When one type of macro financial risk occupies the attention of investors, it leaves them at the mercy of being blindsided by something else.
A stubbornly higher pace of inflation and much higher interest rates are seen widely as a likely legacy of the enormous stimulus by central banks and governments in response to the COVID-19 pandemic.
But what if the outcome turns out to be a less discussed and very undesirable scenario – a less impressive recovery once pandemic stimulus fades that leaves a burden of debt hanging like a dead weight on the economy?
This scenario no doubt strikes some as remote given the scale of the rebound in economic activity unfolding at the moment. The actions of governments and central banks in the past 15 months have spurred expectations of a sustained global economic recovery and a decisive shift upward from the modest expansion that typified the decade before.
Indeed, the U.S. Federal Reserve Board upped its forecast for the rate at which the U.S. economy would expand in 2021 to 7 per cent from 6.5 per cent and maintained a solid growth rate estimate above 3 per cent for 2022. In the wake of the global financial crisis, the U.S. economy failed to match this pace of expansion before the pandemic erupted.
Little wonder that there was a shift in the Fed’s tone at its policy meeting last Wednesday. It signalled the “lift-off” from near-zero overnight interest rates will now begin in 2023 instead of 2024. Details of a reduction, or tapering, in the Fed’s current US$120-billion of monthly bond purchases that it uses to keep rates low should arrive in the next few months and most likely start early next year.
The recognition that strong expectations for the economy will require less monetary medicine beyond this year has stirred financial markets. In truth, the latest Fed shift is a belated recognition of what many investors believe is the base case for markets and the economy in the next few years.
The latest monthly survey of fund managers by the Bank of America notes that they’re “bullishly positioned for permanent growth, transitory inflation, and a peaceful Fed taper.” The survey also showed a preference for financial assets that are boosted by a higher and sustained pace of economic growth, including commodities, energy, industrial and financial companies.
Missing from this bullish growth checklist are steadily rising long-dated U.S. interest rates, an important indicator of a healthy and sustainable recovery. Normally, if there are strong long-term growth expectations and the prospect of a more sustainable inflationary environment, 10-year and 30-year bond yields would be trending upward.
Instead, these important interest rate barometers peaked for the year in late March. This could be because of expectations of continued bond-buying by the Fed. And it might reflect the sheer weight of money looking to be deployed, particularly from pension funds seeking to lock in returns.
But it also suggests that some investors might not have quite as rosy a view of the longer-term outlook as the BofA survey suggests.
There are reasons for that. Recent employment data has highlighted a bumpy process of hiring. If that turns into evidence of a “jobless recovery” in the coming months, there might be a far longer process of healing after the pandemic.
Working against hopes of a strong recovery is a pullback in fiscal spending next year. Northern Trust Corp. has forecast a steady recovery and transitory inflation pressures as its “base-case scenario” for the U.S. economy. However, it does now anticipate risk to growth.
After fiscal stimulus represented 10.5 per cent and 11.5 per cent of the economy in 2020 and 2021, respectively, that boost is seen easing to just 2.3 per cent in 2022, says Jim McDonald, chief investment strategist and co-portfolio manager of Northern Trust’s global tactical asset allocation fund.
“While there is sufficient reason to believe the private sector will pick up the baton from government spending next year, it is a big hurdle,” he says.
Companies face the likelihood of rising wages and taxes at a time when they are dealing with a higher debt load built up over the pandemic. That debt burden, along with increased government borrowing, also offers another interpretation of why longer-dated yields are not rising.
Some analysts suggest it means the Fed will only have a limited capacity to lift interest rates. A sharp increase could trigger a major confidence shock via a severe decline in the stock market and a wave of downgrades for companies with indebted balance sheets.
“The profitability of companies is dependent on low rates and this will restrict the rise in bond yields and also limit the ability of the Fed to tighten policy,” says Thomas Costerg, senior U.S. economist at Pictet Wealth Management.
The prospect of a growth scare is very much a contrarian view at this stage of the recovery, but it is one of which investors should take note.
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