The key themes and risks our House View team expect to drive financial markets.
The path of economic growth during the COVID pandemic almost merits its own nomenclature. The usual words – expansion, contraction, recovery – convey meanings rooted in historical experience and “normal” cycles. This time really has been different.
A slump used to mean GDP dropping by two per cent in a quarter; but it fell by ten per cent, 15 per cent even 20 per cent in some places in Q2 last year. A rebound of two per cent would have been called a surge in growth; we saw quarterly increases of between 15 per cent and 20 per cent in Q3 2020. The recent experience has been more restrained. But one or two per cent growth in a quarter is still very strong (Figure 1).
Figure 1. Quarterly GDP growth: actual and projected
Activity has rebounded strongly in 2021
After the setbacks at the start of the year (global growth estimated at just +0.4 per cent in Q1), GDP rebounded again – perhaps +1.6 per cent in Q2. The Q3 outcome may be a little weaker because of concerns about the Delta mutation, but it will still be above the (estimated) trend rate of perhaps 0.8 per cemt. And Q4 should see similar. These sorts of outcomes mean we will see annual GDP growth of five, six, even seven per cent in the major developed economies in 2021 and only a little lower next year (Figure 2).
Figure 2. Aviva Investors 2022 GDP projections
Post-COVID catch-up points to another boom year
In normal times, these would indicate unsustainable booms. But in present circumstances they represent economic revival and post-COVID catch-up. We expect to see the major regions grow by around six or seven per cent between now and the end of 2022. The exact distribution of that growth will depend on the dynamics of COVID, including vaccination efforts, but it should be heavily weighted to the second half of this year.
Strong, but slowing growth expected between now and the end of 2022
This pattern means growth will be slowing in 2022. That is what we are projecting, with quarterly GDP growth converging to around the trend pace by the end of next year. Slowdowns always give financial markets something to worry about. Do they mean the next downturn is looming? Is another stall or recession likely?
We believe that the answer to both of those questions is “no”. Rather, this pattern of strong, but slowing growth, is simply a reflection of post-COVID dynamics. There are legitimate questions to ask about whether all – or some – economies return fully to the post-pandemic trend in terms of GDP. But a sustained economic recovery over the rest of this year, throughout 2022 and quite possibly well beyond, looks the most plausible outcome. Strong growth in this instance does not necessarily imply the build up of excesses that require monetary and fiscal policy brakes to be applied hard.
It will eventually become appropriate to tighten policy and move away from emergency settings (see below). But in our view policymakers have plenty of time to respond. For now, optimism in a robust and lasting economic recovery in, we hope, a post-COVID era, looks justified.
In economic upswings there are often frictional imbalances between demand and supply: demand revives, while supply initially struggles to keep up, resulting in upward price pressures. Subsequently, supply recovers and the transient inflation impulse fades.
The COVID downturn and rebound have been on a scale barely imaginable, so in one sense it is no great surprise that this has led to rising inflationary pressures in some sectors. Nevertheless, there is considerable debate over how much of recent increases is temporary and how much may be more permanent. Headline rates of inflation have certainly been boosted by special factors and base effects. Energy prices, for example, tumbled at the start of the pandemic but have risen steeply since. It is very likely that this contribution to higher inflation will fall in coming quarters. Changes in indirect taxes have also impacted and distorted headline rates of inflation. But underlying or core rates have risen too, indicating that something more fundamental may be happening (Figure 3). Moreover, even if demand-supply imbalances are largely transient, the special circumstances around COVID mean that they may last for longer than normal. And the longer they do, the greater the danger that they become more entrenched and lead to more damaging (and lasting) second round effects.
Figure 3. OECD CPI inflation
Both headline and core inflation have risen sharply
It is very clear that shortages of certain goods or components have emerged and that transportation costs have surged higher as economies have reopened and trade has resumed. The OECD estimates that higher commodity prices and global shipping costs are currently adding 1.5 per cent to G20 CPI inflation (around 3.5 per cent at present) and they expect such components to remain elevated into 2022.
If these “supply chain” influences endure they may feed through more permanently and lead to a more enduring inflation impulse. Related to this, and arguably more worrying, has been the emergence of shortages in parts of the labour market resulting in pockets of higher wage inflation (Figure 4). These are very different from the last cycle and may also be transient, but many indicators suggest demand for labour is currently very strong. Labour costs are the key driver of underlying inflation pressure.
Figure 4. Labour shortages at record highs
Unusual to emerge so forcefully this early in the upswing
In our central scenario we think that much of the recent increase in inflation will be transitory and will fall back in 2022 as economies reopen more fully. Central banks in most developed markets share this view and are using it to justify maintaining their relaxed stance on monetary policy. Recent changes to their inflation mandates and operating frameworks have made this easier and imply that they will allow (even encourage) inflation. Even so, they may not be able to ignore the latest inflation trends completely, especially if financial markets start to fret more about them or if they become more fully reflected in measures of inflation expectations. We continue to believe that the risks to our central scenario are tilted to somewhat higher and more persistent inflation outturns over the next 12 months.
Ongoing policy support
In other circumstances it might be deemed appropriate to respond to the combination of strong recovery and rising inflation with a touch on the fiscal and/or monetary policy brakes or, at the very least, lifting the foot off the policy accelerator. But in the current environment, ongoing policy support may still be required to help ensure a complete and lasting global recovery.
There are at least three aspects to this.
First, governments need to deploy vaccination efforts as quickly as possible, including programmes of booster shots as we go into the Northern Hemisphere winter. Wealthier nations will also need to drive stronger international efforts to assist lower-income countries.
Secondly, monetary policy will need to remain supportive until durable progress is made towards longer-term objectives and far more economic stability is restored. As discussed above, this may well require “looking through” a period of higher recorded inflation. This does not mean that initial steps towards normalisation should not be made – crisis settings are probably no longer needed. But any actions, at least in advanced economies, will be signalled clearly and introduced slowly. For central banks this implies sequential steps starting with removal of emergency measures, followed by stabilisation of balance sheets and reductions of asset purchases and finally, higher interest rates. Some emerging markets will not have the luxury of such a relaxed timetable. The first policy rate rise in the larger developed markets will probably not be required until next year, although policymakers and markets are now a little less certain of this than a few months back (Figure 5).
Figure 5. Interest rate expectations (1 year ahead)
Markets beginning to look ahead to possible tightening
Finally, fiscal support will only be withdrawn as the need for it subsides. Fiscal policy has done much of the “heavy lifting” during the pandemic and has been critical in ensuring that mothballed sectors have been able to restart with minimal permanent damage or losses (Figure 6). Even the once fiscally conservative IMF has been more relaxed than usual: “[a]ny moderation in fiscal spending in 2022 should come from contingent reductions in crisis-related spending as the economy strengthens and vaccination coverage expands, rather than substantial discretionary consolidation measures”. Many of the support packages (e.g. furlough) will fall away naturally as activity restarts. It is important to acknowledge that people and businesses will require ongoing support during the transition back to normal or to the new normal.
Figure 6. Fiscal balances, advanced economies
Budget deficits have soared, but should correct without “austerity”
Overall, both fiscal and monetary policy are expected to remain supportive over the next year or two. Unless there are new setbacks, no major additional stimulus packages should be needed, so it is not unreasonable to characterise a longer-term mild tightening policy bias. There may well be a greater role for the state in many areas – and this is perhaps most marked in the US (in terms of change rather than level), but this is not a sea change towards acceptance and adoption of Modern Monetary Theory (MMT).
Climate change policies
Decades of procrastination mean that original ambitions for carbon-intensive economies to gradually reduce their dependence on fossil fuels and emissions of greenhouse gases are now increasingly irrelevant. Instead, it has become apparent that the required changes are far more likely to be abrupt.
Recent estimates from the Intergovernmental Panel on Climate Change (IPCC) at the United Nations have shown that emergency action is required to have any chance of limiting potentially catastrophic climate disruption. These realities are now being recognised more widely and are being translated into plans for quicker transitions to carbon neutrality (Figure 7). The International Energy Agency (IEA) recently reported that countries representing 70 per cent of global emissions and GDP have committed to reaching net-zero emissions by 2050 or 2060 (Figure 8). Further announcements and declarations are to be expected in the run-up to COP26 as well as during and after that event. The official judgement on progress – or the lack of it – with regard to the Paris agreement will also be revealed.
Figure 7. Number of national net zero pledges and share of global CO2 emissions covered
Figure 8. Coverage of announced national net zero pledges
There is still considerable distance between aspiration and delivery on climate change initiatives, but it does seem as if some momentum is now building behind such policies. But if even a fraction of the proposals currently being discussed are introduced in coming years, it seems inevitable that climate change policies will have significant macroeconomic consequences across a wide range of different spheres.
A number of countries in Europe have been especially vocal in pioneering real progress on climate change. The European Commission recently announced plans to cut emissions by 55 per cent by 2030 (compared with 1990) instead of the previously legislated 40 per cent. They hope to overhaul energy legislation, broaden the scope of the carbon trading scheme, introduce new technical standards and push through minimum carbon taxation at the national level. Not all such initiatives will survive negotiations between member states, but the new agenda is consistent with stated ambitions of governments so pressure can only grow to align actions with words. Overall, it is reasonable to expect wide-ranging changes for energy, transport and housing as well as more generally for manufacturing, agriculture and services.
Any moves toward more definitive actions in coming years are bound to have immediate economic implications. Some capital equipment will lose economic value, some industrial plants may have to shut down, some employees will have to be redeployed, investment will have to increase in certain areas and parts of the capital stock may need to be repaired, rebuilt or modified. Often these steps have been characterised as a sort of “benign endeavour” rather than as essential, but potentially disruptive, steps that may have meaningful impacts at a macroeconomic level. Some have even compared decarbonisation to the supply-side oil shocks of the 1970s. That is probably too extreme, but the next decade could well see short-run hits as the required adjustments are made.
Living with COVID-19
Over the next few years, it is very unlikely that the COVID virus will be eradicated. But its impact on economic activity around the world should become trivial compared to the experience of 2020-21. This transition may not be entirely smooth, or quite so painless in some countries or regions, but the direction of travel and ultimate destination now seem clear.
The COVID pandemic has been a truly extraordinary event, the legacy of which will be with us for decades. It is estimated that there have been 230 million cases worldwide and nearly five million deaths. Both of these numbers will, sadly, increase, but it seems very clear that we are now moving to a new stage of the COVID episode. For comparison, the Spanish 'flu pandemic of 1918-1920 is believed to have resulted in around 50 million deaths, with high mortality in people 20-40 years old. People and businesses have adapted successfully to the existence of the virus and vaccination programmes (Figure 9) have totally changed the dynamics of the pandemic and its economic impact. Initially it was hoped that the virus would be contained close to its point of origin, but it swiftly became apparent that this was not going to happen. The spread in early 2020 became explosive (Figure 10) and countries had to react, imposing stringent lockdown restrictions to contain the virus.
Figure 9. Percentage of population vaccinated (first dose)
EM nations are far less advanced in vaccination efforts
Figure 10. G7 COVID-19 cases and deaths, daily change, 7-day mavg
Case numbers are falling; death rates are lower
If COVID evolves from a pandemic to an endemic phenomenon, as we expect, then the world will have to get used to living with the existence of the virus in a similar way that it does with the regular episodes of ‘flu which hit us every year. After all, they too are easily communicable and occasionally deadly, and the world does not stop for them.
But even if this is true, the ability of countries to adapt will vary depending on their experience so far. It is now clear that containment of infection levels requires both high levels of immunity from initial vaccination and also from infection itself. The deployment of booster shots may mean other nations have to wait a longer for vaccine supplies.
Meanwhile, countries which had been successful in suppressing the virus initially (such as Australia and New Zealand) will have to accept that a transition to containment must imply a materially higher burden on health systems and greater fatalities than experienced thus far if they are to reopen as Europe and the US have done and accept COVID in its endemic state.
These contrasting choices between the developed and developing world and between early adopters of reduced restrictions and those who stick with suppression may lead to different growth profiles as we move through the next 12-18 months and will present investment opportunities for those who correctly identify the timing of changes. But for most developed nations, the next few years should see an environment where the COVID virus is still present, but increasingly unimportant from a macroeconomic point of view.
China, the world’s second largest economy and biggest 'engine' of economic growth for decades, is in the midst of a major shift in its priorities.
In the near term, the burst of credit to cope with COVID has been far smaller than earlier expansions (Figure 11), and this impacts our global growth forecasts, but the longer-term change is even more important. The directives come from the very top, and our interpretation of how the main philosophical goals of the 19th Party Congress (2017) and 14th Five Year Plan (March 2021) should be interpreted are based around (a) Regulatory Rectification, and (b) Common Prosperity. What these vague and general phrases mean has been much discussed and may change over time, but there are clear shifts away from sustainability and urbanization and towards market reform and ideological and cultural issues.
Figure 11. Credit impulse attenuated as shadow banking quelled
China, social financing, CNY
We think these modifications will include:
- Aiming for self-reliance, with the internal part of the so-called dual circulation economy promoting consumption and local production. Investing in technology that grows domestic supply chains will be a priority. Sectors that are seen as antithetical to these goals 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 state-owned enterprises 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” activity (e.g. gaming, online tutors, celebrity influencers) and higher property taxes.
- Risk reduction: especially in financial risks, i.e. leverage, forced simplification of conglomerates straddling banking or fintech, curbing monopoly or other power that encroaches on CCP dominance, and – the hot topic since the Evergrande collapse began – reducing property speculation that re-emerged after the 2010-14 boom paused for a few years. Reining in “disorderly expansion of capital” encompasses debt ratios, dependence on foreign capital, and market dominance that, by increasing inequality, runs counter to shared affluence. After years of debt accumulation (Figure 12) this will not be an easy process.
Figure 12. High and growing debt presents large financial risks
Debt-to-GDP by sector (per cent of GDP)
For the past year our House Views contained the theme of Strategic Competition, which included the trade war, geopolitical tensions between China and its neighbours, and risks of decoupling.
That thesis is not defunct, but is increasingly shifting to technology, ideology, and global rule-setting, and is part of China’s outward reorientation from an emerging market export powerhouse based on cheap labour and debt-driven investment to a more sustainable, middle- income, consumption-driven technology leader – Korea and Japan being role models in this respect. A slower-growth China aiming to substitute imports and dominate sectors will have spillovers to other countries via trade and capital flows, while China’s internal model will impact markets as it continues to try to open up, attract foreign capital, and integrate into global markets.
Concerns about the current inflationary impulse being more lasting have risen in recent months. Although parts of the supply-demand imbalance should fade as economies reopen, as should the energy price impact, there are fears that some supply-side weaknesses may be more persistent, leading to more serious and lasting price pressures.
There are particular worries about parts of the labour market, where pockets of severe shortage, leading to noticeable wage rises, have appeared. Economies and financial markets are presently drawing considerable comfort that central banks will 'look through' high inflation and keep policy looser for longer. If that assessment were to change because of stubbornly high inflation – in other words, the view that monetary authorities have to react to worrisome inflation takes root – then the landscape for both the growth outlook and for markets changes considerably.
If central banks choose to raise policy rates earlier and by more than had been anticipated, then bond markets will have to react, pushing yields higher. At present they offer little protection against higher inflation (Figure 13). It has been a long time since a 'conventional' overheating episode; after an extended period of below-target inflation, it would represent a meaningful shock, even if it were modest by historical standards. For economies, monetary tightening would weaken demand and lead to slower growth to help drive inflation back down. If output gaps had in fact moved significantly into positive territory, then a period of below-trend growth would be warranted.
Figure 13. Bond yields have risen a little in EMs, but near lows in DMs
Long-term interest rate estimates
That would be a very different environment to that which has prevailed for much of the last decade or more. In extremis, an inflationary episode could challenge the hard-won belief that central banks had defeated the high inflation problems of the past. Stubbornly high inflation may well be more of an issue for emerging market economies, some of which have already responded to its threat.
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 (Figure 14) and has added significantly to public sector debt burdens.
Figure 14. Public borrowing as a per cent of GDP
Deficits have soared but should narrow automatically
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. While that remains a threat, the worst fears seem to have diminished, largely because growth has resumed, inflation is still quite subdued and borrowing rates – in particular real rates – have remained historically very low. 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.
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. In contrast, several emerging market 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/or currencies.
Sharp movements in either can quickly push such countries onto untenable paths and severely curtail market access. Knowledge of these possibilities has meant that most have not increased debt burdens as much as the major developed countries (Figure 15). But government deficits have still widened sharply, and vulnerabilities have increased, especially as EM yields have risen. 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.
Figure 15. Net public debt as % of GDP
DM ratios are higher, but vulnerability could be greater in EMs
The vast 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 as circumstances allow.
The extent of the underlying damage will only become apparent when the various schemes are withdrawn, a process that has only just begun but which will become 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; 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 – the likely true extent of which has been hidden by various support schemes – will rise. 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.
The latest signs have been encouraging – unemployment has been falling fast for many quarters (Figure 16) – but it would be premature to conclude that labour markets will fully heal. Moreover, it is not a binary issue – whether there is a job to return to 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. Fewer hours may be made available to workers in such an environment, even if only temporarily.
Figure 16. Unemployment rates
Jumped most in the US but have fallen back everywhere
All these factors imply lower incomes, spending and output. Even if resources can be redeployed elsewhere, transitions will not be painless or immediate. If permanent damage is worse than feared, the supply-side hit to economies could have damaging knock-on impacts on long-term growth.
Although the more transmissible Delta variant still dominates the dynamics of COVID (and there may yet be other troubling mutations), impressive vaccination efforts as well as the longevity of the pandemic itself, mean that it is appropriate to adopt a more hopeful outlook on the progression of the virus from this point. A year ago, there was far more uncertainty – and no known vaccines – but now it is neither overly optimistic nor complacent to accept the idea that vaccinations do work, and that booster shots over the Northern Hemisphere winter will reinforce favourable global trends for case numbers and complications.
Different country experiences have also revealed what can and cannot be done in the face of COVID. First, the distribution of vaccines has been far from uniform around the world. Many lower income countries have not been able to extend vaccination programmes anything like as much as developed nations. They will need ongoing assistance in vaccine provision and distribution. Moreover, while the virus exists anywhere, it is a potential threat to everywhere, both in its current form and in any future mutations.
Secondly, countries which adopted a zero-COVID policy, such as Australia and New Zealand (Figure 17), are now facing difficult choices. With experience, many countries have changed their approach to better reflect the realities of virus transmission. It may well be the case that a number of countries in south-east Asia as well as China will have to adopt a similar change in strategy. Different countries also have different cultural parameters which influence the approaches which have been adopted.
Figure 17. COVID cases, 14-day total per 100K
Pattern of case numbers very different in some places
Overall, although we believe it is right to embrace a brighter prospect for the post-COVID future, there are still clear risks over the next year or two related to further outbreaks and virus variants.
China slowdown/policy mistake
The growing importance of China on the world stage means that the impact of any slowdown there – whether unavoidable or as a result of a policy mistake or mistakes – will have a significant impact on the global outlook. Recent history shows that it is incredibly rare for developing nations to transition to wealthier status without experiencing some damaging shocks along the way.
China is treading a distinctly different path in terms of economic development and participation in global politics and commerce (see themes earlier). And it will continue to be very forthright in its pursuit of strategies to achieve its longer-term goals.
Such transitions are never easy and policy mistakes should probably be expected. It is possible that China has already or is already making such errors. Its share of world GDP is now approaching 20 per cent (Figure 18), so any slowdown in China will have global ramifications. As the authorities there seem determined to push ahead with bold and ambitious plans to cement their position in the world hierarchy, it seems sensible to recognise the risk of a discrete China slowdown.