For now, policy remains a tailwind
When it became clear early in 2020 that the COVID-19 pandemic stood to convulse the global economy, central banks acted swiftly, slashing interest rates to near zero and establishing programs to buy government and corporate bonds by the hundreds of billions of dollars, euros, and pounds.
The global financial crisis was fresh enough in memory to underscore the perils of not acting quickly or boldly enough. And the nature of the pandemic’s shock promised to differ from the manmade, structural shock of the global financial crisis. Solid ground would be visible across the chasm that the pandemic would create, giving policy-makers confidence that they could decisively bridge the gap.
Now, amid hope that vaccines will drive immunity and enliven economic activity this year, investors are starting to wonder what comes next. What happens when a “whatever it takes” approach to fiscal and monetary policy gives way to an unwinding of bold actions?
‘We’re still very much in the middle’ of the pandemic
Investors should remind themselves that much of the world remains firmly in the pandemic’s grip—from both human and economic perspectives—and that the policy response stands to remain supportive in the months ahead.
“We’re still very much in the middle of this,” said Josh Hirt, a U.S.-based Vanguard senior economist. “It may feel less like an emergency now, and we think we have a better understanding of an eventual end point thanks to vaccine developments. But the trajectory of the economy still very much depends on health outcomes.”
The idea, Mr. Hirt said, is to limit “scarring,” providing enough support so that reduced economic activity doesn’t turn into insolvencies and temporary job losses don’t become permanent.
Fiscal and monetary support has been unprecedented
Notes: Change in fiscal policy is represented by the change in the cyclically adjusted primary balance from 2019 through September 30, 2020.
Sources: Vanguard, U.S. Congressional Budget Office, Board of Governors of the U.S. Federal Reserve System, and International Monetary Fund, as of September 30, 2020.
The United States passed the $2.2 trillion CARES Act in March 2020 and a further $900 billion relief package in December and is considering further fiscal support. The U.S. Federal Reserve has committed to indefinite purchases of U.S. Treasuries and agency mortgage-backed securities totaling at least $120 billion per month.
The similarly accommodative European Central Bank expanded its Pandemic Emergency Purchase Programme in December to a total of €1.85 trillion (USD 2.25 trillion) and extended its purchase window through at least March 2022. On the fiscal side, most European governments have run large deficits over the last year to support jobs and businesses. The €750 billion (USD 910 billion) Next Generation EU pandemic recovery program begins disbursements this year.
Meanwhile, China—where the pandemic originated—is widely viewed as having controlled the virus effectively. Its fiscal and monetary support was modest compared with other large economies, and its economy registered growth for full-year 2020.
“Life was largely back to normal in the middle of last year in China,” said Alexis Gray, a Melbourne-based Vanguard senior economist. “People were going back to offices, and restaurants and cinemas were open. There have been some regionalized outbreaks, but those have so far been squashed. So if you look on a national level, life is for the most part normal, which is obviously very different to what we’re seeing in the United States and in Europe.”
Easy monetary policy means easy borrowing terms
Note: The forecast represents 3.5% nominal GDP growth, an average debt interest cost of 1.2%, and a 2.5% budget deficit.
Sources: Vanguard calculations, based on data from Refinitiv and the International Monetary Fund, as of September 30, 2020.
The confluence of fiscal support and accommodative monetary policy isn’t coincidental, said Shaan Raithatha, a London-based Vanguard economist: “Emergency quantitative easing programs have helped financial conditions remain easy. This, in turn, has allowed governments to borrow large amounts of debt in a more sustainable way.”
With COVID-19 still raging, Mr. Raithatha doesn’t foresee monetary policy normalizing for at least the next 12 months. In Europe, he said, the risks are actually skewed toward further acceleration of quantitative easing purchases in the short term amid tighter virus-containment restrictions.
The low-interest-rate environment should help governments avoid the sorts of restrictive austerity measures that prolonged recovery from the global financial crisis, most notably in Europe. Government borrowing to finance the recovery from the pandemic is locked in at today’s ultralow rates, Mr. Raithatha noted.
“As long as nominal GDP growth rates exceed the nominal cost of debt and budget deficits start to normalize from their current exceptional levels, which you’d expect once the threat from COVID-19 has passed, government debt-to-GDP ratios are likely to gradually fall over time,” he said.
How will investors react to a bump in inflation?
Although the fight against the pandemic remains front and center, ever-forward-looking investors have begun to fret about the timing and implications of an unwinding of support—something that the Federal Reserve said on January 27 was premature to consider. Here again, recovery from the global financial crisis holds the power to inform. In what became known as the “Taper Tantrum,” U.S. Treasury yields spiked upon news, in 2013, that the Fed would trim asset purchases. This time, the Fed emphasizes that eventual scaling back of asset purchases will be clearly signaled well in advance.
Reversal of quantitative easing is a logical first step toward policy normalization, for which the benchmark interest rate is the primary lever. Investors’ underlying fear is that inflation could drive rates higher—and a test may lie ahead. “We anticipate a decent bump above 2% inflation in the United States sometime in the middle of the year,” Mr. Hirt said. “What does this do to investor psychology?”
Vanguard believes that this bump will be transitory, in part because of base effects, or low year-earlier comparisons, and that structural forces will keep full-year U.S. inflation below the Fed’s 2% target. It should be noted, too, that the Fed in 2020 adopted an “average inflation targeting” strategy, allowing inflation to exceed its target without fostering a rate hike as long as inflation averaged 2% over time.
“There is a risk for portfolios,” Mr. Hirt said, “that in a well-supported policy environment the eventual vanquishing of the pandemic unleashes strong demand and ‘animal spirits’ that could influence inflation psychology, pressuring the Fed to act sooner than currently anticipated.” Such a scenario could engender capital losses in bond portfolios and remove some of the justification for the higher valuations currently supporting equity markets.
Vanguard doesn’t anticipate such a scenario this year. As we note in the Vanguard Economic and Market Outlook for 2021: Approaching the Dawn, we see it unlikely that short-term rates will rise in any major developed market as monetary policy remains highly accommodative. And we see global equities as neither grossly overvalued nor likely to produce outsize returns.
An ever-present risk for investors, meanwhile, can be trying to outsmart the market as to when—and whether—potential scenarios play out. That’s why we advocate that investors follow Vanguard’s Principles for Investing Success: Set clear investment goals, ensure that portfolios are well-diversified across asset classes and regions, keep investment costs low, and take a long-term view.
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