With so much uncertainty, scenarios are helpful. Here I consider 2 vectors – the course of Covid-19 and the political fallout. Will Covid-19 be ‘tamed’ or will it ‘stay a severe threat’. And will 'national and international cohesion hold up’ or will ‘political instability’ create additional problems of bad policy, prolonged weak business confidence or even revolution or war. From these two vectors I derive a matrix with four possible scenarios.
FOUR SCENARIOS
Good chances for Recovery soon (scenario 1)
We are all hoping for scenario 1 so that we can get most people back to work in coming weeks (even if sectors like travel, hospitality, sports, cinema etc are still partially closed or face weak demand for many months). The virus may also be tamed by clinical success with various existing treatments, (for which there are some positive reports though, so far, no magic bullets). I give this scenario a 50% chance.
I don’t want to minimise how bad things will be, even in scenario 1. GDP will likely not return to 2019 levels until 2022, as the recession works through. Social distancing will keep everyone cautious (consumers saving and business not investing) until well into next year or until a vaccine is widely available. And the damage from higher unemployment, company bankruptcies and increased debt will last for a long time.
Risk of a Long Slog (scenario 2)
There is a risk that, as countries open up from lockdown, it becomes clear that we are actually going to be in scenario 2 (Long Slog). Covid-19 may remain a severe threat, with the opening now in Europe and the US bringing a second wave of infections, forcing a new lockdown. There may be disappointing news on treatments or vaccine prospects too. Note that the full resolution of this vector (i.e. Covid-19 completely in the rear-view mirror) could take 1-2 years or perhaps much longer if a vaccine proves difficult or impossible. I give the Long Slog scenario 30% probability.
Depression risk is low but real (scenario 4)
Political instability is perhaps most likely to emerge over time so there is a risk that from scenario 2, we progress to scenario 4 (Depression) as political problems turn the downturn into something worse. There is certainly a danger of major political instability even in developed countries - think of the stress in the EU created by the single currency, the pressure on the UK with Brexit, or the political polarisation in the US. In emerging countries, the risk of something breaking politically is much greater, perhaps particularly for oil-producing countries, but also for China, at the end of its long debt-fuelled expansion.
Political instability will extend the economic downturn by impacting business confidence. It could also make it more likely that there will be monetary policy mistakes, which could turn what is otherwise a disinflationary process into renewed inflation, or even hyper-inflation. Money supply is rising rapidly and there may be a temptation to inflate out of higher debts. Again, it might be my excessive optimism but I give the Depression scenario only 5%.
Patchy recovery is possible (scenario 3)
Even if Covid can be tamed, so that we avoid scenarios 2 and 4, political instability could still drop us from scenario 1 into Scenario 3 (Patchy Recoveries). In this scenario some countries do fine, so there is no worldwide depression, but others face severe problems. Again, it is impossible to forecast which might be in trouble but emerging countries and perhaps the euro area are most at risk. Even without a complete breakdown of trade, globalisation could be severely curtailed which would depress productivity growth in the years after Covid. I give this scenario a 15% chance.
My hunch is that stock markets are betting mostly on scenario 1, with perhaps a bit of 2 and 3 in the calculation. So, if scenario 1 is confirmed in coming months there is more room for stocks to rise. However, if one of the other scenarios starts to look more likely, there is renewed downside.
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