Not Out of the Woods

by Eric Knutzen, CIO, Multi-Asset Class, Neuberger Berman

The discipline of scenario planning helps us focus on what has been achieved, rather than what we hope will be achieved.

Neuberger Berman’s Asset Allocation Committee held an extraordinary meeting on May 5 to reassess the COVID-19 crisis “Playbook” and investment views it had set out at the end of the first quarter.

The Playbook assigned a 15% probability to the bearish scenario of an “L-shaped” recession. We put a bullish “V-shaped” outcome at 20% and our base-case “U-shaped” outcome at 65%. Asset allocation views prioritized caution and favored quality U.S. large caps and investment grade credit.

Notwithstanding an apparently strong rally through April, the underlying defensiveness of the stocks and bonds leading the rebound played into our favored asset classes.

Members therefore re-endorsed the Committee’s initial views, while acknowledging the potential for investors to reposition rapidly—toward cyclical or value-oriented large caps, quality small and mid-caps, high yield bonds and non-U.S. assets—should data stop surprising on the downside and begin surprising on the upside.

Last week, there were signs that investors may be readying for that move.

While a “V-shaped” recovery still seems optimistic, is it time to reduce the probability of an “L-shaped” recession—or even dismiss it entirely?

Vaccine

Sentiment is buoyant for a number of reasons.

With China now back at work for six weeks, much of Europe a week or two into reopening and more than half of U.S. states easing restrictions, there have been no reports of a serious second wave of infections.

On the ground, credit card spending has picked up, as have contacts with real estate agents and taxi rides. Some airlines report new bookings outnumbering cancellations.

On the policy front, central banks and governments have been reassuring markets that they have not run out of ammunition. In Europe, Germany and France have thrown their weight behind a plan to issue bonds to finance a €500 billion recovery fund as part of the European Union’s budget. This could allow fiscal transfers that do not add to the debt burdens of the worst-affected countries.

Most significantly, U.S. biotech firm Moderna, one of the many centers of research into a SAR-COV-2 vaccine worldwide, announced last week that participants in its phase-one trial had developed antibodies.

Risks Have Not Gone Away

This is all encouraging news.

But to decide whether the probability of our bear-case scenario of an “L-shaped” recession can now be discounted, we need to revisit precisely what that scenario assumed.

On the virus, it saw the peak of initial SARS-COV-2 infections stretching into late summer. It assumed that lifting restrictions triggers a second wave of infections before we can treat or vaccinate against the disease.

We appear to have cleared the first hurdle in China, Europe and the U.S., but work by our Data Science team suggests that it is too early to rule out the possibility of a second wave. Some parts of the emerging world are reopening before suppressing their first wave. Questions were immediately raised over Moderna’s vaccine-trial data and we have already seen “false dawns” on potential treatments. These risks have not gone away.

On the economy, our “L-shaped” scenario anticipated U.S. unemployment reaching 24%, whereas our base case put the peak between 15% and 20%. Unemployment already broke 15% in April, and Goldman Sachs, for example, now forecasts a peak of 25% in May. That’s before any second wave of infections gets the chance to disrupt the reopening process.

On the policy response, our concern focused on Europe, where the European Central Bank’s toolbox is both constrained and controversial, and there is strong resistance to collective fiscal action. While the Franco-German plan is encouraging, nothing has been agreed to yet. In the meantime, post-Brexit negotiations could be an unwelcome distraction.

Parameters

In short, when we revisit the assumptions that define our bear-case scenario, few can be discounted. Most of these things—a second wave of infections, a cycle of lockdowns that increase economic and financial stress, a serious falling out in Europe—can easily still happen.

We therefore retain our “L-shaped” scenario, and maintain a risk of 15%—although when uncertainty is so high, possibility is arguably more important than probability.

This is the value of scenario planning, and of setting out clear, simple parameters for changing one’s views: The discipline of it keeps us focused on what has actually been achieved rather than what we hope will be achieved.

Optimism is warranted, even necessary. We still assign a greater probability to a “V-shaped” recovery than an “L-shaped” recession. But we are not out of the woods, and the bear may yet be hiding in the trees.

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