions, and another 31% if it persisted for a few months. Similarly, the Society for Human Resource Management's (SHRM) survey found that 12% of small businesses would need to shut down in under a month in this environment, 20% more under 3 months, and another 20% under 6 months.
That said, there are programs in place that should help mitigate the damage including the Fed's corporate credit facilities and Main Street Lending Facility. However, the details of the Main Street Lending Facility are still be ironed out, and it is hard to say how successful it will prove to be. The Payroll Protection Program (PPP) is designed to bridge the gap for small businesses (< 500 employees), but it appears that demand is exceeding the amount of funds allocated to the program and although the funds will help cover payroll costs, there will still be the strain of other expenses which might make staying in business unviable.
Bankruptcies are likely to be more disruptive and painful for certain industries than others. Naturally there is concern over retail, which was suffering prior to the COVID recession. Additionally, certain service companies such as restaurants and hospitality are at risk. This can leave workers displaced and struggling to find employment that fits their skill set. Of the total net jobs lost thus far in the cycle, 38% have been in leisure and hospitality and another 10% in retail (Chart 4). One has to therefore worry about the path of commercial real estate which creates another path for the shock to multiply. We are concerned about the adverse feedback loop that can be triggered by bankruptcies.
Bottom line: This cycle does not fit a mold. The downturn was painful and abrupt. There are now signs of life in the economy upon reopening. But the last stage of the cycle - the true recovery - will be challenging.