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.