Four-Letter Recovery: The Shape of Things to Come
Fully recognizing that we are now in the heart of the deepest and swiftest economic downturn in modern times, attention is now turning to the shape, strength and timing of the recovery. Many are trying to assign a particular letter to the recovery, which in some sense could roughly answer all three questions in a single metric. Cutting to the conclusion, we suspect that this recovery will probably not fit neatly into any one of the four letter boxes—just as the downturn is unique, so, too, may be the recovery.
First, we need to set some ground rules. When we are talking about the shape of the recovery, we need to distinguish between the level of activity and the growth rate. Arguably, every recovery in U.S. economic history has been some form of a V, when looked at in growth terms (Chart 1). The only outlier was in the early 1930s, when the economy carved out a nasty W in the middle of the Great Depression, with the right hand slide even deeper than the initial drop. However, there have been plenty of U-shaped recoveries (and even one temporary L), when we instead look at the level of activity. As an example of how a recovery can look so different when comparing growth rates and levels, consider U.S. employment from 2007 to 2014 (Chart 2). While no one would consider U.S. jobs to have done anything but a lazy U in the aftermath of the financial crisis, even then the growth rates did rebound quickly, and managed to carve out something approaching a V. Since almost everyone would consider jobs to have been in a U during that episode, we will focus on levels, not growth rates.
Let’s consider what each one of the four letter scenarios would broadly look like, and we’ll use Chart 3 as a guide:
V-shape (35% chance): Activity bottoms in April, but shutdowns lighten sharply in May, helping activity snap back quickly. Perhaps supported by an effective mitigation drug course, as well as the wave of fiscal spending, economy-wide activity is roughly back to normal by the summer. And, by next year, losses have been recouped, and the economy is back on its long-term trend by the end of 2021.
U-shape (40%): The shutdowns drag throughout May and most of June, and the longer shutdowns cause deeper, lasting damage to the economy. As a result, the recovery takes longer to gather strength, as business remains wary about rehiring and consumers remain wary about returning to stores, service vendors, and restaurants. However, the economy finally gathers some momentum by next year, and is roughly 1% below trend by the end of 2021.
W-shape (20%): A broadly similar pattern to the U-shaped recovery with one key difference—we are hit with another serious outbreak of the virus heading into the winter of 2020/21. While the shutdowns may not be as hard as the first round, and business is much better prepared to deal with such, the second outbreak causes a dispiriting slump in consumer and business sentiment. While growth does crawl back in the second half of 2021, output is still down almost 5% from pre-crisis levels even by the end of next year.
L-shape (5%): The shutdowns remain largely in place as we go through this year, as the virus persists. Even as health conditions finally improve in 2021, damage to the economy has been so serious that business and consumer spending recovers only weakly.
We don’t think the recovery will neatly fit into any one of these boxes, and thus we’ve assigned the corresponding probabilities. Perhaps the end result will have some characteristics of all four letters, and China’s experience may provide a guide. There is the very real probability that different sectors and regions will experience a different letter. Some particularly affected industries could feel like an L, such as parts of the travel sector (e.g., cruise lines), while even a mild secondary outbreak could cause a W in other sectors (sports, entertainment). Some are likely to see a pretty vigorous V as soon as the shutdowns end (specifically things like education, construction, and some must-have services—think dentists, barbers). But, for the overall economy, activity will likely return somewhere between a V- and U-shaped pattern, or a somewhat lazy V. But note that such a recovery is not necessarily the same thing as suggesting everything will be back to 'normal'.
In any case, if the shutdowns lighten even slightly in the summer, almost by definition activity and growth will see a bounce in Q3. With some sectors and businesses going straight to zero in early April (i.e., the very start of Q2), it is a plain fact that activity will be firmer in Q3—and thus growth will go from massively negative in Q2 to at least a small positive in Q3, even in a dire scenario. Note that compared to the most recent consensus, we look for a much deeper drop in Q2 than other forecasters, but also see a much bigger rebound in the second half, yet are in the same range on the full-year outlook for GDP (-4% for the U.S. and -4.5% for Canada).
Two other key points as the data roll in: 1) The quarterly GDP figures are annualized. Even shocking estimates of something around a 45% a.r. drop translate into a 14% actual drop in activity in a quarter. 2) After a steep drop in Q2, it would take an even more massive rebound in Q3 just to get back to pre-crisis levels. In other words, simple arithmetic shows a 45% drop in Q2 would require an 82% rebound in Q3 to offset that damage. And, we don’t see Q3 offsetting Q2’s drop.
More generally, while we are quite mindful that the recovery will be dictated by the path of the virus, we would not rule out a forceful recovery when it begins. Many have asserted that so much damage has been done by the shutdowns (some businesses and thus jobs lost forever), that a V-shaped recovery is just not possible for sectors like restaurants and retail. But we would point to some recent international examples of shocking economic hard stops, and how quickly they recovered. Look back to some major emerging markets in the mid-to-late 1990s that faced three different shocks that brought their economy to an abrupt halt: Mexico and the peso crisis in 1995, Korea and the Asian currency crisis in 1998, and Russia’s debt default later that same year (Chart 4). All of those episodes almost came like a bolt from the blue and caused sudden quarterly GDP declines of more than 20% annualized. Yet, in each case, the economy came roaring back within one or two quarters from a terrifying decline. And, that was despite the fact that all three had to recover in the face of extreme external financing constraints and harsh austerity measures—the exact opposite of what most major economies will be looking at in coming quarters.
The Bottom Line: Assuming that shutdowns begin to ease meaningfully by June and that some industries could take years to get back to “normal”, our forecast has something between a U and a V for the level of activity in the months ahead. However, in growth terms, we suspect that just like every other challenging environment of the past 120 years, it will ultimately look more like a V (Chart 5). These are all based on our best assumptions. Ultimately, the virus will dictate the shape of the recovery, as well as the policy responses, and that’s something that economists and financial analysts simply cannot accurately predict.