When will the global stimulus and the period of low rates end, and how will the global economy and the stock market react to this?
In the coming years, the dynamics of key rates will develop under the influence of the COVID-19 pandemic and the response to it from governments and financial regulators. The situation in the USA will have the greatest impact on asset prices. The investor should take into account the new policy of the American regulator and not miss the moment of trend change.
For the US economy, analysts began to predict the onset of a cyclically determined recession as early as 2019, which would be a natural development of events after 10 years of growth. However, a cyclical slowdown and an acute crisis are different scenarios and, accordingly, different reactions of regulators. The COVID-19 pandemic has made its own adjustments, at an accelerated pace, sending the GDPs of most countries to a negative zone. Governments around the world have urgently adopted and implemented comprehensive anti-crisis packages, filling markets with liquidity through monetary instruments and directly supporting businesses and citizens with subsidies, incentives and tax deferrals.
For example, the US Federal Reserve has sharply cut interest rates, returned to buybacks from the market, relaxed a number of regulatory requirements on banks, and took additional steps to regulate the corporate and municipal bond market and other vulnerable market areas. The key rate of the Federal Reserve in March 2020 decreased from 1.5-1.75% per annum to 0-0.25% and remains at this level. The last time the Fed cut the rate to 0.25% to overcome the financial crisis was December 2008.
Thanks to the regulators actions, financial markets stabilized quite quickly. The volume of new issues of corporate bonds in a number of countries is setting historical records, despite the natural increase in the level of defaults. Equity markets quickly compensated for the drawdown in March. Many analysts praised the effectiveness of the stimulus measures, leaning towards a fast V-shaped recovery in the US economy, perhaps even around 2020. However, the second wave of the pandemic this fall again added nervousness to the markets and caution in forecasts.
The protracted nature of the pandemic makes it possible to conclude that regulators will continue to stimulate the economy in the future at least in 2021. According to various estimates, aggregate fiscal measures reached a record 8% of global GDP in 2020 and are likely to remain high in 2021. In September, the British authorities announced a new round of support measures, in France, the Macron government decided on another stimulus package in the amount of 100 billion euros, the countries of the Eurozone continue to implement measures for 750 billion euros, which were decided at the summer summit. In Japan, the new prime minister announced support for a third budgetary package to rebuild an economy hit by the pandemic.
Interestingly, the Japanese government already receives more interest on its debt than it pays, since more than 2/3 of the government’s debt is in negative interest rate territory. Even China, despite the rapid passage of the peak of the pandemic and good dynamics of economic activity, continues to support its economy.
New US approach
The policies of financial regulators in the United States, the world’s largest economy, have a powerful influence on global financial market trends. The Fed uses the key rate as leverage to slow down or warm up the economy. To make decisions on the composition of the investment portfolio, hedging and the planning horizon, it is necessary to understand how the situation in this area will develop.
In theory, the following factors can lead to a reduction in liquidity stimulation or the beginning of tightening of monetary policy:
- pressure from the growing national debt;
- change of power and priorities following elections;
- overheating of the economy or its significant growth.
In practice, at the moment there are no prerequisites for one of these factors to work. Moreover, it is possible to continue the policy of low rates and cheap money for a rather long time – at least the next two to three years. There are several reasons for this.
Both of the country’s main political parties are leaning towards populist scenarios, which is a good indicator of the continued policy of large budget deficits and an increase in national debt. The shocking growth of the US budget deficit by 3 times per year – to a record $ 3.1 trillion at the end of September (the current national debt is $ 27 trillion) – will not become an obstacle to the policy of cheap money. Another reason is that, while formally remaining in the positive zone in terms of yield, US Treasury bonds are trading at negative real rates, taking into account inflation in the country. Such a situation is beneficial to the debtor, which means that the market situation does not create incentives to terminate the current policy.
The key argument in favor of such a forecast is the new approach of the US Federal Reserve presented in September – MPF (monetary policy framework). In order to achieve maximum employment, the regulator intends to keep base rates at the current minimum levels until inflation reaches 2% in the long term, and at the same time is ready to allow inflation to exceed 2% in the short term.
This approach, firstly, departs from the classic Taylor rule (the rule of monetary policy), which says that rates must be raised every time unemployment in the economy reaches an equilibrium level. Second, in the future, the Fed will strive to keep the inflation rate in the economy at the level of 2% on average – it starts targeting the average inflation rate. This means that with current inflation below the target, the regulator will have to keep rates low for a much longer period and, in fact, allow a certain overheating in the economy. The Fed does not expect the new targets to be met until 2023.
What should an investor do?
From my point of view, the new approach of the FRS suggests that even the growth of the US economy will not lead to a corresponding increase in rates, as has happened in the past. As part of its new approach, the Fed, and behind it and other leading central banks, most likely will not return to the topic of rate hikes for at least another two to three years. In this regard, for the investor and asset manager, the answers to two questions are of particular relevance.
1. What does prolonging the period of low rates for two to three years mean in terms of portfolio and risk management?
Share rate. Any drawdowns in the stock market of developed countries can be noted to accumulate medium-term positions in stocks. Equities should outperform fixed income instruments (bonds, etc.) amid accelerating global economic growth, which will certainly come next year due to the emergence of coronavirus vaccines and massive budget support from the world’s leading countries.
Weakening dollar. Additionally, it is worth looking at the continuation of the trend for the weakening of the dollar against the currencies of the G10 countries. We saw the beginning of the trend this year. Firstly, dollar interest rates have declined this year much more significantly than other G10 countries, and secondly, the dollar tends to weaken during the acceleration of global economic growth. Finally, we continue to see a growing US current account deficit.
Commodity currencies and shares. A historically weak dollar has been a good driver for commodity prices, commodity currencies and stocks. A consequence of the previous trend may be an increase in quotations in these assets.
2. What will happen when the era of “free” money ends?
In order not to miss a change in trend and assess the future consequences, it is necessary to monitor inflation dynamics, primarily in the United States. The exit of the world economy from the pandemic, the achievement of an equilibrium state of unemployment in an era of low rates may lead to the fact that we will see a fairly strong increase in inflation. This risk has been talked about for the past 10 years, but now we live within a new paradigm of the Fed’s actions, which is also an indicator for other central banks – and now inflationary risk has become higher.
Targeting just average inflation is positive for stimulating economic growth, but it means a fairly high tolerance of regulators to high inflation at a particular point in time. This position will obviously be quite popular for politicians as well. However, if, amid massive fiscal stimulus and low rates, inflation ultimately consolidates above its target on average, the Fed will have to start pursuing even tougher policies than ever before. This is unlikely to cause a positive reaction from politicians and voters, which may impede the necessary tough decisions of the regulator. We can witness the development of stagflation, when inflation is combined with an economic downturn, in the second half of the 2020s.
In the event that the world economy falls into a state of structurally high inflation, along with an increase in rates, a noticeable blow to the stock market will be dealt. To hedge from this development of the situation, investors should distribute a certain share in their portfolio in favor of gold and similar real assets. They are able to play the role of a defensive asset at both stages: they will enjoy support both in the weakening dollar, which is likely to be a trend in the coming years and in the event of possible future stagflation.