Many of us had thought or hoped that the end of 2020 would herald a return to normality. In fact, Covid-19 showed little sign of loosening its grip during the first quarter of 2021, with new, more transmissible variants of the virus driving a strong rise in global cases this year. For investors, we’re still very much in uncharted territory, and analyzing the long-term economic and financial implications of Covid-19 is challenging. More importantly, the pictures from India and Brazil are reminders that Covid-19 is still exacting a terrible human toll and that the virus is not beaten until it is beaten for us all.
The views set out in the podcast represent the latest thinking to emerge from the quarterly Global Investment Group, or GIG. The GIG’s role is to characterize the current and future risk-return environment at a high level.
Many of us had thought, or hoped, that the end of 2020 would herald a return to normality. In fact, Covid-19 showed little sign of loosening its grip during the first quarter of 2021, with new, more transmissible variants of the virus driving a strong rise in global cases this year. Vaccine rollouts have started, helping drive down infection rates in certain countries, while elsewhere, political issues and low take-up rates are hampering efforts to combat the pandemic. The pictures from India and Brazil are reminders that Covid-19 is still exacting a terrible human toll and that the virus is not beaten until it is beaten for us all.
So, after another quarter dominated by Covid, we again take stock of where we are now and what may lie in store.
Hello and welcome to the latest episode of Aberdeen Standard Investments’ Market Insights podcast.
For investors, we’re still very much in uncharted territory, and analysing the long-term economic and financial implications of Covid-19 is challenging. To help our clients do just that, we’re setting out the views and opinions of our Global Investment Group, or GIG. The GIG’s role is to appraise the current and future risk-return environment at a high level, providing guidance to fund managers with the aim of providing positive outcomes for our clients.
Let’s start by taking a look at the economy in the first quarter of this year, when global growth momentum took a big step down. On measures of mobility, the UK was particularly weak given its stringent lockdown measures, although Eurozone mobility was also subdued. The largest recoveries in mobility occurred in places like India and Brazil, where there’s greater cultural and political willingness to tolerate higher levels of the virus. However, this tolerance has been tested, as I said earlier, over the past months as cases and deaths have continued to rise. And then there are places like Australia and Japan, where efforts to contain the virus have been more successful.
Our forecasts confirmed these trends, suggesting the UK and Eurozone economies contracted in Q1. The recent US economic growth numbers show growth has moderated but remains positive. We should see it re-accelerate from here once government spending kicks in.
Recent economic data has also revealed marked differences across sectors. Industrial activity has continued to grow strongly in many economies, as factories adapt to restrictions and demand for goods remains buoyant. But activity in the services sector has been mixed. In the US, service sector output continues to improve. But in Europe and Japan, tightened restrictions have weighed on retail sectors. That same pattern is reflected in the latest purchasing managers’ indices (or PMIs), with services PMIs lagging well behind manufacturing, and actually contracting in many economies.
Turning now to the outlook, two main forces will drive a strong rebound in the global economy over the next three years. The first of these is widespread vaccine rollout, which will allow a progressive easing of lockdowns. The second boost comes from additional large-scale US fiscal stimulus against a backdrop of still-supportive monetary policy. With these tailwinds, we’ve revised up our global GDP forecasts, to 5.7% for 2021, 4.6% for 2022 and 3.8% for 2023. These rates of growth are all above-trend. But growth will fall back towards trend by the end of 2023.
It’s true that the first of these two drivers, vaccine rollout, hasn’t been plain sailing. Supply issues and (especially in Europe) low take-up have hampered the initial rollout, with the US and UK being notable exceptions. But we think vaccine coverage in the major economies will build rapidly over 2021. That will allow restrictions to ease and activity to rebound. Many developing countries though will take far longer to achieve herd immunity, delaying their recoveries and keeping international travel restrictions in place well into 2022. So, we’re expecting lockdowns to gradually ease over 2021. But at different paces in different economies, and with some restrictions lasting much longer.
For the second driver, US fiscal stimulus, our forecasts include a 1.9 trillion dollar Covid relief plan, allied with significant additional infrastructure spending plans. This will provide a big boost not just to the US economy, but will also have positive spill-over to the rest of the world. This spillover may be smaller than usual as demand shifts from internationally traded goods towards services. Consumers have generally been able to buy goods under lockdown, but there’s been scant opportunity to spend money on outings, entertainment and other services. This is likely to partially reverse during re-opening, which means emerging market exporters and cyclical stocks may not benefit as much from strong global growth as they’ve done historically. In fact, that shift of activity from goods to services during re-opening will have wide-ranging implications.
The strong cyclical outlook doesn’t mean the global economy will shrug off the Covid crisis without permanent scarring. Supply-side damage may be limited in China, thanks to its superior handling of the pandemic, and in the US by the sheer size of the fiscal impulse. But in the UK, Europe and Latin America, the economic contraction was deeper, the initial policy responses were tentative and the recovery more gradual. So, these countries will probably suffer a lasting hit to their GDP potential, in terms of both the level of GDP reached and the rate of growth.
Let’s look now at the outlook for inflation and monetary conditions. Headline inflation rates are continuing to rise, pushed higher by a combination of factors: energy base effects, higher commodity and food prices, expiring tax cuts, and re-weighting of inflation baskets to reflect lockdown consumption patterns. These drivers could push headline inflation well-above central bank targets in many economies by the middle of this year. But most of these drivers are temporary in nature, and we’re expecting inflation to drop back below target through the second half of 2021.
Admittedly, the scale of upcoming US fiscal stimulus has fuelled speculation that more lasting and damaging inflation may be on its way. But we think this view understates the longer-term disinflationary forces acting on the US and other economies. And it forgets that economies will need to run ‘hot’ for a long period of time if they’re to reach central bank inflation targets.
So, while markets have brought forward the expected date of interest rate rises in a number of economies, we think this is overdone. The US central bank, the Fed, has welcomed a ‘hot’ economy, so we don’t expect it to start tapering its quantitative easing programme until early 2022. And we don’t expect the first US rate hike until the second half of 2023. For central banks in most other developed markets, tighter monetary policy is even further away. Indeed, the recent rise in bond yields is unwelcome to most central banks because it’s unduly and prematurely tightening financial conditions.
In fact, the European Central Bank’s mantra of “maintaining favourable financing conditions” has already seen it push back against market expectations of tighter monetary policy. Some other smaller developed market central banks have done the same. And though the Fed has taken a neutral approach so far, we’d expect it to respond strongly to any meaningful increase in financial stress. That stress might take the form of a large correction in the equity market, significantly wider credit spreads, sustained higher volatility or a sharp increase in the dollar.
In China, financial conditions are shifting in a more neutral direction, given the rebound in the Chinese economy and policymakers’ concerns about financial stability. We’re not expecting China to tighten monetary conditions to the extent it might be a major headwind to global growth and asset markets. But even so, China will certainly not provide the enormous boost it did when the world was recovering from the global financial crisis.
What about the geopolitical landscape? We might be tempted to think that a Biden presidency, a Brexit trade deal and a new Italian government under Mario Draghi all point to a calmer global political scene. However, the deeper forces that have driven political risk over the past decade haven’t gone away. In fact, they may actually worsen during the uneven recovery from the crisis. The US and China are still engaged in a strategic rivalry; vaccine nationalism is a potential cause of geopolitical tension; the UK may face another referendum headache in the form of a Scottish independence push; and a contentious debate about reform of EU fiscal rules is looming.
Let’s consider the risks to our growth forecasts. There are wide confidence intervals around our projections, so focusing on ranges and scenarios is more useful than point forecasts. The risks around our baseline forecasts are probably skewed to the upside, given the cautious assumptions we’ve made about the size and scale of US fiscal stimulus, multiplier effects and the pace of lockdown easing. Even so, there are still downside risks posed by fast-spreading variants of the virus which may resist the current crop of vaccines. There’s also the risk of a possible tightening in financial conditions that isn’t justified by the economic environment.
What does all this mean for asset classes? Market moves since our last GIG meeting have been dominated by the sell-off in global government bonds, which was led by the US. The speed and magnitude of the resultant rise in yields exceeded most forecasts. However, in recent weeks, we have seen a stabilisation in these markets and indeed some retracement of the yield rises. However, the original moves didn’t look inconsistent with the stronger growth outlook - at least at the longer end of the yield curve in the US. There may be scope for bond yields to rise further from here, but the extent of any further rise will depend on the willingness of major central banks to allow this trend to continue. Central banks are likely to push-back much harder if financial conditions tighten in a way that’s disorderly, or excessive relative to growth prospects - and if markets continue to price in a premature policy normalisation.
For fixed-income investors, credit markets, including emerging market debt, may be a better place to take risk. Admittedly, spreads in high-yield bonds and especially investment-grade bonds are expensive compared with historic averages. And, for emerging market debt, the fundamental backdrop has become more mixed given that positive spill-over effects from US growth will be only moderate. Rising US yields could potentially cause the dollar to strengthen and Chinese financial conditions are turning neutral. However, our forecasts of a strong economic growth rebound, the transient nature of the drivers of higher inflation, and continued easy monetary policy should act as an anchor to prevent a sustained, aggressive rise in spreads. The more recent strength in some emerging market currencies would suggest that in general investors are willing to look through the Covid-related shorter-term problems. However this may change as cases significantly increase in some emerging markets.
Turning to equities, the favourable global growth outlook and the likelihood of several quarters of very strong earnings growth should be tailwinds. Unloved areas of the market, like value, selected cyclicals and UK stocks may enjoy the strongest earnings rebounds, making them more attractive, at least for a few quarters. Admittedly, equity multiples are elevated. There’s also the risk that rising bond yields could negatively impact equities. Remember, too, that the sector composition of the economic and earnings rebound is likely to be different from past cycles. Services bore the brunt of the Covid shock and will benefit most from vaccination programmes and reduced restrictions on activity. Our short-term timing indicators would suggest some caution, but our longer-term frameworks would still leave us favouring equities.
The word ‘granularity’ is one that keeps cropping up at GIG meetings. The macro outlook, while positive, is complex and uncertain. Likewise, the terms ‘value’ and ‘growth’ don’t capture the nuances within markets. Within asset classes, we’re likely to see continued large dispersions in returns, reflecting the big fundamental gaps opening up across countries, sectors and companies. We should see this as a healthy sign, and one that’s needed to let markets move forward from here. But, while we’re happy to lean towards more cyclical markets and sectors, some companies face big challenges. Recent US results have shown profits well-above expectations – but also good results from a wide variety of sectors and stocks. A mix that talks to balance in portfolios.
To summarise, we’re expecting three years of above-trend global growth, driven by vaccine rollout and big US fiscal spending. We see the upward moves in inflation as temporary and expect inflation rates to start falling this summer. Meanwhile, central banks will maintain their supportive monetary stance for some time to come. The main risks to our forecasts are: new Covid variants that escape the current batch of vaccines; and premature increases in bond yields that aren’t justified by global economic conditions. In terms of asset classes, we prefer equities to bonds, and corporate bonds over government bonds (although in some countries the latter are starting to offer value). Finally, country, sector and company divergences will become more pronounced as we move through the recovery, so we continue to emphasise careful security selection.
Thank you for listening today. I hope you’ve found this summary of our current thinking useful. For further information and insights, please visit our Website www.aberdeenstandard.com Compliance statement (Automated Voice): This podcast is provided for general information only and assumes a certain level of knowledge of financial markets. It is provided for information purposes only and should not be considered as an offer, investment recommendation or solicitation to deal in any of the investments or products mentioned herein, and does not constitute investment research. The views in this podcast are those of the contributors at the time of publication and do not necessarily reflect those of Aberdeen Standard Investments. The value of investments and the income from them can go down as well as up and investors may get back less than the amount invested. Past performance is not a guide to future returns, return projections are estimates and provide no guarantee of future results.
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