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Beyond COVID – policy-led reflation: House View Q&A (Q3 2021)

We recently published our House View Q3 2021. Michael Grady (MG), Head of Investment Strategy and Chief Economist and Fabio Faltoni (FF), Multi-asset & Macro Investment Director discuss our latest economic outlook and its implications for global investment markets.

House View Q3 2021

FF: Last quarter’s House View publication stated: “We believe that economic recovery will still be a key theme throughout 2021 and well beyond.” Do you still agree with this remark?

MG: The global economy remains on track for a rapid and broad-based economic recovery from the COVID pandemic. Notwithstanding concerns around new variants of the virus, restrictions are generally being eased, as the vaccine roll-out progresses well, allowing economies to more fully re-open. At the same time, the extension of fiscal packages has ensured household incomes have remained supported and consumer demand robust.

FF: Could you quantify this recovery outlook?

MG: While there are risks on both sides of the outlook, we judge that the balance of risks to be on the  upside, given the pent-up demand and excess household savings that could be deployed over and above our relatively conservative estimates. We expect global growth of around seven per cent in 2021, followed by 4.5 per cent in 2022 – with the level of activity rising above the pre-COVID level across all major economies at some point this year.

FF: Inflation has risen noticeably in recent months in many developed economies, leading to debate over how much of the recent increases are transitory and how much might be permanent What’s your take on this?

MG: Headline rates are always buffeted around by “one-off” factors. But “core” rates have risen too, suggesting that there is something more fundamental happening.

Current policy settings are loose and likely to remain supportive for some time

We think that underlying inflation pressures will be somewhat stronger in 2022 and 2023 than they were pre-COVID. That reflects our view of limited spare capacity, particularly in the United States; by early 2022, the re-opening of economies, pent-up demand, excess savings and damage to parts of the supply-side of economies may result in frictional mismatches or more lasting shortages and bottlenecks. In addition, current policy settings are loose and likely to remain supportive for some time, while central banks are now adopting a more explicitly pro-inflation stance.

FF: Could you clarify what you mean by “central banks are now adopting a more explicitly pro-inflation stance”?

MG: Despite the risks of higher inflation, we expect the major central banks to be willing to accommodate a higher level in order to deliver a more robust recovery, as well as a sustained increase in actual inflation and inflation expectations.

The new framework adopted by the Federal Reserve in 2020, known as Flexible Average Inflation Targeting (FAIT), will require them to start raising interest rates only once inflation has been above two per cent for a period of time and full employment has been reached. That does not mean they will be oblivious to the risks and may therefore signal lift-off somewhat earlier should the economic situation warrant it, but that they will wait until those criteria are met before moving. We expect that to be in 2023.

The European Central Bank also recently announced a somewhat more tolerant attitude to higher inflation. However, with the euro zone economy likely to take quite a lot longer than the US to eliminate spare capacity and create sustainably higher inflation, the prospect of rate rises is more remote.

FF: Would it therefore be fair to assume that an inflation overshoot presents a material downside risk for financial markets?

Monetary tightening of this nature will help usher in the next economic slowdown

MG: While our central case only leads to modestly higher underlying inflation compared to pre-COVID, we think this is a possibility given our upside risk to demand and potentially greater pass-through into pricing. If this is what happens, then at some point, investors will have to react. Monetary tightening of this nature will help usher in the next economic slowdown in order to suppress demand and squeeze inflationary pressure back out of the system.

FF: Are there any other risks you are particularly worried about?

MG: The massive amount of assistance that has been provided during the COVID crisis aims to support companies and individuals financially so that both can resume commercial activities when circumstances allow. Sadly, it is inevitable that not all will survive. The extent of this damage, or “long-term scarring” as we call it, will only actually become apparent when the various schemes are withdrawn, a process that has only just begun but which will become far more advanced in the second half of the year and into next.

Some firms will go under, others will reduce the scope and size of their operations. Some jobs will not be there to return to, unemployment will rise, while GDP may be permanently lower than it would otherwise have been. As in many other areas, this is totally new ground – there is no precedent so we can only estimate the possible extent.

FF: Let’s switch the discussion to asset allocation. What are your views on the equity market?

MG: The key House View themes of strong growth, pro-cyclical fiscal support, and expansionary monetary policy persist. We maintain our highest conviction asset allocation views in equities, where even though stock markets are at or near record levels, further gains are in order as earnings expectations are revised higher.

FF: So more positive on equities, but less so on credit. Is this a fair statement?

MG: Credit spreads have not been tighter than they are now since the Global Financial Crisis – and before that were grossly overvalued – so excess return from investment grade and high yield credit will come from this limited carry and rolling down somewhat steep credit curves. This may not suffice to offset losses from the interest rate duration, especially for the longer-dated maturities, although they should still outperform government bonds.

We continue to recommend underweight positions in investment grade

Eventually, should a slowdown raise the risk of a recession, or a global shock materialise, spread widening can unravel many quarters’ worth of excess returns as well. Even though we don’t see such a negative event on the investment horizon, we continue to recommend underweight positions in investment grade, and are neutral on high yield and hard currency EM (which benefit more from global growth and upgrades).

FF: What about duration?

MG: Government bond yields have moderated from their highs earlier in the year, possibly reflecting a combination of over-extended market positioning and some concern about the Federal Reserve raising rates too soon. Despite this, we continue to expect the growth and inflation backdrop to once again put upward pressure on yields, particularly as we see the Fed sticking to their FAIT framework. As such, we are underweight duration, most notably in the US.

View the latest version of the House View here.

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