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Reopening at the Tipping Point

With Ellen Zentner and Andrew Sheets

How should investors think about the recovery as the U.S. balances reopening with concerns over a second wave of coronavirus infections?

In this addition to the Thoughts on the Market series, Chief U.S. Economist Ellen Zentner translates the sometimes complex world of economics, helping investors identify early indicators of market-moving trends. 

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Episode Transcript

Andrew Sheets: Welcome to Thoughts on the Market. I'm Andrew Sheets, chief cross asset strategist for Morgan Stanley.

Ellen Zentner: And I'm Ellen Zentner, chief U.S. economist for Morgan Stanley. And on part one of this special edition of the podcast, we'll be talking about the effects of the coronavirus on the US as well as the rest of the global economy. It's Thursday, June 25th, at 9:00 a.m. in New York,.

Sheets: And it's 2:00 p.m. in London.

Sheets: Ellen, you and your team have just released your updated forecasts for the U.S. economy for this year and next. Maybe a good place to start is what do you expect as your base case and how do you think this compares relative to other investors you've been speaking to recently?

Zentner:  So right now, we're going through a period of pent up demand that's coming through now that the economy's opening up and this is putting us on the sharpest part of that V-shape recovery that I know we've discussed on this podcast in the past but we have even more conviction around it now. So this V-shape recovery is coming through, and it slows a little bit around the fall because we do have an assumption that a second wave of infections is coming through. That's in line with Matthew Harrison, our biotech analyst's expectation. A little bit more risk aversion creeps in there. But then as we get a broadly dispersed vaccine in the spring, we have an inflection in growth and that gets us back to pre-Covid levels on the economy by the end of next year. Now, that's really where we are out of consensus because consensus is looking for return to pre-Covid levels, more like the middle of 2022, whereas we have it returning more quickly. Now, just to give you a comparison, that's an eight quarter return to pre-Covid levels for real GDP. That compares with 14 quarters after 2008. So that's your V shape. It's a faster recovery that we're expecting in the economy.

Sheets: You know, another topic I know that you spent time on is the level of inequality in the U.S. and the fact that you do have a quite unequal distribution of wealth across the population. And when you think about that consumer picture, but also the stimulus that the government has provided. How do you think that's impacting the economic recovery and maybe how does that shape what type of stimulus would be more or maybe less economically effective going forward?

Zentner: Yeah, so I think this is a very important point as well. We've gotten a fiscal policy response that dwarfs what we saw after 2008 by multiple times over and focused on really supporting households at an incredibly difficult time where not only is unemployment very high, but the prospects for going out and getting a job have been very low. And so that critical support: unemployment benefits that we are adding to with a $600 weekly supplemental, that is aimed toward the most income constrained households, which means they will spend it. Now because we were shut down, structurally we weren't able to spend all of that. So what did we do during that time? We built up a savings rate that peaked at 33%. Incredible. And so that's a nice tailwind when activities are opening up, when the economy is opening up, that households can draw down upon in order to spend. And that's part of what's driving the pent up demand that's coming through. And so, you know, when we think about the economic impact of fiscal policy, we think about it in terms of multiplier effects. And that's why it's always important that you focus on the lower income groups in the U.S. because they're what we call "marginal propensity to consume." How much they spend out of that support tends to be quite high. And so that fiscal policy is another key element that does get us back-- fiscal and monetary policy-- incredible support there that does get us back to pre-covid levels more quickly.

Sheets: Another issue that comes up quite a bit is this issue of reopening the economy, so to speak, and how does that happen when Covid-19 is still so prevalent in the U.S.? How have you thought about those dynamics when you're trying to forecast, you know, what the U.S. economy looks like over the next 12 months?

Zentner: Yeah, so the forecasting environment is extremely difficult. This isn't just for economists, it's for strategists like yourself as well. Right? Because we've never dealt with having to pull in a baseline of something so unknown, like the evolution of how the virus might play out. So it really is important that we try to find the right balance here so that we don't end up with lasting damage to the economy. By the time we're going through a second wave in the fall. Governors have a checklist: what is hospital capacity like? Well, they'll have continued to expand hospital capacity during this time. What are  the various treatments like? We're probably going to get some selective localized restrictions that go back into place. And we're even seeing today in the U.S. where governors of some states, weren't even requiring people to wear masks and now requiring people who wear masks. And some of the localities in those states have said we're going to not follow the governor's recommendation and restrict the movement of our own people because we don't agree with the governors assessment. So I think we'll continue to see that and see differences of opinion. And look, we tried to take into account in our outlook sort of this general risk aversion that curves around that time. I mean, think about it. Even if we don't return to restrictions, if you're a consumer and you're watching the TV, second wave of infections is rising, you might decide to self restrict your activity. And so we do assume there's some element of risk aversion that comes back in. And that flattens the growth path a bit around the fall.

Sheets: There's obviously a very kind of live debate at the moment about whether or not the government will pass an additional fiscal stimulus measure as some of these current measures are set to expire. I was just hoping you could talk a little bit about how much of a difference that would make in terms of a passage versus a non passage of additional stimulus. How much of a difference that makes to your economic forecasts looking ahead?

Zentner: Mike Zezas has been critical, our U.S. public policy strategist, in following his expectations. Just as important to our baseline as sort of the path of Covid playing out are his expectations on fiscal policy. It looks like Congress is on track to pass what we think will be around a trillion dollar package this month, in the month of July. It'd be the last major legislation before the presidential election. And it includes extending measures that if they don't get extended, you would create this fiscal cliff, if you will, which we can't afford right now.

Zentner: So you've got the extension of the terms of the Payroll Protection Program. That was important, that was already done outside of this legislation. But critically, we've still got two parts that need to be passed ,that are included in our outlook. One, some sort of extension of the weekly supplemental to the unemployment benefits. Now, there's a difference of opinion in Congress as to whether you should just extend the $600 a week all the way into January of next year, whether you should let that go away and replace it with a return to work bonus of $450, or, what we think is a good compromise and the most likely, ratcheting down or stepping down that $600 weekly supplemental overtime. So that's a critical piece that has to be in there. And the other pieces: funding for state and local governments. So you can imagine when your state shuts down, revenues do too. And that creates a massive budget hole and states cannot run deficits in perpetuity like we can at the federal level, they have to run a balanced budget. And if they don't get help to plug that hole in revenues from the federal government, then they will have to make draconian cuts to Labor. So you could imagine that that would stop short any further improvement in the unemployment rate. So those are key pieces that we expect to be in there. We think Congress is moving in that direction. We think this comes in July. But that does create a big risk to the outlook, of course, if Congress is not able to pass something.

Sheets: So, Ellen, my final question would be in February, March, and April, we probably saw one of the sharpest, fastest draw downs of economic activity in American history. And I'd just be curious, as an economist, looking back on what we've seen over the last several months, what surprised you the most and maybe challenge, kind of, previous economic assumptions that were out there?

Zentner: You know, I think what surprised me the most was how early the economy started contracting. So there was this view going into the government shutdowns that because April was really the month that over the course of the month, we finally got to all 50 states shutting down, it was largely expected that the data would look ugly in April. But the data started coming in in March and subsequent revisions to that only deepened this, that the decline really started in March. And so I think that was the surprise. It really suggested that households were internalizing the threat of Covid much more quickly than governments were across the US. And so, in a sense, that means households have been shut down for longer than the states have and can underscore why we would have such a sharp rebound in pent up demand because households themselves were shut down for longer.

Sheets: Thanks for listening. We'll be back in your feed soon with more of my conversation with Ellen Zentner. If you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcasts App. It helps more people find the show.