- The monetary and fiscal policy response to the COVID-19 pandemic is unprecedented, with debt-fueled government spending and ultra-accommodative monetary policies injecting abundant liquidity into the markets.
- The shift among central banks from an anticipatory reaction function to an outcome-based one increases the risks of policy mistiming and inflation.
- The COVID-19 pandemic has created massive supply chain dislocations and a less connected world, leading to an inflationary shock.
- Excessive debt slows gross growth and diverts human capital away from the private sector, resulting in slower economic recovery.
- The policy divergence between the US and China will result in capital flowing eastwards, providing a tailwind for China’s markets and economy.
- Central bank policies have exacerbated inequality by inflating the value of financial assets, leading to concerns about potential asset price bubbles.
- The underperformance of value stocks relative to growth stocks is among the most prominent features of equity markets, indicating potential investment opportunities.
- US Treasuries are no longer hedging equity risk, and emerging markets and Chinese government bonds may be alternatives for fixed-income portfolio allocations.
The resumption of business activity in the wake of the COVID-19 pandemic, ballooning central bank balance sheets, inflation’s resurgence, and the competitive dynamics between the United States and China set the stage for an enriching dialogue featuring Rob Arnott, founder and chair of Research Affiliates; Joyce Chang, chair of global research at JPMorgan; and Louis-Vincent Gave, CEO of Gavekal.
Their conversation, moderated by Brian Singer, CFA, partner at William Blair, took place at the inaugural Alpha Summit by CFA Institute in May and offered an insightful look at the policy landscape and the implications for investment strategy.
1. The Policy Response to COVID-19
The effectiveness of lockdowns has varied across the world, causing lost output and job opportunities everywhere. The monetary and fiscal policy response to the economic crisis is unprecedented, with debt-fueled government spending and ultra-accommodative monetary policies injecting abundant liquidity into the markets. One key development in monetary policy has been the shift from an anticipatory reaction function to an outcome-based one, where rates are set to rise after inflation and unemployment targets are realized. However, this increased focus on outcome-based policies raises the risks of policy mistiming and inflation.
Gave highlighted that the pandemic has created massive supply chain dislocations and a less connected world, leading to an inflationary shock. This inflationary pressure, coupled with the expansive monetary policy impulse, could result in significantly higher inflation going forward.
On the fiscal policy front, excessive debt slows gross growth and diverts human capital away from the private sector, leading to a slower economic recovery. Arnott emphasized that if the US government piles up debt without any plans to make good on it, there will be dire consequences in the long run.
2. US and China Divergence
The fiscal expansion in the United States is at a scale with few parallels in recent history, while China is already tightening monetary and fiscal policy. This policy divergence between the two largest economies will result in capital flowing eastwards, providing a tailwind for China’s markets and economy. Despite tensions between the two superpowers, inflows supported by measures to liberalize financial market access and ownership structures should continue to strengthen China’s markets. The appreciation of the renminbi against the US dollar is expected to transfer purchasing power from the Western to the Chinese consumer.
3. Inflation and Asset Prices
Central bank policies have exacerbated inequality by inflating the value of financial assets, leading to concerns about potential asset price bubbles. Global inflation is projected to be higher this year compared to last year, with a reflation tilt continuing over the medium term. The current asset price reflation could continue due to excess savings and historically low consumer debt. Arnott highlighted the importance of considering underlying fundamentals and valuations when investing, as unrealistic growth expectations can indicate a bubble. Examples include stocks like Tesla, where implausible growth assumptions are required to justify current prices.
4. Investment Opportunities
The underperformance of value stocks relative to growth stocks is a prominent feature of equity markets. The spread in price-to-book ratios between growth stocks and value stocks has reached a wide gap, indicating potential investment opportunities in value stocks. In the fixed-income space, US Treasuries are no longer hedging equity risk, leading to the exploration of alternatives such as emerging markets and Chinese government bonds for fixed-income portfolio allocations.
