Is the post-COVID rebound peaking?

We’re now in the middle of what promises to be a stunningly good year for growth – both in terms of economic output (GDP) and company profits. Of course, that’s largely a function of 2020 being so stunningly bad. But with the rebound continuing to exceed expectations, even as the easing of social restrictions has lagged, do tougher times lie ahead?

Global and US GDP are likely already back above their pre-COVID high watermark; on some measures, cyclical parts of the stock market have enjoyed an unprecedented run relative to defensive segments. But our analysis suggests it would be premature to start positioning for tougher times right now. We expect global leading economic indicators to remain near current elevated levels until late 2021, supported by a cycle of capital expenditure that looks like it’s just getting going, the rebuilding of depleted inventories and the continuing rebound in spending on consumer services. Especially as growth becomes more synchronized across the developed world, with Europe and Japan joining the UK and US in the reopening party.

We expect global leading economic indicators to remain broadly range-bound at today’s elevated levels until late 2021. From there, we see these high economic growth rates decelerating throughout 2022, but staying above their historic norm thanks to a continuation of central bank and government stimulus. We don’t think a change in investment strategy would be warranted until we start to see a decline in the key indicators that we believe give the best picture of where economies are headed. 

Growth rates in countries that suffered the largest contractions in 2020, such as the UK, will likely stay a little more elevated as they have further to ‘bounce back’. However,  many of these countries operated job retention or furlough schemes (as opposed to the income-replacement policies of the US, for example) and there is some uncertainty over what their closure might do to employment, corporate defaults and consumer confidence.

Is inflation here to stay?

We do not agree with theories of runaway inflation, currently a hot topic among market commentators. To summarise briefly, the main reason for the spikes we are seeing today is that prices were abnormally low a year ago, and the rate at which they have risen since has been exacerbated by COVID-related dislocations in spending, employment, production and logistics.

We have been warning about a very uncomfortable spring since early this year (see the lead article in our latest InvestmentInsights publication). And yet inflation in the US has risen by more than our already above-consensus expectations. However, for inflation to continue spiralling upwards, wage inflation would have to accelerate perpetually and inflation expectations would also need to untether from where they have been anchored over the last quarter century, around the 2% rate embedded by independent central bank regimes across the developed world.

While the speed of the growth recovery has exceeded expectations, the speed of the employment recovery has not. In the US there are still more than seven million fewer people in work than before the pandemic. We do expect evidence of skills shortages to push wage inflation a little higher over the remainder of the year, but not to a de-stabilising degree.

Inflation expectations extracted from a broad swathe of gauges still haven’t broken out above the normal range of the last 25 years. Some – although not all – measures of consumers’ short-term inflation expectations have broken out, but these measures have poor ‘track records’ as forecasts.

We believe – as US Federal Reserve Chairman Jerome Powell has been at pains to note – that unusually high US inflation will be transitory. But it’s worth clarifying what we mean by transitory. We don’t mean that inflation will be back on target by year end. Instead, we see it peaking in the next month or two, before falling back toward 2% throughout 2022.

Certain about uncertainties

The bottom line is that no-one can say they fully understand the consequences of the unprecedented degree of money creation during the pandemic. The degree of uncertainty around the inflation outlook is larger than anything investors have had to face for the best part of a decade (and arguably three). That also creates considerable uncertainty around the outlook for bond yields and equity valuations. Inflation risks over the next 18 months are skewed to the upside, which is something we think it’s wise to be positioned for, in and of itself.

It’s clear that the global economic recovery has gathered momentum since the start of the year and that it’s broadened out to encompass more geographies and economic sectors. But we believe the recovery trajectory has further to run, which is why we believe better valued cyclical themes could have further to run.

We are keenly aware that tougher times may lie ahead, particularly if immediate inflationary pressures prove more stubborn than we currently expect. We believe earnings momentum will be key, given the headwinds to valuations.  In particular, as global yields and inflation risks rise, Europe’s relatively cheap bank and energy sectors are likely to continue to do well.

Meanwhile, we will be keeping a close lookout for any risks that our favoured leading indicators might start to decline. It’s at that point – but not before – that a change of investment strategy might be warranted.