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Potential for upside surprises in 2021

Most indications are that early 2021 will be weak but there should be potential for a fast recovery in 2021 if high hopes about vaccines prove correct. And maybe inflation will make a comeback as the economy gets back on firmer ground. Read Reflections from SEB economists Håkan Frisén and Marcus Widén.

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During 2020, economic performance has mainly been determined by the various phases of the Covid-19 pandemic. The unexpectedly strong mid-year recovery still dominates official statistics. But given increasingly large-scale lockdowns due to the pandemic’s second wave, the year will still end on a negative note. Most indications are that early 2021 will be weak, too, and that a normalisation of economic activity will not happen until vaccination campaigns have progressed far enough to change the playing field. Expectations for 2021 as a whole have already been adjusted much lower. The recovery process implied by the consensus forecast is highly reminiscent of what occurred after the 2008-2009 global financial crisis. Considering that economies were hampered at that time by underlying imbalances as well as official policy dilemmas, there should be potential for faster recovery in 2021 if high hopes about vaccines prove correct. Although new types of risks have emerged due to the Covid-19 crisis, inflation has remained low. This is has increased manoeuvring room for exceptional stimulus measures, but it cannot be ruled out that central banks’ “playing with inflation fire” may become more controversial a bit further ahead as the economy gets back on firmer ground and balance sheets have swollen in both the private and public sector.

Conditions for macroeconomic forecasting have been exceptional in many ways during 2020. Economic performance has mainly been determined by patterns of Covid-19 infection as well as the various lockdown strategies of political leaders and public agencies. In addition, the rapid economic policy response by governments and central banks has been highly important. To some extent it has also been possible to use historical parallels to analyse indirect effects, for example related to investments, home prices and labour market trends. Partly because performance has been so highly dependent on factors that macroeconomists have little chance to assess, it has been hard to diverge in a credible way from mainstream forecasters. This has probably contributed to a more conformist mentality than usual.

Downplaying, followed by deep pessimism

Reflecting on the various phases during 2020, obviously it took time before economic forecasters realised the severity of the situation.

Looking at the monthly compilations published by Consensus Economics, only in the April survey did the first big downward adjustment in full-year GDP forecasts took place. Although there is always some time lag in reporting, at first there was probably a tendency among major international organisations like the International Monetary Fund (IMF) and the Organisation for Economic Cooperation and Development (OECD) to try to avoid scaring financial markets and other actors with excessively alarmist forecasts.  Here we can also see a parallel with the World Health Organisation (WHO), which waited quite a long time before classifying Covid-19 as a global pandemic. Once the spread of the virus seriously accelerated and broad lockdowns were imposed in most countries, there was a tendency to exaggerate in the other direction, especially in the forecast updates the IMF and OECD unveiled in June. Deep pessimism about Sweden and other Nordic countries was especially clear.

Increased divergence during the second half

SEB’s forecasts for advanced economies were at their gloomiest in the Nordic Outlook that we published in early May. At that time, our assessment was that full-year Swedish GDP would fall by 6.5 per cent during 2020. Our corresponding forecast for the mainly affluent OECD countries as a whole was -7.0 per cent. After that, it gradually became clear that differences in the lockdown strategies of various countries would have a major impact on their GDP growth. This contributed to wider geographic divergence in forecasts. At a somewhat later stage, it also turned out that economies could recover unexpectedly fast once they had eased their pandemic-related restrictions. The rebound was at its strongest in June, but this positive trend continued during the third quarter of 2020, though modestly in this context.

Transition from strong outcomes to new lockdowns

Before we are ready to close the books on 2020, it remains to be seen how severe the economic consequences of the current “second wave” of the pandemic will be. Although the number of Covid-19 deaths, or in any case the mortality rate, is still lower than last spring, the latest surge has been more powerful than expected in terms of the spread of infection and resulting lockdowns.

Because of the special conditions now prevailing, it is important to analyse developments on a monthly basis. High-frequency data can then provide useful information. The above chart shows the association between a mobility index and monthly economic activity in the euro area and the United Kingdom. This association appears quite stable, but not in Sweden. Statistical offices in many countries are now also publishing monthly measurements that are rather close to the GDP concept, which also makes it easier to monitor these trends. The latest wave of lockdowns was imposed in late October in major Western European countries. It is thus not surprising that incoming data are now showing that the recovery continued into October. Purchasing managers’ indices (PMIs) and other confidence indicators have nevertheless continued to show considerable resilience. It is conceivable that the responses in these surveys are coloured by the earlier positive trend, combined with optimistic news on the vaccine front, and that they have thus not fully incorporated all the consequences of new lockdowns. Yet we cannot rule out that these new restrictions will have smaller consequences than expected, and that the intention of decision makers to allow as much economic activity as possible has helped.

Manufacturers are far more resilient than last spring

The second wave of the pandemic is affecting practically all economies, but like last spring the scale of the lockdowns varies. Most indications are that the downturn in Sweden, other Nordic countries and Baltics will once again be milder than in most of Western Europe. Large Western European countries have again imposed tougher restrictions, and the United Kingdom is also affected by uncertainty about Brexit and future trade relations with the European Union. When we divide our Nordic Outlook quarterly forecast into individual months, British GDP ends up about 15 per cent below its pre-crisis level in November, which is the lowest month. Last April and May, British GDP was down a full 25 per cent. As for the euro area, we predict a low in December about 13 per cent less than the pre-crisis level. This, too, is about 10 percentage points milder than the low last April. The Nordic countries have implemented new lockdowns a bit later than major economies. This applies especially to Sweden, where for a long time the authorities hoped that a higher degree of immunity would contribute to a milder second wave. But as the disease situation has worsened, restrictions have gradually been imposed. It is highly uncertain whether they have peaked yet.

However, our monthly forecast projects a low in December that is 7 per cent under the pre-crisis level, compared to an 11 per cent decline in May. The reason why activity levels are not falling as deeply as last spring is that the manufacturing sector in all of these economies now seems to be performing far better.

The US does not publish monthly GDP figures, but looking at actual data, industrial production remained strong until November while household demand slowed after a previously robust recovery. In November there was a broad decline in retail sales, mainly with the exception of groceries and building materials. The labour market recovery is also losing momentum, judging by weekly statistics for new unemployment claims and the November jobs report, but sentiment indicators for the corporate sector have generally remained at levels that imply continued economic expansion. Our forecast in the November Nordic Outlook that GDP will fall during the fourth quarter thus seems to have been overly pessimistic. Instead the risk of negative growth will shift to Q1 2021. Generally speaking, US economic trends reflect the dual nature of the Covid-19 crisis, with interest rate-sensitive sectors (durable goods purchases and the housing market) holding up compared to traditional patterns during recessions, while the corporate sector except for specific sectors and small businesses has shown resilience during the latest coronavirus waves.

Tug-of-war between extended restrictions and vaccine optimism

Economic performance early in 2021 will be determined largely by how quickly Covid-19 vaccines will change the playing field. Although some countries, including France, have already signalled an ambition to ease restrictions, the pandemic situation is generally so serious that it is hard to expect any significant normalisation without the help of vaccines. This is confirmed by Germany’s decision to extend its restrictions on the retail sector until mid-January. So far the pattern of Covid-19 spread has proved so erratic that making credible predictions for example based on patterns from last spring or from earlier epidemics is difficult. Looking at our monthly projections for the first half of 2021, it is possible that we are too optimistic about the first few months, and that activities such as winter tourism in Europe will be drastically curtailed. However, due to progress on the vaccine front our forecast for the second quarter seems rather cautious, with a GDP level in May and June 2021 that is on a par with the October 2020 figure.

Second wave will mainly impact 2021

When the outlook for full-year 2020 turned gloomy last spring, it was natural to believe that a sizeable proportion of the GDP downturn would be regained in 2021, especially in light of the powerful official stimulus measures that central banks and governments quickly launched. Since then, however, the relationship between the two full years has changed somewhat. Because the latest wave of lockdowns is occurring so late in the year, it has no time to have a major impact on the full-year 2020 GDP figure, but is instead overshadowed by the upside surprises recorded during the third quarter. Instead the current lockdowns will weigh more heavily on full-year 2021 figures, since we will soon enter the new year at a low level of activity that is expected to persist to a fairly high degree during the first half of the year.

Increasing divergence between economies

The above chart shows total GDP growth in 2020 and 2021 and how the consensus forecast has changed over time. This can be interpreted as a measure of how “normal” economic activity during the full year 2021 is expected to be. The difference between the latest figure and expectations early in 2020 before the pandemic struck can be regarded as a rough measure of how large the GDP gap is during 2021 in full-year terms. Our forecast for the United States is now back at zero, since GDP growth in 2021 is expected to be equivalent to the decline in 2020. This implies a level that is 4 percentage points lower than at the start of the year, when the consensus expectation was trend growth of around 2 per cent yearly. In the UK, the trend has been in the opposite direction and has gradually worsened in response to major lockdowns and the negative consequences of the uncertain trade conditions. We now expect the level of British GDP in 2021 to be nearly 9 per cent below pre-crisis expectations. Given continued gridlock in the negotiations on a post-Brexit trade agreement with the EU, further downward adjustments in our GDP forecast are likely. The Swedish pattern has largely followed the US curve, but has diverged somewhat downward in the latest figure. Our own forecast is now that Sweden’s GDP upturn during 2021 will reach only 2.7 per cent and that the big recovery year will now instead be 2022, when we expect GDP to increase by 4.4 per cent.

Better conditions than during the financial crisis

If we consider the forecast outlook a little further ahead, it is worth asking whether successful vaccinations as well as our experiences of the rapid recovery in mid-2020 might suggest a faster recovery than the current forecast indicates. Compared to the trend during the 2008-2009 global financial crisis, the initial decline this time was much deeper, but after the third quarter rebound our November 2020 forecast in Nordic Outlook for the OECD countries is remarkably similar to the pattern from the financial crisis. Compared to the current situation, the crisis that followed the Lehman Brothers crash of September 2008 had significantly larger elements of a balance sheet crisis, with sharp declines in share prices and home prices eroding wealth. In particular, the need for households to repair their balance sheets after major declines in home prices has historically been the most important reason why some recessions have been characterised by protracted healing processes. Looking at the entire recovery pattern after the acute winter 2008-09 downturn, there are big differences between countries in terms of how long the effects lingered. Countries like Germany and Sweden coped relatively well, since their moderate home price declines meant that domestic demand was able to recover fast while manufacturing bounced back rather quickly. Despite large home price declines, the US economy recovered quite rapidly when powerful economic relief measures were enacted. But many European economies experienced long-term hangovers, since their subsequent balance sheet problems were exacerbated when the euro crisis led to mandatory fiscal tightening.

EM economies not as resilient

Although the outlook is brighter when it comes to imbalances, the same support from emerging market (EM) economies cannot be expected as during the global financial crisis. The Chinese economy continues to show signs of strength, with expected growth of 2 per cent this year and 8 per cent in 2021 nearly keeping up with the yearly trend of just below 6 per cent. But many other countries, led by India, have been hard hit by the pandemic. GDP according to SEB’s aggregate EM metric is expected to fall by around 3 per cent this year, compared to a roughly equal increase in 2009. At that time, China's very large investment programmes also helped to maintain demand for raw materials and certain types of industrial products, easing deflationary pressure. This time around, Chinese growth is more focused on consumption than investments and therefore less import-intensive.

The financial crisis was fraught with policy dilemmas

Looking back at the years surrounding the global financial crisis, it is striking how decision-makers faced a series of worrisome trade- offs, perhaps partly self-inflicted. In the initial stages of the crisis, there was a reluctance to act in a way that would benefit those players which had pursued various forms of excesses, mainly those active in the American mortgage market. It was not until October 2008 more than a year after the first serious signs of stress in the sub-prime mortgage market that powerful measures began to be launched as the financial system was collapsing. The European Central Bank (ECB), and in particular Sweden’s Riksbank, hiked their key interest rates during this period in order to offset inflationary impulses from the previous commodity boom. When the countries of southern Europe, in the aftermath of the crisis, suffered from confidence problems in the wake of weak competitiveness and high public debt, it became clear how fragile the euro area really was. Because problem countries were being forced to enact significant austerity measures, the recovery quickly derailed. The issue of inflation also emerged fairly quickly on the post-crisis agenda in Europe, contributing to the Riksbank’s decision to begin interest rate hikes as early as 2010 and the ECB in the spring of 2011. The US Federal Reserve acted more calmly, but in retrospect the Fed’s early normalisation measures, mainly trimming its balance sheet (leading to the “taper tantrum”), has been criticised for having been launched unnecessarily early.

Today's economic policy environment is diametrically opposite to that of the financial crisis. Since the economic downturn has been a direct consequence of the pandemic and the medical and political decisions that followed in its footsteps, stimulus programmes could be implemented quickly and without regard to "pedagogical aspects". A long period of bias towards falling short of inflation targets has also changed the way central banks view the risk picture, so instead of overreacting to early inflation threats, they now want to convince the market that they are prepared to "play with inflation fire" by allowing a period of overshooting of inflation targets, if given the opportunity.

Interactions between monetary and fiscal policy are also completely different, with central banks trying to encourage governments to take bold fiscal stimulus initiatives and promising to keep bond yields down by employing quantitative easing (QE). Another difference is that while fiscal policy was largely used during the years after 2008 to prop up the financial system, recent fiscal stimulus money has instead moved directly out into the economy. So far, pricing in the stock and fixed income markets indicates that decision makers are achieving a Goldilocks scenario with this policy.

Will new policy dilemmas crop up ahead?

The question is whether this seemingly harmonious economic policy situation will change during 2021. Today there is already a discussion about various drawbacks of the current policies, such as widening economic gaps due to rising share and home prices. Over time, continuous central bank actions and asset purchases will also contribute to distortion of market signalling systems and will encourage unsound risk-taking. Chronically low interest rates and bond yields will also play a part in decreasing pressure for change and creating “zombie companies”. So far, these drawbacks have been regarded as a reasonable price to pay in order to ease other acute consequences of the pandemic.

The future inflation outlook will play a key role. During 2020, there has been a focus on special inflation risks. This has applied, for example, to risks of supply side-driven inflation due to production disruptions or large fluctuations in demand patterns because of hoarding or sharply higher consumption in areas still accessible to households. Another issue is whether powerful monetary expansion can create its own shortcuts to inflation, for example by driving up inflation expectations. But so far, not much has happened in the final economic data. Clear price increases are evident in parts of the consumption basket, but they have been temporary and not broad enough to change the overall picture. The channel between wealth accumulation and consumption is also weaker in a situation where an increasing proportion of assets is held by rich households with a low marginal propensity to consume. In 2021 it is likely that we will return to more traditional cyclical inflation analysis, especially in the United States. Our current forecast is that US unemployment will reach 4.5 percent by the end of 2022: on a par with the Fed's previous equilibrium estimate. However, we may possibly get to that point earlier if the vaccination process is successful.

Will the Phillips curve be revitalised during 2021?

Considering that wage and salary increases have been relatively insensitive to the labour market situation for a long time, it is difficult to muster any big inflationary concerns. For example, US employment was as low as 3.5 per cent in late 2019 without clear signs of overheating, and the labour force participation rate was higher than today. But a certain shift in the risk situation is likely as the recovery reaches ever-firmer ground. It is already clear that the fixed income market is not insensitive to indications that inflationary pressures will build up in the long run. The impact of this year’s large fiscal stimulus measures on demand may be delayed a bit into 2021, as opportunities for consumption in previously closed areas reopen. At that point, we may be more inclined to ask whether it is really a wise strategy for central banks to keep encouraging increased debt in both the private and public sectors, thereby increasing underlying interest rate sensitivity and vulnerability. In other words, we cannot be sure that letting central banks play more and more boldly with the fire of inflation will continue to be greeted as favourably by financial markets as has been the case so far. The kind of forward guidance that the Fed has now launched has made it easier to deal with today’s problems, among other things by keeping inflation expectations up, but on the other hand this may pose some problems further ahead if conditions change quickly.

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