"Central banks have become much more open to adopt unorthodox monetary policy measures."
Global economy
Anchor: pandenomics
Pandenomics: After the shock
The year 2020 has been like no other. The global lockdown during the first wave of the COVID-19 pandemic triggered the strongest economic contraction in modern history. Most economies recovered sharply thereafter, but a second wave of COVID-19 set the economy back again. Yet growth should accelerate gradually in 2021 without triggering a rise in inflation or interest rates, despite much higher government debt.
“Shock and awe”
Due to the lockdown of the global economy, 2020 will go down as a historic year with a truly unique economic trajectory. The deepest quarterly global gross domestic product (GDP) contraction on record in Q2 was followed by the sharpest quarterly rebound on record the following quarter, as the lockdown restrictions were eased and fiscal and monetary stimulus kicked in. Yet, when the COVID-19 pandemic threatened to get out of control, policymakers around the world used a “shock and awe” tactic to deal with the economic fallout from this public health crisis. What was different this time? In a “normal” downturn, the cyclical parts of the economy like construction typically contract, while the service part of the economy fares better. But this time around, the shock affected cyclical manufacturing sectors and the service economy simultaneously, leading to extreme swings in economic activity. This is rare.
In the USA, the service sector has contracted only three times in the past seventy years: in 1973, 2008 and 2020. During the 2020 recession, cyclical sectors slowed as the economic closure of entire countries disrupted supply chains. In the service economy, several sectors came to a standstill during the quarantines, as “normal” operations suddenly became unsafe for clients and staff amid the pandemic (e.g. running a hair salon or a restaurant). This also explains the sharp rebound in economic activity once lockdown restrictions were lifted, as supply chains were restored and previously closed businesses re-opened with new COVID-19 safety restrictions. Massive fiscal and monetary stimulus provided additional support for the recovery.
Another unusual macroeconomic feature of the 2020 recession was the simultaneous increase of savings ratios in the USA, Europe and Asia. Fiscal and social support programs supported household income during the lockdowns, leading to much better consumer spending than would otherwise have occurred. But because service spending (as opposed to physical goods spending) was constrained by social distancing, households were able to save at high rates too. As a result, household balance sheets improved, an unusual situation in a recession. Further spending improvement is likely if rising hours and falling unemployment continues, and a switch back to service spending will occur once the pandemic ends.
Wages face headwinds
The International Labor Organization (ILO) estimates that during the Q2 lockdown, more than 15% of all working hours worldwide were lost, which corresponds to almost 500 million jobs. In the USA alone, more than 21 million people lost their jobs at the height of the crisis in March and April. The labor market in Europe also saw large declines in hours but fewer job losses, as governments provided short-time work programs. In these schemes, companies can apply to reduce their employees’ work hours, with the government topping up the difference in salaries, usually up to a cap of 80%. Asian economies and emerging markets (EM) with high public sector employment also maintained relatively stable employment throughout the crisis. However, countries with low social security protection (the USA and some EM) experienced significant turmoil in labor markets, with a wave of layoffs during the lockdown, followed by hiring during the recovery.
At the time of writing, the labor market situation worldwide had improved significantly from the trough in Q2, but unemployment remained significantly higher than before the pandemic. Over the coming months, the rate of re-hiring is likely to slow as the initial positive effect of the re-opening of businesses fades. As it will take time for the economy to reach pre-pandemic activity levels, unemployment rates are likely to remain elevated over the next two years. However, this need not be a permanent development. In regions with relatively flexible and free labor markets such as the USA, unemployment should head back toward equilibrium even if output stays below pre-pandemic levels. While underemployment persists, it is likely that wage growth will face headwinds, although regulations will likely limit this problem in Europe and Japan.
14.7%
US unemployment peaked in April 2020, with over 20 million people losing their jobs.
Creative destruction and productivity
A shock like the COVID-19 pandemic also influences productivity. One measure of this is the growth of labor productivity, i.e. real GDP growth minus real growth in hours worked. During the pandemic, labor productivity jumped as hours worked fell more than output. As employees return to their jobs, however, this should reverse and productivity growth could slow. Still, productivity is always very volatile over short time periods. In the longer term, the pandemic could enhance productivity, at least in a number of sectors.
The lockdown has created plenty of disruption, which will likely boost new business models such as online medicine and new ways of working. There will be short-term costs to these disruptions, but emerging business models can generate efficiencies in the long run, especially if companies and governments invest in the right areas, such as digital infrastructure.
Central banks on hold
With wages under pressure and/or – depending on the region – unemployment levels rising, inflation looks set to remain subdued. We expect global inflation of 2.3% in 2021 – lower than the pre-pandemic level of 2.5% in 2019. In the USA, we expect inflation of 2.0% in 2021 versus 1.0% for the Eurozone and 2.5% for China. These low inflation numbers mean that central banks will be in no hurry to raise interest rates. During the lockdown, the US Federal Reserve (Fed) joined other major central banks in cutting rates to around zero, and they re-launched or extended major asset purchase programs.
Their objective was to depress real interest rates further in order to support the economic recovery. We do not expect any of the major central banks to hike interest rates in 2021, and most likely well beyond. In fact, we could even see an increase in asset purchases if growth falters or if inflation fails to rise.
Fog over fiscal future
While the effects of the pandemic should help keep inflation in check in 2021, the long-term consequences of the crisis on inflation are less clear. Over time, ballooning budget deficits and public debt are likely. This destabilization of public finances can lead to inflation, but only if central banks are ineffective or inactive in responding to future inflation pressure. This could happen, for example, if central banks succumb to outside pressures or if they begin to allow concerns over government debt service to influence their rate decisions. This is a risk case for the post COVID-19 period. We cannot exclude the possibility that central banks are pressured into financing overly ambitious fiscal programs.
Central banks could also simply respond too late or weakly to accelerating inflation. Yet the Fed’s shift toward average inflation targeting does not limit its ability to respond quickly to a rapid overshoot in inflation. In Europe, the constitution of the European Central Bank (ECB) renders this especially unlikely. In countries with high public debt, fighting inflation becomes more difficult for central banks than fighting deflation. This is because inflation makes it easier to manage a high debt burden while deflation makes it more difficult to do so.
Central banks have thus become much more open and eager to adopt unorthodox monetary policy measures such as quantitative easing, negative interest rates or yield curve control to avoid deflation than to tighten monetary policy in the face of rising inflation when the economy is weak. This puts central banks in a delicate position to fulfill their mandates. For now, it is too early to assess such tail risks, but investors should stay attentive to the sustainability of public finances.
Inflation holds the fate of financial assets
For financial assets and investors, it is key to determine which inflation regime will prevail in coming years. For most developed countries and emerging markets, 0%–4% headline inflation is a moderate inflation regime. In such a regime, equities tend to outperform bonds. In high inflation regimes (typically when headline inflation is above 7.5%), equities stop producing positive total returns while bonds tend to perform negatively. In deflation regimes (negative headline inflation), bonds outperform stocks.
The debt legacy
Many countries implemented fiscal stimulus measures amounting to 10% of GDP or more during the crisis. By the end of 2020, the ratio of government debt to GDP in the USA will rise above 130%, according to International Monetary Fund (IMF) data, and to more than 160% for Italy and more than 260% for Japan. Although policymakers will be increasingly concerned about rising debt, pressure to provide additional fiscal stimulus will increase if economies fail to fully recover. In the USA, additional stimulus will be limited in size given the Democrats’ failure to achieve decisive majorities in Congress.
Additional stimulus measures of the magnitude of 2020 are quite unlikely, however, given the expected recovery of the world economy and the low probability of further full COVID-19 lockdowns. Whatever the trajectory of the global economy, high government debt will remain a challenge for policymakers going forward. So long as interest rates remain at or close to their current lows, debt will remain sustainable. However, governments will be constrained in fighting any future recession and, more importantly, financing growth-enhancing expenditures. High debt is thus likely to be one of the lasting burdensome legacies of COVID-19.
Protectionism to persist
Over the past 20 years, China has gone from producing roughly 5% of worldwide industrial output to 30%, while the USA’s share has fallen from 25% to 18%, according to our estimates. Many western politicians have pledged to boost local export and manufacturing capacity and jobs, but doing this on such a scale that could lead to a rapid rebound in the US or European share of global production is highly unlikely. However, trade barriers and frictions that have increased since 2016 are likely to persist. While tariffs are unlikely to increase between Western economies – in fact, a trade deal between the USA and EU is in the making – tensions over technology and investment are likely to remain in place or may worsen. In response, China is currently making significant investments in the semiconductor industry to reduce its dependence on other less friendly trading partners. This could lead to a duplication of supply chains.
Protectionist tendencies may also increase in the area of pharmaceuticals, with lobby groups trying to suggest that the COVID-19 crisis proves the need to produce strategic supplies nationally. A much better approach would be to ensure, via multilateral or bilateral treaties, that diversified global supplies are available in a future health crisis.
US elections: Limited leeway for President-elect
Biden
While Joe Biden won the US presidency, the Democrats’ room for maneuver will remain limited given their failure to achieve decisive majorities in Congress. The USA is therefore unlikely to see significant changes in tax policy, while added expenditures in areas such as the "green" economy will also be limited. Changes in health care legislation or regulation will also remain limited. However, the tone from the White House is likely to shift markedly.
Anchor: status-quo
So long status quo
Crises often become a transformative force. While some developments turn out to be temporary, others prevail long after the crisis is over. As we take stock of the COVID-19 pandemic, we identify several long-lasting consequences.
The rapid spread of COVID-19 in early 2020 caught most of the world by surprise and turned the global economy upside down. The pandemic made us aware that contagious diseases can still threaten society as a whole and that such outbreaks are in fact by-products of human progress. All along history, however, health crises have helped to drive scientific and social innovation, shaping the paths of future economic development. We believe that the current health crisis will be no exception.
Yet, rather than being a complete game-changer, COVID-19 has accelerated existing trends. The digitalization of everyday life, the trend toward more flexible work arrangements, the deceleration of globalization, the weakening of multilateralism, the expansion of the state or the vulnerability of cities – all of these developments were already underway prior to the virus outbreak.
The speed at which these trends are now progressing challenges human capacity to keep pace. Legislation is lagging behind in several areas, from data protection to labor laws, and governments, just like companies, have to strengthen their resilience by adopting more sustainable economic paradigms.
Acting now with a view to the world after COVID-19 can help minimize the likelihood of another pandemic-driven global crisis. It can also provide an opportunity to address issues that have undermined growth and prosperity in the last few decades.
Anchor: regional-outlook
Regional outlook
Going into 2021, the growth picture differs across regions. As the world economy still struggles with the coronavirus pandemic, some countries are further ahead in the recovery process. On top of the COVID-19 crisis, some countries have additional political challenges to address in the year ahead.
USA
A gradual recovery from the second wave
Growth is likely to be above potential (the growth rate that can be sustained over the long term) as the USA stages a multi-year recovery from the pandemic. We expect a similar level of inflation in 2021 as in prior years, but both deflation and inflation tail risks have grown.
Government and external debt, which have swelled due to policies to address the fallout from the COVID-19 crisis, may prove to be destabilizing forces over time. In terms of the quarterly growth profile, we are likely to see a gradual acceleration after a renewed setback in Q4 2020. Even under the new Democratic administration, we are unlikely to see much of an improvement in the relationship with China. Changes in taxation will be limited, as will increases in spending on “green” infrastructure.
Latin America
Growth diverges
Mexico’s long-term growth prospects appear to be worsening as President Andres Manuel Lopez Obrador maintains an antagonistic stance toward the private sector. Global risk appetite has driven the stability of local financial markets, but remains at risk given the financial fragility of heavily indebted and state-owned oil company Pemex. In contrast to the deteriorating growth outlook in Mexico, the decline of interest rates in Brazil could allow the economy to grow faster and bolster confidence in the sustainability of the public debt. For this to occur, however, President Jair Bolsonaro will need to show strong political ability to carry out fiscal reforms.
UK
Life after the EU
The UK’s departure from the European Union’s Single Market and Customs Union is likely to impose long-term costs (e.g. for trade barriers and bureaucracy) and slow the country’s recovery from the COVID-19 pandemic. The expiration of the transition period at the end of 2020 will thus be an additional shock for the UK economy – with or without a trade deal, in our view. Furthermore, there is the potential for long-term damage if the UK government withdraws fiscal support prematurely.
Eurozone
Pandemic strengthens ties
European countries reopened their economies earlier than the USA and were therefore a bit ahead in terms of the economic recovery. As Europe is hit by a second wave of COVID-19, we are seeing a renewed setback. However, once the pandemic subsides the Eurozone appears poised to grow above potential, especially as fiscal policies have successfully mitigated much of the damage lockdowns would have inflicted on businesses and jobs. However, government finances are stretched in several key countries like Italy, and investment demand is soft. Challenging demographic trends (i.e. an aging population) pose an additional headwind to growth potential. A successful long-term recovery from the COVID-19 crisis will depend on further effective fiscal and political integration. The creation of the EU recovery fund was a step in the right direction, in our view.
China
Benefits from a head start
China is ahead of most other countries when it comes to recovery from the pandemic. It was the first country to impose lockdowns and the first to lift them. By now, Chinese industrial production has recuperated most of the lost ground, and China will be the only major economy to post a positive growth rate for 2020 (we expect real GDP growth of 2.2%). The course of the recovery from here on will be more reliant on a rebound in employment, which continues to face challenges (the travel and entertainment sectors are still reluctant to hire). Further out, we anticipate three key policy categories to be emphasized in the next five-year plan: technology advancement, labor productivity and land reform. The authorities aim to engineer a smooth deceleration to GDP growth as the economy.
Japan
Innovation to the rescue
Marginally positive real GDP growth should be achievable in 2021, as demographic headwinds are offset by stable productivity gains thanks to continued technological innovation. Nevertheless, persistent but mild disinflation, along with low nominal interest rates, is likely to continue to pose a threat to the banking industry, forcing it to undergo major consolidation.
Switzerland
Holding up
The coronavirus crisis also badly hit the Swiss economy, which held up better than others for three reasons. First, lockdown measures were not as strict as for example in Italy or Spain, as construction or manufacturing sites, for example, were not closed nationwide. Second, measures to mitigate the fallout from the crisis were very timely and effective: short-time working and COVID-19 loans had a positive impact right from the beginning of the crisis. Third, Switzerland has a relatively advantageous industry sector breakdown, with a high proportion of value creation coming from pharma, chemicals and other sectors (including commodities trading, banking and insurance) that were not directly affected by the restrictions or that even saw demand increase due to COVID-19. Going forward, however, the pace of recovery is likely to be similar to that of Switzerland’s main trading partners.
