For Markets, It's the Economy's Direction That Matters

(Bloomberg Opinion) -- This is not your typical economic recession, with the cycle from peak to trough likely both narrowed in time and widened in magnitude. The shocking speed and magnitude of the hit to the economy can cause us to lose focus on the fact that all downturns eventually become upturns. Moreover, that shift in the economy will soon come even if the data remains dismal, leaving us to struggle with how to interpret the data.

For market participants, it is probably best to keep an eye on the direction of change and leave the level of activity to policy wonks. It’s important to recognize that the magnitude of the weakness in the data is not driven by what we would think of as typical business cycle dynamics where a negative shock expands over time throughout the economy. Instead, we literally flipped a switch and told companies to close. You can’t feign surprise at layoffs in the leisure and hospitality sector when restaurants and entertainment venues are all shuttered overnight. You can’t expect retail sales to do anything other than plummet if activity is limited to only a narrow class of essential providers.

Hard as it might be to accept, the depressed data is a feature of policies enacted to slow the spread of Covid-19. It is not a bug. Moreover, the data is severely lagging our understanding of the cycle. There are really no leading indicators for this recession, other than perhaps initial unemployment claims, which shot up from around 200,000 a week to 6.87 million over the course of 14 days in late March. 

Any business cycle economist would say that rising unemployment claims is a leading indicator that the economy is deteriorating while falling claims signals improvement. So, if you knew nothing about the magnitude of initial claims, you would conclude that the decline in claims from the peak on March 27 to 2.44 million in the latest survey was a positive development. But you could easily miss that point while in shock over the speed at which claims rose, to say nothing of the heights at which they still remain, with some 25 million workers receiving unemployment benefits, up from the pre-pandemic average of about 1.7 million.

Similarly, you might be so caught up in the sharp decline of housing starts that you missed the improvement in builder confidence, the rebound in home builder stocks, or rising numbers of purchase applications. The decline in retail sales was severe, but sales will, or have already, started recovering as social distancing restrictions ease. 

None of this is meant to imply that the depth of the decline in activity isn’t important. From a policy perspective, it is important to emphasize the depth over the direction. There is too much risk that fiscal policy makers become complacent as economic activity bottoms out and begins improvement. We should continue to support the economy with such policies as a continuation of enhanced unemployment benefits that phase out as the economy improves and aid for state and local governments. Such policies would help speed along the recovery and policy wonks are right to keep driving this message home.

Market participants would be equally right to focus on the direction of the data. Market prices incorporate expectations of future levels of activity. It’s not wrong for an analyst to declare that the peak of initial jobless claims or the bottom of retail sales is behind us. The economy may be growing again in June if not already now. Policy wonks and the more bearish elements of the commentariat might hate it, but market participants can’t hide their heads in the sand because markets will lead the economy. 

Don’t forget that the last bull market began while unemployment was still rising and continued even as the recovery limped along for years. For market participants, the direction was more important than the level. The same will hold true in this cycle as well, but the usually tension between those “level” and “direction” people is magnified by the speed and depth of this cycle.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Tim Duy is a professor of practice and senior director of the Oregon Economic Forum at the University of Oregon and the author of Tim Duy's Fed Watch.

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