What the Worst GDP Decline in History Means for Investors

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As August begins, the economic recovery is sending mixed signals. This is primarily due to the accelerating number of COVID-19 cases in many parts of the country which has sparked new restrictions by governments and businesses. Despite this, there are signs that the worst is behind us at a national level, and jobs can slowly return as local businesses find their footing.

Historic decline in GDP

In particular, last week’s GDP data for the second quarter showed that the economy suffered its worst decline in history over those three months. 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 interpreting these numbers.

Chart: This chart shows the growth rate of the U.S. Gross Domestic Product (GDP). It measures the change over each quarter as an annualized and seasonally-adjusted growth rate. The recent data for Q2 2020 was the worst quarterly decline in history.

Clearnomics ML GDP 2020 08 04
Sources: Clearnomics, Bureau of Economic Analysis

Key points when interpreting today’s GDP numbers

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

In this case, the magnitude of this 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% – both compared to the first quarter and compared to the same quarter a year ago. While this is still terrible, it can’t truly be compared to the Great Depression which lasted a decade and technically consisted of two economic declines.

Second, the GDP numbers are naturally backward-looking since they are only released quarterly with a lag. The reason that many stocks continue to reach all-time highs is because these numbers were widely anticipated. In fact, it’s already been officially determined that a new economic cycle began in March.

Finally, the GDP numbers don’t take into account what we’ve learned since the economy was in free-fall: that it’s possible for businesses to successfully re-open and that the economic numbers can improve. Of course, this is highly dependent on the public health trends.

Signs of improvement

Going forward, if businesses can continue to run and expand their operations – even at partial capacity – jobs can return and corporate profits can recover. There were clear signs of this in the jobs data during May and June when the unemployment rate improved. Even if it takes time for retail sector jobs to return, there are 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.

Try not to react to backward-looking data

Ultimately, it’s important for investors to maintain discipline and see through this interim period in order to benefit from the economic recovery. After all, financial markets are forward-looking and can react to these trends even before they happen. This is one reason that stocks have performed well over the past few months despite the on-going crisis. Thus, it’s important for investors to maintain discipline and not over-react to backward-looking data in the coming months.

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