Central banks around the world are pumping money into their respective economies, sparking fears of soaring future inflation rates, but these fears are unfounded for now.
Instead, we are seeing inflation collapsing at present, even while money supply explodes upwards as a result of the efforts to counteract the fallout from Coronavirus’ (COVID-19) crippling lockdowns.
Governments and central banks around the world have unleashed extraordinary levels of monetary stimulus to support economies hard-hit by the global pandemic. In South Africa (SA), the Reserve Bank (SARB) loosened monetary policy by cutting the repo rate from 6.25% to 3.75% and has also stepped in to buy South African government bonds to prevent bond yields from rising too high.
These similar massive levels of stimulus globally have raised concerns that the extreme liquidity could result in runaway inflation down the line.
This is unlikely.
In the United States (US) and other major economies, money supply and inflation have become largely disconnected in the decade since the 2008 global financial crisis. Despite massive injections of fiscal and monetary stimulus in the aftermath of that crisis, inflation in developed economies has remained benign and we have not seen a surge in consumer prices.
Similarly, in SA core inflation has been stable, remaining within the SARB’s 3-6% target range. Inflation as measured by Consumer Price Index (CPI), is expected to remain muted, falling as low as 2% in the next few months and averaging around 4% in the next 12 months.
We do not expect the inflationary environment to change in the next year as a result of the exploding liquidity around the world. Instead, the additional liquidity in markets will more likely be fuel for an equity fire.
Investors will favour equities simply because few other asset classes are expected to deliver healthy returns in this environment. With interest rates close to zero or even negative in some economies, the yields on developed market bonds, for example, are not attractive.
We therefore see the abnormal levels of global liquidity underpinning the equity markets for the next six to 12 months. But, given the COVID-19 crisis, it is likely to be a bumpy ride, with highly volatile periods.
In this type of environment, we favour high quality resilient companies.
Despite this view, now is not the time to go overweight equities, however.
Given the nature of how the COVID-19 spreads and the possibility of a second wave of infections, leading to further lockdowns of some sorts, don’t bet on a quick recovery in company earnings as there may still be the threat of a relapse. In that environment, one would want to favour those companies that are able to ride out a storm for an extended period – those with resilient balance sheets and a resilient business model.
A vaccine for COVID-19 is absolutely critical to the full recovery of economies and the health of companies. But the development of a safe and effective vaccine in the time scale envisaged has never been done before, which calls for a cautious approach when it comes to equities, despite the liquidity underpin.