Shock to bond and stock indices

Many measures of performance put bond and stock indices down between 15% and 30%. 

Things will probably improve in time; it is hard to imagine a similar performance next year. But what about the long-term, once all this Covid/supply-chain/inflation/rate-hike turmoil is over? Will asset prices revert to the strong and steady gains we saw before the pandemic?

To see this, we need to take a very over-arching view of what’s been driving asset prices before the pandemic and afterwards, and use this to try to predict the future. The decades before Covid-19 were marked out by rapid globalisation, particularly in China, and helpful demographics which created a sharp rise in the world’s effective labour force.

These two things meant that strength in global demand for goods and services could be met by ever-increasing supply. The result was low inflation - often too low in fact. Central banks responded to this– and various shocks such as the global financial crisis – by cutting rates to zero, or near zero and, when that was not enough, bought assets to expand liquidity further.

While the global supply of goods and services was increasing and weighing down on inflation, the price of assets was increasing sharply as supply here was constrained. In the case of bonds, it was clearly constrained by QE while, for stocks, supply was constrained by firms’ voracious appetite for buy-backs, particularly in the US. Any setbacks to this strength in asset prices proved short-lived because low inflation gave the central banks room to do even more QE when economic conditions deteriorated.

But then came the pandemic and the crucial aspect here was that it dramatically accelerated the nascent trends towards deglobalisation (following the US trade war with China), and worsening demographics, particularly in advanced countries.

In short, the supply of goods and services was hit hard. Resulting inflation prevented central banks from putting out the liquidity punch-bowl again; in fact, they have had to take it away by lifting rates and ending QE. Asset prices have understandably reacted very adversely to this and the fall might not be over yet.

In the future, once central banks get inflation under control and rates start to fall, there may be hope that asset prices will rebound in a strong and sustainable way. However, when it comes to bonds, it is still likely to be the case that the many decades of falling yields before the pandemic will not return. For a start, inflation will stay higher than pre-pandemic levels because deglobalisation and poorer demographics are likely to keep price pressures higher than they were in the pre-pandemic heyday. In addition, debt levels have increased considerably and central banks still have huge amounts of bonds that they need to sell back to the market to return their balance sheets to more normal levels.

“On the equity side, we mentioned before that firms were lucky enough to experience relatively low costs of employing labour and capital in the pre-pandemic era. Wage growth was very low given the positive globalisation/demographic trends and the cost of making investments was held down by very low interest rates”, said Mr. Steve Barrow, Head of Standard Bank G10 Strategy.

As a result, firms were often able to respond to rising profits, and, in some cases, tax cuts, with big dividend increases or buy-backs. But Mr. Steve Barrow said, in today’s post-Covid world, a bigger proportion of firms’ expenses would have to go towards the costs of capital and labour and that’s going to leave less for dividends and buy-backs. Now this will not stop equity prices from going up, perhaps even in a sustainable way, but the returns are likely to be paltry compared to what we’ve seen in the decades before Covid – and the same goes for bonds too.