The Covid-19 crisis is exceptional in many ways. It is the most serious health crisis since the Spanish flu a century ago. This crisis resulted in an unprecedented contraction of activity in 2020 and in the deepest global recession since World War II. However, this recession has been the shortest and was not accompanied by a financial crisis thanks to fiscal and monetary policy responses, which have cushioned the economic shock. The exceptional measures put in place aim to buy the time needed to emerge from the health crisis.
The pandemic is not over yet, and is not even under control in many countries, especially in emerging market (EM) economies. However, the ongoing vaccination campaigns are paving the way for a recovery, at least in most developed economies (DE). Uncertainty about the global economic outlook remains high, mainly due to the evolution of the pandemic. After an estimated contraction of 3.3% in 2020, the IMF expects global GDP to grow at 6.0% in 2021, moderating to 4.4% in 2022. Real GDP growth has been revised upwards since the beginning of the year thanks to additional fiscal support in some major economies and the (expected) success of the vaccination campaigns.
Global growth is expected to moderate in the medium term, due to lower supply potential and ageing populations (lower working-age population growth) in both DM and EM economies. History has taught us that major pandemics leave deep scars on the economy. Thanks to the unprecedented policy mix, the Covid-19 crisis should leave fewer scars than the Great Financial Crisis (GFC) in advanced economies. This may not be true in emerging economies, which have been hit harder than advanced ones.
The absence of a financial crisis does not mean that the foundations are strong. The Covid-19 crisis has damaged significantly the global economy. Economies have become more fragile. Output losses have been particularly large for countries that rely on tourism and commodity exports and for those with limited policy space to respond. Inequalities have increased: young people, low-skilled workers, and women have been particularly affected, especially in emerging economies where an additional 95 million more people fell below the extreme poverty line in 2020. Income inequality has increased in both advanced and emerging economies.
As a result, the balance sheets of households, companies and governments have deteriorated on a global scale. Even without a financial crisis, these developments may require restructuring and recapitalisations in the medium term, which may be costly for both governments and taxpayers. Since the onset of the pandemic, governments have relied on expansionary monetary and fiscal policies to offset the sharp declines in economic activity associated with widespread lockdowns and containment measures. DE had a decisive advantage in their ability to respond.
The measures have provided relief to households facing declining incomes, as well as to businesses, particularly in the service sectors subject to lockdowns. Credit conditions have remained artificially accommodative. However, these support measures will have to end eventually. An early tightening of credit conditions could have a severe impact on small- and medium-sized enterprises (SMEs) and on low-income households, which could dampen the prospects for economic recovery. Many emerging markets have already reached the limits of what their monetary policy can do.
The high level of corporate debt in the run-up to the pandemic may amplify the balance sheet problems of the financial sector. In the United States, China, and some European countries, companies are highly leveraged. The sharp increase in dollar-denominated corporate debt is undermining emerging economies. It will take time to repair balance sheets. There will be a long period of deleveraging ahead with banks being more cautious in their lending.
Many questions are unanswered, especially since uncertainty remains high. When should governments stop supporting their economies? When should central banks (CB) abandon their zero or negative interest rate policies or their quantitative easing (QE) measures? How should authorities ‘accompany’ the changes brought about by the crisis? How high can public and private debt levels rise? Will inflation come out of the crisis? If so, how will central banks react? Finally, on a structural note, how can governments correct the inequalities that have increased with this crisis and how can they make growth more inclusive?
The short-term outlook remains closely linked to the health situation in each region and to the effectiveness of economic policy measures. There are no simple answers: this is an environment that can lead to economic policy mistakes. The questions raised go far beyond the economic order alone. The new social and political issues are also challenges that need to be addressed. Interest rates are being kept artificially low in DE to protect the productive system and employment. Looking ahead, central banks’ policies will be decisive in anchoring inflation expectations. The private and public debt-to-GDP ratios have reached new records worldwide.
De facto, these debts have been partly monetised in the major advanced economies. The absence of inflation allowed CBs to pursue the same objective of economic stabilisation ‘hand in hand’ with governments. Looking ahead, conflicts between objectives may arise. While the duration and severity of the pandemic -- and the short-term economic trends -- are exogenous, the medium-term scenarios are to some extent endogenous, as they will depend on the behaviour of private (corporates and households) and public (governments and CBs) players following the crisis.
This is a period of multiple regime changes for which investors should be prepared. Under the new regime, inflation will be higher and real growth will be slower. This will challenge portfolio construction, as the traditional 60/40 approach should no longer deliver appealing risk/ adjusted returns in a world of lower expected returns for asset classes compared to the last decade. As such, the equity share of any balanced portfolio should be higher structurally, focusing on those stocks that could offer protection against rising inflation, a sort of real asset. There will be challenges also on the fixed income share: if inflation expectations are de-anchored, there might be rising pressure on bond yields and, consequently, investors should embrace a short-duration approach. Traditional fixed-income benchmark exposure, with high duration risk and low implicit yield, should leave the space for a flexible allocation across the full fixed income spectrum.
Here, we consider three possible dimensions of regime change: the first concerns the level of growth and inflation, the second concerns the volatility of the economic cycle, while the final one concerns economic policy, and more specifically the articulation between fiscal and monetary policy. These dimensions are interlinked with each other. The sequences are uncertain, particularly in the economic policy area. The monetary policy rules (e.g., Taylor rule), to which investors had become accustomed, have de facto disappeared from the radar screen. The Covid-19 crisis will give way to a more turbulent system, which is by its nature prone to policy mistakes and in which investor expectations may themselves be subject to jolts. These changes have deep consequences for investors’ asset allocation, which we attempt to summarise in the final section.