What shape will the coronavirus recovery take? - Capital Economics
UK Economics

What shape will the coronavirus recovery take?

UK Economics Update
Written by Andrew Wishart

The shape of the economic recovery from the coronavirus crisis mainly depends on the spread of the virus, the effectiveness of the policy response and the extent to which consumers and businesses change their behaviour. This Update sets out how and why the shape could be different from our central forecast.

The shape of the economic recovery from the coronavirus crisis mainly depends on the spread of the virus, the effectiveness of the policy response and the extent to which consumers and businesses change their behaviour. This Update sets out how and why the shape could be different from our central forecast.

1. “Long Tick” Shaped – Our Forecast: Our forecast is based on the number of people contracting the virus falling and being kept under control once the lockdown is eased. At first, we suspect that activity will recover quickly as a direct result of restrictions being eased. But then the impact of business insolvencies on supply and of unemployment and consumer/business caution on demand will become a constraint, causing the recovery to slow. This creates a “long tick” shaped recovery, like the trademark of a well-known sports brand. The result is that cumulatively between 2020 and 2022 about 25% of GDP is lost and the economy is almost 5% smaller than it would otherwise have been at the end of 2022. (See Chart 1 & here.)

Reasoning: Government schemes have done a lot to protect employment and firms from the economic shock of the lockdown, so the bulk of pre-crisis demand and supply is intact. That said, the sheer size and speed of the downturn means that many workers and firms slip through the cracks, leading to high unemployment (see here & Chart 6 ) and a sharp rise in business insolvencies. (See here.) The resulting hit to incomes at the same time that consumers and firms become more cautious means that the recovery takes time. In our view this is the most likely scenario, with perhaps a very rough probability of about 50%. (See Table 1.)

2. “V”-Shaped: The virus is quickly vanquished and the sharp drop in activity is recovered fully and swiftly, with unemployment falling back as quickly as it rose. The economy returns to its pre-crisis trend by the end of the year. The cumulative loss is “only” 9% of GDP, and the economy is the same size at the end of 2022 as it would have been had coronavirus never happened. (See Chart 2.)

Reasoning: The recession is a consequence of self-imposed social distancing policies, so when the restrictions lift activity can return to normal. That’s fine in theory, but in practice there is already evidence that workers have been laid off. So we think there is only a slim chance of this scenario, of about 10%.

Chart 1: GDP in our Forecast (100 = Q4 2019)

Chart 2: GDP in a “V”-Shaped Recovery (100 = Q4 ‘19)

Sources: Refinitiv, Capital Economics

Sources: Refintiv, Capital Economics

3. “U”-Shaped: The lockdown is extended beyond Q2 and/or the recovery is slower than we have assumed. The unemployment rate rises close to double digits and takes years to recover. Almost 45% of GDP is lost cumulatively, and the economy is still 5% smaller than it would have been by Q4 2022. (See Chart 3.)

Reasoning: Fear of the virus and the possibility of a second wave may lead to consumers and businesses exercising extreme caution and significantly changing their behaviour from before the virus in a way that means that they don’t spend much. At the same time, the huge cost of the government’s policies could mean that the support is reduced or even withdrawn, leading to a second wave of unemployment and insolvencies. But with most incomes currently protected and the Bank of England ensuring that borrowing is very cheap, it is difficult to imagine that consumers will not resume social activity when the lockdown is eased. And if fiscal support were reduced, it would force many back to work. We think that there is perhaps something like a 15% chance of a “U”-shaped recovery.

4. “W”-Shaped: The government lifts the lockdown and activity recovers in line with our forecast. But a surge in new virus cases forces another lockdown, perhaps in Q1 2021. GDP does not drop as low the second time around as more businesses have contingency plans to stay open practicing social distancing. But the equivalent of 35% of GDP is lost, and the economy is 6% smaller at the end of 2022. (See Chart 4.)

Reasoning: It all depends on the virus. The huge fiscal and economic cost might incentivise the government to lift the lockdown early. But amid criticism of its handling of the virus so far, it seems more likely to us that the government errs on the side of caution and only eases the lockdown when its test, track and trace regime is in place. We tentatively assign this outcome a 15% probability.

Chart 3: GDP in a “U”-Shaped Recovery (100 = Q4 ‘19)

Chart 4: GDP in a “W”-Shaped Recovery (100 = Q4 ‘19)

Sources: Refinitiv, Capital Economics

Sources: Refintiv, Capital Economics

5. “L”-Shaped: It is not possible to contain the virus and/or there is only a small recovery in activity when the lockdown is lifted. Unemployment stays very high, the equivalent of 53% of 2019 GDP is lost and the economy is still 18% smaller than it would have otherwise been come the end of 2022. (See Chart 5.)

Reasoning: Restrictions of some form could be in place for a long time, and there could be a significant permanent change in behaviour. If the government reduced its policy support it would increase the permanent scarring and suck demand out of the economy. But the experience of China suggests that lockdowns work and can be ended. And government policy appears to be effective in minimising the reduction in supply and demand, while we doubt the change in household and business behaviour will be this drastic. There is perhaps a 10% probability of this worst-case scenario.

Chart 5: GDP in a “L”-Shaped Recession (100 = Q4 ‘19)

Chart 6: Unemployment Rate in Different Recoveries (%)

Sources: Refinitiv, Capital Economics

Sources: Refinitiv, Capital Economics

Table 1: Possible Recovery Scenarios

“Long Tick” (CE F’cast)

“V”

“U”

“W”

“L”

Probability (%)

50

10

15

15

10

2020

-12

-7

-19

-12

-15

GDP (% y/y)

2021

10

10

5

0

-1

2022

4

2

15

12

2

Cum. Loss of GDP in 2020-22 (% 2019 GDP)

-24

-9

-43

-35

-53

Level of GDP vs Counterfactual (Q4 2022, %)

-4

0

-5

-6

-18

2020

7.0

6.0

8.0

7.0

7.5

Unemployment Rate (%)

2021

5.7

4.5

8.3

7.5

8.3

2022

5.3

4.0

6.0

6.0

8.3

Source: Capital Economics


Andrew Wishart, UK Economist, +44 7427 682 411, andrew.wishart@capitaleconomics.com