Concerns about the pace of the global recovery are creating conflicting currents as key indicators point to slowing growth even as stock markets continue to hit new highs.
The two main drivers of an unstable outlook for economic growth are a moderate China slowdown, and the impacts of the Delta strain of the COVID-19 virus currently causing population mobility restrictions in many locations across the world, including Australia.
Expectations are already high Australia’s economic growth will contract at least 1 per cent in the September quarter, according to the Reserve Bank of Australia (RBA). The RBA has not ruled out two consecutive declines, which would signal a technical recession, but it considers this unlikely.
The RBA’s outlook
In fact, although the RBA is a conservative institution, it’s outlook, by many standards, is positively bullish.
In its August Statement on Monetary Policy, the RBA outlook includes:
- Implied full year economic growth of 4.8 per cent in 2021 and 4.25 per cent in 2022.
- Assumes majority of population vaccinated by year end, allowing for less onerous population mobility restrictions in the latter part of the year.
- Remains on track to start winding back stimulatory measures currently in place to support the economy, indicating its outlook is skewed to continued economic recovery.
Broadly, we view the RBA’s outlook as reasonable, although we have deeper concerns that risk remains skewed to the downside if controlling the pandemic and implementing the vaccine rollout hits headwinds.
On this basis, our 2021 economic growth forecast is a little lower at 4.5 per cent, as is our 2022 forecast of 3.8 per cent growth.
This fits in with out global view that although there is evidence the world has ‘learned to live with Covid’, in the sense that increases in social distancing no longer damage gross domestic product (GDP) to the same extent as in mid-2020, it remains the case that restrictions on mobility – either government-led or self-induced – creates downside risks for activity.
Yet even as economic data creates growth uncertainty, indicators continue to point to rising inflation, especially in advanced economies. We believe this is mostly due to impacts on global supply chains.
Focus on supply chains
Prior to the pandemic, supply chains were already on our radar as a bottleneck to growth, as years of uncertainty and a lack of confidence in consumers had led businesses to meet demand, rather than build up stock in expectation of rising consumer demand.
COVID-19 exacerbated the problem, through a combination of crashing demand, uncertainty and manufacturing bottlenecks.
Supply chain issues are difficult for investors to track, but we can see the impact in Australia through the housing market.
One way to distinguish between transitory and more persistent inflation is through housing-related costs. Rents and owner-occupier dwelling purchase costs are the two largest components in the consumer price index (CPI) basket. While it’s true that some temporary supply chain disruptions would raise the cost of housing items in the short term, these costs will only continue to be passed onto consumers if demand remains firm.
We have examined housing related costs and find that price increases will likely remain orderly. This strengthens our view that the current outbreaks of inflation are transitory and will dissipate, allowing central banks to retain accommodative monetary policies and deliver an orderly transition out of numerous stimulatory packages designed to maintain liquidity and confidence in financial systems.
Why are equities going higher?
If we track back to December last year when the Delta coronavirus variant was first detected in India, the global outlook was strongly positive. Many parts of the world appeared to have the pandemic under control and as populations emerged from lockdowns, consumer spending spiked rapidly.
The global spread of the Delta strain has placed additional burdens on economies, as seen locally with additional government subsidies to support locked down workers on the east coast of Australia, with a particularly strong impact on the greater Sydney area.
Unlike the last series of lockdowns last year, this time we have vaccinations to help break the nexus between infections and impacts on mobility, which although still in the ramp-up phase to get major population centres vaccinated in most countries, provides a pathway for a more open world in 2022.
As share markets are forward looking, rising market indices indicate an expectation for a rapid recovery from the current bout of lockdowns once they are removed.
At 7584.30 at the close on August 11 the ASX200 was at a record high and up 15 per cent since the start of the year, according to Bloomberg.
Other key indices like the US S&P500 and UK’s FTSE 100 are also at record highs, according to Bloomberg.
This leads us to the global trends we are seeing. These include:
- We currently have US GDP growth at 10% and inflation at 5% however we are beginning to see US treasury yields decline instead of going higher. A decline in yield is typically associated with slowing growth, so falling yields could be telling us that there are future growth concerns on the horizon.
- Equity market indices continue to make new highs, however if we look a little deeper we can see that the market breadth is very thin. This means that the rally is led by a few stocks while much of the markets underlying are not making new highs. This signal could suggest that the rally is becoming exhausted.
- We also have risk currencies selling off. The Australian dollar is down from its peak of US80c to below US0.74c. much off this sell-down is associated with the unwinding of the relation trade which involves selling commodities and commodity currencies and rotating back into growth sectors such as technology. More recently it has also been negatively impacted from the recent lockdown from the delta variant and low vaccination rates, and falling iron ore prices.
The combination of lower US yields, a flatter yield curve and lower commodity prices could suggest the market is concerned about growth slowing. If we look at the Citi economic surprise index it has also been on the decline, this index compares the current growth readings relative to market expectations and while economic growth remains very strong, the growth is disappointing relative to what is now very high market expectations.
This is partly because much of the economic growth has been a result of a sugar rush on the back of fiscal stimulus. Once it fades, we could be left with weak underlying structural growth and a poor appetite for credit, which can be seen in the decline of money velocity in the US. The pace of US consumer goods spending is cooling after the stimulus fades.
Will US inflation spread across borders?
The US Federal Reserve remains focused on inflation being transitory, and the bond market as well as inflation derivative markets agree, with both coming off their highs as the reflation trade is being unwound. Much of the high inflation prints are in transitory items, amid an expectation that supply bottlenecks are a resolvable issue.
Inflation expectations are falling as the Fed has signalled it won’t tolerate runaway inflation. It is no longer closing its eyes and screaming ‘transitory’ - instead it has shown it is prepared to act.
Bond yields have fallen as we continue to see seasonal weakness in US data through the winter, especially US employment. A big part of the drop in yields is driven by the Fed’s bond purchases, which is less needed when the market has become more comfortable with inflation risk.
We doubt the COVID-19 Delta variant will derail overall risk sentiment, but admittedly some countries/regions will fare better than others over the summer. For economies where vaccination coverage is high, the early signs are that major vaccines are effective in preventing severe disease and death from the variant. But this leaves many emerging markets facing the risk of renewed stringent lockdowns.
What should investors do?
Our analysis suggests earnings and margin forecast look most unrealistic for consumer staples and utilities given higher costs we model for next year. However, healthcare and financials are showing fewer extreme assumptions on margins relative to history. We currently favor a barbell approach with both quality defensive and financials.
The healthcare sector also tends to do well even if the rate of change on economic growth is declining given their predictable earnings and relatively attractive valuations. The other side of the barbell strategy utilises financials which perform well should long end yields rise. The combination of these two sectors provides a strong diversification approach for portfolios.
Any advice is general advice only that does not consider your individual situation. The content in this document is based on objective, verifiable facts and analysis performed by the Citi research team and is not in the interests of Citi’s research staff, the product issuer(s) or any other party.