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Why the bulls should not leave the stage yet

Photo caption: L to R: James Elliot & Iain Cunningham

March 2020 marked the point of maximum pain for the global economy. Economies around the world have rebounded strongly since, initially in a V-shape, followed by more bumpy progress as localised lockdowns were put in place. The release of better-than-expected vaccine trial results in November, and the subsequent roll-out of vaccination programmes have enabled financial markets to look through recent economic volatility and begin to discount a likely acceleration of the economic recovery in the second half of this year.

Vaccine programmes are set to reach the point where a return to normality in major developed markets can be achieved within the coming months. As this takes place there will likely be an acceleration in the recovery supported by pent-up demand particularly for services, with policy measures remaining highly accommodative.  

The extent of the fiscal and monetary measures that authorities implemented as a response to the pandemic a year ago gave us confidence to take on risk in our strategies. The impact on the real economy has since been evident; never before has a sharp rise in US aggregate disposable income taken place at the same time as a significant rise in the unemployment rate. The US administration, under President Biden, has since doubled down on fiscal support with an additional relief package and, as a result, the average US household disposable income is 7% higher than at the start of last year, while the unemployment rate is now 6.2% versus 3.6% over the same period. 

This dynamic is somewhat similar in other major nations where savings rates have spiked, and these savings should add impetus to pent-up demand and the recovery as social-distancing measures are removed through the rest of this year.  

Fed tapering is unlikely to come this year 

At the same time, central banks are generally committed to maintaining highly accommodative policy well into the recovery in the coming years. To date, major central banks have slashed interest rates and created US$9 trillion, which has aided the economy, ensured easy financial conditions, and ultimately inflated asset prices. Major central banks have committed to print money until the end of 2021, before likely tapering next year, and keeping interest rates at their current level for some time. 

We continue to believe that the Federal Reserve’s (Fed) policy framework review remains underappreciated by investors; it has committed to achieving an average core inflation rate of 2% over time, yet historically this has not been achieved. As a result, the Fed currently forecasts that interest rates will be kept near zero until 2023. We believe it will keep policy loose relative to economic fundamentals for at least the next 12-18 months in seeking to deliver an inflation overshoot, which will likely keep real interest rates very low versus history. Such an environment has historically been constructive for risk assets and has ultimately fostered speculative activity. 

Inflation spikes are largely down to base effects 

The degree of stimulus and the corresponding growth in money supply raises questions about how inflation will evolve in the coming years. Over the next few months, we expect inflation to accelerate sharply. However, this is largely a function of mechanistic base effects in the calculation of inflation statistics; prices plummeted dramatically a year ago. We anticipate that inflation will peak in early summer of this year (northern hemisphere), before falling thereafter, and expect major central banks to view this as transitory. Over the medium term, our expectations are that a durable spell of inflation takes years to form and that the inflationary decade of the 1970s had its roots in the monetary policy mistakes that began in the early 1960s.  

If inflation does rear its head in the coming decade, then it’s most likely to be in the US given the structural backdrop for demographics, leverage, the health of the banking system and the degree of policy action. We believe the Fed will only tighten policy once the economy is closer to full employment and post a period of core inflation being above 2%. In our view, the near-term peak in cyclical inflation will likely create investment opportunities while investors are currently looking the other way (i.e. positioning for higher inflation).   

Pay close attention to China 

China is further into its economic recovery, having managed COVID-19 more effectively earlier on, and policymakers are ultimately seeking to enact more orthodox policy relative to other major nations. Chinese authorities are now in the process of moving their credit cycle into a down phase by reducing the pace of credit issuance (a primary policy lever in China). The Chinese credit cycle has strongly influenced the global cycle and risk-on/off periods in asset markets over the past decade. The leads and lags feeding into economic growth are typically 9-12 months, so the impact will take a while to be felt, but we remain cognisant that the pace of Chinese economic growth will likely be moderating into next year. 

On balance, we believe the outlook for growth assets remains constructive over the next year and we continue to bias our strategies in this direction. Economic growth is likely to be strong, policy is set to remain easy and cyclical inflation should peak in the coming months, in our view. We will continue to monitor China’s credit cycle, the progress in vaccine roll-outs and the willingness of central banks to maintain highly accommodative policy as the economic recovery accelerates, believing that these are the primary forces driving financial markets from here.  DM/BM

 

This article was written by James Elliot, Head of Multi-Asset, and Iain Cunningham, Portfolio Manager, Multi-Asset, Ninety One

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