With quarantine measures to tackle the COVID-19 coronavirus outbreak causing a sharp plunge in global economic activity data, investors are asking when and how the current crisis will end, and how the recovery will take shape.
With this in mind, we describe three scenarios for the expected economic and asset market recovery (the central case, the downside case and the upside case). A guiding principle is that asset markets will react first and foremost to the peak in infection rates, with economic data the next to turn and employment data the last to follow.
Three major questions guide our analysis:
- How long will the restrictions stay in place, preventing any meaningful recovery from taking hold?
- To what extent will second-order effects kick in, such as failing businesses producing additional layoffs and spending cutbacks?
- How will individual behaviour change once social distancing measures have lifted?
POTENTIAL OUTCOME CASES
Stylised quarterly profile for US activity data in each scenario (Q4 2019 = 100)
In each scenario, the US economy dips into recession. In our central case, we see a gradual-but accelerating-recovery starting in the third quarter. In our upside case, the recovery occurs more rapidly, while in our downside case the virus lingers through the summer and delays the economic rebound until early 2021.
Central case - gradual but accelerating recovery
The central case scenario assumes successful social distancing measures force a flattening of the virus infection rate.
The patterns seen in China and South Korea imply a peak of new COVID-19 cases by the middle of the second quarter and a lifting of quarantine measures by mid-year. China and South Korea, which were among the first to feel the effects of the virus, shut down their economies early and saw infection rates fall. As both countries return to work, infection rates have remained low. It is too early to declare victory, but so far so good.
The sharp rise in market volatility and the distortions created by central bank intervention are increasing the opportunities for skilled active managers to add value across equity, fixed income and multi-asset portfolios—whatever the eventual recovery scenario.
Virus backdropQuarantines are required until May/June but prove successful in flattening the curve; the lifting of quarantine measures follows the South Korea/China model.
Economic backdrop Weakness persists in the second quarter. Growth picks up by the end of the year and stimulus tailwinds last into 2021.
Asset allocation considerations - Overweight to cash.
- Meaningful underweight to equity, favouring defensives and the US; Look to bring equity exposures up on confirmation of virus cases slowing.
- Modest underweight to credit, favouring higher quality securities.
- Overweight to duration.
Downside case – 2020 in recession
The downside case scenario assumes the virus spread is worse than expected and persists well into the third quarter.
The economic and market recovery will have to wait for a vaccine to be developed, which currently is expected to take 12 to 18 months. In this scenario, governments have difficulty imposing quarantine measures, which would mean that the China and South Korea models do not work, while the lifting of quarantines in Asia spark a second wave of the virus outbreak.
The sharp rise in market volatility and the distortions created by central bank intervention are increasing the opportunities for skilled active managers to add value across equity, fixed income and multi-asset portfolios—whatever the eventual recovery scenario.
Virus backdrop
The South Korea/China model doesn’t work – quarantine measures are hard to impose and aren’t lifted until a vaccine is available. The drawn out spread means the virus is prevalent throughout the year.
Economic backdropThe suspension of quarantine measures sparks a second wave of the virus. The subsequent prolonged economic weakness spills over into 2021, leading to credit stress and high unemployment.
Asset allocation considerations- Overweight to cash
- Meaningful underweight to equity, favouring defensives vs. cyclical markets
- Meaningful underweight to credit, favouring higher quality securities
- Overweight to duration across all developed market bond markets, negative on inflation
Upside case – quick recovery
The Upside case scenario assumes better treatment measures, improving seasonal temperatures and stringent lockdown measures lead to a quick fall in the spread of the virus.
Treatment therapies begin to produce successful results and healthcare systems are able to cope with severe cases. Wide- scale testing and a stronger belief in the concept of “herd immunity” allows workers to return to work quickly and the second quarter marks the low in economic activity. In this scenario, Asian economies (China, Korea and Taiwan) return to work quickly, opening up supply chains and providing a cushion globally as developed market activity falls.
The sharp rise in market volatility and the distortions created by central bank intervention are increasing the opportunities for skilled active managers to add value across equity, fixed income and multi-asset portfolios—whatever the eventual recovery scenario.
Virus backdropBetter treatments and testing allow a quick lifting of quarantine measures.
Economic backdropThe second quarter is the trough for global growth, with a sharp recovery in the second half of the year with limited second round effects.
Asset allocation considerations- Neutral to cash
- Overweight to equities, favouring cyclical equity markets vs. defensive, and equity markets outside the US.
- Overweight credit exposure, favouring non-US markets
- Neutral duration, favouring the US, and positive on inflation