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What’s happening this week in economics? Deloitte’s team of economists examines news and trends from around the world.
To no one’s surprise, real GDP in the European Union (EU) fell at a record pace in the second quarter, declining even faster than was the case in the United States. In the 27-member EU, real GDP declined at an annualized rate of 39.8% from the first to the second quarter. In the 19-member Eurozone, real GDP declined at a rate of 40.3%. By comparison, US real GDP declined at a rate of 32.9%. The sharp second-quarter decline in Europe followed a steep decline in the first quarter. Specifically, Eurozone real GDP declined at a rate of 13.6% in the first quarter while EU real GDP declined at a rate of 12.2%. This compares to a decline of 5.0% in the United States. Thus, in the first half of 2020, Europe’s economy collapsed as governments imposed severe economic restrictions in order to contain the virus. Restrictions only began to be lifted in May, and then only gradually.
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The good news is that the severe decline in economic activity was successful in suppressing the spread of the virus. By the end of the second quarter, the number of new infections in the EU was very modest. Moreover, there are indications that economic activity is starting to expand rapidly without generating a massive outbreak of the virus—although there have been isolated outbreaks. There are two factors that are helping to avoid a second general outbreak. First, it appears that rules about social distancing are mostly being followed. Second, most countries in Europe have testing and tracing regimes that enable quick suppression of isolated outbreaks. Still, considerable risk remains, as evidenced by the troubling outbreak now taking place in the Catalonia region of Spain, which is wreaking havoc with the key tourist industry. However, what likely distinguishes Europe from the United States is that, after a catastrophic decline in activity in the second quarter, Europe can expect relatively strong growth in the third quarter, something not likely to take place in the United States where a large outbreak is already having a negative impact on consumer spending and mobility.
By country, real GDP declined at a rate of 34.7% in Germany, 44.8% in France, 41.1% in Italy, and 55.9% in Spain. For the Eurozone, activity in the second quarter remained 15.0% below the level from a year earlier. Our Deloitte forecast calls for a return to a normal level of GDP by 2023. Spain’s decline in the second quarter was clearly the worst. Indeed, its GDP in the second quarter was 22.1% below a year earlier, more than wiping out all the gains of the last decade. Spain’s decline largely reflects the severity of its lockdowns. Italy’s decline was not as bad. However, given that Italy’s economy barely grew in the last decade, GDP has fallen to a level not seen since the 1990s. Germany did better, possibly due to an early implementation of testing and tracing capacity. Early reports suggest that Germany is returning to pre-crisis levels of consumer activity more quickly than its southern European counterparts. Indeed, it was just reported that German retail sales in June were 5.9% above the year earlier level. However, retail sales fell 1.6% from May to June after having increased 12.7% in the previous month. In Italy, nonetheless, retail sales increased 12.1% from May to June after having increased 24.0% in the previous month. Despite such strong monthly growth, June sales remained 2.2% below the level a year earlier. Other data point to Germany’s relatively better situation. For example, the number of job vacancies relative to pre-crisis levels, while low, is much higher in Germany than in France, Spain, or Italy.
Part of the problem is that the three latter countries are each heavily dependent on tourism. Recent new outbreaks in these countries have scared tourists away, causing a sharp decline in tourist-related revenue after an initial resurgence. Meanwhile, there is concern about a second wave of the virus in Europe, with outbreaks in various places. Of most concern right now is the outbreak in Spain. This has led the United Kingdom to require that tourists returning from Spain be quarantined. Germany is warning its citizens against travel to Spain. These decisions, in turn, will surely hurt Spain’s economic recovery. Britain’s Health Secretary, Matt Hancock, said, “I think you can see a second wave starting to roll across Europe, and we've got to do everything we can to prevent it from reaching these shores and to tackle it. It's not just Spain ... but there are other countries too where the number of cases is rising. And we are absolutely determined to do everything that we can to keep this country safe.” Hancock’s comments come as Britain reports the highest rate of excess deaths in Europe. That is, the number of deaths in the past few months in proportion to the norm from the past five years is very high relative to other European countries.
As far back as March, it was widely expected that US real GDP would decline at a historic pace in the second quarter. Early estimates from various Wall Street firms predicted annualized declines in the 20-40% range. Our own Deloitte forecast has evolved over time. At one point we were exceptionally pessimistic, predicting that second quarter GDP would fall at an annual rate of 57%. Our view at that time was that activity would decline very sharply in April and then stay down for a few months, rebounding strongly in the third quarter after the virus had been suppressed. We were right about April but failed to see that activity would rebound in May and June, in part due to early reopening by many US states. Over time our forecast was adjusted to account for what we were observing through high-frequency data. A few weeks ago, our prediction was that second-quarter GDP would fall at an annual rate of 35%. Last week we learned that second-quarter GDP fell at an annual rate of 32.9%. It was the sharpest quarterly decline since the US government began keeping records more than 70 years ago. Note that second-quarter GDP fell less than previously expected due to an early rebound in economic activity. Yet that early rebound has contributed to a second wave of the virus which, in turn, is already having negative economic consequences. Hence, third-quarter GDP is likely to be worse than previously expected.
The latest report indicates that consumer spending declined at an annual rate of 34.6%. This was despite the fact that real disposable personal income increased at a rate of 44.9% due to massive transfers from the Federal government. Notably, real Federal government non-defense purchases increased at a rate of 39.7%. This was not due to the cash transfers to households. Rather, this reflected purchases meant to support the fight against the virus. In any event, the divergence of spending and income meant that consumers saved a great deal. In fact, the amount that households save tripled from the first to the second quarter. The savings rate increased from 9.5% in the first quarter to 25.7% in the second quarter. As for consumer spending, the lion’s share of the decline was due to a reduction in spending on services. Spending on durable goods only fell 1.4% and spending on non-durables fell 15.9%. Yet spending on services fell at a rate of 43.5%. There were especially sharp declines in spending on health care, recreation services, and food services and accommodations (restaurants and hotels). These three categories alone accounted for 60% of the decline in GDP. So long as the virus remains a threat, spending on recreation, restaurants, and hotels is likely to remain suppressed. Also, the sharp decline in spending on health care might seem surprising, but it reflects people not visiting their doctors and dentists during the crisis.
There was also a sharp decline in investment spending. Non-residential business fixed investment fell at a rate of 27.0%. Investment in structures fell 34.9% and investment in equipment fell 37.7%. However, investment in intellectual property only fell 7.2%. Evidently businesses were keen to pay software engineers to write code while working from home. Residential investment was also down, falling at a rate of 38.7%.
International trade took a big hit early in the crisis, and this is reflected in a sharp decline in US exports and imports in the second quarter. Real exports of goods fell at a rate of 67.6% in the second quarter and real imports of goods fell 48.8%. The only major category of GDP to increase significantly was Federal government spending.
The GDP report is a look back at history. Events are moving rapidly. The GDP report tells us little about where we are right now. For a better understanding of the current situation, it is useful to look at initial claims for unemployment insurance that was reported last week. The report indicates that, in the prior week, there were 1.434 million new claims for unemployment insurance, a slight increase from the previous week. It was the second consecutive of week-on-week increases and the first time this has happened since early April. As such, it indicates that the US job market is stalling. That is not surprising given that, with the rebound of the virus, there has been an evident decline in consumer time spent at restaurants, retail establishments, and entertainment venues. It is likely, therefore, that employment at such locations is now declining. The government will release its jobs report for July on Friday and there is a good chance it will show a decline in employment and an increase in the unemployment rate. Meanwhile, what happens in August will depend, in part, on whether the US Congress passes another spending package. For now, it seems unlikely that a compromise will be reached any time soon. As such, it is likely that personal income will decline, contributing to a further decline in spending and a weaker third quarter GDP number.
In response to last week’s news, there was a decline in US equity prices while bond yields fell. Most likely investors were not responding to the GDP report, which was not unexpected. Rather, the increase in initial claims for unemployment insurance signaled the growing weakness of the US economy, boding poorly for the quick recovery many had hoped for. The yield on the US government’s 10-year bond fell to 0.54%, the lowest level since March and the second-lowest ever. This reflects expectations of weak credit demand rather than expectations of lower inflation. In fact, the so-called “breakeven” rate, which is an excellent proxy for expectations of inflation, has risen in recent weeks. The 10-year breakeven rate is now 1.53%, meaning that investors expect average annual inflation to be 1.53% during the next 10 years. This is the highest breakeven rate since the crisis began but remains below the pre-crisis level of about 1.7%.
The main focus of government policy in multiple countries has been to give money to businesses while they shut down and to households while they stay at home. The idea is to allow people and businesses to survive while, at the same time, encouraging social distancing in order to suppress the spread of the virus. The hope is that, as in Europe and much of East Asia, this suppression will be accomplished quickly so that the economy can get back to work. This did not happen in the United States; instead, the outbreak is continuing and accelerating. The effect of this is a suppression of economic activity as consumer fear of the virus leads to reduced spending and mobility.
Now, the US Congress is in the midst of a debate about another round of assistance to households and businesses. Yet it is clear that the focus of the two parties is very different. The Democrats want to provide funds to support households while they stay home from work and engage in social distancing. The Republicans want to use government to encourage people to return to work and to make it easier for businesses to reopen. The latter policy is predicated on the belief that the economy can function well even if the virus is not yet under control. The Republican plan provides much more limited unemployment insurance in order to encourage people to return to work, liability protection for businesses that rehire workers, subsidies for small businesses that reopen, subsidies to communities that reopen their schools, subsidies for businesses to clean their facilities, and full expensing of business meals to encourage people to return to restaurants. The Democrats, in contrast, provide uninterrupted enhanced unemployment insurance, aid to state and local governments, and additional forgivable loans to small businesses that remain closed. Both sides want money for testing and tracing.
Philosophically, the two sides are far apart even though they both intend to spend a large amount of money. It can be argued that both sides have a point, but there is a discrepancy about timing. The Democrats want to enable the economy to be shut down again in order to attempt to suppress the virus. This makes sense now while the virus remains a big problem. Provided such a policy succeeds in the manner that happened in Europe, at that point the Republican proposal would make sense to implement. That is, once the virus is suppressed, the government can attempt to reignite economic activity Meanwhile, so long as consumers are nervous about the virus, government efforts to boost economic activity might fail. The good news, however, is that the so-called reproduction rate, known as R(t), has fallen in the United States in recent weeks, signaling that consumer fear might have been effective in stymying the spread of the virus by enforcing social distancing. If so, then the future might be more promising in the medium term.
The Republican plan to cut unemployment insurance benefits, predicated on the idea that this will encourage people to return to work, will not necessarily generate increased employment in industries that face weakened demand such as restaurants, movie theatres, and airlines. Instead, it could lead to significantly reduced personal income which, in turn, could cause a sharp decline in consumer spending. Meanwhile, the Republican plan is sufficiently controversial that a significant number of Republican legislators oppose the plan.
In any event, the two sides will negotiate with the goal of quickly reaching some sort of agreement. Yet not only are there differences between Democrats and Republicans, there also remain differences among Republicans and differences between the White House and Congressional Republicans. This may bode poorly for a quick resolution of the problem.
Meanwhile, the US Federal Reserve left monetary policy unchanged last week and pledged to continue aggressive action in order to keep credit markets open and functioning. Investors reacted positively, driving up equity prices. However, Fed Chairman Powell reiterated that the Fed’s ability to drive the economy is limited and that “the path of the economy is going to depend to a very high extent on the course of the virus, on the measures that we take to keep it in check. We can’t say it enough.” Indeed, the recent surge in new infections and deaths was soon met by a downward shift in economic activity. The virus and the economy cannot be delinked.
Powell also noted that the economy appears to be weakening. He said that data on consumer spending and hiring indicates as much. The jobs report for July will be released later this week and, given that initial claims for unemployment insurance are now rising, there is a significant chance it will show a decline in US employment in July. If so, it could signal that real GDP might not grow at all in the third quarter. The weakening began a few weeks ago following a sharp rise in new infections that was followed, in turn, with a sharp rise in deaths. Powell suggested that the best solution is to suppress the virus by implementing policies that enforce social distancing. He said that “social distancing measures and fast reopening of the economy actually go together. They’re not in competition with each other.”
With the Fed having cut interest rates to near zero and having engaged in massive asset purchases and injections of liquidity, there is not much more it can do. Rather, Powell suggested that fiscal policy is now key, saying “fiscal policy can address things we can’t address.” Yet, as noted above, the debate continues about fiscal action.