Whenever the economy is put through the ringer, levels of optimism and pessimism about its potential recovery can vary greatly. The current state mid-pandemic is no exception. This graphic first details the various shapes that economic recovery can take, and what they mean. We then dive into which of the four scenarios are perceived the most likely to occur, based on predictions made by CEOs from around the world.
The ABCs of Economic Recovery
Economic recovery comes in four distinct shapes—L, U, W, and V. Here’s what each of these are characterized by, and how long they typically last.
L-shape This scenario exhibits a sharp decline in the economy, followed by a slow recovery period. It’s often punctuated by persistent unemployment, taking several years to recoup back to previous levels. U-shape Also referred to as the “Nike Swoosh” recovery, in this scenario the economy stagnates for a few quarters and up to two years, before experiencing a relatively healthy rise back to its previous peak. W-shape This scenario offers a tempting promise of recovery, dips back into a sharp decline, and then finally enters the full recovery period of up to two years. This is also known as a “double-dip recession“, similar to what was seen in the early 1980s. V-shape In this best-case scenario, the sharp decline in the economy is quickly and immediately followed by a rapid recovery back to its previous peak in less than a year, bolstered especially by economic measures and strong consumer spending.
Another scenario not covered here is the Z-shape, defined by a boom after pent-up demand. However, it doesn’t quite make the cut for the present pandemic situation, as it’s considered even more optimistic than a V-shaped recovery. Depending on who you ask, the sentiments about a post-pandemic recovery differ greatly. So which of these potential scenarios are we really dealing with?
How CEOs Think The Economy Could Recover
The think tank The Conference Board surveyed over 600 CEOs worldwide, to uncover how they feel about the likelihood of each recovery shape playing out in the near future. The average CEO felt that economic recovery will follow a U-shaped trajectory (42%), eventually exhibiting a slow recovery coming out of Q3 of 2020—a moderately optimistic view. However, geography seems to play a part in these CEO estimates of how rapidly things might revert back to “normal”. Over half of European CEOs (55%) project a U-shaped recovery, which is significantly higher than the global average. This could be because recent COVID-19 hotspots have mostly shifted to other areas outside of the continent, such as the U.S., India, and Brazil. Here’s how responses vary by region: In the U.S. and Japan, 23% of CEOs expect a second contraction to occur, meaning that economic activity could undergo a W-shape recovery. Both countries have experienced quite the hit, but there are stark differences in their resultant unemployment rates—15% at its peak in the U.S., but a mere 2.6% in Japan. In China, 21% of CEOs—or one in five—anticipate a quick, V-shaped recovery. This is the most optimistic outlook of any region, and with good reason. Although economic growth contracted by 6.8% in the first quarter, China has bounced back to a 3.2% growth rate in the second quarter. Finally, Gulf Region CEOs feel the most pessimistic about potential economic recovery. In the face of an oil shock, 57% predict the economy will see an L-shaped recovery that could result in depression-style stagnation in years to come.
The Economic Recovery, According to Risk Analysts
At the end of the day, CEO opinions are all over the map on the potential shape of the economic recovery—and this variance likely stems from geography, cultural biases, and of course the status of their own individual countries and industries. Despite this, portions of all cohorts saw some possibility of an extended and drawn-out recovery. Earlier in the year, risk analysts surveyed by the World Economic Forum had similar thoughts, projecting a prolonged recession as the top risk of the post-COVID fallout. It remains to be seen whether this will ultimately indeed be the trajectory we’re in store for. on Last year, stock and bond returns tumbled after the Federal Reserve hiked interest rates at the fastest speed in 40 years. It was the first time in decades that both asset classes posted negative annual investment returns in tandem. Over four decades, this has happened 2.4% of the time across any 12-month rolling period. To look at how various stock and bond asset allocations have performed over history—and their broader correlations—the above graphic charts their best, worst, and average returns, using data from Vanguard.
How Has Asset Allocation Impacted Returns?
Based on data between 1926 and 2019, the table below looks at the spectrum of market returns of different asset allocations:
We can see that a portfolio made entirely of stocks returned 10.3% on average, the highest across all asset allocations. Of course, this came with wider return variance, hitting an annual low of -43% and a high of 54%.
A traditional 60/40 portfolio—which has lost its luster in recent years as low interest rates have led to lower bond returns—saw an average historical return of 8.8%. As interest rates have climbed in recent years, this may widen its appeal once again as bond returns may rise.
Meanwhile, a 100% bond portfolio averaged 5.3% in annual returns over the period. Bonds typically serve as a hedge against portfolio losses thanks to their typically negative historical correlation to stocks.
A Closer Look at Historical Correlations
To understand how 2022 was an outlier in terms of asset correlations we can look at the graphic below:
The last time stocks and bonds moved together in a negative direction was in 1969. At the time, inflation was accelerating and the Fed was hiking interest rates to cool rising costs. In fact, historically, when inflation surges, stocks and bonds have often moved in similar directions. Underscoring this divergence is real interest rate volatility. When real interest rates are a driving force in the market, as we have seen in the last year, it hurts both stock and bond returns. This is because higher interest rates can reduce the future cash flows of these investments. Adding another layer is the level of risk appetite among investors. When the economic outlook is uncertain and interest rate volatility is high, investors are more likely to take risk off their portfolios and demand higher returns for taking on higher risk. This can push down equity and bond prices. On the other hand, if the economic outlook is positive, investors may be willing to take on more risk, in turn potentially boosting equity prices.
Current Investment Returns in Context
Today, financial markets are seeing sharp swings as the ripple effects of higher interest rates are sinking in. For investors, historical data provides insight on long-term asset allocation trends. Over the last century, cycles of high interest rates have come and gone. Both equity and bond investment returns have been resilient for investors who stay the course.
