Recovery continues but at a more sustainable pace

The global economy continues to recover from the short, sharp pandemic slump that occurred through the first half of 2020. While the pace of recovery has slowed back to a more sustainable pace from the 2020/21 surge, the outlook remains positive. That said, the global economy is facing into stronger headwinds with challenges including:

• the spread of the more contagious Delta variant
• China restructuring towards the consumer, including getting serious about curbing excessive debt-fuelled property speculation, with the crisis surrounding property developer Evergrande a prime example of this shift
• soaring energy prices following supply shortfalls in commodities including gas and renewable energy production
• an intensification of consumer demand for goods, pressuring global supply chains and causing prices to rise.

Let’s face into the headwinds

Close to 50% of the world’s population now has some immunity to COVID-19 ^[1] . Steady vaccine progress has seen the pandemic become a much-reduced drag on economic growth - while the rapid spread of the Delta variant has been more challenging, vaccination rates have dramatically reduced hospitalisations and deaths. The pandemic isn’t over yet, but many parts of the economy have shown an ability to continue ‘business as usual’ with other sectors now benefitting from re-opening.

For China, new consumer focussed policies will hinder economic growth in theshort term but mark a welcome re-orientation of the economy. Debt-led property investment has pushed housing prices in China’s major cities to completely unsustainable levels that would make even Australia’s property boom pale into insignificance.

The severe shortage of electricity in China is due to a reduction in imported coal, weaker hydroelectric outputs due to drought, and government emission reduction targets that has forced coal mines to close. The shortage has caused blackouts and a need for energy rationing and is another factor shifting China towards lower but more sustainable growth.

While concerns about a permanent lift in the price of goods and services (inflation) are credible, central banks have undershot their inflation targets for some time and are still committed to getting back to target ranges. We think the current lift in inflation is temporary, but should labour shortages and rising wages become permanent, inflation would rise well above the central bank targets. The key risk is of higher inflation becoming entrenched, slowing growth draining policy support much more rapidly than currently expected. This would result in rapidly slowing earnings which would result in share market disruption.

The demand for consumer goods remains high, but many sectors haven’t been able to get production back up and running quickly as economies have re-opened and this has caused prices to lift. We consider that supply chains will eventually respond and the spike in the price of consumer goods is likely to ease as supply is ramped up, although this could take some time.

Putting it into perspective

While the headwinds we’ve outlined have contributed to the recent pause in markets, we shouldn’t forget the incredible bounce back we’ve seen since the pandemic-driven recession. Considerable, unprecedented levels of policy support were put in place to sustain the recovery so it’s expected that markets will become concerned that this extreme policy support will eventually be removed.

Now Australia has relatively high vaccination rates re-opening can begin. While slower Chinese growth may challenge the local economy, particularly as it has driven the recent plunge in iron ore prices, this has been offset by a surge in coal and gas prices. Although we don’t expect energy prices to continue to rise through to 2022, this is supporting the Australian dollar and economic activity for now. We also consider the Reserve Bank of Australia (RBA) is likely to keep policy highly supportive next year (2022) as the economy continues to heal.

What may be ahead?

Most market challenges should ease in time. While the outlook has clearly softened, supports remains in place with policy still incredibly stimulative and expected only to be removed gradually. Economies are continuing to re-open and social distancing will become less of a growth inhibitor.

This does not mean that the high ‘pandemic bounce back’, double-digit returns will last. We expect solid but more modest returns as the recovery matures, as growth eases and costs rise.

We believe we’re a long way from any sharp drop in economic growth that would justify more caution and a much lower allocation to growth assets such as shares. All up, it’s still a positive market outlook story.

By Dan Farmer, Chief Investment Officer

[1] Our World in Data, Data as at 25 October 2021 - https://ourworldindata.org/covid-vaccinations

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