Covid continues to restrain the recovery

It now looks increasingly likely that the global economic growth rate peaked in May this year. While output is still expanding, it will probably increase at a slower pace in the second half of the year than the first.

Unusually, the deceleration is not just about demand – it also reflects problems with supply. This is starting to show up in economic data. For instance, the UK’s Office of National Statistics said last month that growth slowed to a negligible pace over the summer due to falling construction activity: “delays in the availability and sourcing of construction products (notably steel, concrete, timber and glass) were the main reason for the decline.” Shortages and bottlenecks throughout the global supply chain will take time to resolve.

The continued spread of coronavirus – and countries’ relative success at vaccinating their populations – has also caused significant divergences to emerge between regions.

The impact of the pandemic is now greatest in many emerging markets, where vaccination rates remain low. Europe, by contrast, is faring relatively well. For the first time since 2007, its economy is set to expand at a faster pace than the US. After a slow start, many eurozone countries have now vaccinated a higher proportion of their populations than the US, fuelling their rebound. Europe’s furlough schemes have also made it easier for businesses to get staff back to work, avoiding the labour market challenges of the US.

Against this backdrop, markets have continued to perform well, with the MSCI World All Countries World Index up 11.3% to the end of September (in sterling terms). Equities have benefited from an impressive rebound in corporate earnings as well as the fall in government bond yields over the summer. This source of support may be falling away as yields start to rise again.

The evolving growth outlook has had an impact on the pattern of returns. After rallying very strongly early in the year, more cyclical sectors have made little progress since May as the recovery has lost some momentum. Growth sectors, whose earnings are less dependent on economic recovery, have since taken the lead and pulled indices higher – especially in the US.

Value still leads the way but growth is catching up

Performance of global growth and value sectors following news of successful Covid vaccine

^{Source: MSCI, Refinitiv Datastream, Cazenove Capital}

Central banks planning to scale back support

Economic activity will likely remain strong enough to allow the US Federal Reserve to slow its asset purchase programme later this year. It may begin by reducing its purchases of mortgage-backed securities (currently $40 billion per month, alongside $80 billion of US Treasuries). Given the strength of the US housing market, this seems an unnecessary level of policy support. There may also be recognition that monetary policy cannot help fix the supply chain constraints facing the US economy. In fact, stimulating the economy in a period of supply shortages could be counterproductive.

It also looks very likely that the European Central Bank will end its Pandemic Emergency Purchase Programme (PEPP) as planned in March next year. “The first P in PEPP stands for pandemic, not permanent,” quipped the President of Germany’s Bundesbank. This means that the ECB’s asset purchases will fall from some €240 billion per quarter currently to €60 billion by the second quarter of 2022.

So far, the market reaction has been subdued. This is in marked contrast to the “taper tantrum” of 2013, when the start of policy normalisation caused bond yields to rise sharply, in turn unsettling equities. Some of today’s bond market investors may be taking the view that the right response to the end of monetary stimulus is to buy rather than sell bonds: if it does lead to a further growth slowdown, demand for the safe haven of government debt may only increase.

Inflation settling at higher base

Central bankers’ view that this year’s spike inflation would be transitory continues to hold sway. US inflation reached 5% earlier in the year as oil prices rebounded and companies raised prices amid strong pent up demand. The latest data suggests that US inflation is moderating and we should see it falling back towards 3% by year-end.

It is possible that inflation will return to its pre-pandemic patterns, when it was persistently below central bankers’ targets. However, we think this is unlikely. Ongoing supply chain bottlenecks will continue to exert inflationary pressure, as will the rising price of many other commodities, such as aluminium and natural gas. As labour markets continue to recover, rising wages could push inflation even higher.

Investors have been relatively sanguine about the tapering of monetary stimulus, but inflation that is persistently closer to 3% could trigger sharp rotations, and possibly corrections, within equity markets.

US inflation set to remain above pre-pandemic levels

US inflation has moderated, but this isn’t expected to last

^{Source: Schroders Economics Group, September 2021}

20 years since 9/11

America’s controversial withdrawal from Afghanistan is unlikely to have near-term consequences for global investors. However, it is a reminder of the huge political and economic shifts that have taken place over the past two decades.

Perhaps the biggest change has been the emergence of China as the key global geopolitical competitor to the US. Joe Biden was clear that the withdrawal will allow the US to shift its strategic attention to Asia. Relations between the US and China remain tense and there could well be further tussles over trade and technology. As we saw in 2018, these can be a significant headwind to global growth.

There is plenty else to keep investors involved in China preoccupied. While the ongoing regulatory interventions - and the uncertain outlook for the property sector - could cause further volatility in the near term, we continue to see a long-term case for Chinese markets.

The huge rise in government debt has perhaps been the other key macroeconomic change. US military expenditure has been an important contributor – but the response to successive economic crises has been the bigger driver. US federal debt to GDP now stands at well over 100%, almost twice the level at the start of the millennium. Other developed markets face a similar burden, prompting the UK government to push through an unpopular tax rise. Public debt is not currently a concern for markets. But it has been in the past – and could become so once again.