What makes the Covid-19-induced economic cycle unique is that it was created by both supply-side and demand-side disruptions resulting from government-enforced lockdowns. The government stimulus measures that boosted disposable income ahead of the reopening of the economy resulted in higher prices and a build-up of excess savings.
When inflation started to climb in 2021, central banks initially ascribed it to shortages in the economy due to supply-chain disruptions. They saw this as ‘transitory’ – the situation would return to normal once economies fully reopened. By late 2021, however, central banks became concerned that inflation wasn’t as transitory as first supposed, but that excess demand was fuelling inflation, necessitating a sharp rise in interest rates in 2022 and 2023.
Global asset prices had a weak year in 2022 when the higher interest rates resulted in assets repricing (especially the hyped-up digital economy beneficiaries of the Covid-19 period). Investors also became concerned that the interest rate cycle would result in a recession, in line with historic precedent.
While an imminent US recession was the consensus view at the start of 2023, the year turned out much better than most had anticipated. Not only did economic growth surpass expectations, but inflation also cooled. Many have referred to the current environment as a ‘Goldilocks’ economy, meaning it is neither too hot (causing inflation) nor too cold (resulting in falling growth) – the ideal scenario for central banks. As markets warmed up to the prospect of such a perfect outcome over the past year, global equities rallied. Goldilocks seems to have laid herself down in the most comfortable bed.
NOT TOO COLD
The growth side of the Goldilocks coin is perhaps the more surprising, considering the material increase in central bank interest rates and the reduction in global money supply. We think this can be attributed to several factors that have offset the impact of interest rate hikes, especially in the US:
- Households and corporates have become less sensitive to interest rate hikes due to the high prevalence of long-term fixed-rate debt in the economy. The private sector has also entered the rate hiking cycle with relatively healthy balance sheets, making it more resilient against higher rates.
- The large amounts of excess savings accumulated during the Covid-19 era are now being deployed in the economy, extending the cycle. However, these are expected to be depleted during the course of this year.
- The federal government has continued to run large budget deficits, which has supported income levels and countered the impact of tighter monetary policy. These have been funded largely from the available excess savings pool – therefore not yet crowding out the private sector. However, the current trajectory of the US fiscus is not sustainable over the long term as the higher debt burden will result in a ballooning interest rate bill over the next decade.
NOT TOO HOT
If financial conditions remained looser than expected due to the factors explained above, how did Goldilocks manage to still get such a good inflation outcome? We think this was due to the healing of supply chains in 2023 as economies fully reopened. Some of the ‘transitory’ inflation arguments in 2021 did in fact play out. As input prices normalised from their high levels in 2022, the 2023 inflation numbers declined materially. The shortage of labour in the economy also reduced as more people returned to the workforce and immigration soared.
However, despite these tailwinds, inflation remains stubbornly above central bank targets and we’re unlikely to see the same benefit in 2024 in the absence of a slowdown in economic growth.
WILL THE BEARS COME HOME SOON?
While the market has warmed to the idea of a soft landing for the global economy, it is in our view premature to claim this victory. As some of the tailwinds of the past year dissipate, there are risks to both inflation and growth. Whichever plays out will have a material impact on relative asset class performance.
Monetary, fiscal and geopolitical actions will have a significant impact on the shape of the cycle, making the outcome difficult to forecast. In this context, it is crucial to build resilient, well-diversified investment portfolios with assets that can provide performance across various market scenarios. Fortunately, the high interest rate environment has created more opportunities to build better diversified, higher-yielding portfolios.
Given the large support from government spending in the current economic cycle, a key question to consider is for how long the market will be willing and able to fund the large fiscal deficit, especially once excess savings have been depleted and governments start crowding out the private sector. Many governments have taken on huge amounts of debt to raise their economies in the aftermaths of both the GFC and the pandemic. Low interest rates have made this possible, but a world of structurally higher inflation and interest rates will make it increasingly more burdensome to service this debt. Goldilocks shouldn’t get overly comfortable in Little Bear’s bed.
