VantageVantage Point Point Q2 2020 Q3. 2020 AlphabetAlphabet SoupSoup V U W L Lorem ipsum dolor sit amet, consectetuer adipiscing elit, sed diam nonummy nibh euismod Lorem ipsum dolor sit amet, consectetur adipiscing elit, sed do eiusmod tempor tincidunt ut laoreet dolore magna aliquam erat volutpat. Ut wisi enim ad minim veniam, quis incididunt ut labore et dolore magna aliqua. Ut enim ad minim veniam, quis nostrud nostrud exerci tation ullamcorper suscipit lobortis nisl ut aliquip. exercitation ullamco laboris nisi ut aliquip ex ea. Vantage Point Q2 2020 Alphabet Soup IntroductionV Since the last edition of Vantage Point, Covid-19U has Looking ahead, we once again describe an alphabet wreaked both human and economic devastation on soup of potential recovery scenarios from here. We the world. At the time of writing (June 25), worldwide describe a ‘V’, a ‘W/U’, an ‘L’, and an ‘I’ scenario. Crucially, over 9 million people have contracted theW disease and we also define precisely what we mean by each more than 450,000 have died from it. The response scenario, differentiating them by the time it takes to has been to lock down a number of economies in an recover the pre-crisis level of GDP. Given the scale of attempt to reduce the transmission rate andL reduce the decline to date, growth rates in the second half of the so-called R number to below 1. The upshot has the year are likely to be very high, even if economies been the largest global economic contraction since are only in reality opening up slowly – so GDP levels economic records began: the world economy could are what matter here and we have recast our GDP fan have shrunk by around 10% in Q2, with huge knock-on charts into levels to make that point clear. effects onto employment and business profitability. What kind of recovery we get depends fundamentally The economic policy response has been impressive, as on the course of the disease from here. If a large both central banks and governments have stepped in number of economies can exit lockdown without to prevent recession turning into depression. In this seeing the frequency of cases spike beyond levels Lorem ipsum dolor sit amet, consectetuer adipiscing elit, sed diam nonummy nibh euismod edition, we look back at what we’ve been through, look health systems can cope with, then a ‘V’-shaped ahead to what might happen, assess the tinciduntmonetary ut laoreet dolore magna aliquam erat volutpat. Ut wisi enim ad minim veniam, quis nostrud exerci tation ullamcorperrecovery suscipit is on lobortis the cards, nisl ut aliquip. with global GDP returning to and fiscal policy response, analyse the impact on pre-crisis levels by the middle of 2021. However, if markets and finally draw some broad investment there is a large second wave, possibly in the Northern conclusions in what is a highly uncertain and rapidly- Hemisphere Fall/Autumn that necessitates a return to evolving situation. partial or full lockdown, then a ‘W/U’-shaped recovery There is good news and bad news about what we’ve becomes likely and we are unlikely to see pre-crisis been through. The good news is that we may be past levels of GDP restored until 2022. If, in either case, we the worst: the world economy probably troughed in see permanent demand and capacity destruction, a late-April or early May. The bad news is that the worst prolonged, slow or ‘L’-shaped recovery, becomes likely. was, economically speaking, very bad indeed. The That scenario could also trigger another bout of epicenter of the disease moved from China in Q1 to financial market instability, especially if a wave of Europe and the US in Q2. Some European economies bankruptcies and defaults causes parts of the credit – Italy, Spain, the UK – may well contract by a quarter market to collapse. Finally, our ‘I’ scenario refers to to a third in the second quarter. The US economy is ‘inflation’; it is a variant of the ‘V’, in which a stronger- likely to have shrunk by upwards of 10% (quarterly than-expected recovery, coupled with some reduction change, not annualized), while unemployment has in supply capacity, causes inflationary pressure to rise risen by over 30 million. Lockdown measures are in 2021 and forces central banks to reconsider their beginning to ease now and we should see a pickup in ultra-easy stance much sooner than markets activity shortly, but the extent and duration of the currently expect. recovery remain hugely uncertain. 1 Quarterly Outlook Q3.2020 As usual, we attach probabilities to these scenarios and crisis. They seem to be pricing in a relatively strong present all our forecasts in the form of ‘fan charts’, ‘V’-shaped recovery and, although realised volatility which describe not just the most-likely and weighted- remains high, and measures of financial market stress average outcomes, but also the level of uncertainty and such as Libor-OIS spreads remain higher than they where the balance of risks lies. In times like these, were pre-crisis, markets do not seem to be pricing in investors need to take account of risk as well as return as much downside risk as our fan charts would imply. and our fan charts help them to do that. After much As a result, the investment advice is nuanced: debate, we have settled on the following probabilities cautious but gradually increasing allocation to risky for our scenarios: the ‘V’ gets 50%; ‘W/U’ 30%; ‘L’ 15% assets (equity and credit), but at lower-than-normal and ‘I’ just 5%. In short, we are a little bit more levels of overall portfolio risk, coupled with hedges optimistic about the chances of a ‘V’ than we were last where possible. That’s a difficult message to get over, time, but the balance of risks remains firmly shifted to let alone for investors to implement, but it reflects the the downside. Our downside scenario probabilities add precariousness and uncertainty of the situation we up to 45%, so are slightly odds against, but the find ourselves in. Let’s hope we emerge from it soon. outcomes in those scenarios are so negative that a number of our fan charts display a large negative skew. We conclude with some broad investment conclusions. One difficulty is that equity markets in particular have been rallying strongly since late March, on the back of decisive central bank SHAMIK DHAR intervention designed to stave off another financial CHIEF ECONOMIST 2 Vantage Point Q2 2020 Alphabet Contents Soup EXECUTIVE SUMMARY 4 V SECTION 1. ECONOMICS 8 1A) SCENARIOS 9 1B) FORECASTS U14 SECTION 2. CAPITAL MARKETS 18 2A) WHAT IS PRICED IN 19 W 2B) MARKET SENTIMENT 25 SECTION 3. INVESTMENT CONCLUSIONS 28 APPENDIX 32L Lorem ipsum dolor sit amet, consectetuer adipiscing elit, sed diam nonummy nibh euismod tincidunt ut laoreet dolore magna aliquam erat volutpat. Ut wisi enim ad minim veniam, quis nostrud exerci tation ullamcorper suscipit lobortis nisl ut aliquip. 3 Quarterly Outlook Q3.2020 Executive Summary WHAT WE THINK – ECONOMIC SCENARIOS 50% 30% V-shaped recovery W/U-shaped recovery We are past the trough in global economic activity and Covid-19 virus cases resurface in the northern hemisphere peak lockdowns. Economies continue to reopen. Fall/Autumn leading to substantial and widespread Health care systems are able to manage any new outbreaks. Even if more localized, the virus spread is large outbreaks. Consumers and businesses adapt helping enough to require a return to partial or full lockdowns to limit the transmission rate from spiking higher. A despite better equipped health systems. Similar to the first second round of lockdowns is prevented and GDP in wave, global economic activity falls sharply. Renewed most countries recovers to pre-crisis levels by the weakness from already vulnerable economies and second half of 2021. Fiscal and monetary stimulus, uncertainty trigger widespread risk-off sentiment, pent up demand, and less supply side disruption which lasts longer than seen during February and March. support growth. Credit markets ease further and risk A second financial shakeout ensues as stocks decline assets continue to gain as investors increasingly learn towards the lows in March and Treasury yields approach that the long-term growth consequences of the 0%. Policymakers struggle to put a floor on rapidly disease will be limited. deteriorating sentiment and stress in dollar funding markets picks up, particularly for countries not included in the Fed’s existing swap lines agreements. Markets bottom by mid-2021 and GDP does not recover to pre-crisis levels until the second half of 2022. 4 15% 5% PROBABILITY* L-shaped recovery I is for Inflation SCENARIO Just like our W/U scenario, this scenario sees a In terms of the path of the virus, this sizeable second wave in major countries in Q3-Q4 scenario is much like the V-shaped one. 2020 that necessitates partial or full lockdowns. The difference here is that the US growth Unlike our W/U scenario, there is a permanent hit recovery is stronger than expected, capacity to output in major economies (hence the L-shape constraints begin to bite, and the pick-up in recovery), as outbreaks trigger severing of global US inflation is more rapid, prompting the Fed supply chains and accelerate existing to tighten in Q2 2021, much sooner than deglobalization trends. The impact on both Europe markets currently expect. US remains the and the US is huge with permanent demand and most resilient economy and resumes its capacity destruction. The disruptions to supply upward trajectory in Q3 2020. Tighter US chains lead to higher global costs and inflationary policy depresses activity in the Eurozone and pressure.