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If you had asked me a year ago if I’d expected to see such a rebound in markets in 2021 I would probably have thought it unlikely. Economies had already weakened in 2019 with many still struggling to emerge from the 2008 Global Financial Crisis (GFC). A global pandemic looked likely to deal a fatal blow.
Between March to June 2020 the global economy had, very quickly, spiralled into a very deep recession as societies and economies locked down. COVID cases were spiking upwards and the containment measures to try to control the spread were destroying jobs, trade and industry. The key question for us was – when will we see the infection rate controlled enough to allow for the economic system to successfully reopen? As vaccines usually have at least a two to three-year rollout the outlook looked grim.
However, even as the awful tragedy of COVID continued, signs were emerging as early as June 2020 that the outlook was tentatively improving and vaccine development was well ahead of schedule. In contrast to most other recessions, by the latter half of 2020 most developed economies, and in particular China, were showing robust signs of recovery with solid equity returns, particularly for technology stocks that thrived in the social distancing/work from home environment of 2020. In some ways the recovery looks to be a continuation of the post-GFC environment, although the good news is that emerging from the pandemic we are finally seeing the stimulus that wasn’t delivered post the GFC.
Well clearly a number of factors drove the turnaround:
As 2021 has progressed we have observed a shift in growth and equity markets from the technology stocks that drove 2020 returns to the re-opening stock exposures that benefit from stronger growth such as resources and banks. Many equity markets are now above pre-pandemic highs and the outlook continues to brighten.
We’re clearly not out of the woods yet with variant virus strains emerging which explains why policy makers are committed to driving the recovery for some time. While there is much talk about inflation, policy makers remain acutely aware that we skated very close to sustained disinflation or even deflation after the GFC to at least 2019. As was the case in Japan, it is much more difficult to banish deflation than cap a lift in inflation.
This means policy makers remain more comfortable trying to lift inflation and wages back closer to pre-GFC levels. They’d like more growth ‘in our back pocket’ as insurance before we enter the next downturn/recession to ensure the risk of a sustained Japanese-style deflation is reduced.
While the vaccination rollout has been extraordinary, there remains a huge disparity in vaccine rollout programs and levels of reopening with some emerging countries continuing to have high rates of infections. We also face the risk of more deadly and transmissible mutations, which could hamper vaccine progress and may slow re-opening.
In Australia, snap lockdowns have demonstrated the need for a massive ramp up in local vaccination programs to ensure that re-opening does not lead to the hospital system being overwhelmed. The borders need to reopen to sustain our economic recovery and this requires a substantial ramp up in vaccination rates.
While news is positive on the whole, policymakers worldwide are now facing the very difficult challenge of determining when, and in what form, they can return to pre-COVID life. Do we need to live with the virus, or can it be eliminated? The world will be looking to countries like England to assess how successfully they can reopen without overwhelming the hospital system. Success in containing variants will ‘make or break’ the recovery.
Clearly a key risk is that virus variants may arise and challenge the efficacy of current vaccines. To date, while the Delta variant is more infectious with cases surging, it appears that hospitalisation and mortality rates are well controlled by vaccines.
Australia’s economy is already back at pre-pandemic levels with better than expected GDP growth of 1.8% in the March quarter following solid consumer spending, particularly in the services sector, supporting growth. However, we should not forget that the pre-pandemic economy was operating well below capacity with inflation too far under the RBA’s target range and wages growth weak. The current recovery will have to continue for some time to absorb under-utilised labour and recent lockdowns have no doubt eroded confidence.
A similar picture to Australia is apparent across most developed economies with sectors outside of technology struggling to deliver the jobs and wages growth experienced pre-GFC. To some extent this shortfall has underpinned the relatively volatile politics of recent times.
We expect that over the next decade inflation will be somewhat higher than the post-GFC decade and this transition may lift volatility, particularly as policy makers start to wind back current extraordinary stimulus measures.
We should be aware that central banks are looking for a somewhat higher pace of inflation than the rate that was attached to the post-GFC world. While inflation is likely to rise in the coming months as the effects of pandemic recession slow and economies re-open, to date most central banks expect that any large lift will be temporary and they’ll want evidence that there’s a sustained upward shift in wages supported by a continued fall in unemployment before raising rates.
The main risk to the recovery is if central banks were to start to raise interest rates before the recovery is well anchored and variants controlled so that we can start living with the virus. We consider this is some way down the track and central banks can be expected to keep monetary policies ‘loose’ to further support the economic recovery and jobs.
If, as we expect, we successfully navigate back to more normal economic and inflation growth rates, we may face a challenging period of somewhat higher inflation and fears that sooner or later that extraordinary policy support will be curtailed. Bluntly put, if central banks are successful, good economic news could become a headwind to markets as fears of tighter policy rise.
If global economies can rebalance and drive more broad-based jobs and wages growth this should ease the social and political pressures of recent years and that is good news. On that upbeat note, I, together with the IOOF investment team, would like to wish you all the best for the new financial year.
Chief Investment Officer