While the global economy is expected to continue its transition “from hurting to healing” this year, there are several risks that could challenge this economic recovery, according to PIMCO’s Joachim Fels and Andrew Balls.
Global economic adviser Fels and chief investment officer – global fixed income Balls believe the global economy will make good progress in 2021 as vaccines are rolled out while fiscal and monetary policy support remain in place.
“Coming off a low base, world GDP growth in 2021 is expected to be the highest in more than a decade,” said the pair.
“We forecast economic activity in the US 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.”
Inflation is likely to increase only moderately and remain below central bank targets, despite a forecasted sharp growth rebound, as output and demand continue to operate below normal levels for some time given the depth of the recession and unemployment.
“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,” they said.
“Thus, policy rates are likely to remain at present levels in the foreseeable future or could even be reduced further in some countries.”
Furthermore, central bank asset purchases – or quantitative easing – are likely to continue throughout 2021, “and likely well beyond”.
Nevertheless, they warned that there are risks to the global growth outlook.
One risk that faces some advanced economies, the pair warned, is ‘fiscal fatigue’.
Although PIMCO's base case assumes continued fiscal policy support – aided by loose monetary policy – they warned any sign of ‘fiscal fatigue’ would be a significant risk to the economic recovery.
“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,” they said.
However, such fiscal support should not be taken for granted.
“In the US, while additional fiscal support this year looks likely after the Democrats secured a slim majority in the Senate with the Georgia run-off, later this year the focus may well shift to potential increases in corporate and top personal income taxes to be enacted in 2022,” said Fels and Balls.
While fiscal stimulus is “largely backed in the cake for 2021” in Europe as a result of already agreed national budgets and upcoming disbursements from the EU Next Generation Fund, the reality of large deficits could affect policymakers’ willingness to “stay the course” and launch additional stimulus if needed.
“The budget season for the following year traditionally starts after the summer in Europe, and a change in the fiscal policy course for 2022 could thus come into view by the second half of this year,” said Balls and Fels.
“This will be aggravated by the debt brake in the German constitution, which was temporarily waived for 2020 and 2021 but will require budget cuts in 2022 and beyond.
“Expectations of future fiscal belt-tightening via spending cuts and tax hikes may well start to affect consumer and corporate spending plans in the course of this year.”
The second risk to the global recovery in 2021 is the transition of China from credit easing to tightening.
While growth was “a decidedly sub-par 2 per cent or so last year”, PIMCO is anticipating the Chinese economy to grow by 8 per cent or more in 2021.
Having rebounded strongly from the initial impact of Covid-19, Chinese authorities may decide to focus on deleveraging this year to avoid further credit bubbles and ensure long-term growth sustainability.
Although such a move could impact its near-term growth outlook.
“Calibrating just the right amount of credit easing or tightening in a highly leveraged $14trn economy is fraught with difficulties, which implies a real risk of overtightening causing a sharper-than-expected growth slowdown with negative global repercussions in economies and sectors heavily dependent on demand from China,” they said.
Finally, the pair said ‘economic scarring’ could pose a further risk to the recovery preventing a return to pre-pandemic levels of activity.
“Given the unprecedented nature and size of the Covid-19 shock, it is hard to gauge the behavioural changes of households and firms,” they said.
Although they expect significant pent-up demand to be unleashed this year as the roll-out of vaccines opens up economies, there is a significant risk that “private households and firms remain more cautious in their spending and investment patterns for longer”.
Furthermore, labour force participation, which declined in many countries during 2020 as the pandemic spread and forced more people to stay at home, may not recover quickly.
Fels and Balls added: “Lasting damage to corporate balance sheets and business models could only become apparent during the recovery as government support expires over time.”
Notwithstanding its more positive base case for 2021, the pair said the overall low level of yields, tight credit spreads and low volatility means it will place “significant emphasis” on capital preservation and liquidity management.
“We will look to be patient and flexible, to guard against a rise in market volatility, and seek to add alpha in more difficult market conditions,” they concluded.
“While risk markets can continue to perform well over the coming months in response to broadening vaccine rollout and policy stimulus, investors may have become too complacent as reflected by the bullish consensus positioning. As these risk factors [outlined above] underline, we see this as a time for careful portfolio positioning and not for excessive optimism or risk-taking.”