Markets

From All Systems Go to a Deep Recession in One Month

The economy has gone from the equivalent of 60 to 0 in the blink of an eye after social distancing directives permeated the nation. To try to understand the magnitude of the crisis, Anirban Basu compares it to previous events and evaluates the significance of events.
By Anirban Basu
May 13, 2020
Topics
Markets

The first reported case of COVID-19 occurred in China in November 2019. At that time, the U.S. economy was humming, supporting a 50-year low in unemployment and approaching 2020 with what appeared to be irresistible force. Worker and skills shortages were impacting many industries, including construction, driving wages higher in conjunction with a growing number of companies, states and municipalities raising minimum wages for a variety of reasons.

The result was a consumer spending cycle that foretold of no immediate end. Rising home prices and a booming stock market intensified the spending power of economic actors and their confidence in the future, resulting in additional economic momentum. As if that were not enough, inflation and interest rates remained low, albeit steady, amid the lengthiest expansion in American history, keeping the cost of capital low. From the perspective of fomenting demand for the delivery of construction services, this represented a nearly perfect environment.

Economists who had been predicting recession because of a set of emerging vulnerabilities (e.g., massive indebtedness at household and corporate levels, lofty asset prices) began to doubt their own projections. America’s economic expansion appeared indefatigable.

Recent History: A Shock to Demand

In an attempt to better understand the economic implications of the ongoing crisis, many people have attempted comparisons between the current period and other periods of economic distress. The most popular comparison appears to be with the 2007-2009 recession.

Here’s what happened. Following the economic recovery after the 2001 recession—combined with low mortgage rates and demographics—created a demand for housing. Home prices drifted higher, inducing many renters to pursue homeownership in an attempt to participate in the rally. This produced further home price increases in much of the nation.

Mortgage bankers, seeing an opportunity to generate income for their financial institutions, began expanding their lending. Because associated loans are backed by collateral (the American home), and because that collateral was becoming more valuable, perceived risk appeared low.

But to continue to make loans in large numbers and to generate the requisite levels of liquidity, bankers needed new sources of funds. Those making mortgages looked to Wall Street to package mortgages together, securitize them and sell them to investors in the form of collateralized mortgage-backed securities. As previously made mortgages were sold off in large amounts, the resulting proceeds could be used to fund the next series of mortgages.

Major ratings agencies looked favorably upon these mortgage-backed securities, giving them a thumbs up. As if that were not enough, investors were able to buy insurance against default in the form of credit default swaps. This appeared to be a perfect setup, with more individuals participating in the American dream, investors safely earning returns and mortgage bankers, insurers, title companies, realtors and others earning large fees and commissions in the process.

This was also a phenomenal period for construction firms, as commercial construction followed residential development. The problem was that some people were allocated mortgages they could not hope to repay. By late-2005 and into 2006, more Americans were missing their payments.

Predictably, credit began to dry up as lenders sought to avoid additional defaults and delinquencies. Suddenly, there was a dearth of buyers. Home prices began to decline, and with it the collateral available to back loans. Major investment banks found themselves on the brink of catastrophe.

By September 2008, financial markets were crashing, unemployment was skyrocketing and the construction backlog began to dry up. The fundamental problem was that the financial system and broader economy were drained of liquidity and capital. The money disappeared. The global financial crisis that began when Lehman Brothers faltered on Sept. 15, 2009, produced a shock to demand.

In response, the Federal Reserve and the Treasury Department identified various mechanisms by which to pump money back into the economy (e.g. quantitative easing, TARP), and that ultimately helped to fashion the lengthiest economic expansion in American history.

2020: A Shock to Supply

While it is true that the economic dislocations suffered during that period were massive, including for construction firms, the current period defies comparison.

This time is truly different from all others in that America is now experiencing a supply shock. The economy went from the equivalent of 60 to 0 in the blink of an eye as social distancing directives permeated the nation, first and foremost in major employment centers on the East and West coasts.

After three rounds of stimulus help, the latest being Phase 3 of the CARES Act which includes $2.2 trillion in federal aid, even stimuli of this magnitude cannot hope to significantly contain the near-crisis. That’s because a stimulus helps the payments side of the economy, but it doesn’t position Americans to go back to work and begin adding to gross domestic product. Thus, despite the stimuli, U.S. unemployment is headed toward 20% and the second quarter GDP is set to decline in the range of 25% on an annualized basis, perhaps more.

Normally, construction backlog helps shield contractors from the early stages of economic downturn. Nonresidential construction is among the last economic segments to enter recession for this reason, as contractors toil on projects initiated before the downturn began. Here, too, this factor is different. Social distancing directives have impacted contractors in parts of Pennsylvania, Massachusetts, California and elsewhere. Projects are being postponed or even canceled in large numbers, as would-be purchasers of construction services strive to preserve their own liquidity. Consequently, backlog is not the shield that it normally is, and it is shrinking rapidly.

To try to understand the magnitude of the crisis, economists and other observers have been fixated on weekly initial unemployment claims. The frequency of this data is assistive because monthly and quarterly data have, thus far, failed to capture much of the damage done to the U.S. economy.

In the final two weeks of March, more than 10 million people filed a claim for unemployment benefits. Over the first three weeks of April, another 16 million filed a claim. Moreover, many others tried, but failed due to overwhelmed computer systems and bureaucracies. To put this into perspective, these 26 million claims were more than the previous 10 years combined. When the official jobs numbers were released in early April, the economy had lost 701,000 jobs on net, while the unemployment rate rose from 3.5% to 4.4%.

Much like the balance of the economy, the construction sector experienced a loss of jobs in March, losing 29,000 jobs on net. This was the most significant loss registered since February 2019 when wintry weather undid the industry’s momentum, albeit only briefly.

This time, weather played no role in fomenting job loss. What’s more, a near-term turnaround is not in the offing. If anything, matters are set to further deteriorate as commercial construction activity grinds to a halt and as state and local governments watch finances crash.

While certain construction segments will experience a jolt of activity during the foreseeable future, including fulfillment centers, medical facilities and data centers, most construction segments will experience decline, including office, lodging and retail segments.

According to the most recently available data, the construction unemployment rate stands at 6.9%—1.7% percent higher than at the same time one year earlier. The industry’s unemployment will climb rapidly during the months ahead, providing contractors with an opportunity (at least theoretically) to more easily recruit highly competent personnel. Construction wages are also less likely to rise rapidly given the significant dislocations of construction workers in much of the nation.

Looking Ahead

While the initial stage of recovery from the current downturn will be sharp as people return to work and the economic engine restarts, it will also be incomplete. Complete recovery from the recession will likely take years.

One of the reasons for this is that state and local government budgets are now under severe pressure. With retail sales, hotel and income tax revenues declining, many state and local governments are now experiencing the emergence of massive gaps in their budgets; budgets that must be balanced each fiscal year. There will also be many empty storefronts, fewer occupied apartments and office suites, as well as a diminished tally of employers available to jobseekers once the pandemic has passed.

The good news is that more stimuli is on the way. As of the end of April, there have been four stimulus bills passed by Congress. Phase 1 was an $8.3 billion bill in support of coronavirus vaccine research and development; Phase 2 was a roughly $104 billion package focusing on supplying paid emergency sick leave for some workers; and Phase 3 is the $2.2 trillion stimulus. Phase 4 includes another $484 billion deal that includes $321 billion to replenish the small business Paycheck Protection Program, which allocates $11 billion in administrative costs for the program. A fifth package, one focused on investments in infrastructure, also seems probable.

The hope is that the federal government will supply additional support to state and local governments. With interest rates so low, it actually is a good time for the federal government to float Treasuries. Failing that, the recovery to come is likely to be considerably weaker than forecasted, in part because shrinking state and local government outlays would undermine the expansion in the private sector.

by Anirban Basu

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