The news flow on the financial markets has been negative for a while now: rising rates of new infections, falling economic indicators, rising inflation, and monetary policies that are slowly but surely tightening have been on the front pages. This situation notwithstanding, equities and other risky asset classes are on the rise. Does this add up?
The global economy is going through a cyclical recovery phase. This translates into economic growth that is significantly above the long-term trend and above potential growth until full employment has been achieved. The headwind has picked up in recent months. More and more growth indicators suggest a declining growth momentum, such as the purchasing managers’ indices, consumer and business sentiment, retail sales, industrial production, and company investments.
For recovery to continue ….
In order for the recovery phase to continue (i.e. for it not to be interrupted), the economic momentum cannot decline any further. We can see five necessary conditions that need to be met to ensure said continuation:
- In the base case scenario, the negative impact of the Delta variant is of a temporary nature and insignificant. The recovery is carried by more and more countries and by private consumption in the service sector, which in many cases is still clearly below pre-pandemic levels.
- The pandemic created shortages on the supply side (semiconductors, closed port terminals, long supply chains) as well as on the demand side (a lack of personnel in the service sector). This has resulted in limited production and high purchase prices and the inability faced by businesses to build inventories. In the base case scenario, shortages decrease, production increases, the pressure on prices falls, and the very low inventories will be restocked.
- In China, the economic indicators suggest weakening economic growth. Indeed, real GDP stagnated in Q3 on a quarter-on-quarter basis. This is due to the termination of the generally loose politico-economic stance, which has led to falling credit growth, restrictive measures aimed at containing the Delta variant, and regulatory reforms. In the base case scenario, China will take measures to support the economy.
- The phase of elevated inflation rates exceeds the forecasts from the beginning of the year both in terms of duration and extent. By definition, the inflation drivers are of a transitory nature (constraints on the supply side due to bottlenecks, strong demand growth in the sectors that are taking steps towards re-opening). Some key questions remain unanswered for the time being. How long will this phase last? To what level will inflation fall after the pandemic? Will there be a long-term inflation problem in the second half of this decade? Spill-over and second round effects are the medium-term (cyclical) risk. The prices of other goods and services that are not directly affected by the pandemic have also increased more significantly than expected. This could set off a wage-price-spiral, and we have to keep our eyes on it.
World Bank forecast: real gross domestic product (GDP) growth by country group from 2018 to 2023 (year-on-year)
For the long-term economic outlook, it is crucial whether the structural (disinflationary) forces that are dampening inflation disappear (scenario A) or, quite the opposite, reverse (scenario B).
Scenario A: the opening of China dampened inflation. That was a one-off. In the future, new technologies hold the potential of productivity growth. That, too, would contain inflation pressure.
Scenario B: the receding growth of the employable population and the rising share of people aged 65 and above could have an inflationary effect – especially if the monetary and fiscal policies remain supportive despite full employment having been achieved. In the base case scenario, the high inflation rates will subside again, but it will be important to monitor the medium- and long-term development.
- An increasing number of central banks have been tapering their ultra-expansive measures. In those emerging economies where inflation is a problem, the key-lending rates have already been raised. In the developed economies, a gradually increasing number of central banks have been hinting at a cut in bond purchases. This also applies to the most important central bank, the US Fed. However, the Fed has been operating very cautiously, trying to prevent a so-called tantrum, i.e. a negative market reaction to any restrictive measures taken by the central bank. So far, this has worked well. Although the Fed is getting closer to announcing the tapering (i.e. reduction) of its bond purchases, the markets have not reacted with losses. The Fed has been preparing the market participants for such a step for months. The same is true for rate hikes. The first hike is becoming increasingly likely to happen in Q4 2022. Here, too, we can expect the Fed members to carefully prepare the markets in numerous statements. In the base case scenario, the monetary policy of the developed world remains expansive, i.e. supportive.
There are two reasons for the good performance of the risky asset classes. First, the negative developments are being ignored because they are probably only temporary (Delta variant, shortages, China, inflation) and the central banks have proven to be smooth operators. Second, there is an enormous savings glut, i.e. excess of savings. In the medium term, this does of course come with risks for financial stability. But in the foreseeable future, it will support the share prices.
Prognoses are no reliable indicator for future performance.