Have financial markets got ahead of themselves?

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After a huge equity rebound since the March lows, we should expect the markets to chop around and we could see another sizable decline. I’m generally inclined toward a bullish outlook. Throughout the previous bull market, I stayed upbeat at times, such as December 2018, when many people thought a new bear market was upon us. Even now, I remain optimistic for the next five years. The economy was in structurally decent shape prior to the COVID-19 pandemic. 

Nonetheless the downturn has been staggering.

The “V-shaped recovery” voices have started to sound more doubtful in recent weeks. The main uncertainty is how long the lockdown measures will remain in place. There are also questions about the severity of the lockdowns, their impact on economic data and how statistic authorities will treat these unprecedented events. 

For the labour market, the biggest risk relates to insolvencies. If there is a significant rise in business failures, there will be fewer jobs for workers to go back to as the economy recovers. While voters are being generous to Boris Johnson’s government over its handling of the COVID-19 crisis, despite very serious early errors, they will not be so forgiving about a recession. The Prime Minister may be right not to end the lockdown, yet, but the economy is paying a price in businesses and jobs for every extra week that it holds. The furlough scheme is, in the words of the former Deputy Prime Minister Michael Heseltine, “a form of masked unemployment”. Many on it face redundancy as soon as the pandemic ends.

The composition of the recession is likely to be unusual. Typically, households will try to smooth their consumption spending as much as possible, while firms slash capex. Household consumption barely fell through the financial crisis. With the COVID-19 pandemic, we expect a double-digit drop. The current lockdown means households are unable to consume many goods and most services. When shops, restaurants and entertainment venues re-open, consumer spending is expected to rise rapidly – provided the furloughing measures, fiscal cushions and central bank lending schemes meet with success. 

The unusual consumption-led nature of this recession could mean an unusually sharp GDP recovery. This is the consensus view.  Given emerging scale of Covid-19 crisis, talk of rapid bounce back could be wishful thinking.