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Why this time is different: A ‘stay at home’ t-shaped recession

19/03/2020

Whenever there is the threat or the reality of recession, it usually follows a typical pattern. It is engendered by tight financial conditions, a real economy or market bubble bursting, a dramatic rise in the price of oil, or a combination of the above.

This time it is different: this is a stay-at-home recession. The 2020 economic slowdown isn’t due to any of the usual suspects. Rather, it is due to the coronavirus outbreak leading not to a policy error, but a policy-led recession.

In response to the pandemic, governments around the world have reacted understandably by encouraging their populations to curtail day-to-day activity. This dramatic change to daily life will result in a collapse in economic activity, as measured by gross domestic product (GDP).

We enter this economic recession with very supportive monetary policy from central banks. Monetary policy takes about two years before we can see its effect in the economy. For example, we saw a slowdown in 2018 a couple of years after the Federal Reserve raised US interest rates into 2016.

Fortunately, in the world’s largest economy at least, interest rates have been on the way down since last year. In March, the Fed steeply reduced interest rates by one percentage point, following the Bank of England’s half of a percentage point cut. The European Central Bank unfortunately has less scope to react, since interest rates are already at rock bottom.

There are three stages to a recession – how is this one going to be different?

Stage 1: Into recession

This is the most certain recession we have ever seen: we can all observe the dramatic fall in daily activity around us. Discretionary spending has been curtailed, and the most expensive discretionary spend, travel and tourism, has been hit the most. This is not a slow evolution where individuals gradually discover the new economic reality, this is an instruction to everyone to stop consuming. This instruction is worldwide and instantaneous – something that has never happened before.

Recessions are usually described as “V” or “U” shaped, with respect to how GDP charts end up looking. The first leg of this recession will resemble the U-shaped form. It will be vertical and dramatic, and perhaps the largest ever collapse in GDP on a weekly and monthly basis in many countries.

Stage 2: End of recession

Given that the recession’s speed and depth is due to coronavirus and resultant government action to prevent us mingling, we have an unusually strong idea of when and how the recession ends. This virus appears to exhibit seasonal patterns like influenza and, once it has made its way through the population, immunity could build up. At some point therefore, presumably within months, government policy will be changed and we can potentially return to normal behaviour. This bounce back will be enormous, as the population is no longer told to stay at home. Thus, economic data will show a rapid rebound: it will not be a V or U-shaped recovery, rather it will look like an “l”. I expect it to be the biggest ever jump in GDP on a weekly and monthly basis in many countries.

Stage 3: Post-recession

This dramatic collapse and recovery will cause some longer-term damage to the economic system. Firstly, from an overall business and personal confidence level, and secondly due to the unprecedented nature of the severe short-term pain of the recession. Human behaviour may change, and vulnerable companies relying on short-term discretionary spending will have been weakened and potentially permanently impaired. While some consumption will just be deferred (like buying a car, for example), much will be lost (things like going to the cinema).

On the positive side, unlike most other recessions, developed economies exhibit very low unemployment and considerable numbers of the population are likely to remain employed; many businesses could remain stable. Hopefully there will be fiscal support through government tax and spending for those who struggle more.

I expect economic growth will return to normal post-recession, but will initially be unlikely to regain its previous levels. This would make this type of recession t-shaped: a sharp pull down, a sharp rebound, and then back to the normal economic cycle, albeit with probably a lower level of economic activity. For the economies most affected, the initial crash in the economy will be steeper, and the damage may be more permanent.

For investors in corporate bonds during this time, it is important, as always, to differentiate between the quality of debt. Defaults (risk of non-payment of principal or interest) among high yield bonds – those considered to be at higher risk of default in the first place – can be expected to rise (Previous recessions have seen up to 30% of high yield companies defaulting over five years). However, investment grade companies are so-called because they should be able to survive in a tough economic climate.

This recession is different

We know why it is happening, I believe we have a far clearer idea than usual of its length, and can strongly postulate how it will come to an end. Different governments and central banks are therefore working on measures to get us through the short-term GDP flash crash. This has allowed the authorities to act in a bold and aggressive manner that is different. This unprecedented support is likely to stay in place beyond the shock, to offer the best chance to the global economy to recover to its previous level.

The value and income from a fund's assets will go down as well as up. This will cause the value of your investment to fall as well as rise and you may get back less than you originally invested.

The views expressed in this document should not be taken as a recommendation, advice or forecast.


The information on this website is for Professional Investors only. Specifically, the information on these pages should not be used or relied upon by the public of Hong Kong or any other type of investor from any other jurisdiction.

 

The above materials and/or information is for general guidance only and should not be relied upon as, or treated as a substitute for, specific advice. Neither M&G Securities Limited nor its affiliates accept any responsibility for any reliance on any of the information contained in these materials or any direct or indirect loss which may arise therefrom. If you are in any doubt about the contents above, you should seek independent professional financial advice.