“Far more money has been lost by investors trying to anticipate corrections, than lost in the corrections themselves.”
~ Peter Lynch”
As Covid crisis unfolded last year, I came across conflicting prophecies of both boom and doom for the economy in the year ahead. A year later, both sides claim to have been proven right. Optimists point at the economic recovery, the jobs growth, and the surge in corporate profits. Pessimists point at the economic uncertainty, the spike in inflation and the sky-high valuations of asset prices. Meanwhile the markets shrug and move on. Which side is right, and what is an investor to do?
Boom – Get ready for the roaring 20’s version 2.0 – optimism abound. We’ve come out of a global pandemic, similarly to the 1920’s where automobiles and electricity powered the economy, we’re bursting with new technologies set to launch us into the new decade. Monetary and fiscal policy will support and springboard the economy into high gear. Interest rates will remain low and asset prices, while already at record levels, will continue to power ahead.
Doom – The counter to this view is a negative one. Too much debt will slow economic growth, while too much money in circulation will push up inflation, leading to a ‘stagflation’ scenario (stagnated economy plus inflation), this is similar to what took place in the 1970’s. The high levels of inflation will force Central banks to raise interest rates to combat inflation, thereby slowing the economy and we’ll see a repricing of financial assets lower.
Looking to the future, I have no idea exactly which path the economy will take. I do however believe that we’re in for a decade of lower than usual asset returns and a wider range of inflation outcomes than we’ve become used to. Not a disaster, but not very exciting either. There are no magic cures for lower returns. Investors who aim to protect or grow their wealth will need to take on more risk than in the past. The best assets to cope with this environment are time and patience.
I hope you’re making the most of the summer!
Call me with questions.
On my mind: Something has to give
Sonal Desai, Ph.D., Chief Investment Officer, Franklin Templeton, Fixed Income
Published, July 9th, 2021
US Treasuries have rallied sharply over recent weeks with yields dropping by about 30 basis points,1 and analysts are scrambling with differing explanations. However, the growth outlook has not actually changed. I see three possible scenarios, which I discuss below. But regardless of which scenario plays out, something in the current constellation of asset prices does not add up. Over the next six months, most likely, we will find out what does.
The unusual degree of uncertainty in the current macro environment allows for a wide variety of views on how things will play out. I don’t have a crystal ball, but I would not bet on the dream constellation of strong policy-supported economic growth, low and stable inflation, loose monetary policy and ever-rising asset prices that markets seem to hope for. Something has to give. I see three main possibilities.
A first possible scenario sends us back to secular stagnation. Growth fizzles out by the end of the year. Maybe political disagreements will close the door to additional US fiscal stimulus. Or a resurgence of COVID-19 cases could trigger another round of restrictions (I could see this happening in Europe after the summer tourist season). After a strong brief rebound in growth and a sharp short-lived jump in inflation, we quickly get back to a long run of slow growth, low inflation and low interest rates. This by the way is the view implicit in the official growth forecasts of the US administration (as embodied in the budget assumptions, and consistent with those of the Congressional Budget Office).
What doesn’t add up here? Asset prices. If economic growth fizzles out, the stock market needs to reprice for modest earnings expectations. And if slow growth is as good as it gets, the Federal Reserve (Fed) will need to accept that loose monetary policy cannot boost activity and will have to unwind its massive monetary easing—which again should translate in lower asset prices. Or, the Fed could decide to maintain a very easy monetary stance anyway—but that sooner or later will result in increasing distortions in markets, leading to financial instability, or inflation, or both—again bad news for markets.
A second scenario envisions a productivity renaissance. The policy-fueled demand surge generates a proportionate supply response: workers come back into the labor force and companies quickly ratchet up production, easing bottlenecks. Meanwhile, both governments and companies redouble their research and development efforts, accelerating innovation and infrastructure and generating a rapid pickup in the pace of productivity growth. The supply response and productivity acceleration enable fast economic growth and healthier wage gains.
What doesn’t add up here? Interest rates. The current ultra-loose monetary stance will appear unnecessary even sooner. The Fed will be under heavier pressure to bring forward its policy tightening, especially if inflation remains elevated. In principle, faster productivity growth should help cap inflation. In practice, it’s likely to take longer for greater investment to translate into faster productivity growth. Meanwhile, we’ll have an economy at full employment and firing on all cylinders; and stronger productivity growth implies a higher natural rate of interest, the infamous “r-star.” Markets will have to start pricing in higher rates. Stock markets will be supported by the tailwind of productivity on earnings, corporate bonds will benefit from a healthier profitability outlook, but long-duration “safe-haven” assets will look markedly less attractive.
The third scenario sees a classic overheating. Demand continues to recover at a fast pace as post-pandemic life gets back to (almost) normal: supply struggles to catch up; industries need more time to work through supply chain disruptions; labor force participation remains below pre-COVID levels; past underinvestment in raw materials extraction keeps their costs elevated. In short, an extension of what the data are telling us now.
What doesn’t add up here? Inflation. In this classic overheating scenario, loose monetary and fiscal policies feed sustained inflation. Not (necessarily) a return to the 1970s, but a persistent 3%–5% that gets entrenched into wage and price setting seems quite realistic. This will put the Fed in a bind: the longer it waits to reverse course, the harsher the tightening when it finally comes. Market rates will move up faster than the Fed, punishing duration exposure in fixed income. Stock markets should be initially well supported, but then increasingly nervous as the Fed gets ready to tighten.
I don’t have a crystal ball. I have my most likely scenario, but you can pick your own. At the moment, the economic data are mostly consistent with the overheating scenario, whereas market reactions suggest something in between the secular stagnation (with the recent decline in 10-year US Treasury yields) and the dream scenario (with stock indices still at record high). Something has to give. Place your bets, and get ready for more volatility as we find out what does.
- One basis point is equal to 0.01%.
Here is a link to the full article: On my mind: Something has to give
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