The world is slowly emerging from the global COVID-19 pandemic, although the recovery will be uneven with the prospect of deadly variants looming in the background. Still, for much of the developed world, the worst is now behind us.
Unlike the 2009 Financial Crisis, the pandemic has impacted every aspect of modern life. The shutdown of economies around the world has created hardships for millions of people, especially in the hard-hit service industries. Although global commerce came to a virtual halt in the early months of the pandemic, the world’s population adapted with admirable speed, often aided by leading-edge technology now available on a large scale. Changes in work habits, like remote working and video teleconferencing, are likely to have lasting effects, leading to permanent changes in such areas as business travel and office real estate.
The recovery in financial markets has been particularly impressive, reflecting the immediate and large-scale responses of governments and their central banks to resuscitate economies from the COVID recession. The lesson learned from earlier downturns is that a strong infusion of liquidity is the most effective way to stabilize markets and the economy, saving jobs in the process.
While the infusion of liquidity pulled the global economy back from the brink during the financial crisis in 2009, the amount expended this time was many times greater. The level of deficit spending by governments has been unprecedented, with much of the debt issuance being purchased by central banks rather than actual investors. Notably, the U.S. Federal Reserve now owns $5.2 trillion of U.S. Treasury Bonds, compared to only $500 billion in 2008. This is not a viable long-term strategy.
These actions have held interest rates at historically low levels since 2009, benefitting the economy, employment growth, and politicians. In our opinion, this is economically artificial, and untenable. At some point, central banks must begin to reduce money supply. Interest rates, as a result, will start their inevitable rise, which may cause a disruptive shock to financial markets. As global credit markets are three times greater than the combined value of the equity markets, even a slow and gradual increase in rates will have a widespread impact on asset values.
This situation is further exacerbated by the fact that the current economic recovery has been strong and is already causing bursts of inflation. The question is whether the surge in prices is temporary or the start of a more established trend. A number of economists make the transitory argument, claiming the wage-price relationship is not as tight as it was in the 1970’s. With so many of the items we purchase now manufactured in low wage countries, the potential for a wage-price spiral is diminished. In addition, the advent of technology has brought a measure of productivity to the economy that has little to do with wages. However, should this higher level of inflation be sustained, central banks will need to shift away from their accommodative monetary policy.
Artificially low interest rates may have saved the economy but have also inflated the value of almost everything. In Canada, house prices have soared, driven by very low mortgage rates. Margin debt has also surged to historic levels. In the United States, there is now $850 billion in investor margin debt, 400% higher than 20 years ago. Many novice investors are using borrowed money to invest in securities without any consideration to valuations.
Central banks have already started telegraphing a rise in interest rates to start sometime in late 2022 and into 2023, or earlier if necessary. The equity market, like the much bigger credit market, will not react well to rising rates. It will be critical to own equities of companies with solid operations trading at fair values that can consistently perform in this context. Furthermore, fixed income investments will focus on short-dated bonds, as all others will suffer a material decline in value. We will continue to monitor this situation carefully for you.