The Post-COVID Economy
David
Shulman
Senior
Economist, UCLA Anderson Forecast
June
2020
It
will take time for all the king’s horses
and
all the king’s men to put the economy
Induced by the COVID-19 pandemic, the
economy had a great fall during the March-May time period. Nonfarm employment
declined by 22 million nonfarm jobs and the unemployment rate skyrocketed from
3.5% in February to 14.7% in April. Make no mistake, the public health crisis
of the pandemic morphed into a depression-like crisis in the economy. To call
this crisis a recession is a misnomer. We are forecasting a 42% annual rate of
decline in real GDP for the current quarter followed by a “Nike swoosh” recovery
that won’t return the level of output to prior fourth quarter of 2019 peak
until early 2023. (See Figure 1) On a fourth-quarter-to-fourth-quarter basis,
real GDP will decline by 8.6% and then increase by 5.3% and 4.9% in 2021 and
2022, respectively.
Similarly, employment won’t recover
until well past 2022 and the unemployment rate will be around 10% in this
year’s fourth quarter and will still be above 6% in the fourth quarter of 2022.
(See Figure 2 and 3) Thus for too many workers the recession will linger on
well past the official end date of the depression. We are assuming a start-stop
return to normalcy with vaccines available in early 2021 and, most importantly,
most of the nation’s public schools reopen in the fall.
Figure 1. Real GDP, 1Q2018 – 4Q2022, In
$ Billions, SAAR
Sources: U.S. Department of Commerce and
UCLA Anderson Forecast
Figure 2. Nonfarm Employment, 1Q2018 –
4Q2022F, In Millions, SAAR
Sources: Bureau of Labor Statistics and
UCLA Anderson Forecast
Figure 3. Unemployment Rate, 1Q2018 –
4Q2022F, Percent, SA
Sources: Bureau of Labor Statistics and
UCLA Anderson Forecast
Fiscal
and Monetary Policy Response
Both the Administration and the Federal
Reserve Board responded with unusual alacrity to the crisis. The $1.8 trillion
CARES Act moved quickly through Congress (more will be needed, most likely in
July) and the Fed immediately moved to a zero interest rate policy and
committed itself to supporting the corporate bond market for the first time
ever. (See Figure 4) As a result the Fed’s balance sheet ballooned by $4.1
trillion from late-February to $7.1 $trillion in early June. (See Figure 5)
Further, it seems that the Fed is about
to embark a yield curve maintenance program that will work to fix the long end
of the Treasury curve. (See Figure 6) That policy is a throwback to the Fed’s
support of the treasury market during World War II; an inflationary program
(initially suppressed by price controls) that ended with the famous Treasury
Accord of 1951. In essence, the Fed acted as an arm of the Treasury during
World War II and didn’t regain its independence until after the Accord.
Figure 4. Federal Deficit, FY2012-FY2022F,
In $Billions, Annual Data
Sources: Office of Management and Budget
and UCLA Anderson Forecast
Figure 5. Federal Reserve Banks, Total
Assets, Dec 2007 – June 2020, In $ Millions, Weekly Data
Source: Federal Reserve Board
Figure 6. Federal Funds vs. 10-Year U.S.
Treasury Yield, 1Q2018 – 4Q2022F, Percent
Sources: Federal Reserve Board and UCLA
Anderson Forecast
Although inflation will likely remain
muted throughout the forecast period, it is our view that by the mid-2020s the
Fed’s 2% inflation target will be handily exceeded. (Figure 7) Why? There are
several theories as to what causes inflation: monetary, fiscal deficits and
cost-push. We discussed the fiscal and monetary stimulus above and cost-push
will come reorganizing the economy for resilience rather than efficiency, more
on that below. However, many of those forces were at work after the Great
Financial Crisis of 2007-2009 and inflation was quiescent.
What is different this time? First new
banking rules made restoring liquidity rather than lending a priority and
second fiscal policy in the U.S. and Europe turned from stimulus to austerity.
The latter is not likely to happen this time. Thus the way is open for
inflation to return later in the decade.
Figure 7. Headline Consumer Price Index
vs. Core CPI, Q12018-Q42022F, Percent Change Year Ago
Sources: Bureau of Labor Statistics and
UCLA Anderson Forecast
Why
will the Recovery be so Moderate?
Despite all of the stimulus being poured
into the economy, we anticipate a moderate recovery. Simply put, despite the
Paycheck Protection Program too many small businesses will fail and millions of
jobs in restaurants and personal service firms will disappear in the short-run.
We believe that even with the availability of a vaccine it will take time for
consumers to return to normal. (It took more than two years after 9/11 for air
travel to return to its prior peak.) With businesses taking on a huge amount of
debt, repayment of that debt will take a priority over new capital spending. And do not forget that state and local
budgets suffered a revenue collapse that even with federal assistance it will
take years to recover from.
Housing:
A Bright Spot
Responding to a prolonged period of
under-building earlier this year housing activity was on a tear. New starts
exceeded an annual rate of 1.5 million units in January and February and prices
were rising. With the shutting down of the economy, housing starts dropped to
890,000 in April. Nevertheless, despite the spike in unemployment underlying
consumer demand appears to be strong and that the forces in play earlier this
year will reassert themselves, especially with the availability of sub-3%
mortgage rates. We expect the recent tightening of credit standards will loosen
as employment growth begins to pick up. As a result, after starts declining to
1.11 million units this year as a whole, we forecast that activity will be running
at a 1.3 million unit annual rate by the end of 2022. (Figure 8)
Figure 8. Housing Starts, 1Q2018 –Q42002F,
In Millions of Units, Quarterly Data SAAR
Sources: Bureau of the Census and UCLA
Anderson Forecast
Speculations on the Post-COVID World
“There are decades where nothing happens, and
there are weeks where decades happen.”
Attributed to Vladimir Lenin
First, to state the obvious, the trends
that were in place prior to the outbreak of the pandemic accelerated. For
example, the trend towards the increased digitization of the economy and cloud
computing ramped up to a new higher level.
Online shopping, benefiting from social distancing and the closure of brick and
mortar stores, accounted for a record 28% of retail sales less automobiles, gas
and restaurants in April. A year ago it was 21%. The trend toward
de-globalization was in train prior to the pandemic and that too will continue.
I will now take in turn the changes I see in global geopolitics, domestic
politics, the work environment, urban density, the housing market, the new
rental dynamics of retail, and the popping of the higher education bubble. I do this fully understanding the
admonition of the Nobel Prize-winning physicist Nils Bohr who noted “It is very
hard to predict, but especially the future.”
*Geopolitics
A
new cold war with China arising from
trade tensions and Chinese expansion into the South China Sea was smoldering
prior to the pandemic. It ignited with the Chinese being less than candid with
their responses to the COVID-19 pandemic which originated in Wuhan, China. It
was further exacerbated by China’s new legislation that limits freedom in Hong
Kong, pending congressional legislation to have greater oversight on the
listing of Chinese securities on the U.S. markets and China gradually devaluing
its currency.
As the pandemic hit full force in the
U.S. Americans realized that a host of critical medical supplies and bio-active
ingredients were largely sole-sourced out of China and of a sudden became very
hard to get. Where for many decades the
watchword for the economy was “efficiency;” the new watchword will be
“resilience.” What that means is American companies under the pressure of
tariffs were already diversifying their supply sources out of China will
accelerate that move and will also return production to the U.S. That
production will likely locate in the lower-cost South and Midwest and much of
it will be automated.
In contrast, the European Commission
announced a $1.35 trillion virus recovery plan that will have the effect of the
rich north subsidizing the poorer south. With that policy reversal, largely by
Germany’s Angela Merkel the risks of a Eurozone breakup have been reduced
thereby working to prevent a potential banking crisis.
*Domestic
Politics
As we noted above the U.S. government
will be running mega-deficits for years to come. Ultimately that will mean
higher taxes, especially on the wealthy.
Whether the pandemic leads to an entire rethinking of the social safety
net remains open to question, but the virus has laid bare the problems
associated with employer-based health insurance. With unemployment lagging the
recovery in the economy it likely Congress will finally get around to funding a
major infrastructure package that will be able to be financed at very low
interest rates.
*The
Work Environment
What we have learned from the pandemic
is that the economy can work from home (WFH), at least for the 37% of jobs that
are amenable to that environment.
Firms from Morgan Stanley to Facebook have noted the success of the WFH
experiment has been so successful that they plan to radically reduce their
office footprint. Indeed Facebook Founder and CEO Mark Zuckerberg noted, “Over time location will hopefully be
less a factor in how many people work … And we’ll have technology to feel truly
present no matter where we are.”
He further noted that perhaps half his current workforce of 45,000 could be
working from home in five years. And if
you can work from home, it can be practically anywhere.
Office purists argue the WFH environment
works against corporate culture and the internal and external agglomeration
economies associated with dense office environments. They further argue that
the Yahoo WFH experiment failed in 2013. There
is merit to those arguments, but given recent advances in telecommunications (e.g.
Zoom) it seems to me that agglomeration economies will become less a prisoner
of geography than now believed.
An offsetting factor for the demand for
office space will be a partial undoing of the two-decade-long trend to densify
office space. The WeWork model of having 75-100 square feet of office space per
employee does not work in a virus conscious world of social distancing. Office
workers will have more space and there will quite a bit of Plexiglas separating
workstations.
For primary caregivers (almost all
women) of children, WFH will open up a host of opportunities for a better
work-life balance. It will be far easier to take care of a sick child and go to
a school event.
*Urban
Density
Since the late 1990s, we have witnessed
a renaissance of many of America’s great urban centers, especially on both
coasts. Density linked with mass transportation has been the holy grail of real
estate developers and owners. Now that whole concept has been called into
question as the pandemic thrived in dense urban environments. Simply put dense pedestrian-oriented
environments and mass transit (both horizontal and vertical as in elevators) do
not work in a socially distancing environment. The arrival of a vaccine
will certainly ameliorate the situation, but the shock of the shutdown and the
fear that the virus or another virus may return has been seared into the
consciousness of the citizenry.
If office work becomes more dispersed,
the urban amenities of restaurants, bars and entertainment will be under stress
for the lack of customers. That is, of
course, assuming that most of the restaurants reopen after the virus shutdown
which seems unlikely. Why be in an expensive city that lacks amenities.
*The
Housing Market
If WFH becomes prevalent post-crisis
there will be less need for people to live in expensive urban environments and it
will be hard to justify paying $3,000-$5000 a month for small apartments that
were never designed to be a home-office environment causing rents to fall. It
will take some time before pandemic-scarred commuters accept mass transit as a
transportation solution. Hence the much-reviled automobile will once again
become the commuter’s choice. This view is supported by a recent Citi survey of
5,000 urban households which indicated a strong desire to move to the suburbs,
especially the higher-income ones.
What all of this means is that, even as
urban rents fall, suburban housing will once again become a choice solution for
both millennials and empty nesters who so recently returned to an urban
environment. It also means that many
workers won’t have to live close to their workplace. The recent civil
disturbances associated with the largely peaceful protests around the police
murder of George Floyd and moves to “defund” the police will give added impetus
to the move to the suburbs l envision. Instead of living in San Francisco, New
York or Los Angeles workers can now choose to live in the relatively less
expensive suburbs of Austin, Raleigh, Nashville and Denver. All that is needed
are fast internet connections and a decent airport.
For those workers who chose this
lifestyle commuting times will be radically reduced. Indeed with less commuting
carbon emission will be reduced as well.
The
New Rental Dynamics of Retail
Under the onslaught of online
competition, it is no secret that brick and mortar retail has been in a world
of hurt for the past several years. As we noted above the pandemic telescoped
all of retail’s worst fears in three months. Historically the rent-paying
ability of retail tenants was based on sales per square foot. However, under
the competitive hammer of online competition, retailer gross margins have been
squeezed and rent is actually paid out of gross margin, not sales.
Let me present a stylized example. A
store in typical Class A regional mall generates around $700/square foot and
the tenant pays a net rent of $62/square foot with an additional $25/square
foot of common area charges. A few years ago a clothing retailer would
generate a 40% gross margin in sales, or about $280/square foot. However, prior to the pandemic that margin was
squeezed to around 36%. Thus the new gross margin was running at around
$252/square foot, a $28/square foot reduction and that is assuming sales
remained at $700/square foot, a heroic assumption. Thus, with the gross
margin/square foot reduced by $28/square foot, the $62/square foot of rent is
hardly sustainable and it is likely that when the economy returns to something
approximating the pre-COVID normal mall rents will be under intense downward
pressure. I am not saying rents will
decline by nearly 50% as indicated by my example, but a decline on the order of
15%-30% seems likely. We would note that the analysis presented above
ignores the raft of department store closings and retail bankruptcies that have
occurred in the past three months.
The
Popping of the Higher Education Bubble
Aside
from a few dominant elite schools, higher education was already in trouble
prior to the pandemic. Small private colleges were failing and now many more
are on the brink of failure.
The fundamental question is “who will pay big bucks for an online program.” As
schools reopen, the rules of social distancing will drastically change campus
life making college less attractive. Lower cost online education should surge
especially from elite institutions.
On the financing side, with state
budgets under intense pressure, higher education will be in the crosshairs of
budget cutters. Adding to the pressure will be the lack of student visas for
foreign students, especially those from China. Remember it is those students
who invariably pay full tuition. Although not normally discussed in an
education context the major hospitals associated with state and private
universities have taken a huge financial hit with the near shutdown of high-margin
elective surgeries thereby putting additional pressure on university budgets.
As a result, colleges will close, more
than a few academic departments will shrink or close, and with that, the demand
for Ph.D.’s to receive degrees and to teach classes will collapse. The hitherto
cloistered world of academia will face the restructuring pressures that have
been felt elsewhere in the economy. Trust me, it will not be a pretty picture.
Conclusion
The public health crisis induced by the
COVID-19 pandemic has morphed into an economic crisis bringing with it swift
depression-like declines in output and employment. Although the economy apparently has bottomed it will take time before
output and employment levels are restored to the levels achieved in the fourth
quarter of 2019. Both fiscal and monetary policy reacted with great
alacrity that thus far has prevented long term decline. However, the huge debt
buildup in both the public and private sectors will work to dampen output in
the future. To be sure, inflation will remain muted over the near term, but the
combination of cost increases coming from prioritizing resilience over
efficiency, record increases in the Fed’s balance sheet and high fiscal deficit
regime as far as the eye can see will leave the way open for inflation later in
the decade.
The pandemic has telescoped trends that
were already in place in the economy towards increased digitization of business
functions and online commerce. It has increased already rising tensions with
China and brought the E.U. closer together. A major response to the pandemic
has been the success of work from home which looks like it will lead to long
term changes in work and urban environments as workers avail themselves of more
work/life options. In a nutshell,
economic and housing activity will shift from large cites to mid-sized cities
and away from the urban centers to the suburbs.
