As the world’s largest economies reopen, economic activity is bouncing back, with China in the lead. Recoveries in the US and the Euro area are also expected to be relatively fast, with fiscal and monetary policy working together at an unprecedented scale.
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The world’s largest economies are bouncing back from deep coronavirus recessions at a pace more or less in line with our expectations from the May Economic Outlook. However, the pandemic has left a much bigger mark on emerging economies than hoped, prompting a downward adjustment of the forecast for the world economy for this year.
We now expect the global economy to contract by 3.5% in 2020, followed by a return to positive growth rates in 2021. Only towards the end of the forecast horizon – extended to 2022 in this Economic Outlook – do we see activity returning to pre-coronavirus levels in the US and the Euro area.
China is the odd one out, having returned to pre-coronavirus economic activity levels already in the second quarter of this year. It offers a glimmer of hope for the countries that experienced the lockdowns and subsequent reopenings a couple of months after China and where huge increases are expected in third quarter GDP.
GDP growth forecast, % Y/Y
Second wave uncertainty
Uncertainty reigns when it comes to the virus’s second wave, but the pendulum is currently swinging back towards more restrictions in some countries. Although we find large-scale lockdowns unlikely at this point, soft measures and travel restrictions are likely to remain in place for a while, slowing the economic recovery and adding to the risk of bankruptcies and permanent layoffs in the sectors that remain restricted. Thus, we stick to our cautious view and see risks skewed to the downside until an effective vaccine can be mass produced or the pandemic has petered out from natural causes.
China’s surprisingly rapid bounce-back in the second quarter was not due to a complete reopening. On the contrary, restrictions have been lifted slowly, soft measures remain in place, offline services such as theatres and fitness centres remain closed and travel restrictions continue to apply to foreigners. Rather, China has returned to its old growth model, where growth is driven by credit-fuelled infrastructure investment. As a result, the recovery is asymmetric across sectors, with parts of manufacturing and construction supported by infrastructure spending while sectors related to consumer spending are suffering. Yet, sometime next year, at an aggregate level, all foregone production during the lockdown will be caught up!
China has returned to its old growth model, where growth is driven by credit-fuelled infrastructure investment.
Amy Yuan Zhuang, Nordea Chief Analyst
Massive fiscal spending ahead
Fiscal spending is at the heart of the expected recoveries of most countries. In the US, it’s a key topic in the November presidential election campaigns for the incumbent as well as the challenger, Joe Biden. Both candidates promise more fiscal spending despite an unprecedented level of fiscal measures already announced – around 16% of GDP so far this year, dwarfing every year since World War II.
But the nature of fiscal easing is changing in the US and elsewhere, from the initial – successful – attempts at safeguarding economies and preventing vicious cycles to boosting demand and supporting fast recoveries. The US economy is still in for a miserable year, with a sharp rise in the unemployment rate. Even with the massive easing of economic policies, it will take time to recover, but fiscal policy could be the ingredient that was missing during and after the global financial crisis. Consequently, we see potential for a relatively fast recovery once the pandemic is over.
Both US candidates promise more fiscal spending despite an unprecedented amount of public money already being poured into the economy.
Morten Lund, Nordea Analyst
Trump vs Biden – the trade war goes on
With the caveat that pollsters had it wrong in 2016, Joe Biden is the favourite to win the presidential election, and the Democrats could take both chambers of Congress. We believe the latter could prove to be as important as the former for the US economic outlook when it comes to getting the fiscal packages that both candidates want through Congress. While Trump would likely opt for lower taxes, Biden is likely to favour higher taxes and more regulation of the financial sector. Moreover, we expect Biden’s trade policy to be less aggressive, albeit still tough, on China.
With the pandemic casting its shadow over the phase one trade deal between the US and China, it is becoming quite clear that China will not catch up with its commitments to the US. China’s purchase of US goods is running well behind the USD 264bn specified in the deal. While China was ready for bilateral talks, President Trump postponed the half-year review on 15 August, thereby giving China more time to buy US goods. Trump probably has not turned less protectionist – as seen in his tough talk on the Chinese-owned media platform TikTok – but he may not be willing to jeopardize “his success” in the trade war a few months before his re-election bid. Regardless of the outcome of the presidential election, we believe the trade war will continue, although a Biden win could make US policies less aggressive and more predictable. Taking on China is about much more than just Trump, and it is the one thing that unites US politicians across the parties.
Tourism is dividing the Euro area
Caught in the middle, the Euro area is vulnerable to global supply chain disruptions from the trade war as well as from the pandemic. However, while Germany is most vulnerable to another flare-up in the trade war, many Southern European economies are much more concerned with the lack of tourists, although foreign tourists have to varying extents been replaced by domestic tourists. Out of the large economies, Spain seems to suffer the most, and we expect the deepest recessions and the shallowest recoveries in Spain and Italy.
Had the pandemic hit ten years ago, high-debt Euro-area economies would have been in double trouble, forced to tighten fiscal policy into a recession to prevent a financial market panic caused by debt sustainability concerns. This time around, public deficits are above 10% in many countries and sovereign bond yields are but a whisker from their all-time lows in countries such as Italy and Spain, permitting all countries to support their recoveries by allowing automatic stabilisers to work and easing fiscal policy on top.
Historic EU solidarity
A major step towards increased solidarity within the EU was the EUR 750bn Recovery Fund agreed upon this summer, of which EUR 360bn are loans and EUR 390bn are grants targeted at members having the worst economic difficulties. It will be financed by European Union bonds and backed by the EU budget and guarantees from EU member states. The fund implies a lower risk of another sovereign debt crisis in the Euro area as well as a faster and more even recovery among member states. We would be surprised if the Recovery Fund is anything but the first step towards a more coordinated fiscal policy in the years to come.
Not all summertime news was good news, however. On the Brexit front, the UK and the EU decided not to extend the transition period, meaning that the UK will leave both the Single Market and the Customs Union on 1 January 2021. Therefore, although we expect the two parties to finalise a simple free-trade agreement during the autumn, disruptions at the borders and in supply chains are inevitable in 2021. The risk of a “No deal 2.0” is much higher compared to in 2019, and Brexit uncertainty will likely be a large drag on the already weak UK economy (the UK had the worst Q2 GDP numbers among G7 countries). We expect the UK economy to be one of the worst performers among the major economies in the coming years.
Old and new monetary policy easing
Monetary policy has several crucial roles to play, too. Both the Fed and the ECB were very quick to ease policies as the pandemic hit, adding liquidity to the financial system and not least buying a big chunk of the fresh government bonds that had to be issued to finance the massive easing of fiscal policy. Still, more is likely to be needed from both central banks.
First of all, though, the big central banks are preoccupied with maintaining easy and stable financial conditions, which is one of the main reasons why equity and bond markets have rallied as much as they have. Bigger corrections in risk appetite would jeopardise the recoveries and prompt immediate monetary policy easing. Moreover, since governments are expected to have huge funding needs in the years to come and debt levels are already elevated in most large economies, central banks are bound to be on QE in the foreseeable future, and financial conditions are likely to be easy.
An old enemy has still not been defeated, namely inflation or rather the lack of inflation. Inflation is a much bigger problem to the ECB than to the Fed, although both have seen inflation below their respective 2% inflation targets ever since 2012, with the exception of some months. Gently put, markets have lost much more faith in the ECB’s ability to ever get inflation back at target than they have in the Fed’s. With tailwinds from recovering economies and unprecedented fiscal support, more central banks might, like the Fed, opt to redefine their inflation-targeting frameworks to incorporate some form of average inflation targeting – where past undershoots are offset by temporary overshoots – in order to re-anchor medium- to longer-term inflation expectations at target. If successful, it could make current monetary policy much more expansionary, as it would lower real long-term interest rates, which is probably what matters the most to the economy at the end of the day.
That leads to the second possible invention, at least for the Fed and the ECB, namely some form of yield curve control. There is simply no way to allow sovereign bond yields to rise before growth and/or inflation has returned. Debt is too high and sustainability risks would quickly rise with higher sovereign bond yields. Thus, policymakers are all-in on easy monetary and fiscal policy, and it is hard to imagine an exit plan drafted and ready in the drawers on either side of the Atlantic. If such a plan were to exist, it could include capping interest rates until nominal growth is strong enough to make public debt sustainable even with higher interest rates.
We expect the ECB to expand its Pandemic Emergency Purchase Program (PEPP) – probably at its December meeting and probably by around EUR 500bn – and we expect more TLTRO auctions at potentially sweetened terms to make sure that all Euro area banks have enough liquidity. The ECB’s Strategy Review is due mid-2021 and could include some form of average inflation targeting, especially if the Fed decides to go down that road in the coming months, as we expect. We also expect the Fed to experiment with some form of yield curve control.
The big central banks’ commitment to buying bonds in large quantities should keep bond yields low for an extended period.
Jan von Gerich, Nordea Chief Analyst
Bond yields on a mild uptrend
Bond yields face resistance to the upside. During recent months, inflation expectations have rebounded, which would normally coincide with higher nominal yields. This time, nominal yields have not moved much, and instead real yields hit new lows in the US. The big central banks’ commitment to buying bonds in large quantities should keep bond yields low for an extended period. However, also the downside to bond yields looks limited, since neither the ECB nor the Fed appear willing to cut their policy rates further.
If anything, central banks are pondering ways to strengthen their forward guidance and signal that
monetary policy will remain easy for a long time. The ECB has started to emphasise that the future of its PEPP is tied to the inflation outlook rather than the continuance of the pandemic. The inflation outlook, in turn, will likely require very low real yields for a long time. The Fed is moving towards linking its forward guidance more concretely to the development of economic variables, especially inflation. In other words, both the Fed and the ECB will likely strive to keep even longer bond yields low for a long time.
Longer out, especially longer-term bond yields should come under upward pressure as the market starts expecting changes in central bank policies, the economic recovery progresses and excess capacity diminishes. The short end of the curve should remain anchored throughout our forecast horizon, so gradually rising long yields would steepen the curve. Risks are tilted towards a faster rise in long yields if the economic data starts surprising on the upside in earnest and a vaccine boosts recovery hopes. Even in such a case, we would expect central banks to try to prevent a rapid rise in yields as it could pose a risk to the recovery.
Broad-based USD weakness ahead
A broad-based negative USD story is playing out. A widening US budget deficit paired with a continued trade deficit is an issue for the USD – but mostly when the rest of the world catches up growth-wise, as has been the case since the reopening of most large economies during the second quarter. Why should foreigners accept funding persistent US twin deficits if the USD level is already very strong? This question is particularly relevant when tail risks abate elsewhere. The USD was, as usual, sought after during the crisis. Because the truckload of global USD debt leads to a dash for USD cash when the storm is fierce. But as the Fed responded by providing massive amounts of liquidity, the USD ended up having a rough summer.
The scope for a weaker USD is intact, and there is even a risk of a pretty large move in a weaker direction. If EUR/USD moves above 1.20, the ECB is likely to enter the equation with verbal intervention, but the trend is still likely to be up, and we look for levels around 1.26 towards the end of 2021. The EUR has not been priced in an overly strong direction versus other peers such as the CHF, SEK, NOK and DKK, which have all gained versus the EUR since the early summer. Had this repricing in EUR/USD been a EUR story, we would have seen EUR/CHF follow suit and move higher. This is not yet the case. The EUR has further to go when/if the market realises that the tail risks are much smaller now compared to 9-12 months ago.
The USD will likely weaken over the next 12-18 months against most, if not all, major peers, with the biggest question mark surrounding the emerging market currencies. The GBP has also rallied against the USD but remains weak versus the EUR. We see little scope for GBP weakness versus the EUR and the Scandies as, for example, EUR/GBP remains sensitive to the Brexit negotiations. As long as no clear exit route is outlined, we would argue that EUR/GBP should be above 0.90 and maybe even a tad higher than that before the new year. We would argue that the scope for a stronger GBP is pretty substantial, should a managed exit finally take place, but a lot of noise will be seen between now and then.
Oil prices have climbed since May, supported by the reopening of economies and the production cuts from OPEC+. Short term, plenty of spare capacity limits the scope for a sharp rise in prices, despite a continued increase in oil demand. As demand recovers in tandem with the economies, available production capacity will gradually decrease. The futures curve suggests a very gradual rise to USD 50/bbl towards end-2022. With oil companies now scaling back new investment due to low prices and high uncertainty, the risk to oil prices further out is on the upside.
Foreign exchange rates, monetary policy rates and bond yields, end of period
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