WELCOME TO THE LATEST EDITION OF VANTAGE POINT
Since the last edition of Vantage Point, COVID-19 has wreaked both human and economic devastation on the world. At the time of writing (June 25), worldwide over 9 million people have contracted the disease and more than 450,000 have died from it. The response has been to lock down a number of economies in an attempt to reduce the transmission rate and reduce the so-called R number to below 1. The upshot has been the largest global economic contraction since economic records began: the world economy could have shrunk by around 10% in Q2, with huge knock-on effects onto employment and business profitability. The economic policy response has been impressive, as both central banks and governments have stepped in to prevent recession turning into depression. In this edition, we look back at what we’ve been through, look ahead to what might happen, assess the monetary and fiscal policy response, analyse the impact on markets and finally draw some broad investment conclusions in what is a highly uncertain and rapidly evolving situation.
There is good news and bad news about what we’ve been through. The good news is that we may be past the worst: the world economy probably troughed in late-April or early May. The bad news is that the worst was, economically speaking, very bad indeed. The epicenter of the disease moved from China in Q1 to Europe and the U.S. in Q2. Some European economies – Italy, Spain, the UK – may well contract by a quarter to a third in the second quarter. The U.S. economy is likely to have shrunk by upwards of 10% (quarterly change, not annualized), while unemployment has risen by over 30 million. Lockdown measures are beginning to ease now and we should see a pickup in activity shortly, but the extent and duration of the recovery remain hugely uncertain.
Looking ahead, we once again describe an alphabet soup of potential recovery scenarios from here. We describe a ‘V’, a ‘W/U’, an ‘L’, and an ‘I’ scenario. Crucially, we also define precisely what we mean by each scenario, differentiating them by the time it takes to recover the pre-crisis level of GDP. Given the scale of the decline to date, growth rates in the second half of the year are likely to be very high, even if economies are only in reality opening up slowly – so GDP levels are what matter here and we have recast our GDP fan charts into levels to make that point clear.
What kind of recovery we get depends fundamentally on the course of the disease from here. If a large number of economies can exit lockdown without seeing the frequency of cases spike beyond levels health systems can cope with, then a ‘V’-shaped recovery is on the cards, with global GDP returning to pre-crisis levels by the middle of 2021. However, if there is a large second wave, possibly in the Northern Hemisphere Fall/Autumn that necessitates a return to partial or full lockdown, then a ‘W/U’-shaped recovery becomes likely and we are unlikely to see pre-crisis levels of GDP restored until 2022. If, in either case, we see permanent demand and capacity destruction, a prolonged, slow or ‘L’-shaped recovery, becomes likely. That scenario could also trigger another bout of financial market instability, especially if a wave of bankruptcies and defaults causes parts of the credit market to collapse. Finally, our ‘I’ scenario refers to ‘inflation’; it is a variant of the ‘V’, in which a stronger than-expected recovery, coupled with some reduction in supply capacity, causes inflationary pressure to rise in 2021 and forces central banks to reconsider their ultra-easy stance much sooner than markets currently expect. As usual, we attach probabilities to these scenarios and present all our forecasts in the form of ‘fan charts’, which describe not just the most-likely and weighted average outcomes, but also the level of uncertainty and where the balance of risks lies. In times like these, investors need to take account of risk as well as return and our fan charts help them to do that. After much debate, we have settled on the following probabilities for our scenarios: the ‘V’ gets 50%; ‘W/U’ 30%; ‘L’ 15% and ‘I’ just 5%. In short, we are a little bit more optimistic about the chances of a ‘V’ than we were last time, but the balance of risks remains firmly shifted to the downside. Our downside scenario probabilities add up to 45%, so are slightly odds against, but the outcomes in those scenarios are so negative that a number of our fan charts display a large negative skew.
We conclude with some broad investment conclusions. One difficulty is that equity markets in particular have been rallying strongly since late March, on the back of decisive central bank intervention designed to stave off another financial crisis. They seem to be pricing in a relatively strong ‘V’-shaped recovery and, although realised volatility remains high, and measures of financial market stress such as Libor-OIS spreads remain higher than they were pre-crisis, markets do not seem to be pricing in as much downside risk as our fan charts would imply.
As a result, the investment advice is nuanced: cautious but gradually increasing allocation to risky assets (equity and credit), but at lower-than-normal levels of overall portfolio risk, coupled with hedges where possible. That’s a difficult message to get over, let alone for investors to implement, but it reflects the precariousness and uncertainty of the situation we find ourselves in. Let’s hope we emerge from it soon.
BNY Mellon Investment Management
What We Think - Economic Scenarios
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