A year has passed since the World Health Organisation (WHO) declared the spread of COVID-19 a pandemic. In the year since, tremendous efforts have been exerted in an attempt to stop the spread of the virus, and protect people and economies. Equity markets were falling sharply this time last year, and corporate bond spreads were widening dramatically. In stark contrast, many equity indices have reached new highs and corporate bond spreads have narrowed, as these efforts have proven effective in many parts of the world. Economic data has improved, and a cyclical recovery appears to be underway, supported by vaccine rollouts and additional monetary and fiscal policy.
In the US, President Joe Biden has signed the latest in a long line of stimulus packages. The $1.9 trillion American Rescue Plan was agreed less than two months after his inauguration. He is already working on an infrastructure plan, with an emphasis on sustainability and the green economy. The initial proposition is for a further $2.25 trillion in spending, funded mostly by corporate tax increases, which is likely to be hotly debated over the quarter. Meanwhile, the Federal Reserve (Fed) remains committed to purchasing $120 billion of bonds each month, and has indicated that it will give markets plenty of notice before tapering these purchases. The huge stimulus has sparked concerns over inflation. The market has started to price in rate hikes ahead of the Fed’s expectations. Whilst the Fed has promised to maintain low interest rates until at least the end of 2023, it has stopped short of further interventions despite sharp upward movements in bond yields. The Fed reinforced its view that inflationary pressures are transitory; however, it seems investors are unconvinced. The concerns being if inflationary pressures prove to be greater than expected, the Fed will be behind the curve, resulting in a faster pace of rate hikes later on.
The continued sell-off in longer dated bonds causing a tightening of financial conditions, has led the European Central Bank (ECB) to announce that they will significantly increase the pace of bond purchases under the Pandemic Emergency Purchase Programme (PEPP). They too predict that any rise in inflation this year will be transient, and expect it to fall below the 2% target over the next few years. The vaccine rollout in Europe has been slow, with doubts raised about the safety and efficacy of some of the vaccines. Cases have risen again; and renewed lockdowns have been enforced, delaying the economic recovery. ECB President, Christine Lagarde, called on the EU to speed up the delivery of the €750 billion pandemic recovery plan that was agreed last year.
Meanwhile, the UK and US have pushed ahead with their vaccination programmes with a sense of urgency. Given the vaccination rate, the US and UK economies should recover sooner than those in Europe. Whilst we continue to expect a strong rebound in growth this year, we do not see this as evidence of change in longer-term price pressures. Annual inflation in the US will rise over the next couple of months, largely because of the base year effects of low oil prices, temporary tax cuts, stimulus cheques and supply shortages. All these should be one-off factors that will push inflation higher over the short-term; however, sustained, long-term inflationary pressures remain muted. Indeed, prior to the pandemic, there were deflationary pressures, many of which will remain in place after the pandemic.
On balance, we agree with central banks expecting the rise in inflation to be transitory, and believe there remains considerable uncertainty around the path of recovery. Given the higher government and corporate borrowing incurred during the pandemic, central banks will likely be slow to raise interest rates, which should continue to support equity markets. The companies that suffered during the pandemic will recover some of their earnings, but their balance sheets have been damaged, and they may come to depend on low interest rates in order to service their debts. Those looking to smooth long-term returns should look to companies with more stable earnings and strong balance sheets. Prolonged low interest rates also justify some fixed income exposure in balanced portfolios.