Is America heading for a V-shaped economic trajectory after the Covid-19 shock? Or does a U, W — or dreaded L — shape loom instead?
That is the question preoccupying many investors — particularly since the equity markets have recovered with a remarkable V shape. But looking at these Roman letters might actually miss the point.
Instead, for my money, there is a better image to ponder: a shape I first drew 23 years ago when I was a rookie reporter learning Pitman shorthand. It is the symbol for “bank”, which is akin to a curvy square root sign.
I first had reason to ponder the delicious symbolism of this image as a forecasting tool 11 years ago, when a similar debate about a V-shaped trajectory was occurring after the 2008 financial crisis. Back then I argued that the “bank” shape was oddly relevant since the need to “fix” finance after the collapse of Lehman Brothers would cause an initial economic rebound to subsequently flatten out, creating that curved square root shape. I was broadly right.
Now, that “bank” shape seems relevant and symbolic again — but with a twist. Unlike in 2009, it is not the need to fix private sector banks that is likely to lead an economic rebound to flatline; big US banks are more healthy now, as shown by recent earnings.
This time, the “bank” that investors should ponder is the US Federal Reserve. Since the Covid-19 pandemic hit, the American central bank has responded with stunning shock and awe; Deutsche Bank analysts reckon that the Fed balance sheet will double during 2020 to $8.3tn, because of all the monetary support it has provided.
The Fed has splashed this money to keep markets functioning (after initial jolts) and credit flowing to the real economy. Its interventions have also made it easier for the US Treasury to sell the mountains of debt it has needed to fund a fiscal response to the pandemic. That, in turn, has softened the coronavirus economic crash in March and helped spark a subsequent rebound — creating a growth chart that looks like the “b” and “n” shape in the shorthand sign for “bank”.
“A variety of data suggest the economy bottomed out in April and rebounded in May and June,” Lael Brainard, a member of the Federal Reserve board of governors, observed in an important speech this week.
She noted that the jobless rate fell from 14.7 per cent in April to 11.1 per cent in June, retail sales jumped 18 per cent in May and the manufacturing and non-manufacturing Institute for Supply Management indices rose into expansionary territory in June. This week the optimism index for small businesses also increased 6.2 points to 100.6 in June — regaining three quarters of its plunge earlier this year.
But the rub is that rebound may already be fizzling out. “Some high-frequency indicators tracked by Federal Reserve board staff (including mobility data and employment in small businesses) suggest that the strong pace of improvement in May and the first half of June may not be sustained,” Ms Brainard noted.
It is easy to imagine why. Fresh outbreaks are already triggering new lockdowns in California, Texas and Florida, the three largest states by population. The US faces the confidence-sapping prospect of an ugly presidential election this autumn. A nasty political fight is under way about how or whether to replace the current pandemic-fighting fiscal package, which is due to expire at the end of July.
Then there is another issue: the limits of Fed power. This spring’s remarkable actions undoubtedly delivered a positive jolt to the economy. But it will be extremely difficult for the Fed to deliver a similar shock to sentiment again anytime soon; we are now in the territory of incremental action. And the Fed cannot plug the ever-widening holes in the balance sheets of insolvent companies, replace lost consumer demand or reverse all job cuts. Even fiscal support can probably only delay, not remove, the pain.
To understand this, consider airlines. This spring, US carriers received fiscal support and pledged in exchange to not cut staff until October 1. But in the past two weeks, Delta has announced 17,000 early retirements and United sent furlough notices to 45 per cent of its US employees.
Or look at the action of banks. This week JPMorgan Chase, Wells Fargo and Citi set aside a record $28bn for bad loans, more than expected. This shows they fear a wave of corporate and consumer bankruptcies.
The bank is “prepared for the worst-case scenario” since “we don’t know what the future is going to hold,” JPMorgan’s Jamie Dimon observed. Or as Ms Brainard said: “The [economic] recovery is likely to face headwinds even if the downside risks do not materialise.” Citi’s scenario included the unemployment rate peaking in the “low to mid-teens” and US gross domestic product falling sharply.
The bottom line is this: central bank action can spark a V-shape rally in equity prices; but on its own, it cannot create sustainable growth after that. Therein lies the reason why the current economic rebound could run out of steam — and why that symbol for “bank” is both a portent for the future and an illustration of the plight US president Donald Trump faces as he tries to revive the economy.