What Recovery Pessimism Means for Stocks

Weakening economic expectations lowers the bar for reality to clear.

With countries gradually reopening from COVID-19 lockdowns, investors’ focus seems to be shifting from the economic contraction’s depth to its duration. Where at first hopes seemed high that reopening would mean a swift return to normalcy, pessimism seems to be growing. A number of outlets now argue that even if lockdowns end swiftly, it won’t be a magic economic elixir—dooming the economic recovery to look more like an “L” than a “V.” In our view, the recovery’s eventual speed and trajectory aren’t knowable now, as they rest on a number of unpredictable variables. But from an investment standpoint, more pessimistic expectations widen the range of outcomes that could generate positive surprise.

As most states and countries are opening gradually, we have only a very limited look at how businesses and consumers will respond. In the US, about half the states have started phased reopening processes, with Georgia the first locked-down state to lift restrictions and Texas the largest so far. Overseas, the UK announced slightly eased restrictions, while Germany, Italy and Spain are a couple weeks into reopening.

Economists are creating models tracking activity to gauge states’ and countries’ progress. Georgia selectively opened gyms, salons and tattoo parlors on April 24. Dine-in restaurants and movie theaters followed a few days later, with stay-at-home orders expiring April 30. But some models now suggest the state’s reopening hasn’t meant much for consumer spending thus far.^[i] This finding has many now extrapolating Georgia’s experience to other states—and America as a whole. They say people’s individual decisions trump government decrees. With uncertainty still running high—about viral contamination and personal finances—ending official lockdowns allegedly won’t buoy economic activity.

Sentiment overseas is similar. The UK’s central bank, the Bank of England (BoE), forecasts a -14% GDP contraction this year—the worst in 314 years—with most downside occurring this quarter.^[ii] Some call that too optimistic. Even with relaxed restrictions, the BoE expects a -25% q/q cut in Q2 national output (versus contracting by a third with full lockdowns remaining in place). But the outlook then paints a scenario where GDP “recovers relatively rapidly in Q3, as social distancing measures are gradually lifted, and rises further in Q4”—a “V”-like rebound. More pessimistic economists warn that snapback may not happen. A second wave of infections could recur, forcing folks back into sheltering in place. Meanwhile, others believe reinfection fears mean the slow pace of reopening will bankrupt businesses en masse—there will be no bounce back.

Across the channel, the European Commission forecasts EU GDP will shrink -7.4% this year.^[iii] The head economist making this projection cautions, “The danger of a deeper and more protracted recession is very real.”^[iv] The report itself calls it: “A deep and uneven recession, an uncertain recovery.” Then, because the EU is the world’s biggest economic bloc, America’s top trading partner and China’s second largest, some think “L”-shaped stagnation in Europe could flatline the global recovery.

Although we don’t know if March 23 will mark stocks’ trough, these types of fears are normal at bull markets’ beginnings. As Sir John Templeton explained, “Bull markets are born on pessimism, grow on skepticism, mature on optimism and die on euphoria.” Sentiment is typically most dour when the downturn is at its deepest. Few can fathom how it will ever get better. This is precisely what happened in 2009 and 2010 as stocks and the economy exited the global financial crisis. In March 2009—when the bull market began ahead of June’s economic turnaround—headlines warned about the first global economic contraction since World War II. Even once GDP resumed growing later that year, fears of a sluggish “L-shaped” rebound lingered and lasted through most of 2010. As late as 2011, headlines were warning a double-dip recession was imminent.^[v]

For investors though, what matters for markets isn’t the recovery’s shape per se, but how it compares to expectations. When the White House and other countries’ governments announced loose reopening plans last month, we saw a chance that expectations could get too high and detached from reality. This could have created the potential for disappointment if reopenings were uneven or if people didn’t return to normal behavior right away—fodder for a second leg down for this bear market, in our view. But as plans have become more concrete and preliminary results roll in, it seems most—from government officials and economists to businesses and households—remain cautious. Expectations don’t seem lofty—at least for now.

It is still too soon to declare the bear market over. The more pessimistic expectations get, though, the more negative surprise power is sapped. While this doesn’t rule out a second leg down for other reasons that markets don’t currently appreciate, we don’t presently see something of this magnitude. At least as it pertains to the likelihood of investors’ general expectations for a recovery being overzealous, things look encouraging. We will know only with the clarity of hindsight whether recovery will be painfully slow or not, but perhaps counterintuitively, it is a good sign for stocks that so many think worse lies even beyond official reopening.