The key themes and risks our House View team expect to drive financial markets.
The pattern of economic rebound from the COVID downturn in 2020 has been dictated by trends of the virus itself and by the related extent to which it has been possible for countries to ease lockdown restrictions. The adaptability of businesses and individuals in the face of those constraints has also been critical in defining the shape and strength of recovery.
Essentially the ability of companies and households to get used to restrictions has meant that the impact on activity from the ebb and flow of restraint has been successively lower in each wave. Meanwhile, the successful roll-out of vaccination programmes has greatly reduced the threat from the virus. Although COVID is almost certain to be with us for some time – and there can of course be new variants in the future (see the risks section) – it should have less and less of an effect on economies.
The impact of lockdown restrictions on economic growth has been progressively lower
The impact on economies has been well-documented. Global GDP fell sharply in Q1 and Q2 last year, before staging a huge revival in Q3. As successive waves followed, activity slowed abruptly again in Q4 and Q1 this year – falling once more in a number of regions, although the gyrations have been much less extreme than during the initial wave (Figure 1).
Figure 1. G7 quarterly GDP growth, 2020-22
Growth should be strong in Q2 this year but will slow thereafter
Variations in case numbers have also led to a greater disparity in experience between countries. But a more lasting recovery now looks to be underway – there is still the possibility of renewed restrictions if circumstances change, but with vaccination efforts progressing, any future disruptions should be minimal. However, as we have stressed on many occasions recently, just as this was no ordinary downturn, it will be no routine upswing either. There is no template from history to follow.
Some activities have rebounded swiftly. Households have quickly adapted to new ways of retail spending, with home deliveries replacing many shopping outings. Manufacturing production and construction activity have also recovered to close to “normal” levels. World trade flows have revived sharply too, although there has also been a post-Trump (remember the US-China induced trade spat?) rebound here as well. Other activities, those that involve or even require close social contact, will take longer to recover and some may be impacted for years or decades to come. But service activities are gradually returning, and many are expected to continue to do so over the rest of 2021 and beyond.
The recovery is becoming more broad-based. The next 12 or 18 months will see a considerable amount of growth catch up with, in our view, upside risks (Figure 2). The exact pattern is more difficult to predict but we – like most forecasters – have spread it out over time as a base case. As a result, we have an historically strange pattern of strong growth that slows steadily from now until the end of 2022.
Figure 2. Difference between Aviva Investors and consensus GDP growth forecasts
Upside growth potential in 2021
Fiscal – becoming pro-cyclical?
Fiscal policy has been crucial in providing financial support to businesses and households during the COVID pandemic. Measures had to be large, open-ended and immediate, and although there were some extraordinary moves in GDP, and also minor delays at the start, by and large that is what we got (Figure 3).
Figure 3. Size of fiscal support in response to COVID, % of GDP
Extent and nature of support has varied across nations
As the Iinternational Monetary Fund (and others) continue to insist, it is vital that fiscal backing is not withdrawn prematurely, but instead continues to support both individuals and companies as activities restart and people return to their jobs (or begin new ones). There will inevitably be considerable fragility that implies the need for ongoing support during such transitions. It will take time to get back to normal, and many organisations and individuals could be hampered by, for example, debts taken on during the pandemic.
Fiscal metrics should improve automatically during the economic recovery
Many fiscal aggregates will improve automatically – and it is hoped quickly – as the various support schemes are withdrawn because they are no longer needed, or at least not to anything like the same extent. This process is already underway, but further progress should be made in the rest of this year and into 2022. This should not be mistaken for premeditated fiscal tightening or “austerity”, even if some in the media choose to characterise it as such. It is simply the removal of emergency measures. As a result, public sector borrowing should fall back sharply from the ten per cent to 20 per cent of GDP figures that were common in 2020 to something more like five per cent to ten per cent this year and lower in subsequent years (Figure 4). It is estimated that the COVID pandemic will effectively add around 20 per cent to public debt to GDP ratios in all of the major developed nations.
Figure 4. Public borrowing as % of GDP (IMF Fiscal Monitor)
Deficits should shrink rapidly in 2022 and 2023
But the fiscal landscape is not all about COVID. As we outlined in the last House View, there has also been a well-defined change in attitude towards fiscal policy.
Perhaps we are not returning to the overt fiscal activism of the 1960s and 1970s everywhere, but in a number of places, fiscal policy seems to be stepping back into the limelight. COVID may have been a catalyst in this process. This has been most apparent in the US, previously thought to be the place least likely to embrace activist fiscal demand management policies over the last 30 years or so. If these trends continue, then it is right to consider an evolution from fiscal support to fiscal stimulus as a key part of the possible policy backdrop in coming years.
Whatever the micro-economic merits of the various Biden administration proposals, it is impossible to ignore the likely macro-economic impact in 2021, 2022 and beyond. Fiscal measures are now quite clearly adding to overall demand, to the extent that US GDP could easily exceed the pre-COVID path very soon. Stimulus packages are less grand elsewhere, but it does seem appropriate to accept that fiscal policy is back in vogue.
Monetary policy re-boot
For the major developed nations, the period between the early 1990s and the onset of the Global Financial Crisis (GFC) in 2007/8 has been described as the “Great Moderation”. It was characterised by a marked reduction in the volatility of business cycle variations compared with post-war history.
It is no coincidence, in our view, that this was also a time when most central banks had adopted strict inflation targets – typically around two per cent. And most achieved these targets, more or less (Figure 5). Between 1992 and 2007, the relevant inflation measure averaged precisely two per cent in the US and UK and 2.2 per cent in the euro zone. Japan was the exception, averaging just 0.2 per cent. Since 2008, inflation has generally been lower, especially in Europe and Japan, and that has contributed to a reassessment of monetary policy. This has been most radical in the US, where an explicit “flexible average inflation targeting” (FAIT) regime has recently been adopted by the Federal Reserve.
Figure 5. US core PCE inflation
The Great Moderation
This monetary policy re-boot, as we have termed it, is a major change in the policy framework. Essentially it implies that, rather than automatically resisting any inflationary impulse – often in anticipation – central banks will instead try to achieve an inflation target on average, over a longer time period. This implies a greater tolerance of higher inflation in the future. But as economies recover from the COVID experience and re-open, the new regime has immediately faced the challenge of some sharp upward moves in inflation.
The Fed is unlikely to swiftly backtrack in response. Instead, they are likely to use the flexibility of recent changes to hold back from responding to higher inflation outcomes (and forecasts) as they would almost certainly have had to do in the previous regime. Financial markets seem to have some faith in the new regime; so far, they pencil in only very modest policy rates rises over the next few years (Figure 6). In other words, the monetary re-boot remains firmly in place and will continue to frame the monetary policy backdrop around the developed world in years to come.
Figure 6. Policy rate expectations in the major developed regions
Markets expect only modest tightening over next 2/3 years
At present, much of the attention has focussed on the Fed and the US where the recent spike in inflation has been most marked. But others, including the ECB, the BoJ and the Bank of England have all edged in a similar direction. The ECB is set to report on its own strategic review this September, when it is expected to clarify and present an amended (and symmetric) inflation objective, alongside measures that shift it in the same direction as the Fed.
Given the ECB’s serial under-achievement in recent years, the guiding principle should be one which openly nurtures higher inflation. As has often been the case in Europe, change is more gradual – evolution rather than revolution, but steps in this direction should still be acknowledged as an important change.
Inflation has risen noticeably in recent months in many developed economies, leading to debate over how much of the recent increases are transitory and how much might be permanent (Figure 7).
Figure 7. Headline CPI inflation in the major regions
Above-target inflation has been a rarity in recent years
Headline rates are always buffeted around by “one-off” factors. But “core” rates have risen too, suggesting that there is something more fundamental happening. But care needs to be taken because of the extraordinary – unique even – times that we are living through. COVID has come after a lengthy period of “low” inflation and has coincided with a major reassessment of how inflation-fighting central banks should conduct monetary policy (see policy re-boot theme above). This combination means that there are many moving parts to both the explanation of and the prospects for inflation. The present blend of elements makes it more likely than not that we will see modestly higher underlying inflation than we have perhaps got used to in recent years.
This should not necessarily be seen as an alarming development. Indeed, although it may bring about a shudder to those brought up in the inflationary 1970s and 1980s, a little bit of higher, positive inflation is deemed a “good thing” by many and is a stated ambition for at least some central banks, especially those in Europe and Japan.
Deflation fears – quite prevalent not that long ago – would be a far bigger concern
The alternative of low, even negative inflation or outright deflation is a much more dangerous phenomenon and one that all central bankers wish to avoid. The pervasive deflationary impulse in Japan over the last several decades and the much shorter, but at the time very real, concern over the possibility of similar developments in the euro zone in the wake of the sovereign debt crisis there has cast a pall over these economies, and has been a key part of the secular stagnation thesis that has coloured much recent thinking.
There is today a potentially potent combination of factors that argue for higher inflation. They include the re-opening of economies, pent-up demand and excess savings and damage to parts of the supply-side of economies that may result in frictional mismatches or more lasting shortages and bottlenecks. In addition, current policy settings are loose and likely to remain supportive for some time, while central banks are now adopting a more explicitly pro-inflation stance.
Ultimately, underlying inflation trends will be determined by the balance between supply and demand, although some allowance needs to be made for temporary mismatches as economies restart after COVID. Our projections indicate that output gaps will close by the end of this year or in early 2022 (Figure 8). Policymakers should have time to react, but if growth has not slowed back to trend rates by then more action may need to be taken to make that happen. We do not believe that inflation will be a major policy problem, but it would be complacent not to recognise the risk (see below).
Figure 8. Output gap projections
All should have closed by the end of 2022
The G7 summit in Cornwall in June laid bare many truths about progress, or the lack of it, in key areas of climate change policy, with frustrations from a number of developing and emerging economies coming to the surface regarding the $100bn commitment outlined in the Paris Agreement. Many expressed their irritation at the very limited steps taken so far, with a clear suggestion that developed nations – who after all are ultimately responsible for much of the current crisis – are not facing up to their responsibilities, honouring their laudable commitments and delivering the finance that can actually start to make the required changes happen.
There are a number of key set-piece events over the coming four months
Attention will now move on to the G20 finance summit later in July, pre-COP meetings in Milan in September and the full G20 meeting in October, before COP26 itself in Glasgow in November. As always, the devil is in the detail. The G7 communique at the end of the Cornwall summit contained several climate-related goals, including further detail on net-zero commitments, ambitions to reduce or eliminate public funding support (such as subsidies) for coal and other polluting activities, support for moving towards mandatory disclosures based on TCFD – the Task Force on Climate-related Financial Disclosures – which aims to improve and increase clear and accurate reporting on climate-related financial information. Commitment to the $100bn climate finance for developing countries is one thing, but much more detail on actual delivery is urgently needed. Finally, the communique referred explicitly to the need for an “optimal use of a range of policy levers to price carbon”. Since the last House View was published, the European carbon price, for example, has risen from around €40/tonne to well over €50 (Figure 9).
Figure 9. EU trading: indicative carbon price
Has risen sharply in 2021, but probably has further to go
There are essentially four goals at COP26. First, mitigation – to secure global agreement to deliver net zero emissions by 2050, thereby helping to ensure that global temperature increases are restricted to 1.5 degrees Celsius by 2100. 2030 nationally determined contributions (NDCs) will have to align with these two objectives. Far more progress has been made on this than the remaining three goals. Second, adaptation – to make real progress on dealing with the impacts of climate change that are already occurring. Third, to mobilise the $100bn of annual climate change finance to low- and middle-income countries meaningfully. Fourth, collaboration – finalise the detailed operational rules of the Paris Agreement by creating fully-functioning carbon markets and establish practical climate change cooperation between governments, businesses and civil society.
The Notre Dame University Global Adaptation Initiative (ND-GAIN) uses data from multiple indicators to rank countries based upon their vulnerability to climate change and their readiness to successfully adapt (Figure 10). A higher number is “better”, with Norway and New Zealand currently at the top of those rankings.
Figure 10. Latest ND-GAIN index values
Higher numbers signify countries that are adapting to climate change better
Global regulation and taxation
Taxing and regulating international businesses have always been areas of extreme complexity and dispute.
Increased globalisation has contributed to capital becoming exceptionally mobile internationally, able to respond quickly to differences in tax and regulation incentive structures around the world. These trends have been compounded by the increasing digitalisation of commerce.
As tax and legal authorities have attempted to keep up, rushed and piecemeal legislation and rules have been put in place, often in a haphazard manner. There is now growing momentum behind efforts to establish an international consensus-based solution to prevent the proliferation of such uncoordinated unilateral measures. If successful, this should also help avert a worldwide “race to the bottom” on tax and regulation.
Important progress has been made recently, but still a gulf between theory and implementation
Those efforts have been led by the OECD who, after wide-ranging discussions with relevant nations spanning several years, were able to announce an historic international agreement on global tax reform at the G7 meeting in Cornwall. This focussed on an “ambitious two pillar global solution to tackle the tax challenges arising from an increasingly globalised and digital global economy.” (G7 communique, 5th June 2021.)
Under Pillar One, the largest and most profitable multinationals will be obliged to pay tax in countries where they operate, rather than solely where they have their headquarters. Under Pillar Two, the G7 also reached agreement on the principle of a minimum global corporation tax rate of 15 per cent. There is less disparity between national tax rates than there was, but it is still significant (Figure 11).
Figure 11. OECD estimates of corporation tax rates
Still significant differences across nations
There is also still a wide gulf between theory and implementation. And it may still take several years to establish the necessary organisational infrastructure and systems to complete the task. But the direction of travel is now clear, and agreement of the basic principles of global tax and regulation architecture for the future is a vital foundation step. These initiatives will frame the multinational operating environment for years to come.
Several developing nations depend disproportionately on corporation tax revenues
These latest developments are actually only a part of a range of issues that the OECD have been looking at in recent years under the banner headline of “base erosion and profit shifting” or BEPS. These comprise tax planning strategies used by multinationals to exploit gaps and loopholes in international tax rules. As the OECD points out, developing countries’ greater reliance on corporate income tax means that they may be losing out from BEPS disproportionately. It is estimated to cost between $100bn and $240bn annually in lost revenue globally.
The EU has good reason to wish to expedite change quickly since the region has some of the largest and most generous welfare systems in the world, and financing them is no small task. Unsurprising, therefore, that European governments have concentrated attention on companies, especially large ones which have flourished with the abrupt shift to an on-line world. Internationally coordinated efforts are the benchmark, but it is also possible that the EU (for example) embarks on additional or more stringent measures.
Global strategic competition
This theme evolved from the trade war conflict between the US and China that was initiated under the Trump administration, to encompass the broader area of medium-term strategic competition between major nations in a number of areas.
The main proponents are the same, but others are becoming more involved. Trade sanctions in the form of tariffs are still in place and these will doubtless be used as bargaining chips during future negotiations between the relevant countries. It seems reasonable to assume that relations will be less overtly confrontational than they were under Trump, but the notion that there would be an immediate rapprochement under President Biden was always unlikely.
There will always be differences between China and the US (and others), but that should not prevent compromises being reached
In the previous House View, we had characterised the Sino-US relationship as likely to exhibit at least some similarities to the Cold War relationship of the US and Russia in the 1980s. Now, as then, there will be moments of heightened tension. But that need not prevent some form of workable co-existence becoming established.
Political experts from Columbia University have suggested that the Cold War analogy should not be stretched too far. After all, China and the US are not engaged in ideological struggles to win the hearts and minds of third countries, neither is leading alliances that could foster war or nuclear conflict, and the world is very different today. Even so, it seems plausible that US-China (and indeed World-China) strategic competition may assume some ideological dimensions that will have to result in an effective agreement to differ.
One of the key differences is that China today is experiencing an inexorable rise in the global rankings that is expected to continue (Figure 12). The Soviet Union in the 1980s was in decline. China will, presumably, continue to embrace a model of authoritarian state-led capitalism – rather than “conventional” open-market democracy. But there must be room for some for compromises and movement towards abiding with a rules-based international order.
Figure 12. China is moving to top spot in the global GDP rankings
China GDP as % of US GDP
These sorts of issues are likely to frame international diplomacy in the future. They may not disrupt or upset the global balance – and financial markets – as much as some of Trump’s more controversial initiatives, for example. But they are not unimportant. Positive progress in some of these areas would enhance the overall outlook; stalemates and non-resolution would cloud prospects.
It is to be hoped that all sides will see the value in reaching solutions where differences exist, even where it proves impossible to bridge known gaps. There are clear risks for less than optimal resolutions: China has strengthened its cooperation with Russia and has signed a strategic partnership with Iran, but it is obviously doing so for its own ends – not to foster revolution and political uprising.
Hacking operations have, unfortunately, become well-established, and it is widely suspected that both Russia and China have made use of cyberspace to spread on-line disinformation which aims to destabilise western democracies. There can be conflict and difference – even on a protracted basis – over national values and geo-political and economic interests. But there is still room for more harmonious co-existence which must, in the end, be in all parties’ interests.
At the simplest level, inflation is determined by the balance of supply and demand and by whether central banks accommodate any inflation impulse or not. For now, all continue to stress their belief that higher inflation is transitory. Sovereign bond markets appear to agree: yields have risen a little but are still low (Figure 13). The risk is that inflation is not benign, transitory and desirable.
Figure 13. 10-year sovereign bond yields
Offer no protection against a big rise in inflation
Instead, it reflects excess demand, meaning inflation will continue to rise (or at the very least remain uncomfortably high) and that it will become embedded in expectations. In this case, damaging second round effects – wage bargaining behaviour for example – will start to become more visible and Central banks will be obliged to react, possibly quite aggressively.
If this is what happens, then at some point, bond markets will have to react.
Monetary tightening of this nature will help usher in the next economic downturn in order to suppress demand and squeeze inflationary pressure back out of the system. A good old-fashioned, if modest (we hope), overheating episode. The shock of this sort of event would be all the greater for coming after an extended period of below-target inflation which has led to a cosy acceptance that such episodes are a thing of the past (Figure 14).
Figure 14. 10-year breakeven inflation rates
Expectations have risen, but remain reasonably contained
Any return to inflation, even if minor compared to earlier instances, would be deeply damaging. Household and business optimism would weaken and the hard-won belief in Central banks’ ability to achieve low and stable inflation would be shredded.
The algebra of fiscal sustainability is well understood, with key relationships between variables including the rate of economic growth, pace of inflation, initial public debt ratio, primary budget balance and rate of interest.
The COVID episode has resulted in yawning budget deficits and has added significantly to public sector debt burdens (Figure 15). At the start of the pandemic, there were worries that those countries which already had delicate fiscal balances might be swiftly pushed onto explosive and unsustainable public debt.
Figure 15. Net public debt as % of GDP and IMF forecasts
COVID has added 10% to 20% of GDP to public debt
While that remains a threat, the worst fears seem to have diminished, largely because growth has resumed, inflation is low but positive and borrowing rates, although a little higher, have remained historically very low. Real rates have stayed historically very low too, despite subdued inflation (Figure 16). 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. Estimate of G7 real interest rate
Low real rates ease fiscal burden enormously
However, not all countries are equal. Some developed economies were already on the cusp of sustainability before the COVID pandemic and therefore remain vulnerable to any sudden changes in circumstances.
More fundamentally perhaps, several emerging market (EM) economies do not have the luxury of being able to take on extra borrowing and/or debt without potentially damaging consequences for their bond markets and currencies. Sharp movements in either can quickly push such countries onto unsustainable paths and severely curtail market access.
Knowledge of these possibilities has meant that most have not increased debt burdens anything like as much as the major developed countries. But deficits have still widened sharply in the face of COVID and vulnerabilities have increased. 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 emerging markets.
The massive amount of assistance that has been provided during the COVID crisis aims to support companies and individuals financially so that both can resume commercial activities when circumstances allow. Sadly, it is inevitable that not all will survive. The extent of this damage will only actually become apparent when the various schemes are withdrawn, a process that has only just begun but which will become far more advanced in the second half of the year and into next.
There is always a continuous long-term process of business creation and destruction. But COVID will have exaggerated this. Some firms will go under, others will reduce the scope and size of their operations. Some jobs will not be there to return to, and unemployment will rise. It already has (Figure 17) but the likely true extent has been hidden by the various support schemes. GDP may be permanently lower than it would otherwise have been. As in many other areas, this is totally new ground – there is no precedent, so we can only estimate the possible extent.
Figure 17. Unemployment rates in the major nations
Furlough has hidden unemployment and underemployment
Using the UK as an example, the Office for Budget Responsibility (OBR) has estimated that GDP could be two per cent lower indefinitely because of such effects. That would be an immense permanent economic loss.
The COVID experience may have a lasting impact on the ways in which many activities take place
Moreover, it is not a binary issue – whether there is a job to resume or a company to restart. The COVID experience is widely expected to have altered some behaviours profoundly, especially in areas characterised by close social contact. It may take far longer, for example, for international or business travel to return to “normal”; working practices may have changed permanently, meaning less need for as much office space or public transport and lower demand for any attendant services. Less hours may be made available to workers in such an environment, even if only temporarily.
All these factors imply lower incomes, spending and output. Even if resources can be re-deployed elsewhere, transitions will not be painless. If permanent damage is worse than feared, the supply-side hit to economies could have damaging knock-on impacts on long-term growth.
The last three months have brought mixed news on the COVID front, with greater hurdles to tackle in the shorter term, but perhaps increasing confidence in the slightly longer term.
The recent dynamics of virus variation have shown how quickly they can develop and become dominant. So far, existing vaccines have proved effective against new variants and that remains the central view. But given the uncertainties, it would be complacent to ignore the possibility that something more dangerous and damaging emerges, obliging authorities to once again impose restrictions and usher in another economic setback.
So far, existing vaccines are proving effective, but transmission patterns can change quickly
The recent experience of the Delta variant of the virus has for the first time combined faster transmission with a material impact on the effectiveness of vaccines. Thankfully at this point it seems that the reduction in efficacy is a delay to protection rather than significantly less eventual protection.
Prior to this variant, the level of protection of a first dose of vaccine had been beyond initial expectations. The most recent news is that the efficacy of that first dose of protection has been significantly reduced. This has the impact of delaying the population level benefits of high levels of immunity even for those vaccine programmes which are relatively advanced. The damage is further exacerbated by the higher levels of transmission, which mean that countries which had previously been able to contain the pandemic with a high degree of success are now struggling, with many countries (particularly in South East Asia, Figure 18) recently suffering their largest waves of infection.
Figure 18. New waves in south-east Asia
Latest trends illustrate the dangers of renewed infections
Longer term, the evidence that existing vaccines retain strong efficacy after the second dose increases confidence that science can remain ahead of the pace of mutations. Not only do we have multiple vaccines which are currently effective, but we already have evidence that relatively soon we will have an additional cushion against further mutations.
Recent studies have shown that third doses, mixing the vaccines for the two doses and also new updated vaccines (specifically targeting the beta variant) all have a material impact on increasing the quality and quantity of antibodies. Although this evidence suggests that scientific progress will allow us to remain on top of COVID dynamics, it is still sensible to consider the risk of a worse outcome.