Running on high pressure

Running on high pressure

As economies reopen, we’re likely to see two overlapping patterns – a ‘bungee jump’ driven by a focal point created by the resumption of activity as mobility picks up, and a more traditional ‘cycle’. The bungee jump is about the short-term displacement of activity as governments closed down entire economies by decree and deployed massive stimulus at the same time. With limited possibilities to spend, consumers shut at home accumulated large pent-up savings. They’re now being spent. This catch-up phase is already triggering strong consumer spending and corporate activity. The cycle is playing out from a medium-term perspective – it’s all about normalisation supported by policy. Following the catch-up phase, it will likely reassert itself and lead to solid but more moderate rates of activity. The final outcome is the overlap of the bungee jump and the cycle, which makes the macro data quite tough to interpret at this juncture. Our Counterpoint 2021 mid-year update explores these key questions: given the US inflation spike, are we overheating? Do policymakers really want to run the economy ‘hot’? Are cyclical recovery and reflation still in play?

Spring has sprung: The world economy will likely make up for the lost ground over the next few quarters. As economies reopen and government stimulus is implemented, GDP should continue to bounce back strongly in the US, getting back to pre-pandemic levels as soon as this quarter. It may take another quarter to return or perhaps even exceed the level of GDP we estimate we’d be at had the pandemic not occurred. While the pace of growth in overall activity will probably begin to slow at that point, we think it will stay rather solid, as policymakers should continue to stimulate in an attempt to boost job growth and get the economy on a self-sustained path. After all, despite labour shortages in some sectors, there’s still quite a bit of slack in the wider system.

A hot summer: Policymakers want to run the economy hot to make up for large shortfalls in activity and employment. This means that they’ll aim to be ‘behind the curve’ – they want strong, pressurised growth and are pursuing inflationary policies. This is likely to show mostly in the form of asset price inflation rather than consumer price inflation (apart from the ongoing transitory spike driven by pent-up demand meeting supply bottlenecks). We’re poised for strong growth, thanks to vaccination programmes and stimulus measures. This may be priced in, but we’re more bullish than the consensus on the US and, indeed, on the global economy. It’s no longer about replacing lost demand; it’s about boosting demand beyond pre-pandemic levels.

Here’s why this matters:

Our big-picture playbook: Cyclical rotation will likely continue to work, but perhaps less so, as shifts from reopening to recovery would require strong economic and earnings data just to keep up with easy comparisons caused by depressed numbers during the pandemic. It’s not just about sectors that have been shut down by government decree; it’s about gaining exposure to growth and fiscal stimulus as before, but also to global trade, infrastructure spending – often related to sustainability – and industrial activity. Europe is a laggard, but should pick up too, just like Japan. Certain investments that could work as potential return enhancers given low rates, such as private markets and multi-strategies, should remain well supported.

Some key market details: Tactically, we continue to have an overweight allocation to risk, with a preference for equities over bonds (particularly US and UK small cap stocks), credit risk (EM sovereign hard currency and Asia high yield debt) over low-yielding investment grade bonds, plus US Treasuries (currency hedged) over EUR bonds for carry and diversification. Some investments that have already lost lustre could remain under pressure in the near term, such as emerging market equities, though they could come back in vogue as and when valuations are ‘right’. Despite the rally, oil looks supported through the summer, as mobility as well as international travel and trade pick up further, boosting road fuel and jet demand.

Meanwhile, busy week for central banks…

To taper or not to taper, that is the question: This Wednesday, the Fed will update its macro forecasts. We expect the new projection for core PCE inflation – the key gauge – to be further above target in 2021, slowly converging in 2022-23. The markets are likely to scrutinise several aspects of the Fed’s decision. First, whether the growth, jobs and inflation data are finally enough for a slight majority of the committee to now project at least one 25 bps increase in the federal funds rate by end-2023 (our forecast), which would still be more dovish than market pricing. Second, whether Chair Powell will say that the Fed has started to brainstorm on the mechanics of tapering the central bank’s asset purchases – we would expect an announcement later this year. Third, how far the labour market is from “substantial further progress” before any tapering can start.

Daniele Antonucci | Chief Economist & Macro Strategist

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