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V, W or L: what shape will the recovery take?


Keith Wade

Keith Wade

Chief Economist & Strategist

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The world economy is in the midst of a sudden stop where activity has been brought to a halt by official action to suppress the coronavirus. On our forecast, the contraction in global activity in 2020 of 3% will exceed that seen in the first year of the Global Financial Crisis (GFC) when global GDP contracted by 0.5%. However, unlike the GFC, we do see a relatively rapid bounce back.

Rather than an L-shaped recovery, we forecast this time’s recovery to follow a V-shape path this time, with the US returning to its previous level of activity in the third quarter of this year. Such an outcome reflects expectations of the lifting of restrictions on movement and the return to work as business restarts, shops re-open and normal activity resumes.

Not everything will come back at once and there will be some permanent damage, but the return to work will bring a significant reacceleration in growth, especially when supported by loose monetary and fiscal policy.

The key risk to our baseline V forecast is a potential return of the virus in the third quarter this year, resulting in another shutdown in Q4. Such a risk is consistent with the influential analysis from Imperial College London (here).

We have attempted to capture this with a “Covid-19 lingers scenario” which sees the economy take a second dive in Q4 this year before experiencing another rebound in Q1 2021. Our assumption is that a vaccine is developed and successfully deployed in Q2 2021 thus allowing a resumption of normal activity in Q3. The result is a “W” path for US GDP, which contrasts with the “V” in our baseline and the “L” experienced during the first two years of the GFC (see chart). The path of global GDP would be similar with other countries following the same policy of attempting to suppress the virus so as to manage the outbreak in line with the capacity of their health system.

20200402_hk_eng_chart_1.jpg

On this projection, the level of output still returns to that seen in the baseline by the end of 2021 with growth likely to be robust at the end of the period as confidence returns to the economy and spending strengthens. We expect monetary policy to remain loose during this period spurring a resumption of borrowing and investment in housing and business equipment.

Fiscal policy is also likely to remain loose as the economy will still be struggling when budgets are set.   

However, the greater volatility in output in the “Covid-19 lingers scenario” means that the impact on incomes would be greater with more unemployment and lay-offs. There would be tremendous strain on workers with children in the event of further school closures and those with elderly relatives, resulting in a fall in labour supply.

For the corporate sector, it would mean two major falls in activity in 2020 such that, compared to 2019, corporate profits decline by nearly 40% versus a baseline forecast where they decline by 15%. The rebound is stronger, but the risk of default and bankruptcy is clearly higher, such that the question will be which companies can survive the downturn to see the recovery.   

Official support will be key as the programmes put in place by central banks and governments will have to absorb much greater losses and incur far more debt than in the baseline. Estimates from the Office for Budget Responsibility (OBR) suggest that UK government borrowing rises by 0.7% of GDP for every 1% fall in GDP and on this basis would be 5.4% of GDP or roughly £125 billion higher. This is before factoring in the cost of support programmes worth another 2% to 3% of GDP.

Other countries can expect to see similar outcomes resulting in a global surge of debt issuance. At this point, the extra paper is likely to be absorbed by central bank balance sheets as they step up asset purchase programmes (QE). Ultimately though, it would mean higher taxes and cuts in spending elsewhere if we are not to see higher borrowing costs.

 

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