Production of COVID vaccines is rapidly growing and expanding with more vaccine candidates in the pipeline. Vaccinations are administered in increasingly higher numbers with countries like the United Kingdom and United States among those with the highest vaccination rates so far. As restrictions are gradually  being loosened, the economic recovery is all but certain to take shape throughout the remainder of 2021 and to get into full swing in 2022.

The anticipation of this economic recovery already became clear last November. When Pfizer and BioNTech first announced the high success rate of their vaccine and vaccine roll-out to start the following month, stockmarkets worldwide soared by double digits on the anticipation that things would more or less turn back to normal again and that an economic recovery was just around the corner. An economic recovery generally entails increased production and consumption, climbing GDP growth, lowering unemployment, improving profit margins, more business volume and more. With all these benefits of an economic recovery, why have the markets been so jittery for the past few months?

As is the case with every market recovery, certain concerns are also part of the equation. As consumer demand increases, companies need to produce more to keep up with demand. The increased demand for goods as well as services puts upward pressure on prices, and when inflation picks up, the central banks step in to ensure it doesn't spin out of control while simultaneously trying to ensure continued economic growth and low unemployment. Climbing inflation is usually a gradual process, but the COVID crisis is far from usual and causes additional concern for several reasons.

In addition to the usual pickup in demand during a recovery, there is the influence of the COVID stimulus packages. In 2020 the US spent more than 2 Trillion dollars on COVID-related expenses. A large portion of that money was in the form of direct deposits to American citizens and a large portion of that however was not used to cover basic needs as intended, but rather to pay off debts, placed into savings accounts or invested in the market. In December last year an additional 900 Billion dollar stimulus was agreed upon and a week ago yet another 1,9 Trillion dollar »American Rescue Plan« was signed into law by President Biden, providing even more money to US citizens. Also in Europe the savings rate soared and is currently at the highest level since at least 1975.

In short, households are currenly sitting on a massive pile of cash and, after basically having been locked up at home for a whole year, they can't wait to go out and spend lots of it once the whole economy reopens. This is referred to as »catch-up spending« and is expected to put more upward pressure on inflation in an economy which is already showing its initial phase of recovery. Also companies will participate in catch-up spending as they postponed planned investments in 2020 to save cash during the lockdowns but will want to take full advantage of the economic recovery and execute those postponed investments.

In addition to the anticipated accelerated growth in demand, there is also the question on whether supply will be able to keep up. Most companies cannot simply switch from running at low capacity during the lockdowns to full capacity overnight - it is a process that takes time. Looking at the prices of commodities, supply shortages are already becoming a concern. Copper prices are at the highest since 2011, the oil price has nearly doubled over the past four months and companies are competing with each other for supply of Lithium, among other commodities. Climbing commodity prices are yet another factor that puts upward pressure on inflation. 

Even though inflation is currently still well below central banks' target levels of 2%, the fact that it is already beginning to pick up while the lockdowns are still largely in effect and with more stimulus money incoming, is a concern for investors and keeps the markets on edge.

Typically central banks gradually increase the interest rate to keep inflation under control, but they have pledged not to raise the interest rate until at least 2023, and for good reason. Even though the interest rates have been at historical lows for several years, a higher interest rate could put downward pressure on economic growth in a situation where the economy is just beginning to recover from the COVID crisis. Moreover, the COVID stimulus packages have been quasi entirely financed by debt. In case of the United States, the national deficit of 2020 amounted to 3,1 Trillion dollars, pushing their federal debt to currently around 28 Trillion dollars, well above the size of their GDP. An increase of the interest rate would be bad news for the national debt for which they currently already pay close to 400 Billion dollars annually in interest expenses.

Lately however 10-year Treasury yields have increased from roughly 1,0% at the end of the 2020 to currently 1,7%. In order to keep the long-term yields low, central banks will almost certainly purchase long term debt. At the same time they try to reassure the market that inflation remains well under control. One thing the central banks will not allow to happen is for long term interest rates to exceed economic growth for an extended period of time as this would hurt the economy.

In my personal opinion, 1,7% yield on 10-year treasuries is actually not high at all, especially for an economy that is just beginning to recover. A 2,5% yield was very common as recently as two years ago. Investors are just very sensitive when it comes to the subject of interest rate increases. I guess interest rates have been close to zero for so long that perhaps they've gotten used to it. So while the stockmarket may occasionally tremble on the news of long-term bond yields and inflation concerns (as it did over the past few months), bare in mind that this is something that is actually supposed to happen during a recovery phase. And for central banks it's essentially a delicate balancing act under unusual circumstances.

With all this considered, we maintain a positive outlook for the stockmarket this year and intend to take advantage of the current environment for most of our equity funds, including our largest fund, PSP Modra Linija. We're allocating more weight into cyclical stocks that usually benefit from economic rebounds, and we're also adding more weight to the basic materials sector on anticipation of continued gains of commodity prices as a result of growing demand.

Rudy Marchant
Fund manager Primorski skladi d.o.o. Koper