Friday, April 23, 2021

K-shaped recovery for real and financial markets - A world of dispersion


As we examine the COVID economic rebound and reflation more closely, it has more characteristics of what some have called a K-shaped recovery rather than one that resembles the lifting of all boats. There are many lettered variation on recovery, but K-shaped seems to best fit the environment. We are not dealing with a classic inventory build recession or a banking crisis recession. A recession is always a time for dramatic economic change and technological upheaval as new methods for enhancing productivity are employed out of necessity; however, the relative impact of the COVID pandemic may make this recession more extreme.

The pandemic has changed both buying habits and the use technology and can be viewed as relative allocation adjustments associated with changing tastes. Taste and behavior adjustments will be more disruptive of the status quo which will create the divergent K-shaped recovery. Given this type of multi-dimensional recovery, it is unlikely that blunt instrument policies will work to help those on the bottom-end of the K and may lead to excessive on the top leg of the K. 

A K-shaped recovery means that some industries and groups will see a strong rebound beyond pre-COVID growth while others will suffer from a slow rebound or be hit with the costs of economic failure and have no opportunity for renewal. There are long-term winners and losers, and the job of an investor is to find the winners and avoid those losers. Policy-makers may desire to contain the losses and temper these excesses while allowing the macro adjustments to realign resources in this new world, but policy-makers cannot change the tide of taste changes.  

It is not clear that all businesses should be supported, or all job protected, but policies should attempt to focus on the bottom leg of the K to manage this transition. First, anything that supports stemming COVID infections supports the bottom leg of the K in order to minimize the cost of underproduction and underuse of labor. Second, lowering rates to support speculation without affecting the credit channels for lending to small businesses only helps the upper half of the K. Additionally, excessively low rates will also lead to over-valuation and excessive demand for the "good" firms versus "bad" firms. The result is a wider dispersion in valuation as seen in the graph below. There is no value judgment here. It is a current reality.  


The K-shaped recovery, a wide dispersion recovery, has already shown significant rotation among industries. Tech growth was a primary driver to stock returns prior to November only to see a rotation to value and more out of favor industries over the last 4 months. The vaccine-driven recovery will likely continue with the value gain; however, those firms driven by taste shifts will start to fall behind a create a success and failure return gap that will be skewed by companies that may not be survive. Current focus should pivot to finding the survival and failure portfolios as we deal with the time beyond initial recovery.

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