Late last week, Deutsche Bank’s head of FX research George Saravelos attended a “virtual macro dinner” with a mix of real money, hedge fund and public sector institutions. Here is a summary of the main observations he made during the event
Mind the gap. Many would argue that there is a linear continuity in the global economic reopening throughout the year. We don’t agree. It is better to look at 2021 in two discrete phases. The first half has been marked by truly unprecedented procyclical government intervention: an immense fiscal stimulus led by the US, a lifting of restrictions on activity, and a massive vaccine roll-out program. This unprecedented mix generated the “gangbusters” recovery narrative of H1. But the second half of the year will be completely different: fiscal support is being withdrawn across the globe; the initial burst of activity in a return to “normal” is complete; and the G3 vaccine roll-out has run its course. The next few months will be all about the hand-off in growth drivers to the private sector. It is this period that is crucial to understanding what the “new normal” will look like; we should be very cautious in projecting the H1 macro story to H2, and it is precisely this caution that the market has been pricing in recent weeks.
What have we learned so far? As this handover has started to take place, we have learnt a few important things, which have leaned negative.
First, bottlenecks and price increases have caused greater demand destruction than one would have assumed. This can be seen in the sharp slowing in US housing and global auto demand, for example; or in consumer surveys, which show intention to buy goods because of rising prices as collapsing, rather than accelerating like the 1970s. Put differently, the impact of price increases has been more stagflationary rather than inflationary.
Second, we are seeing tentative signs that consumer spending is not as boomy as one would have thought. We first noticed the pattern in Israel a few months ago. But you are also now seeing it in the UK where credit card spending in June is below what it was in May, and in the US where consumer spending forecasts for late Q2 are being brought down.
Third, we have learned that vaccines are not a panacea. The new delta variant mechanically brings herd immunity out of reach due to much higher transmissibility. But crucially we are seeing that vaccination rates tend to stall at around 60% of the population, with the stalling in the US the most noticeable.
Fourth, we have learnt that the China cycle is very different from that in 2008-10, with the risks already shifting to monetary easing and much less structural support for the commodity supercycle compared to the previous global recovery.
All of these are important developments that took the steam out of the reflation trade in Q2.
The trillion dollar question. The reflation debate is not about fiscal policy. It is about how much of the excess savings generated from fiscal policy will be spent, ie the private sector’s marginal propensity to consume [something we discussed last week in “America Goes On A Buyer’s Strike: Explosive Inflation Leads To Record Collapse In Home, Car Purchase Plans“]. While there are reasons for optimism, there are reasons for caution too. First, empirical evidence shows that pandemics historically lead to very large increases in the precautionary savings motive, equivalent to r* declines of 150-200bps. The question therefore is not whether the fiscal stimulus we have seen is big, but whether it is large enough to offset such huge declines in real neutral rates.
The temporary nature of the stimulus augurs for caution. Beyond the impact of the US mid-terms on American fiscal policy, it is notable for example that the UK fiscal debate is already shifting to significantly more tightening. Second, recoveries from services recessions have historically tended to be more mediocre. There are a limit to how many restaurant meals someone can catch up on. This is a two-speed economy with a booming/overheated goods sector and a yet-to-heal services sector, and it is the latter we should be focused on. Third, aside from the cyclical drivers, we cannot overlook the huge structural change that COVID has created. The digitalization of goods distribution and the workplace would have normally taken decades to materialize. Time will tell what the impact will be, but experience of the last decade has shown that technology has historically been disinflationary. Finally, the global economy cannot be ignored because inflation and real neutral rates have been globally co-determined over the last decade. EM output gaps are projected to stay large for the foreseeable future; the fiscal overshoot in the rest of the world is much smaller than in the US. The market has flip-flopped between “gangbusters” pricing in Q1 to a more pessimistic view on r* driven by all of the above. Whatever the new steady state, watch the consumer in H2. It all boils down to how much he or she is willing to spend in the new post-COVID steady state.
The dollar outlook. We were wrong about our weaker dollar call over the summer. But we have gained confidence in the validity of our framework: what matters most for the USD is not long-end yields but Fed lift-off and front-end rates; this is why we changed view right after the June FOMC meeting. By reducing its commitment to the “transitory” inflation narrative, the Fed weakened implicit calendar-based guidance and has allowed the market to price in greater rate hikes in coming years. If market pricing is correct and the Fed lifts off in 2022, we will revert to a pre-COVID world of exceptionally flat curves and a strong USD. In a low r* world even small changes to rates attract large (unhedged) inflows similar to the 2015-19 period: EUR/USD could drop all the way back down to 1.10. Ultimately though, it boils down to what regime we are in: if, in contrast, the back end of the curve is correct in its growth and inflation pessimism, it is unlikely that Fed hikes get realized and we revert to a weaker dollar. We agree with our house view of delayed/slow lift-off, so our bias is for a weaker dollar to eventually return.