With the fastest drop from peak to bear market in history behind us, is it too soon to start contemplating a V-shaped recovery for the economy, much like the markets have seen? Will the market continue in its upwards trajectory, or do we see a classic bear market bounce? I believe the chances of seeing markets continue to perform remain high. However, the economic recovery is likely to remain a slow and arduous process. I see corporate profits returning to pre-virus highs within 6 months of the end of lockdown (excluding some travel sectors i.e. airlines). However, jobs’s growth is likely to remain weak for months if not years are firms see opportunities to cut workforce and increase optimisation efforts.
Market V-Shaped Recovery
Markets rocketed back up towards highs this month, posting some of the most significant gains since the great recession. The question on recover shapes for the markets has narrowed U, and L-shaped moves seem out the picture with the likely view of a W or V-shaped recovery on the cards. The focus now, however, has shifted off markets and to the economic recovery.
The Fed’s money printer has been significantly boosting markets with the real turnaround in equities coming after the Fed announced its unlimited purchase strategy. The Federal Reserve’s unlimited purchase of U.S. Treasuries, mortgage-backed securities, and municipal bonds have provided significant liquidity halting what could have been a considerable liquidity crisis, and these products have retraced half of their losses since this announcement. In other fixed income such as corporate debt, we have seen a third of the losses recovered. This is pointing towards a fast recovery as these markets historically have been slow to recover, especially in the 08 financial crisis.
Volatility on the S&P 500 and in equities, in general, has dropped over 60% from their highs in mid-march. This 60% retracement in Vol took seven months during the 08 crisis and five months during the 2011 European debt crisis.
Economic V-Shaped Recovery
The always hoped for V-shape recovery in the economy had shown early signs of success with Chinese manufacturing PMI bouncing back to pre virus levels. March Chinese Caixin manufacturing PMI bounced back to expansion territory with a post of 50.1 up from 40.3 in February. Aprils Number was slightly weaker but still showed signs of a return to normality at 49.4.
Assuming a “first-in first-out” view to the virus impact than from the end of May, the rest of the world, including Europe and the U.S., will likely begin to see a significant improvement in economic activity as monetary and fiscal stimulus kick in and we see a relaxation of lockdowns.
Following on from Chinese PMI, U.S. PMI numbers posted significant losses in April, dropping from 49.1 to 41.5. However, this beat estimates of 35 and was seemingly in line with Chinese PMI number at the same stage of the virus. The U.S. has seen a far greater spread of the virus than China reported. As such, we could expect potential 2 or 3 months of poor results before expecting to see the rebound the Chinese manufacturing sector experienced.
The significant disparity between the operational stresses on different industries has become all too apparent over the preceding months. In travel and tourism, leisure and, retail, the view to a quick V-shaped bounce seems distant. For a real V-shaped recovery, we’d be expecting traveler to jump straight on a flight after lockdown with restaurants full and malls bustling with shoppers catching up on missed purchases. In the current climate seems extremely unlikely, and it would be foolish to expect a quick return to normality.
Airlines are some of the worst-performing firms. The decimation of demand for air travel has been catastrophic for an industry where margins are historically low, and competition is fierce. British Airways recently announced 12,000 redundancies with an expectation of the recovery taking serval years. BA also announced they might halt all flights from Gatwick permanently indicating potential longer-term implications of the virus. Ryanair doesn’t expect demand to return to pre-virus levels until 2022 with Norwegian Air Shuttle expecting to remain grounded until a demand pick-up after 12 months.
“If it’s a V-shape recovery, well, we’ll all high-five each other and we’ll go buy some more airplanes. But I don’t think that’s the most likely outcome right now.” Southwest Airlines chief Gary Kelly said in their Q1 earnings call.
Tech and online services have seen a small boost from consumer’s inability to leave home. However, given Amazons recent lackluster earnings, Alphabet and Facebook having weak ad outlooks for Q2 and many other online services seeing more fragile than expected demand as consumer’s pockets get squeezed as U.S. jobless claims rush above 30k since the start of the virus.
Historic Recessions – What Can We Learn About the Current Economic Outlook
China, especially recently, has become a more inaccurate predictor of the true speed of recovery from the virus, from potential inaccuracies in reporting to harsh and sometimes violent tactics to prevent socializing, which would not be tolerated in the west. The limited historical comparisons and inaccuracy of using china as a bellwether sparked debate about differences from this recession to the past. It is yet to be seen if the V-shape recovery in growth (that GDP recovered to pre-recession highs in equal or fewer months then the recession lasted) seen from 6 of the last 7 recessions can prevail.
Source: Fred Economic Research
The exception to the V-shaped recovery in GDP was the 08 financial crisis. On average, in recessions lasting over 1-year, the recovery to pre-recession GDP levels took nine months. During the 08 financial crisis, this process took 21 months after the downturn in GDP lasted 18 months with the job recovery from the crisis taking significantly long, over six years. However, in 08 corporate profits saw a much faster recovery taking only 12 months, this slow job growth high-profit growth environment seems a likely outcome of the COVID-19 outbreak. Given the current state of employment and jobless claims being higher than at the peak of the 08 crisis, serious questions should be raised about the elasticity of jobs and the speed at which jobs will return.
Recessions caused by equity or housing bubbles bursting have persisted significantly longer and have required more extended recovery periods. Both the housing bubble in 2008 and the “Dot Com” tech bubble in the late ’90s needed multiple years to have full recovery to pre-recession levels while recessions in the 1970s, 1980s, and 1990s only took months to return to pre-recession levels.
Financial markets can help investors understand the true and lasting impact of a recession and at what speed we can expect a recovery. Credit spreads between U.S. treasuries and other corporate debt markets exploded during the initial market downturn with fixed income investors fleeing to safety as corporate debt saw huge increases in default risks. This spread has significantly reduced since the peak, a retracement back to pre-recession levels has typically taken around 18 months. However, due to the size and speed of the Fed’s action, we may see a shorter time frame now.
As mention above, we could be looking at a much bleaker outlook. An L-shaped recession is possible, like the one seen during the Great Depression, where the economy didn’t recover for years or a W-shaped double-dip recession, as seen in Europe during the sovereign debt crisis after the 08 crisis or seen in the 1980s in the U.S.. It is currently too early to tell the true shape of the recession with little economic data. However, it remains likely that a V-shaped recovery will prevail stemming from the demand shock nature of this event.
As always, the past is not a predictor of future performance. However, given historical trends in markets and the economy, I can say with a high degree of certainty that we have likely seen the market low from this event and that investors should see dips and buying opportunities and not a need to liquidate positions to protect capital.