Growth is peaking. What comes next?
- The global economy is growing at its fastest pace in decades as COVID-19 vaccinations allow consumers and businesses in an expanding list of countries to return to normal.
- Markets spent the first half of 2021 pricing in better-than-expected economic data, but investors must now grapple with decelerating growth, albeit from a very high peak.
- Supply has struggled to keep up with explosive demand growth, but we do not expect labor or materials shortages to trigger a lasting inflationary spiral.
- The path of interest rates over the balance of 2021 could hold the key to how asset class correlations behave and whether diversified portfolio returns remain solidly positive.
- This is a sequenced — rather than synchronous — global recovery, which should make the descent from peak growth less bumpy.
A booming economy brings with it new opportunities — and risks.
The global economy is booming, but that’s no surprise
At the start of the year, we described our outlook for 2021 as a bright light at the end of a dark tunnel. Six months in, we’re nearly through that tunnel, and the light is already brighter than we expected. Our upside scenario coming into this year has become our base case: The global economy is booming as COVID-19 cases plummet. Financial markets have priced in this surprising and welcome news in (mostly) orderly fashion, to the benefit of diversified investors. But, while the global recovery is still running ahead of schedule, expectations for the U.S., in particular, have caught up to reality (Figure 1). What happens now that the world’s largest economy has lost its ability to surprise us?
That sets the stage for our view that we are at or near peak growth. What do we mean by “peak growth,” you may ask? The answer comes with a note of warning for anyone still traumatized by their high school calculus courses: Both the level of output and its first derivative (growth) remain quite strong. It’s the second derivative — the change in the rate of growth — that has started to fall, presenting a challenge for investors and policymakers alike (not to mention those charged with making economic forecasts). This doesn’t mean that growth will actually be negative from here. We think it will be quite strong. But it does mean that the rate of growth is slowing. Economic stimulus policies are largely tapped out in the U.S., though the effects of income support provisions in the American Rescue Plan endure in the form of higher savings rates and increased household net worth. The eurozone is set to unleash its own coordinated fiscal stimulus shortly, just as the continent pulls back on economic restrictions.
Equity and credit markets have undoubtedly been supported over the past year by the recovery’s reliably better-than-expected trajectory, even before vaccines came online. Now that consensus expectations have caught up to reality, that key driver — the element of surprise — may be missing. We’re already seeing the effects: Global interest rates have surrendered some of their first quarter advance and equity market valuations have begun to descend from very high levels.
Will the bright light become blinding as the U.S. economy overheats?
As the world makes a relatively quick economic comeback from the pandemic and appears set for strong growth well into 2022, most investors have identified U.S. inflation as the next serious risk on the horizon. The high monthly U.S. inflation readings for April and May have validated their concerns. But, while the dual demand shocks of fiscal stimulus and post-pandemic reopening have created acute price pressures in a handful of industries, inflation for most goods and services is up only modestly over the past year (Figure 2).
A period of persistent inflation driven by higher wages feeding into higher prices could lead to tighter financial conditions and put this young expansion in jeopardy. But we remain in the camp that expects inflation to moderate from here, for several key reasons:
- U.S. labor supply should increase as virus-related obstacles diminish and unemployment aid becomes less broad and less generous; this should ease upward pressure on wages.
- Investment-driven improvements in worker productivity will help companies avoid passing along costs of higher wages to customers.
- The demand shock that has led to supply shortages for certain goods should wear off as accumulated savings and stimulus payments are spent over the summer and companies restock their shelves.
We’ve likely already seen the highest monthly inflation readings of 2021. Year-over-year inflation may remain elevated over the balance of the year before dropping quickly in 2022.
We expect inflation to remain elevated over the coming quarters without rising to levels that will hamper growth.
The puzzle for the second half of the year: What happens to rates?
Of course, investors’ inflation concerns are not just about inflation itself, but about policymakers’ responses to it. How the Federal Reserve reacts (or doesn’t) to elevated inflation is a key risk to markets in the second half of the year. Judging by the very low volatility in interest rates — indeed, long-term rates are lower than they were three months ago — the bond market trusts the Fed not to end its asset purchases or raise interest rates until the economy has made what it calls “considerable further progress.” While we share the markets’ assessment, we also believe it to be consistent with the Fed’s and other central banks’ likely plans to taper their quantitative easing programs beginning in 2022 and signaling their intentions to do so before the end of this year.
History rarely repeats itself, but it often rhymes. Recent periods of monetary tightening — including the now infamous 2013 “taper tantrum” that occurred the last time the Fed drew down its asset purchases — have been challenging for diversified investors as correlations between stocks and bonds have turned positive while their prices have dropped simultaneously (Figure 3).
The best lesson to draw from this experience is to maintain composure. Any tapering announcement would likely bring a lurch higher in real interest rates. But history tells us that a variety of asset classes can perform well over all but the very shortest time horizons in this environment including, significantly, the equity market. Beyond stocks, parts of the bond market like senior loans that are less susceptible to rising interest rates could represent an attractive opportunity. Real assets can also often be challenged during periods of rising rates, but in the context of elevated inflation and a booming economy, we continue to regard them as key components of diversified portfolios.
The “peak growth” baton will travel east during 2021
The pace of vaccinations may have peaked in the U.S., but it’s still ramping up impressively in the rest of the world (Figure 4). This suggests that economic momentum will shift from the U.S. to the rest of the world. But what, if any, implications does this have for financial markets?
First, we think the U.S. dollar is likely to continue weakening. As the center of global growth moves from the U.S. to other major economies, the dollar may lose further support, particularly if emerging economies succeed in vaccinating their populations.
We also see the sequential nature of the recovery contributing lower market volatility, especially compared to a hypothetical synchronous boom. With demand gaining steam in various parts of the world, the recent rise in commodity prices could prove sticky, as could the drop in financial market volatility since the early days of this year.
Investors trying to tactically time markets have had a tough time of it this year. Growth and value have treated market leadership like a hot potato. And while cyclical stocks have generally benefited from the acceleration in the global economy, the dispersion among individual country returns has been quite narrow.
We still prefer a bottom-up approach to portfolio construction rather than one that uses top-down factors to hopscotch from one country to the next chasing a winner. In fact, the recent outperformance of European stocks may reflect a general belief that the continent will be the next beneficiary of vaccinations and reopening. Europe’s best chance to continue its outperformance would be for the global economy to outperform expectations, providing cyclical stocks with a longer runway to outperform.
Expect a solid second half with fewer upside surprises
The global pandemic has produced a unique economic pattern that renders traditional economic models obsolete. This is why we’ve spent the bulk of the recovery to this point noting that things are going “better than expected.” Now that those expectations have caught up to reality, we expect market returns to be somewhat harder to come by. Global growth will decelerate into the end of this year as stimulus wears off and economies return to normal. It will do so from an extremely high rate, giving us confidence that holders of diversified portfolios across public and private assets will continue to be rewarded in the second half of the year and beyond.
Climate change: no longer an optional consideration for investment processes
Climate change is no longer a niche theme — in fact it has solidly emerged as both an investment opportunity and risk that must be managed across all asset classes to generate performance for our clients.
We are incorporating climate change considerations across portfolios in a number of ways, including traditional approaches such as focusing on stocks and corporate bonds of clean and renewable energy generation or including climate elements such as hurricane risks when selecting municipal bonds. We are also looking for ways to enhance the environmental profiles of real estate and real assets through efforts such as improving farmland irrigation, focusing on water sustainability for agribusiness and prioritizing other ways to reduce carbon emissions.
We also see other opportunities, such as private equity investments in solar, wind and bioenergy electric generation; engaging in public/private lending programs to fund metropolitan clean energy initiatives; and investments in the local circular economy to reduce methane-producing food waste.
Across these investments, we note one important caveat: We must not only analyze where these investments are today, but also where they are heading. In other words, today’s ESG leaders are not necessarily tomorrow’s. We acknowledge the risk attached to investing too early in certain climate-related trends, but strongly believe the “too early” phase of climate change is likely behind us. In fact, we may be getting dangerously close to “too late.”
For our clients, we think climate risks should increasingly be part of their managers’ holistic investment process. And the time is now to seek out investment strategies that focus on climate solutions, as these will be critical to reducing changes to the climate that may hamper economic growth and investment performance in the future.
All market and economic data from Bloomberg, FactSet and Morningstar.
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