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While little has changed in my view of the global economic outlook, the policy framework is shifting profoundly, and I believe this will have important and long-lasting implications for markets in the years ahead.
The data has confirmed what we already knew: the global economy contracted at an unprecedented speed and scale during the first half of this year. Activity has since rebounded sharply, as the latest reading from our proprietary Global Cycle Index (GCI) confirms (Figure 1). While this is the third consecutive month of improvement for the GCI, the gains are modest and the level remains well below its pre-COVID level. That said, I expect the global economy to recover more lost ground over the rest of this year, with China and Asia more broadly leading the way.
But there is so much more to think about in the current macro environment than how fast the economy returns to normal.
Ironically, while macroeconomic themes have rarely been more critical, it’s hard to think of a time when the macro data has mattered less for markets. Quantitative easing (QE) has created a record gap between the GCI and equity prices. Central banks know how to prevent deflation and ensure markets remain liquid, and their actions have impacted every price on our screens.
But it isn’t just the unprecedented monetary response that matters. The pandemic is permanently changing policymakers’ objectives. And that could have a lasting impact on private-sector behaviour, with or without a vaccine.
The nature and objective of monetary policy has changed dramatically.
Historically, the role of an independent central bank was by design simple, transparent and clear — generate the conditions for low and stable inflation. But over time it has become more complicated, obscure and unclear. In the course of my career, I’ve never seen central bankers as confused as they are now. As politicians, the market and even some central bankers have lost faith in the merits of low and stable inflation, central bankers have increasingly pursued other goals — from seeking to narrow income inequalities within society to promoting efforts to combat climate change. These are admirable goals, but they encroach on the agenda of elected officials and erode central bank independence.
A recurring theme in my conversations with central bankers over the past five years has been their loss of faith in their own models, their ability to forecast and their understanding of how their tools feed through an economy to generate inflation. They react, but they acknowledge that they are reacting in the dark. If QE failed to generate inflation, maybe they just hadn’t done enough? If setting interest rates at zero fails to generate inflation, should they just push rates into negative territory? And, if their policy tools aren’t working, shouldn’t they keep them in place for longer and longer periods? Faced with diminishing returns on the economy, central bankers have ventured deeper into unconventional policy. Even as central bankers have lost confidence in their own abilities, their importance for and standing in the markets has reached new heights.
The only thing central banks are sure about is what they want to avoid. They will not accept the market pricing of risks. They have effectively put a guarantee on the price of all assets. In addition, central banks and governments have increasingly forced banks to lend, with their guarantees. So not only money creation but also credit distribution has become nationalised. And since allowing markets to determine rates will make the government and private-sector debt loads unaffordable, policymakers won’t let that happen. It has never really been about fixing the problem but avoiding the consequences. Similarly, on the fiscal side, the policy of guarantees is now creeping into society.
The nature of fiscal policy is changing too.
The fiscal response to the pandemic has been unprecedented because the shock has been unprecedented. Governments urgently needed to soften the blow as the private sector was forced to hoard cash. While the next round of fiscal support in the US is critical for near-term developments, it is proving difficult to deliver. But more fiscal support is coming and will remain a persistent feature for most countries.
As with monetary policy, it isn’t just the scale of the fiscal policy being announced. The nature of it is changing too. So far, the fiscal response has been less about supporting discretionary spending and raising productivity and more about lowering the cost of unemployment and providing credit to companies irrespective of demand and viability. If these higher guarantees remain in place, the incentives for the private sector will change. As in asset markets, the downside will have less cost, so behaviours will change accordingly and prices will adjust.
But whereas central banks’ policy prescription has been similar across the globe, the fiscal response is likely to have different shades. Already, we have seen the US subsidising unemployment benefits while Europe has instead chosen to nationalise wage bills. For investors, it will be important to understand the political objectives and different responses, as these are creating more idiosyncratic country investment themes.
This is a big topic which I think will have profound consequences for markets and economies as well as individual companies. A few of the implications for the medium term are likely to be more volatile economic cycles, lower productivity, lower trend growth, rising inflation and ever higher government debt. For markets, the period of central control will continue, putting a higher value on assets with fixed supply.
While none of these forces is set in stone, the probabilities have shifted. Central banks haven’t been able to generate inflation, as they have failed to change the incentives for the private sector or to raise the natural rate of interest. But their guarantees have certainly generated asset price inflation. More fiscal support won’t necessarily generate inflation either. But, by permanently raising the value of their guarantees, governments may be able to change private-sector behaviour, if they can avoid the perception that more fiscal support today will just mean higher taxes in the future. Whether they succeed remains to be seen, but the momentum is moving in that direction. And the implications for markets are profound.No