Gravity's Pull Isn't Strong Enough Yet
In advanced economies, storefronts have opened, effective vaccines are rolling out, and people are ready to return to “life as we knew it.” However, normalcy will not return until the pandemic is over globally—unless borders remain closed, with unknown collateral damage. Fears of COVID variants plague headlines as vaccinations are stalling. Meanwhile, U.S. infrastructure spending faces tough negotiations while worries of a premature Fed rate hike are leading bond markets to price in our “Gravity Prevails” scenario of slower growth. Despite these fears, economic data continue to come in strong, and the laws of gravity are not nearly strong enough at this stage to overcome the overwhelming momentum behind the current recovery.
Closing the remaining slack in the economy will provide further impetus to growth. Consumers with healthy balance sheets are ready and able to spend. Moreover, supply is responding to elevated demand, and labor markets are on the path to recovery. While a mismatch between supply and demand are boosting price pressures, markets and central banks continue to view these as transitory. Meanwhile, policymakers are showing their readiness to support a full recovery. In China, the central bank preemptively cut reserve requirements to ensure the recovery will be sustained. In the U.S., despite a move higher in the median dot, FOMC leadership remains steadfast in its commitment to an accommodative stance and the new inflation framework. In Europe, the recovery fund and a change to a higher inflation target by the ECB will provide further support to growth.
For these reasons, we have raised the odds of our central scenario of “The Best of All Possible Worlds!” for the next 12–18 months from 60% to 70%. A strong rebound and transitory price pressures will be supportive of risk assets. In light of market uncertainty about the Fed’s stance, volatility is bound to prevail in the U.S. yield curve, torn between a call for safety and a desire to believe in a full recovery. Given that inflation data is being fueled by temporary reopening factors and markets themselves are pricing in lower long-term inflation, we have lowered our odds of Inflation Anxiety from 30% to 20%. Meanwhile, our Gravity Prevails scenario remains at 10%, as FOMC leadership reiterates it won’t raise rates too soon.
In the U.S., inflation data surprised to the upside but was boosted by temporary reopening factors. Economic growth is strong. Consumer spending is robust and is set to be supported by a further draw down of savings and easing bank lending standards. Meanwhile, capex is impressive as companies gain confidence in the outlook and deploy their excess liquidity, which should boost productivity growth. Additionally, more fiscal spending over the next decade is poised to increase potential growth in the U.S. Spreading variants and slowing vaccinations remain a risk to the outlook, but reinstating restrictive measures would be difficult to accomplish politically.
Europe’s recovery remains strong. As things are getting back to normal, consumers are regaining confidence and ready to spend. Industry is now running at full capacity to fill the demand. Labor markets are recovering but, given remaining slack, inflation is not a concern. The biggest risk to the recovery is with the spreading COVID variants, but so far hospitalizations and deaths have remained much lower than in prior waves thanks to effective vaccines.
In Asia, China’s preemptive dovish move is supportive of a continued rebalancing of growth drivers towards investment and consumption into year-end. While the same path can be expected in Japan, risks are tilted to the downside as restrictions remain in place, delaying the recovery. For the rest of the region—particularly in Southeast Asia—contagion risk remains amid the unabated spread of the Delta variant and lagging vaccinations.