The dichotomy between massive stimulus efforts and the coronavirus, our preferred method of understanding the economy in such a volatile and uncertain time, has served us well. This framework was necessarily blunt and reductive; both the monetary and fiscal support for the economy and the terrible public health impact of the pandemic were towering forces that overwhelmed all historical precedents and economic theorizing. But as of this writing, we are well past the peak of each of those factors, and despite rumblings over the rest of the Biden agenda and Covid concerns when the weather turns colder, these factors will likely continue to fade from view. Stimulus vs. virus, you have served us well, but it is now time to retire this overly blunt framework.
In its place, we suggest going back to the basics of everyone’s first introduction to the subject of economics: supply and demand. The intersection of the two determines the price and quantity of economic activity. Importantly, each side of the economy is flexible, adapting to each other and to changing external conditions over time. As we think about issues around the labor market, supply chains, the housing market, and the broad outlook for inflation, this simplifying mechanism will allow for a clarification of complex and often emotionally-charged issues. After a turbulent 15 months, going back to basics is a comforting thought indeed.
Before turning to the outlook for the back half of the year, let’s check in with growth trends around the globe. At a high level, the economic recovery continued to gain steam in the second quarter as the winter surge in Covid cases faded and vaccines began to find their way into arms. This was especially the case in the U.S., fueled by continued fiscal stimulus from Washington after the passage of an additional economic support package in late March and an effective vaccine distribution campaign. As can be seen from the chart below, the U.S. is the exception, not the rule, in terms of the pace and level of its economic recovery – combined 2021 and 2022 GDP growth is expected to be higher in the U.S. than in the emerging world!
Much of the U.S. economic exceptionalism has to do with its forceful stimulus response to the pandemic overcoming the economic impact of the virus, a long standing view of Horizon’s since the dark days of last spring. The after-effects of that stimulus remain; there is considerable dry powder in the system to propel the expansion in the coming quarters. But more nuanced analysis is needed now that the crisis period has passed. Digging into the supply and demand dynamics in various segments of the economy will be our primary focus in the back half of the year.
Here are the things we are paying attention to in the coming months.
Debates, both polite and otherwise, around inflation are all the rage these days, especially after May’s 5.0% year-over-year CPI reading in the U.S. While we are inclined to view the impact of the last 15 months as temporary and not a permanent change to the inflation picture, we are watching how the data evolve in the coming months for signs that something else is afoot. The labor market is a particular focus of ours because, if we are going to see sustained inflation above prior trends, wages will have to be a major driver of it. The simple supply/demand framework will come in handy here, and we will be paying particular attention to how quickly and at what wage levels workers reenter the workforce as the summer fades to autumn. Productivity, often underlooked, will also play an important role in determining whether any increase in wages leads to real growth or inflationary pressures. Additionally, consumer spending habits, distorted by the pandemic, have exacerbated the strains in the supply chain for many household goods. There are emerging signs of consumption shifting to services, a phenomenon that would go a long way toward easing some of the inflationary pressures in certain segments of the economy. Lastly, expectations of higher inflation can be self-reinforcing, so we are keeping a close eye on price- and survey-based measures of inflation.
Delta and Other Variants
Although the worst of Covid-19 is likely behind us, we cannot ignore it. This is especially the case for parts of the world that have lagged the U.S. and Europe in their vaccination efforts, including most of Asia and the emerging world. The WHO is currently tracking eight separate variants across the globe (https://www.who.int/en/activities/tracking-SARS-CoV-2-variants/), and we are focused on the effectiveness of existing vaccine technologies on case spread and, most importantly, severe illness and death rates.
The days of massive stimulus efforts are behind us, but not all countries will approach the policy trade offs the same way as economic growth continues to recover. The Federal Reserve is obviously important to pay attention to, especially in light of the focus on inflation in the economic community. After a flurry of victories, the Biden administration appears bogged down in negotiations over the next round of his agenda; fiscal thrust in the U.S. is likely to be much weaker than it has been in the past year. While Europe and Japan appear to be stuck with accommodative monetary policies across any reasonable timeframe, many central banks in the emerging world are another story. Already this year EM central banks have started aggressively hiking rates from rock-bottom levels to try to support their currencies and head off any inflation pressures, a likely headwind to their economic recoveries.
China’s High Wire Act
China, the world’s second largest economy, also bears watching closely on the policy front. Credit creation appears to be contracting, often an ominous sign for global growth. But just after the end of the second quarter, their central bank initiated an unexpected easing of monetary policy. These confusing actions appear to be at odds with each other and their overarching goal is unclear, but given their heft in the global economy and impact on growth dynamics, we are paying attention.
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