Outlook on the stimulus measures post Covid
By Andrew Boulds, Senior Financial Adviser of Milestone Financial
There has been a great deal of discussion in the financial press regarding the reduction of post covid government economic stimulus measures, both in the US and Australia, and the risks these pose for investors. This reduction is expected as it is intended to return us to ‘normal’ economic settings.
Quantitative Easing and Government Bond Purchases
The Reserve bank of Australia (RBA) is currently engaged in a bond buying program, a form of quantitative easing (QE) which is designed to inject additional money into the economy to provide stimulus. The RBA announced in July that it will begin a gradual reduction or ‘tapering’ of this program, reducing its bond purchase program from $5 billion per week to $4 billion, commencing in September. This is expected to continue until February 2022 until it is reviewed.
In August in the US the Jackson Hole symposium, a forum for US economists to discuss major policy issues, was uncontroversial. Jerome Powel, chair of the US federal reserve (the Fed), presented a message consistent with that of recent months in that they are committed to process of gradual reduction of their bond purchase program, the Fed’s QE. This is the beginning of the process of normalising economic policy settings in the US. Expectation is now that the tapering of QE in the US will begin this year. This is likely to be announced later in the year to provide more time to assess US post covid recovery.
The Fed is the most important central bank globally, but it is not the first mover on the move towards normalising economic settings. Besides the RBA which has already communicated its approach, other jurisdictions have already moved, such as the central banks of Canada and South Korea with the former well into their tapering program and latter already having increased interest rates. Canada is currently experiencing core inflation of 3% compared to its target of 2%.
A point of note is that tapering just means a reduction in the rate of QE not a reversal of it – so even a tapered bond buying program could be viewed as inflationary by continuing to increase the money supply and in turn could cause inflation.
A significant change to government and central bank economic policy post Covid has been a consistent approach between monetary and fiscal policy.
Interestingly, governments around the world are continuing to implement stimulatory economic policy despite the improved economic outlook. This can be seen in the US government’s infrastructure and social initiative spending packages, totalling around five billion US dollars, which are currently going through their legislative process. This level of spending will clearly have benefits in terms of economic activity in the US and beyond.
Government spending has also increased in Australia, with an increase of 2.5% to A$134.7 billion in the June quarter. This has added 0.7 percentage point to gross domestic product (GDP) going a long way towards helping to avoid recession.
The next step in economic normalisation once QE has been tapered would be raising interest rates. The Fed of course will need to ensure the US economy is in a position to handle the loss of support, as would the RBA in Australia, something which they have provided assurances they are prepared to do.
The risk is there that the increased government spending combined with the post covid economic recovery generates higher than expected inflation. Maintaining inflation within target is the Fed and RBA’s primary objective and the major tool available to them to control inflation is to raise interest rates. It is not considered practical to raise interest rates while simultaneously engaging in QE as they have contradictory impacts. This may offer a clue as to why the central banks are keen to proceed with tapering despite the current uncertainty regarding the Delta strain of the Covid-19 virus.
Risks to Investors
When the US QE tapering is announced, the risk to Australian investors will be if markets assess it as being too rapid in nature. The announcement of a lower than anticipated taper would most likely be positive for investors, at least in the short term. History can provide some insights into what is likely to happen in the event of a taper. On the initial announcement of the post GFC taper in 2013, this caused an initial collapse in bond prices and an initial (but short lived) drop in share prices. This tells us if the taper is poorly communicated to the market, or the market is surprised by the rate of the taper, then they are likely to suffer a short-term setback. The difference in 2021 relative to 2013 is that both the Fed and the RBA have suitably prepared markets for their tapering at a time when the economic recovery appears to be broadly under way. A more aggressive taper by the Fed would result in an increase in the US dollar which could be negative for Australian investors in some international shares.
The combination of QE (even at reduced rates), government spending and the economic recovery of a post covid reopening (assuming that continues to be the case) could be viewed as inflationary in nature. Once QE has ceased, this is likely to result in increased interest rates, which again will need to be applied with care by the central banks to avoid unwanted economic shocks. Rising interest rates are generally negative for share investors as they negatively impact company earnings and also bad for bond investors as the yield on an existing bond is less attractive than that on a new bond. Inflation is even more damaging to cash investors however as the returns are not generally sufficient for the investment to hold its true value.
Due to these foreseeable risks great care needs to be taken with portfolio construction. Milestone’s investment committee is constantly working to assess these risks and incorporate this assessment into our portfolio construction process.
This document contains information that is general in nature. It does not take into account the objectives, financial situation or needs of any particular person. You need to consider your financial situation and needs before making any decisions based on this information. The examples used are illustrative only and are not an estimate of the investment returns you will receive or fees and costs you will incur.