By Tim Sharp, Hottinger Investment Management
The Covid-19 crisis has in many ways been unprecedented and aside from the human tragedy that has unfolded the effects have been very difficult for economists and investors to forecast with any degree of accuracy. As we have pointed out in previous articles, comparisons to previous crises have proven mixed because there has not been a global pandemic since the Spanish flu outbreak in 1918 and globalization and technology have changed society significantly since then.Many investors have decided that the 1st quarter reporting season is largely irrelevant because the fact that the world is in recession and companies are in lockdown is already known. The important issues are whether balance sheets are strong enough to withstand this cessation in activity in a manner that will allow them to meet 2021 and 2022 earnings estimates.
Many companies have turned to governments for help with emergency funding, others have gone to the corporate debt markets with new issuance and many bellwether companies are being questioned as to whether the disruption to operations poses a meaningful risk to balance sheet strength. Visibility over future profits has disappeared as companies suspend guidance for the year leaving investors to try and figure out what the global economy may look like in the medium term.
The shape of the recovery becomes key to the ability of society to return to normal or a new normal and companies to meet future earnings estimates. The ferocious sell-off in stock markets in February / March followed by an equally unbelievable recovery by certain sectors point to a belief by many in a V-shaped recovery. However, the economic forecasts suggest perhaps a U-shaped recovery or even worse an L-shaped recovery, not to mention a W-shaped or even theoretically a J-shaped (or Nike “whoosh”) recovery. But what does this mean and to what does it translate in real terms?
The shapes of recessions principally relate to the shape created by a basket of economic measures used by economists to measure a recession when plotted on a graph. The much talked about V-shape recession is characterized by a sharp economic decline followed by a quick and sustained recovery. In other words, the economy will quickly return to normal once the virus recedes with no lag or loss of momentum much the same as often seen following a natural disaster such as a hurricane or floods. If this crisis follows this path, then we would expect to see the unemployment rate that has spiked so strongly fall back just as quickly as economies re-open and people return to work. We would also expect economic activity to return immediately to pre-crisis levels as pent-up consumer demand is satisfied and pre-pandemic activity resumes.
Absolute Strategy Research (ASR) point out some differences between natural disasters and pandemics most notably that natural disasters tend to be geographically isolated events rather than having a synchronized global effect. Furthermore, natural disasters tend to provide an immediate stimulus to the economy as society physically rebuilds whereas pandemics tend to suffer a demand and supply shock through the quarantining of the population that depresses the possibility of output to recover its previous peak . We tend to agree that a V-shaped recovery looks unlikely and it will be a slow, cautious return of activity over a prolonged period.
The Global Financial Crisis (GFC) of 2008/09 caused a recession through damage inflicted on the financial sector through extended activities that were conducted “off-balance sheet” in what became known as the shadow banking sector. ASR reminds us of the rule that downturns which coincide with a financial crisis tend to be deeper and longer lasting than otherwise[i]. An L-shaped recovery is, therefore, characterized by a steep decline caused by plummeting economic growth followed by a shallower upward slope, indicating a long period of stagnant growth that can sometimes take several years to recover [ii]. We hope that the recovery from Covid-19 does not take 5 years or more to recapture its previous strength, but this may depend on the level of defaults seen within the corporate sector[i]. The levels of corporate debt have spiraled in recent years as companies have taken advantage of cheap finance to restructure their balance sheets and buy back shares. Therefore, the robustness of corporate balance sheets combined with the support provided by governments and central banks may hold the key to the strength of the recovery [ii].
ASR calculate that households appear to have significantly increased their savings since the start of the pandemic, which may be a sign that spending habits have permanently changed but is more likely to be the result of an inability to follow normal spending patterns due to the lock down. Although, consumption opportunities not taken will probably be lost to the economy it is likely that household spending could support a recovery[i].
The 1973 Oil shock caused rapidly increasing oil prices and led to the 1973-1974 stock market crash that affected most stock markets and economies in the developed world. Developed economies turned down in 1973 showing only slight signs of growth before recovering again in 1975 in what is often described as a U-shaped recover[ii] .
The current situation could also resemble a U-shaped recession if the steep decline into quarantine does not create a depression (L-Shape recession) with the return of a slow, cautious reappearance of economic activity over the next 18 months.
As governments start to formulate exit strategies and economies begin to re-open, should a V-shaped recovery take place then we fear that the acceleration to normal activity in the very short term could precipitate a second wave of the virus bringing us to a W-shaped recession.
A W-shaped recovery, often called a double-dip recession, is when an economy passes from recession to recovery and immediately turns back down into another recession which can be particularly painful for investors that are drawn in too early into financial markets by the swift recovery in activity.
The unprecedented relief offered by governments and central banks have underpinned the real economy in the short term and led many investors to bet on a V-shaped recovery in activity. For our part we favour a U-shaped recovery but as countries rush to re-open even though new outbreaks are still occurring, we fear a second wave of the virus in the autumn creating a W – double dip recession.
Policymakers may need to ensure that they follow up their initial support with additional relief measures once the economies have re-opened and the size of the challenge that lies ahead becomes more evident. The effectiveness of the economic and humanitarian policies in place for the next phase may well decide which shape the Covid-19 recession-recovery resembles.
[i] ASR – What shape will the recovery be? – Dominic White / Ben Blanchard – May 5, 2020
[ii] Investopedia – A Guide to Economic Recession – Jim Chappelow – April 20, 2020