Capital Ideas^TM

Quarterly macro and market insights from Capital Group’s fixed income team

Financial markets rallied amid stronger-than-expected recoveries in many parts of the global economy and signs that central banks intend to remain more accommodative than had been widely anticipated earlier in 2021. Growth is accelerating, despite persistent lockdowns in parts of Europe, Asia and Australia and growing concern around the rapid spread of COVID-19 variants.

The US and Europe are leading the rebound in activity. Following a significant rebound from 2020 lows, PMIs in China and Japan plateaued. US growth should continue to out-pace. Patchy policy support and less access to vaccines set the scene for emerging markets’ gradual recovery.

US inflation may climb through year end, before decreasing toward the Federal Reserve’s 2% target. Rising demand as most restrictions are lifted, supply chain bottlenecks as well as accommodative monetary and fiscal policies, have all contributed to higher inflation. The pandemic’s ongoing impact on supply chains and consumption patterns suggests it may be some time before inflation rates stabilise and reflect long-term expectations.

Market pricing doesn’t seem to reflect concern about variants, or the possibility of diminished vaccine efficacy. Despite rising infection rates in parts of Europe and elsewhere, the path of Fed policy appears to be the market’s focus amid positive and well supported economic growth.

It may be many months before the Fed begins to taper its asset purchases, in our view. While inflation has climbed significantly, the labour market’s recovery is far from complete. The participation rate remains below pre pandemic levels. Although employers added 850,000 jobs in June, the unemployment rate rose to 5.9% and Household Survey data also showed signs of weakness.

Any interest rate hike is, in our view, at least 12 to 18 months away, after the taper. Comments by Federal Reserve Chair Jerome Powell suggest that he expects inflation to return toward the 2% target once “transitory supply effects abate.” Furthermore, the fact that the Fed has been “talking about tapering” underscores the sequential nature of its likely playbook for tapering and hikes.

Economic growth in Europe looks well supported through year-end. The vaccine rollout has accelerated, and further easing of mobility restrictions should boost activity. That said, the UK and other nations are seeing COVID-19 infections climb due to the Delta variant. Despite near-term inflationary pressures, we expect monetary policy to remain highly accommodative as the European Central Bank looks through temporarily higher inflation. The key policy question that will need to be considered in the medium term is: To what extent are higher nominal and real interest rates justified by the recovery?

Emergency fiscal support in the Eurozone has been extended through 2021 and the European Union’s Recovery Fund should boost growth over the next few years — especially in Italy, France, and Spain. Elsewhere, the Bank of England expects a strong rebound and the absorption of spare capacity over the next two years, consistent with some withdrawal of policy stimulus.

We expect growth in China to continue slowing through year-end. Rising property prices in tier-one cities and broad inflationary pressures are adding to concerns among officials in China, which was the first major economy to rebound from the impact of the pandemic. Restrictions on credit growth may further dim economic prospects.

 

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