Executive summary

Growing pains – strong demand, constrained supply and elevated inflation

The course of economic recoveries and expansions never runs smoothly. Businesses need to adjust to the changing environment and are just as likely to be surprised by the strength of demand as by any unexpected weakness; still, the current global economic expansion is unique.

Following the unprecedented decline in activity in 2020, economies have recovered rapidly – much more briskly than many forecasters, businesses or households had expected. Supported by extraordinary fiscal and monetary policy support and driven by a rapid recovery in consumer demand, economies experienced a material shift in the mix of consumption, towards goods and away from services.

The pace of recovery has seen some major economies, such as the United States, already surpass their pre-COVID recession level of activity, with others such as the Euro zone and United Kingdom expected to reach that point by the end of 2021. As a result, these economies have regained their pre-crisis GDP within around 18 months of the deepest recession on record. That compares with between three and seven years to return to the prior peak in activity following the global financial crisis (GFC) of 2008. Moreover, we and many other forecasters expect economies to return to their pre-COVID trend path of activity by the end of 2022, something that most economies never achieved following the GFC (Figure 1).

Figure 1. Global activity: a recovery to pre-COVID trend, unlike the post-GFC experience

However, the combination of manufacturing shutdowns in 2020, the speed of recovery in demand in 2020/21 and the lingering effects of COVID restrictions in parts of Asia (that have either pursued a zero-tolerance approach to infections or currently have low vaccination rates), has led to some growing pains. These have become more evident over the course of 2021, as commodity, manufacturing and retail inventories have fallen sharply, with production unable to keep pace with the level of demand.

Figure 2 shows just how extreme those inventory issues have become, with both manufacturing and retail at historic extremes in the low level of inventories (relative to those desired). It is also a vastly different experience to the same point in the recovery from the GFC, when inventory levels were around average. The situation today reflects a range of factors, including: under-investment in the years preceding the COVID crisis; factory closures in H1 2020 and sporadically thereafter; final demand for goods well in excess of pre-COVID level of demand; and “just-in-time” inventory management. The decline in inventories has resulted in ever longer supplier delivery times, increased backlogs of work and significant upward pressure on producer prices. While the direct impact of higher energy prices has pushed consumer inflation up significantly, rising supply chain costs have also fed through into parts of the consumer basket. In addition to raising prices, the supply-chain problems have curtailed growth as well, as industries have essentially been unable to source certain components, such as semiconductor chips.

Figure 2. Surveys responses to level of inventories
A larger number indicates lower inventory levels or greater inventory

More recently, the supply challenges facing businesses appear to have gone beyond materials and intermediate inputs, to also include labour. Surveys of businesses in the United States, Euro zone and United Kingdom all indicate that they are having more difficulty sourcing labour than at any time in the past 30 years or more. That is also reflected in job openings, with vacancies at record highs which is somewhat surprising given the number of people who left the labour market during the COVID crisis, alongside a still elevated unemployment rate.

Perhaps the apparent labour shortage will resolve itself once some COVID-related support schemes, such as furlough and enhanced unemployment benefits are wound down. Or perhaps it will normalise as vaccination rates increase further and concerns around getting COVID subside, bringing people back into the labour market. However, if people have left the labour market permanently, then there is potential for wage pressures – which are already relatively high for this stage in the recovery – to increase further.

The confluence of strong demand, constrained supply and elevated inflation presents challenges for policymakers, particularly central banks that have dual mandates to support both full employment and deliver price stability. For now, the major central banks continue to expect the supply constraints to be only temporary in nature, and therefore the resulting increase in inflation to also be transitory.

If that were the case, there would be no urgency to start removing policy accommodation. Rather, with recently revised mandates at the Federal Reserve and ECB in particular, they should wait to raise interest rates from the effective lower bound until much of the slack created by the COVID crisis is absorbed and inflation is sustainable around 2 per cent. That would suggest a lift-off in rates in late 2022 or early 2023 in the United States, with the ECB likely to be at least a year or more after that. However, recent comments from each of the Fed, ECB and Bank of England suggest some increasing concern about how persistent the supply constraints may be (in the face of still strong demand) and the potential for isolated increases in goods price inflation to become more widespread, feeding into wages and price-setting more broadly. In that case, interest rates could rise sooner and more quickly than anticipated.

While we have modestly downgraded our growth projection for 2021, we have pushed much of that lost activity into 2022, leaving the demand outlook at the end of next year little changed from where we were three months ago. As a result, we expect global growth of around 6½ per cent in 2021 and around 4¾ per cent in 2022, with all the major economies growth well above potential (Figure 3). However, the risks to that outlook have become somewhat more balanced, having been previously tilted to the upside. One factor in that assessment has been recent developments in China, which we see as weakening growth there (described in more detail in the themes and risks section).

Figure 3. Major economy GDP growth projections

We have revised up our inflation outlook for this year and next, reflecting the temporary impact of supply constraints in 2021 and early 2022, but more robust underlying inflation through the course of 2022 (Figure 4). We judge the risks to the inflation outlook to be to the upside. We expect the Federal Reserve will begin tapering asset purchases in December, with an end to purchases by mid-2022. In our central scenario we expect a first rate hike from the Fed in Q4 2022. We expect the Bank of England to cease asset purchases at the end of 2021 and raise rates in Q2 2022, while the ECB is expected to end the COVID-related asset purchases (PEPP) in March 2022 and modestly expand/extend the pre-existing Asset Purchase Programme.

Figure 4. CPI inflation projections: expected to fall back towards target in 2022

Going into the final quarter of the year, our asset allocation remains broadly pro-risk (Figure 5). We continue to be modestly overweight global equities, albeit we have scaled that overweight back a little given the growing pains economies are now experiencing, which could impact sales and margins. We have also tilted to a mix of more defensive sector exposures (such as healthcare) in addition to existing cyclical sectors (such as energy and industrials). We also remain modestly underweight duration, but again have scaled our positioning back. Credit spreads have widened a little in the last few months, but remain relatively tight and as such we continue to see corporate credit as less attractive than equities.

Figure 5. Asset allocation summary