The shape of economic recovery to come: U, V or W?

In February global markets could not contain themselves, and indices like the Dow Jones Industrial Average, the Nasdaq Composite and the S&P 500 Index reached extraordinary highs. Less than a month later, in mid-March, markets had fallen between 25% and 35%, apparently pricing themselves for Armageddon. 

Since then, weirdly, most markets have delivered positive returns with the S&P 500 up 5%, the JSE Capped SWIX Index up 13% and the All Bond Index up 2%.

This is despite the continued spread of the coronavirus around the world, leaving a trail of death and economic devastation in its wake.

Investors can be forgiven for wondering what is happening.

“In times of crisis, the market always acts as an efficient discounting machine, hence the ruthless manner in which the Covid tragedy was priced into risk assets,” said Coronation CIO Karl Leinberger in a note to clients.

The market bounce was encouraged by the $8-trillion injected at record speed into markets by the likes of the US Federal Reserve and European Central Bank, which has eased liquidity constraints and reassured investors.

“Investors believe there is light at the end of the tunnel,” adds Hannes van den Berg, co-head of SA equity and Multi-Asset at Ninety One. “They are reassured that lockdowns do work.” 

This is not to suggest that markets will resume their upwards trajectory and investors can relax. 

“We have seen the second wave of infections in some economies, which highlights the risks of re-opening economies,” Van den Berg says.

This means markets could retrace and head back down again. 

Investors can be forgiven for not knowing what to do. Should they sell out? Stay in? Move out of cash and into risky assets?

Economists around the world are modelling furiously and are talking about a U-, V- or W-shaped recovery. 

What does it mean and should investors care? 

The base case is for a U-shaped recovery, says Sanisha Packirisamy, an economist at Momentum Investments. This scenario suggests limited results from policy interventions and a delayed and sluggish upturn following a more protracted slowdown.

Under this scenario, disrupted global supply chains are only restored subsequent to the peak in Covid-19 fatalities in the third quarter of 2020, resulting in an economic recovery taking hold only from late 2020 and extending into 2021.

The bull case scenario, or V-shaped scenario, which markets hope for, is one where the globe undergoes a rapid growth slowdown in the first half of 2020, followed by rapid recovery from the middle of 2020, as the virus spread is contained, allowing annual growth rates to fully absorb the shock. 

This is a best-case scenario and requires strong public health structures and highly effective policy responses. 

However, modelling by the Covid-19 Response Team at Imperial College London suggests that deaths in the US will only peak in June 2020 (if inadequate control measures are taken), making the likelihood of a V-shaped recovery taking hold with only a short-lived dip in global demand increasingly unlikely, Packirisamy says. 

“A protracted U-shaped or double-dip W-shaped recovery is our bear-case scenario,” she says. In this case, a second wave of the Covid-19 outbreak flares up globally and in South Africa, with quarantine measures extended to more regions and for longer. In addition, new cases could rise in other parts of the world, despite a change in seasons, dragging out the peak in global infection rates.

A re-emergence of disruptions in supply chains are likely under this scenario and these bottlenecks would exacerbate and prolong the downturn in local demand and exports. This would, in turn, negatively affect corporate profitability, with corporate credit risks rising as a consequence.

At this point, predictions are difficult. As the world emerges from lockdown investor attention will shift to earnings and real economic data.

“We do think the numbers will be bad,” says Clyde Rossouw, co-head of quality at Ninety One and manager of the Ninety One Opportunity Fund. “It is more likely that we will see a W than V-shaped recovery.”

This is not a reason not to invest, but a reason to be particularly careful in what you invest in.

Given that the US Federal Reserve and other central banks will underwrite risk in the extreme, is there an argument for investment in distressed assets? Now is not the time to be a hero, says Rossouw.

“It’s too early and too soon to chase businesses that were struggling before this crisis.” 

Instead, investors should zoom in on quality businesses with strong balance sheets and resilient earnings built into their business models. 

“It sounds like motherhood and apple pie but it’s amazing how few investors do this.”

This is not to say that his fund is bulletproof. The Opportunity Fund is invested in Booking Holdings (which owns Booking.com and Priceline.com) and online booking company Amadeus, whose businesses have been decimated by the global lockdown.

“We are not sure when their numbers will come back,” he says.

What is important though, is that the strong businesses will be back stronger than before — even if it takes two years.

While understanding the U, V and W of the economic landscape is useful, the investment team at Coronation is taking the long view, regardless. “As tragic as the Covid epidemic is, we will come out the other side,” says Leinberger. 

And when that happens, most economies will benefit from pent-up demand, unprecedented fiscal and monetary stimulus, and record-low oil prices. Markets, he says, are likely to rally when we all least expect it.

“Will it be a medical breakthrough (which could happen at any time)? Will it be the point of peak infections? Will it be the lifting of lockdown? Who knows?”

Thus this is not the time to sit in cash, he believes.

Coronation has moved from an extremely defensive position (underweight equity) to an overweight equity position over the past two weeks, but has maintained cash reserves. 

“We believe that both domestic and global equities are attractive to any long-term investor, which is in contrast to our view throughout 2019, where we felt that global equities were fully priced.”

He adds that current market turmoil is providing a unique opportunity to buy high-quality stocks at great prices locally and globally. 

“It is not often that one gets the opportunity to buy great businesses, with excellent management teams, at low prices. We are confident that these stocks will give investors good risk-adjusted returns, even if the tough economic environment endures.” 

It sounds easy — but how is the average retail investor to know whether to invest in Pick n Pay, Shoprite and Woolies which have lost on average 45% of their value this year?

Or banks like Capitec, FirstRand and Absa which are offering real value but are on the frontline of the economic crisis?

Or Sasol, which could go to R200 as easily as it could go to zero?

Experienced investors will have a field day — however, some investors may prefer to go the unit trust route.

And at this time some might prefer the active management route over passive index trackers.

“It is in environments like this where active investment managers have to show their colours,” says Van den Berg. “You can’t passively hold your position through these times. Where are the new growth opportunities? Managers have to identify them and move into new positions.

“This is the ideal time to show our colours.” BM