16 March 2021

In the past week, the Biden Adminstration passed its historic American Rescue Plan (ARP) and UK Chancellor Rishi Sunak unveiled his budgetary program for the coming years. The message from both is clear, the immediate priority is to provide Covid-related relief to household and businesses. Concerns about rising public sector debt would have to wait until economic recovery is more firmly established. Indeed, while the UK Chancellor did outline specific future corporate and household tax hikes, the Biden plan did not address the issue of the future debt burden.

To be sure, global policymakers are correct to keep the pedal to the metal, e.g. to maintain macro-stimulus until the economic growth and unemployment outlook is more certain. The recent US and UK decisions require upward adjustments to our GDP forecasts for this year and 2022. Moreover, the continuation of policy stimulus will have important implications for the outlook for inflation, equities, bonds, and currencies. The outlook is best where the Covid pandemic is best contained, the vaccine rollout most successful, and fiscal policy most supportive. The USA is beginning to perform better on all these fronts. In addition, the scale of the ARP’s near-term support may have ramifications for the rest of the Biden Administration’s economic agenda.

Biden: Going Big……Too Big?

Haunted by concerns that the fiscal stimulus following the GFC was too small (contributing to the tepid economic recovery), President Biden decided to “Go Big”. But, is the $1.9-trillion price tag TOO big? The Covid recession left a huge gap between the actual level of US GDP and the economy’s “potential” level. From a macro-perspective, economists tell us the objective of fiscal stimulus is to fill this gap. The Chart above illustrates the US confronted a cumulative GDP gap of 5-6% of GDP, e.g. $1.2-trillion. Arguably, therefore, the ARP is larger than it needed to be to “fill the gap”.

Scrutiny of the ARP’s details appear to support this conclusion (Chart above). The highly-credible Committee for a Responsible Fiscal Budget (CRFB) indicates direct Covid-related spending accounts for about 35% of the Biden Plan, which most view as absolutely necessary. Meanwhile, transfers to state and local governments represent another 25% of outlays ($400-500billion). However, despite the warranted initial concerns about strained local government resources, 22 US states actually collected more revenues last year compared to 2019. Of the states experiencing lower receipts, which totalled $18-billion, only 6 states accounted for nearly 70% of the shortfall. The Chart below indicates that many observers believe local aid is much higher than required.

In addition, the additional $1,400 direct monthly payments (and other rebates) account for nearly 25% of outlays. During the past year, US households have increased bank deposits by roughly $3-trillion, suggesting that many higher-income beneficiaries have been saving these payments. Finally, roughly 25% of ARP outlays are not directly related to battling the Covid crisis, and represent downpayments on other Biden Administration spending priorities.

President Biden’s decision to “Go Big” has important implications. First of all, the earlier Chart indicates America’s output “gap” will be eliminated faster, by early 2022. Indeed, I am raising my GDP forecast to 7% in 2021, followed by 4% next year! Similarly, the unemployment rate will decline more quickly; hopefully, approaching 4% by the end of next year. Potentially, the stronger recovery and earlier end to the pandemic (hopefully) will help minimise Covid’s long-term economic consequences as well (so-called “scarring”). Even the non-Covid-related spending, e.g. increased Child Tax Credits, ACA health expenses, etc., will help boost labour supply and productivity; thereby, supporting the recovery both in the short term and over the long run.

On the other hand, however, the unsustainable rise in the government debt ratio will need to be addressed eventually. The CBO indicates debt/GDP has will rise to 110% by the end of 2021 (pre-Covid 80%), and could reach 259% by 2051 (the gap between the red and tan lines in the Chart above largely represents ARP’s impact). Will this endanger the rest of President Biden’s eagerly-awaited supply-side agenda, including the promised $2-trillion for infrastructure and climate-related programs? Not necessarily, but future plans will need to be financed by the $3.5-trillion tax increases on corporations and high-income earners. I suspect this will not occur until next year, after unemployment is much lower and the recovery more secure. Just in time for the 2022 mid-term elections!

Global Update: Consumer Leads the Recovery

The post-Covid global recovery (sounds good to contemplate that) will be led by the consumer: provided unemployment continues to decline (or does not rise too much in Europe as furlough schemes end). Not only is there pent-up demand, but households have money in their pockets. In the USA, for example, the Chart above illustrates that household balance sheets are much healthier compared to the post-GFC upturn.

In addition to the ARP stimulus payments, the US consumer’s savings rate is sky-high (next Chart), as reflected in the enormous increase in households’ bank deposits. Even the US government is flush with cash, as the US Treasury issued over $1-trillion more debt than needed last year (which should limit the rise in the debt/GDP ratio in the near term). On the other hand, US corporations have taken advantage of low interest rates, and enter the recovery with higher leverage than in the past.

The USA is not alone, as European consumers are also poised for higher spending. The Chart below indicates the savings rate is high, and household balance sheets are in good shape.

The strength of economic recovery in individual countries during the next two years will be determined by the ability to contain the pandemic, the success of the vaccine rollout, and the scale of the fiscal stimulus. First of all, while all countries have implemented massive fiscal stimulus, the USA leads the way. Europe lags. Within Europe, however, the UK (especially) and Germany have adopted the largest programs. Despite the high level of Covid deaths in Italy and Spain, government support has been more modest. As Covid has been contained more successfully in Asia, fiscal stimulus has been smaller. While both Mexico and Brazil have suffered greatly during the pandemic, the fiscal response has been much larger in Brazil.

The recent worrisome upturn in Covid cases in Europe stands in contrast to improving trends in the United Kingdom and the USA. The following Chart highlights the particularly troubling developments in Italy and Eastern Europe. In large part, this distinction reflects the far more successful vaccination rollout in the United Kingdom. After a shaky start, the US vaccination rates are rising sharply.

As a result, I expect the United States’ 2021 GDP growth of 7% will top Europe’s 4.5%. I have also raised my 2022 projections to 4% and 3.4% respectively. The UK’s fiscal stimulus and successful vaccination campaign should lead to stronger growth than on the Continent, at least in the near term (UK GDP advances 5.5% in 2021). Brexit poses a medium-term headwind relative to both EU nations and the USA. Indeed, trade disruptions in the Q1 2021 represent a risk to both EU and UK growth this year. Fortunately, I expect these teething pains will be short-lived.

I project China’s GDP to expand 9% this year, compared to the government’s conservative (boring) 6%-plus forecast. Will the USA out-grow China?!

Strategic Considerations: 40-Year Bond Rally is Over!

• As a result of the robust economic recovery and bloated budget deficits resulting from the ARP, US bond yields will rise above 2% by the end of the year and towards 2.5% in 2022. To be sure, the 40-year bond market rally is over (Chart above). To fully negate the downtrend, however, 10-year interest rates will need to rise above 5% during this economic cycle. At this stage, that seems unlikely.
• The ARP probably reduces US dollar risks in the near term (stronger GDP growth) but increases long-term vulnerability (swollen budget and current account deficits). I target Euro 1.25 and Yen 99 by year end.
• The US “GDP gap” will be eliminated by early 2022. Accordingly, US inflation will rise, and remain consistently above 2% by the end of next year. Nevertheless, if the US Federal Reserve actually implements its Average Inflation Target, American short term rates may remain on hold well into 2023. The yield curve will steepen significantly further: 10yr yields exceeding 2yr by 250bp .
• Despite the region’s economic under-performance this year, European equity and bond markets may outperform, reflecting low inflation risks and better public finances than in the USA (who saw that coming!). Following the recent sell-off, Asian markets also should outperform, although I am increasingly concerned about the implications of the Chinese government’s recent treatment of Alibaba.
• The Chart below indicates global bond markets may have entered a new phase. During the past six months, only Turkey and Brazil under-performed as US yields rose, as investors continued to be attracted to high-yielding options. More recently, however, markets have been more volatile, and bond spreads have widened also in Russia, Philippines, Indonesia, Australia, Mexico, and South Africa. For now at least, investors appear more attracted to low-inflation safe havens (e.g. Europe and East Asia), and are avoiding more risky options. A few months of consistently low inflation results may be needed before the “hunt for yield” resumes.