Last year’s collapse in global economic activity differed in pace and scale from any previous recession. Equally the recovery, now well established in most economies, will be unlike anything we have seen before. The global V-shaped recovery is complete, with global GDP above the pre-pandemic level in 2021 Q1. This has predominantly been driven by China, though the US is within a whisker of its 2019 Q4 level. Where we go from here will partly depend on how rapidly households in the major economies spend their excess savings pots, which are estimated to be worth 8%-9% of GDP in the US and the UK, and a little bit less in the euro area. Here we outline four broad scenarios considered in Fathom’s Global Economic and Markets Outlook for 2021 Q3, and what each of them means for the inflation outlook.
In our first scenario, which we have named ‘Steady as she goes’, households remain cautious, fearing further disease outbreaks, and pandemic savings go largely unspent. Here, the rise in inflation proves transitory and inflation returns to target sharply. In ‘Goldilocks’, our second scenario, 25% of pandemic savings are spent this year, pushing inflation higher. Survey data collected and published by the Bank of England, the New York Fed and the US Census Bureau are consistent with households either having spent, or intending to spend, around a quarter of their pandemic savings. However, inflation expectations remain firmly anchored, such that inflation returns to target within a year or two. Collectively, Fathom places a 40% weight on these two scenarios, where monetary policymakers have very little to do.
The remaining 60% of the distribution of possible outcomes covers two scenarios where the cyclical pickup in inflation, that occurs as 25% of pandemic savings balances are spent, gets embedded into expectations of higher future inflation. Early evidence is indicating that higher US inflation is impacting household and corporate expectations. This would leave monetary policymakers with a dilemma. Central bankers have the tools to deal with an overshoot of the inflation target, but the question is, with asset prices (including those of government bonds) underpinned by an expectation that policy rates will remain close to zero more or less indefinitely, will they deploy them?
In our two remaining scenarios, policymakers either deal with higher inflation — perhaps by withdrawing some of or indeed all the post-pandemic QE, as well as raising interest rates — or they roll with it and shift the goal posts. In our ‘Inflation — deal with it’ scenario, policymakers choose to tighten in order to return inflation to target within the medium term. Fathom expects that this would cause a recession early next year.
However, if policymakers choose ‘Inflation — roll with it’, inflation remains markedly above 2% for some time, and central banks opportunistically raise the inflation target either explicitly or implicitly through a variety of measures that have the same net effect. We have seen the early signs of this, as last year the Fed announced it would target ‘an average’ of 2%, whilst earlier this year the ECB announced a change to a symmetric target around 2%, an effective rise from a preference of below 2% inflation. More may yet be to come in this regard.
This is not an easy environment for asset allocators. In Fathom’s judgement, a robust macro recovery is largely priced in for most asset classes. There is perhaps still scope to profit from investing in assets that offer protection against inflation — while a transitory increase in inflation is widely expected, few currently imagine that it will persist. If inflation does persist there is a possibility of stagflation, as growth begins to slow beyond its cyclical peak. In that world, exposure to currencies may offer diversification.
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