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Macroeconomic & Geopolitical

Scenarios Around the “Not Quite Recovery”

30 September 2020 - 10 min read

We’ve come a long way since March, but there’s still a long road ahead. So far, the recovery is encouraging but the permanent damage to employment remains to be seen, as does the resilience of company balance sheets.

This high-stakes summer, where social life restarted at full speed—at least among some young people—and delivered thousands of new daily cases in many parts of the world, but mostly without a rise in hospitalizations or mortality. We expect this to remain the case. Better understanding of the symptoms, better prevention, and more flexible and more targeted restrictions may succeed in containing the coronavirus. Our fingers are crossed that confusion with flu symptoms does not overwhelm hospitals through the Northern Hemisphere winter or trigger school closings and a setback for economic activity.

So far, the recovery is encouraging. Spring was a shock for everyone, but innovative public policies assured continuing cash flows to most households and firms. Activity stopped and more savings were built up. When economies reopened, these buffers proved useful in supporting pent-up demand. Retail spending provided enough momentum so firms could start recalling some of their furloughed employees. But the permanent damage to employment remains to be seen, as does the resilience of company balance sheets.

These dynamics look rather similar across the world, adjusting for each country’s timeline of exit from lockdown, severity of social distancing restrictions and continuing government support. In China, output is already above pre-pandemic levels, while the U.S. and large euro area countries follow, with activity having reversed about 90% of the lockdown slump. The
U.K. and Spain lag still further with less decisive policies to contain the pandemic and a larger and more vulnerable service sector.

Political risks may also roil markets in the weeks ahead if the U.S. presidential election tips into confusion or, to a lesser extent, final Brexit negotiations disrupt European trade. The outlook is gloomier for emerging markets in Latin America, India, and parts of Africa, where limited access to health care and less-restrictive policies hamper virus containment.

After what will likely prove to be a dynamic rebound in Q3, the pace of recovery may slow, dragged down by a service sector still handicapped by mobility restrictions, lingering worries about overall demand and government support that will start to slow even where it still looks generous. Also, firms may hesitate rebuilding workforces in full with a view to strengthening balance sheets before having to pay back government support—or to save for more investment. Slack in capacity utilization could spill over to other countries if the trade recovery starts to lag.

For all these reasons, we call our central scenario for the next 12-18 months the “Not Quite Recovery.” It includes growth slowing, unemployment stuck at elevated levels and governments struggling to offer support even as they look for an exit. It’s probably a good scenario for credit and equities, but less so for sovereign bonds.

The outlook could worsen if a second wave of fatalities forced broad lockdowns or governments exited too fast. We think the odds of a Fiscal Cliff scenario remain low, but the risks bear watching. Currently, the U.S. looks most likely to fall short of enough fiscal support through the recovery, although the call to balance budgets will return to Europe sooner or later. Of course, many Emerging Markets don’t have the luxury to borrow through the crisis and already face difficult recovery.

Another scenario, which probably carries even lower odds, is what we call the “Kitchen Sink,” in which flagging growth or further shocks force both monetary and fiscal authorities to throw everything they have at supporting demand. In this outcome, central banks find themselves trapped in a world of keeping rates low so governments can afford their interest bills. At some point, this could create risks of overheating and inflation, but only after a significant recovery period.


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