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The Brave New World

19 October 2021 - 10 min read

Supply chain disruptions persist, making the global reopening much less smooth. Contagious variants still weigh on activity, and vaccination levels in major emerging markets have progressed marginally. An energy price shock has added to the unpleasant mix.

While wage and price expectations remain well-anchored and base effects point towards inflation normalizing over the next few months, there’s no denying that uncertainty over its future path has risen. Periodic bouts of anxiety have hit investors who are still unsure just when disruptions will dissipate and how transitory inflation will prove to be. This is no longer the “Best of All Possible Worlds!”

China’s recovery also faces challenges. The government continues to restrict overinvestment in real estate and environmentally damaging export industries while trying to boost domestic purchasing power and consumption. This has sparked fears of a property market slowdown and triggered energy shortages that weigh on output. New restrictions in the tech sector have soured investment sentiment, too. It all looks managed, but it is still a managed slowdown that will affect the post-pandemic global recovery.

Our central scenario for the next 12–18 months still envisions a period of limited inflation pressures and strong growth. We call it a Brave New World and assign it a 60% probability. All of the ingredients for a lasting expansion (healthy household and corporate balance sheets, high consumer confidence and saving buffers, buoyant investment plans, and supportive policy) remain in place. But it may take months for more normal supply chains and China’s slowdown to stabilize.

We also recognize that the recovery will bring inflation that is higher than recent averages. Central banks will likely wait for disruptions to dissipate without moving to raise rates prematurely, but tight supply of goods in some markets and ample slack in others will continue to deliver a confusing inflation picture until supply chains normalize over the next few months.

As disruptions and energy shocks subside in the next two quarters, our scenario will be favorable for risk assets, credit, and private markets. Emerging Markets should do well as vaccines finally contain COVID fears. Demand will be marginally slower and new post-pandemic patterns will emerge. Money will be marginally more expensive and investment choices will require a sharper eye to identify balance sheets and business models that can adjust.

The central risk to this scenario involves disruptions that last longer or high energy prices that persist. In this case, either investors will start pricing in persistently higher inflation or policymakers will be forced into brisk rate hikes. Or both. Markets challenging the Fed’s credibility, a sharp rise of short-term rates, dwindling confidence, and an equity market drop bring all the ingredients of a Perfect Storm. This scenario would eventually turn disinflationary just as the “Stagflationary” 1973 oil shock did, but only after a fresh bout of inflation, causing financing conditions to tighten and ultimately a sharp slowing of growth, towards the end of next year. Inflation poses little risk in Europe or Japan, but U.S. price dynamics admittedly look less benign and predictable, creating risks for Fed policy and market expectations more globally. We thus attach a 30% probability to this scenario.

Both of these scenarios entail a departure from everything the world has experienced since at least 2008, when declining growth and inflation rates built a case for “secular stagnation.” Headwinds to long-term growth from demographics, technology, and globalization persist and may return faster than we expect. For now, however, we keep the odds of the Gravity Prevails scenario, in which government bonds look like the best haven, at 10%.

- Matteo Cominetta


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