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Island Investing

Riffs, rants, and the upside of investing from way off Wall Street


What the Worst GDP Decline in History Means for Investors

From an email sent out to IIM investors…

Good evening, IIM investors.

The economic recovery continues to send mixed signals in early August. Increased COVID-19 cases in many parts of the country have led to increased restrictions by local governments and businesses. Nonetheless, there are clear signs that the economy is getting back on track. The data suggest that the worst is behind us at a national level, and that jobs will slowly return as businesses find their footing.

Recent GDP data for the second quarter showed the economy suffered its worst decline in history. On an annualized basis, the economy shrank by 32.9% – worse than any quarter during the Great Depression nearly a century ago.

However, it’s important to keep a few facts in mind when seeing those headlines.

First, we often annualize economic numbers in order to understand trends. Normalizing the data helps better compare measurements…by imagining what would have happened had these events been stretched out to a whole year.

In this case, the magnitude of that GDP decline is not expected to last a full year – since the worst likely occurred during April and May. The actual quarterly decline was 9.5% – compared to the first quarter, and the same quarter a year ago. While that is still awfully ugly, it really shouldn’t be compared to the Great Depression, either – which lasted a decade and technically spanned two economic cycles.

Second, those GDP numbers are backward-looking – since they are only released quarterly, and with a lag. Many stocks continued to perform well over that same time because those numbers were widely anticipated. In fact, the consensus forecast for a 34.5% decline in GDP was nearly right on point – and we already knew that a new economic cycle began in March, according to the National Bureau of Economic Research.

Finally, those GDP numbers don’t take into account what we’ve learned since the economy first went into free-fall: that businesses can successfully reopen, and the economic numbers can improve. That’s highly dependent on COVID, of course, but if businesses can continue to run and expand their operations – even at partial capacity – then jobs can return and corporate profits can recover.

There were clear signs of this in the jobs data during May and June when even weekly jobless claims were improving. As retail sector jobs return, there are also signs that business and industrial activity has picked up. Various manufacturing and non-manufacturing levels are now rising at pre-crisis rates – a positive sign for the rest of this year and into 2021.

As expected, corporate profits are trending with the economy. It’s estimated that earnings fell between 35% to 40% during the second quarter (they are still being reported) and will likely decline in 2020 overall by a little more than 20%.

However, estimates also suggest that corporate profits will return to pre-crisis levels by the end of 2021.

While a two years of lost profit growth is not what anyone wants to see, let’s keep some perspective there, too. Namely, this is occurring after the worst quarterly economic decline in history – and it may be shorter than the four years of flat profits we saw after the 2008 financial crisis.

Ultimately, it’s important to see through this interim period in order to benefit from the economic recovery. Financial markets are forward-looking…one reason that stocks have performed well over the past few months despite the on-going crisis.

So, please consider this a reminder that it’s still important to maintain discipline and not over-react to backward-looking data in the coming months.

Below are three charts that put recent economic trends in perspective.

1. The economy has experienced its worst decline in history


The Q2 GDP decline was the worst in history. The economy fell 32.9% at an annualized rate or 9.5% on a quarterly basis. Still, unlike in prior recessions and depressions, this is not expected to continue at this pace. There are already many signs that the economy is rebounding, even if the pace is uncertain due to the on-going COVID-19 crisis.

2. However, the recovery is still continuing


Other data show that activity has been returning since the economic bottom. The ISM manufacturing and non-manufacturing indices both show that business activity has returned to a healthier pace. While these numbers will depend on how local governments and businesses deal with COVID-19 outbreaks, the overall trends are positive.

3. Profits are expected to take two years to recover


In the end, what matters to investors is how the economic data affect corporate earnings. So far, earnings have trended with the economy. Profits are expected to recover in the second half of the year and into 2021. This trend is one reason that stocks have recovered in recent months.

The bottom line? While the Q2 GDP report was the worst in history, that was widely expected. There are many signs that the economy has been recovering since then – and will continue to do so, through 2021.

Please let me know if you have any questions. 

Thank you and hang in there.

– Cale