Post-Pandemic, Not Really

While news about the pandemic has receded from capturing daily headlines, its effects will continue for years to come. Right now, investors are concerned about a possible recession, with its roots in government and central bank policies and decisions made by both consumers and corporations over the last two and a half years. Understanding each of these drivers may assist us in determining the kind of recession we’re likely to have, if we have one.

Policies

As the pandemic took hold around the globe, most countries began with the lockdown approach not dissimilar to what we see in China today, where Shanghai, a city of 26 million, has been closed for two months. It was recently announced that lockdowns in Shanghai would be relaxed a bit. The Chinese government will be allowing people back to grocery stores and factories, albeit at a reduced capacity. China’s policies will continue to affect global supply chains for the rest of this year and move production capacity around the globe for years to come.

The beginning of the pandemic in early 2020 saw much of the world take this approach, before we had vaccines. This caused a hole in global economies that was filled in many ways by governments providing stimulus, including through trillions in cash direct to consumers and businesses.

As for central bankers, they made liquidity more widely available—although with economic growth crashing, that liquidity was not borrowed by companies and individuals stimulating demand, so it went into investments, resulting in higher asset prices.

The Federal Reserve’s balance sheet grew to over $9 trillion as a result. Short-term interest rates went to 0% and continued to become more negative in other parts of the world. The Fed’s balance sheet grows as it purchases Treasury and mortgage debt, which provides liquidity for the banking system and works to lower interest rates. Now, as the Fed begins its program of reversing this trend, by letting $47.5 billion run off the balance sheet each month, it will have the opposite effect. We’ve seen some of this already with higher interest rates. This balance sheet reduction will have the effect of tightening financial conditions, raising the cost of borrowing and reducing stock prices as they’ve adjusted for higher interest rates.

Consumers

The Federal government provided consumers with trillions in cash. This resulted in a significant increase in consumer saving and spending. Savings rates more than doubled as many took in this cash and saved it, not knowing how long the pandemic would last. Others spent the money they were earning plus this cash on things they could use while locked up at home. While airlines and cruise lines were crashing, home gym equipment makers such as Peloton and consumer goods companies like Amazon were having their best days ever.

Now those “pandemic stocks” are crashing as demand for their products declines rapidly, leaving companies with an excess of inventories and warehouse space. Amazon is leasing warehouses to third parties and Peloton acknowledges it overbuilt for manufacturing. These companies will see a decline in earnings, which is why their stock prices adjusted lower (Peloton is down 87% from its high while Amazon is down 22%).

Consumers are now benefitting from a tight labor market. Last Friday, the unemployment in May dropped to 3.6%. However, this ultra-low level looks like a short-term situation as consumer confidence and corporate confidence have declined rapidly in the face of a sticky inflation situation. In addition, while savings rates have plummeted from highs, savings themselves remain high with consumers retaining over $4 trillion in cash balances. That may be prudent for consumers, but it doesn’t help the companies expecting to make sales.

Many, including us, thought the inflation situation would be moderating already. However, the China supply chain issues remain, demand for goods has stayed higher than expected, and tighter labor markets have continued to put upward pressure on wages. While these factors will moderate, it will still be some time before price inflation abates.

This means that consumers will become more cautious, spending less, and therefore reducing demand for goods and services.

Corporations

Reduced demand will likely lead to slower growth for companies and lower earnings growth. While higher interest rates have been priced into stocks, a slower earnings growth environment may not be.

Companies were quick to increase inventories in some sectors and now have more goods than they need as demand wanes. This will be good for inflation news however won’t help with earnings in the near-term.

The higher cost of transportation also can’t be absorbed and so will make its way into prices for products and services. It looks like oil prices will remain above $100 per barrel for some time, so gas and diesel prices will be elevated as well. This will likely have a deleterious effect on demand that further suggests a slower growth rate for the economy in the next several months.

Still, companies have invested in themselves and will benefit from automation and investments made in new markets and developing labor. This should act to reduce those negative effects to some degree. In addition, companies have been banking cash—to be ready for new opportunities and to weather storms—with cash positions currently near historical highs.

All of this is to say that while we like to say we’re in a post-pandemic environment, the reality is we’ll be feeling its effects for years to come. If we have a recession, we would expect it to be a moderate one representing the challenges of managing the inflationary environment, changing consumer demands and continued supply chain alterations—rather than something resulting from a more meaningful demand shock.