March 22, 2020 | Expert Perspective

A sharp contraction, then an upswing

Joe Davis

Joe Davis
Vanguard Global Chief Economist

In only a few months, COVID-19 has spread around the world. The extreme measures being taken to protect us, to combat the disease’s spread, should be positive for public health. But such a step necessarily involves a trade-off. In appropriately prioritizing human health, we in essence must shut down large swaths of the economy, closing schools and businesses and limiting human interaction.

Having to do so makes it unfortunately clear that a global recession is at hand.

A deep (and we hope short) U.S. recession

Given increased efforts to contain the spread of the coronavirus, we anticipate a sharp (but we hope short) contraction in the U.S. economy, which likely has already entered into recession this month. The coming months are likely to witness a profound fall-off in the real economy.

For some time, we have been estimating the likely impacts of the virus' spread through a number of channels, including reduced trade, restrictions in supply chains, tighter financial conditions, and, perhaps most significantly, social distancing measures. This latter effect is leading to a profound decline in consumer spending in the "face-to-face" sectors of the economy, namely hotels, restaurants, air travel, and related activities. We expect consumer spending in the months ahead to decline at the sharpest pace since at least World War II, with clear impacts to employment.

As shown in the illustration, real GDP is likely to contract in the coming quarter by nearly 17% on an annualized basis. This would mark the deepest quarterly decline since at least the 1950s. This will be a trying time for all of us, and certainly for the U.S. economy.

We expect, however, that this could also turn out to be among the shortest recessions in our history. Importantly, we assume that the need to significantly restrain activity, such as the closure of non-essential businesses, will dissipate by late in the second quarter. Under such a scenario, and with aggressive fiscal and monetary policy measures, we would foresee a rebound in growth in the third quarter to mark the end of this sharp yet short recession.

A sharp but short contraction

Quarterly annualized real GDP growth chart 1980 to present

Sources: U.S. Bureau of Economic Analysis historical data, Vanguard calculations.

A bear market in stocks, and a ray of light

Financial markets have sold off significantly over the last several weeks, with eye-watering volatility. While we noted in our annual economic and market outlook that there was an elevated risk of a correction in the stock market, the speed of this bear market has certainly taken me by surprise.

A positive side, however, is that the long-term picture has brightened for equities. As the illustration shows, the recent sharp downturn has brought returns more in line with the previous outlooks provided by our Vanguard Capital Markets Model®. As you can see, over longer periods we've had a fairly good record of anticipating where future stock returns would be, on average, over the next ten years. Our forecasting accuracy results from our framework that is based, in part, on stock-market valuations. Until the pandemic, valuations were elevated, explaining why we expected muted stock returns.

A ray of light is that, looking over the next ten years, our stock market outlook is starting to improve. The reason? The role that current valuations, which have contracted in the recent sell-off, play in our long-term forecast. Put simply, the price of most equities has become much lower than it had been, giving equities more room to grow before they reach what we'd consider to be their fair value. The theme broadly holds true for ex-U.S. equities. A similar dynamic also occurred in 2009, when the global economy was in a deep recession and stock prices were low.

Ten-year forecasts remind us to think long-term

Ten-year expected returns chart

Notes: Forecasts correspond to the 25th to 75th percentile of distributions of 10,000 Vanguard Capital Markets Model simulations for ten-year annualized nominal returns, in U.S. dollars, based on the MSCI US Broad Market Index.

IMPORTANT: The projections and other information generated by the VCMM regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. Distribution of return outcomes from VCMM are derived from 10,000 simulations for each modeled asset class. Simulations are as of December 31, 2019, and March 12, 2020. Results from the model may vary with each use and over time. For more information, please see the important information below.

Source: Vanguard

The months ahead will be trying times for all of us, as consumers, as investors, and as people contending with the virus. But I have faith that there are better days ahead.

Impact of coronavirus on economic growth

In this 4 minute video, Vanguard Global Chief Economist Joe Davis shares his outlook for global growth during the coronavirus pandemic.

Greg Davis: Well, it’s great to have you with us today, Joe. And for our clients, Joe is our global chief economist and you’re seeing just a complete look at the world in terms of what the coronavirus is doing from an economic impact. We’ve seen states, cities being shut down virtually from an economic activity standpoint. I’d love to get your perspective of the impact that’s going to have on economic growth and what that means.

Joe Davis: Thanks, Greg. I mean, it’s profound. I mean, I’ve been watching the global economy for over 20 years and this is one of the biggest shocks to ever hit the global economy. I mean we’ve seen as, you know, and as investors know, the COVID-19 in one sense, positively the efforts to try to control the spread of the virus. But the very act of trying to do so is obviously really leading to shuttering of businesses and a significant now contraction in the global economy. It started in China and now we’re witnessing significant disruptions in both Europe as well as the United States.

The global economy is now entering recession, which means business activities contracting or falling, and we anticipate further declines. They are going to be significant over the coming months—the severity of which really depends on two things. One would be how long the containment measures are necessary, right? Which we don’t exactly know. And then secondly will be the policymakers’ response, which has been positive I’d say to date. And we would expect some more.

But bottom line is, the U.S. economy has entered a recession. It will likely be in our judgment, one of the sharpest declines in our history, at least to records going back to World War II. I would also say one positive, potentially, is that it could also be among the shortest recessions because the nature of the recovery really hinges on our need for further containment measures. The less the need for that, then that would allow businesses to reopen and we would see a resumption of some activity, which would be positive for growth. But you know increasingly the financial markets are anticipating the significant fall, and we do share that forecast, at least over the next several months.


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  • IMPORTANT: The projections and other information generated by the Vanguard Capital Markets Model regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. VCMM results will vary with each use and over time. Simulations are as of December 31, 2019, and March 12, 2020. Results from the model may vary with each use and over time.

    The VCMM projections are based on a statistical analysis of historical data. Future returns may behave differently from the historical patterns captured in the VCMM. More important, the VCMM may be underestimating extreme negative scenarios unobserved in the historical period on which the model estimation is based.

    The Vanguard Capital Markets Model® is a proprietary financial simulation tool developed and maintained by Vanguard's primary investment research and advice teams. The model forecasts distributions of future returns for a wide array of broad asset classes. Those asset classes include U.S. and international equity markets, several maturities of the U.S. Treasury and corporate fixed income markets, international fixed income markets, U.S. money markets, commodities, and certain alternative investment strategies. The theoretical and empirical foundation for the Vanguard Capital Markets Model is that the returns of various asset classes reflect the compensation investors require for bearing different types of systematic risk (beta). At the core of the model are estimates of the dynamic statistical relationship between risk factors and asset returns, obtained from statistical analysis based on available monthly financial and economic data from as early as 1960. Using a system of estimated equations, the model then applies a Monte Carlo simulation method to project the estimated interrelationships among risk factors and asset classes as well as uncertainty and randomness over time. The model generates a large set of simulated outcomes for each asset class over several time horizons. Forecasts are obtained by computing measures of central tendency in these simulations. Results produced by the tool will vary with each use and over time.