The key themes and risks our House View team expect to drive financial markets.
After the wild gyrations in growth of the last two years, the next year or so should see a return towards a more “normal” and more stable pace of expansion around the world.
2021 and 2022 will see very strong GDP increases across the world
The exact pattern will continue to be influenced by the transmission patterns of the virus (and by any policy or behavioural reactions to those), but it is very likely to be at an above-trend pace in most places between now and the end of 2022. That is largely a reflection of post-COVID-19 catch-up as countries re-open more fully and/or adapt to the “new normal”. Once that process is almost complete, economic growth should revert to the rates that were considered to be the norm before the pandemic.
For most developed economies that will be somewhere between one and two per cent. For China it will be closer to five per cent and for the world as a whole perhaps 3.3 per cent or so. Nevertheless, the way that GDP is measured means that both 2021 and 2022 will see annual growth rates well above those rates for most nations (Figure 1).
Figure 1. Annual growth estimates
2021 and 2022 will see strong increases compared with history
Moreover, the fact that GDP growth is slowing should not by itself be a major concern, given where we have been.
After the initial rapid catch-up, it was inevitable, a reflection of the ongoing transition back towards a resumption of normal activity. It would be wrong to interpret such trends as a conventional cyclical slowdown which might have to be met with looser policy settings. Instead, they should be seen as structural adjustments to a unique set of circumstances which will, we hope, never be repeated.
Equally, any conclusions reached that are modelled on what happens during “normal” growth slowdowns should be treated with great caution. There are few if any lessons that can be drawn from historical experience because there has been nothing remotely comparable to COVID-19-in the modern age.
Instead, the emphasis should be on ongoing robust growth rather than any incremental deceleration. The key comparison is that most countries will have returned to pre-COVID-19 levels of activity by early 2022 (many already have) and a number look as if they will approach (or even exceed) their pre-COVID-19 trend by the end of next year (Figure 2). That is an outcome which looked highly improbable as recently as a year ago.
Figure 2. GDP relative to pre-COVID-19 trend
Economic recoveries have been better than hoped
Perhaps the chair of the Federal Reserve in the US, Jerome Powell, is right and we should stop using the term “transitory” to describe the current wave of higher inflation. Every bout of inflation passes, so they are all temporary in that sense.
More importantly, although it has been less than a year that high inflation has been with us and we continue to believe that it will fall back in 2022, the transitory/permanent distinction is less helpful and relevant now. Inflation has been high enough, for long enough, to matter in terms of influencing sentiment, behaviours and expectations.
At the simplest level, changes in prices are driven by imbalances between supply and demand. During the pandemic spare capacity (excess supply) opened up, although not as much as in normal recessions because there was a big shock to supply as well as demand. Price pressures initially fell as a result, but when demand recovered sharply, output gaps closed quickly (Figure 3).
Figure 3. G7 countries output gap, IMF estimates
Negative gap closed quickly as demand recovered and supply was constrained
Although output gaps can only be estimated, the stylised facts do help explain recent inflation trends – both the sudden return of inflation as well as its subdued nature in the decade that followed the Global Financial Crisis.
It is entirely possible that demand growth now moderates after the initial rapid jumps, while supply constraints after the COVID-19 shock ease in 2022, leading to a waning of underlying inflation pressures. Nevertheless, while some of the factors which drove inflation rates to multi-decade highs (Figure 4) are likely to prove transitory, it still looks likely that a broadening of inflation pressures from conditions of modest excess aggregate demand will in coming years be sufficient to sustain underlying inflation rates above the average levels which have prevailed for much of the last two decades.
Figure 4. G7 annual CPI inflation
Inflation has spiked higher over the last year
For much of that period, the major developed market central banks (Japan and Europe in particular) have struggled to achieve their inflation targets, chronically missing them to the downside. In some extreme cases, deflation became a more meaningful threat although, outside of Japan, this has been largely avoided.
This contrasts sharply with the experiences of the inflationary 1970s and 1980s and led to a general acceptance that runaway inflation had largely been beaten or at least controlled by successful monetary policy. Sceptics have suggested that it may yet prove spectacularly ironic timing that the low inflation backdrop resulted in several central banks – led by the Fed in the US – to recently adopt a more relaxed approach to inflation-targeting, approving new regimes that effectively encourage higher inflation.
We believe that inflation will remain high compared with the average since 2000, but that it is not out of control and that central banks can contain it satisfactorily. But the confluence of factors affecting inflation currently clearly point to upside risks.
End of emergency policy settings
The special circumstances surrounding COVID-19 have complicated monetary policy decision- making considerably. In normal times, the combination of above-trend growth and above- target inflation would surely have led to at least some policy tightening, especially since current settings were effectively in maximum stimulus mode.
But as in the aftermath of the GFC a decade or more ago, a cautious approach to the withdrawal of support has been warranted. There are still legitimate concerns about the path of the virus from here and there will doubtless be further bumps along the way.
The end of emergency policy settings is now appropriate in most places
Recent history has amply demonstrated that both fiscal and monetary policy levers can be pulled quickly and effectively. It is now appropriate to consider more explicitly the timing, extent and configuration of the end of emergency policy settings, and it is this debate that has been taking place in financial markets whenever extraneous influences such as the virus do not dominate the mood and the headlines.
The first steps have already been taken. A number of emerging market central banks have already raised policy rates, and the first developed market peers have now followed. Moreover, all of the major players have signalled either a reduction in or a planned end to unconventional policy initiatives, as a precursor to eventual rate hikes. And markets have listened: current expectations are for a very modest and measured pace of policy interest rate hikes over the next few years (Figure 5).
Nothing is certain, especially with understandable worries about the possible adverse ramifications of the Omicron variant. Against the backdrop of high inflation, central banks may be uncomfortable about keeping policy “loose”. But if they foresee downside risks to growth, they can easily amend their tightening timetable or, in extremis, put them on hold. They have had plenty of practice over the last 12 years.
The ECB in particular will be nervous: they will be very keen to improve on their misguided attempts to raise rates in the past – the last two occasions are now generally accepted to be significant policy mistakes. The fact that even they are now going to some lengths to prepare markets and economies for tighter policy is one of the clearest indications that we are – finally – entering a hiking environment.
Figure 5. Policy interest rate expectations
Slow and limited pace of hiking expected by financial markets
Fiscal policy settings around the world will also be guided by the path of the virus and the related pace and shape of economic recovery. Fiscal policy did much of the “heavy lifting” during the pandemic and it is not out of the question that it could be called on again if there are renewed lockdowns or severe restrictions on activity in some areas. But absent that, budget deficits are already shrinking automatically as emergency assistance programmes are withdrawn. Our base case is that this will continue in coming years, but there will be no return to the “austerity” which followed the GFC (Figure 6).
Figure 6. Cyclically adjusted budget deficit as per cent of GDP (advanced economies)
No return to post-GFC austerity is expected
Climate change policies
Even the optimists believe that, after COP26 in Glasgow, there is precious little chance of achieving the oft-cited goal of limiting global warming to just 1.5°C.
At COP21, in Paris, all participating countries had signed up to pursue efforts towards it, agreed to contribute towards initiatives to get there and settled on periodically assessing ambitions and developments through five-year national climate plans. Progress since Paris has been lacklustre at best.
COP26 did see updated and new pledges from countries around the world to increase efforts to tackle climate change alongside some additional goals. But the overriding impression is that nowhere near enough is being done, even if all of the actions revealed in Glasgow were implemented. Essentially, to stand any chance of meeting the Paris goals, the issue will require “constant effort and unrelenting pressure on all governments, especially the major emitters”, according to the EU climate chief Frans Timmermans.
All analyses of the global climate pledges made at COP26 show a credibility gap between stated climate goals and the actions planned in order to achieve them. In all scenarios apart from the most optimistic, the world is on course to overshoot the Paris climate goals on a massive scale.
Essentially, the actions planned to achieve the Paris goals are simply insufficient and targets need to be reset. Climate Action Tracker (CAT) warns that if all official 2030 targets are implemented, global warming would still reach 2.4°C. Getting below 2.0°C would in addition require full achievement of net zero emissions pledges. That credibility gap has been reduced since Paris, but it is still significant (Figure 7).
Figure 7. Progress since Paris
The gap has closed a little
Modelling shows including all 2030 pledges could shave 0.1°C off central warming projections, reaching 2.3°C. Add the long-term promises and we could even reach 1.8°C. But there are crucial gaps.
The first is the obvious gap between all the projections and 1.5°C. That is particularly acute at the 2030 point, where emissions need to be roughly half their 2010 levels to give us a fighting chance. Annual emissions are currently above 2010 levels. The latest national climate plans and COP pledges close that 2030 emissions gap, but only incrementally.
The second gap relates to delivery. The vague, post-2030 accelerations to net zero are, in most cases, simply aspirations. The 1.8°C should therefore be taken with a mountain of salt.
But momentum from COP26 can help close both gaps. Another round of climate plans in 2022, the roll-out of targeted financing partnerships and renewed US-China collaboration all offer hope. And public interest and scrutiny has never been greater. Scepticism is understandable given the poor historic record. But if the mood and momentum do result in major changes to climate change policies, then the economic consequences would be vast. The rapid rise in the carbon price (Figure 8) in 2021 is indicative of the way the global mood is shifting.
Figure 8. European carbon futures price
Carbon price has quadrupled in 2021
Living with COVID-19
The recent emergence of the Omicron variant of COVID-19 has highlighted the difficulties in predicting the likely path of the virus (Figure 9 & Figure 10). It has also brought home the reality that we will be living with this virus, in all likelihood, for years to come. Although it remains reasonable to expect a transition from pandemic to endemic in coming months or years, the latest developments have demonstrated that, while the virus is still here, it will evolve and mutate (that is what viruses do), obliging the medical profession to make constant efforts in order to keep one step ahead.
There is still great uncertainty about Omicron, only part of which will be resolved before the end of the year. It is not yet clear whether it is more transmissible or capable of causing more serious illness among either the vaccinated or unvaccinated. The two key variables are transmissibility and whether it is more likely to evade the immune protection provided by vaccines or prior infection.
Figure 9. The Omicron variant is driving a new wave of cases in South Africa
Figure 10. Global COVID-19 case numbers
Cumulative 14-day total per 100k population
There have been some encouraging early signs that Omicron is not more dangerous and that existing vaccines do provide protection. It is also a reminder that COVID-19 is not a fixed target – it is an evolving one. And countries would be wise to accept that living with the virus will inevitably mean adapting to swiftly changing circumstances at times.
Governments will have to be nimble in imposing any new guidelines or restrictions if they are deemed necessary, and businesses and households will have to be compliant in respecting any such measures if more damaging infection trends are to be avoided.
Omicron is a reminder that this virus will be with us for some time
The best case is that Omicron is milder than previous variants and therefore vaccine protection from severe disease is high. Booster doses would then provide protection above that seen thus far in the pandemic. If this is right, then whilst the pace of infections would still need to be monitored, governments and central banks can look forward to a post-pandemic world with greater confidence and can set policy accordingly. But if new vaccines are needed, they are unlikely to be ready until next spring, so it would be more sensible to provide ongoing support.
In the worst case, where some lockdown restrictions are needed again (even if more local and specific), then economies would probably require a renewal of limited income support measures.
While most of the world continues to adapt to living with COVID-19, China has chosen a different route. Beijing has adopted a tougher zero-COVID-19 approach which has left it isolated from the rest of the world and which is coming at some economic cost. Other countries in the region that had also previously followed elimination strategies have changed and moved towards acceptance of the disease as endemic, allowing them to reopen more fully and recover economically.
In typical fashion, Chinese authorities have so far remained resolute in their insistence that their way is best. While such policies are retained, the risk of economic pain is far greater, while the continued existence of the virus globally will be a much greater threat to China: there are huge question marks over the efficacy of their own vaccines, while the national policy means a very low level of infection-induced protection.
China is in the midst of a major shift in its economic and social priorities as it heads towards the 20th Party Congress (Autumn 2022), in which President Xi Jinping will break with recent tradition and elevate himself to leader-for-life. How the state-dominated economy implements its key goals will be critical.
For the next year, stability and ensuring the ‘transition’ proceeds smoothly is a key priority, with a desire to avoid embarrassment around the Winter Olympics, the exit from the Zero-COVID-19 policy, and overdoing the pressure on real estate. A slower-growth China is expected (Figure 11) which will have spillovers to other countries, while China’s internal model will impact markets as it continues to try to open up, attract foreign capital, and integrate into global markets.
Figure 11. Low credit growth and lockdowns hamper growth
Based on the outcome of the Five Year Plan and 6th Plenum in 2021, China will aim for:
- Greater self-reliance, with the internal part of the so-called dual circulation economy promoting consumption and local production. China is more paranoid than ever about external threats but realises that it needs to integrate and participate more fully in the global economy, partly in order to have a say in global rule and standard-setting. Sectors that are seen as antithetical to these goals – ones that open it up to foreign influence or supervision – may face regulatory hurdles and political opposition.
- High-quality development rather than merely high growth, led by investments that raise living standards and expand clean energy generation. Infrastructure and capital-intensive manufacturing will not be stopped, but SOEs will upgrade to become more efficient and less polluting. On the flip side, there will be taxes and transfers that are painful for those sectors that have grown dominant, limits on “negative” activities (gaming, online tutors, celebrity influencers) and property taxes once that sector is more stable.
- Risk-reduction: Ensuring stability is a priority not only because President Xi needs to ensure a smooth transition in the short term, but also because long-term growth is now weaker, and setbacks can damage strategic priorities. The main concerns are financial risks: the large and growing leverage in corporates and households, sprawling conglomerates attempting to straddle or arbitrage regulatory limits, and the property sector overall (Figure 12). A key term is “disorderly expansion of capital”, an umbrella term that encompasses not just debt ratios or dependence on foreign capital, but market dominance that runs counter to shared affluence. These efforts may precipitate a hard landing, one of the risks to our 2022 House View.
Figure 12. China’s real estate crackdown is taking a toll
China and the US will seek to de-escalate the trade war and reduce risks of decoupling, but overall relations and geopolitical tensions between China and its neighbours are at multi-year lows; the pithy label of a Cold Peace from Eurasia Group is the correct characterization.
Strains will continue but are increasingly shifting to technology, ideology, and global rule-setting, including ‘unfair’ competition via SOEs and official/state bank support. In contrast to the Trump tariffs, a multilateral approach is being taken under Biden, together with the EU, the UK, and allies in Asia like Australia and Japan. They will look to compete with China, cooperate where possible (e.g. on climate) and punish when necessary (human rights, interference in politics).
It turns out that restarting economies after large parts have effectively been put into an induced coma is not that easy. Perhaps it should not have been a surprise – there is no comparable playbook to follow in today’s singular circumstances.
In “normal” upswings, there have often been periods after demand recovers when supply has struggled to keep up, at least initially. Given the unprecedented extent of recent falls and subsequent rebounds in activity levels, it is quite possible that we are simply experiencing extreme examples of this pattern and that imbalances will fade away once economies reopen more and supply can respond more fully. But even if true, this does not make the present experience any less uncomfortable.
Moreover, mismatches have been compounded by exceptionally low inventory levels which have resulted from the inexorable drive towards just-in-time stock management methods, as well as restarting frictions in key parts of the global transportation system. Although stock levels are still low (Figure 13) and delivery times lengthy in many goods sectors, a number of these difficulties had appeared to be starting to ease recently.
Any renewed frictions as a result of Omicron and any subsequent containment measures would re-aggravate supply-side challenges and add to, or at the very least, sustain cost-inflationary pressures.
Figure 13. German inventory levels, IFO survey
Many inventories are at all-time lows
Supply-side shocks are not uncommon, part of the normal cyclical process of disturbance and revival. But what has been unique about the recent experience has been the number of sectors across the world simultaneously facing a “once-in-a-century” shock to supply.
One of the reasons that initial estimates of the extent and scale of disruptions proved too optimistic was that they were largely based on supply-chain guidance from firms via business surveys that in turn reflected their own historical experience. But companies have only limited visibility over the entire – and very interconnected – commercial network which their small chain makes up only a small part.
The coordinated and massive aggregate supply shock meant that taking the average guidance from firms was misleading. It also complicates any assessment of the resolution of supply-side issues: it may not be until nearly all aspects correct that a durable improvement will be seen.
There are some encouraging signs. Most industries are operating again which will allow orders to be met and inventory levels to be rebuilt. Microchip manufacture levels, for example, are returning to normal. Transport bottlenecks are easing, and goods trade has recovered well. Shortages of key commodities – including energy – should diminish next year, especially if new supply can come on stream.
It now seems plausible that supply-side problems will last well into 2022, even if they do moderate a little. A final worry is that any transition of spending back to services (Figure 14) may ease pressure on goods but could intensify those on services (mainly labour).
Figure 14. Consumer spending trends in the US – goods and services
Spending on goods has soared in the pandemic
Inflation rates of four to six per cent in the major developed economies that have been recorded recently might already be described as an outbreak of dangerously high inflation (Figure 15). And in strict numerical terms that is a fair depiction, especially in the context of the history of the last 20 years or so.
But if inflation rates do fall significantly next year, as we expect, then the present apprehension about excessive inflation will ease quickly. There is a unique confluence of factors pushing inflation higher at present, including the energy price spike and the unprecedented effects of reopening mothballed economies.
There are some limited parallels with the aftermath of the GFC: G7 CPI inflation spiked to 4.6% in July 2008, but fell back swiftly, averaging just 1.3% over the following three years. But inflation might be more stubborn this time around – the spike is bigger, policy is looser, supply strains may continue, and central banks have become explicitly more tolerant of higher inflation.
Figure 15. CPI inflation in 2021 vs average since 2000
Inflation has spiked higher almost everywhere
History has demonstrated that if inflation is allowed to become established, it can become more difficult to shift.
One of the greatest concerns is that if higher inflation becomes more entrenched in expectations, then it will feature more prominently in wage- and price-setting behaviours, thereby ensuring that the inflationary impulse continues or accelerates. This is the sort of inflation outbreak that central banks really fret about and recent events have conspired to produce a set of circumstances which have intensified that risk.
Policymakers are on high alert for clearer evidence of “old school” overheating and damaging second round effects. There have been some signs of higher wage inflation, but so far they have been reasonably contained. If these became more worrying, central banks may feel that they have no choice but to tighten policy significantly to slow demand. This would represent a major shock to financial markets and in the worst-case scenario could threaten the hard-won credibility of inflation-targeting central banks.
At the start of the COVID-19 pandemic, conventional wisdom was that many countries were already running up against the limits of fiscal sustainability. For example, the January 2020 Debt Sustainability Monitor published by the European Commission identified medium-term risks in several large European economies including Belgium, France, Italy, Spain and the UK, as well as lower grade risks almost everywhere else.
Since then, COVID-19-related fiscal programmes have boosted public debt ratios by 15 to 20 per cent of GDP on average (Figure 16) and budget deficits are still significant everywhere. But attitudes have evolved: there has been greater tolerance of higher borrowing in current circumstances and a recognition that perhaps debt and deficit ratios should be seen in a context other than simplistic comparisons to annual GDP.
Figure 16. Public sector net debt as % of GDP and IMF projections
80% of GDP was once considered the upper limit for sustainability
Nevertheless, the algebra of fiscal sustainability still holds, and key relationships remain between variables including the rate of economic growth, pace of inflation, initial public debt ratio, primary budget balance and rate of interest.
The more enlightened approach to acceptable fiscal metrics allowed policy to provide critical support during the pandemic, but there may still be limits and these will vary enormously across countries.
Several emerging market economies do not have the luxury of being able to take on extra borrowing (Figure 17) and/or debt without potentially damaging consequences for their bond markets and/or currencies. Sharp movements in either can quickly push such countries onto untenable paths and severely curtail market access. The IMF has been notably more relaxed about the fiscal situation in all countries, but still recognises that a credible medium-term fiscal framework will be needed in many EMs and perhaps some DMs too.
Figure 17. Overall budget balance (% of GDP)
EM public borrowing has been more restrained
Nobel laureate economist Paul Krugman famously said that productivity isn’t everything, but in the long run it is almost everything. A country’s ability to improve its standard of living over time depends almost entirely on its ability to increase output per hour worked.
It is well known that trend productivity growth tends to slow as economies develop because they transition towards service sector activity where it is far more difficult to increase output per hour worked – more output usual requires more worker input. But the slowdown in the last 20 years has been far greater than expected (Figure 18). (Note that the leap at the end of the chart simply reflects the special circumstances of COVID-19: official hours worked fell far more than aggregate output.) There is some tentative initial evidence that the pandemic re-set is persuading businesses to re-examine their attitudes towards productivity-enhancing investments and to innovation in general.
Figure 18. G7 productivity (GDP/hours worked) growth rate
Productivity growth has slowed significantly since 2000
If the COVID-19 experience does act as a catalyst to the introduction of any such measures, then there is a reasonable chance that such change could boost underlying productivity growth, with wide-ranging positive consequences for potential economic growth.
The vast majority of developed market economies are currently struggling with the slow-burn and ongoing hit to trend growth from the ageing populations which is severely reducing the population of working age (conventionally defined). Any offsetting boost from improvements in productivity growth would be a hugely valuable counterweight to this demographic inevitability.
It is far too early to reach definitive conclusions, but productivity boosts could come from accelerated growth of ecommerce, increased adoption of automation and AI, more flexible working practices as well as from the more general acceptance of different attitudes towards change and innovation that have been ushered in by COVID-19. If productivity growth were to get a meaningful boost, the dynamics of growth would change significantly.
China policy mistake
China’s importance in the global economy makes the impact of any slowdown there significant. China has had a series of policy-induced problems in the past, from stock market crashes to massive capital outflows and bank restructurings. But they have always managed to keep their growth model intact.
China is now treading a distinctly different path in terms of economic development and participation in global politics and commerce (see themes earlier), with less emphasis on growth and an effort to reduce risks, including corporate and real estate leverage following a long-lasting property boom (Figure 19), and a crackdown on corruption and rogue oligarchs who do not toe the line.
After initial success with COVID-19, China has yet to find a safe way out of its “zero COVID-19” strategy, which is also damaging output and employment. Longer term, geopolitical strains with neighbouring countries and the world’s dominant superpower continue to cause tension, but the proximate risk is that the property downturn causes damage to household and bank balance sheets (Figure 20) and that negative wealth effects hamper spending, while credit loosening is too slow to cushion a severe downturn.
Figure 19. Property crash?
Investment and land sales dropping precipitously
Figure 20. Debt by sector
Leverage has grown tremendously, posing repayment risks
The additional uncertainty introduced by the discovery of the Omicron variant is a timely reminder of the risks of mutations to the COVID-19 virus. Whether this latest version proves to be a major problem or a minor hiccup, it has become clear that as long as the virus is still with us (and that looks plausible for at least the next couple of years and quite possibly much longer), there will be bumps along the road to the post-COVID-19 future.
The various waves of infection of the last two years have been driven in substantial part by the ebb and flow of these variations. These have, in turn, determined the timing and extent of any resulting lockdown restrictions and hence the magnitude of the economic hit that followed. That is likely to be the pattern again in 2022 and perhaps beyond, although the experience of the last year has demonstrated how quickly and how comprehensively businesses and households have been able to adapt to restrictions.
Further COVID variants have the capacity to influence the pattern of growth
The combination of this escalating adaptability alongside the protection provided by vaccinations (and inflection-derived resistance) means that it is extremely unlikely that any single country will experience anything remotely comparable to the shocks of national lockdown of last year and early in 2021. However, it is still possible that Omicron – or some future variant – may yet need to be countered by limited or localised restrictions to activity. Or that their existence leads to changed behaviours that impact supply, demand or both. To the extent that they do, macro-economic outcomes will be impacted.
Again, these things are more likely to change the journey (growth, inflation and policy timepaths) rather than the end-destination. But while they exist, the impact of the virus – including both shorter-term inflation drivers (further supply-chain disruptions) and long-term scarring effects – should not be ignored.