One possibility is a U-shaped recovery path which will unfold in the course of 2020 into early 2021. This view is underpinned by very low visibility on the effectiveness of unconventional policy intervention. Also, supply chain disruptions could be worsened by defaults in the upstream sectors if the demand fallout worsens as a result of lockdown or social distancing lasting for longer.
Given the massive reallocation of resources, kickstarting the global economy won’t be an easy push on the button once social distancing is no longer needed. Giving unemployed households and small business owners paycheck compensation in the meantime does not make up for steady income that can be used for discretionary consumption, making the multiplier effects of government stimulus lower.
A V-shaped recovery (bull case) or L-shaped (bear case) recovery are both non-negligible tail risks to this outcome. In the V-shaped scenario, the timely, targeted and significant fiscal and monetary stimulus packages will prevent a massive surge in unemployment, keeping the demand fallout from the consumer side limited. Given a more resilient consumer base, limited effects on consumer wealth and house prices, the multiplier effects of fiscal stimulus are fairly high. However, also given the scale of the unprecedented economic shock to the world, we think this is wishful thinking.
In the L-shaped scenario, the external shock is amplified by endogenous shocks that cascade through the economy. A financial crisis emerges as a result of an unprecedented drop in corporate profits and household income which governments can’t plumb without endangering debt sustainability. Credit/mortgage spreads blow out further, and the ensuing bankruptcies are followed by a prolonged deleveraging cycle. However, this can be avoided if fiscal stimulus is enough to prevent a recession becoming a permanent slowdown. My reasoning is explained more fully below.
The ship that ‘could not sink’
Parallels can be drawn between the fact that nobody saw the coronavirus coming and a famous ship they said could not sink more than a century ago. On 15 April 1912, human disaster struck when the Titanic collided with an iceberg at full speed. Its captain, Edward J. Smith, said in 1907 that he “could not imagine any condition which would cause a ship to founder. Modern shipbuilding has gone beyond that”. He was among the 1500 people who perished aboard the doomed liner on that tragic night. Unimaginable things do happen.
Few people saw human disaster coming late in 2019 and fully anticipated the impact of the coronavirus on society and the global economy in early 2020. As of 27 March, Covid-19 has infected 550,536 people globally and claimed the lives of at least 24,904. Former Fed Chairman Ben Bernanke, a recognized authority on the Great Depression, has said we are experiencing something much closer to a major snowstorm or a natural disaster than a classic 1930s-style depression. He is right – this is certainly not a typical downturn. It is a completely different animal, and therefore particularly unnerving.
Economic models didn’t see it coming either. A business cycle monitor which has been able to call previous US recessions with 90% accuracy had just shifted back to ‘full expansion’ mode again in February, evidencing reflation (GDP growth back to trend). Previously it had been signaling a decelerating expansion for 18 consecutive months. In a twist of irony, the long-awaited ‘all clear’ from the model proved to be the dead calm before the storm.
A tale of two scenarios
In Robeco's 2020 outlook, ‘A tale of two scenarios’, we hinted at the possibility of a worst-of-times scenario. When it was published in November 2019, we said: “The impact of a worst-of-times scenario would be so big that it would be unwise to ignore it completely. A >20% fall of the equity markets is not unthinkable if things do turn sour.” Things have indeed turned sour, but not in the way we expected.
This time around there was no overtightening by central banks, nor a gradual snowballing of minor excesses in the economy into something substantial enough to bring about a typical recession. A deliberate partial lockdown of society in order to prevent a health crisis from worsening deviates significantly from the classic recession playbook.
The fastest slide of equities into bear market territory since 1929 evidences the unprecedented uncertainty. Today’s exceptional market volatility is a reflection of tomorrow’s exceptional macroeconomic volatility.
With governments around the world enforcing lockdowns and imposing social distancing to flatten the curve of new Covid-19 cases, the longest post-WW2 economic expansion has come to a sudden stop. The extent of the damage to the global economy will greatly depend on the evolution of the pandemic, the duration and effectiveness of the social distancing measures taken to mitigate the health crisis, as well as the effectiveness of policy measures to dampen the economic impact.
Hotels, restaurants and airlines have taken the first massive direct hit, as offline social life has come to a halt. There are winners – like in every crisis – as well, for instance in the consumer staples sector. At this point in time, we only are able to see the tip of the iceberg, given the lack of hard macro data on when exactly the social distancing measures took effect. Nonetheless, the first glimpses are rather shocking. Initial jobless claims in the US shot up to 3.3 million last week, dwarfing peak numbers recorded during other any other post-WW2 US recession.
Two black swans
It’s not just the coronavirus that has raised the threat of recession. An oil price war was already underway as the severity of the outbreak started to become known. The global economy has therefore been confronted by the mutually reinforcing effects of two black swans: Saudi Arabia maximizing output to gain market share after failed talks with Russia about joint production cuts, and the social distancing required to flatten the Covid-19 curve aggravating the impact of the positive oil supply shock as mobility slows.
Given the cumulative impact of these two exogenous shocks, the question is whether the real economy and financial system can fully absorb the coronavirus scare, or will allow it to be amplified by a subsequent endogenous shock as pre-existing vulnerabilities in the economic system are exposed. These include elevated US non-financial corporate leverage, weak covenant quality in credit markets, and rising economic inequality.
In contrast to the global financial crisis, banks are now well capitalized, and could act as shock absorbers rather than amplifiers. This would prevent a negative feedback loop from the financial system to the real economy. However, the fact that the Ted spread – a key indicator of perceived credit risk in the interbank market – is still rising is far from reassuring in this respect.
The Eurozone last experienced a recession in 2012.
Source: Refinititiv Datastream, Robeco
Incisive policy response
This global recession that is likely result from the lockdowns could be the deepest in post-WW2 history, and that is why the policy response has to be the most incisive since the Great Depression. Given the paltry conventional policy space – interest rates have now hit the effective lower bound in most advanced economies – policymakers are already paving the way for unconventional policy. This includes lowering the countercyclical buffers for banks to protect the flow of credit to the real economy, and liquidity assistance for corporates, as well as wage subsidies to keep workers employed.
The ECB has taken bold steps with its pledge to purchase an additional EUR 750 billion in assets remove the issuer limit, enabling the central bank to buy more than a third of a country’s eligible bonds. Who would have thought the Bundestag in Germany would approve a stimulus package of EUR 750 billion and de facto abandon its policy of schwarze Null – literally, ‘black zero’, meaning a balanced budget?
Most governments in advanced economies have responded relatively swiftly, and now put in place targeted fiscal measures worth around 2% of GDP. More is likely to follow when the true depth of this global recession becomes apparent.
Awaiting the recovery
So, what will the ensuing recovery look like? Nobody really knows at this point. Recessions caused by external shocks tend to be rather deep and short, making a V-shaped recovery an obvious candidate. However, this is no ordinary exogenous shock. Unlike the 2011 Eurozone crisis, the dual economic impact of this Covid-19 virus representing both a negative supply as well as a negative demand shock make it very difficult to read the economic compass.
A simultaneous positive supply shock in oil compounds the navigational challenges, though very low oil prices bode well for a recovery in manufacturing in 2021, given its long lead time with G7 industrial production activity. We must not underestimate human creativity and the willingness of people to bring out the best in themselves in the worst of times. In the efforts to overcome this crisis, the frontier of technological possibilities is being pushed really hard, which could create productivity gains once the virus has been defeated.
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