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Economic and Market Commentary

Bounded Optimism on the Global Economy

Vaccinations and fiscal support should lift the global economy in 2021, but several risks call for careful portfolio positioning.
12 January 2021
  • Global output and demand are likely to rebound strongly in 2021, driven by the rollout of vaccines and continued fiscal and monetary policy support. Inflation should creep up only moderately in 2021. Central banks’ policy rates are likely to remain low, and asset purchases will likely continue.
  • Key risks to our baseline cyclical outlook include fiscal fatigue (in which governments return to a more cautious stance), a negative credit impulse in China, and pandemic-related economic scarring.
  • While equity and credit markets seem to have priced in a return to normality, we see opportunities in non-agency mortgages and other structured products, select corporate credits, and emerging markets. We remain focused on careful portfolio positioning, capital preservation, and liquidity management: This is not a time for excessive optimism.

Economic Outlook

We expect the global economy to continue its transition from hurting to healing  in 2021 and make good progress on the long climb  back to its pre-crisis trend (as we discussed in prior outlooks), especially in the second half of this year. However, while risk markets can continue to perform well in the near term as the dual impact of policy stimulus and vaccine rollout takes hold, much of this is now priced in, and on the path to full recovery investors should beware of obstacles that command careful portfolio construction to weather renewed bouts of volatility in financial markets.

Fiscal fatigue in some advanced economies is one such risk. Another is the likely transition in China from credit easing to tightening in the course of this year. Moreover, economic scarring could impede the return to pre-pandemic activity levels and make the recovery bumpy and uneven across countries and sectors.

Growth bounce

Following an outsized contraction of economic activity in 2020, global output and demand are likely to rebound strongly this year. We expect the current renewed weakness due to lockdowns in major economies to give way to accelerating economic growth from around the second quarter, driven by the broadening rollout of vaccines and continued fiscal and monetary policy support. The sectors most hit by COVID-19-related restrictions – travel, lodging, restaurants, leisure, etc. – should benefit the most. Coming off a low base, world GDP (gross domestic product) growth in 2021 is expected to be the highest in more than a decade. We forecast economic activity in the U.S. to reach pre-recession peak levels during the second half of this year, while Europe, due to its current double-dip, is unlikely to fully make up the output losses until the middle of 2022 despite the sharp growth bounce we expect from the second quarter (see Figure 1). Meanwhile, the Chinese economy, which already operates above pre-crisis levels and has exhibited strong growth momentum into the new year, should record GDP growth above 8% in 2021, after a decidedly subpar 2% or so last year.

Figure 1: Projected path of the level of real GDP in three major economies

Figure 1 plots the projected path of real GDP (gross domestic product) in three major economies – the U.S., euro area, and China – against trend GDP and the level of GDP for each in Q4 2019. Real U.S. GDP, after falling precipitously in the first half of 2020, is projected to return to Q4 2019 levels only in the middle of 2021 and return to its trend level later in the year. Real GDP in the euro area is projected to remain below both trend GDP and Q4 2019 GDP levels through the end of this year. By contrast, real GDP in China, based on chained 2015 yuan, overtook Q4 2019 levels in the middle of 2020 and has already returned to its trend growth level and is on track to top 25 trillion yuan by year end 2021. 

Source: Haver Analytics, PIMCO as of December 2020
Sectors most affected by COVID-19-related restrictions should benefit greatly from the recovery.
Mother holding child’s hand, walking through airport

Inflation targets remain elusive

Consumer price inflation is likely to creep up only moderately during this year and generally remain below central banks’ targets in all major economies. Even with a sharp growth rebound, output and demand will continue to operate below normal levels for quite some time given the depth of the recession and unemployment, which, while likely to decline, will remain above levels generally associated with full employment. In the U.S., low mortgage rates and downward pressure on rents in the next couple of quarters will weigh on the shelter component of the consumer price index (CPI), which accounts for slightly more than 40% of core CPI. Globally, however, while near- and medium-term inflation pressures are expected to remain low, we reiterate our secular view that the pandemic and related policy responses have increased both longer-term inflation and deflation risks. If monetary and fiscal policies remain expansionary for several years to come even after economies return to full employment, inflation could exceed central banks’ targets eventually. Conversely, deflationary risks could result from a possible return to passive or restrictive fiscal policies or from bursting asset price bubbles and deleveraging of the private sector. As a consequence, we think markets will have to price in higher long-term inflation uncertainty. 

Central banks stay the course with bias for further easing

Central banks will remain hostage to inflation running below target and the need to keep borrowing costs low in order to enable ongoing fiscal support for years to come. Thus, policy rates are likely to remain at present levels in the foreseeable future or could even be reduced further in some countries. For example, while not our base case, an excessive appreciation of the euro could induce the European Central Bank (ECB) to further cut its deposit rate, which currently stands at −0.5%.

Global central banks will likely offer continued economic support.
Central bank of Switzerland

Moreover, central banks’ asset purchases are likely to continue throughout, and likely well beyond, this year. In the U.S., the Federal Reserve adjusted its guidance in December, stating that it intends to continue with purchases of U.S. Treasuries and agency mortgage-backed securities (MBS) at least at the current pace until “substantial progress” toward its statutory goals of maximum employment and price stability has been made. We see a distinct possibility that the Fed will increase the weighted average maturity of its bond purchases this year if the economy disappoints or if yields rise too fast and too far. In an adverse scenario of renewed economic and financial market turmoil, we would also expect the Fed to restart several of the lending facilities put in place during the 2020 crisis, with equity backing from the Treasury led by incoming secretary Janet Yellen via the Exchange Stabilization Fund or with a new authorization from Congress. Conversely, if the economy rebounds even more strongly than in our base case and inflation surprises on the upside, the Fed may start to gradually taper its purchases already in late 2021 or early 2022.

Meanwhile, the European Central Bank (ECB) recently increased the overall “envelope” for its Pandemic Emergency Purchase Program and is likely to flexibly fill the envelope in the course of this year, aiming to keep euro area bond yields anchored via a form of loose yield curve control. Most other central banks in advanced economies are pursuing similar policies and are likely to stay the course as well. Moreover, further monetary easing appears likely in a number of emerging market economies where real interest rates, while below historical norms in many cases, still have room to decline.

Fiscal policy supportive for now

In addition to virus containment through the rollout of vaccines, fiscal policy remains the main swing factor in our cyclical outlook (see more on the downside potential in our Risks section). Aided by monetary policies that keep funding costs low, most governments are likely to keep propping up household incomes via transfers and supporting companies via loan guarantees, subsidies, and tax breaks (see Figure 2). In Europe, the agreement on the European Union (EU) budget in December paved the way for sizeable disbursements of loans and grants from the new EU Next Generation Fund in the course of this year, thus complementing the support coming from national budgets.

Figure 2: Forecast for fiscal deficits in four major economies (as percentage of GDP)

Figure 2 is a bar chart forecasting fiscal deficits in the U.S., euro area, U.K., and Japan as percentage of GDP in  the years 2019, 2020, and 2021. For the U.S., the fiscal deficit ballooned to 17% of GDP in 2020, up from 5% in 2019. It’s expected to fall to 14% of GDP in 2021. In the euro area, the fiscal deficit rose to 10% of GDP in 2020, up from 1% in 2019. The deficit is expected to fall to 7% of GDP in 2021. In the U.K., the fiscal deficit soared to 18% of GDP in 2020 from 2% in 2019 and is expected to retreat to 12% in 2021. The fiscal deficit in Japan also rose sharply in 2020, to 18% of GDP from 7% in 2019. It’s expected to fall back to 11% of GDP in 2021. 

Source: Haver Analytics, PIMCO calculations as of December 2020

In the U.S., the latest pandemic relief package passed by Congress during the lame-duck period will underpin income and demand in coming months, extending the bridge to economic recovery. Additional significant fiscal support later this year has become likely with the Democrats securing a slim majority (with Vice President-elect Kamala Harris’s vote acting as tiebreaker) in the Senate following the Georgia runoff on January 5. However, given that several new Democratic senators won their seats in traditionally more fiscally conservative states, we do not expect a shift to more radical fiscal policies in the foreseeable future.

Capital markets seem to have priced in a recovery, but a focus on resiliency remains critical.
Covid-19 vaccines in fridge

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