Clearer evidence is emerging that in most major economies the joint monetary, fiscal, and health policy response to the pandemic is proving faster, bigger, and better-targeted than we expected.
Fiscal policy has managed to minimize income damage. Savings and wealth have grown for most households, and more support is coming. Monetary policy kept credit and money growing faster than expected, and corporates of all sizes have benefited, replenishing their cash buffers. Finally, vaccination programs are reducing contagion and fatality rates much faster than what was expected only two months ago.
As a consequence, the damage inflicted appears smaller and the scars look less deep than we feared. We call our new central scenario “The Best of All Possible Worlds!” because the next 12–18 months look likely to deliver strong growth and low inflation. Developed market economies should exit lockdowns in the next two quarters, providing an ideal summer for spending households’ extra savings. Cheap funding and an improving outlook will likely maintain the current momentum behind corporate investment. Public investment will add to it. All this should be good for risk assets with smaller exposure to rising interest rates like value stocks, high yield credit and private assets, but more challenging for duration.
The economy will not overheat, because policy largesse is still filling the hole blown by COVID on activity and labor markets: in manufacturing, capacity utilization and hours worked are still well below pre-crisis levels, strong balance sheets on aggregate may mask weakness in some struggling sectors, and household savings rates will remain higher than normal amid lingering uncertainty. Cognizant of this, central banks will look through temporary signs of overheating, keeping the helm straight towards accommodation until unmistakable signs of closing GDP and employment gaps.
We attach a 50% probability to “The Best of All Possible Worlds!” but we put it in quotation marks because we are not convinced that current policies will make this sustainable beyond our current time frame; we will need to see strong signs of higher potential global growth to abandon the irony in our tone of voice.
For now, however, labor markets have started healing fast even in the most COVID-impacted sectors, and consumers have kept consuming all throughout the pandemic, with their confidence rebounding to 2019 ranges. Where consumption is still lagging, exports and investment fueled a sharp manufacturing rebound. Industrial production is now back at pre-crisis levels and survey data is pointing toward more to come.
The main risk to our central scenario is Inflation Anxiety, a market overreaction to rising prices that upsets the smooth transition toward a full employment regime, to which we assign a 30% probability. Inflation flare-ups may prove temporary, but the world could still shift towards the self-fulfilling prophecy of volatile markets, high-risk premia, and slower growth. As John Maynard Keynes famously said, markets can remain irrational longer than you can remain solvent. With earlier rate hikes and sharply higher inflation becoming priced in the U.S. yield curve, the Fed would have a harder time staying the course, resulting in tighter financing conditions and headwinds to growth. Over-levered corporates and mismanaged Emerging Markets may snap under the pressure.
We still attach a 20% probability to a more disappointing outcome, what we call Gravity Prevails. The consumer binge that everyone expects could prove short-lived as households save more for an uncertain future. Firms’ investments could be curtailed or constrained to adapt to new consumption patterns, rather than expanding production. America’s infrastructure talk or Europe’s new recovery fund might stumble. We could then find out that most of the recovery is already largely behind us, as many sectors are already operating at full speed. Government support may fade faster than we expect, too, if old political debates re-emerge.