Economic recovery: the shape of things to come

BMO chief economist Douglas Porter takes a look at the possible chart formations tracking a post-pandemic economic recovery. Give me a “U”, give me a “V”; give me a . . .


BMO Financial Group chief economist Doug Porter looks for a post-pandemic economic recovery chart to take a “V” or “U” shape.

After bottoming out in late March, financial markets had a strong April, as the S&P 500 headed for a double-digit advance. The TSX quietly turned in three consecutive weeks of gains, a positive outlier. Asset prices were buoyed by news hinting at COVID-19 reaching an apex in some key countries and regions, even as the economic news harshened, particularly on the jobs front.

But fully recognizing that we are in the heart of the deepest and swiftest economic downturn in modern times, attention is now turning to the shape, strength and timing of the economic recovery. When we are talking about the shape of the recovery, we need to distinguish between the level of activity and the growth rate.

Arguably, every recovery in US economic history has been some form of a V shape, when looked at in growth terms.

The only outlier was in the early 1930s, when the economy carved out a nasty W in the middle of the Great Depression, with the right-hand slide even deeper than the initial drop. However, there have been plenty of U-shaped recoveries (and even one temporary L), when we instead look at the level of activity.

4 chart patterns of a recovery

Let’s consider what each one of the four letter scenarios would broadly look like. First off, the V-shaped recovery (35 per cent chance): Activity bottoms in April, but shutdowns lighten sharply in May, helping activity snap back quickly. Perhaps supported by an effective mitigation drug course, as well as the wave of fiscal spending, economy-wide activity is roughly back to normal by the summer. And, by next year, losses have been recouped, and the economy is back on its long-term trend by the end of 2021.

U-shaped recovery (40 per cent): The shutdowns drag throughout May and most of June, and the longer shutdowns cause deeper, lasting damage to the economy. As a result, the recovery takes longer to gather strength, as business remains wary about rehiring and consumers remain wary about returning to stores, service vendors, and restaurants. However, the economy finally gathers some momentum by next year, and is roughly one per cent below trend by the end of 2021.

W-shaped recovery (20 per cent): A similar pattern to the U-shaped recovery with one key difference—we are hit with another serious outbreak of the virus heading into the winter of 2020-21. While the shutdowns may not be as hard as the first round, and business is much better prepared to deal with such, the second outbreak causes a dispiriting slump in consumer and business sentiment. While growth does crawl back in the second half of 2021, output is still down almost five per cent from pre-crisis levels even by the end of next year.

L-shaped recovery (five per cent): The shutdowns remain largely in place as we go through this year, as the virus persists. Even as health conditions finally improve in 2021, damage to the economy has been so serious that business and consumer spending recovers only weakly.

Which chart shape will our recovery adopt?

We don’t think the recovery will neatly fit into any one of these shapes (that is, V, W, U or L). Perhaps the end result will have some characteristics of all four letters. There is the very real probability that different sectors and regions will experience a different letter.

Some particularly affected industries could feel like an L, such as parts of the travel sector (e.g. cruise lines), while even a mild secondary outbreak could cause a W in other sectors (sports, entertainment). Some are likely to see a pretty vigorous V as soon as the shutdowns end (specifically things like education, construction, and some must-have services—think dentists and barbers).

But, for the overall economy, activity will likely return somewhere between a V- and U-shaped pattern, or a somewhat lazy V. But note that such a recovery is not necessarily the same thing as suggesting everything will be back to ‘normal’.

In any case, if the shutdowns lighten even slightly in the summer, almost by definition, activity and growth will see a bounce in the third quarter.

Q3 will show some growth

With some sectors and businesses going straight to zero in early April (the very start of the second quarter), it is a plain fact activity will be firmer in the third quarter—and growth will go from massively negative in the second quarter to at least a small positive in the third quarter, even in a dire scenario.

Note that compared to the most recent consensus, we look for a much deeper drop in the second quarter than other forecasters, but also see a much bigger rebound in the second half, yet are in the same range as consensus on the full-year outlook for GDP (-4 per cent for the US, -4.5 per cent for Canada, and global growth is now expected to fall 0.8 per cent this year).

The bottom line is, assuming that shutdowns begin to ease meaningfully by June and that some industries could take years to get back to ‘normal’, our forecast has something between a U and a V for the level of activity in the months ahead. However, in growth terms, we suspect that just like every other challenging environment of the past 120 years, it will ultimately look more like a V.

These are all based on our best assumptions. Ultimately, the virus will dictate the shape of the recovery, as well as the policy responses, and that’s something that economists and financial analysts simply cannot accurately predict.

Interest rates and CAD unlikely to change thru 2021

However, the outlook for interest rates is straightforward, with rates now essentially at the lower boundary for both the Fed and the Bank of Canada. We expect no further rate moves right out to the end of 2021, and also no move to negative rates by either bank.

The Canadian dollar has firmed further after buckling heavily last month, in part due to a retreat in the US dollar, but with little thanks to oil prices. Even with the bounce, we see the currency remaining under pressure in the months ahead, with a possible test of the $1.45 level (or below US$0.69).

We look for the loonie to settle down along with other markets by the second half, but it will be challenged to get back above the US$0.75 level even in 2021.

Our forecast estimates assume a middle ground for now, both in terms of the length of the assumed full-on closures and the weekly economic hit. And, of course, any lightening of measures will not be an on/off switch; more likely will be a carefully staged easing, much as the US is currently considering. With all of those uncertainties, we arrive at roughly a six percentage point direct cost to the North American economy from the shutdowns.

With underlying pre-crisis growth likely headed for roughly two per cent this year, that leaves US GDP down four per cent for all of 2020—and that is a much more important metric than some of the wild monthly and quarterly readings we are going to witness in coming days.

In Canada, we see a somewhat deeper GDP drop this year (4.5 per cent) due to the added crunch from the oil shock.

Douglas Porter is chief economist and managing director, economics of BMO Financial Group.

This is an edited version of an article that was originally published for subscribers in the April 24, 2020, issue of Investor’s Digest of Canada. You can profit from the award-winning advice subscribers receive regularly in Investor’s Digest of Canada.

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