US equity and bond markets have staged a remarkable comeback since their demise in March when lockdown measures were imposed to address the spread of the novel coronavirus.

The recovery in financial markets has also spread globally on optimism over the reopening of economies as well as encouraging news of rapid progress and a reduced timeline for a COVID-19 vaccine.

Many observers, however, have been wondering how and why financial markets, particularly equity markets, have been doing so well when the global economy is perhaps experiencing the worst recession since the Great Depression of the 1930’s. They also question the longevity of the financial markets’ rebound.

The durability of the market rally is likely dependent on the path to recovery from the COVID-19-triggered economic downturn.

Economic indicators suggest the US economy is likely to record the largest quarterly contraction in the second quarter since the Great Depression. However, while there is consensus about a recovery happening in the second half of the year, there is less agreement on how long it will take the US economy, the so-called engine of global growth, to return to pre-COVID-19 levels and continue on its previous growth path, or simply put what letter will best describe the shape of the recovery or recession.

Will it be a V, U, L, or something else like a W, and how will it affect your investment decision?

Four letters are commonly used to characterise recessions and their recoveries, namely: V, U, W, and L.

A V-shaped recovery is one that is characteristic of a steep downturn in economic activity followed by a quick return to pre-recession economic levels.

A U-shaped recovery lasts longer than a V-shaped one, and economic activity may contract for several quarters and only slowly return to pre-crisis level.

In an L-shaped recession, an economy experiences a severe recession and does not return to trend line growth for many years, if at all.

An L-shaped recession is commonly referred to as a “depression”; while, a W-shaped recession or a double-dip recession is one wherein an economy falls into a recession, recovers with a brief period of growth, then falls again into a recession before finally recovering to trend growth.

Investors’ expectation of a V-shaped recovery appears to be driving the exuberant performances in financial markets since late March.

Investors have been betting that the recovery from the self-induced recession will be swift and sustainable because:

(a) there is an unprecented amount of financial support being provided by central banks and governments,

(b) there is positive news about a reduced timeline for a vaccine,

(c) economies have been reopening and there are signs of a faster than previously thought rebound in economic activity (such as May’s US jobs’ report which saw a surprise record jump in hiring) and

(d) there is optimism that there won’t be a second wave of the virus prompting another round of restrictions.

The Federal Reserve chairman at the conclusion of the June 10 meeting, however, appeared to be dampening expectations of a quick recovery by saying that the federal funds rate may need to remain close to zero until at least 2022 to continue to aid in the recovery of the US economy.

He also suggested that it could take years for the US labour market to return to the level it was before the coronavirus pandemic.

Equity markets retreated sharply last Thursday after his comments, before recovering some of the losses on Friday.

The stark reality is that the downturn has been triggered by a biological crisis, and not a financial one, so the timeline to recovery will be based on continued advancements in treatments, testing, and vaccines that support the safe reopening of the US and global economy. The ultimate determination of the shape of the global recovery will therefore hinge on how quickly, affordable, and readily available a vaccine and or effective treatments can be developed for the coronavirus, so that lives and livelihoods can return to some semblance of normality.

Nevertheless, the injection of monetary and fiscal stimuli, et al, have helped to fuel the resurgence in equity and bond prices, but the recovery in equity prices, so far, appears to have largely outpaced those in bonds, suggesting that opportunities in bonds still exist.

The expected shape of the recession, therefore, could have meaningful implications for a bond investor’s decision to invest.

If the investor believes the outcome is likely to be V-shaped, then he or she may need to act expeditiously in order to capitalise on existing deals while they still last.

If a U-shape is expected, it implies that bargains should remain on offer for sometime and therefore affords the investor more time to take advantage of them; while evidence of an L-shaped recovery suggests that many bond yields could remain elevated for a considerable time as corporations struggle/grapple with a prolonged period of below-normal economic activity.

As always, and in spite of your letter of choice, speak with your investment advisor to help determine what investments are appropriate for you based on your investment objective and horizon, the amount you wish to invest, and the level of risk you are willing to bear. That said, have a safe and rewarding investing experience.

Eugene Stanley is the VP, Fixed Income & Foreign Exchange at Sterling Asset Management. Sterling provides financial advice and instruments in US dollars and other hard currencies to the corporate, individual, and institutional investor. Visit our website at www.sterling.com.jm Feedback: If you wish to have Sterling address your investment questions in upcoming articles, e-mail us at: info@sterlingasset.net.jm.