Markets See Living with Covid-19 as the New Normal
Worries about the strength of the global economic recovery have re-surfaced as the highly contagious Delta variant has caused Covid-19 cases to rise. While the vaccines have dramatically changed the growth outlook, whether or not the virus can be eradicated has economic implications. In our view, global financial markets are adjusting to a lower growth path.
The new normal
Countries that were successful in containing the original Covid-19 strain are struggling with the Delta surge, including parts of Asia that are key players in global supply chains. For financial markets, which are always forward looking, the main risk lies in the winter months as the virus keeps mutating. The variant may delay the lifting of mobility restrictions or bring a new wave of restrictions. For a global economy that is struggling to resolve supply bottlenecks, a mishap in China — the world’s production center — can be a big concern.
Other countries, such as Israel, have indicated they may impose new lockdowns. If vaccines break the link between infections and hospitalizations, which can obviously change as the virus evolves, the probability of lockdowns in countries with high vaccination rates remains low. However, economic activity can be disrupted when a sizeable number of people get infected or are exposed to those infected, especially in the fall or winter months.
A rise in positivity rates could lead to more people self-isolating, adding to labor shortages. Another problem related to rising infections is the behavioral response as people become more cautious. This can be especially pronounced in the winter months when economic activity is mostly confined indoors. This dynamic can slow the path to normalization.
In July, financial markets started to react to worries about the Delta variant. Growth expectations had been elevated for months. It is highly possible investors’ reactions to the Covid-19 resurgence was the channel through which markets started to reprice medium-term growth prospects. The fear now is this may not be just a near-term disruption. The Delta variant’s ability to overcome immunity generated by the vaccines might be a wake-up call for those positioned for the full normalization of life. The markets might have started pricing in “living with the virus.” The realization that the virus may not be fully eradicated seems to be the key reason for downward revisions in growth.
Some governments are considering mandatory vaccinations, while others require people visiting theaters, cinemas, sports venues, or festivals to show either a proof of vaccine or a negative test. While this can accelerate the pace of vaccinations in the near term, the medium-term impact may not be growth friendly. Some unvaccinated people may choose to avoid these pass-requiring activities, and others may quit their jobs to avoid getting the vaccine. So, life may never fully normalize back to pre-Covid-19 levels.
Financial markets look for growth trends
Beyond the medium-term growth impact of living with the virus, the pandemic has long-term growth implications. U.S. and global growth may remain supported by re-openings and is likely to stay strong over the near term. But, for financial markets, the long-term trend matters. When vaccines were first made available, markets priced in the reopening theme. As financial assets have largely priced in the normalization of life, many investors are now starting to think about the end game.
The long-term trend, or potential growth, is the growth rate an economy gravitates toward when there are no external factors affecting potential growth. Gross domestic product (GDP) is a flow concept. Personal consumption is the largest chunk of GDP. The main factors determining GDP growth in developed countries are population growth and technological change. The impact of technological change on growth is slow but sustained. When population growth rates increase, the number of consumers and producers rises at a faster pace — leading to stronger growth. Potential growth changes slowly since population growth rates move gradually. In the United States, as in many other countries, the population growth trend is down. The pandemic has enhanced this downtrend.
Within the population, the relative balance between net savers and net consumers also matters because GDP is a measure of consumption. When the share of net consumers in an economy increases, spending and GDP growth also trend higher, and vice versa. As the share of net savers or the desire to save rises, interest rates decline.
The pandemic has intensified the downtrends in economic growth and risk-free real interest rates. The world is likely to enjoy high growth rates as the normalization of life continues, but without a major change in fertility rates or in life expectancy, once the economic adjustment comes to an end, the growth rate will materially slow.
The “Humpty Dumpty” Economy
We are living in a Humpty Dumpty economy. Echoing the fate of the ovoid nursery rhyme character, U.S. gross domestic product (GDP) dropped into a pandemic-led chasm in 2020, and “all the King’s horses and all the King’s men” have been unable to put the economic pieces back together again. That’s because the COVID-19 crisis imposed what we believe are permanent reductions in the economy’s productive capacity, and actions taken to cushion the fall caused some of the pieces to become misshapen. This is leading to some of the sharpest changes in relative prices ever, prolonging a period of elevated uncertainty, and increasing the risk that inflation will trend higher than U.S. policymakers are comfortable with.
The pandemic forced parts of the U.S. economy to shut down and limited provision of services to contain health risks: restaurants, education, discretionary healthcare, and travel & leisure activities were some of the more prominent sectors where household spending was sharply limited by the risks of social consumption. In response, policymakers made unprecedented efforts to support vulnerable businesses with low-cost loans and grants to tide them over until activity returned to normal. The U.S. Federal Reserve (Fed) ensured that financial markets continued functioning by providing enough liquidity to keep financing available, even as investors’ assessments of risk changed drastically, inducing massive portfolio turnover. Those measures prevented the healthcare crisis from spiraling out into an even worse economic and financial crisis.
At the same time, Congress passed legislation to sustain household income and spending. The income transfers were so large that disposable personal income rose sharply despite U.S. Bureau of Labor Statistics (BLS) data showing a rise in the unemployment rate to a peak of 14.8% in July 2020. As workers reoriented their workplaces to their homes and awaited the development of vaccines, spending shifted dramatically from services to durable and non-durable goods, and demand for housing surged.
A Not-So-Normal Recovery
Simultaneously, retailers and owners of office space were confronted by heightened uncertainty as they gauged how much future floorspace would be needed as online shopping gained share rapidly, and hybrid work arrangements took hold. A very sharp drop in vacation travel also upset capital spending and expansion plans in the United States and abroad in an industry that accounts for 2% of global GDP.
As vaccination and natural immunity increase at different rates across geographies both within and between countries, the “shape” of the recovery in GDP has been very different from the pre-pandemic structure of the economy. For example, data from the BLS show that spending on goods is far above the pre-pandemic level, or what might have been expected based on the prior trend, while spending on services is much lower. Residential construction spending, after almost 15 years of depressed activity, has surged while nonresidential construction is much lower. And the large shortfalls in imports and exports of services reflect low levels of leisure and business travel.
While the recovery in GDP to the previous peak has taken place on a somewhat normal timetable, the position of the various spending categories relative to trend is by no means normal for the stage of recovery that the economy has attained. Spending on goods is highly exaggerated compared to previous recoveries, straining supply chains and inducing very large price increases. Meanwhile, consumer spending on services, normally the most stable portion of aggregate demand, is deviating in the opposite direction. As complete recovery lags, and fiscal support ebbs, capacity in many parts of the services sector is being moth balled.
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Did You Know?
JUST TAKE UBER
– The price of used care and trucks in the United States is up +45.2% for the 1-year period ending 6/30/21. Over the same period, the price of “medical care services” is up just +1.0% (source: Bureau of Labor Statistics).
THE HIGH COST OF CARE
– 12% of US retirees, i.e., 1 out of 8, will spend at least 4 years in a nursing home (source: Center for Retirement Research at Boston College).
For God is the one who provides seed for the farmer and then bread to eat. In the same way, he will provide and increase your resources and then produce a great harvest of generosity in you.” – 2 Corinthians 9:10
“Planning is bringing the future into the present so that you can do something about it now.” – Alan Lakein