APRIL 2020

The Road to Recovery From Alphabet City

Category: Managing Directors, Portfolio Management, Senior Management

By Doug Cohen, Managing Director, Portfolio Management

With so much being written and said about the rapidly changing market environment, I will not attempt to break any new ground on the key issue—the magnitude and duration of the COVID-19 outbreak. I’ll leave that to the infectious disease experts who, not surprisingly, remain sharply divided on the likely trajectory. While we are surely still in the early stages of a recession, there will just as surely be a recovery. I summarize below the alphabet soup of likely recovery scenarios from my window overlooking New York’s Alphabet City neighborhood:

V-Shaped Recovery (25% Probability)
This is easily the most straightforward scenario. A sudden discovery of an effective medical treatment would be the most obvious catalyst. With about 60 programs under way to identify a treatment and more than 40 seeking to develop a vaccine, there is certainly reason for hope. Absent that good fortune, under a V-shaped recovery, the Covid-19 contagion would be significantly contained over the next month or so with the existing social distancing protocols, the virus would eventually mimic many (but not all) other coronaviruses and wither in the northern hemisphere's summer heat, and the likely autumn re-occurrence would be limited by enhanced precautionary measures ahead of a potential early vaccine by next winter. In this instance, the combination of the Fed's necessarily fast and bold steps to keep the financial system functioning, combined with last week’s $2.2 trillion in congressional relief, would buy enough time for the vast majority of consumers, businesses, and local and state governments to ride out the crisis. Strong pent up demand would result in an economic return to pre-crisis GDP and employment in the second half of 2020, much as Treasury Secretary Mnuchin touted this past weekend on the Sunday talk shows. In this scenario, the capital markets would be expected to recover at least several weeks ahead of a turn in the economy.

How realistic is the above scenario? As per our 25% anticipated probability, it's not very likely. Any realistic chance almost surely begins and ends with a medical breakthrough large enough to restore business and consumer confidence that it is safe to return to a close approximation of our former normal lives.

U-Shaped Recovery (45% Probability)
This is the consensus base case. It features a sharp downturn, a few quarters of bouncing along the bottom for both the economy and the financial markets and a meaningful recovery during which the equity markets turn at least one calendar quarter prior to the economy.

The underlying COVID-19 assumption is that medical conditions soon begin to gradually improve across much of the globe (probably with a lag in the southern hemisphere) and that most businesses resume close to normal activities in the second half of 2020. Further outbreaks are mitigated by social distancing and other protocols and, at a minimum, a viable vaccine is available for healthcare workers by next winter. Still, unlike the V-shaped scenario, economic growth is highly uneven due to the major dislocations of the current crisis/response period. Travel and leisure activity recover slowly as it takes time for consumer fears to wane. Many small businesses (in particular) struggle to survive despite government aid and demand is weak enough that hiring levels fall well short of the pre-crisis period (unemployment rates of say 5%-7%). Some large corporate borrowers also become strained, leading to cost cutting and lower investment levels. The equity and credit markets may be weak but are fully functional, likely with additional monetary and fiscal support beyond what has already been announced. The same broad patterns are evident globally, albeit with even more pressure on globalization relative to the pre-crisis period. It is easy to envision the current cross border nature of supply chains becoming more domestic. There is enough normalization that US equity markets can at least begin to take a shot at what "normalized" 2021 earnings might look like (the current implicit assumption implies about $163 per share for the S&P 500—roughly equal to the 2019 total—implying a 2450 or so level for the index assuming a 25-year multiple average of 15x). Interest rates likely stay very low, but soon turn positive for all Treasury maturities.

While the political implications of this scenario are clearly difficult to forecast given the multi-faceted nature of the coming US elections, President Trump's re-election chances likely decline somewhat if the economy remains under meaningful pressure. It is unclear whether a President Biden and the Democrats would encourage sizable tax increases during an economic downturn, but it's safe to assume that the market would not embrace that approach until a recovery was well in place.

W-Shaped Recovery (25% Probability)
So-called "double dip" recessions are rare—the last domestic one was in the early 1980's. The Great Depression of the 1930's contained two severe double dips when short-lived economic recoveries gave way to deeper downturns (the equity market followed a similar jagged pattern, with a series of lower lows that reached an 86% decline at the nadir).

From a medical perspective, it's fairly easy to envision a W in conjunction with a major dissipation of the virus this summer and a major re-occurrence by early winter. We still don't even know if those infected once may be infected again, particularly if the virus begins to mutate as influenza often does. With no effective treatment or vaccine, that's a key element of the lingering uncertainty that the market will have to contend with until herd immunity takes hold and something that would make a quick return to pre-crisis levels extremely challenging. Moreover, it may become evident that the extraordinary March stimulus measures were either insufficient or had unintended side effects, ranging from key macro elements, such as inflation and interest rates, to potentially divisive debates such as government's role in picking winners and losers. Despite the early central bank triage, will there be a second order effect where small banks and their customers will become squeezed? Will companies that rely on the high yield markets, including many energy companies, be saved? Will Corporate America make a concerted effort to retain workers in 2020 only to find that sluggish demand and resulting margin pressure leads to a major increase in layoffs come 2021? Will dramatic increases in money printing finally lead to a sizable uptick in inflation, a highly negative scenario for most bond investors (but possibly a bullish one for gold bugs)?

Note that a W-type pattern is more common for equity markets than for the broad economy. For example, many bear markets have had a sharp initial downturn (although nowhere near as sudden and dramatic as this one), a subsequent rally that recouped roughly half of the initial sell-off, and then a further re-test (or breach) of the initial low. That was the case in 2008/9. It also seems like a distinct possibility following last week's "best in nearly 90 years" 20% three-day surge.

L-Shaped Recovery (5% Probability)
This is the dreaded depression scenario—a dramatic plunge followed by many years of stagnation. While the 1930's Great Depression had some of those characteristics, as noted above, there were multiple fits and starts that probably come closer to an unusually deep and elongated W. In some ways, Japan's 30-plus year economic quagmire comes closer to a classic L. Either way, this is clearly an awful scenario for most risk assets and would likely include elements of the deflation that central banks have sought to avoid since the onset of the Great Financial Crisis. It would almost surely trigger more social strife in the US than has occurred in Japan. We won't dwell on the prolonged societal and market impacts of an L—they would certainly be painful. But we can't dismiss this scenario out of hand. Heck, if something as seemingly isolated and idiosyncratic (but highly leveraged) as long-term capital could threaten to take down the global financial system and economy in 1998, a prolonged global pandemic that has shuttered much of the world could do the same.

The good news is that central banks throughout the world have taken steps that are unprecedented in size and scope to help buy time. It's unfortunate that there was not more of a buffer for conventional interest rate cuts to help prevent a health crisis from morphing into a full-fledged economic and financial crisis, but a most unconventional crisis was going to warrant highly unconventional policies regardless. As we've previously highlighted, we have some significant worries about the longer-term implications of Modern Monetary Theory as it pertains to the country's (and the world's) longer-term growth potential. However, the move to act aggressively in this case was almost indisputably the right decision to help minimize the probability of deep and prolonged economic and market downturns.