Perspective

Post-pandemic recovery: how far and how fast will it run?


When I wrote my review and outlook last spring, markets were in freefall and governments were imposing restrictions on their citizens that were unprecedented in peacetime. A year later, I have just had my jab at the Science Museum. While the UK is still subject to restrictions, and Covid-19 will not disappear entirely, we can be reasonably optimistic that the virus will move from a public health crisis into a manageable threat.

Surprisingly, the tumult of the past year has resulted in something of a sweet spot for equity investors. Lockdowns left many consumers with a significant increase in savings, providing fuel for a strong rebound. Companies that were anticipating a gradual shift towards digitalisation suddenly saw their growth turbo-charged. Meanwhile, policymakers have provided huge levels of support. With unemployment at relatively high levels around the world, there is little prospect this will change in the near term.

The political backdrop is also less fraught than it has been, which should give businesses and consumers more confidence in the recovery. In the UK, a Brexit trade deal was agreed at the very end of last year, removing the not insignificant risk of disruption in the flow of goods. In the US, Joe Biden took office smoothly and has secured agreement for a near $2 trillion stimulus package.

Schroders’ economists expect this extra spending to significantly boost global growth. It will have an impact this year, but the benefit will be offset by sluggish growth in Europe amid a slow vaccine roll-out. The bigger impact will come next year, which should also see growth well ahead of the tepid average of the last decade.

Global growth upgraded thanks to extra fiscal stimulus

Contributions to World GDP growth (y/y)

600891_global-growth-bar-chart.gif

Source: Cazenove Capital, Schroders Economics Group. Forecasts are not guaranteed and should not be relied upon. 

Some signs of excess in markets...

This economic recovery should continue to provide a tailwind for shares. While valuations are far from cheap, we do not view markets as prohibitively expensive.

Having said this, there have been some clear signs of speculative excess. The combination of easy money and exciting new technologies are the classic ingredients of financial market bubbles. It may well turn out that some of the stratospheric valuations in today’s market – with Tesla and Bitcoin the prime examples – prove to be hugely over-optimistic. Time will tell.

The wild moves we saw earlier this year in a handful of US stocks, notably video game retailer GameStop, were another kind of excess. This strange episode was not accompanied by the usual narratives that drive bubbles, but it also depended on liquidity and technology. It was initiated by an army of retail investors flush with savings and easy, online access to derivative exchanges. The volatility caused meaningful losses for some prominent hedge funds but otherwise seems to have had little consequence. The more recent collapse of finance company Greensill Capital could be a more worrying sympton of excess in the credit markets.

…but too early to worry about overheating in real economy

In the US, long-term inflation expectations are now back above 2% – the Federal Reserve’s target – for the first since late 2018. This has taken a toll on government bond markets, which tend to be negatively correlated to inflation. Bond prices have fallen sharply, driving yields higher. In the US, the benchmark 10-year Treasury bond now yields over 1.5%, against a low close to 0.5% last summer. The speed of the move has been uncomfortably fast. It has been exacerbated by concern that higher inflation may prompt central bankers to step back from their bond-buying programmes and bring forward interest rate rises.  

We do not think inflation is a worry yet. Higher commodity prices will feed through into higher headline readings. But they should not impact core measures of inflation, which strip out food and energy prices and are the focus of policymakers. A US unemployment rate close to 6% suggests the economy should have enough spare capacity to keep inflationary pressures at bay.

Inflation uncertainty: a longer-term concern

Even so, the unusual circumstances of the past year mean the inflation outlook is particularly uncertain. There will be some industries – like air travel – where a rush of pent-up demand meets reduced capacity, resulting in price hikes. This may be short-lived. The bigger worry is the huge increase in money supply. Incredibly, almost 20% of all US dollars currently in existence were created in 2020, thanks to the Federal Reserve's various support measures.

Inflation hawks – as those who worry about excessive inflation are known – have cried wolf in the past. It was widely feared that quantitative easing after the financial crisis of 2008 would lead to runaway inflation. It didn’t. But this time may be different. The scale is much greater today. And the banking system is not under the same pressure to shrink its balance sheet as it was a decade ago. This could mean more newly-created money makes its way into the real economy.

A period of somewhat higher inflation would help major economies deal with the debt taken on to respond to the pandemic. However, it could rattle markets. If higher inflation brings higher interest rates too quickly, financing costs could become problematic. It could also undermine the valuation of equity markets, which depends on interest rates remaining low. 

The Great Inflation Debate

  Deflationary Inflationary
Short run (0-2 years)
  • Elevated unemployment
  • Large "output gap" (the difference between an economy's potential and actual output)
  • Acceleration in money supply
  • Strong pent-up demand allows companies to raise prices
  • Covid-19 raising costs of doing business 
  • Recovery in oil price
Medium term (2-5 years)
  • Greater use of cost-reducing technology
  • De-globalisation and tariffs
  • Continued excess demand driven by strong growth
Long run (5-10 years)
  • High levels of debt reduce investment for growth
  • Ageing populations save more and spend less
  • Greater manufacturing efficiency
  • Fed and other central banks facilitate higher inflation, reducing the real burden of debt

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