As a result of government-imposed lockdowns to curb the coronavirus, the global economy faced a sudden shock in 2020 and a significant decline in economic activity. The extent of the decline in GDP draws comparisons with the 2008 to 2009 global financial crisis, but when looking beyond GDP declines, the underlying nature of the recession should mean the recovery is markedly different.
During the global financial crisis, central banks reacted by easing policy aggressively, but their main transmission mechanism into the real economy, the banking sector, was broken. Years of painful deleveraging were required for banks to recapitalise themselves and reduce their systemic risk, with many businesses unable to invest, or even survive, as sources of finance were cut off.
In this cycle, there is a very different dynamic.
Governments have stepped in to counter the economic pain with vast fiscal stimulus packages, supported by equally vast quantitative easing programmes. Unemployment has risen, but to a lesser degree than during the global financial crisis, and both consumers and corporates have built cash reserves, potentially creating significant pent-up demand for the future. Even if demand does not return more broadly, we are likely to see concentrated demand in certain sectors where supply may have been reduced as a result of the crisis, which would create pricing pressure at least in the short term.
Money supply is soaring1
It may be wise not to count on central banks to contain inflation in this cycle
For investors that are worried that inflation is going to return, they would be wise not to rely on central banks to act as prudently as they have in the past.
In 2020, following an extensive review, Federal Reserve (Fed) Chairman Jerome Powell announced that the central bank would shift to a new policy framework: flexible average inflation targeting. This means that in future, if inflation persistently fails to meet the 2% target, it will be allowed to run moderately above target such that inflation averages 2% over time.
Although the Fed has never purely targeted inflation alone, Powell has also indicated that reducing inequality is now a policy priority – and a tight labour market is an obvious tool that can be used to achieve that goal.
Under this new framework the Fed are likely to wait until after inflation has already reached their 2% target before viewing interest rate rises as a necessity, as this is the only way they can be certain it is not prematurely slowing the economy.
In the UK, Chancellor Rishi Sunak changed the remit of the Bank of England (BoE) in the 2021 budget to include a requirement to support the government’s climate change goals – helping the UK to transition to an environmentally sustainable and resilient net zero economy.
As the pressure grows for central banks to consider issues beyond inflation alone, it is uncertain how their future reaction function will change as they seek to balance multiple objectives.
Supply constraints are also an issue in key sectors
In commodity markets, metals and food prices have been trending upwards for some time, with oil joining the rally more recently. Rather than being speculative in nature, the move appears to be underpinned by supply deficits, which suggests it could be sustained in nature until higher prices trigger a new investment boom.
But it isn’t only basic commodities that are in short supply: there is also a global shortage of semiconductor chips, in turn restricting the supply of a variety of high-tech goods, including cars. With around a six-month lead time to bring new semiconductor capacity online, the shortage is expected to continue until at least 2022, constraining supply and pushing up prices.
Although the low inflation/low yield environment appears deeply embedded, an unexpected rise in inflation is a tail risk that could undermine that status quo. If perceptions change, and central-bank policy becomes constrained as a result, it could have far-reaching implications for asset prices. Concerns about the future path of inflation are clearly growing in some markets, yet few investors appear to be entirely hedged against this risk.