What shape will the economy recovery take after it takes a beating from COVID? V is the popular shape, we want it, we like it. However, we might not get want we want. There is no V in this. There is a W and a U. The answer actually depends with the point of reference: Financial Markets or The Real Economy.
Financial Markets — At first, the curve will look like a V shape but the initial upswing will be short-lived, the V will turn into a W . The middle legs of the W will not be as high as the other legs. A “W” is essential a Double “V”. Financial markets are obsessively looking at 3 things:
- the progression of COVID numbers (peak infections, flatter curve)
- the effect of lockdowns (unemployment claims, business closures, expiry date of lockdowns)
- government’s stimulus responses (size and timing of packages)
Markets will react positively to the peak of infections with a new rally because the peak of infections seems to indicate the bottom, doesn't it? And with billions being pumped into markets by governments, an initial rally is inevitable. However, the rally will turn into yet another downward spiral when economic data shows that the economy is still in trenches, even though infection rates have slowed down. The argument that the peak of infections is the bottom of the fall is fallacious (at least for the real economy). When markets realize this, they will hit another bottom, and then eventually rise together with the economy.
Real economy — will almost certainly be a U. It will follow the trajectory of the virus. The flatter the COVID curve, the longer the recession. The damage already done is too much to be still thinking of a V, there will be no quick way out of the bottom. At the present moment, we are not 100% sure if we have hit the bottom.
The peak of COVID infections does not necessarily mirror as a bottom on the fall of the real economy. Wall Street wants the virus to be contained and the global economy to be opened up as soon as the infection rates fall. But you cannot have both an open economy and low infection rates. Markets want both. Its desirable but its unattainable.
Reasons why Financial Markets will be a W
- Governments are pumping excessive amounts of money (liquidity) into financial markets. Think of it as an artificial price support. Or rather picture a company with facing a falling share price, and the directors think the market is overreacting, so the company goes into the market and buys back its own shares. Nice price support. But what happens when the company runs out of cash do buybacks? The support crumbles and the share price starts to fall again. This is what governments are doing to financial markets, especially Trump’s government.
- At the present moment financial markets are a bad proxy for economic activity. Under normal circumstances , financial markets are a mirror reflection of the real economy. Asset prices are priced-to-perfection. But these are abnormal times,there is too much noise and too much government intervention in markets. Intervention distorts markets. Because of the “bad proxy problem” financial markets will take a shape that’s different from the economy’s U.
- Realization that government support is not enough, in the sense that its not doing wonders on the real economy. This might trigger the second sell-off.
- We do not have a financial crisis, as yet. We have a public health crisis and an economic crisis. Our banks are strong, our insurance companies are strong and our hedge funds are not over-leveraged. Markets are generally a leading indicator, thus they are highly-likely to quickly bounce up once we reach the bottom. As the real economy stalls at the bottom, the fundamentals of financial service firms will be affected (more defaults, foreclosures etc) and the rot will affect financial markets. The false rally will reverse back to the initial “bottoming level”. The tail cannot pull the dog for a long time.
- Prevalence of cockeyed exuberant trend-following optimists on Wall Street in comparison to rational fundamentalists. Whatever we are saying , whether its right or wrong, doesn’t matter to a chartist, all that matters is the trend. They don’t care if P/E multiples are reaching dizzying heights or reaching unrealistic lows, they ride the wave. If a rally starts at the bottom (its highly likely to start) , chartists will ride it all the way up until another event (like having banks in trouble) invokes a downward trend. If we did not have an abundance of irrational chartists in markets , Warren Buffet wouldn't be such a star, would he?
Reasons why the real economy will be a lucid U
- The need to contain the virus. Governments across the globe don’t seem to have a strategy in place , they locked down because they had to but did not have a clear strategy of ending the lockdowns. And the reason behind locking down will still be persistent. This means that certain sections of the economy will remain closed for some time. Even if we find a vaccine now, the factors below will mean the real economy might still endure an elongated U
- Weak corporate balance sheets have prevailed for a long time. Most companies have not been ready for the tiniest of shocks. A shock of this scale was unprecedented but balance sheets were generally weak, globally . We have existed in and exalted a high-risk taking culture by corporates where CAPEX has not been financed by free cash flows.The only exception is Tech Unicorns, utilities and Mainland China export-oriented manufactures (these winners usually have billions of idle cash on their balance sheets). It will take time for most companies to recover from this which suggests that economy will dance around the bottom level for a while before an eventual take-off.
- Damage done to SMEs, they say small business are the backbone of the economy. They contribute to almost 40% of GDP in most countries and employ more than 50% of the workforce in most countries. The average SME has just enough liquidity to last 27 days. Beyond that , its a working capital struggle. The damage is already done. Some SMEs have already closed down and retrenched employees. What does this mean to the recovery curve? Two things : a) If the global economy is re-opened today it will take more time for SMEs to rebuild working capital and operate than it took to close down the economies and b) 50% of consumers will be cash-strapped for a longer period of time
- Worker Output and Demand Displaced permanently and temporarily. Some sectors will face demand destruction of a nature that cannot be compensated by demand creation elsewhere within a short period of time. Demand permanently displaced is economic activity lost, its water spilled from the bucket, its gone. Some workers are not going to get their jobs back, not in the next year or so. Some workers have died (though an insignificant portion). Some workers will get sick during the year and will have to be out of action for at least 3 weeks. The real economy might stall at the bottom for 12–18 months.
- Economic Activity might not pick-up early enough and fast enough because of depleted working capital as mentioned above. Governments will have to inject more stimulus packages to kick-start the economy. But at that time most governments will have run out bullets needed to stimulate the economy. This unavailability of a second stimulus package points to a U shape.