The financial markets will eventually recover, but what letter shape will it resemble?

When COVID-19 started making a significant impact in the U.S., some market pundits were calling for a V-shaped recovery. As the situation worsened, the consensus forecast seemed to shift to a U-shaped recovery. And now that the virus has effectively shut down the nation for an indeterminate period, some are positing an L-shaped trajectory which, based on the horizontal bottom line of the letter “L,” does not denote a recovery anytime soon.

UBS laid out three COVID-19 market scenarios in its April investment strategy guide, with each scenario respectively corresponding to one of the three above-mentioned letter-shaped profiles.

Upside Scenario/V-Shaped
Strong compliance with social-distancing measures, coupled with viral seasonality (i.e., if the virus spreads more slowly in warmer temperatures) and/or pharmaceutical breakthroughs, could enable the U.S. and Europe to see infections peak by mid-April. If so, sheltering mandates could be relaxed starting in early May, meaning that government stimulus would be sufficient to prevent lasting economic damage.

That could provide the backdrop to a V-shaped recovery in this year’s third and fourth quarters, with the S&P 500 Index ultimately trading at roughly 2,900. (It finished Friday’s trading at nearly 2,305, and it ended last year at almost 3,231.)

Central Scenario/U-Shaped
Much like in the upside scenario, new virus detections peak in mid-April and sheltering restrictions loosen in early-May. But the virus isn’t completely eradicated, and sheltering restrictions are reimposed when needed in certain countries throughout the year. UBS expects “softer” restrictions to be in place for the rest of the year. While coordinated monetary and fiscal responses from central banks and governments will provide necessary funding to support affected businesses and industries in this scenario, it will arrive too late to protect all of them.

This would produce a U-shaped recovery that takes hold in the fourth quarter, putting the S&P 500 at about 2,650 by year end.

Downside Scenario/L-Shaped
Containment measures are too late and new virus infections keep rising in the U.S. and Europe into May and June, keeping most sheltering restrictions in place until June or July, and possibly intermittently for the rest of the year.

“In this scenario, government policy would not meaningfully offset the lengthy demand shock, leading to a sharp rise in bankruptcies and joblessness,” according to the UBS report. “Companies would forgo significant revenue, and losses would be borne by shareholders, creditors, and banks.”

If that happens, UBS foresees an L-shaped growth profile for the remainder of the year and the S&P 500 trading at roughly 2,100 by year end. But if past bear markets are a guide, it could close lower at between 1,650 and 1,950. 

Asset Allocation
UBS offers four hedging strategies in the current environment: asset-class diversification (despite low interest rates, "Treasuries still function as a form of portfolio insurance by helping to protect principal"); geographic diversification; alternative assets (it favors gold and private equity); and dynamic asset allocation based on a quantitative framework that takes emotional considerations out of the equation when determining when to exit and re-enter markets.

Regarding equities, UBS noted the stock market’s stunning descent likely means that many portfolios are underweight to equities regarding their long-term targets. “We generally recommend rebalancing back to target allocations, although in volatile times addressing asset allocation gaps through averaging-in, or combining the sale of put options with the purchase of call options, may help investors reduce timing and overcome the human behaviors that drive underperformance.”

Its recommendations include global quality stocks and companies involved in Asia’s 5G rollout, along with focusing on secular themes that can benefit from the ongoing virus-induced reality such as fintech, e-commerce, online gaming and online education.

Government Backstop
UBS opined that in order to stabilize the markets, governments will need to transfer 1% to 2% of annual GDP to the private sector for every month that sheltering restrictions are in place. That would represent 0.75% GDP per month to pay most of the wages for half of the small-business employees in an economy, with the remainder going to large companies in sectors negatively impacted by the virus such as airlines, railroads, hotels, retail and leisure.

“If properly structured, this would allow most small- and medium-sized enterprises (the most important employers in most economies) to stay afloat, and provide some bailout packages for larger companies. Provided these transfers only occur for the duration of the crisis, and total less than 15–20% of annual GDP, we think this can be achieved,” said Mark Haefele, UBS’s global chief investment officer at its wealth management unit, and one of the authors of the investment strategy guide.

While he noted the large size of the aid packages announced thus far in the U.S., U.K., Germany and France, Haefele said the key to success is finding the proper mix between loan guarantees, deficit spending measures (including payroll tax cuts) and direct support.