The pandemic caused a sharp downturn in 2020, but now the world is experiencing a somewhat unusual boom. Global economic growth has returned, and the initial market bounce, which was focused on sectors such as tech, has evolved into a broad market recovery.
The world needs to find ways to move on from covid-19, and meaningful progress is cause for celebration. However, the economic boom is also a cause for concern. We consider three main risks or hurdles which must be overcome if the recovery is to be sustained.
The first hurdle involves vaccination. Life can only return to normal if offices, venues, and retailers can reopen permanently, and this relies on vaccines reaching critical mass in each country. However only 40% of the world’s population have received their first dose and only a third is fully vaccinated. Vaccine doses remain relatively scarce globally, with demand still forecast to outstrip supply through to the end of 2021. In addition, concerns around waning immunity have prompted some countries to start administering booster doses, exacerbating the shortage.
The second hurdle involves more general supply and demand distortions and imbalances across the globe. For example:
There are significant labour shortages in the service sector in the US and UK. In the UK, workers from the EU had been suppressing wage inflation in the service sector before the Brexit vote in 2017.
Source: M&G, ONS, 30 June 2021
2. House prices have surged in both countries.
3. A shortage of microchips has disrupted the manufacture of electronics and cars, making it difficult to meet strong demand.
4. The cost of shipping goods around the world has increased sharply from pre pandemic levels, as shown in the global container index below.
(Note: The Freightos Baltic Daily Index measures the daily price movements of 40-foot containers in 12 major maritime lanes)
These effects are causing upward pressure on inflation on both sides of the Atlantic.
The third hurdle concerns the withdrawal of financial stimulus. In the West, fiscal and monetary support measures are gradually being withdrawn, creating a drag where there has been support. Central banks in the advanced economies have now acquired over $10trn of assets since the pandemic began. The challenge now is how to unwind the support measures without causing tantrums in capital markets. Emergency government schemes, such as furlough and direct stimulus cheques to households, are coming to an end. So far, there has not been a wave of defaults and bankruptcies, but firms will be tested when loans require repayment and workers can no longer be furloughed.
Assessing the risks
It is hard to perceive that an event as extreme as a pandemic, combined with the unprecedented government response to it, would not have consequences for the global economy. Some economists are concerned about a return to 1970s-style inflation, where others argue that the effect will be transitory as economies and societies gradually return to normal.
In the US, with its extensive vaccine roll out and vast levels of stimulus, there is perhaps the greatest risk of overheating. Over the last few months, inflation has reached levels not seen since the 1980s and the US labour market is experiencing distortions. Despite a positive jump in employment, the number of people working in hospitality and leisure is still 12% lower than pre pandemic levels. There seems to have been a cultural shift with workers reluctant to return to working in low paid industries, which is pushing up wages in those sectors. All this suggests the US economy will remain the most a risk of overheating, with pressure on the Federal Reserve to raise interest rates and reduce quantitative easing.
In other advanced economies the outlook is less buoyant. Europe is catching up on vaccines, but the lower level of stimulus means that inflation has not increased as much. British inflation hit a more than 9 year high last month after the biggest monthly jump in the annual rate in at least 24 years, but this was largely due to a one-off boost reflecting the “Eat Out to Help Out” scheme that pushed down restaurant meal prices last year. In these economies the risk is that policymakers react prematurely to imported inflation which may be temporary. Withdrawing support and tightening financial policy too early may cause economies to stutter.
Emerging markets face more significant challenges. At a time when they should be benefiting from surging global demand for commodities and other goods, they are short of jabs. The result is that the lowest income countries are expected to grow relatively slowly as they catch up with vaccinations. Furthermore, the prospect of higher interest rates in the US is likely to cause weakness in emerging market currencies as investors buy dollars, raising the risk of financial instability.
The speed of the economic recovery has been frenetic, leaving the snap recession behind in its wake. We expect that, by mid 2022, most people will be vaccinated, business will have adapted to new patterns of demand, and stimulus will be unwinding in an orderly way. However, the road back to normality is unlikely to be a smooth.
Against this backdrop, we remain disciplined in sticking to our investment philosophy. Our portfolios are well diversified and designed to reduce volatility, and it is important to maintain a long term investment horizon in these uncertain times. Within equities, we continue to focus on companies with strong balance sheets, dominant market positions, and the potential to generate cash. In addition, we value companies that are best placed to withstand inflationary pressures. These companies produce low cost, repeat purchase products, such as toothpaste (Proctor & Gamble), or provide vital services via subscriptions, such as software (Microsoft). These are the companies that will emerge stronger over the next few years.