Lessons Learned from “COVID Economics” and the Path Forward for Investors
Two years into the COVID-19 pandemic, investors continue to grapple with the challenges it has borne upon the global economy. How did we get here, how do we understand the current situation, and what should investors do in response?
The Backdrop for COVID Economics
The last great downturn the world experienced, prior to COVID-19, was the Global Financial Crisis of 2008. Those times were unprecedented in recent history and led to the most dramatic economic stimulus ever unleashed. Opinions were split on whether central banks did enough. Those on the “do more” side argued that the Bernanke Fed did not spend sufficiently to revive the economy. Those on the “do less” side remained wary of returning to the highly inflationary economy of the 1970s and cautioned that the addition of more and more “stimulus” into an economy would quickly pass diminishing returns and become actively harmful. But whatever camp you were in, one thing was clear: a new monetary playbook had been written, which involved large-scale usage of relatively novel approaches like printing massive amounts of money.
When COVID-19 struck the US, the Fed quickly dropped interest rates to zero and began another herculean balance sheet expansion (i.e., more money-printing). However, this crisis was not exactly like that one that came before. Governments deliberately froze pieces of the economy in order to stop the spread of the deadly disease and save lives, but many of the underlying fundamentals in the economy remained resilient. What’s more, this monetary stimulation was buttressed by intense fiscal stimulation (such as the checks distributed as part of the CARES Act), which created a surplus of demand. This led to a much quicker bounce-back in overall spending as economies re-opened. Supply chains buckled under the combination of COVID-related disruption and still-strong demand, and prices started to rise.
Where Are We Now?
As we emerge from the COVID economy, we are seeing the worst inflation in forty years - a far cry from the outcome of global financial crisis stimulation over a decade ago. Investors are left with a smattering of questions. How will the Fed walk the tightrope of stabilizing inflation while maintaining growth? Will we see further coordination between monetary and fiscal policy? Will we see continued disruptions in the ability to produce and ship goods around the world? What does it all mean for the economy, markets in general, and personal portfolios? Already, interest rates have started to tick up, causing equities to reprice, particularly in the more speculative and rate-sensitive portions of the market. It remains to be seen how well the real economy will shrug off this higher cost of capital. Add to that an emergent war in Europe compounding supply-side issues with potential commodity shortages and further inflationary pressures, along with all the requisite uncertainty of such an event, and investors are left with a wider range of outcomes and downside scenarios than usual.
A Sophisticated Investment Response
Given all the variables at play, it is worth distilling the problems of economics down to the key drivers that really matter. The outlook for growth, inflation, interest rates, aggregate liquidity, and currency fluctuations we know to impact all asset classes in reliable ways. As investors, a first principle is to measure exposures to these underlying drivers and to balance their impact across one’s portfolio in the case that they trend in a particular direction.
Of course, that’s not all we can do. By delving into the inter-linkages of the economy, we can also seek to understand the long-term trends and how they might play out over time. Does the level of foreign investment in an emerging country drive its growth? Does the capacity utilization of an economy anticipate its inflation rate? Can the interest rate be predicted by balancing growth and inflation considerations? These are simple examples of the type of analyses that can yield macroeconomic predictions about the world for the savvy investor that wants not just to immunize their portfolio from macroeconomics, but also benefit from their directionality.
Making predictions, however, is hard. Advanced data science and real-time economic data sets are also invaluable contributors in shaping this understanding. For example, increased employment and retail spending in a specific area could be linked to an increase in tourism in holiday destinations, but the average investor might not have the resources to unearth such a relationship. And all predictions are subject to being wrong, so using confidence intervals and building a probabilistic view of the world can help ensure that portfolios are positioned for the full range of potential outcomes.
No matter where we stand on the passive versus tactical spectrum, investors (institutional and retail alike) should be prepared to embrace the new tools available to guide them to make stronger, better informed decisions. Each crisis and each subsequent policy regime yields a new challenge for investors, but because the principles behind markets and economies are foundational, advanced analytical tools are here to help. Only then can investors rest assured that they are managing their finances towards strong returns while making sure they are adequately protected from the next market shock.