Expert: Shamik Dhar, Chief Economist, BNY Mellon Investment Management Facilitator: Henry Cobbe, Elston Consulting
In this roundtable, the expert led a discussion on the macroeconomic and markets outlook.
The key areas of discussion requested by delegates can be grouped by the following topic areas; Macro drivers and Central Bank policy, Quantitative Easing, Sovereign Risk and Asset Class outlook.
MACRO DRIVERS & CENTRAL BANK POLICY
Looking at the key macro drivers in turn.
The 2020 was not a typical cyclical recession. It was a short sharp “exogenous” shock.
On the positive side, world GDP growth bounced back to 4q19 by 4q20, despite expectations that it would not recover to pre COVID levels to mid-2021. This is an achievement in itself, thanks to huge stimulus. This has happened without the spending of excess savings. Savings rate still very high at 20%. It was therefore unusual – a technical “Recession” but without unemployment or bankruptcies that are typically associated with recessions owing to the policy response. This has helped support the growth recovery.
BNY Mellon’s Central scenario is that US inflation could run up to ~4%, potentially higher in the UK, until mid 2022 before moderating.
As regards concerns around inflation risk, it was noted that it was important to differentiate between inflationary pressure and sustained inflation. Inflation only becomes sustained inflation if Central Banks allow it to.
Higher inflation rates could lead to tighter monetary policy quicker than markets expect.
3. Interest Rates
US unveiled its new inflation targeting approach last year, but the framework is opaque. The concept of 'average inflation targeting' is not clearly defined.
The concern is that there is a risk of a policy mistake – most likely from the Fed – if they leave rates to low too long.
Doing Nothing: Thus far, there has been no reaction – and the central assumption is that the Fed will let inflation run hotter for longer. In the meantime, risk assets and real assets should perform well, because real yields (nominal yields adjusted for inflation) are low or negative. The steepening of yield curve is a bear-market indicator.
Intervening: Alternative is they intervene – raise rates sooner than market expects, the Fed and the Bank of England could potentially raise rates in late 2021/early 2022. This would be a shock for markets as we would see a “bear flattening” or even inversion of the yield curve, with the short end up, long end down. Risk assets would sell off and immediately. Negative for equities, property and credit in the short-term. Longer term – better following inflation. But this action would be preferable to a policy mistake.
Depending on the two different scenarios, portfolios should be positioned accordingly
- Inflation and no rising rates: focus on growth-bias and longer duration equities/bonds
- Inflation and rising rates: focus on value-bias and shorter-duration equities/bonds.
The worst scenario is that the real equilibrium rate (balance between saving and investment) steadily rises.
4. Quantitative Easing
Government and Central Bank debt levels are high owing to Q.E. This is not necessarily hyperinflationary unless accompanied with an economic catastrophe.
There has not been an increase in UK employment mobility (retraining) as yet.
Whilst furlough has ended – the impact is not visible yet, but we should start to see in a few months. Furlough policy has kept workers stable but it has also slowed the need to transition to areas where there are skills shortages.
For example, only 1 in 10 left HGV drivers are EU citizens. Those who left the industry is because of age >50. Driver shortage is more COVID-related, but Brexit hasn’t help.
Overall labour supply/demand should match out with time in the UK, but remains disrupted in the near-term.
Of far greater impact to UK workers have been the two historic labour shocks
- Manufacturing: hit by China labour supply and globalisation (from the 1970s)
- Services: EU worker influx from 2004
Having taken those shocks, wages and employment could potentially now increase, which would be inflationary.
GEOPOLITICS & SOVEREIGN RISK
It was highlighted that China is trying to develop its third economic model in 30 years
- Original China growth model: this was a shift to manufacturing from agriculture, and supported domestic growth, and exported disinflation
- Financial crisis: during the financial crisis there was a need to guarantee employment – move to credit based model. Expansion of money supply. Credit driven fiscal pump priming. Expansions in investment and export industries.
- Domestic shift: Move to consumer domestic spending. “Financial repression” means consumers forced to save in low yielding bank deposit which is used to provide cheap finance to State Owned Enterprises. The question is how to adjust this model going forward. Potential to move into a lower growth era. Also, from top-down perspective, there is political momentum to reduce imbalances in society.
China won’t change its rhetoric. Taiwan strategically useful semiconductor. Despite sabre rattling, it’s unlikely that there would be an invasion. China is more strategically focuses in exercising influence and control through economic, trade and infrastructure clout, e.g. Belt and road.
The view is that crypro is a solution in search of a problem. The blockchain technology is undoubtedly exciting. There is an almost visceral hatred of fiat money for some proponents of crypto investing.
However, it’s unlikely that Governments and Central Banks will allow a decentralised currency to prosper in place of their own currencies or future digital currencies.
MULTI ASSET PORTFOLIO CONSTRUTION
Key question on manager’s minds is within a multi-asset context how to reconsider the bond side of the portfolio.