Post-pandemic economic expansion: Not inevitable, but likely

Economic data and market signals indicate better than expected economic recovery. If the present momentum continues for the rest of the financial year, we are likely to end the year with a contraction in economic growth around 8 percent and not 10 percent as feared earlier. RBI has projected a positive growth rate in Q3 FY21. Leading indicators like GST collections, direct tax advance payments, consumption of electricity and petroleum products, sales of automobiles and railway freight indicate better-than-expected recovery in economic growth.

What are the factors driving growth?

Will the momentum sustain? Are the markets signaling the beginning of an expansion cycle?

These are the relevant questions.

The skeptical view

Without doubt, the low interest rate regime has turned out to be a major tailwind for sectors like auto and construction. Since these sectors have high multiplier impact on the economy, it is helping in growth and job creation too. But economists are divided on whether the growth momentum would sustain. The skeptics argue that the revival in demand is largely pent-up demand and therefore, cannot sustain. Also, there are concerns about the central bank’s ability to continue with the cheap money policy and highly accommodative monetary stance since the inflation print has been above the Monetary Policy Committee’s target for many months now.

The optimistic view

The optimists, however, have a different view. They believe that the global economy is on the cusp of an expansion cycle. The major driving force of this cycle is the ultra-loose monetary policy of the leading central banks of the world, led by the Fed. The Fed has committed to keeping interest rates close to zero through 2023. The proclaimed stance of the Fed is to keep rates low long enough to revive growth. The Fed expects cumulative GDP growth of 9.5 percent and unemployment rate of 4 percent by end 2023. Keeping interest rates near zero for three more years have huge implications for the cost of capital globally. When capital becomes so cheap, it can trigger new investments since it would be relatively easier to generate Return on capital employed (ROCE) above the cost of capital. This, along with other mega trends like accelerating digitization and the pandemic-triggered innovations have the potential to initiate and sustain a new expansionary economic cycle.

Which of these two outcomes will play out? Only time can tell. So investors have to wait and watch.

Remain invested

If the optimistic scenario – it has high probability – plays out, the present bullish phase in the market will sustain and expand further. This expansionary phase can turn out to be somewhat similar to the global boom of 2003-07, which lifted even sub-Saharan Africa above 5 percent growth rate. So, it makes sense to remain invested in this market even though valuations are stretched.

Fixed income losing luster

The inevitable consequence of this ultra-loose monetary policy is the crash in bond yields. Presently, 80 percent of world’s investment grade debt yields 1 percent or less. The US 10-year real interest rate is at a record -1 percent. If the Fed sticks to its guidance, the real interest rate could dip to -2 percent by end 2023. This has huge implications for global interest rates. Bonds are likely to underperform for a long period. In brief, the composition of investment portfolio should be, ideally, skewed towards equity.

The pandemic has triggered many innovations. For instance, the IT industry has innovated Secured Borderless Work Space (SBWS) as a new business model. Firms have learned to cut costs through a variety of ways. India Inc. reported a 25 percent increase in operating profit for Q3 FY21 largely through cost-cutting initiatives.

There is a flip side to this. The organized sector in general and large corporates in particular, have grown at the expense of the unorganized sector. The pain in the unorganized sector is huge. Many MSMEs are unlikely to survive. This may adversely impact aggregate demand in the economy constraining growth revival. But, from the investors’ perspective the trends appear    positive.