Quarterly Outlook: An investor’s inflation and growth playbook

Fri 16 Jul 2021

Investing during the past twelve years has been underpinned by a basic principle: market participants have been encouraged to take risks, mainly to offset the trust shock that came with the 2008 financial crisis (GFC). Each time equity prices have fallen significantly, the Federal Reserve, the world’s de facto central bank, would suggest an increase in money printing, or actually go ahead with it if volatility persisted. Bond prices, meanwhile, kept going up, as central banks and pension funds were all too happy to relieve private investors of their bond holdings even at negative yields. Market risk was all but underwritten. The Federal Reserve always knew that the strategy came with limitations and often tried to disengage from it. It ceased asset purchases in early 2015. Consequently, for two years until 2017, US stocks gained a mere 3.9% per annum, as opposed to the 10%-11% in the previous years.

Still, the US tax reform swiftly projected after the Republican party’s 2016 electoral gains spurred a significant stock rally for a year and, for a brief time, equity returns and Fed asset purchases decorrelated. The Fed took advantage of the bullishness and started reducing its balance sheet very slowly in early 2018. Until it resumed asset purchases in September 2019, US stocks yielded a total of just 4.15%, or 2.5% annualised. On resumption, and with the balance sheet more than doubled from $3.7tn to nearly $8tn after Q3 2019, US stocks have gained nearly 50%, or 25% per annum. With one brief exception, (Trump’s tax reforms ), monetary accommodation has consistently been the ‘only game in town’ for risk assets.

For years, our basic approach to investors has been that ‘over the longer term you should be comfortable with some risk (appropriate to one’s profile), as risk is encouraged and underwritten by central banks. During downturns we would re-emphasise the point and wait for the Fed to step in. When asked ‘what can end this singular factor that would drive asset prices up or down?’ the answer was ‘we don’t know yet, but it’s our job to tell you when we see it’.

We believe that this is a time worth considering the question again.

In 2021, a new US president, Joe Biden, was sworn in. Markets rejoiced in his choice for the Secretary of the Treasury, Janet Yellen, a former Fed Chair and a policy dove. Ms Yellen, fully aware that the Fed could not forever alone shoulder the burden of the economy, came up with a very ambitious plan to proceed with unprecedented fiscal stimulus. The money reserved for investors was now to be redeployed in the real economy. 

We immediately recognised this development as a potential paradigm shift. In the next few pages, we will discuss how possible, or plausible, it is that the way we have invested in the past decade, may have come to an end.  We will examine four scenarios: a) A return to ‘Secular Stagnation’, b) A brief ‘Stagflation’ (stagnation + inflation) interlude, c) A ‘Managed Growth’ scenario, by which the US government achieves its exact objective and d) a ‘Breakout Velocity’ scenario that would see a re-empowered consumer and a material pickup in investments in the real economy.

However, before one proceeds with reading, we need a caveat: When asked to rethink how the post-Covid world might be reshaped, one needs to see the present and the past as it is, not as it should be. This publication maintains a healthy modicum of irreverence for historical narratives on the nature of inflation and fiscal stimulus that may pose a challenge to economic orthodoxies.