How and when will the biggest global health and economic crisis since World War II end? The short answer is that three months into the worldwide Covid-19 pandemic, we still don't know. But as a result of another ad-hoc strategy meeting, we can communicate some educated guesses, based on intensive work across our investment platform in recent weeks.
Our base case is that even though it will take a while for the world economy to recover, we believe we should start to see signs of stabilization in the coming months. Most countries are already experiencing a sharp recession, including where it is not yet officially labelled as such. Because of social-distancing measures, large swaths of economic activity suddenly came to a halt. The recovery will probably be slow. The consequences of the crisis will likely linger, as captured by our economic forecasts (see PDF).
We now expect global gross domestic product (GDP) to shrink by almost 3% in 2020, before recovering by more than 5% in 2021. These are rounded figures. Given the large bands of uncertainty, we would honestly be delighted – and quite surprised – if we got each digit, let alone the decimal points, in our country forecasts right. What probably matters more is the relative performance of the leading economies. We expect the recession in the United States to be shallower than in the Eurozone, and the U.S. recovery to be faster, roughly in line with global GDP growth. That primarily reflects the outsized U.S. fiscal stimulus, leading to a budget-deficit forecast of about 18% of GDP this year. In our opinion, inflation will be dragged down by the decline in oil prices this year, but probably recover next year, as pent-up and fiscally-stimulated demand may start to run up against supply-side constraints.
Obviously, there is plenty of uncertainty around this outlook. In addition to leaving mountains of government debt in its wake, Covid-19 will very likely change the behavior of workers and households, businesses and financial intermediaries. We would caution, however, as it is still very early in the crisis, to speculate about the precise nature and magnitude of these changes.
What is already becoming clearer is the current assessment of the situation by financial markets. At the time of writing, equity markets appear determined to look through the crisis. Within a few weeks, U.S. markets in particular have moved from panic back to valuations that would have looked frothy not so long ago, even in the absence of a global pandemic. Of course, sentiment can change and we would not be surprised if the March lows get tested again. For now, though, Wall Street appears willing to ignore the carnage it looks set to cause in company earnings, which we do not expect to fully recover until 2022. Add unprecedent fiscal and monetary stimulus, and we consider it quite possible that equity markets will be up by around 10% in a year.
As for bond markets, we think that accommodative central bank action will continue or even accelerate. Generally, interest rates look set to remain low for longer and we believe that European-Central-Bank (ECB) and European-Union (EU) measures will succeed in tightening periphery spreads for countries such as Italy and Spain. Corporate bonds should benefit from central-bank asset purchase programs, especially in the comparatively shallow Eurozone bond markets. Emerging-market bonds, issued by both corporates and sovereigns, should tighten somewhat from current levels once we see the turnaround in economic-growth numbers. In terms of the relative risk-return profiles, we prefer high-yield to investment-grade, and investment-grade to emerging-market bonds. Selection and active management will be key in all these categories, given the rising default and headline risks.
Which takes us to our penultimate point. We expect the U.S. dollar to hold on to its recent strength in an environment of lingering uncertainty. This is likely to remain the case unless or until the medical progress for the pandemic changes, thanks, for example, to better treatment options or a vaccine being found. On a final note of caution, we would stress that additional waves of the pandemic, followed by renewed shutdowns, constitute a material risk not captured in our forecasts.