With Covid-19 persisting and the inflation outlook uncertain, investors should tread cautiously

There have been two major themes driving market dynamics lately. One is inflation, which affects interest rate expectations, central bank policy stances and, in turn, asset price valuations. The other is the pandemic, which is exacerbating the K-shaped recovery between those who have successfully contained the virus and those who are still struggling because of their inability to halt its spread or vaccinate a large swathe of the population to reach herd immunity. In the case of India, Covid-19 is quickly turning into a humanitarian crisis, with the new variant spreading to nearby countries. So far, however, markets seem to be taking the worsening coronavirus situation in their stride. Even in India – the new epicentre of the crisis – the equity market has been tracking effectively sideways over the past month, and remains one of the more expensive in the region. Investors may be taking comfort from the fact that the Indian economy has continued to chug along, with the latest PMI showing little damage caused by the virus resurgence. But, without a forceful response, the country risks long-term pain along with its short-term gains, with a prolonged public health crisis that delays the full economic recovery. It’s increasingly doubtful that vaccines alone can save the world from a protracted pandemic. After some careful number crunching – based on our current understanding of the virus, and vaccine efficacy and coverage – our research concludes disconcertingly that very few countries will be able to reach herd immunity by relying on a vaccine alone, and Covid-19 is likely to become endemic. Some simple maths can illustrate the point. Assume that herd immunity requires at least 70 per cent of the population to be vaccinated. This excludes some 20 per cent such as children who cannot be inoculated right now. Within the adult population, some who are strongly against vaccination also need to be excluded. Surveys show this could be up to 20 per cent in some developed countries. Even incorporating those who already have the antibodies after contracting the virus, our study shows that most countries will still struggle to achieve herd immunity. Hence, before vaccine and pharmaceutical technologies make another breakthrough, we need to be prepared to coexist with the virus in the coming years, and markets have to adapt their growth and inflation expectations to the new environment. Let’s turn to the second theme – rising interest rates. The key issue behind tighter monetary policy expectations is clearly the inflation outlook, which should be examined over short-, medium- and long-term horizons. In the near-term, few would disagree that CPI readings will spike in most places in the coming months. The rise of China’s April producer price index to 6.8 per cent and US April consumer price index to 4.2 per cent is clear evidence of rapidly increasing prices due to a combination of recovering demand and supply bottlenecks. Beyond the next few months, US inflation is on a structural uptrend thanks to the rapidly disappearing negative output gap and rising inflation expectations. Runaway inflation? It’s still too early to make that conclusion A detailed analysis of the Fed’s favourite inflation indicator, the personal consumption expenditures (PCE) price index, suggests that most its sub-components will follow the growth rebound, taking trend inflation to well above 2 per cent by early 2023. This analysis supports a more hawkish view on policy expectations than the Fed’s, anticipating central bank tapering throughout 2022 before hiking rates twice in the second half of 2023. The long-term outlook for inflation is the most contentious. On the one hand, few would agree that the structural drivers of disinflation over the past decades – namely ageing populations, globalisation, central bank credibility, rising inequality and high debt levels – have disappeared. In fact, some of these forces have gained strength because of the pandemic. On the other hand, the unprecedented monetary stimulus, propagated by the ballooning of central bank balance sheets, has to have some effect on inflation. The market has yet to reach a consensus on which force will be dominant, which probably explains why the Treasury market has struggled to find direction lately. However, the eventual outcome for inflation is likely to be binary and extreme. Either the world will revert to very low inflation, after a short-term spike, consistent with secular stagnation, or inflation will continue to push higher and become unanchored as a result of the excessive monetary stimulus. Keeping inflation stable – at 2 per cent – will be difficult for central banks, while higher price volatility also poses a challenge for economic and financial stability. For investors, extra caution is warranted as the macro path gets bumpier. Aidan Yao is senior emerging Asia economist at AXA Investment Managers