The Eurozone has already experienced a second contraction, more slowdowns are expected.
After 2020's severe economic contractions, the hope was that economies would quickly rebound and converge to long-run activity rates. With more contagious variants and supply-side bottlenecks, forecasters are downgrading growth prospects and renewing fears of double-dip recessions. In addition, rallying inflation - contested as transitory - is causing equity dips and stagflation talk as governments crowd out the private sector. Meanwhile, previous structural problems have worsened throughout.
Virus versus vaccines
Often the virus is used as a scapegoat to explain market corrections. Taking a medium-term position, investors realise in waves that the virus spread is faster than expected, explaining the consolidation in riskier equities and currencies. Psychology is often tied to a news piece, a story not necessarily serious but enough to tip sentiment and cause a selloff. Obviously, there is a transmission mechanism between the virus spreading and economic growth even with increased vaccinations; more are isolating with the virus or due to a close contact causing labour shortages, fewer hours worked and lower output. This view is prevalent in markets more days than others. So, using the virus as reasoning is valid, especially considering the market's sensitivity to worsening virus spread as seen in the 30% decline in major US indices in March 2020; there is also a considerable amount of unknown information about virus mutations and no widespread use of genomic sequencing.
The battle between virus and vaccines has two interpretations: the race to administer vaccines versus the upward trajectory of cases and the ability of vaccines to combat new variants. The former refers to the threat of unvaccinated populations experiencing a rise in cases, hospitalisations and deaths thereby lockdowns will need to curtail the spread. In countries such as Australia and other Asia-Pacific nations experiencing an uptick in cases with low vaccination rates, the current strategy of early lockdowns minimises the economic contraction over the medium term. Vaccinated populations with relaxed restrictions are likely to experience high cases but fewer deaths relative to unvaccinated populations. The second definition refers to the increased probability that stronger genetic variants that overcome vaccines will stem from unvaccinated individuals. Observing the UK's virus restriction relaxation, given 90% of adults are vaccinated new variants are less likely to develop.
Note the daily confirmed cases is highly dependent on testing capacity, it's the sign of the first derivative of the case curves and positivity rates that instead hold meaning. Distinctions are made by continent where outbreaks are initially bound before spreading globally. As already established, in developed economies the virus is generally tackled through fast lockdowns or vaccinations - new variants from now are unlikely to develop in these locations.
However, the bigger danger is from populated regions, mainly underdeveloped Africa and Asia, with lower vaccination rates, poor testing infrastructure and weak quarantine laws. Vaccines are a merit good and distribution is vital in these areas, potentially even more than in developed economies due to the variant risk harming the global recovery. Although, the vaccine hierarchy will prioritise richer countries acting in self-interest, creating a social dilemma. The threat is somewhat subdued by weak global travel demand, a luxury, in undeveloped markets. If new variants do emerge from these areas, the quickest way to stunt transmission is to quickly deploy stringent international quarantine laws; this poses a heavier concern to the UK and rich economies that use flawed, lagged metrics to decide restrictions.
Rising cases in Asia will cause slowdowns and potentially contractions in emerging markets. Conversely, from a macroeconomic standpoint waves of COVID cases are disconnected, stable exports will support trade balances but it will take time to return to pre-COVID levels worldwide. In conclusion, unless there is an unprecedented new vaccine-busting variant or the duration of immunity is under expectations, another global recession is far from likely.
Current states
In 2020, government deficits spiralled and debt-to-GDP ratios soared whilst supporting incomes and providing business tax relief. Government purchases in their trillions will crowd out the private sector. The root causes of crowding out are a savings shortage causing the upward pressure on real interest rates, making fewer investments profitable and also a hampering of the income effect. The first is not currently an issue given central banks are using quantitative easing to hold rates at artificially low levels so the savings and loanable funds markets have stayed relatively stable since the crisis began. Secondly, the spending type is mainly infrastructure which is often outsourced to private firms through competitive tendering. It is important that governments pursue contractionary fiscal policy in the recovery regardless of political motivations.
The Eurozone dipped into a second recession in 2021 Q1, the systemic social issues, poor vaccine trust and secondary virus waves were unable to instigate an immediate recovery. Services demand is expected to overwhelmingly drive the economy upon lockdown easings but accumulated savings from last year's reduced leisure consumption are unlikely to be driven down instantly as a consumption smoothing byproduct. Property price appreciation will contribute to wealth effects and consumer confidence, the ECB also cite positive Tobin Q effects leading to increasing housing investment. Although, supply-side shortages and price increases reduce real purchasing power, slowing output relative to quickening demand; IFO business climate figures peaked in May. Additionally, Eurozone countries struggle with high-tech innovation, losing market share to competition in Asia and the US. For example, the Eurozone are frantically finding ways to construct a 'global EU' through masses of regulation to compete with China's $2.5tn Belt and Road initiative, a series of ports, rail and roads connecting Europe with Asia. Nevertheless, only imports from outside the zone will cause a slowdown when measuring GDP, leaving the diversified economy to rebound an expected 4.6% in 2021, followed by 4.7% in 2022.
Close geographically to the Eurozone, the UK is expected to have a stronger 7.25% rebound, the BoE projects. However, since these forecasts the recovery stalled in May skewed by a 16.5% drop in transport manufacturing, 16% of exports, due to the global microchip shortage. On the upside, Brexit has meant the UK are no longer bound by EU laws; the UK has been dropping regulation around the finance industry. Since October 2020, Sunak has outlined reducing insurance capital allowances, rewriting MiFID II, de-regulating off-exchange trading and dropping limits on commodity holdings boosting FDI to maintain the UK's firm services trade surplus and LSE's competitiveness to attract firms looking to go public. Although, if the Brexit deal is breached a third-party on state support grounds mediator will intervene - this is unlikely to occur upon removing cumbersome EU red tape.
China trades off geopolitics and the economy. The nation is growing rapidly and could overtake the US by 2031, it supports emerging markets acting as a major commodity purchaser and demand is further bolstered by the growing middle-class. As well as developing economies, China provides cheap labour and lower prices to producers and consumers in advanced countries with minimum wages and multinationals racing to the bottom. Economic activity regulation, most recently forcing the shutdown of 90% of Bitcoin mines and banning profitable private tutoring to promote equality and lessen criminal activity and money laundering. On the other hand, reducing the reserve ratio requirement in mid-July 2021 increased the scope for loans upon June's muted month-on-month growth figures, potentially causing bubbles and overheating the economy. In addition, high commodity prices have been partially offset by the government unleashing aluminium, copper and zinc stock to boost domestic production. China's inconsistent regulatory response, beggar-thy-neighbour policies and leveraging Taiwan and North Korea and creating geopolitical tensions with the West over cybersecurity, Hong Kong and Uyghur treatment will not maximise growth prospects, and will eventually harm trade worth 18% of GDP. Despite tensions and remaining tariffs from the Trump administration, US-China trade volumes are at record highs, both nations benefit by maintaining stable relations. It would take a lot of bad decisions by China to plunge the economy into a double-dip recession.
Conflicting US leading metrics month-to-month and across microeconomies are casting doubt on short-run growth forecasts but if interest rates remain lower for longer aggregate demand is likely to see a larger medium-run spike. Consumer confidence, manufacturing PMIs, durable goods orders are all firm but new housing permits and starts and industrial production figures are dragging. Record numbers of job openings have been recorded in the US labour market, but the matching process is slow and unpredictable with non-farm payroll figures ranging from 269K to 850K in the last 3 months. Companies have begun raising wages and offering perks such as free food to hires.
Inflation is here but not to stay
Inflation by definition reduces real GDP growth figures and in the long run productive efficiency and per capita incomes. Those in support of the transitory inflation narrative argue base year effects, virus-related bottlenecks and demand booms are distorting the inflation figures, those who believe otherwise assert the underlying inflation trend in core goods is growing. Central banks of developed economies all take the transitory argument but are most likely to underestimate the level of inflation with their forecasts as they have done for years. However, the transitory argument is more logical, inflation expectations are unlikely to adjust permanently when the memo is inflation is transitory. The 5-year breakeven rate dropped to 2.3% from a 2.7% peak. Therefore, inflation will only impede real economic growth minorly for a short period of time.
Overall, the huge global contraction seen when COVID-19 initially hit will not replicate itself due to severe imperfect information about the virus originally and supply chains are now more adaptive to lockdown strains. However, filling economic slack and pairing employers with employees alongside the previous structural issues such as productivity will bring about slowdowns. Furthermore, the inequality between developed and undeveloped nations will be exacerbated by slow vaccine rollouts. Inflation by definition will exacerbate these issues and will have additional ramifications for consumers, especially those on low incomes, if not transitory or met with wage growth.
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