Global Outlook

The US economy behaved much as we expected in 1Q21, and the contrasts we see in the status from one industry to the next have sharpened. That is, output levels in manufacturing and construction have largely caught up with aggregate demand in those sectors, and so we think it is likely that growth in these sectors will actually slow in the months ahead. There have been some signs of such slowing recently, as factory orders slipped a bit in February, and, more importantly, new-home sales and housing starts appear to have gone flat in recent months. Consensus opinion has blamed these slowdowns on a winter blizzard that shut down Texas power supplies for a few days in February. Those power shutdowns could indeed have suppressed homebuilding and manufacturing activity, but we think there is more to the recent slowdowns there than merely weather, especially as new-home sales have been flat to down for the last six months. Then again, March payroll data showed strong job growth in both these sectors. Prior to March, while output had recovered nicely, staffing levels were still markedly depressed from pre-Covid levels. So, it will be interesting to see whether the March job gains signal further output growth in manufacturing and homebuilding or merely a catching up of staffing levels with output levels already attained.

Meanwhile, for the service sectors, where essentially all the remaining "slack" in the US economy resides, any reopening has so far been only halting, and growth there has been accordingly sluggish. Restaurants had reopened to something like 25% indoor capacity in California, and entertainment venues are only now reaching these levels. The new White House administration has not yet announced any timetables for a more complete reopening of these sectors.

Absent a complete full-capacity reopening of restaurants, hotels, airports, theaters, etc. and with manufacturing and homebuilding already having fully recovered, we are inclined to think that realized US growth will fall short of the expectations that seem to be built into market pricing, given how sharply term yields have risen in recent months. Finally, as might be inferred from the previous remarks, we are skeptical that there is any substantial economic stimulus in the bills that have been passed by Washington recently.

Rebound expectations for continental Europe have been hampered by the slow vaccine rollout and by renewed lockdowns in Q1 and early Q2. We view this as a delay in the economic rebound rather than a fundamentally altered trajectory, especially as vaccine supply is picking up markedly in Q2. On the fiscal side, we expect to see more countries echoing Germany’s important recent signal and provide additional fiscal support throughout H1 to deal with this recovery delay. Fiscal rules and debt breaks remain suspended for now—at the European level until GDP has reached its high-water mark, which we expect to happen in mid-2022 for the EU as a whole. First disbursements from the Next Generation EU (NGEU) recovery fund are likely to flow in Q3, and will play a much larger role in 2022 outcomes. The case against German participation in the NGEU, currently before the German Constitutional Court, has created some legal uncertainty that could prove long-lived even if the current injunction is rejected and the project goes ahead. The already legislated US stimulus will also add to European growth on the margin.

Looking beyond significant volatility in 2021 due to base effects, inflation in the eurozone is likely to remain muted over the medium term. Wage agreements in key sectors have been geared at protecting employment, but have been lackluster in terms of wage growth. This will allow the European Central Bank (ECB) to focus its interventions on ensuring favorable financing conditions in light of higher and more volatile global interest rates. Purchases under the Pandemic Emergency Purchase Program (PEPP) facility have been rising already in anticipation of the significantly higher pace promised by ECB President Christine Lagarde for Q2. Ultimately, the speed at which these purchases occur together with a potential extension into Q3 (which we expect in the June ECB decision) will determine whether there is a need to enhance the PEPP envelope. The higher purchase pace is partly met by higher issuance plans in eurozone economies and the EU level, but should still lead to a net absorption of government bonds.

The UK has made substantial progress in its vaccination campaign and is already in the process of reducing pandemic restrictions for good with imminent upside potential for the service sector—a very different picture from the developments on the continent. That said, substantial parts of the UK economy (e.g., tourism) rely on economies on the continent and globally to reopen at roughly the same pace and we see risks to the economic take-off on both sides. The new trading arrangements post Brexit have had a significant impact on the flow of goods and services between the UK and the continent, with exports down substantially at the beginning of the year. We expect this pattern to normalize somewhat as teething problems are overcome, but trade will no longer be free of frictions, and the pending decisions on EU market access for certain UK service sectors will also be significant. The recent UK budget was relatively expansionary in the near term by extending key support programs over the summer but will lead to a higher tax burden over the medium term. The Bank of England (BoE) so far has looked through inflation (and output) volatility, but given the progress on reopening the economy, we expect the BoE to be one of the earlier developed market central banks to turn the corner toward a less accommodative stance.

The National People’s Congress (NPC) was held from March 5 to 11 and reiterated its focus of balancing a sustained growth recovery with managing financial risk. Beijing reintroduced the annual GDP growth target for this year (above 6%) and stated that it will continue to set an annual GDP growth target in the coming years. A larger than expected annual quota for special local government bonds (SLGB) at RMB3.65 trillion (RMB3.0 trillion expected) and an official fiscal deficit of 3.2% of GDP (3.0% expected) means the broad-based fiscal deficit is expected to reach 6.5% of GDP this year (8.4% last year and 5.0% in 2019).

In contrast to the 13th Five-Year Plan (2016-2020) that emphasized growing the service sector, the new guidance for the 14th Five-Year Plan (2021-2025) has set a goal of keeping the manufacturing sector’s share of the economy stable. More specifically, Beijing has increased its focus on more self-sufficient supply chains and technology upgrading against the backdrop of US-China trade tensions as well as potential supply chain disruptions, as highlighted by the COVID-19 situation. The government may set a target of 3% of GDP for R&D spending in the 14th Five-Year Plan (from 2.5% of GDP in the 13th Five-Year Plan). There is no change to our view for range-bound yields in China given that we expect slower credit growth, slower sequential economic growth momentum and no sharp U-turn in the monetary policy stance. We continue to expect China to be an anchor of stability for growth, though such growth will increasingly be domestically driven with less spillover demand from the rest of the world.