Friday 19th November, 2021
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With winter fast approaching, dark clouds have gathered over Europe once more as a potent new wave of covid-19 takes hold across the continent. This is despite the availability (indeed, abundance) of highly effective vaccines to combat the spread of the virus. To the collective dismay of a weary population, so-called vaccine passports, mask mandates, work-from-home guidance, and other such social distancing restrictions have made a comeback in many countries and regions already. However, this time around and in most places, the harshest restrictions have been targeted at those who refuse to get jabbed so as to protect the freedoms enjoyed by everyone else (for as long as possible). Governments also hope that severe differential treatment of the as-yet unvaccinated population will encourage greater take-up from this hesitant minority who are most at risk. Austria, which has one of the lowest rates of vaccination in Europe, was the first country to order a full lockdown of the unvaccinated on Monday. But the Czech Republic and Slovakia have since followed suit. Meanwhile, Germany has announced similarly severe lockdowns of the unvaccinated in those provinces where cases are skyrocketing. How sustainable these partial restrictions will prove in the face of rapidly rising covid-19 cases is questionable, and there is a growing threat that strict national lockdowns will return right across Europe this Christmas. Indeed, just this morning Austria expanded its targeted lockdown to the population as a whole and announced that vaccination would be a legal requirement for all from February 2022! The current wave of cases is very bad news for growth and should serve as a reminder that the pandemic is far from over (however we all felt about it this summer). The Delta variant has made it impossible to achieve herd immunity without complete (or near-complete) inoculation or past infection of the population; and it has also made it inevitable that we will get there – one way or the other.
At least so far, equities have not suffered much in response to surging covid-19 cases in Europe, even as CHF (which is considered to be a safe haven currency) hit a six-year high against EUR this week. Indeed, major equity indices – and US indices in particular – remain at or near their all-time highs, thanks to a mix of (still-)abundant liquidity provided by DM central banks, some better-than-expected economic data out of China and the US, the rapid pace of the global growth recovery (which is still-ongoing at a very fine rate indeed), and the signing into law of a historic bipartisan infrastructure package in the US on Monday, after much-wrangling across the aisle. Given how markets have behaved throughout this pandemic, we suspect that monetary policy (rather than conditions in the real economy) will be the principal focus for investors through year-end and into next year, particularly if the pandemic takes a turn for the worse and corporate fundamentals are unable to justify toppy near-term multiples. Therefore, the future will be determined by how far inflation is set to rise, how persistent this rise turns out to be, when central bankers recognise this persistence, and what they do about it given the high chances of making a mistake.
Our base case is that inflation will be a problem until covid-19 goes from pandemic to endemic virus in most, if not all, of the world’s largest, most integrated economies. Demand remains strong, but global growth has slowed markedly since the summer due to supply and labour shortages brought on by the pandemic. And these imbalances (periodically shifting in a disruptive manner) are likely to remain an issue for some time, not least because cases of covid-19 are on the rise once more, and new restrictions are likely to be imposed in many places (where they have not been imposed already). Such trade and business frictions will sustain if not exacerbate the dislocations that have driven up costs for firms and households this year, contributing to further price rises down the line. And a more socially distanced winter in the Northern Hemisphere is likely to keep the pressure on depleted inventories as consumer spending (again) shifts away from services and towards goods. Meeting this excess demand for goods will be hard for companies that have underinvested in new capacity over the past 18 months; and, with so much uncertainty at play, we believe that CAPEX plans are unlikely to regain their pre-covid ambition for some time yet (leading to more persistent price rises). Meanwhile, China’s ‘Zero Covid’ approach, whereby the country tests and/or lockdowns whole cities if just a handful of cases emerge, is likely to cause logistical mayhem until the country changes tack. The issue for Xi, however, is that China has inoculated the whole population with a vaccine that does not prevent infection… so we think that there is little prospect of a policy reversal anytime soon.
Putting these inflation drivers together, we think that price rises will prove persistent in the medium-term and central banks will gradually have to respond. However, given the scale of national debts, and the risks to the recovery of tightening monetary policy too fast, we see limited space for them to do so. Of course, bond purchases are already being tapered in the US, and they will be in Europe too. However, the pace and extent of tapering will very much depend on what happens with covid-19 this winter and how markets react to long-end rates rising towards 2%. No one wants a sell-off, and if fundamentals deteriorate then someone will have to keep investors happy… Policy rates, meanwhile, are unlikely to move much higher unless central bankers can see a clear path out of the pandemic. Inflation is a threat, but recession is too; and the former would have some positive impact on the real value of outstanding governments debts. Therefore, we do not see short-end rates rising much if at all in 2022. And if Biden decides to drop Powell as Fed Chair in February, and then pack the board of governors with doves and progressives, you can forget about rate hikes to keep inflation in check. From an investment point of view, therefore, today we favour equities and commodities – asset classes that tend to win in more inflationary environments – while being underweight fixed income given tight credit spreads and our expectation that long-end rates will rise (albeit modestly in our base case).
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