18 November 2020

2021 Economic Outlook: Policy Takes the Reins

  • The “Three Ps” – pandemic, politics, and policy – will continue to drive the outlook for economies and markets in 2021, with policy taking the lead.
  • We noted a shift toward policy-driven market regimes in our outlook last year, and the Covid pandemic has reinforced this trend, with massive monetary and fiscal stimulus the key to bridging the gap to recovery.
  • Politics – particularly elections, which can rapidly shift policy goals – pose the greatest risk in a policy-driven market environment. The pivotal US presidential election, Brexit, and upcoming contests in Germany and France are developments to watch.
  • After contracting steeply earlier in 2020, global growth expectations may be starting to turn. The IMF dropped its forecast for the world economy from 2.9% in January 2020 to -3% in March and -4.9% in June, but has since revised its forecast to -4.4% – still a steep decline, but a sign that expectations are improving.
  • We are in a new business cycle where growth is reacting to mechanical closings and reopenings of the economy, making traditional forecasts largely backward-looking and less meaningful. Our preferred growth measure looks at the rate of change in GDP between fourth-quarter 2020 and the same period in 2019, the last “Covid-clean” quarter.
2021 Economic Outlook: Policy Takes the Reins

Many people are looking toward 2021 with a fair degree of relief, after a year that brought us not only one of the most severe health crises in a century but also one of steepest recessions in history. The coronavirus pandemic has already taken more than 2 million lives globally, and the crisis is still not behind us. In response to the first Covid-19 wave in the spring of 2020, governments around the world, with few exceptions, relied on broad-based shutdowns of economic activity to slow the infection’s spread. Oxford University's Stringency Index, which allows us to quantify and compare policies such as school and workplace closings or stay-at-home orders, tracked the dramatic rise in containment measures in March and April. The result was a record-breaking decline in GDP growth across the world. Developed world GDP growth contracted at an annualized rate of 33% in the second quarter.

The good news is, global growth expectations may be starting to turn. Back in January 2020, the International Monetary Fund (IMF) still forecasted a fairly decent 2.9% growth rate for the world economy. By March, when the pandemic’s impact had snapped into focus, the fund downgraded its forecast to -3%, followed by another downgrade to -4.9% in June. However, since then, the policy-induced rebound across most economies around the world has largely surprised to the upside, and the latest IMF projections (from October 2020) upgraded the forecast to -4.4% – still a steep decline from 2019, but the turn in expectations signals that we’re on the road to recovery.

Stringent Covid Containment Measures Pushed Developed World Economies Into Recession

Stringent Covid Containment Measures Pushed Developed World Economies Into Recession

Source: Macrobond, Oxford University, Markit, and PineBridge Investments calculations as of 16 November 2020.

Policy takes the lead, reinforcing our framework for macro and markets

If the pandemic was unprecedented, so was the global policy response. Monetary policymakers deserve high marks for their swift and decisive actions. They clearly heeded the lessons from the global financial crisis and immediately embraced the role of “buyer of last resort.” We think this was a rational decision to prevent increased financial market instability from exacerbating an already severe health and economic crisis. Since the start of 2020, central banks have poured over $7 trillion into the financial system through large-scale asset purchases, which represent about 15% of developed world GDP.

Governments were also quick to enact fiscal policy. The US Congress passed a record $2.2 trillion stimulus package that quickly returned household spending back to pre-Covid levels. Meanwhile, the European Union not only suspended its strict deficit rules, but also created an EU-administered stimulus fund for the first time, cracking open the door to a more unified fiscal policy. Looking at the IMF's structural budget deficit forecasts for 2020, which exclude the impact of automatic stabilizers, the emergency fiscal stimulus was worth at least 7.5% of developed world GDP. This amounts to a combined policy stimulus of about 22.5% of developed world GDP, highlighting the critical role of economic policy support in avoiding an even deeper and more destructive recession.

Surging Monetary and Fiscal Stimulus Expands Budget Deficits

Surging Monetary and Fiscal Stimulus Expands Budget Deficits

Source: Macrobond, IMF, and PineBridge Investments calculations as of 16 November 2020.

Despite the dramatic impact of the global pandemic, our broader framework to evaluate the interaction between macro trends and markets remains very much intact, and is perhaps even stronger. In our outlook for 2020, we argued that markets were increasingly driven by policy over macro fundamentals. The actions of central banks have had a greater impact on the trajectory of equity and bond markets in the past few years than economic growth or inflation. In the past, we envisaged an environment characterized by frequent regime-switching between macro- and policy-driven markets. The pandemic seems to have pushed us more permanently into a policy-driven market regime.

That's why we now spend more time tracking the willingness and ability of central banks and fiscal authorities to maintain and increase monetary and fiscal policy support for the recovery, which will still be needed in 2021. The greatest risk in a policy-driven market environment is still a sudden change in policy priorities. And what is the most likely source of such a change? Elections. That's why economists will need to double as political analysts and assess the risks associated with major elections, like the one we just went through in the US, and even more so, contests coming up in Europe over the next few years.

A closer look at the ‘Three Ps’ driving our outlook

Pandemic: Despite positive vaccine news, it’s going nowhere fast. The biggest near-term determinant of economic activity is still the global pandemic. Despite encouraging news that we’re getting closer to a vaccine, Covid-19 will not fade away quickly. Most experts believe it will take until the end of 2021 to immunize a large-enough share of the population to truly return to normal. That means many activities, mostly services-oriented, will remain subdued next year, holding back a faster and more complete economic recovery.

That said, the existence of a vaccine is likely to sharply reduce the probability of renewed closings of the economy – and those are what caused a severe health crisis to spill over into an equally severe economic crisis last spring. Thus far, the US experience with a second and now a third infection wave, which largely occurred without significant re-closings, has showed that the economy can continue to recover despite a re-acceleration in infections and hospitalizations.

While the first Covid-19 wave eventually hit the entire world, creating recessionary conditions virtually everywhere, the autumn resurgence in infections and hospitalizations is mostly a North American and European problem. The pandemic is under good control in Asia, and most emerging market countries have seen falling infection rates in the second half of the year, which should mitigate the adverse impact on the global economy. 

Policy: Even more dominant, and lasting, in the post-Covid era. Central banks and fiscal authorities stepped in quickly to support markets and the economy, but none of that comes without a cost. Government debt ratios will be substantially higher when the stimulus dust settles; in most developed world economies, they will exceed 100% of GDP. In the past, such debt ratios could have prohibited a country from raising more debt in the bond markets or caused a sharp increase in interest rates, which in turn would depress economic activity. That’s what led to the 2012 European sovereign debt crisis. In today’s world of large-scale and widespread central bank quantitative easing (QE), access to debt financing is not the problem anymore.

The growing involvement of central banks in government bond markets – the Bank of Japan owns close to 50% of outstanding government bonds, while the Federal Reserve owns just under 30% – increases the pressure to maintain lower interest rates for ever longer. Allowing bond yields to rise would not only increase the cost to governments of carrying the substantially increased debt burden; it would also raise the risk that private sector borrowers would have to cut investment or payrolls, all of which would create the very headwinds accommodative monetary policy is designed to fight. The more central banks act to maintain low interest rates to stimulate the economy, the greater the cost – and the lower the chances – of retreating from the market and allowing interest rates and bond yields to be determined by supply and demand. That’s why policy-driven market regimes will become even more dominant in the post-Covid era.

Politics: The most likely source of sudden changes in monetary or fiscal policy priorities. The US presidential elections were the biggest political uncertainty event of 2020, but the full extent of potential policy changes will only become clearer in 2021. In the very near term, the pandemic will continue to dominate government actions around the world. More important for the economic outlook is the question of whether fiscal policymakers have learned lessons from the previous business cycle and don’t repeat the mistake of removing fiscal policy support too early. That's what held back the last recovery in the US and helped create Europe’s debt crisis. The likely sources of political uncertainty will shift to Europe next year. 

Brexit is finally – yes, really – happening in 2021. Of course, no comprehensive new EU/UK trade deal has been agreed upon due to the inextricable “Northern Ireland problem.” The UK would have to stay in the customs union to avoid a hard border between the province and the Republic of Ireland, but that would betray what brought Prime Minister Johnson to power – and it wouldn’t make much sense to leave the UK as a mere rule-taker without the ability to shape EU policy. The alternative is to leave the EU altogether and be responsible for a change in the relationship between the two Irelands, which may accelerate demands for Irish reunification. Again: inextricable. That’s why a no (substantial)-deal Brexit is likely to weigh on UK and EU economic performance at least into the early part of 2021, until trade flows have adjusted.  

Elections in Germany and France may shift policy goals. General elections in Germany in September are likely to bring new leadership to power, and with that a change in tone and possibly policy priorities. These elections are followed in the spring of 2022 by presidential elections in France. So, within the next 18 months, not only will we see a new administration in the US, we may also have new, and potentially untested, governments in Germany and France – the two most influential EU member states. This is where we see the greatest potential risks to the current policy-driven market consensus.

Transition from recovery to a regular business cycle

We are still in the part of a new business cycle where economic growth is reacting to the mechanical closing and reopening (and in some cases re-closing) of the economy. That’s why traditional growth forecasts for 2020 or 2021 don’t tell us much about the underlying economic potential. They are backward-looking and depend almost solely on the stringency of pandemic containment measures and size of policy stimulus. 

What matters more is how much damage individual countries are carrying into 2021, which will help us determine how much more of the recession gap a country has to close. Our preferred growth measure therefore looks at the rate of change in GDP between the fourth quarter of 2020 and the same period in 2019, the last “Covid-clean” quarter. Our year-over year forecast for the GDP-weighted developed world average growth rate in fourth-quarter 2020 is for a 3.8% contraction, with countries including the US (-2.4%), Japan (-3.2%), and South Korea (-2.1%) expected to outperform the peer group average. In fact, Taiwan is the only economy in this group expected to recoup its recession losses before the end of the year. As a result, these countries are likely to experience slower economic growth in 2021 as they converge more quickly to a more normal GDP growth trend.

Meanwhile, countries with larger recession gaps, such as Canada (-6.6%), Singapore (-6.8%), and the UK (-9.2%), will remain in the mechanical phase of the cycle for a more extended period and will likely experience stronger growth rates next year. However, critically, that will not be an indication that they are speeding away from their peers, but rather a sign of how far behind those economies are in the process of returning back to normal, fundamentally-driven growth rates. 

In the meantime, expect policy to remain the key driver of economies and markets heading into 2021.  

For more PineBridge views on what to expect across economies and asset classes in 2021, visit our 2021 Outlook page.

Banner Curve

Related Insights

View More Insights