Most major economies are progressing toward the mid-cycle phase of expansion, with varied levels of activity based on vaccine rollout and reopening progress.
For the first time in decades, both fiscal and monetary policy will likely remain easy during an accelerating expansion — a significantly different backdrop from the low-growth, low-inflation period following the 2008 financial crisis.
The post-World War II shift to a peacetime economy, which catalyzed a cyclical rebound of nominal growth and inflation, may be the closest historical analog to the upcoming post-COVID era where vaccinations and reopening gain steam over the course of 2021 and 2022.
Similar to the late 1940s, nominal growth and inflation may receive a boost from households flush with pent-up demand and high savings, government policies to maintain low interest rates and high debt levels, and a repaired banking system poised to lend.
Rising nominal growth may remain a tailwind for cyclical assets, but the markets face several risks that could generate volatility over the next 12 to 18 months, including elevated valuations and uncertainty about inflation and the monetary outlook.
Global business cycle progressing
Key developed economies appear to be progressing toward the mid-cycle expansion phase as activity improves at the margin, and the rollout of COVID-19 vaccines broadens the prospects for full economic reopening.
The global vaccination effort is resulting in the daily administration of millions of COVID-19 vaccine doses and a decline in virus cases. Though progress is likely to move in fits and starts, we expect a boost to global activity as nations increase the pace of inoculations, reduce virus-related social distancing measures, and move to reopen their economies.
Business cycle framework
Many global economies are advancing toward the mid-cycle phase of expansion amid vaccine progress and reductions in virus cases.
There is not always a chronological, linear progression among the phases of the business cycle, and there have been cycles when the economy has skipped a phase or retraced an earlier one.
We believe that Israel may be considered a bellwether for economic activity. Israel has led the vaccination campaign with more than 85% of its population having received at least one dose of a COVID-19 vaccine, compared with less than 25% in the United States. Levels of mobility in Israel, a proxy for economic activity, have shown encouraging signs of improvement and are now higher than those in Europe.
In Europe, the extension of strict social distancing measures may continue hindering service industry activity. However, key drivers of business-cycle momentum, such as business confidence and manufacturing, have been relatively resilient.
The rate of economic improvement in China may moderate as the expansion matures. Industrial production appears to be peaking, consumption and services activity continue to recover gradually, and monetary policymakers have shifted away from easing and toward addressing medium-term financial risks.
The US economy appears to be progressing toward the mid-cycle expansion phase, as activity continues to incrementally improve.
US bolstered by pent-up demand and excess savings
US consumers are positioned to unleash their pent-up demand as the reopening occurs, boosted by a massive buildup of excess savings.
US consumers accumulated roughly $1.7 trillion in excess savings since the beginning of the pandemic due to a decline in spending and an income boost from hefty transfer payments and other fiscal stimulus measures.
Surging asset prices pushed household net worth above $120 trillion, an all-time high.
These gains have not been evenly distributed, resulting in even higher inequality than before the pandemic.
With cash positions and savings rates at extremely elevated levels, US consumers in the aggregate are well-equipped to increase discretionary spending amid the economic reopening.
Policy to remain extremely accommodative
US fiscal and monetary policies are highly accommodative, and they are likely to remain supportive of nominal growth through the reopening of the economy.
Following more than $3 trillion of emergency stimulus in 2020, an additional $1.9 trillion relief package was signed into law in March.
Similar to the aid approved last year, this relief bill also focuses on emergency spending, including enhanced unemployment benefits, checks to households, and additional spending on emergency services.
The White House has signaled its intention to subsequently propose a multi-year package of infrastructure and other spending, which will likely include some tax increases. Such legislation would likely mark an end to the pandemic aid phase and signal higher fiscal support that would occur during and after the full reopening of the economy.
The Congressional Budget Office estimates that the baseline fiscal-year 2021 deficit will be higher than during the recession in 2009. With the latest emergency package, the deficit may be even higher than it was last year when the economy was in recession.
The Federal Reserve (Fed) continues to underscore that its monetary policy will remain highly accommodative, with $120 billion of monthly quantitative easing and zero interest rates for an extended period.
This represents the first time in several decades that both fiscal and monetary policy are poised to remain easy during an accelerating expansion, and the backdrop appears significantly different from the low-growth, low-inflation period following the 2008 financial crisis.
After major fiscal stimulus during the recession in 2009, budget deficits shrank in the subsequent years as policy shifted toward austerity.
Today, fiscal deficits might grow even as the economy is reopened, and an infrastructure package may focus on high-multiplier spending that would further support nominal economic activity into 2022 and beyond.
The Fed has expressed even greater patience in the midst of potentially higher inflation, vowing to keep policy rates low in order to overshoot its inflation target to make up for past misses.
These policies might also find the economic backdrop more conducive to an acceleration in nominal growth and inflation. Compared to the aftermath of 2008, banks are better capitalized and able to support lending, supply constraints and deglobalization pressures are putting upward pressure on goods prices, and economic reopening may provide a faster catalyst for reducing unemployment.
Post-WWII analog: COVID peace dividend?
Perhaps the best historical analog for the upcoming economic reopening is the US exit from World War II (WWII) and the cyclical transition to a peacetime economy.
After a sharp recession that began as the war wound down, the US outlook was bolstered by a number of conditions that appear similar to today — households flush with pent-up demand and high savings, government policies to maintain low interest rates and high debt levels, and a repaired banking system poised to lend.
The end of the war catalyzed these factors into a cyclical rebound of nominal growth and inflation that began in 1946 and gained steam in 1947. This episode may offer lessons for the upcoming shift to a post-COVID era, as vaccinations and economic reopening gain steam over the course of 2021 and 2022.
Similarities between COVID-19 reopening and post-WWII period:
Short-lived, sharp recession: In both the second half of 1945 and the first half of 2020, US industrial production declined at a nearly 50% annualized rate and rebounded sharply thereafter. Following modern history’s shortest, sharpest recession during the first half of 2020, new orders for durable goods are already above pre-virus levels.
High debt levels and fiscal support for economic transition: US public debt surged to a record level above 100% of GDP during WWII. In 1946 Congress approved the GI Bill and Employment Act of 1946 to provide opportunities to transition its work force to a peacetime economy. In 2020, public debt eclipsed 100% of GDP for the first time since the post-war era, with additional fiscal spending still on the way.
Low interest rates to aid fiscal financing: The post-war Fed implemented extraordinarily easy monetary policy to essentially cap long-term Treasury yields at 2.5% until the Treasury Fed Accord in 1951. Through forward guidance, the Fed is currently targeting policy rates to remain at the zero lower bound until at least 2023.
Healthy banking system: Following the Great Depression and Global Financial Crisis, newly imposed banking regulations helped improve bank stability and financial market functioning. Bank balance sheets are currently well-capitalized and in position to support lending activities.
Pent-up demand and surge in household savings: Wartime rationing dramatically constrained consumer spending, and more recently, COVID-related restrictions have limited consumer activity. In both instances, personal savings rates surged to above 20% of disposable income. After the war, consumers released their pent-up buying power on discretionary consumption. Today, we expect a significant jump in spending in areas where there is considerable pent-up demand, particularly in services such as travel, leisure, and hospitality.
The similarities between the post-WWII and COVID-19 era suggest we could enter a period of high nominal growth and inflation over the next 1–2 years. This suggests assets with exposure to high nominal growth rates, including value stocks and commodities, may hold up well whereas bonds could struggle.
Asset allocation outlook
Rising nominal growth tends to boost corporate profits, and the prospect of an acceleration may continue to provide a tailwind for cyclical assets, particularly value and small-cap stocks, commodity and commodity-producer stocks, and non-US equities.
Higher nominal growth expectations may also continue to provide upward pressure on Treasury bond yields, making it a challenging return environment for bonds.
The potential for higher inflation continues to warrant diversification in inflation-resistant assets, including TIPS, commodities, and gold.
While the cyclical backdrop remains favorable, financial markets will face several risks over the next 12 to 18 months.
Elevated valuation levels across most asset categories imply that a significant amount of positive macroeconomic and corporate earnings expectations is already built into current asset prices, leaving potentially less room for upside surprises.
Asset valuations that are above historical averages are justified in part by low interest rates, suggesting a continued ascent of Treasury yields may act as a headwind for stock valuations.
If inflation and inflation expectations sustain their rise, investors may at some point begin to question the Fed’s commitment to patient accommodation.
Given the Fed’s central role in boosting financial market liquidity and asset prices, uncertainty surrounding inflation and the monetary outlook has the capacity to generate greater volatility in asset markets.
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