Facing up to the Covid-19 trade-offs

19 May 2020 | Markets and Economy


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By Peter Westaway, chief economist and head of investment strategy, Vanguard Europe.


Deciding how to invest isn't a life-or-death question. Nonetheless, the trade-offs we make as investors when weighing up risk and reward provide a useful framework for understanding the challenges governments now face as they try to navigate a way out of this deadly Covid-19 crisis. 

There's no one route out of lockdown. That's clear from the different approaches being taken across Europe, let alone in the rest of the world.

Politicians have to trade off the uncertain impact of a policy on virus mitigation versus the effect it has on economic activity. This includes evaluating the short run benefit of higher activity today if the lockdown is lifted, against the risk that the economy will be hit even harder tomorrow if a second wave of the virus emerges and a further lockdown needs to be imposed.

It's a tricky balancing act. But then taking calculated risks is part of everyday life. It's there when we board a plane, drive a car and in the lifestyle choices we make, as well as in the proportion of shares and bonds or degree of home bias in our portfolios.

Now one important concept governments talk about is the so-called R number, which provides a snapshot of the infection rate of the virus. The higher this number, the more quickly the virus spreads in the population.

And the good news is that the social distancing measures and lockdown we've seen to date have caused this R measure to fall sharply. The flipside is that easing the lockdown could send it back up.

By getting R below 1, the hope is that the virus will die away of its own accord or at least buy time until an effective vaccine is developed and rolled out to the population. But estimates differ, as the chart below shows.

Effective reproduction rate may now be below 1 but what will happen as lockdown is lifted?

Real-time estimates of R, 7-day

Source: Humboldt University, Berlin. As at 12 May 2020.


The chart above, for example, is based on estimates from Humboldt University in Berlin. It shows R in the UK at around 1 still, well below 1 in Italy, but increasing again in China where the crisis has the longest track record. Researchers at the London School of Hygiene and Tropical Medicine, though, have a lower estimate of between 0.5 and 0.8 for the UK.

Despite these very uncertain estimates, some big calls are necessarily being made to free up lockdowns due to an overwhelming desire for a return to economic normality.

Indeed, people are already starting to move around more. The chart below, for example, shows how global traffic activity in big cities is still very depressed. But look how driving is gradually creeping up, especially in the US and Germany.

Signs of global traffic activity picking up as containment measures gradually lifted

Apple mobility trends – driving

Source: Apple. As of 9 May 2020.


For all this, our forecasts for economic growth have turned slightly more pessimistic in recent weeks, so we now expect activity in 2020 to be just under 10% lower than a year earlier in the UK and slightly worse than that in the euro area. This is mainly because we think the lockdown is going to be unwound more slowly and that even when supply comes back on-stream, the demand side of the economy will still be very subdued as the fear factor predominates.

By the middle of next year, we expect UK activity still to be around 12% to 16% below its pre-virus growth trajectory, and euro area activity 15% to 20% below. It's not much better in our upside scenario. And it's much lower in our downside scenario where we assume that Europe could be hit by a series of second and third waves of the virus and a resumption of the lockdown too.

Only public services will likely show no sign of a downturn and may even end up higher than before. By contrast, manufacturing will recover about half its lost output by the end of the year in our main case but will be held back by supply chain disruption, with wholesale and retail trade doing much better but still failing to regain their previous expected path. Worst of all are the face-to-face service sectors such as arts and entertainment as well as tourism and travel, which we expect to stay at least 10% below normal levels of activity even well into next year.

Against such a backdrop, it's hard to know whether stock markets will sustain the fragile recovery we've already seen or fall further. As of May 14th, the FTSE All Share index is now down some 24% off its 2020 peak but was down as much 34% in March. It's the same story with the Euro STOXX 50, which is down about 28% but had been as much as 38%1. The best performing major stock market is in the US where the S&P 500 is now only 16% down as a result of the crisis. However, it's reasonable to assume that market sentiment will be tested in the coming months as the scale of the bad economic data begins to sink in and the reality of continued lockdowns in some form hits home.

It's why addressing that ever-present risk/reward dilemma with an investment strategy that is appropriately diversified and aligned with your investment goals remains as important as ever.


1 Source: Vanguard. Local currency terms.



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© 2020 Vanguard Investments Switzerland GmbH. All rights reserved.


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