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No easy answers for those who need to ride out the trends

21 July 2021 Myra Knoesen

As the world economy begins to emerge from the great lockdown, Schroders economists took a closer look at the key trends which define the post pandemic environment at the Schroders inescapable truths: long-term impact of COVID-19 webinar.

The webinar delivered first-hand insights into the macroeconomic trends now being driven by the pandemic and leveraged the recent research produced by Schroders Chief Economist, Keith Wade, and Senior European Economist and Strategist, Azad Zangana.

From the accelerated adoption of technology, a greater focus on environmental issues and the long-term impact of COVID-19 on public finances, Schroders economists analysed the world economy as it begins to emerge from the lockdown.

Three disruptive factors

Wade focused on three key disruptive factors which will influence the medium-term outlook: the accelerated adoption of technology, increased populism and a greater focus on environmental issues, particularly climate change.

“The world economy is emerging from the great lockdown, but progress is patchy. The US and UK appear to be leading the way, while China remains robust. The eurozone is following, albeit more slowly due to an uneven start with its vaccine programme. Nonetheless, the overall picture is one of developed markets outperforming emerging markets, with economies like India and Brazil struggling to contain the virus. The other fault line opened up by the pandemic has been inequality within economies which has likely increased on both an income and wealth metric,” said Wade.

“Meanwhile, on a more positive note, the ability of economies to adapt, facilitated by the acceleration in technology, holds out the promise of stronger productivity growth. We have raised our medium-term forecasts as a result, despite the persistence of adverse demographics,” he added.

“Increased technology may make the efforts of policymakers to address inequality more difficult as the fourth industrial revolution displaces more workers. So, although populism has not reared its head and become an accelerated truth during the pandemic, it is likely to return. History shows social unrest increasing after a pandemic is over, creating an environment for more populist policies,” continued Wade.

“Environmental issues have come into increasing focus with greater efforts to tackle climate change. Much attention has been on the Biden administration’s decision to take the US back into the Paris Accord and increase infrastructure spend in this area, but we have also seen China set a target to be carbon neutral, bringing the world’s two biggest polluters into alignment. The energy transition creates significant opportunities, but it also threatens to exacerbate inequalities between developed and emerging markets,” he said.

A look through the lens

“Government finances have deteriorated significantly during the pandemic, raising questions about debt sustainability. Nonetheless, there has been a shift in thinking on fiscal policy with governments unwilling to return to austerity and squeeze the public sector. Economic recovery will help, but given the extra spending demands of healthcare and climate change going forward, the pressure on government finances is likely to remain. Higher taxation seems inevitable, and governments are training their sights on the corporate sector,” added Wade.

“The increasing dominance of monetary policy by fiscal considerations means financial repression is likely to continue. Interest rates remain lower for longer despite the improved growth outlook. Alongside this, however, comes an increased tail risk of higher inflation. Although we expect the recent pick-up in inflation to be transitory, cyclical pressures are building and monetary policy will need to be tightened in 2022. Looking further out, it is not difficult to construct pessimistic scenarios. An example would be that persistent inequality fuels populist governments who then undermine central bank independence such that inflation gets out of control,” he said.

“Yet there are still powerful forces pointing the other way. Technology tends to drive down prices through increased competition in both product and labour markets. Also, there is still a consensus in favour of low inflation amongst central banks and the shifts in policy are recognition that in the face of structural forces inflation has been too low,” emphasised Wade.

“Against this backdrop there are no easy answers for investors who will need to ride the disruptive trends and find the pockets of growth in the world economy. What seems clear is that governments may now be playing a greater role in driving those trends,” he added.

The global economy

Zangana, looked at the long-term scarring for the global economy, specifically the impact of public finances.

“Governments have been forced to borrow eye-watering amounts during 2020 to support households and firms as restrictions on activity were imposed. Most of the borrowing was due to expansionary fiscal policy, but a significant amount was down to lost revenues too,” said Zangana.

“Though most countries have tried to use temporary spending increases and tax cuts, most will need to use austerity to reduce annual borrowing and stabilise their growing debt positions. Interestingly, not all countries are expected to complete their austerity programmes by 2025,” added Zangana.

“As a result of higher borrowing, debt levels will reach unprecedented levels as a share of GDP, which will inevitably raise questions about affordability and sustainability,” he said.

“With regards to debt affordability, thanks to the help from monetary policy in the form of lower interest rates and quantitative easing, many countries should see the cost of servicing their debt actually fall, despite higher debt levels. Central banks are keen not to repeat past mistakes, in particular, those following the global financial crisis. Early exits of fiscal stimulus are seen as possibly having contributed to higher inequality and the rise of populism. Though central banks are officially politically neutral, it is clear that we are in an age of fiscal dominance, and the political imperatives for fiscal expansion will require central banks to keep monetary policy very loose,” emphasised Zangana.

Emerging markets on the whole

“Such a course of action risks higher inflation. This is not a topic for this note, but it partly explains why emerging markets on the whole will struggle to follow the same path as developed markets. Perceived excessive fiscal and monetary stimulus in emerging markets would risk currency devaluations and worse still, potential questions over debt sustainability,” continued Zangana.

“In thinking about debt sustainability, we encourage readers to also consider the starting point of private debt and the forecast increase in age related expenditure. The former is harder to put off, as the private sector doesn’t have the privilege of tax raising powers. The latter shows the importance of pension reforms, and an affordable healthcare system,” he said.

“Finally, our analysis on fiscal space shows that a significant number of countries are in danger of being ill prepared for the next cyclical downturn. By 2025, projections show one quarter of major economies may still lack fiscal space to manoeuvre, while simultaneously still suffering a drag on their annual budgets from sub-trend cyclical performance. These countries, especially in emerging markets, have historically been forced to either devalue their currencies, or to restructure their debts,” concluded Zangana.

Writer’s Thoughts:
Progress remains patchy as the world economy emerges from the great lockdown, with many countries ill prepared for the next cyclical downturn, Schroders Economists cautioned. As the world economy begins to emerge from the great lockdown do you believe these key trends will define the post pandemic investment environment? If you have any questions please comment below, interact with us on twitter at @fanews_online or email me - [email protected]

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