The recovery from the Covid 19 pandemic has been quite extraordinary
- Saturday, October 30, 2021
We should not loose sight of the fact that the recovery from the Covid 19 pandemic has been quite extraordinary. Nothing in living memory has matched it. By the summer of 2021, global GDP had not only passed its pre-crisis level but was catching up on the pre-crisis trend levels of economic activity that we might have expected if the pandemic has not struck. We are therefore further ahead in our recovery than the IMF and OECD predicted at the beginning of 2021.
This economic activity has supported some optimistic equity market returns throughout both 2020 and 2021. The S&P 500 is now up +35% over its February 2020 level while Japan’s Nikkei 225 is up +20% and Europe Euro Stoxx 50 up +10% but the UK’s FTSE 100 is still down -5.5%.
Despite this encouraging background, world markets have turned their attention to some of the near-term consequences of this growth. Global supply chains have been put under pressure with shipping and haulage struggling to match demand. This has resulted in headline grabbing shortages and backlogs, leaving inventories at exceedingly low levels. This has been compounded by labour markets that have struggled to meet the redeployment of workers to match the manufacturing and service sector demand despite high unemployment. The higher transmission rates of the Delta variant of Covid have had an impact on workforce productivity.
Supply shortages have been most acute and sensitive in the energy sector with natural gas prices soaring over the course of 2021. UK natural gas futures are now US$228 p/therm up from US$60 p/therm in January, a rise of 380%. This has resulted in many smaller and newer players in the gas distribution market being unable to match the contract price and force into administration.
The inevitable result in supply disruption and commodity price rises while demand is high is inflation. To some extent the high inflation growth now is a result of lower costs 12 months ago. In this context it could be seen as a spike and ultimately short-lived, once business resolves its supply chain inefficiencies. As the months go by the rolling 12-month inflation growth figure will slow and then decline. Higher Inflation will remain well into 2022 and place pressure on central banks to end their stimulus programmes and think about interest rate hikes.
We expect the benchmark 10-year US treasury yields to move higher from the current 1.6% when the Fed starts to taper its QE asset purchases, which we expect to start in December at a rate of US$10b per month. While interest rate rises may come somewhat later, the only direction treasury yields are expected to go is upwards.
Europe is catching up the USA in economic activity so we can expect European inflation rates to pick up. While there is an expectation for US interest rate rises in 2023 there is no such feeling that the ECB will take action that early. European equities therefore can benefit from lower for longer interest rates. The European recovery has broadened to include more nation states and a return to pre Covid levels of activity should also be a stimulus for equity markets. The ECB QE programme is due to expire in March 2022 but analysts expect the programme to continue beyond that cut off. ECB interest rates are still in negative territory at -0.5% with inflation at 3.4%.
The economic slowdown in China this year has been the result of the authorities seeking to cool an overheated Chinese economy and this has had an impact. Beijing has been unwilling to loosen fiscal policy and to reverse the credit tightening that was recently imposed. China is now focused upon rebalancing their economy toward low to medium income families and to deleverage. For this reason, they have been less active in credit driven fiscal stimulus. With the recent coal shortages and electricity blackouts to contend with China’s recovery has slowed. Many commentators are now expecting Beijing to start to ease fiscal constraints and support the economy more.
China is continuing on the path of greater state control with social objectives having some primacy over growth. GDP rates have declines on a rolling 12-month basis to levels in Q3 that policy makers can no longer ignore and therefore after a period of tightening there is an expectation for loosening of fiscal and monetary controls. Therefore, after a six-month period of lower exposure to China we are planning to increase our allocations. Hong Kong’s Hang Seng Index has had a very disappointing summer falling 17.7% since February’s high point. But a shift in fiscal policy will give markets some encouragement and has given the index a healthy lift in October.
Looking ahead we have not seen significant reductions in the excess savings built up during lockdown. These savings will at some time be spent. This will create demand as fears over Delta Covid and supply problems ease. If this demand runs ahead of economic capacity to supply then price rises will continue. Persistent inflation will cause central banks to tighten monetary policy sooner than markets would want. Any early intervention by central banks and particularly the Fed or PBoC could be an issue of concern but at this point does not look to have impacted markets.
Equity markets can tolerate price inflation unlike the fixed interest market. Credit markets are more vulnerable to rising yields and inflation than equities. For this reason, we have extended our inflation protection in our bond holdings to include such assets as floating rate funds, target return bond funds and maintained short durations.
Tactically we will maintain our equity exposure as we expect to see in due course a re-acceleration in activity and interest rates to remain relatively low. Areas of the equity markets that look most appealing are US small and mid-cap markets as they will benefit from domestic activity, European equities are attractively valued and are now benefiting from a strong growth backdrop and lower for longer interest rates. The UK markets are fairly valued but still have some trading challenges to overcome that may last longer than business would want. Japan will be aided by the global recovery and enjoy attractive valuations, while China after a weak period is expected to pick up. Indian equities have been performing well and showing a positive outlook for an economy that alongside China is taking up more of the worlds GDP growth.
Chris DaviesChartered Financial Adviser
Chris is a Chartered Independent Financial Adviser and leads the investment team.