The Playbook assigned a 15% probability to the bearish scenario of an “L-shaped” recession. We put a bullish “V-shaped” outcome at 20% and our base-case “U-shaped” outcome at 65%. Asset allocation views prioritized caution and favored quality U.S. large caps and investment grade credit.
Notwithstanding an apparently strong rally through April, the underlying defensiveness of the stocks and bonds leading the rebound played into our favored asset classes.
Members therefore re-endorsed the Committee’s initial views, while acknowledging the potential for investors to reposition rapidly—toward cyclical or value-oriented large caps, quality small and mid-caps, high yield bonds and non-U.S. assets—should data stop surprising on the downside and begin surprising on the upside.
Last week, there were signs that investors may be readying for that move.
While a “V-shaped” recovery still seems optimistic, is it time to reduce the probability of an “L-shaped” recession—or even dismiss it entirely?
Sentiment is buoyant for a number of reasons.
With China now back at work for six weeks, much of Europe a week or two into reopening and more than half of U.S. states easing restrictions, there have been no reports of a serious second wave of infections.
On the ground, credit card spending has picked up, as have contacts with real estate agents and taxi rides. Some airlines report new bookings outnumbering cancellations.
On the policy front, central banks and governments have been reassuring markets that they have not run out of ammunition. In Europe, Germany and France have thrown their weight behind a plan to issue bonds to finance a €500 billion recovery fund as part of the European Union’s budget. This could allow fiscal transfers that do not add to the debt burdens of the worst-affected countries.
Most significantly, U.S. biotech firm Moderna, one of the many centers of research into a SAR-COV-2 vaccine worldwide, announced last week that participants in its phase-one trial had developed antibodies.
Risks Have Not Gone Away
This is all encouraging news.
But to decide whether the probability of our bear-case scenario of an “L-shaped” recession can now be discounted, we need to revisit precisely what that scenario assumed.
On the virus, it saw the peak of initial SARS-COV-2 infections stretching into late summer. It assumed that lifting restrictions triggers a second wave of infections before we can treat or vaccinate against the disease.
We appear to have cleared the first hurdle in China, Europe and the U.S., but work by our Data Science team suggests that it is too early to rule out the possibility of a second wave. Some parts of the emerging world are reopening before suppressing their first wave. Questions were immediately raised over Moderna’s vaccine-trial data and we have already seen “false dawns” on potential treatments. These risks have not gone away.
On the economy, our “L-shaped” scenario anticipated U.S. unemployment reaching 24%, whereas our base case put the peak between 15% and 20%. Unemployment already broke 15% in April, and Goldman Sachs, for example, now forecasts a peak of 25% in May. That’s before any second wave of infections gets the chance to disrupt the reopening process.
On the policy response, our concern focused on Europe, where the European Central Bank’s toolbox is both constrained and controversial, and there is strong resistance to collective fiscal action. While the Franco-German plan is encouraging, nothing has been agreed to yet. In the meantime, post-Brexit negotiations could be an unwelcome distraction.
In short, when we revisit the assumptions that define our bear-case scenario, few can be discounted. Most of these things—a second wave of infections, a cycle of lockdowns that increase economic and financial stress, a serious falling out in Europe—can easily still happen.
We therefore retain our “L-shaped” scenario, and maintain a risk of 15%—although when uncertainty is so high, possibility is arguably more important than probability.
This is the value of scenario planning, and of setting out clear, simple parameters for changing one’s views: The discipline of it keeps us focused on what has actually been achieved rather than what we hope will be achieved.
Optimism is warranted, even necessary. We still assign a greater probability to a “V-shaped” recovery than an “L-shaped” recession. But we are not out of the woods, and the bear may yet be hiding in the trees.
In Case You Missed It
- Japan 1Q 2020 GDP (Preliminary): -3.4% annualized rate
- NAHB Housing Market Index: +7 to 37 in May
- U.S. Housing Starts: -30.2% to SAAR of 891,000 units in April
- U.S. Building Permits: -20.8% to SAAR of 1.07 million units in April
- Japan Purchasing Managers’ Index: -3.5 to 38.4 in May
- U.S. Initial Jobless Claims: +2.44 million in the week ending May 16
- U.S. Existing Home Sales: -17.8% to SAAR of 4.33 million units in April
- Japan Core Consumer Price Index: -0.2% in April year-over-year
- Eurozone Purchasing Managers’ Index: +16.9 to 30.5 in May
What to Watch For
- Tuesday, May 26:
- S&P Case-Shiller Home Price Index
- U.S. Consumer Confidence
- U.S. New Home Sales
- Thursday, May 28:
- U.S. Initial Jobless Claims
- U.S. Durable Goods Orders
- U.S. 1Q 2020 GDP (Second Estimate)
- Friday, May 29:
- Eurozone Consumer Price Index
- U.S. Personal Income & Outlays
Statistics on the Current State of the Market – as of May 22, 2020
|S&P 500 Index||3.3%||1.7%||-7.8%|
|Russell 1000 Index||3.5%||2.1%||-7.8%|
|Russell 1000 Growth Index||3.2%||4.5%||3.0%|
|Russell 1000 Value Index||4.1%||-0.9%||-19.3%|
|Russell 2000 Index||7.9%||3.5%||-18.3%|
|MSCI World Index||3.2%||1.2%||-11.2%|
|MSCI EAFE Index||3.0%||-0.7%||-18.2%|
|MSCI Emerging Markets Index||0.5%||-2.0%||-18.2%|
|STOXX Europe 600||4.4%||-0.2%||-19.7%|
|FTSE 100 Index||3.4%||1.9%||-19.4%|
|CSI 300 Index||-2.2%||-2.1%||-6.5%|
|Fixed Income & Currency|
|Citigroup 2-Year Treasury Index||0.0%||0.1%||2.9%|
|Citigroup 10-Year Treasury Index||-0.1%||-0.2%||12.3%|
|Bloomberg Barclays Municipal Bond Index||1.0%||3.0%||1.0%|
|Bloomberg Barclays US Aggregate Bond Index||0.4%||0.2%||5.2%|
|Bloomberg Barclays Global Aggregate Index||0.5%||-0.4%||1.3%|
|S&P/LSTA U.S. Leveraged Loan 100 Index||1.2%||1.6%||-5.4%|
|ICE BofAML U.S. High Yield Index||2.7%||2.7%||-7.4%|
|ICE BofAML Global High Yield Index||2.6%||2.6%||-7.9%|
|JP Morgan EMBI Global Diversified Index||3.2%||5.8%||-6.3%|
|JP Morgan GBI-EM Global Diversified Index||3.1%||3.1%||-9.1%|
|U.S. Dollar per British Pounds||0.5%||-3.4%||-8.0%|
|U.S. Dollar per Euro||0.7%||-0.6%||-3.0%|
|U.S. Dollar per Japanese Yen||-0.2%||-0.5%||1.1%|
|Real & Alternative Assets|
|Alerian MLP Index||10.7%||7.4%||-31.2%|
|FTSE EPRA/NAREIT North America Index||7.5%||-4.6%||-26.9%|
|FTSE EPRA/NAREIT Global Index||4.3%||-4.7%||-27.0%|
|Bloomberg Commodity Index||1.8%||3.0%||-22.2%|
|Gold (NYM $/ozt) Continuous Future||-1.2%||2.4%||13.9%|
|Crude Oil WTI (NYM $/bbl) Continuous Future||12.6%||76.5%||-45.5%|
Source: FactSet, Neuberger Berman.