What to make of the global economic recovery?
By David Crosoer and Prieur du Plessis
GLOBAL financial markets have been spooked in the last couple of weeks by rising global long bond rates on the back of improving global growth. So far, it’s early days, but how should investors respond to these recent developments?
Global long bond rates are the discount rates that price the future expected cash flows of all global financial assets. These rates have been kept artificially low for over a decade by a concerted effort from most developed market central banks to anchor short-term rates at close to zero levels, and by the aggressive use of their balance sheets to purchase longer-dated government bonds in extraordinary quantities to keep prices high (and yields or rates low). At the same time, these policies have remained credible (and arguably necessary) while economic growth has been subdued and global inflation contained.
What, if anything has changed? Central banks have continued to signal that they have no intention to increase short-term interest rates anytime soon, and the US Federal Reserve even went as far as to say it would tolerate higher inflation for an extended period before it even thought about raising short-term interest rates. And, central banks have continued with quantitative easing and could intervene more aggressively in bond markets if required.
Even expectations of the rebound in economic growth (shown in shaded bars in the accompanying graph) are not off the chart, despite the Covid-contraction of 2020 being much more severe than the financial crisis of 2008.
Sure, the International Monetary Fund (IMF) clearly expects the global economy to grow more strongly in the next five years than the five years prior to 2019. However, its current expectations (revised upwards in January) are barely different from how the global economy grew after the 2008 financial crisis, which, at the time, disappointed (shown in grey bars), and are not yet close to how the global economy grew through the previous commodity super-cycle in the five years prior to 2008.
How could inflation possibly surprise on the upside? One reason could be that the growth expectations remain too pessimistic, and the global economy will grow much stronger than forecasters expect. While this might be the case, it’s certainly not yet reflected in consensus economic forecasts, despite several asset managers we speak to being excited about a potential rotation to emerging markets and the potential of a value-based cyclical rally of bombed-out old economy stocks.
But even here it’s far from clear why future growth should be more inflationary than prior growth, let alone whether the kind of economic growth we can expect in future will favour these more cyclicals (and presumably capacity constrained) companies in the transition to the green economy, or (like before) the more innovative disruptors to existing business models.
Of course, given how low interest rates have been globally for so long, any increase in rates need to be substantial to be unsettling for markets. So far, the yield on the 10-year US bond has edged back up to around 1.6 percent on the back of improving economic sentiment. This yield is still very low by historical standards, although it’s meaningfully up from where it traded prior to the vaccine announcements last November.
Central banks clearly want to allow more inflation into the system, if only to reduce nominal debt burdens and avoid deflation. But there is also no indication that central banks have any intention of raising short-term interest rates any time soon, and they don’t mind expanding their balance sheets to purchase government bonds, as they have done several times in the previous decade, to force longer-term yield lower.
Where does this leave us? As always, we caution investors against making radical changes to their investment portfolios. The improvement in global economic conditions undoubtedly provides a favourable backdrop for growth assets, but we think it’s far too early to say central banks will be forced to raise short-term rates aggressively to prevent inflation expectations from getting out of hand.
Having said that, an investment thesis that is dependent on abnormally low interest rates lasting into perpetuity is clearly not a robust investment case. At the same time, while the recent improvement in economic conditions has clearly provided a lifeline to many assets that were under severe economic pressure, an investment thesis that simply extrapolates the short-term improvement in returns without asking whether these investments will remain relevant in the years and decades to come is equally deficient.
The future will surprise all of us, and continue to provide opportunities for asset managers to take advantage of market conditions. It’s up to all of us to remember this when we become fearful of short-term market movements.
David Crosoer and Professor Prieur du Plessis are chief investment officer of PPS Investments and Chairperson of PPS Multi-Managers respectively; email: [email protected]
*The views expressed here are not necessarily those of IOL or of title site