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Markets rallied at the start of the week, with the S&P 500 up 7% yesterday, on increasing evidence that lockdowns are effective at slowing the spread of the virus, with falling daily growth rates in cases across major European economies. Spain reported several days of declines in the number of COVID-19 fatalities. In New York, the epicentre of the US crisis, there were signs that social distancing measures were having their intended effect, too. There is an increasing consensus that the sudden shock in economic activity will lead to unprecedented falls in GDP. We announced downgrades to our own near-term forecasts in yesterday’s Recession Watch. However, investors may be complacent about the outlook further out. With no country having successfully exited a lockdown, and some that have suffered from the virus for longer re-imposing restrictions, the big question is, what happens next?
In Europe, the first signs of continental exit strategies have appeared. Austria announced a timetable for the gradual removal of restrictions yesterday: smaller shops will be allowed to re-open after Easter, with some other businesses allowed to do so in May, including potentially cafes and restaurants. However, social distancing measures are to remain in play, and large gatherings are expected to remain banned for several months to come. Face masks will be mandatory in supermarkets as well as public transport, as its government seeks less restrictive methods to reduce the transmission of COVID-19. Meanwhile, the Danish government said some schoolchildren would be allowed to return to school after Easter as it also judged the worst of the outbreak to be behind it . In badly hit Spain, the government has said that some non-essential workers will be allowed to return to work next week.
In January, we believed that liberal democracies would find it more difficult to impose Wuhan-style lockdowns than China. And while the severity of restrictions in Europe has been a surprise, there remains evidence that democracies have imposed less stringent measures than authoritarian governments. A higher Fathom Political Index score, indicating higher levels of democracy, is associated with less severe restrictions in Q1 as measured by the University of Oxford. There must be a corresponding risk, then, that democracies will be quicker to remove them on the other side – either due to a greater desire to restart economic activity, or as a point of principle related to individual freedom.
A relaxation of government restrictions is a necessary condition for our V-shaped recovery. However, in the absence of a clear medical breakthrough, it remains to be seen how quickly normal life resumes. If cases do not fall to zero, and there is no effective treatment or vaccine, there remains a high risk that businesses and households will choose not to spend even in the absence of government restrictions. While there is no modern precedent for COVID-19, the experience of 9/11 may be instructive. It took more than a year after those terrorist attacks before US domestic air travel returned to its pre-9/11 peak, as fear remained. The Iraq War appears to have then led to a second wave of decline. Meanwhile, NYC subway ridership also felt the scars of the attacks for some time. That suggests spending may lag the removal of government restrictions as people worry about their health – both economic and physical.
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The experience of countries further ahead in the battle against COVID-19 also suggests the road to recovery will not be straightforward. While there are signs of a resumption of normal life in China, including in Wuhan, cinemas have closed again. Meanwhile, Singapore, which had implemented a much-touted test and trace system, was forced into announcing a more formal lockdown, effective today, as it was unable to effectively squash the virus. A sustained market rally, then, appears predicated on a more sustainable health solution. News on that front remains mixed for now. Scientists have suggested that millions of antibody tests ordered by the UK government are ineffective, while there is no sign yet of an effective medical treatment. Estimates suggest a vaccine could be 18 months away. The bad news is that unless and until there is clearer evidence of a health solution that can win the public’s trust, the economic outlook, and that for asset prices, will continue to face severe downside risks. The good news is that lockdowns and government policies are buying time as the public and private sector seek a badly needed medical answer.
Fathom forecast scenarios
Economic forecasting is difficult even at the best of times. It is particularly difficult today. At Fathom, we think in terms of scenarios and seek, wherever possible, to downplay point forecasts. A severe contraction in global economic activity through the first half of this year is inevitable – we are facing what French economist Pierre-Olivier Gourinchas has referred to as a ‘sudden stop’, something the global economy has never experienced before. But how long will it last? In our Global Economic and Markets Outlook for 2020 Q1, we set out three scenarios. The first was a V-shaped recovery, in which the number of cases peaks within months and begins to decline, allowing activity by the end of this year to return to normal levels. The second was a U-shaped recovery, where the virus continues to spread, depressing activity until a vaccine is found, but the economic and financial market infrastructure remains in place to deliver a strong rebound when that occurs. The third was an L-shaped recovery. Since we finalised our forecast on 17 March, a number of major economies have placed more severe restrictions on movement, and imposed a temporary shutdown on more industries than we had thought likely. This more aggressive action has caused us not only to anticipate an even sharper contraction in economic activity in the first few months of this year, but to increase the weight we attach to a V-shaped recovery. At the same time, we have also increased the weight we attach to our more severe risk scenario, making the outlook somewhat bimodal. In the event that COVID-19 returns with equal or greater vigour once restrictions that are holding back economic activity are lifted, then a severe financial crisis will be very hard to avoid.
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