Headwinds for the global economy

Headwinds for global economy are starting to emerge such as labour supply strains, substantial house price strength, and creeping policy tightening by central banks...

Headwinds are starting to emerge such as labour supply strains, substantial house price strength, and creeping monetary policy tightening by central banks. Add to this the elevated levels of most asset prices, and “caution” seems appropriate when it comes to investments.

Economic recovery continues apace – even if the COVID-19 pandemic flare-ups caused by new strains of the virus mean that the road to recovery is still a bumpy one. Policymaker support remains extensive on both the fiscal and monetary side but the introduction of new fiscal action to lift activity is thinning out. While some central banks have started to wind in their stimulus as they taper bond buys or start to consider lifting policy rates.

A self-sustaining recovery does seem to be on the cards, particularly as consumers run down involuntary savings accumulated through the pandemic. Hence, the need for policy support is less pressing and, in certain areas, such as the Fed’s purchases of mortgage-backed securities, it seems to be overkill. Adverse spill-over effects are becoming more noticeable, particularly when it comes to house price inflation – and not just in the US. The more general rise in CPI inflation could prove another adverse spillover effect, although the jury is still out on whether this is just a temporary base effect and supply-chain disruption story. Major policymakers all see it as temporary, with inflation rather magically returning to target in the next year or two after this year’s overshoot.

“We think that’s fanciful. Inflation is likely to prove more stubborn than most policymakers anticipate but, with inflation in most G10 countries having been below target for some time, the question is whether inflation now becomes stubborn around the 2% target that most banks have, which would be a good thing, or stubbornly above 2%, which could prove problematic. Bond markets seemed to fear the latter earlier in the year but have since calmed down. We expect this angst to rise again and push yields back up again, led by treasuries where the 10-year note yield should rise above 2% over the next 6-12 months”, Mr. Steve Barrow, Head of Standard Bank G10 Strategy forecasted.

With coronavirus being a symmetric adverse demand and supply shock, it is not surprising that we’ve seen growth slump, and then recover, while inflation initially fell but has now come back with a vengeance. Just about all countries have seen these trends, albeit to differing degrees. The synchronicity of these movements, plus the sedative for financial assets that comes significant monetary easing, has meant that exchange rate divergence has not been significant. Of course, there was the surge in USD in the early days of the outbreak but, since then, it has fallen back, range-trading has become the norm and FX volatility has declined to very low levels again.

In Mr. Steve Barrow’s view, in short, it does not look as if coronavirus has changed the currency landscape too dramatically, at least amongst G10 currencies. Over time, he expects the global economic recovery and the fading influence of the pandemic to engender a positive risk bias and so weaken USD at the expense of the higher-yielding currencies, and even the lower-yielding ones such as EUR. But a good deal of optimism is already priced into the markets. Add to this the fact that there are headwinds now, in the shape of policy tightening and more, and it suggests that the greenback is not quite ready to slide.

The dollar is still expected to weaken over the long haul and our euro/dollar target range is still up in the 1.30-1.40 area. But near-term risks abound, particularly with respect to inflation because it seems that the risk of higher US prices is greater than elsewhere and, if that prompts the Fed to tighten quickly, asset prices will crash and the dollar surge. Thankfully, that’s not our central scenario. But we do envisage that inflation will give the markets bigger concerns than currently priced into assets such as treasuries, and that could spill over to a temporarily stronger dollar as well, said Mr. Steve Barrow.

In sum, the strong economic recovery is unlikely to bring with it significant rallies in assets such as stocks or non-dollar currencies at this stage. Prices of many assets are already high and the risks – particularly inflation – seem too elevated to engender too much bullishness amongst investors at this stage.