2Q 2020
Economic Outlook:
The economy draws
a wild card

The U.S. economy is currently facing the greatest crisis of most people’s lifetime. And while a path to recovery exists, much of it will depend on how we play our hands over the next six to 12 months.

August 12, 2020
Drawing a wild card
  • Pandemic radically altered trajectory of the economy
  • Worst recession in roughly 75 years
  • Economy arrives at critical juncture
  • Path forward depends on controlling outbreak and policy
  • CRE faces noteworthy challenges, even in our upside scenario

Since we last wrote our quarterly economic outlook in mid-February, the world and the economy changed so dramatically it sometimes feels like we are discussing completely different matters. At the time the economy was already slowing, but not collapsing. And we warned in our closing remarks that the economy faced many risks, including the coronavirus:

Yet many wild cards exist: trade policy, coronavirus, domestic political uncertainty, etc. If any of them unfold the wrong way or occur in the wrong combination, then that could create problems. Such idiosyncratic risks prove unpredictable – literally beyond anyone’s ability to consistently predict or forecast.

Six months on from that warning and drawing one of those key wild cards, the economy faces the greatest crisis in most people’s lifetime. A path to recovery exists, but that will depend how we play our hand over the next 6 to 12 months.

The hand we were dealt

Heading into 2020 the economy maintained solid, if not spectacular, momentum. Yet signs of faltering had already emerged in various corners of the economy: private business investment had turned negative, open jobs declined, and the Fed started cutting rates. Growth had slowed, but not dramatically, and the risk of a recession did not rise appreciably in the latter half of the year – it looked like we held a pretty good economic hand. And then we pulled a key wild card out of the deck, except unlike beneficial wild cards this one proved calamitous. The coronavirus spread with alarming speed, pervading the entire planet in just months. As COVID-19 rapidly moved around the word, two key events occurred that dramatically impacted the economy. Governments quickly started shutting down businesses to slow the spread. More importantly, at the same time, consumers began opting out of purchasing many goods and services because of health concerns. That produced an abrupt halt to economic activity, atypical of a downturn.

Usually, growth starts to slow, and data looks inconsistent for a period, before turning clearly negative. For example, heading into the Great Recession, real GDP growth started slowing noticeably in 2007 before the onset of the technical recession at the end of 2007/beginning of 2008. And the labor market showed signs of slowing in late 2007 and early 2008 before accelerating markedly by mid-2008. In this downturn, that typical pattern did not occur. Even though widespread lockdowns and marked changes in consumer behavior only emerged in mid-March, those drastic changes produced sudden and stark consequences. GDP declined during the first quarter at an annualized rate of 5%, a rate unseen since the fourth quarter of 2008 during the depths of the financial crisis, and activity came to a screeching halt.

Government policy pivoted sharply to help support the economy. The Fed cut interest rates to effectively zero for the first time since the Great Recession. It also began purchasing assets again after spending the last few years slowly shrinking its balance sheet. The new asset purchase program expanded beyond even what it had implemented during previous crises, including purchases of exchange-traded funds (ETFs), corporate bonds and municipal bonds. The moves helped to stabilize fearful markets, keep the financial system operating relatively smoothly and prevent a health-oriented crisis from morphing into a financial crisis, which likely would have further worsened the economy. On the fiscal policy side, the federal government approved spending in excess of $3 trillion, providing support for the health system, households, businesses, and even state and municipal governments. Research shows that the spending programs provided vital support for the economy, even though government policy alone (including monetary policy) could not prevent the downturn. That is because the pandemic is causing the downturn – the economy and the pandemic are not independent of each other. Until the pandemic at least comes under some semblance of control the economy will struggle amidst business closures, restrained consumer spending (out of fear of falling ill or losing employment), job losses, and income declines.

With the pandemic proving as difficult to forecast as to control, uncertainty about the trajectory of the economy increased considerably because the economy now depended on the health crisis. The range of consensus forecasts widening considerably as economists struggled to make predictions based on factors (e.g. number of COVID cases) that fall far outside what they normally consider during a typical business cycle. Recognizing this, we altered our forecast process to produce scenario forecasts, not point forecasts, creating thousands of simulations that helped us produce three generalized cases: a base case, an upside case, and a downside case. These provided general guidance on direction and magnitude under groups of assumptions about the pandemic, policy, consumer behavior, etc.

In early June the National Bureau of Economic Research (NBER), the official arbiters of business cycles, declared that the economy had entered a recession. Economic activity halted so dramatically that the NBER made the formal announcement quickly, unlike previous downturns when the NBER took up to roughly a year to officially decline what data already showed. This was the fastest that NBER declared a recession since the group began formal announcements in 1979. The actual data justified their move: real GDP declined by 32.9% on an annualized basis, the worst quarterly drop on record since the quarterly GDP time series began in 1947. Peak to trough, real GDP contracted by 10.6%, the worst performance since the demobilization effort at the end of World War II and the third-greatest contraction since the Great Depression. That effectively brought the size of the economy back to its level from late 2014/early 2015, swiftly eliminating five years of growth in just two quarters. Both the quarterly and peak-to-trough measures fell roughly in line with (though slightly worse than) the base case in our scenario modeling.

The hand we are holding now

Heading into the third quarter, signs of a nascent recovery emerged. The labor market bounced back with job gains in May and June. Retail spending also rebounded during those periods and unemployment claims had gradually slowed. But by mid-June it became clear that this callow recovery was already losing speed. With case numbers still out of control and rising in many places, economies rushed to reopen. In the process, case levels reached new record levels nationally and in many states. This sapped the economy of needed momentum as re-openings were slowed or rolled back and consumers once again avoided patronizing certain businesses out of fear. Job gains slowed dramatically in July and unemployment claims and permanent job losses stopped falling. The Fed recently reiterated that it will continue to implement its “whatever it takes” approach to monetary policy. And the CARES act, the main fiscal stimulus program, expired at the end of July with no replacement. Congress is currently debating specifics and negotiating with the White House, but that process could drag on into next month, further putting any recovery at risk if supports to households, businesses, and governments lapse completely or decline too greatly. Why? Because the normal corrective mechanisms that right an economy during a downturn will not occur as consumers shy away from activities, such as traveling and dining out, that may risk their health. 

Rebound in Retail sales


How do we play our hand going forward?

The economy will almost certainly grow during the third quarter. Simply by dint of mathematics, reopening any meaningful percentage of the economy should produce growth. Moreover, non-financial downturns typically do not last more than 2 or 3 quarters. If the Fed can keep the financial system from seizing up, that should shorten the duration of the contraction. That means we expect that the technical recession should end relatively quickly despite its severity, breaking the typical relationship between duration and severity of downturns. Our scenario model projects real GDP growth in a range of 3% to 22% on an annualized basis across our three broad scenarios in the third quarter. The wide range reflects the heightened uncertainty surrounding the trajectory of the pandemic.

The more pressing question: where does the economy head after the third quarter? While the pandemic will not subside fully until we have achieved herd immunity (likely via a vaccine), keeping the outbreak in check would produce benefits for the economy. The more under control the outbreak, the safer consumers will feel and the more likely they will be to reengage the economy, producing economic growth, job growth, etc. Our scenario modeling suggests a narrower range of growth for the fourth quarter, but the pessimistic scenarios include the possibility for another short contraction in growth. Our base case projects continued growth in the fourth quarter, but rests on relatively benign (though not optimistic) assumptions about the pandemic and government policy. The more the pandemic comes under control and the more supportive government policy, the higher the probability of growth. Irrespective of scenario, we expect tough sledding ahead for the economy after the initial growth spurt in the third quarter as job gains continue to slow, business failures persist, and wage growth and spending remain challenged. We will address the scenarios in more detail during next quarter’s economic outlook once we have more transparency on the trajectory of the pandemic. 

Scenario forecast trajectories


Is CRE all in with the economy?

The massive uncertainty and lack of transparency for the trajectory of the economy renders forecasting of commercial real estate (CRE) even more challenging, which is why we have also implemented a scenario approach for CRE forecasting. Across property types and markets the better the outcome for the economy, the better the outcome for CRE, generally speaking. But in no way does that imply positive outcomes. Even in our optimistic scenario, most property types and markets face noteworthy declines in asking rents and meaningful increases in vacancy rates. Some property types, like industrial and multifamily, should outperform the overall sector because of their somewhat less discretionary nature. Across most markets, performance, while challenged, does not look like the worst of what has occurred historically. Exceptions to this include tourism-oriented markets like Miami, which could take longer to recover because the tourism industry is expected to lag the overall recovery. And energy-oriented markets like Houston, which is grappling with a severe downturn in the energy industry.

Closing thoughts and risks

While our base case forecasts growth during the third and fourth quarters, we are contending with asymmetrical risks across scenarios – downside risks clearly outnumber upside risks. The most prominent upside risk, an accelerated timeline for a vaccine development, does not come with a high probability, but would present the strongest case for the economy outperforming our base scenario. Downsides risks abound at every turn. The most prominent risk, a worsening in domestic COVID case numbers, already occurred. If that persists, it would further dampen the economic outlook with continued closed businesses and consumers staying away. Even the shifting geography of the outbreak presents risk. The combined economies of New York and New Jersey, the original epicenter of the outbreak, represent roughly 11% of U.S. GDP. The combined economies of California, Texas, and Florida, current hotspots, represent roughly 29% of U.S. GDP. Geopolitical risk, which we have often highlighted in recent years, has not abated – we have simply become distracted from it by the pandemic. Any number of occurrences from deteriorating U.S.-China relations to global unrest to domestic political strife remain and could create headwinds. The next few cards drawn from the deck should tell us a lot about where the economy is headed during the balance of 2020.