- Global financial markets might be pricing in a “living with the virus” environment.
- Growth in the United States will likely be supported by reopenings and stay strong over the near term.
- The pandemic has intensified the downtrend in risk-free real interest rates and long-term economic activity.
Worries about the strength of the global economic recovery have resurfaced as the highly contagious Delta variant has caused Covid-19 cases to rise. While the vaccines have dramatically changed the growth outlook, whether or not the virus can be eradicated has economic implications. In our view, global financial markets are adjusting to a lower growth path.
The new normal
Countries that were successful in containing the original Covid-19 strain are struggling with the Delta surge, including parts of Asia that are key players in global supply chains. For financial markets, which are always forward looking, the main risk lies in the winter months as the virus keeps mutating. The variant may delay the lifting of mobility restrictions or bring a new wave of restrictions. For a global economy that is struggling to resolve supply bottlenecks, a mishap in China — the world’s production center — can be a big concern.
Other countries, such as Israel, have indicated they may impose new lockdowns. If vaccines break the link between infections and hospitalizations, which can obviously change as the virus evolves, the probability of lockdowns in countries with high vaccination rates remains low. However, economic activity can be disrupted when a sizeable number of people get infected or are exposed to those infected, especially in the fall or winter months.
A rise in positivity rates could lead to more people self-isolating, adding to labor shortages. Another problem related to rising infections is the behavioral response as people become more cautious. This can be especially pronounced in the winter months when economic activity is mostly confined indoors. This dynamic can slow the path to normalization.
In July, financial markets started to react to worries about the Delta variant. Growth expectations had been elevated for months. It is highly possible investors’ reactions to the Covid-19 resurgence was the channel through which markets started to reprice medium-term growth prospects. The fear now is this may not be just a near-term disruption. The Delta variant’s ability to overcome immunity generated by the vaccines might be a wake-up call for those positioned for the full normalization of life. The markets might have started pricing in “living with the virus.” The realization that the virus may not be fully eradicated seems to be the key reason for downward revisions in growth.
Some governments are considering mandatory vaccinations, while others require people visiting theaters, cinemas, sports venues, or festivals to show either a proof of vaccine or a negative test. While this can accelerate the pace of vaccinations in the near term, the medium-term impact may not be growth friendly. Some unvaccinated people may choose to avoid these pass-requiring activities, and others may quit their jobs to avoid getting the vaccine. So, life may never fully normalize back to pre-Covid-19 levels.
Financial markets look for growth trends
Beyond the medium-term growth impact of living with the virus, the pandemic has long-term growth implications. U.S. and global growth will remain supported by reopenings and is likely to stay strong over the near term. But, for financial markets, the long-term trend matters. When vaccines were first made available, markets priced in the reopening theme. As financial assets have largely priced in the normalization of life, investors are now starting to think about the end game.
The long-term trend, or potential growth, is the growth rate an economy gravitates toward when there are no external factors affecting potential growth. Gross domestic product (GDP) is a flow concept. Personal consumption is the largest chunk of GDP. The main factors determining GDP growth in developed countries are population growth and technological change. The impact of technological change on growth is slow but sustained. When population growth rates increase, the number of consumers and producers rises at a faster pace — leading to stronger growth. Potential growth changes slowly since population growth rates move gradually. In the United States, as in many other countries, the population growth trend is down. The pandemic has enhanced this downtrend.
Within the population, the relative balance between net savers and net consumers also matters because GDP is a measure of consumption. When the share of net consumers in an economy increases, spending and GDP growth also trend higher, and vice versa. As the share of net savers or the desire to save rises, interest rates decline.
The pandemic has intensified the downtrends in economic growth and risk-free real interest rates. While the world is likely to enjoy high growth rates as the normalization of life continues, but without a major change in fertility rates or in life expectancy, once the economic adjustment comes to an end, the growth rate will materially slow.
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