Expectations for Economic Growth, Rates and Inflation


Expectations for Economic Growth, Rates and Inflation

May 3, 2021

Expectations for Economic Growth, Rates and Inflation

Host: Hello and welcome to Talking Markets: exclusive and unique insights from Franklin Templeton.

Ahead on this episode: breaking down economic growth expectations in different parts of the world. Plus, differing views on inflation being transitory or more sustained.

Sonal Desai, Chief Investment Officer, Franklin Templeton Fixed Income, Francis Scotland, Director of Global Macro Research at Brandywine Global, and John Bellows, Portfolio Manager and Research Analyst at Western Asset join Franklin Templeton Chief Market Strategist Stephen Dover for this conversation.

Transcript

Stephen Dover: Let's start with the outlook for global economic growth versus expectations.

John, Western has been quite consistent that the outlook for economic growth, at least in the US, in 2021 and beyond is not overheated. What are your thoughts and expectations for growth in 2021 and beyond?

John Bellows: You know, we're really quite constructive on the outlook here in the United States and really for the globe. We're in a period where we are returning to economic normalcy and that return to economic normalcy is a really powerful force that's going to drive above-trend growth rates. And, those above-trend growth rates are really quite, quite significant. They improve balance sheets, they improve incomes, they improve revenues. And so, as that return to economic normalcy supports above-trend growth, again, in the US and around the world, you know, a lot of really good things are happening to corporations, to businesses and to individuals. We're really quite constructive on the outlook for that reason.

Stephen Dover: Sonal, a year ago, you were quite early in your call that the US economy was strong enough to rebound within a few quarters. Given the strength and recovery in the US financial markets and how far we've already come, do you continue to feel that the US economy's growth trajectory is sustainable?

Sonal Desai: It depends on what we really mean by sustainable. The type of growth we're going to see this year is, dare I say it, Chinese in nature likely, right? We're going to look at high single digits in this year. And beyond this year, I don't see a rapid drop-off to those 2-2.5% levels. In particular, in light of the level of sustained stimulus that we're seeing in the US economy. And I think it's really interesting at this time last year, people were talking about Ls, the Great Depression, you know, the alphabet soup of what the recovery would look like. And I think that what we're really seeing is very, very V-shaped. So, yeah, I believe that we're going to see strong growth for a while yet.

Stephen Dover: Francis, mentioning China: China just reported that extraordinary growth of 18.3% for the first quarter. How is Brandywine Global looking at the US and global growth?

Francis Scotland: The US economy really hasn't had a big economic boom since the Reagan tax cuts in the early eighties and 2021 looks like it’s shaping to be another, especially if the vaccinations are successful and the variants spreading around the world, really don't result in meaningful setbacks.

In the United States in particular, the policy stimulus here is incredible. And, it looks like some of the measures that were designed for the public health emergency are going to be extended beyond the crisis. So, that's a big U-turn in the US, where we've gone from, you know, the Reagan Era, when governments were seen as the problem to the Biden Era, where governments are now the solution.

So, whatever your perspective is on this U-turn in American policy, our view is that the current stimulus really supercharges an economy that was already rebounding from last year's lockdowns. And, you know, the March US employment report: it may be a whiff of what could be in store. You know, the script continues to rhyme with a rebound that you get after a natural disaster, not the more drawn out, expanded traditional recession. And by and large, that rebound is playing out around the world, notwithstanding the timing and management of the vaccine rollouts. Global import volumes are completely recovered. PMIs are soaring. In Europe, the surprises are positive, even though they're having problems with the vaccinations. Asian industrial production surging. Here in my country, Canada, 90% of the employment draw down has been recovered. Australian employment is at an all-time new high. So, it really looks like the world economy is recovering very, very strongly.

Stephen Dover: John, how do you look at the continuance of growth on into 2022 in the next, say, three to five years?

John Bellows: I think that's the question, I think there's more or less of a consensus view that growth this year is going to be quite strong. And so, really, the question becomes, what does it look like going forward? As we think about next year and beyond, I'm less convinced that we are going to sustain these high growth rates. And, let me just give you a few considerations.

The first is this year, the really elevated growth rate is driven in large part by the reopening, especially in the service sector, where there's been constraints on how much services you can or want to consume. As those go away, and we start to re-consume services, or re-engage in service consumption, that drives very high growth rates. That reopening, though, is only going to happen once. We're not going to reopen the economy again next year. And so that's really kind of a very clear example of a one-time adjustment that is driving growth rates but will not be repeated.

I think the same thing could be true in fiscal, as well. So, if you think about what the Biden administration has done so far, the $1.85 trillion package, it's a big number and people have talked about that, but what's really striking about that is how fast it goes into the economy. Those checks go out almost immediately, both to businesses and individuals into state and local governments, and then they go right into the economy. And so, what's notable is not only was it a big number, but just how fast it impacted the economy.

In contrast, when you think forward, what's going to happen next, there will be some ongoing infrastructure and other proposals, but it's likely that those are going to be an order of magnitude smaller, in terms of impact. Those are spread out over 10 years. They're offset by taxes. Some of them are just continuations of what's already in place. So, those won't add further to GDP growth. And so, I think it's really important, when you think through the fiscal, kind of, impulse, yes, you're getting a big impulse this year, but what happens after that is likely to be an order of magnitude smaller.

So, as we think forward, I think there's kind of reasons to be suspicious that this elevated growth rate will be maintained. Re-openings only happened happen once. Fiscal policy was very front-loaded. And so, we're somewhat more cautious on what I'll call the secular outlook and at least we think there's questions about whether these high growth rates will be sustained.

Sonal Desai: I would note that when I talk about the outlook on growth, going further forward, in the US for example, I agree it's going to be marked down a lot, but that's from potentially 7.5- 8%. So, I would kind of hope that we'd get a significant markdown next year. It's just that I don't think we would immediately drop down to say 2%, 1.5% in a year from now, because I do think that continued drive is going to play a role.

Stephen Dover: Sonal, you're talking to us from Europe and maybe you can give some comments on the outlook in Europe and if you would like, also in Asia?

Sonal Desai: In the euro area, I think growth by European standards will probably do all right, but you're not going to see that massive impact that you've got in the US. But we've always got to remember, at its best, Europe has never been the driver of global growth. So its impact on the rest of the world, how fast it grows or how less fast it grows, is less important in some ways.

If I look at Asia, on the other hand, I think Asia is going to be extremely strong. So, I would be quite positive overall on Asian growth, more generally.

Stephen Dover: Francis, do you want to follow up with any thoughts on growth outside of the United States?

Francis Scotland: I think one of the really unique features of the macro landscape right now is the divergence between policy in China and policy in the United States. These are the two anchor economies in the global economy. And, the Chinese authorities never applied the degree of policy stimulus that we did over here in the United States with fiscal and monetary policy. The Chinese authorities were much more successful at containing the buyers through social isolation techniques as only China could comply with. So, they managed to get ahead of this without a lot of policy stimulus. And now, they're in the position where they're actually starting to take some of that stimulus out. It may sound very removed from the domestic Treasury scene, but if we look at what happened to the Chinese bond market, it's really instructive.

Going into the pandemic, 10-year Chinese yields were trading around 3%, they dropped to 2.5%, and as China got control of the virus and started to renormalize fairly quickly ahead of everyone else, really, the 10-year bounced right back to 3%. I think it was probably around September, October, and they’ve, more or less, hung around there ever since.

I wouldn't say they've tapped the brakes, but they're starting to take their foot off the gas pedal. They're starting to reign in leverage, or they're focused on reigning in leverage. And the domestic economy isn’t all that strong, to be honest, but it's really the export side of the equation that's really lifting a lot of the leading indicators in China. So, that may have something to say about the next move in Treasury yields.

Stephen Dover: You all agree that growth looks pretty spectacular, at least from historical perspectives. Everyone seems to agree that we're going to see higher inflation in the short-term. The disagreement is whether inflation is cyclical or whether it's long-term secular.

 John, you have pointed out that there are several headwinds to structural inflation coming back, and that there's already pretty substantial inflation priced into the market. So, there's limited upside for investing for even higher inflation. Can you walk us through your thinking around inflation?

John Bellows: We've seen a big move up in bond yields year to date. So, we went from 90 basis points on the 10-year Treasury to 1.75 at the high. And so, I think it's appropriate to step back and say, “well, what is the market now pricing in? What is the consensus?” And, a couple of things strike us about that.

The first is, the market is now pricing in CPI inflation above 2.5% as high as 2.75% recently, over the next five years. So not just three months of higher inflation, but sustained inflation at 2.7%, 2.6% for five years. That is meaningfully above the, where we've been over the last 10 years, and it's meaningfully above the Fed targets. And to some extent, the market's already priced quite a big acceleration in inflation.

I think the other thing that's notable is the market is now pricing in the first Fed hike in December of 2022. And that could happen, but in order for that to happen, you'd have to see a straight line move down in the unemployment rate, and you'd have to see those inflation outcomes be realized. So, I think both on inflation and on the Fed the market is now priced very optimistically in terms of above target inflation sustained for five years, and the Fed achieving a quite accelerated rate path. I think when you think about that pricing, it really strikes us that the risks are pretty asymmetric to the downside, in terms of inflation coming in somewhat lower than that, and the Fed hike being realized somewhat later than that.

So, first on inflation, we see the inflation this year. I think that's pretty straightforward. During this reopening, there's going to be a lot of demand. Some of that in supply constrained sectors. We all want to go out to eat after getting vaccinated, but we certainly didn't build more restaurants in the last year. So, that demand and supply constraint is going to push up prices. We see that. It's much less obvious, though, that that's going to lead to a sustained shift higher in inflation outcomes. I think, to the contrary, if you think about where we were pre-pandemic, pre-pandemic we had a low unemployment rate. We had growth that was okay. Fiscal policy was easy. They had just done a big tax cut, and yet, the headwinds from debt and from demographics, and very importantly, from technology, all put downward pressure on inflation, so we were actually having disappointing inflation outcomes.

I think it's possible that, as we go forward, the world starts to feel more like 2019 than it does like 2021, and that's certainly not priced in markets. And that's something that we need to consider.

And, just to finish the thought on rates pricing, if that were to come in slower on the inflation side, that has obviously implications for the Fed as well. So just to sum up, I think the market's priced for very optimistic outcomes on both inflation and the Fed. And, if the inflation surge that we see over the next three to six months is not permanent and instead proves transitory, I think we can see some adjustment on both those dimensions in the rates market.

Stephen Dover: I think we're going to have some different views here but let me first turn to Francis. You’ve made the comments that the economic boom will probably include an inflation scare. What's your current view on inflation here in the US and also abroad?

Francis Scotland: I share, I think, the consensus view, which is that there's going to be at least a transitory pickup in inflation, perhaps higher than people are expecting. It'll be a scare for all the reasons that we all know. The global supply chain was damaged by the pandemic and the lockdowns, and the problem is it gets worse before it gets better. As economic activity rebounds, policy stimulus is going to charge the rebound. Inventories are low. We know that we've got order backlogs. Commodity prices up, and as John pointed out, the breakeven inflation rates have risen higher now, in some respects, than any time since the GFC.

So, from the bond market's point of view, a lot of investors, I think, have embraced that view. The drawdown we've seen in long bonds to date is about as big as it's gotten any time in the last 30 years. And, Treasury yields have basically normalized now back to pre-pandemic levels, but nominal GDP is still about 7 or 8% below the trend path we were on just before the pandemic. And, US bonds look pretty attractive for foreign investors with the Fed policy going to keep hedging costs next to zero. So, it wouldn't be a surprise to see the market stabilize here for some time. And obviously, if there's a setback in the pandemic, the yields go lower.

But to this issue of the long-term inflation outlook, I think this really cuts to the heart of the credibility of the Fed’s new approach to achieving its inflation goal, and I'm going to assert that, I think, for the Fed to achieve its inflation goals on a longer-term basis, the dollar needs to go lower. So far, the dollar is only a few percentage points below where it was pre-pandemic, despite this multi-trillion-dollar expansion in the Fed's balance sheet. And that stability, relative to the amount of money that's been printed, suggests there's a big demand for dollar liquidity out there, which we associate with this spike in the savings rate and the big increase in the money supply figures. So, trillions of dollars of cash have been saved up by household and business. So, I think to answer this question about where the long-term inflation outlook is, one of the important elements is what happens to those savings. And one possibility is that people start to relax as the pandemic dies down, and they release some of those cash holdings, start to spend the money with the Fed on full throttle.

And under those conditions, I'd say there's a pretty good chance that the dollar weakens, and then the Fed would realize its inflation target. And it's notable, if you go an average core PCE over the last 12 years, since the GFC, it's been about 1.6%. The last time we hit 2.5% was just before the great financial crisis, three or four years before that, and the dollar was trading about 15% lower than it is currently. So, I think a lot of the inflation outlook really speaks to the credibility of the Fed’s new approach to achieving its mandate. They've been pretty clear they intend to be late. They want to shift from looking forward to looking backward. Powell has been arguing that the former process limited the ability to achieve 2%. The new way is going to avoid tightening ahead, and of course, the definition of full employment has been dramatically expanded. I don't think we can have great certainty right now on the long-term inflation outlook, but I think that the things to monitor are what happens to savings, the demand for dollar liquidity and I think the early read on that is going to be the dollar.

Stephen Dover: Sonal, you've been warning recently that the unprecedented amount of monetary and fiscal stimulus may result in actually more inflation than the market's pricing in, and more than the Fed seems to be concerned about. Why do you believe inflation will be more of a concern than it has been for a long time and perhaps more of a concern than either Francis or John think?

Sonal Desai: I'd say that one difference that I see is that at no point in the last 30 years has the federal government increased debt more than 30% of GDP in a two-year period, even before we start talking seriously about how much of that infrastructure bill comes through. Is it going to be $1.9 trillion? Is it going to be $2 trillion. That's a lot of fiscal stimulus.

Number two, of course, is the Fed itself. Its current round of easing is larger than QE1, two and three. And I think that this is definitely something which we need to consider. And the Fed has told us that they're not planning on pulling back.

Thirdly, we do have the vaccines. And, I would say that any one of these three factors would actually justify current market pricing of inflation. We've got all three, and since what we're seeing in terms of policy is different from anything we've seen in 30 years, it wouldn't surprise me if we saw an outcome on the inflation front which was also different from what we've seen in the last 30 years. I'm not talking about inflation in the high single digits, but to say that could we see five years of the Fed more than meeting its 2% target on average? I would say that's quite possible. It's very feasible. All of this, of course, happens at a time when we do see a V-shaped recovery more broad-based, which implies you do have commodity prices also well-supported. And the Fed, indeed, has said inflation is transient. What is transient? Is it two months, three months? Is it a few quarters? Is it a few years? I think that's where the question really comes in. I'm more inclined to think that transient might last a bit longer than we are currently anticipating.

Stephen Dover: Thank you, Sonal. Thank you to all three panelists. This has been really interesting.

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