Few people are talking about austerity right now. Most of Europe, all of the UK and parts of the US remain in some form of lockdown, and even fiscal hawks accept this is not yet the moment to withdraw support. But as vaccines are distributed and pent-up demand released later this year, there’s a chance this accommodating stance will be rolled back prematurely, with major implications for the economic recovery—and investors.
The risks of providing too little support far outweigh those of providing too much, and governments should worry about winning the Covid-19 war before they fret over how to pay for it. But Chancellor Rishi Sunak joked last year that he should take Boris Johnson’s credit card away, given the government’s profligacy. The Treasury has publicly aired debates about how to pay for the crisis response. In May, a leaked document mooted breaking a Tory manifesto promise by hiking taxes, potentially scrapping the pensions triple lock and freezing public sector wages to address the ballooning budget deficit.
Since then, the deficit has risen yet further. In November’s Spending Review, Sunak highlighted that his overarching goal was sustainable public finances. Of course, this was before the new Covid-19 variant ripped through the country. The economy will need more fiscal support, but with the Treasury already worried about the deficit, it may not be forthcoming.
The UK is not the only country at risk of pulling the plug on measures for public services, small businesses and individuals too early. In the US, the Democrats now control the White House, House of Representatives and Senate. But their grip on the Senate is razor thin, so unity will be absolutely key to passing significant new spending plans.
In the EU, the fiscal rules that constrain countries’ budgets have been suspended until the end of this year. But as a vaccine is (hopefully) widely distributed in 2021, countries in the continent’s “frugal north” (which started with more fiscal space to respond to the crisis and may bounce back faster than southern Europe) could put pressure on the Commission to reinstate the rules for everyone.
Maintaining fiscal accommodation for too long risks being unsustainable. But for major developed economies, this risk is low. The Bank of England, US Federal Reserve and European Central Bank have all suggested they will keep borrowing costs down for the foreseeable, holding debt servicing costs low or even negative in real terms. If accommodation is abandoned prematurely, these economies could be pushed back into recession, necessitating even more fiscal support.
If any one of these economies tightens too soon, inflation expectations will sink, pushing bond yields down in turn. Fixed income investors would be left hunting for yield. Equities that are a bet on economic growth—financials, oil and consumer discretionary—would underperform. The nascent switch we are seeing out of “growth factor equities” and into “value equities” will reverse. But the news is not all bad for investors. If governments take their feet off the gas, central banks may have to step in again with more unconventional measures. As we saw in 2020, that can provide major impetus for a market rally.
