The COVID-19 outbreak looks set to result in one of the sharpest economic contractions on record. What will determine the shape of the recovery?
Our Top Market Takeaways for April 14, 2020.
What will determine the shape of the recovery?
- The collapse in U.S. economic activity in the first half of 2020 is widely understood, but what matters more for future returns is the shape of the recovery that follows. Will it be a V, U, or L shape? We have shifted our base case from a rapid “V-shaped” rebound to a more measured “U-shaped” recovery since we now see a more gradual resumption of activity after social distancing measures begin to ease. We expect GDP to contract by -3.2% in 2020 and not to return to its prior peak until 2022.
- Even in the U-shaped recovery, we see GDP rebounding faster than it did following the 2008–2009 Global Financial Crisis, and a lot faster than during the Great Depression. In the end, the virus represents an “exogenous” economic shock, from which the recovery should be swifter compared to “endogenous” recessions resulting from excess leverage in the financial and household sectors.
- We have now transitioned from the “late stage” of one cycle that peaked in February 2020 into the “early stage” of a new cycle that began in March 2020. This is critical information for our investment approach: shifting posture from the defensive selling of the late cycle to an opportunistic buying approach to risk assets.
What will determine the shape of the recovery?
It is now well known that the measures in place to control the spread of the novel coronavirus will result in one of the sharpest economic contractions on record. As we outlined previously, the decline in activity depends on the amount of spending on goods and services that can no longer occur, combined with the duration that social distancing measures remain in place. The collapse in economic activity—reflected in pessimistic surveys, spiking jobless claims and other measures of real activity—will continue to show this historic freeze.
Markets are already trying to reflect the magnitude of the H1 2020 collapse, but the looming questions are: How long will the social distancing shutdown last? And what will the rebound look like on the other side?
To simplify, we consider three paths of recovery: a swift V-shape versus a more gradual U-shape versus a prolonged L-shape.
The shapes of possible recoveries
The V-shaped rebound represents the most bullish outlook. The economy was on a solid footing before the COVID-19 shutdown, and a V-shaped rebound would consist of a rapid return to the same level of output once social distancing restrictions are removed. Growth in H2 2020 would make up much of the shortfall of the first half, and full-year activity would contract just -1.2%. By late-2021, the V-shaped recovery would put the level of GDP back to 2019 levels (chart above). Labor markets would quickly heal, and the steep rise in the unemployment rate—which appears to already be above 10%—would be temporary, as firms reopen and re-employ workers (chart below).1 Unemployment a year from now would not be much above the low levels of the past few years.
The V-shaped recovery is still a possible outcome, but our assessment of its probability has declined in recent weeks (we give it a 30% chance of happening). A V-shape is still possible because the medical models of the virus still suggest peak mortality is only a couple of weeks away in the United States, leaving May as an adjustment month, and by June, the economy potentially could be highly operational. In addition, a V-shaped recovery would probably be propelled by more fiscal dollars in the pipeline to (1) support state and local governments, which are hindered by collapsing revenues; and (2) jumpstart the economy when it reopens, potentially via a ramp-up in infrastructure spending. Crucially, in the V-shaped recovery, there is a limited “psychological hangover” when the economy reopens. Consumers aren’t cautious to go out and spend, people are eager to get back on airplanes, and businesses are willing to reinvest after a period of defensive behavior.
In the U-shaped recovery (55% probability), the pickup in activity happens more gradually. Output does not return to full capacity quickly, and the second-half rebound does not make up for the steep decline in the first half of this year. A U-shaped recovery is not predicated on the virus spreading after social distancing restrictions are removed, but rather a widespread hesitation on consumer and business behavior when the economy reopens. We have seen a more gradual resumption activity in Asia and expect a similar gradual resumption in the West as well, as the U-shaped recovery is our modal expectation. Restaurants likely won’t fill up quickly; people will remain hesitant to travel, and there will likely be a lingering skepticism about attending social gatherings, such as sporting events and music concerts. In this scenario, GDP contracts by -3.2% in 2020, and even by late-2021, GDP has not returned to 2019 levels. The unemployment rise does not reverse as quickly.
To be clear, even in the U-shaped recovery, we see GDP rebounding faster than it did following the 2008–2009 Global Financial Crisis (GFC), and a lot faster than during the Great Depression. In the end, the virus represents an “exogenous” economic shock, from which the recovery should be swifter compared to “endogenous” recessions resulting from excess leverage in the financial and household sectors. The below chart shows how our V- and U-shaped recoveries compare to the post-GFC recovery and the Great Depression. As you can see, the difference is immense, especially relative to the Great Depression.
The L-shape (15% probability) is the most pessimistic outlook, which shows sustained weakness and more permanent damage from the COVID-19 shutdown. Unemployment stays high, and output does not fully rebound for several years. This scenario would likely include more corporate bankruptcies and insufficient policy support. The most likely path to the L-shaped scenario is where the virus never really gets “under control”—every time social distancing is lifted, another wave of outbreaks emerges, making it very difficult for businesses to sustain operations and for consumers to return to pre-shutdown behavior. Eventually, “herd immunity” or a vaccine may end the spread of the virus, but each is a long way off (1–2 years at the earliest). This scenario is more like a “depression,” where even by 2022, activity remains well below 2019 levels, and unemployment lingers at the highest levels since the Great Depression.
What does the shape of the economic recovery mean for markets?
Even if we end up in a V-shaped scenario, we don’t think yields are likely to rise materially. Government budget deficits will be very wide globally, but these likely don’t matter much until the economy reopens, as the government is merely recycling the very elevated flow of savings from the private sector back into the economy, particularly the healthcare sector. Moreover, the elevated level of unemployment that is on the horizon is likely to (again) put downward pressure on wage growth throughout the economy, just as labor income, tragically, was really starting to recover. Reduced incomes translate into disinflationary pressure on major categories of inflation, such as rents (32% of CPI), as well as causing retailers to discount prices to make sales. We do see scope for temporarily elevated inflation in certain supply-constrained goods (such as consumer perishables), but we will doubt it will be long-lasting, and it will be essential (and expected) that the Fed looks through it.
In contrast, we are incrementally more likely to be adding to risk assets, even if we can’t be sure whether we have reached the true market bottom. In 2018 and 2019, we were advocating for defensive positioning according to a “late-cycle playbook.” Now, we are shifting to “early-cycle” thinking, recognizing that opportunities are more plentiful across a wide range of assets. To be sure, V- and U-shaped outcomes could see further pullbacks ahead, but we think stocks are unlikely to retest lows in these scenarios. An L-shaped outcome would likely lead to further market downside, but even then, we think the probability is quite low, given the significant degree of policy accommodation already injected into the system.
As the chart below shows, the greater the degree of fiscal and monetary accommodation, the more markets have already recovered when the economy troughs, historically speaking. Forceful monetary and fiscal support continues to be rolled out: On the monetary side, most recently with the Fed’s announcement last Thursday to expand its credit facilities and launch the Main Street Lending program; on the fiscal side, we see scope for expanded fiscal relief, with additional funding to existing programs for small businesses and municipalities, coming soon.
The bottom line is that whether we are in the V- or U-shaped economic recovery is somewhat beside the point, as markets typically rebound well before the economy rebounds. No matter the shape of the gradual recovery, we are finding value in asset classes and securities that haven’t seemed particularly interesting in quite some time.
1We are already seeing some tentative signs of this. In the latest employment report for March, unemployment spiked, but more than 85% of the spike is attributable to workers being furloughed rather than truly laid off. To be sure, the Bureau of Labor Statistics noted that respondents who were unsure of their status were instructed to list themselves as on temporary leave. Nevertheless, the distinction is critical, and it will be the key item for us that we’ll be tracking in the April employment report, as furloughed workers maintain their health insurance coverage and can begin working at the same job when the economy reopens.
All market and economic data as of April 2020 and sourced from Bloomberg, FactSet and Gavekal unless otherwise stated.
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