Jacob Vijverberg, Investment Manager, Multi-Asset Investing at Aegon Asset Management:
The world economy is at a crossroads. It may continue to navigate the recovery successfully in line with our baseline scenario, keeping inflation at bay and growth steady. However, there are three other potential outcomes: the roaring 20s (reprise); inflation or the gloomy prospect of Japanification.
Below, we look at how these alternative economic scenarios might play out.
There may be no flapper dresses or prohibition, but there are similarities today with the ‘roaring’ 1920s, a decade of strong economic growth. There is the potential for a catch-up in deferred spending. With shops and restaurants closed, and holiday travel limited, there has been less consumption – mainly on services – and higher savings and this may bounce back strongly.
Faster technology adoption could lead to higher productivity growth. Equally, companies may be more willing to spend. Many of them reduced corporate investment in 2020 to preserve capital and liquidity. Now that the economic situation has improved, these companies can restart their investment programs to expand capacity. In particular, companies that have seen supply chain disruption are likely to invest more in domestic capacity to improve their resilience to future shocks.
Another interesting similarity with the roaring 20s is infrastructure spending. A century ago, mass-produced vehicles became commonplace in the western world, requiring large scale infrastructure investments such as roads and bridges. At the same time, the adaptation of phones resulted in telephone lines being strung across continents. Today, governments have established vast budgets to support the energy transition and replace creaking infrastructure.
A roaring 20s scenario would see higher inflation and a stronger labour market recovery. Risky assets would be the preferred asset classes, while safe-haven assets – especially government bonds – could come under pressure.
Global inflation has been in a downward trend over the past decades, variously attributed to globalisation, lower wage pressure, technological advancements and demographics. This has sharply reversed since the start of 2021 and economists are now debating whether it will remain high for an extended period.
Structurally higher inflation is plausible. In general demand has been more resilient than initially feared and companies haven’t been able to raise production to match it. This is currently leading to supply chain disruptions, on top of Covid-19 related disruption, resulting in temporary shortages and higher prices.
At the same time, central banks have followed loose monetary policies. When the liquidity created finds its way into the real economy, this could result in inflation. Wage inflation is picking up due to tightness and friction in the labour market. Companies are also facing higher costs: first, from a reversal of outsourcing to low wage countries as the pandemic revealed the vulnerability of complex and international supply chains, but also due to large-scale investment plans to improve infrastructure and boost renewable energy
In an inflation scenario we would expect assets with a positive inflation link – such as commodities – to do well. Eventually, we believe policymakers will act if inflation becomes persistent, lowering the asset buying programs and raising policy rates. In this case, interest rates on government bonds would shift higher, resulting in negative returns on government bonds. Equities could prove volatile in the short-term, but should perform well in the medium term.
Perhaps the gloomiest scenario is one of weak economic growth, low inflation and low interest rates, akin to the situation in Japan in the 1990s, when the country entered its “lost decade”. Growth could disappoint if a new vaccine-resistant variant emerges or the global economy proves more scarred than currently expected. A fall in GDP or a slow recovery is likely to have a disinflationary impact, as unemployment will be higher and capacity usage low. With rates already low, central banks will be limited in their policy options to get inflation back to their targets.
Although Japan’s history is unique, it is worth noting two factors where the Western world and Japan have similarities: high public debt ratio and weak demographics. While Japanification remains an outside option, it is still possible.
In a Japan-like scenario, central banks will keep policy rates low in an attempt to support inflation and economic growth. In this scenario, real interest rates – despite the low inflation – will remain low or even negative. Assets that benefit from low interest rates, such as long duration government bonds, should perform well. Equities, in contrast, would face headwinds.