The first quarter of 2021 is almost over, leaving behind another round of challenging questions. Are the vaccines working? When will we get back to some sort of normality? What will recovery look like? How can we heal the economic scars COVID-19 inflicted? As at every quarter end, Fathom has conducted a rigorous analysis and prepared a forecast, which offers valuable insights to anyone deliberating questions like these.
A wealth of data from countries with advanced vaccination programmes gives evidence that existing COVID-19 vaccines prevent serious disease and reduce transmission. Although the threat of mutant variants remains, the focus is set to shift gradually towards when economies can reopen and the uncertainties and challenges of the recovery phase. Countries like the UK and the US that have made good progress with vaccinations will probably soon see an end to stay-home restrictions and renewed economic activity in many sectors. The European Union is lagging on the vaccination front so economic activity will likely recover a little later. Israel, on the other hand, is already open after its successful vaccine rollout.
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The reopening of economies does not however guarantee a smooth return to economic health. This has not been a normal recession, and it will not be a normal recovery, thanks in part to the substantial fiscal support put in place to mitigate the impact of the pandemic-related lockdowns. The next chart demonstrates one of the non-ordinary attributes of the recession: whilst consumption of services collapsed due to lockdowns, disposable income has soared — due to government subsidies and fewer options to spend.
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A major unknown is the extent to which households will dip into their excess savings over the coming months. Fathom considers different scenarios of how people might spend their excess savings, and how fiscal and monetary policy could evolve. One case is that people would rush to do the things that were previously banned, abruptly pushing the above chart’s dark blue line (consumption of services) upwards to align it with the other two lines, as per the historical norm. Such a large, positive, consumption shock is plausible, according to data from OpenTable, which shows that restaurant seat occupancy in Australia has surged.
An abrupt consumption ‘correction’ due to post-lockdown ‘pursuit of happiness’ along with loose monetary policy would place inflationary pressures on any recovery scenario. Indeed, inflation expectations have picked up for the UK and US, where the end of restrictions appears closer to hand than in the Euro area.
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The inflationary pressures in Fathom’s central recovery scenario would require central banks to unwind QE and tighten monetary policy. When that happens, or probably in the build-up, it will send shockwaves to capital markets, unsettling asset prices. This domino effect and its various implications are central to Fathom’s quarterly analysis and forecast. The simpler Fed model, which states that in equilibrium there is a positive lead-lag relationship between bond yield and equity earnings yield (inversed PE ratio), indicates the risks on the pathway to recovery. While bond yields are increasing, equity prices remain stable or even rise. This is because the market is currently pricing the stronger macro-cycle conditions and not inflation risks, as Fathom’s factor-mimicking portfolio analysis reveals (described in January’s edition of Fathom the Strategy). But when inflation risks become more material and monetary policy seems about to change, equity prices will likely fall, for both the equity earnings yield and the bond yield to increase as the Fed model prescribes.
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A more detailed explanation of the general macro and inflation outlook, including when, by how much and for how long equity prices may fluctuate downwards, is set out in Fathom’s comprehensive quarterly forecast.
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