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Macroeconomic & Geopolitical

How Deep Are The Scars?

2 March 2021 - 10 min read

What helps reconcile market euphoria with the very mixed global data is that central bankers remain concerned about the pandemic scars and have reiterated their accommodative stance.

The U.S. outlook brightened in February on better consumer data, vaccine rollouts and larger than expected fiscal stimulus, but we remain cautious about corporate balance sheets, global labor market damage and a virus that continues to threaten economic activity in many parts of the world. The recent good news has ignited an inflation debate as markets go all in on the recovery trade with rising sovereign yields, curves steepening and industrial commodities rallying. What helps reconcile market euphoria with the very mixed global data is that central bankers remain concerned about the pandemic scars and have reiterated their accommodative stance.

So just how deep are the scars? So far, the corporate sector seems to have weathered the worst with cheap liquidity to service debt and a rising number of ratings upgrades. Earnings season exceeded initial expectations, too, but smaller firms that depend on bank lending still struggle. Meanwhile, labor markets still face a long and painful recovery. While public support has been successful in replacing income in the U.S. and Europe, rising long-term unemployment will create stubborn headwinds.

Our baseline scenario remains the “Not Quite Recovery” as we believe the massive government response continues to underwrite progress, but cannot ultimately heal all wounds. The better news on U.S. activity has led us to upgrade our more optimistic “Escape Velocity” scenario to 30% odds, but this scenario implies a growth-driven inflation acceleration that we do not see. We still attribute 60% to a more muted recovery over the next 12-18 months, with an only gradual reflation. As the dream of winning over the pandemic comes into view, bouts of volatility will shake markets, but central banks are just as concerned about excess slack in the economy and will reassure markets that an exit from accommodation will not take them by surprise. This should be supportive for risk-assets including equities, credit and Emerging Markets but differentiation is needed in picking winners and losers.

In the U.S., the labor market remains in pain amid elevated shadow unemployment. Fiscal stimulus has proven effective in supporting spending but the tailwind of the December package is already showing signs of fading. With many small businesses permanently shuttered, the timeline between reopening and a jobs revival could lengthen. With bankruptcies and defaults peaking, it appears the worst of the shakeout may be over for larger companies who’ve been able to tap capital markets.

In Europe, an ongoing recovery is evident, although its underlying strength remains partly hidden by blanket government support. Uncertainty remains as to whether furloughed workers in pandemic impacted-sectors will be reintegrated. Meanwhile, the return of private investment to pre-pandemic levels benefits from the easy financial conditions maintained by the ECB and the extension of fiscal support. The recovery funds to be deployed through 2026 should boost the longer-term outlook given their potential to increase productivity and growth, especially in Italy where it is most needed. The main risk in the next few months will come from further delays in the immunization campaign, which will determine how fast the economy can reopen.

In Asia, too, the outlook remains tied to the vaccine rollout. The Chinese government has preferred to ascertain efficacy before deploying the vaccine to its large population and this delay will keep consumers wary. Still, the strong tailwind from global trade and a government focus on technology investment should drive a strong growth rebound and support a capex revival. A double-dip in Q1 is almost unavoidable for Japan due to the most recent lockdown, but the growth momentum should lead to a rebound by Q2. Bankruptcies remain benign, but labor markets, which have seen a bifurcated recovery across the region, have a ways to go before returning to pre-pandemic levels.

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