Too hot to handle?
Despite continued uncertainty, the economic outlook appears to be proceeding roughly as anticipated a couple of months ago. The near term remains weak and we continue to worry about what might go wrong, especially around vaccine efficacy, mutant virus strains and economic scarring.
But what about the upside risks? With the Biden administration pushing Congress to deliver even more stimulus on top of the $900 billion signed late December, if the virus goes away, the chance of an overshoot may be increasing.
The path to a boom
As bad as the virus news appears, with global deaths rates currently double their April peak, we could look back and see this as the turning point. The vaccine roll-out is gathering pace. Alongside those who have gained natural immunity from infection, new cases and especially hospitalisations could fall away quickly in the spring, allowing economies to re-open gradually at first and then more thoroughly later in the year. We saw last year the speed of recovery post-lockdown. If this round of re-opening is accompanied by increasing belief that the pandemic is set to fade, we could see the type of growth not witnessed in a generation.
The ingredients for spectacular growth are most visible in the US. The policy support has been tremendous, more than covering lost household disposable income, with additional stimulus to come.
Following the Georgia election results, we now expect roughly $1 trillion in front-loaded pandemic relief and, later in the year, a further net $1 trillion in recovery spending. The latter will impact the economy more in 2022 and beyond. While politics could lead to another impasse, there is also a decent chance that a compromise involves even more spending and less revenue raising than we expect today.
This comes at a time when US household balance sheets have rarely been better. Savings are very high relative to wealth and much of this is in the form of liquid assets ready to be spent. At the same time, household have completely deleveraged from the accumulation of debt which caused the 2008/09 financial crisis, while mortgage rates have more than halved over this period. There could be huge pent-up demand as confidence returns and people make up for lost time as the economy reopens.
Our central view is that there is sufficient slack to encourage central banks to keep policy loose well into the recovery. But given the potential for rapid growth, there are three sources of higher inflation risk. The first is a pure base effect: some prices which fell sharply in the first lockdown and have remained depressed could suddenly normalise as the economy re-opens. This would lead to a temporary inflation increase, perhaps above target for a short period. But the market should see this through this.
The second is via bottlenecks. The recovery in demand for leisure services could overwhelm available supply, which has been impaired by the restrictions, and it might take time to get people and capital back to work. For example, airlines and restaurants could raise prices if bookings snap back beyond short-term capacity.
The final threat is the one which will get the most attention from the Federal Reserve, and that is sustained rapid growth which leads to traditional overheating. Unemployment could fall dramatically, igniting wage pressures. The US could quickly move to late cycle in 2022 alongside a synchronised global expansion, putting upward pressure on goods prices. This might require the Fed to end asset purchases sooner and hike rates earlier and faster than expected.
Such an outcome could be even more traumatic for markets which appear expensive, but not yet in bubble territory, than if growth disappoints. For now we are monitoring this risk and remain positioned for continued low rates.