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Investors stand at a macroeconomic crossroads with either an inflationary or deflationary scenario on the cards, depending on how data plays out in the coming months. That was the message from Warwick in a recent briefing.
Reviewing the post-pandemic economic lay of the land, Warwick noted that, due to the speedy response of governments around the world, the rebound in economic indicators had been “far greater than any of us could have imagined back in March 2020.”
Nonetheless, he noted that unemployment remained stubbornly high, with furlough and other support schemes remaining in place in many countries. Meanwhile, central banks continue to be “extremely accommodative” in their monetary policies, providing ample liquidity into the system.
Against this backdrop, the biggest question for investors is whether to expect a deflationary “bust” scenario caused by the creation of “an extraordinary amount of public debt” – or whether to factor in expectations of an inflationary regime “driven by a surplus of liquidity, strong demand and constrained supply”.
“This is important to get right,” said Warwick. “We believe portfolios will need to look different depending on which of these scenarios plays out. It’s one of the reasons the onus will be on investors to be dynamic and responsive to changes in the data.”
A constructive near-term view
For the near term, the Global Real Return team continues to be constructive in its view on risk assets. “The vaccine rollout in the US and the UK has been impressive – and Europe is certainly catching up. If it continues at this rate there’s no doubt adults in these countries could be fully vaccinated by the end of the third quarter,” said Warwick.
Even so, policymakers will continue to offer liquidity – and tax increases are likely to be deferred to 2022.1 “In other words, we’ll need to see society begin to return to normal before we can begin to claim victory over this virus,” he added.
Another positive is the strength of balance sheets. “Unlike 2008, this is not a financial crisis,” said Warwick. “Banks’ and corporates’ balance sheets – particularly in the US – are looking healthy, which is incredible given how much the economy has been shuttered in recent months and this should make for a fairly swift recovery.”
Tempering this optimism was the overall level of bullish sentiment in the wider market – which could eventually be a catalyst for the Fed to tighten its monetary policy – but also the speed with which the virus continues to mutate, particularly in the emerging world.2 This in turn poses questions about the efficacy of future vaccines.
Over the longer term, too, investors were facing a structural shift as the end of the Washington consensus3 potentially ushers in a new era of government intervention, an erosion to free trade and the monetization of debt. Rising inflation, increasing government-bond yields and a continued cyclical rotation into hitherto unloved assets could be among the consequences, said Warwick.
Short-term inflation risks
For the short term, however, rising inflation indicators remain front and center in many investors’ minds. “In part this is being driven by a soaring savings rate in the US and an explosion of the money supply,” said Warwick. “It suggests the pent-up demand from consumers will result in sustained inflation. This demand is being met with insufficient supply, as bottlenecks around the world caused by the pandemic create shortages of key materials.”
Yet, rather than point to this as evidence of a renewed commodities super-cycle, Warwick painted a more nuanced picture where new imperatives such as the “greening” of the economy may have been responsible for some of the most pressing supply constraints. With both governments and corporates channeling funds towards economic recovery, however, some of those constraints could be met through increased investment, he observed, albeit with a general increase in broader commodity pricing.
1 Accounting today: Biden’s capital gains tax increase proposals make tax planning tougher. June 10, 2021
2 CNBC: WHO says delta Covid variant has now spread to 80 countries and it keeps mutating. June 16, 2021.
3 The Washington Consensus can be broadly characterized as a set of free market policies promoted by Western democracies during and after the Cold War.
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