The headlines are now turning to the future looking at how deep a recession may be and the shape of the economic recovery. We can only wonder how the economy will recover and how long it will take.
Many experts talk of the ‘shape of the recovery’ using names such as V U W or L to name a few.
These labels come from the shape of the charts typically seen during these periods that track economic activity such as employment, gross domestic product (GDP) – or economic growth – and industrial output.
GDP or Gross Domestic Product is a measure of the size and health of a country’s economy over a period of time, usually a 3-month period or a year.
To measure GDP each quarter, the Office for National Statistics (ONS) collects data from thousands of UK companies, to complicate matters, there are three ways to measure GDP, but the most familiar is what everyone in the country has spent.
GDP = Household spending + Investment + Government Spending + Net Exports (UK Exports-UK Imports)
The Office for Budget Responsibility (OBR) and Monetary Policy Committee (MPC)
The Office for Budget Responsibility (OBR) had produced ‘an illustrative scenario, based on particular assumptions regarding the duration of the measures and their economic impact’. The OBR was at pains to explain this was not a forecast and that the set of assumptions might not be played out. The OBR’s scenario envisaged a whiplash of a V-shaped recovery: a 12.8% GDP fall in 2020 followed by 17.9% growth in 2021 and then a back-to-normal 1.3%-1.5% growth in the following three years.
On Thursday 7 May, the Bank of England joined the not-forecasting business with its Monetary Policy Report. This contained a ‘plausible illustrative economic scenario’, developed by the interest rate setting Monetary Policy Committee (MPC). The scenario is based on ‘a set of stylised assumptions about the pandemic and the responses of governments, households and businesses, and… on the prevailing levels of asset prices and the market path for interest rates’.
Whereas the OBR simplified matters by assuming the economic hit from Coronavirus would be confined to a 35% GDP drop in Q2, the MPC, with the benefit of more data, has allowed for the reality of the initial impact at the end of Q1:
The MPC envisages a 3% GDP fall in Q1, followed by a further 25% decline in Q2. The overall drop in the first half of 2020 is thus close to 30%, somewhat less than the OBR’s figure.
Like the OBR, the MPC sees the GDP recovering ‘relatively rapidly’ in Q3 2020 and rising further in Q4 ‘as social distancing measures are lifted’.
The overall result for 2020 is projected to be a 14% decline in GDP, slightly greater than the fall the MPC suggests will hit global GDP.
Recovery is assumed to continue in 2021, although GDP does not return to its pre Coronavirus level until the second half of the year. Growth in 2022 is 15%.
By 2022 the MPC reckons UK growth will be 3%, still above the 2010-2018 average of 2%.
The MPC scenario shows a remarkably similar V-shaped recovery to that the OBR proposed last month. However, external forecasters are far from unanimous about what happens in 2021, with many expressing the view that after such a sharp decline there will be long term economic scarring. The divergence of opinions is well illustrated in the Monetary Policy Report, which shows external estimates of Q2 2021 GDP growth ranging from nearly +40% to -2.5%.
A summary of the types of possible recovery
A ‘V-Shaped Recovery’ takes place when the economy rapidly contracts into recession and is then this is followed by a sharp and strong recovery. Hence the name V-Shape because a graph of this type of recovery is in the shape of the letter V.
Many economic recoveries resemble this shape because the harder the fall, the stronger and quicker the recovery.
This can be particularly true when the cause of the economic shock is external, as is the case here. If not for the Coronavirus, many would say that we would still be in the middle of the longest bull market in history.
A classic example of a V-shaped recession happened in America in 1953 when the booming post-World War Two economy was upended by high interest rates. After a steep decline growth was soaring again just over a year later.
A ‘U-Shaped Recovery’ is when things recover in a healthy fashion, and relatively quickly, but by no means is it ‘all systems go’. In other words, people get back to business, but in a more gradual fashion. Under this scenario, things are getting better all the time, and there are few setbacks, but it takes months or even a year or more to get to full steam again.
After the 2008/2009 financial crisis, was a U-shaped recovery, albeit a far slower one than normal.
A U-shaped recovery is also the favourite choice of 50 economists surveyed by Reuters.
A ‘W-Shaped Recovery’ takes place when the economy rapidly contracts, appears to sharply recover, only to collapse again before the real recovery. A graph of an economic recovery in this fashion resembles the shape of a ‘W’.
The US recession of the early 1980s was in effect two recessions with the economy shrinking from January 1980 to July that year. That was followed by a period of sharp expansion before the economy fell back into recession a year later, only recovering at the end of 1982.
With an ‘L-Shaped Recovery’, the economy remains weak for many years until it finally recovers This is the worst-case scenario. It also goes by another name: “depression”. It is when an economy experiences a deep recession and does not recover to its previous rate of growth for several years, if ever.
Japan’s so-called “lost-decade” of the 1990s is a textbook example of an L-shaped recession.
So, what are all these predictions essentially worth? Absolutely nothing!
The greatest minds in economics and finance cannot reach any sort of agreement, and the reason for that is because no one really knows what the recovery will look like.
There have been 14 recessions in the UK, this is hardly a sample on which to base anything and we don’t think this can be predicted. There are simply too many variables in play, and they have never intersected in the current fashion before. Also, keep in mind that there were plenty of factors impacting expected market returns before Coronavirus stole the show.
The same can be said for the economy.
The bottom line is that investing based on guesses as to how the economy will move has a word to describe it: speculation. That is because moving your investments around based on the unknown is a guessing game, and in the world of investing, that tends to end badly.
A wise investor is focused on designing and implementing a portfolio that has the highest probability of meeting their short- and long-term needs, regardless of how the economy twists and turns in the short run.
Our position remains the same as it was before the crisis: every investor should hold a portfolio which meets their risk tolerance and capacity.
One final note on recoveries: all major economists have their various predictions on the current situation, but all of them have the word ‘recovery’ in it.
We remain confident that the recovery, whatever shape it takes, is inevitable and in the end, for properly positioned investors, that is all that matters.