The Q3 global economic outlook: a strong rebound gets stronger, but all eyes are on inflation and central banks

15 July 2021

Ross WalkerChief UK Economist

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Michelle GirardManaging Director, Co-Head Global Economics, Head of Strategic Coordination & Business Operations, US

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Kevin CumminsChief US Economist

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Giovanni ZanniChief Euro area Economist

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Peiqian LiuChina Economist. Ranked Top 10 China forecasters by Bloomberg.

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Sam BoughtonDirector, Corporate Syndicate, NatWest Markets

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A stronger-than-expected global economic rebound is afoot as jabs find their way into arms and reopenings continue unabated. But rising inflation – and how central banks go about tackling it – could lead to volatility and presents real risks for corporate & institutional decision-makers. In this deep dive, our specialists outline four key themes driving the global economic outlook and risk landscape in Q3.

Four themes shaping the outlook in Q3:

  • The global economy is growing faster than anticipated: we expect vaccines and reopenings to win out against the Delta variant.
  • Inflation is rising quickly – but we think price pressures are mostly transitory: the only possible exception here is the US, where inflation is rising fast and looks set to broaden.
  • Central banks are staying patient, for now: but we think the US and UK will tighten monetary policy sooner than previously forecast.
  • Credit markets remain well-supported but key risk events later in Q3 could cause volatility: investment demand outstrips bond supply heading into summer, but central bank meetings pose key risks for yields.

Key takeaways:

  • Jabs and economic reopenings are driving a stronger recovery than even we expected, and we now think the economy will grow 7.0% in 2021 (up from 6.6% previously forecast).
  • Europe is poised to lead a growth spurt among advanced economies in Q3, driven by reopenings, vaccinations, large accumulated savings, and supportive economic policies.
  • The Delta variant remains a risk, but a noticeable decoupling of infection numbers and the number of severe cases should ensure it doesn’t derail the recovery.

The rollout of vaccines and reopening of global economies in the first half of this year led to strong growth that exceed even our relatively optimistic expectations, so we are revising up our global growth forecasts for 2021 to 7.0% (from 6.6%) and 2022 to 6.0% (from 5.9%. Having now shed most lockdown restrictions and further supported by expanding vaccinations and accommodative monetary and fiscal policies, advanced economies are leading the economic recovery.

Global gross domestic product (GDP) will rise to new heights (% year on year)

Sources: Bloomberg, International Monetary Fund (IMF), World Bank, Organisation for Economic Co-operation and Development (OECD), NatWest Markets. BBG is Bloomberg’s weighted average consensus of surveyed economists.

In the spring of 2021, relatively rapid vaccine distribution allowed the US and UK to take the lead on economic growth. Heading into the second half, however, Europe seems poised to outperform both, with economic activity accelerating in the wake of lockdown exits. In China, however, the industrial rebound is cooling, as consumption patterns in reopened economies have shifted from goods to services, reducing demand for Chinese imports. On the flip side, this should help ease supply chain- related bottlenecks which just a few months ago appeared to threaten the pace of the recovery in advanced economies.

The Euro Area leads the global economic growth spurt in Q3, driven by reopenings, vaccinations, large accumulated savings, and supportive economic policies

Sources: NatWest Markets. 2021 Q1 – 20212Q4 = forecast. *Our global growth aggregate includes 18 countries together accounting for 82% of global growth. Countries included are the UK, US, Euro Area, China, Japan, Australia, Brazil, Canada, India, Mexico, Norway, Poland, Russia, Singapore, South Africa, South Korea, Sweden, and Turkey.

The Delta variant is spreading quickly as we head into Q3. But evidence suggests that vaccination weakens the link between infection rates and the number of serious cases, reducing the risk that the recovery is derailed. And looking ahead to 2022, we expect global growth to cool but remain elevated versus historical norms, as policy support in developed economies is unlikely to be withdrawn quickly.

Cut to the gist – check out the section at the end of this article for key calls in each region.

Key takeaways:

  • Strong economic growth is leading to a sharp rise in prices as consumers gain more confidence in the outlook.
  • Inflation is rising most acutely in the US across goods and services affected by the pandemic, but we expect that to broaden to other pockets of the economy.
  • In the UK and Europe, we think inflationary pressure are less likely to persist.

Stronger-than-expected global growth may be a boon business and investment, but it has also fuelled concerns that long-dormant inflation pressures have now been ignited. Headline consumer price inflation (CPI) reached 3.5% in May, the fastest rise since 2008, and core CPI in developed markets reached 2.2%, the highest reading in more twenty years. What’s driving the sharp rise? A more certain economic outlook coupled with relaxed restrictions means consumers are more confident about the future and willing to spend pent-up savings, binging on goods like autos and clothing and also taking long-deferred holidays – pushing up airfares and hotel rates.

Take a closer look at how rising inflation could affect corporates in Q3.

Developed markets core CPI inflation will remain elevated, driven by pandemic-affected segments

 

Sources: NatWest Markets

The sharpest price rises have been in the US, where a combination of massive fiscal stimulus, a tight labour market, and increased mobility due to vaccine distribution has been driving up demand. Looking ahead, we think US inflation will broaden in 2022 across a wider range of goods and services – and crucially, beyond those directly affected by the pandemic – including residential rents (which are heavily weighted in regulators’ broader measure of inflation). In the UK and Euro Area, the post-lockdown inflation rise is much less likely to persist.

With global growth remaining robust this year, we don’t expect inflation to suddenly recede, but we do think the recent pickup in price pressures is mostly transitory. Headline inflation in developed markets should start to abate, moving from 3.7% at the end of this year to 2.0% by the end of 2022 as the boost from higher energy prices fades. However, while the magnitude of monthly inflation increases may not be sustained, we do expect annual developed market core CPI inflation to hold above 2% for the rest of 2021, close to a two-decade high, raising the stakes for global central banks.

Key takeaways:

  • The G3 central banks all tend to see inflation as mostly transitory, with the exception of the US.
  • Still, with prices rising quickly, we see risks tilted towards rates being lifted earlier than expected, particularly in the UK and US.

The G3 central banks – the US Federal Reserve, the European Central Bank (ECB) and the Bank of England (BOE) – all tend to view current inflation pressures as mostly transitory.

The majority view within the BOE’s monetary policy committee is that more time is needed to assess how the economy will fare once key pillars of the government’s pandemic support measures are removed. Until then, BOE policymakers appear unfazed by the prospect of inflation inching above target in the months ahead, and if anything, are more concerned about the downside risks of prematurely tightening monetary policy. Bank staff forecast CPI inflation will breach 3% in the coming months – but it has tolerated larger and more persistent overshoots in the wake of the Global Finance Crisis of 2007-08 and the 2016 Brexit referendum. Still, H1 2021 inflation data has been firmer than expected, so we’re pulling forward slightly our forecast for the first BOE rate hike to February 2023 (from mid-2023).

The Euro Area is staging a spritely recovery but there appears to be little prospect of any persistent overshoot in inflation, easing pressure to tighten monetary policy anytime soon. Recent inflation prints appear inflated by one-offs like higher energy prices and the removal of VAT cuts. And the ECB’s recently adopted symmetrical inflation target is clearly more dovish than its previous ceiling-based approach of keeping inflation close to, but below, 2%. As such, it’s still too early to talk about the ECB tapering quantitative easing (QE). We expect it to change tack on the pandemic emergency purchase programme (PEPP) and asset purchase programme (APP) either late in 2021 or early 2022, slowing its asset purchases from around €100 billion (€80 billion of PEPP, €20 billion of APP) per month to around €60-80 billion per month under the APP from spring 2022. Further tapering of QE until late 2024 should pave the way for the first interest rate rise in 2025.

 In the US, the combination of massive stimulus, a tight labour market, and better consumer mobility increases the risk of slightly higher, broader, and stickier inflation – and earlier-than-expected rate hikes. The Fed’s shift to a flexible average inflation targeting (FAIT) regime, which sees it aim to keep inflation averaging 2% over time, combined with a broader and more inclusive employment mandate gives it room to tolerate higher inflation for longer. But a change in tone at the Fed – in June, seven members signalled support for rate hikes in 2022, up from four in March – and an upward revision for year-end 2023 to its “dot plot”, which is used to signal its outlook for the path of interest rates, suggests risks are skewed towards an earlier-than-expected rate hike. We now expect the Fed to start raising interest rates in September 2023 (instead of March 2024), but not before tapering its asset purchase programme. Specific details of the game plan for tapering QE will likely be considered in July and September, and we expect a formal annoucement later this year.

Key takeaways:

  • Rates are forecast to rise but bond markets (and issuers) should remain supported as demand outstrips supply.
  • Key risk events and central bank rhetoric around inflation could cause market volatility.
  • We expect to see green, sustainability and sustainability-linked (GSS) bonds outperform their conventional peers.

We think credit demand will continue to outstrip supply in Q3, a supportive environment for corporate and financial institution bond issuers. Western European investment-grade (IG) funds generated around $8.5 billion (net equivalent) across Euros and Sterling, which combined with a summer slowdown should ensure new bonds issued in both jurisdictions gets a warm reception and see tighter spreads.

Government bond yields (%) are expected to rise across G3

Sources: NatWest Markets. UST are US Treasuries, UKT are UK Gilts, and DBR are German Bunds.

There are a number of risks and key events to navigate in Q3 including a busy macro calendar that could cause volatility to rise, negatively affect credit performance, and narrow issuance windows for corporates. Despite important nuances around monetary policy tightening tactics and timing, we expect a broadly hawkish shift in central bank rhetoric around inflation and economic growth as the recovery progresses – leading to higher bond yields in the UK, Europe, and the US.

Key risks for Q3: inflation data and central bank meetings could make markets tricky to navigate

Sources: NatWest Markets. FOMC is the Federal Open Market Committee.

Nevertheless, we see this uncertainty for credit spreads offset by supportive technical factors including lower-than-expected corporate bond supply as we head into summer. In Euros, we expect total supply for 2021 of around €320 billion, with €146bn of supply in H2. In Sterling, we have revised down our supply forecast for the year to £28 billion, with a modest pickup in supply in H2. As supply picks up after the summer lull and the potential for macro volatility rises, credit spreads may start to widen. All-in funding prices for issuers are likely to be more attractive pre-summer than post. But with central bank QE support remaining robust throughout Q3, and purchases only gradually slowed across the G3 thereafter, we see no major cause for concern.

A stronger economy may risk higher inflation and rising interest rates – but it isn’t all negative for credit. Corporates that are less sensitive to broad shifts in market movements or sentiment – known as low-beta issuers – could benefit from a more gradual rise in interest rates, and lower-rated issuers could also benefit from deepening optimism around the economic recovery. We also see M&A and capex-driven bond issuance to rise in the months ahead, driven by increasing confidence in the outlook.

Finally, we expect to see green, sustainability and sustainability-linked (GSS) bonds outperform their conventional peers. In the corporate space, GSS issuance comprised 31% of total Euro issuance and 53% of total Sterling issuance in the first half of the year, eclipsing full year 2020 volumes in both currencies: €49 billion in H1 2021 vs. €42 billion for all of 2020, and £6 billion in H1 2021 vs. £4 billion in all of 2020. The asset class also grew at a remarkable pace among financial institutions, with Euro-denominated senior and Tier 2 bank issuance up 186% and 216%, respectively.

The UK:

  • Growth: we see GDP rising faster than previously forecast (7.1% growth in 2021, from 5.2%) but should start to moderate in the second half. The UK labour market has been more buoyant than expected but a key test awaits in Q3 2021 with the scale-back of the furlough scheme.
  • Inflation: rising faster than expected (CPI at 3.5% from 2.9% at end-2021) but we still anticipate inflation will fall back to target relatively quickly (end-2022). The breadth of price pressures will matter more than the peak, and ‘noisy’ data should weigh against any overly pre-emptive tightening.
  • Monetary policy: we bring forward our forecast for the first hike in Bank Rate (+15 basis points to 0.25%) to Q1 2023 from mid-2023 and we no longer look for a further QE uplift.

The Euro Area:

  • Growth: we expect a convincing and lasting recovery in 2021 (5.0% GDP growth), 2022 (5.8% GDP growth) and beyond, with business sentiment surveys  reaching all-time highs on the back of re-openings, increasing vaccinations, large accumulated savings, and supportive economic policies
  • Inflation: will accelerate later this year to peak at 1.9% in 2021 but will slow in early 2022 due to base effects, and we think underlying (core) inflation is likely to rise more than consensus expects.
  • Monetary policy: the ECB is in wait-and-see mode until its strategic review in September, when we expect it to turn yet more dovish. In the meantime, the Bank seems ready to tolerate higher inflation.

The US:

  • Growth: with timely support from monetary and fiscal policy and the rapid deployment of vaccines, the economy is booming. We now expect slightly lower GDP growth in 2021 (7.6% vs. 7.7% in our Q2 outlook) and slightly higher growth in 2022 (6.2% vs. 6.1% in Q2).
  • Inflation: prices have been climbing quickly in recent months and we expect inflation to peak at 3.6% in 2021. While we think most rises are transitory, inflation should broaden across non-pandemic affected goods and services in 2022, before settling back down to 2.4% in 2022 (twice the rate seen in 2020).
  • Monetary policy: we are pulling forward our forecast for tightening monetary policy. We now expect the first rate hike in September 2023 (instead of March 2024), and we think the Fed will announce a formal plan on tapering QE later this year.

China:

  • Growth: we see GDP growth moderating in Q3 to 5.7% from 7.7% in Q2 as base effects fade, but we expect a more balanced economic recovery as consumption rebounds and investment growth stabilises.
  • Inflation: producer price inflation has surged due to rising raw material costs but we think it is approaching its cyclical peak and expect supply shortages to ease. CPI inflation should remain soft and below the government’s 3% target.
  • Monetary policy: we do not expect policy rate hikes until at least end-2022, nor do we think the People’s Bank of China (PBOC) will implement currency appreciation measures. Policymakers will fine-tune fiscal and monetary policy to ensure stable growth, though we see upside risks on inflation and downside risks on industrial production if supply shortages persist.

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