When evaluating macro-economic data and how it links back to the impact on asset class returns and portfolio positioning, we normally focus on rates of change. The trend, whether things are getting better or worse, has historically mattered more than the absolutes, whether things are good or bad. This is not necessarily the case when economic data is negative. There is a minimum amount of activity that needs to be taking place for the economy to be growing (breakeven rate), which allows companies to generate enough revenue and cash flow to cover their operating costs, service their debt, pay their employees, and generate a profit. When the economy is shrinking and output is declining, companies start to lose revenue and have to make a combination of cutting their operating expenses, restructuring their debt, and reducing their payroll costs (such as hours, wages, or headcount). This is part of the overall economic, profit, and credit cycle.
Typically, once economic data has bottomed and starts to make improvements (rates of change go positive), the economy gets to a place where revenue can start to get close to breakeven rates and companies slowly start to become profitable again. As economic data continues to improve, revenues will continue to increase, and a virtuous cycle will likely kick in and eventually lead to growth in earnings and hiring. The timeline for this to take place and the amount of improvement that needs to occur is linked to the depths of the decline in economic activity. If economic data is improving, but remains negative, revenue is unlikely to get back to a breakeven level for most companies. Essentially what this means is that the economy is still in a recession, it is just a less impactful recession. When the economy is in a recession, revenue is typically declining, and companies do not have the profits to hire (as mentioned above).
Looking at the current data, there is a high probability that economic data will bottom in May or June, as some indicators are at or near their zero bound/record lows and states are starting to open their economies.
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Copyright 2020 Ned Davis Research, Inc. Further distribution prohibited without prior permission. All Rights Reserved. See NDR Disclaimer at www.ndr.com/copyright.html. For data vendor disclaimers refer to www.ndr.com/vendorinfo/.
Copyright 2020 Ned Davis Research, Inc. Further distribution prohibited without prior permission. All Rights Reserved. See NDR Disclaimer at www.ndr.com/copyright.html. For data vendor disclaimers refer to www.ndr.com/vendorinfo/.
Copyright 2020 Ned Davis Research, Inc. Further distribution prohibited without prior permission. All Rights Reserved. See NDR Disclaimer at www.ndr.com/copyright.html. For data vendor disclaimers refer to www.ndr.com/vendorinfo/.
This would normally be a positive sign that things are about to start improving on a rate of change basis and companies should start to see changes in their financial performance in a few quarters, which risk assets would start to discount in current pricing. These are not normal times. U.S. GDP estimates for the second quarter of 2020 are -25%+ annualized after being down close to -5.0% in Q1. GDP estimates for the rest of 2020 are down 3-4% year-over-year(y/y) in Q3 and Q4.
Source: Bloomberg.
This would suggest that even if the above mentioned data were to bottom in the second quarter, overall economic activity would still be contracting, making it difficult for consumers to have enough income to create the demand businesses would need to get back to prior operating levels. The Hedgeye chart below shows how much GDP has declined from peak to trough in prior recessions. A 3-4% y/y decline would be greater than the average decline in each recession since 1929.
Source: Hedgeye.
This analysis leaves out the impact to businesses that are based on large gatherings or that will have to operate below their normal capacity to meet current guidelines (not to mention the costs associated with meeting those guidelines). This also does not take into account the fact that S&P 500 earnings per share growth was 0% y/y in 2019, corporate profits calculated for national income peaked in 2014, and corporate debt levels were at record highs to start 2019. This would suggest companies may need to go through sizeable debt restructurings before being able to grow again and that economic growth rates may need to get above 2019 levels for the broad corporate sector to start experiencing profit growth.
Copyright 2020 Ned Davis Research, Inc. Further distribution prohibited without prior permission. All Rights Reserved. See NDR Disclaimer at www.ndr.com/copyright.html. For data vendor disclaimers refer to www.ndr.com/vendorinfo/.
Source: Hedgeye.
Source: FRED.
Source: FRED.
While it would be a welcoming sign to see economic data stop declining this summer, it may not carry the same message about the starting point of the next recovery until the economy gets back to a positive absolute growth level.
A unique dataset to track during this period will be the number of new cases and the increase in hiring/business activity for the states that are opening back up. Since this is happening on a staggered basis and at varying degrees, this could act as a leading indicator to how soon the economy and the labor market can get back to positive absolute growth levels.
The views expressed herein are presented for informational purposes only and are not intended as a recommendation to invest in any particular asset class or security or as a promise of future performance. The information, opinions, and views contained herein are current only as of the date hereof and are subject to change at any time without prior notice.
Senior Vice President, Investment Strategy
Boyd Watterson Asset Management, LLC
