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The economic impact of coronavirus continues to surprise. In the spring, previously unimaginable shutdowns pushed economic activity to unimaginable lows. After the initial shock, however, perhaps the biggest surprise has been how fears of systemic meltdown remain unfulfilled — the initial bounce back was far stronger and sooner than expected, and some sectors of the U.S. and other economies have seen complete recoveries to pre-crisis levels of activity.

While the stronger-than-expected recovery aligns with the business experience of many leaders we speak with, they still wonder what drove the gap between expectations and reality — and whether it can last. To answer these questions, we need to look at various recession types and their drivers, how Covid-19 fits in, and what this cycle’s idiosyncrasies are.

Fears Unfulfilled, Hopes Surpassed

As the coronavirus forced the economy into shutdown, a brutal economic contraction unfolded, breaking many (negative) records in the process. Yet, the sustained impact was broadly overestimated — both systemically and cyclically — as the intensity of the shock fueled widespread economic pessimism.

Systemic fears were captured in the popular prediction of a new Great Depression, which would bring sovereign defaults, banking system collapse, and price deflation. Yet after a wobble prices stabilized, sovereign borrowing costs broadly fell across the world despite expansive borrowing, and the banking systems has shown few signs of liquidity problems. (In fact, after hoarding capital banks are looking to return capital again.) The broader systemic fears remain unfulfilled and never looked as perilous as in 2008.

As systemic fears remained unfulfilled, cyclical fears also have proliferated. Unemployment — a cornerstone gauge of economic health — was expected to stay at high levels in the U.S. past the end of 2021. Analysts predicted waves of bankruptcies, a weakening housing market, and a potential collapse after an initial recovery in a “W”-shaped manner.

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Yet, here too the surprises have been to the upside. While still unacceptably high, unemployment fell much sooner and faster than thought: By September U.S. unemployment was lower than it was expected to be by the end of 2021. Housing showed remarkable resilience — with prices barely dipping and activity and sales bouncing back to or near the highs since the housing crisis. Many parts of the U.S. economy have returned to pre-crisis levels of activity. Indeed, as the 3Q GDP release last Thursday highlighted, over the last three months growth has been the highest ever recorded. While this does not indicate that the U.S. economy has returned to health or to pre-crisis levels of activity, it is testament to an extraordinarily vigorous rebound after a historically negative second quarter.

These patterns are true around the world: Economic surprise indices, which show an amalgamation of the differences between realized and expected performance, have spiked to record highs everywhere — with the exception for China, where expectations for a full recovery were the baseline.

Why the Covid Recession Outperformed Expectations

While many business leaders have seen these dynamics unfold in real time, they seek to understand the drivers that explain it in order to better see the path ahead. Charting recoveries remains exceptionally difficult (if not as difficult as predicting recessions), but there is value in thinking about the types of recession, their drivers, and impact — as well as about the idiosyncrasies that will shape the remaining recovery path.

There are three dimensions of economic recessions which – when taken together – can help frame the dynamics of recovery. The Covid recession displays distinctive characteristics within this framework that help explain much of what has been on display:

• Recession nature. This captures the underlying force — for example, an investment bust, a financial crisis, a policy error or an exogenous shock — that’s afflicting the economy. Despite its brutal intensity, the Covid shock is preferable to an investment bust or a financial crisis that were at the heart of the last two recessions (2001 and 2008/09) because it comes without an overhang of excess investment to work off, which is what delays the onset of recovery and weighs on its trajectory. Indeed, the biggest risk of an exogenous shock is that it morphs into a systemic crisis (traditionally, the fear would be a financial crisis).
• Policy response. This decisively shapes the recovery path and is a clear silver lining of the Covid recession. The speed, feasibility, and effectiveness of fiscal policy has been demonstrated, above all in the U.S. There remains a common misperception that virus caseloads and Covid deaths are strict determinants of economic performance. In reality, the correlation is weak — precisely because a strong economic policy response effectively bridges some of the economic damage from less successful virus control efforts. Think of how U.S. efforts at virus control largely failed relative to other rich nations —  in Europe, for example — yet U.S. real growth has still come out ahead. The much bolder U.S. policy effort explains that outcome. Yet, the ultimate impact of policy is to prevent a different type of contagion — household and firm bankruptcies and a wobbly banking system — and this is where structural damage comes in.
• Structural damage. This is the key determinant of a recession’s shape. When a recession leads to a collapse in capital expenditures and pushes workers out of the labor force, an economy’s productive capacity declines. That’s what happened in the U.S. in 2008 as the financial crisis disrupted capital stock growth and made it much harder to return to pre-crisis levels. The Covid recession is more favorable in this respect as there is no “overhang” from the last expansion which did not see excesses in investment or lending that now has to be worked off. Additionally, the fast policy response — unlike in 2008 — contained bankruptcies and drove a strong V-shape recovery in capital goods orders. So far, the Covid recession looks likely to have avoided major structural damage.

It’s quite possible that we were prepared for the worst with the Covid recession because the late and sluggish recovery from the Great Recession is still on our minds. And using the drivers outlined above we can see why: It started as an investment bust that turned into a financial crisis, which in turn impaired financial sector balance sheets and household balance sheets. This was met with a policy response that was quite delayed and kicked in after significant damage was already done. If that serves as in an implicit baseline for how recoveries play out, then the better than expected Covid trajectory should not surprise us. 

Can the Covid Recovery Continue to Surprise to the Upside?

To gauge the next leg of recovery we need to go beyond the above drivers – think of them as the necessary foundations for a continued strong recovery – and look at the idiosyncrasies of the Covid recession for sufficient conditions that show how the strength could be delivered.

Looking at the sectors of the U.S. economy more closely, we can divide it into three parts that were impacted very differently given the nature of the virus-driven recession. This suggests the “easy” phase of recovery is exhausted:

• Sectors unaffected by Covid, such as housing and utility consumption, financial services, and off-premise food. Using a household budget as an analogy, you can think of these as “fixed costs” that cannot be reduced easily. This amounts to about 46% of U.S. consumption and never dipped.
• Sectors affected by lockdowns, but not by social distancing, such as autos and other durable goods. These sectors took a big hit from physical lockdowns, but once those were lifted, they bounced back strongly, often fully — and sometimes even exceeding pre-crisis levels. These sectors represent about 16% of the U.S. consumption.
• Sectors that are directly vaccine dependent, such as transportation, recreation, and food service. Some of these sectors bounced back after the lockdown, while others remain unable to meaningfully recover to pre-crisis activity levels because of the risk of exposure to the virus. These sectors represent about 38% of U.S. consumption.

The next leg of a strong recovery thus hinges on that third group of sectors as the recovery potential of the second group is largely exhausted (and the first never dipped). This really moves the question of vaccines front and center. A timeline for the creation of a safe, effective vaccine that provides immunity for a significant time and can be rolled out quickly is fraught with uncertainty. Currently crowdsourced forecasts project a reasonable expectation that a vaccine will become available and meaningfully distributed (i.e. to those most vulnerable and those most at risk of spreading the virus) around Q2 2021.

How It Could All Go Wrong From Here

Neither the necessary nor the sufficient conditions outlined above are guaranteed. A lot can go wrong, and indeed fears of another economic collapse are common in public discourse.

The truly bad scenario is often captured in warnings about a “W-shaped” recession, which would imply another phase of negative growth. In other words, after the collapse (Q2) and the very strong bounce (Q3) we would need Q4 (or Q1 2021) to be a second window of negative growth.

How likely is this scenario? It would almost certainly require a renewed surge of the virus and stringent lockdown that would hamper the second group of sectors. Hospital capacity will prove the ultimate constraint on policy makers’ balancing act between keeping economic activity high and the population safe. While another lockdown is possible, as we’re seeing in Europe, in the U.S. selective shutdowns are more likely given political dynamics, leaving room for growth to stay above zero.

And while positive growth remains our expectation for Q4 and 2021, a host of other risks lingers. A continued failure to extend fiscal stimulus measures could diminish the slope of recovery — or in the extreme turn it negative. A broader political failure — perhaps related to a contested election outcome — is also on the list of risks.

What It Means for Businesses

In times of crisis it’s tempting to be pessimistic and fearful, particular if the drivers are unfamiliar or the risks pose credible systemic threats. However, this inclination to pessimism and retreat also carries risks itself and we should remind ourselves that 14% of firms across all sectors typically grow both revenues and margins during downturns. This is not just idiosyncratic luck — i.e. being in the right sector and seeing a demand boost because of the nature of the crisis — it’s driven by a firm’s ability to see beyond the acute phase of a crisis and exploit its idiosyncrasies to drive differential growth in new areas. While monitoring the overall macro landscape remains important, leaders should not underestimate the importance of measuring, interpreting, and exploiting the dynamics of their own sectors and markets in order to be able to invest and flourish during the recovery and the post-crisis period.

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