Sit down with a group of economists for a (no doubt scintillating) discussion about the state of the global economy and it won’t be long before you hear the word ‘peak’. While earlier in the year talk in markets was dominated by the notion of ‘reopening’ following the worst of the disruption from the pandemic, the focus now has shifted to the idea that growth is peaking. In this month’s commentary, we explore the factors driving this ‘peak’ narrative and some possible implications for investors.
In some respects, it comes as no surprise that concerns about peak growth have come to the fore in recent weeks. As trends in economic and financial data (GDP, inflation, corporate profits etc.) are often expressed in terms of annual growth rates, recent second quarter figures are being boosted by comparisons with the depressed levels of spring 2020, when the disruption from lockdowns in the advanced economies was at its worst. As a result, the reduced impact of this so-called ‘base effect’ going forward will generally serve to pull down ‘headline’ annual rates of growth and inflation over the next year or so.
Moreover, with much of the economic growth over the last year coming from a normalisation in activity as vaccination programmes have facilitated a reopening of economies, strong ‘bounce-back’ gains are now giving way to less impressive rates of sequential growth. Countries are at different stages along this reopening process. China is most advanced down this path (see our commentary of July 2021), while the US has also seen its GDP rise above pre-covid levels 1. In contrast, the eurozone and the UK are lagging, with second quarter GDP some 3.0% and 4.4% respectively below levels prevailing at the end of 20192,3. The upshot of this is that while the US and China (the world’s two largest economies which together account for around a third of global GDP4) are likely to see slower, more ‘normal’, growth going forward, much of the rest of the world still has significant ‘bounce-back’ potential.
Aside from these statistical phenomena, coronavirus still poses significant risks to the global growth outlook. Although the rollout of vaccines is weakening the link between cases and hospitalisations/deaths, the Delta variant is still causing significant disruption across the globe, most notably in regions where vaccination rates are lower and/or governments are pursuing ‘zero covid’ policies. The recent partial closure of ports in China and factories across emerging Asia has further disrupted global supply chains, with component shortages (notably semiconductors) in turn curbing output in advanced economies. Fear of the Delta variant is also weighing on consumer and business confidence, jeopardising the recovery in the service sector which has taken place as economies reopen. Against this backdrop, data for July showed the global composite PMI (a measure of global activity across the manufacturing and services sectors) falling back further from the 15-year high seen in May5, further fuelling the ‘peak growth’ narrative.
The dialling back of pandemic-related government support measures is also adding to concerns that growth has peaked. In the US, there are no plans for another round of the stimulus cheques that have helped boost consumer spending over the last 16 months6, and federal enhanced unemployment benefits (which currently top up recipients’ weekly payments by US$300 per week) will expire in September7. Elsewhere, the UK’s Job Retention Scheme, under which the government currently pays 70% of furloughed workers’ wages – will also close at the end of September8. Similar schemes in continental Europe will also end during the coming months9.
Nevertheless, increased demand for labour as economies have reopened should go some way in mitigating the impact from reduced government support. Amidst widespread reports of labour shortages in the US and Europe (the number of job vacancies in the US currently exceeds the number of unemployed10), hiring should be strong during the coming months as the expiry of extraordinary government support measures and easing childcare constraints (as schools reopen) combine to increase the supply of workers.
Moreover, as pandemic emergency measures are being phased out, several governments are now looking to increase spending on infrastructure, which should provide a more sustained boost to activity going forward. In Europe, the rollout of funds under the Euro800 billion “Next Generation EU” programme is just getting started and is expected to underpin growth in the region during the next five years11. In the US, a US$1.0 trillion bi-partisan infrastructure bill is currently making its way through Congress, while the Democrats are also working on a partisan plan for an additional US$3.5 trillion of spending which is unlikely to be fully funded by tax hikes. A key takeaway here is that policymakers are wary of repeating the mistakes made in the wake of 2007-08 financial crisis when fiscal policy was tightened prematurely, hobbling the recovery.
Central bankers are similarly cautious. To be sure, at the global level, we have already moved past ‘peak monetary accommodation’. Several emerging market central banks (including those in Russia, Brazil and Mexico12) have raised interest rates in recent months to counter inflationary pressures. Furthermore, the US Federal Reserve is widely expected to announce a reduction or ‘tapering’ of its US$120 billion a month quantitative easing (QE, or buying bonds) programme during the coming months13, following moves to scale back purchases already announced by the Bank of Canada and the Bank of England14. However, with central bankers in the advanced economies indicating that hikes in official interest rates are still some way off, real (i.e., adjusted for inflation) rates are likely to remain negative, and thereby supportive of the economy and risk assets, for a good while longer.
A peak, not a cliff
All of this suggests that although growth in the global economy is peaking and transitioning to a new phase, it is not about to see a dramatic downturn. Indeed, there is a good chance that we will continue to see a few more quarters of above-trend growth. Regions with greater ‘bounce-back potential’ (for example Europe and emerging markets ex-China) can be expected to take over the growth ‘baton’ from those where economic reopening is more advanced (notably the US and China). Coronavirus remains a key risk, but the continued rollout of vaccines and the recent UK experience (where hospitalisations remain muted compared with earlier waves15) offer grounds for optimism. Consumer spending is likely to be supported by pent-up demand and a run down in some of the excess savings built up during the pandemic (estimated to have risen above US$5.0 trillion earlier this year16), although demand for manufactured goods is naturally set to cool as expenditure shifts towards services (e.g., restaurants, travel etc.).
What might ‘peak growth’ mean for financial markets? In line with the bounce-back in the economy over the last year, global equity markets have been supported by a sharp rebound in corporate earnings. Second quarter profits for the biggest 500 companies in the US were up nearly 90% compared with a year earlier17. However, less favourable base effects will result in profits growth slowing sharply during the coming quarters, resulting in a less potent tailwind for markets.
As yet, equity investors seem unfazed by the idea of peak growth; markets in the US and the eurozone have recorded a succession of record highs in recent weeks18. However, analysis from Goldman Sachs suggests that when economic activity (as measured by the ISM manufacturing index) is slowing but still expansionary (as is currently the case), equity returns tend to be lower than when growth is accelerating19.
What’s more, in a potential early signal of waning risk appetite, the spreads on US high yield bonds (i.e., the difference in yield compared to a ‘safe’ government bond of equivalent maturity) have widened out in recent weeks20. These factors might suggest that softer growth and less generous central bank liquidity could increase market volatility and slow the pace of returns going forward. Peak growth in itself is unlikely to see equity markets fall off a cliff, but the landscape could well become bumpier.
17th August 2021