When one type of macro financial risk occupies the attention of investors, it does leave them at the mercy of being blindsided by something else.
A stubbornly higher pace of inflation and much higher interest rates are widely seen as a likely legacy of the enormous stimulus by central banks and governments in response to the 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 deadweight 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 upwards from the modest expansion that typified the decade before.
Indeed, this week the US Federal Reserve upped its forecast from 6.5 to 7 per cent for the rate at which the US economy would expand in 2021 and maintained a solid growth rate estimate above 3 per cent for 2022. In the wake of the financial crisis, the US economy failed to match this pace of expansion before the pandemic erupted.
Little wonder that there was a shift in tone by the Fed at its policy meeting on 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 $120bn 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 noted investors are “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 though are steadily rising long-dated US 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 upwards.
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 have not have quite as rosy a view of the longer-term outlook as the BofA survey suggests.
There are reasons for this. Recent employment data has highlighted a bumpy process of hiring. If that turns into evidence of a “jobless recovery” in the coming months, we might face a far longer process of healing after the pandemic.
And working against hopes of a strong recovery is a pullback in fiscal spending next year. Northern Trust has forecast a steady recovery and transitory inflation pressures as its “base-case scenario” for the US economy. However, it does now anticipate a risk to growth.
After fiscal stimulus represented 10.5 per cent and 11.5 per cent of the economy in 2020 and 2021 respectively, this 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. This 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,” said Thomas Costerg, senior US 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 investors should take note of.
