Our core scenario is for growth to remain robust and inflation to remain above target, but not be sufficiently worrying to warrant a rapid and disruptive withdrawal of monetary stimulus. However, we remain in an unusual environment, and it’s as important as ever to keep an eye on the risks to our central view.
The virus is still causing disruption though the combination of vaccines and better treatments make us more confident that the economic consequences will be more limited and temporary. Our key risks to the central scenario therefore revolve around how the supply side of the economy behaves. In the upside scenario supply bottlenecks, both in goods and labour markets, are resolved allowing for a ‘goldilocks’ period of strong growth, low inflation and ongoing monetary accommodation. The downside scenario by contrast would be that supply side concerns worsen, leading to an unpleasant mix of weak growth and higher inflation.
Weak growth, disruptive inflation
- Supply problems intensify, holding back growth and leading to further upward pressure on global goods prices.
- In developed markets severe labour shortages lead to a sharp increase in wages and unit labour costs, which alongside other cost pressures weigh on corporate earnings.
- Energy prices continue to rise due to insufficient supply response by Opec+ and US shale.
- Monetary: Central banks are forced to tighten policy more than in our central scenario to anchor inflation expectations, even though growth is slowing.
- Fiscal: Rising rates and higher inflation discourage further active fiscal policy to support growth.
- Fixed income: Bond markets are challenged by tighter policy despite weakening growth. Spreads widen on weaker growth. Emerging market debt is vulnerable to tightening financial conditions.
- Equities: Stock markets experience a correction on weaker growth and less accommodative policy. Commodities outperform.
- Currencies: The dollar appreciates on the back of market volatility.
- Alternatives: Real assets provide some inflation protection. Hedge funds, particularly macro strategies, provide potential protection against falling equity and bond markets.
Strong growth, above target inflation
- Nominal growth in developed markets remains above trend. Pent-up consumer demand is released, focused on service sector spending. Labour markets are tight, which feeds wage inflation, only partially offset by productivity.
- Inflation remains high in the first half of the year as energy price increases filter through and supply chain disruptions are prolonged by elevated demand. Inflation moderates later in the year but stays above pre-Covid norms.
- Monetary: The Fed ends quantitative easing mid year, as planned. The emphasis remains on slow and gradual normalisation. The ECB tapers through 2022 but doesn’t raise rates. The BoE raises rates to 0.75% over the year. Dovish central banks, in the face of resilient growth and inflation, lead to increasing perceptions that they will need to do more later.
- Fiscal: US lawmakers agree on another fiscal package. Although part funded, the spending is front loaded. European recovery fund disbursements turn into actual projects and activity.
- Fixed income: 10-year Treasury yields rise to between 2.0%-2.5%. Carry assets outperform core government bonds.
- Equities: Earnings growth offsets moderate P/E compression to lift equity markets. Value outperforms on higher bond yields and P/E compression of growth stocks.
- Currencies: The dollar and sterling strengthen as bond yields rise but downward pressure builds as the global recovery broadens.
- Alternatives: Private equity performs well. Real assets provide some inflation protection and withstand moderately higher rates. Hedge funds, particularly macro strategies, provide diversification.
Robust growth, inflation fades
- Supply problems ease. In the developed world, workers are enticed back into the labour market, easing labour shortages.
- Emerging markets begin a gradual recovery, easing supply challenges but without putting undue pressure on global demand. Energy prices retreat and goods prices cool as spending tilts to services. Productivity is strong, helped by capex.
- Inflation fades back to target.
- Monetary: Central banks remain accommodative for longer. The tightening cycle is even more gradual.
- Fiscal: Low interest rates, and robust growth and tax receipts, reduce the pressure on government cash flows, encouraging easier fiscal policy and more government investment in areas such as low-carbon infrastructure.
- Fixed income: Core government bond yields stay broadly where they are. Carry assets outperform.
- Equities: Strong earnings growth, and valuations that don’t decline, help equity markets end the year even higher. Growth stocks perform better than in our central scenario, while value still rises on higher earnings.
- Currencies: The dollar weakens as growth broadens by geography.
- Alternatives: The environment is particularly strong for private equity and private credit.
Past performance and forecasts are not reliable indicators of current and future results.