Was the pandemic a one-off shock? Do pre-Covid trends reassert themselves, or does the crisis open up the possibility of something more transformational, akin to Roosevelt’s New Deal program of the 1930s? Talib Sheikh, Mark Richards and Matthew Morgan argue that the combination of expansive monetary and fiscal policy, focussed on a green agenda, mean the world could be a different place than many expect.
Investors like to call the market crash of Q1 2020 an “exogenous” event, a “black swan” – perhaps another way of saying that at least this time, it’s not anyone’s fault. Many of us can remember the opprobrium heaped on the financial services industry – not without good reason – after the crisis of 2007-08. That crisis had a profound disinflationary effect: the debt overhang, austerity, the overhaul of the banking system, combined with ageing populations and globalisation, led to a decade of low productivity, growth, and inflation, despite zero interest rates and QE.
It may be natural to see the Covid crisis through that same lens. Many of those trends were accelerated: global indebtedness increased, demand and output collapsed, unemployment is likely to remain elevated. As the world eventually returns to some new normality, why wouldn’t the old regime reassert itself?
Two reasons make the picture more complicated
The first is monetary policy: we have been saying since Fed Chairman Jerome Powell announced the conclusions of the Federal Reserve’s (Fed) framework review last September that we are seeing the most significant change to central banking in forty years, and other central banks will follow suit. We’ve covered this elsewhere in much more detail: The Fed’s strategy is now “outcome-based” rather than “outlook-based”. Fixed income markets and chatter about early tapering suggests that this shift in reaction function isn’t yet fully priced.
The second reason is the increased influence of the state. The pandemic forced governments to intervene in ways we would never have thought possible, such as direct lending, furlough schemes and cash payments. These emergency measures will pass, but a desire to make a safer, fairer world will persist. This is likely to encompass supply chain management, global trade, and wage distribution, but it’s also at its heart a green agenda.
Many see environmental policy as a drag on growth from increased regulation. We see it differently: it can unlock barriers to fiscal expenditure, in particular infrastructure investment. This can potentially have a materially positive impact on global growth. We are seeing climate change coming up the list of voters’ priorities, and that’s helping political reality move in the same direction.
Europe saw a deep period of austerity after the financial crisis. Not only was the European Central Bank (ECB) much slower and more reluctant to implement innovative policies than the US, but fiscal policy was much more restrictive. The sovereign debt crisis of the early 2010s showed the danger of the debt burden and the difficulty of finding a solution acceptable to both the indebted and their creditors. It led to a stricter implementation of the EU Stability and Growth Pact, which sets limits on countries’ deficits and debt. The pandemic has opened up a more flexible interpretation of these rules. Germany has been a key obstacle to looser policy more broadly, expressed by the “schwarze Null” or “black zero” commitment to fiscal balance, but the political debate is shifting.
Climate change makes a powerful moral argument for increased investment. In Germany, the Green party is polling in second place at the time of writing and will likely have a significant role in any coalition government after September’s elections. While the Greens’ final manifesto is yet to be agreed, it will include commitments to sustainable investment and digitization which are difficult to achieve without fiscal expansion. This is no longer a fringe agenda: there is growing consensus around net carbon zero by 2050, and countries such as Russia, China and Saudi Arabia have come to the table to help frame the debate on this joint objective.
US environmental policy lagged Europe during the Trump era but has returned to the forefront under Biden. We last saw major infrastructure programmes under Obama. The key difference this time is that while Obama’s plans were “shovel-ready” projects that gave a short-term boost to demand, Biden’s plans are for both regeneration of the US’s tired infrastructure and a major investment in environmental technology and renewables. If this plan can become law before the Democrats (probably) lose full control of government in the mid-term elections at the end of next year, it can have a significant impact on long term productivity and growth.
Environment takes centre stage
Inflation, productivity and growth repeatedly undershot expectations between 2008 and 2020. Many of the drivers are still intact, and we are a long way from being able to say that we are on a path to the sunny uplands of better economic growth. The only thing that isn’t transitory about the inflation debate is the debate itself: we won’t know whether inflation is here to stay until at least the end of 2021.
The bottom line for our portfolios is that, in our view, the scale of the impact of fiscal policy with the environment at its core, and the change to central banking, haven’t been fully appreciated by investors. Market behaviour and investor commentary continue to presuppose a return to the old regime, but when the world returns to normal it faces a fundamentally different policy backdrop. To navigate this period, you need all the flexibility you can get. Multi-asset portfolios can dynamically adjust the amount of exposure to equities, fixed income, currencies, and commodities across regions.