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Recovery scenarios: The ABCs of Covid-19 recession

July 23, 2020

reading time: 5 minutes

by Calvin Ha, Investment Strategist LGT

assembly of an engine

Most recessions have followed certain shapes over the last decades. Discussing the decline and rise in GDP around Covid-19 now, economists often use these scenarios again – with differing consequences for investors.

Since the onset of Covid-19, nations around the world have taken substantial measures to manage the pandemic, including travel restrictions, suspension of non-essential businesses and the implementation of social distancing policies. These measures have successfully contained the spread of the virus in some countries. But they have also brought severe economic consequences due to the associated "sudden stop" in economic activity, with a large number of countries falling into recession.  

While the development of the pandemic remains fluid, uncertainties remain elevated and it is hard to gauge the duration of the recession, as it is only obvious in hindsight. Having said that, previous recessions have largely followed four common shapes: V, U, W, and L, where the letters describe the trajectory of recovery in GDP and economic conditions. As such, investors are most interested to know the shape of recession in the major economies as they recover from the impact of Covid-19. 

Shapes of recessions explained

The V-shaped recovery path is the best scenario for the pandemic as it features a quick recovery following a steep decline, with limited long-term financial damage. In the early 1990s, the US went through a V-shaped recession, which lasted only eight months, with the economy growing quickly thereafter.

Statue of a girl wearing a mask.
While the development of the pandemic remains fluid, uncertainties remain elevated (Photo: © KEYSTONE, Kevin Hagen)

In a U-shaped recession, the period between decline and recovery is usually longer than that in a V-shaped recovery.  It may take months, if not years, for the economy to recover. The Great Recession from 2007 to 2009 after the bursting of the US housing bubble and the Global Financial Crisis is a good example of a U-shared recession. The recession lasted 19 months and it took years before employment and economic activity recovered to their pre-crisis levels. 

In a W-shaped recession, the economy recovers as quickly as in a V-shaped recession, however is followed by a second period of decline. As such, this is also known as a "double-dip" recession. In the early 1980s, the US experienced a W-shaped recession with the first hit triggered by the oil crisis and high inflation in 1979. The economy fell into a brief recession in 1980, but then rapidly started growing again. However, the US Federal Reserve kept raising interest rates, as they believed inflation was too high, which eventually led to another decline in July 1981. 

The worst-case scenario is arguably an L-shaped recovery, where economic growth falls significantly and does not recover in years. Japan went through an L-shaped recession in the 1990s, when a steep market crash at the beginning of the decade was followed by a credit crunch and other economic turmoil around the world, including the US recession in 1990-91. Afterward, Japan experienced more than 10 years of slow economic growth, which is now commonly referred to the "lost decade" of Japan. 

Which letter of the alphabet will economies follow?

For the Covid-19 recession to be V-shaped, the spread of the virus has to be contained so that the economy can reopen without leading to another surge in cases. Besides, supportive fiscal measures are needed to limit the economic damage associated with job losses and closures of businesses. Among the major economies, we believe China is likely to follow a V-shaped recovery, given its "first in, first out" advantage, and indeed, economic activity has picked up quickly.

On the other hand, if it takes longer to get the surge in coronavirus cases under control, or if economic reopening itself leads to a surge in infection cases, the normalisation in economic activity will take longer and lead to a U-shaped recovery. We believe the US and most EU countries are likely to follow a U-shaped recovery pattern, barring any severe second wave from the pandemic. 

Kid standing up.
While we remain optimistic about the recovery in the major economies, the risk of another round of decline in activity should not be ignored.

Given the recent spike in infections in some of the US states, a second wave of Covid-19 remains possible in the near term. Besides escalated geopolitical tensions, weakened demand, and consumer sentiment may all be potential causes of another decline, leading to a W-shaped recovery.

While we remain optimistic about the recovery in the major economies, the risk of another round of decline in activity should not be ignored. Meanwhile, we believe an L-shaped recession is not likely in the developed countries unless the coronavirus outbreaks continue and lead to prolonged shutdowns of businesses; this scenario remains too pessimistic for now. 

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