Kempen Outlook 2021 Corona scenarios

But now, more than six months on, what can we say about these scenarios, and what do we expect from here?

The recovery was V-shaped at first 
The economic contraction we saw in the first half of 2020 was in line with all the scenarios we developed. After all, it was clear that the pandemic would punch huge holes in the global economy. But in retrospect, we were too pessimistic in March. 

At the time, we assumed there would be a U-shaped recovery, with the global economy still in contraction mode in Q3. This is clearly not how it panned out. Governments and central banks quickly put in place massive bailout packages, which we had expected, but not quite as quickly as they actually did, so we had expected the recovery and peak in growth to come a bit later too. But just as importantly, the strict lockdown measures put in place in spring were relaxed considerably in the summer – in March, there were pessimists around who expected lockdown to last until the end of the year.

The result was that in the first half of 2020, the economies of the US, the eurozone and Japan contracted by almost 12%. The figures for Q3 haven’t been published yet, but the consensus expectation among economists is for growth above 6%. This is roughly in line with the V-shaped recovery we initially forecast. This means that a number of our alternative scenarios can be discarded. Q2 was far too strong for the U-shaped or even more negative scenarios to have been accurate.

When the facts change …
Economist John Maynard Keynes reportedly once said: “When the facts change, I change my mind”. Now that the facts about the first three quarters of 2020 are known, we must also make changes to our scenarios. The most optimistic scenario is for a continuation of the rapid V-shaped recovery. In the consensus scenario, growth flattens but remains positive. In the square root scenario, growth comes to a complete standstill, and in the W scenario, we would see a temporary economic downturn. 

The V-shape scenario
In the V scenario, the lockdowns that are now being imposed once again would have a rapid effect, and would be temporary, regional, and sector-specific. This would quickly bring the second wave under control. In this scenario, doctors also learn to treat the virus better, with the result that seriously ill patients would spend less time in hospital and be less likely to end up in intensive care units. This means we have milder lockdowns. In this scenario, a vaccine would become widely available in Q1 2021.

Economic growth would remain strong in Q4 2020 and Q1 next year, and above trend over the remainder of 2021. The global economy wouldn’t just recover to pre-corona levels, but would surpass them by continuing on its upward trend from previous years. This would be a positive scenario for risky investments such as equities and high-yield corporate bonds. Corporate earnings would recover quickly and balance sheets be repaired. It’s also a scenario that may involve overstimulation , which would lead to higher inflation expectations and create some inflationary pressure. Rising interest rates are detrimental to government bonds and, on balance, to investment-grade corporate bonds as well, because lower risk premiums are unlikely to outweigh the effects of higher interest rates on government bonds. 

Gold could serve as a hedge against inflation in this scenario, but higher real interest rates don’t work in gold’s favour. With this in mind, real estate may offer better protection. Property investments have generally lagged in recent months due to the increase in home working and online shopping during the corona crisis, but this could quickly change in the V-shaped scenario.

The consensus scenario
In the consensus scenario, growth would remain positive, but level off. This slower growth would be caused by the effects of second wave of the coronavirus, and also because the maximum impact of monetary and fiscal policy has passed. Growth would remain reasonably strong in Q4, but fall back towards trend levels in 2021. Under this scenario it would therefore take until the end of 2021 for the global economy to return to its level at the end of 2019.

In this scenario, central banks would keep interest rates low and continue to buy bonds. Capital market interest rates would also remain low. This would make equities attractive, but we would have to be wary of excessively optimistic profit expectations. As a result, high-yield corporate bonds could outperform equities in this scenario, while gold should benefit from the backdrop of low real interest rates.

The square root scenario
In the square root scenario, growth comes to a standstill after Q3, and this persists for some time. Here, the positive momentum in the global economy is offset by second-round economic effects such as mass lay-offs and bankruptcies. With coronavirus still not under control, and lockdowns being alternately relaxed and tightened, fiscal and monetary authorities would be reluctant to intervene any further.

With inflation low and uncertainties abounding in this scenario, defensive asset classes such as government bonds and gold should thrive. But against a backdrop of low capital market interest rates, sovereign bonds would offer a better chance of capital preservation than of yield. Government bonds would therefore not fully offset the effects of falls in the prices of equities and high-yield corporate bonds. Investment-grade corporate bonds should outperform equities and high yield due to direct support from central banks.

The W-shaped scenario
In the W scenario, the virus strikes back fiercely despite the measures taken so far, with infections continuing to increase. Stricter lockdowns would be necessary, and if they were not put in place consumers and companies themselves would become more cautious, much like we saw in Sweden in the spring. The economic contraction would initially be less severe than what we saw earlier in the year, simply because some sectors, such as tourism, business travel and events, have little scope to shrink much further. But the underlying damage to the global economy would eventually be bigger. Companies could no longer postpone lay-offs, and the savings that consumers still had during the first wave would be running out. 

In this scenario there would be another wave of stimulus measures, but the subsequent recovery would be less vigorous than in Q3 this year. At the end of 2021, the world economy would be smaller than what we would expect it to be in the V or consensus scenario, but bigger than in the square root scenario . 

This scenario, of course, would also be negative for risky assets. Equities and corporate bonds alike would be hit by an increasing number of bankruptcies. Investors would see through the second trough of the W at some point, just as they did in the first part of the V in 2020, but only after stock markets had fallen sharply again.

So what’s going to happen?
At present, we haven’t assigned probabilities to the different scenarios. But that doesn’t mean that we consider them all to be equally likely. We think the square root scenario is the least likely: eventually, we’ll learn to live with the virus and there will also be a vaccine, enabling growth to resume again. The V scenario is probably a little too optimistic considering what we’re seeing in the ongoing second wave. 

This leaves the consensus and W scenarios as the most realistic options. We don’t yet know what scenario we are actually in, but if we look at the situation right now we think we might be in a consensus scenario. The virus does seem to be less harmful than earlier in the year, treatment methods have improved, and we have a vaccine in sight. Growth would level off and there would be many uncertainties for investors, but there would also be hope.

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The Author

Joost van Leenders
Michel Iglesias del Sol

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