For now, policy remains a tailwind

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.

Vanguard’s chief economist for the Americas, Roger Aliaga-Díaz, explained the fiscal math behind debt sustainability in a June 2020 blog.

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.