Vantage Point: Transitory?

Quarterly Outlook Q3.2021

Vantage Point: Transitory?

Quarterly Outlook Q3.2021

July 2020

By Shamik Dhar, Alicia Levine, Lale Akoner, Bryan Besecker, Sebastian Vismara

Welcome to the latest edition of Vantage Point, the quarterly economic outlook from the Global Economic and Investment Analysis team at BNY Mellon Investment Management.

Since we last published three months ago, world economic activity has continued to pick up strongly, particularly in those countries that have rolled out vaccinations to a large proportion of the population. As economies like the U.S., euro area and UK continue to open up, we expect economic activity to surge in the second half of 2021, on the back of enormous pent-up demand and the delayed impact of huge fiscal and monetary stimulus. That’s particularly true of the U.S., where the economic impact of the additional $1.9 trillion stimulus package is yet to be fully felt.

 

Elsewhere, however, the pace of vaccine rollout has been less dramatic. Most notably in some key emerging economies, such as India, Brazil and South Africa, distribution and take up have been much slower. The spread of the virus in India in recent months has been particularly alarming and the Indian Variant (or variant delta) is beginning to crop up as the dominant strain in other countries. 

 

Overall then, while the global recovery remains strong and intact, it appears to be more uneven than we felt most likely three months ago. Of course, that unevenness could smooth out over the next few quarters as vaccine rollouts pick up pace in those countries, but for now our forecasts allow for a bit more international variability in economic performance over the next year, with a particular distinction between the major developed world (plus China) and some important emerging markets.

 

Meanwhile, financial markets priced in the strong “V” some time ago, and are now looking beyond, with much focus on what will happen to inflation. Again, that debate is most vibrant in the U.S., where the combination of fiscal and monetary stimulus yet to be felt is on the order of 20% of GDP. One school holds that there will be an uptick in inflation this year, but it is likely to prove transitory – a correction of the price level, if you like, whose impact on the inflation rate will be felt for 12 months or so. The key argument here is that the pandemic saw a collapse of both demand and output, most notably in the close contact services sectors (e.g. hospitality and travel) and that demand and output will bounce back together as the economy opens up again, so long as those firms can hire enough people to staff bars, restaurants and airplanes reasonably quickly. With unemployment still elevated and labor markets reasonably flexible, there is no reason why this shouldn’t be the case according to this school. And the Federal Reserve (Fed) seems to believe this is the most likely outcome.

 

Against that, others – notably ex-Treasury Secretary Lawrence Summers – argue that output gaps (spare capacity) weren’t large going into the pandemic, and didn’t widen significantly during it precisely because aggregate demand and supply fell together. In that case, adding even more fiscal and monetary stimulus to a world in which both demand and output are recovering strongly is just adding fuel to the fire. As Summers puts it, stimulus of 15-25% of GDP with an output gap of just 2-3% can only result in higher inflation, higher interest rates or both. The situation only gets worse if there turn out to be serious bottlenecks in labor markets and supply chains, and supply cannot respond to supercharged demand as rapidly as the optimists would have it. The April and May payroll data in the U.S., which were weaker than expected, bolstered this view of the world in some eyes.

 

A third view is that central banks can afford to wait and see. If we get the strong supply response, then an early monetary tightening could prove to be disastrous, especially with unemployment rates still high. On the other hand, if inflation does prove to be more persistent, then central banks have the tools to deal with that – better an inflation overshoot that we know how to control than another undershoot that we don’t.

 

Our scenarios represent these fundamentally different ways of looking at the world. As usual, we don’t pretend to know what will happen, nor do we claim to be blessed with a unique insight others don’t have. What we can do is use our analysis to assess the arguments and, as a team, assign probabilities to them. As usual, our forecasts come in the form of fan charts, which offer a rich set of metrics on which to base investment decisions: not just the expected outcome, but the uncertainty, balance of risks and fat-tailedness of the outlook too. These fan charts are the result of both rigorous objective economic modeling of the scenarios and our collective subjective assessment of probabilities.

 

Our “good recovery” scenario is similar to the view the Fed appears to hold. A strong supply response to rapid demand growth means we get a very strong recovery in those countries where the vaccine rollout is most advanced, with others following shortly behind. There is an inflation spike in the U.S. this year, but it proves to be transitory. Inflation also picks up temporarily in the euro area and the UK, but not as much as in the U.S. and is more a feature of headlines than core indices. The good recovery story is a bit patchier than it was in terms of the growth outlook for 2021 in emerging economies, but this is fundamentally a story of recovery delayed, as vaccine rollouts pick up during 2022, so countries like India, South Africa and Turkey join the party during 2022. In countries like Japan, South Korea, Australia and New Zealand, where non-pharmaceutical intervention (in the form of targeted lockdown and border closures) has been relatively successful in keeping infection rates low, the economic downturn has not been as severe to date, so the bounce back is unlikely to be as strong either. Nevertheless, even these countries accelerate their vaccine programs during 2022 and see a significant pickup. The “good recovery” scenario remains our single-most likely scenario, at a 45% probability.

 

We retain our two inflationary scenarios, which are distinguished by differing central banks’ reaction to rising inflationary pressure this year. The mismatch between strong demand and a more hesitant supply response drives rising inflationary pressure, and in the “overheating” scenario that translates into a large and persistent rise in inflation itself because central banks remain “strategically patient” and fail to tighten policy until recorded inflation rates are well above target and inflation expectations begin to de-stabilize. This is particularly true of the Fed and the inflationary surge is largest in the U.S. partly because stimulus is larger than elsewhere and partly because the Fed has made a greater commitment to “strategic patience” than other central banks. Ultimately, this manifests itself as a “policy error” since the Fed is eventually forced into tightening sharply, generating a big market selloff and sharp economic downturn towards the end of our forecast period. 

 

The “overheating” scenario is closest to Larry Summers’ view of the world.

 

The second inflationary scenario is called “tighter money.” It sees a similar rise in inflationary pressure this year, but unlike “overheating” central banks respond much earlier. Specifically, the Fed signals tightening to come at a lower trailing average rate of inflation and slightly higher level of unemployment than under “overheating.” The upshot is an earlier, but ultimately smaller monetary tightening, that jolts markets in 2022 but ultimately means a smaller and shorter economic slowdown than under “overheating.”

 

Finally, our “bad recovery” scenario allows for new variants to disrupt the re-opening of economies as vaccines prove less effective than currently hoped. The result is the re-introduction of social restriction in a number of countries and further economic turbulence. It also magnifies the divergence between countries, in that the virus spreads further and quicker in countries that are currently under-vaccinated, exacerbating the unevenness of economic performance worldwide. 

 

We have changed our scenario probabilities a little this time. Until recently we had been worried that central banks and the Fed in particular had “painted themselves into a corner” by committing to leave monetary policy looser for longer, so we were inclined to put the largest weights on “good recovery” and “overheating.” But the Fed’s communication on June 16th allayed those fears somewhat, so our two most likely scenarios are now “good recovery” and “tighter money,” which get 45% and 30% respectively. “Overheating” and “bad recovery” get 15% and 10% respectively, reflecting the view that an inflationary policy error or virus resurgence are less likely than they were.

 

I don’t want to exaggerate the change in tone however. We still remain on course in a number of key economies for a strong and vigorous economic recovery. I have long argued that this recession was different: it wasn’t prompted by a major imbalance in the economy, such as high embedded inflation or excessive debt. Rather, it was an “exogenous” shock which, once passed, would allow a sharp bounce back to pre-existing levels of economic activity relatively quickly. We look set to enter that phase over the next few quarters, with a positive outlook for markets as broad economic recovery facilitates a broad market one too. Let’s hope we can all enjoy it.

 

Shamik Dhar

Shamik Dhar

Chief Economist

BNY Mellon Investment Management


 

Executive Summary

What We Think - Economic Scenarios

Vaccines prove effective and rollouts pick up around the world so that global herd immunity is reached over the course of the next 12 months. There is a strong bounce back in demand during 2021 in countries where the vaccine rollout has been rapid, including the US, Euro area and UK. Other countries lag behind on rollout, but pick up during the course of 2021 and into 2022 and experience their own recoveries with some delay (Japan and a number of emerging market economies). Pent-up demand and the lagged effects of huge fiscal and monetary stimulus drive the recovery in demand. The supply response to the rebound in demand is strong too – notably in service sectors that have been locked down. The main constraint – labour availability – proves to be temporary and employment rates rise as labour is redeployed quickly into sectors where demand is strongest. Because supply adjusts rapidly, excess demand is limited and inflationary pressures prove transitory too – a temporary inflation spike driven by base effects and short-term mismatch is followed by a return towards targets during 2022 and into 2023. Central Banks are able to keep policy loose and broadly follow the very gradual tightening paths implied by their forward guidance. Specifically, the Federal Reserve (Fed) tapers in 2022 and QE ends at the end of the year or at start of ’23. The first rate rise is towards the end of our forecast horizon, while quantitative tightening follows after a few more rate rises. A benign environment for markets, with equities making steady progress while bond yields evolve in line with current forward expectations.

 

Advanced economies go through a reopening boom, with demand higher than before Covid-19 but supply is lower due to (i) labour supply issues and (ii) disruptions to trade and global value chains (GVCs). The US is the most vulnerable to this outcome: too much stimulus is poured into a recovered economy, which generates higher-thanexpected inflation that lasts longer thanks to stickiness in the labor market. The Fed continues to see these issues as temporary and stays resolute in its strategic patience as it pursues the full employment goal, accepting higher inflation as part of its average inflation targeting, possibly even implicitly raising its inflation target. However, it underestimates the likelihood of destabilizing inflation expectations. These start to move higher towards the end of 2021 and wage bids start to rise. The Fed initially looks through as 2021 is a Fed-declared noisy year but by end-2022, it is clear that forward guidance has been too dovish and the Fed is forced to hike rates quickly. The monetary tightening is sharper and lasts longer since it takes time to bring inflation expectations back down. The upshot is a sharp downturn towards the end of our forecast period, with nasty spill over effects to other economies, notably dollar-financed emerging markets (EMs).

 

Similar growth trajectory and build up in inflation as ‘overheating’. Prices, wages, and housing continue to move higher into the fall. Concerned it may be behind the curve and that inflation expectations are becoming unanchored, monetary policy tightens much sooner than expected. The Fed tapers and signals additional tightening in Q4 2021. Although recovery is less strong in developed markets ex-US, other central banks also tighten early given their more ‘traditional’ strategy. Since central banks respond sooner, there is ultimately less tightening than in ‘overheating’ and the economic and market impact is lower. A short slowdown is followed by a resumption of growth. Equity markets and other risk assets sell off in late 2021 and early 2022, as the yield curve flattens and inverts. But markets soon discount a short, sharp economic downturn and begin to recover again in early-to-mid 2022.

 

In this scenario ‘bad news’ dominates ‘good.’ New variants disrupt the re-opening of economies as vaccines prove less effective than currently hoped. The result is the re-introduction of social restriction in a number of countries and further economic turbulence. It also magnifies the divergence between countries. The virus resurges in some EMs due to a combination of new strains and low vaccination rates with further restrictions/ lockdowns required. China rebalances and addresses financial stability issues and the world lacks an engine of growth. Overall, global growth is sluggish and inflation is low as global recovery is de-synchronised. Monetary and fiscal policy remain supportive. Risk premia remain elevated since there is little central banks can do to counter the rise in uncertainty. A generalized flight from risky assets ensues. US markets outperform rest of the world, but the S&P 500 falls sharply by end-Q1 2022. Credit markets weaken especially in high yield. Bond yields trend lower and remain depressed. Fixed income performs well relative to equities in this scenario.

 

Investment Conclusions

 

Equities 

 

  • Overall, we believe equities remain an attractive option in risk assets. We expect the remainder of 2021 to be characterized by sector and stock selection as markets transition to a mid-cycle theme, continued economic strength and stronger focus on valuations. With the Fed removing inflation tail risk we see a broadening of sectors to include cyclical, secular growth and healthcare. We expect European equities to have potential for a strong second half. Many of the tailwinds remain including better valuations compared to US equities and an economy which benefits from trade and strong consumer.
  • The pandemic has changed the risk-reward balance for EMs, and there is significant dispersion of region and country outcomes. From a macro standpoint, we distinguish between EM winners and losers based on three factors: 1. Speed of vaccine rollouts vs new infections; 2. Monetary and fiscal policy space; 3. Idiosyncratic, country-specific risk factors. For countries that come out of lockdowns, cyclical sectors will fare well. North Asia will likely continue to attract flows as the opportunity set is wide in both growth and value space. We expect countries such as Mexico, Chile, and Brazil to benefit from elevated commodity prices and continued demand for real assets.

 

Fixed Income 

 

  • Although yields have consolidated in Q2, particularly in the US, the rise in inflation expectations globally is likely to put pressure on DM sovereign bond prices through the end of 2021 and into 2022. That said, higher bond yields, e.g. in the US, provide higher income returns as well as hedging benefit for some of our downside scenarios.
  • This quarter, our outlook on the credit space has become more widely dispersed among scenarios and we remind the reader that the scores and attractiveness on our heat map are based on price return potential, income potential and expected hedging properties. For US investment grade credit, we have become more cautious in the shorter term but remain positive further out.
  • Much like the investment grade space, we do not see much change in the very near-term for high yield credit, as default risk has plummeted. Next year could become more challenging though. Too-hot inflation data and rising yields could pose risks to the high yield space as the cost of borrowing rises.
  • Given expectations for higher US rate volatility, we suggest a diversified approach to allocation within EM local, HY and sovereign USD debt.

 

Alternatives

 

  • With heightened inflation and rate risk, alternatives can provide uncorrelated exposure to traditional asset classes. Precious metals remain attractive in the face of higher inflation risk, and gold in particular continues to be a hedge against short-term drawdowns in the case of a market shock.
  • As US rates converge closer to rate levels in the rest of the world, the appreciation may be somewhat limited. However we do not believe the narrowing of interest rate differentials to be sufficient to drive broad USD weakness.

 

FX

 

  • Compared to Q2, we have increased the upside risk to the USD due to A) two inflationary scenarios (‘tight money’ and ‘overheating’) which make up 45% probability and B) the Fed’s June communication weakened the market’s USD bearish conviction somewhat.

Read the full report

Shamik Dhar

Chief Economist, BNY Mellon Investment Management

Lale Akoner

Senior Market Strategist and Economist, BNY Mellon Investment Management

 

 

Alicia Levine

Chief Strategist, BNY Mellon Investment Management

 

 

Bryan Besecker

Market Strategist, BNY Mellon Investment Management

 

 

Sebastian Vismara

Financial Economist, BNY Mellon Investment Management

 


 

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