V, U, L, J, or W?
There has been lots of talk about the shape of the recession. Correctly anticipating the shape of the recession will improve investors chances of re-entering equities at a good price level. Every pundit has their opinion on the shape that the current recession will take. We review below the different possible scenarios for this recession and give our assessment of each.
The V-shaped recession. This is what everyone is hoping for, but a very unlikely outcome in 2020. V-shaped recessions are characterized by a sharp drop in economic activity (that, we are getting) followed by an equally quick recovery in economic activity. We saw V-shaped recessions in 1991 and 2001. While not impossible for this recession, a V-shaped recovery depends BOTH on a rapid containment of the virus and a full re-opening of the economy. The virus has been surprising us with the speed on infection and the impact of public psyche. On one hand, we fear that the virus will prove difficult to eradicate. On the other hand, people are truly afraid of infection and will take a while to get over this phobia. Even when Trump declares the economy open, be sure that malls and restaurant will be sparsely attended. While ideally everyone would like pent-up demand to be released suddenly, this won’t happen. A V-shaped recovery will be impossible in this environment.
The U-shaped recession. This is what we are hoping for. We attach the highest probability with this scenario. U-shaped recessions begin with a slightly slower decline but then remain at the bottom for an extended period of time before turning around and moving higher again. We saw a U-shaped recession in the 1970s. The reason why a U-shaped recession fits for 2020 is that we expect both a progressive victory over the coronavirus and a gradual re-opening of the economy. If all goes well, factories will return to full capacity by early 2021.
The J-shaped recession. This swoosh recession pattern is similar to the U-shaped, except business and consumer spending resumes slowly after an initial spurt off the bottom. The level of economic output stays beneath the level of its pre-crisis trend well into 2021, people remain cautious, and excess precautionary savings occur. We can’t know à priori if our U-shaped recession will become a J-shaped recession.
The L-shaped recession. This would be bad news and implies that the current recession may be as bad as 2007-2009. In this case, the economy falls off quickly then a recovery fails to materialize. A good example of a L-shaped recession is the Japanese recession that began in 1990 and dragged into the 2000s (dubbed the “Lost Decade”). This scenario cannot be ruled out, but we are optimistic that an L-shaped recession will be avoided. Why? For an L-shaped recession to occur, the virus would have to run into the second half of the year, social distancing becomes instilled in people’s behaviour, and all the stimulus money injected into the economy proves worthless. That’s a lot of stuff that needs to turn out badly.
The W-shaped recession. This scenario, like the L-shaped recession, is also undesirable. This is a double-dip recession, like we saw with the 1980 recession followed by the 1982 recession. A W-recession could occur if the economy is re-opened before the virus is fully defeated and social distancing rules are prematurely loosened. The virus returns, restrictions are re-imposed, and economic activity dries up a second time. Another risk for a W-recession is if the economic slowdown creates a secondary crisis, such as a credit crisis, which cuts short a rebound on coronavirus containment. This is a painful event for investors who are whiplashed and forced to sell assets a second time into collapsing prices.
Knowing the shape of the recession will be critical for investors looking to get fully re-invested. While today pundits can only make guesses, thoughtful investors need to first monitor the progression of the coronavirus. We believe that 2-3 months of patience are required should the U-shaped scenario play out, but we will not be dogmatic and will change our outlook based on the evolution of the virus.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.