2021 is off to a volatile start with inflation uncertainty a large enough tail risk
The US economy faces short-term headwinds due to the pandemic, with early signs of weakness evident in the labor market. Indeed, nonfarm payrolls declined by 140k in December, the first drop since April 2020, with the weakness concentrated in leisure and hospitality (see Economics). We expect real GDP growth of circa +2.5% qoq saar (-0.2% yoy) in Q1:2021. However, the victories of Ossoff and Warnock in the Georgia elections flipped the Senate to a Democratic majority opening the door for another stimulus package of between $0.5 to $1tn (4% of GDP) in the following months. Overall, we foresee real GDP growth of +4.9% yoy in 2021 from -3.5% yoy in 2020.
In a similar vein, euro area real GDP growth is expected to be +0.7% qoq saar (-3.2% yoy) in Q1:2021, as activity restrictions and harder lockdowns are re-imposed across the continent hurting domestic spending. Governments need to demonstrate that they can ramp up vaccinations markedly, following a slow rollout, in order to quicken the return to normalcy. On a positive note, the manufacturing upswing continues, due to higher demand for consumer and investment goods from China, where data flow points to strong momentum (Chinese Q4:2020 GDP due on January 18th with consensus expecting annual growth of +6.2%). Receding trade uncertainty (new US Administration, a deal-Brexit) could fuel further manufacturing gains. In all, we expect euro area real GDP growth of +4.0% yoy in 2021 from -7.3% yoy in 2020.
Central banks appear committed to support the economic recovery, at least until the pandemic’s effect dissipates. As a result, policy interest rates are expected to remain at near zero levels in 2021 and beyond, whereas asset purchase schemes will continue with the same velocity. We doubt that the Federal Reserve will move towards tapering those purchases around the end of the year. On the other side of the Atlantic, the European Central Bank recently expanded the PEPP envelope until at least March 2022. As both central banks implicitly aim to limit sudden and rigid rises in nominal yields, breakeven inflation expectations will continue to receive a steady bid (see graph page 3). Higher actual inflation outcomes may test new strategic frameworks (Average Inflation Targeting), albeit prints up to 2.5% will be tolerable. Note that food price inflation is running above headline indices at 4% vs. 1% (US) and 2% vs -0.2% (EA).
Global markets entered 2021 on a strong footing despite the US political mayhem. Investors have discounted that the likelihood of increased US corporate taxes appears low for 2021, with Democrats eventually passing tax increases for 2022 and beyond. Following gains of 14% in 2020 (see our Asset Scoreboard), the MSCI ACWI was up by 2.7% wow, with euro area and Emerging markets overperforming. Energy, Financials and selected cyclicals led the move, as increased expectations for further fiscal support revitalized the “rotation” play. Regarding fixed income, the 10-Year UST yield has increased by 20 bps to 1.10% Year-to-Date with the 2/10s term spread (95 bps) at its highest level since 2017. The Georgia election (more fiscal > stronger growth > higher inflation > but with the Federal Reserve sticking to its guns) is expected to lead to a fresh round of consensus’ upward revisions for end-2021 US Treasury yield targets (see graph below). Finally, Speculative Grade credit spreads have narrowed by 10 (USD) to 20 (EUR) bps, due to risk-on sentiment and higher oil prices.