Could economies and markets return to 2019 levels?
A commentary by Tiffany Wilding, Pimco Economist who analyzes recent macro signals and the possibility of a return to pre-pandemic conditions and 2019 levels for economies and markets.
In the more than two years since March 2022, when the Federal Reserve began raising rates in an attempt to tame U.S. inflation, the 10-year Treasury yield has fluctuated, sometimes sharply, but generally remained steady. a wide range between 3.5% and 5%.
The sharp swings in the 10-year yield have coincided with both renewed concerns about inflation (particularly earlier this year) and financial stability (banking sector turmoil in March 2023). However, while stabilizing between these episodes, the 10-year Treasury yielded 3.87% on the last trading day of 2022, 3.87% on the last trading day of 2023, and most recently, an average of 3.87% in August 2024, despite the wave of volatility in global markets, including violent swings in Japanese currency and stock markets.
As of this writing, the 10-year yield is slightly below its August average, but the question to ask is: are the recent swings just one more fluctuation within a U.S. government bond market largely range-bound?
POSSIBLE RETURN TO PRE-PANDEMIC CONDITIONS IN DEVELOPED MARKETS?
Market developments and unpredictable shocks are prone to confound any forecast. That said, the economies of industrialized countries are more similar to those of 2019 than they have been at any time since the pandemic. In this context, we believe the most pertinent question is: Why are interest rates still well above those of 2019?
In five critical ways, economic conditions in developed markets today more closely resemble those of 2019. Consider these macro developments:
Inflation: After peaking between 8% and 10%, overall inflation levels in developed markets have returned to 2-something points. As of July 2024, overall inflation in industrialized countries (weighted by GDP) was 2.8%. This is still a little more than a percentage point above the average headline inflation of 1.5% achieved between 2016 and 2019, but within reach of central banks' targets. Core services inflation accounts for most of the difference, but the cooling of labor markets should favor a normalization of these more “sticky” inflation categories.
Labor markets: The post-pandemic years characterized by labor market imbalances and severe labor shortages are probably behind us. In the US, UK and Canada, the ratio of vacancies to unemployed workers (a measure of the balance between labor supply and demand) is now at or below 2019 levels. And with unemployment rates overall rising, labor markets are likely to be at risk of overshooting.
Real wealth: Government subsidies during the pandemic have led to an increase in real wealth accumulated by both households and businesses in many developed markets. This supported growth across countries to varying degrees, especially in the United States, where larger aggregate fiscal stimulus took longer to normalize. However, high inflation and low nominal savings rates have largely normalized these balance sheets. Based on developed market fund flow balances, liquid assets and household net worth as a share of GDP are now at or below pre-pandemic trends in all developed markets, including the United States, which previously they particularly stood out. Evidence that US real wealth has normalized can also be seen in the delinquency data: according to a recent study by the San Francisco Fed, the normalization of these balances in the US has coincided with an increase in delinquencies in various groups of income.
Supply chain: The pandemic has put global supply chains to the test. Data on manufacturers' lead times, shipping costs, warehouse capacity and logistics congestion have increased dramatically. While shipping costs on some routes have recently risen again, as global logistics operators look to stockpile inventories amid rising trade uncertainty, the broader range of these measures have returned to pre-pandemic levels, according to the New York Fed's Global Supply Chain Pressure Index.
Inflation Expectations: Over the period 2015-2019, long-term inflation expectations appeared to slip below central bank targets (typically 2%) after a decade of below-target inflation. The pandemic and subsequent inflationary shocks appear to have brought long-term expectations back to levels more consistent with central banks' objectives. However, in general, inflation expectations have remained very anchored during this period. The Survey of Professional Forecasters now predicts inflation of 2% over the next five years in Europe, similar to expert views in the United States. Similarly, market-implied inflation expectations (measured by the 5-year break-even inflation rate five years ahead, i.e. the difference in yields between nominal and inflation-linked Treasuries) indicated long-term inflation expectations term of 2%-2.5% from January 2021.
CRUCIAL EXCEPTIONS
Despite all these macroeconomic similarities to 2019, there are notable exceptions. We can limit them to three:
Public Budgets: Without more pronounced fiscal austerity, a persistent long-term consequence of the pandemic would be increased public debt loads. The outlook for US debt appears particularly challenging, with the potential for the term premium to rise over time.
China: Downside risks to the Chinese economy have increased. The dramatic post-pandemic contraction of China's real estate sector leaves the country increasingly dependent on an export-led growth strategy. Given growing trade tensions – not only with Western countries, but now also with many emerging countries – the sustainability of this strategy is in question. Without further direct consumer support from the government, which officials appear reluctant to provide, it is difficult to see how China can maintain a 5% growth target in 2025 and beyond.
Central bank monetary policy rates: Although they have started to decline in some countries, central bank rates in general remain not only well above 2019 levels, but also above the optimal levels indicated by simple policy rules monetary. The implication of “being late” to cutting relative to economic conditions is that there may now be wiggle room to cut rates more quickly under a range of economic scenarios.
DO ECONOMIES SIMILAR TO 2019 REQUIRE RATES SIMILAR TO 2019?
Returning to the original question, with industrialized country economies more similar to those of 2019, why shouldn't 10-year yields also set new lower ranges? Perhaps the 10-year Treasury yield won't fall to 2019 levels, for a variety of reasons: Long-term inflation expectations now appear more anchored to central bank targets than below them; a lasting legacy of the pandemic will be rising public debt loads; and US elections are a factor of potential interference.
However, China's post-pandemic real estate crisis and potential constraints on its export-led growth strategy mean that China poses a greater risk to global growth than before. Furthermore, if you compare the current assessment of the expected 5-year and 5-year real interest rate of 1.7% to our estimate of the neutral real interest rate range of 0%-1% , it emerges that there is room for a normalization of rates in a range of economic scenarios.
This is a machine translation from Italian language of a post published on Start Magazine at the URL https://www.startmag.it/economia/le-economie-e-i-mercati-potrebbero-tornare-ai-livelli-del-2019/ on Sun, 15 Sep 2024 03:35:50 +0000.