Executive summary

Beyond Covid – policy-led reflation

The global economy remains on track for a rapid and broad-based economic recovery from the Covid pandemic. 

Notwithstanding concerns around new variants of the virus, restrictions are generally being eased, as the vaccine roll-out progresses well, allowing economies to more fully re-open. Moreover, the tightening of restrictions in many countries earlier this year proved to be less economically damaging than feared, as governments, businesses and individuals found ways of limiting the number of jobs and industries impacted. At the same time, the extension of fiscal packages has ensured, household incomes have remained supported and that consumer demand has stayed robust. 

As a result, we have revised up our growth forecasts for 2021 to reflect the better start to the year than we expected, locking in the higher level of activity. Looking further ahead, our growth expectations remain strong for this year and next, somewhat above consensus across all the major regions. While there are risks on both sides of that outlook, we judge that the balance of risks to the growth outlook are to the upside, with still significant pent-up demand and excess household savings that could be deployed over- and-above our relatively conservative estimates.

We expect global growth of around seven per cent in 2021, followed by 4½ per cent in 2022, with the level of activity rising above the pre-Covid level across all major economies at some point this year. Among the major economies, the quickest recoveries in activity have been in China, the United States and Canada, where the amount of policy support has been greatest. Recovery in Europe is expected to be a little behind those economies, but should see activity back to pre-Covid levels by 2021Q4. Our growth outlook for the major economies is shown in Figure 1. We expect the high point in quarter-on-quarter growth to be 2021Q2, when the impact of re-opening is likely to be largest, with a steady return to more normal quarterly growth rates by the end of 2022.

Figure 1. Major economy GDP growth projections

The role of both monetary and fiscal policy in supporting the recovery remains key. 

Monetary policy is expected to remain easy for some time, especially in those economies where inflation has been below the central bank target in the years before Covid (although, as discussed, below recent inflation outcomes have raised some questions). With the worst of the lockdowns likely behind us, the vast amount of support for household incomes through furlough and/or enhanced unemployment benefits can recede. That is not a fiscal tightening, but rather a natural consequence of these schemes having been designed to support incomes when needed given government restrictions on activity, but to then wind down when activity returns. But beyond the income support schemes, pro-cyclical fiscal policies are underway or planned across all the major economies. Many of these policies are focussed on the goals of meeting climate change targets and reducing economic inequality. As such, significant government infrastructure plans are already agreed in the euro zone and United Kingdom, with the United States Congress expected to pass an even more sizeable (as share of GDP) infrastructure bill later this year. Some increases in corporate and high-income earners tax rates are also expected, but much of the revenue from these measures is expected to be directed to spending programmes for lower-income households.

There have been many aspects of the Covid-induced recession and subsequent recovery that have been unconventional. Unlike a more typical economic shock, where the hit to demand is the dominant factor, leading to increased spare capacity and lower inflation, the Covid shock has impacted both demand and supply. While that was clearly disinflationary in 2020, more recently the acceleration in demand (supported by excess savings and re-opening) has outstripped the available supply in some industries, creating so-called supply-chain “bottlenecks”. That has put upward pressure on commodity prices, as well as further along the manufacturing supply chain and into some consumer goods. Part of that reflects the impact of lockdowns on production in 2020, resulting in insufficient inventories to meet the rise in demand. But part of it may also reflect the unexpected speed of recovery for many businesses. Business surveys indicate supplier delivery times will remain challenging over the next six months, suggesting that some bottlenecks may persist through to the end of 2021 (Figure 2). 

Figure 2. US surveys of supplier delivery times

We expect elevated consumer price inflation to persist through to early 2022 (Figure 3), by which time the supply disruptions should be alleviated, with stronger employment and increased capacity. Moreover, the year-on-year change should fall back as it has been boosted by the unusually weak inflation outturns in 2020. Some may describe that outlook as one of transitory inflation. But rather than getting hung up on the description, we think it is more important to focus on the likely underlying inflationary pressures as we head into 2022 and the balance of risks to that outlook.

Figure 3. CPI inflation outlook

Figure 4. Monetary policy to stay loose

We think that underlying inflation pressures will be somewhat stronger in 2022 and 2023 than they were pre-Covid. That reflects our view of limited spare capacity, particularly in the United States, by early 2022. Alongside that, with wage growth (once adjusted for composition effects) remaining remarkably resilient through the Covid shock, and with inflation having been boosted by bottlenecks in 2021, we think there is greater potential for that limited spare capacity to drive wage demands and household and business inflation expectations higher. While in our central case that only leads to modestly higher underlying inflation compared to pre-Covid, we think the risks are tilted to the upside given our upside risk to demand and potentially greater pass-through into pricing.

Despite the risks of higher inflation, we expect the major central banks to be willing to accommodate that in order to deliver a more robust recovery and a sustained increase in actual inflation and inflation expectations. 

The new framework adopted by the Federal Reserve in 2020, known as Flexible Average Inflation Targeting (FAIT), will require them to start raising interest rates only once inflation has been above two per cent for a period of time and full employment has been reached. That does not mean they will be oblivious to the risks and may therefore signal lift-off somewhat earlier should the economic situation warrant it, but that they will wait until those criteria are met before moving. We expect that to be in 2023. 

The European Central Bank is due to announce the outcome of its own framework review later this year, whereby they are also expected to be more tolerant of somewhat higher inflation. However, with the euro zone economy likely to take quite a lot longer than the US to eliminate spare capacity and create sustainably higher inflation, the prospect of rate rises is more remote. The Bank of England finds itself somewhere in between the two in terms of the expected speed of recovery and elimination of spare capacity, and has not had the same issue of inflation shortfalls over the past decade. In many emerging market economies, the hiking cycle has already begun, reflecting the impact of currency depreciation and producer prices on domestic inflationary pressures.

The combination of our global reflationary outlook, alongside supportive monetary and fiscal policy leads us to be overweight global equities. That is despite somewhat lofty valuations, reflecting our expectation of positive earnings surprises, rather than further multiple expansion. In terms of regions, we are slightly more overweight in the US and UK, with an underweight in emerging markets given they offer too little valuation cushion given the increased risks there of rising US bond yields, weaker local currencies and tighter domestic monetary policy.

Government bond yields have moderated somewhat from their highs earlier in the year, possibly reflecting a combination of over-extended market positioning and some concern about the Federal Reserve raising rates too soon. Despite this, we continue to expect the growth and inflation backdrop to once again put upward pressure on yields, particularly as we see the Fed sticking to their FAIT framework. As such, we are somewhat underweight duration, mainly expressed through US Treasuries (Figure 5). The upside from tighter credit spreads appears to be limited given the narrowing already seen, and therefore we are also slightly underweight investment grade and neutral in high yield. Finally, we have a neutral view on currencies (Figure 6).

Figure 5. US 10-year nominal and real yields and breakeven inflation

Figure 6. Asset allocation summary