A crash of rhinos

The capital sins of forecasting are flip-flopping (rapidly switching from one view to another, back and forth) and salami-slicing (frequently making incremental, insignificant changes). Dealing with uncertainty is a key part of forecasting. There are two types of risks. Black swans, such as Covid-19, are unknown unknowns, high-impact but very rare events that investors often underappreciate. The pandemic remains a key downside risk, especially for Europe. Grey rhinos are known unknowns, more clearly defined events investors can see from afar, but with uncertain timing. The upcoming surge in global demand led by the US is one such risk, to the upside, as we believe the consensus may underestimate its strength. If this turns out to be right, it may mean that cyclical assets as well as beneficiaries of economic reopening and steeper yield curves could benefit further. Bond market volatility may increase, though, and inflation is likely to remain a key market debate.

Black swans | Unknown unknowns: To us, the most important risk remains the pandemic – including further mutations. New Covid-19 cases have risen in several European countries. The more infectious B.1.1.7 variant has become the dominant virus strain in continental Europe. Although EU countries have now resumed AstraZeneca vaccinations after a brief pause on safety concerns, the rollout continues to lag. This may put renewed upward pressure on hospitalisations in the region. Of course, there are many unknown unknowns other than pandemics: extreme events that may have large consequences, from natural disasters to wars; technological breakthroughs are black swans too. It’s very hard to prepare for these outliers, as no one really knows what they might be. However, scenario analysis is helpful to think through the potential ramifications.

Grey rhinos | Known unknowns: From geopolitics to climate change, some of the known unknowns out there are more immediate while others look distant. Economies preparing for these risks stand a better chance to cope as and when they come. But, in the near term, a risk – a crash of grey rhinos running at us – is economic activity overshooting to the upside and returning global growth back to its pre-pandemic trajectory soon. The timing looked uncertain when the pandemic started. It’s now approaching. The key driver is the US consumer, which is likely to unleash significant ‘excess’ savings, courtesy of large-scale fiscal stimulus and reopening as the vaccine rollout picks up. While Asia should benefit too, Europe is lagging behind, given logistical challenges on the vaccine front, rising infections, lockdown extensions and a lesser fiscal impulse.

Here’s why this matters:

Sharper and shorter bounceback: This early-cycle recovery should continue to be a positive for risk-taking, though it’s also likely to be different from previous ones: rather than gradually gathering pace, we think it could be more like a very strong bounce initially followed by a period of normalisation and moderate rates of growth. We do think that cyclical assets remain well supported at this juncture, with the reopening, reflation and rotation trade still having further to go. Beneficiaries of steeper yield curves should continue to do well too – as we see the upcoming inflation spike as temporary and don’t expect central banks to hike rates for quite a while. But bond market volatility may increase, especially at the height of the growth and inflation rebound we expect next quarter, potentially testing the Fed’s resolve to stay dovish – at least in the eyes of the markets.

Both upside and downside risks: The pandemic remains a key risk in Europe, where vaccine delays and more protracted restrictions to mobility point to downside risks. But we see upside risks to US, UK and China growth. We think bond yields are rising mainly because of a cyclical upswing, which is a positive. But a more pronounced or persistent inflation overshoot than we forecast could lead to further market repricing, flatten the yield curve as rate hikes become a possibility sooner rather than later and turn into a negative for risk assets. The overall US fiscal stance is likely to stay expansionary, but higher taxes – should they come – would be a direct hit to corporate profits. Easy year-on-year comparisons, while still providing some helpful optics to first-quarter earnings, should peak soon – so the rate of improvement in many indicators is likely to slow.

Meanwhile, watch the labour market…

Happy Easter (from a safe distance): Given diverging US (better) versus Europe (worse) virus, vaccine and lockdown developments, tracking the numbers in all these areas remains important. The US jobs report for March should reveal a further gain in payroll and the unemployment rate edging down to about 6% – still higher than the ‘natural’ rate of perhaps 4.5% below which inflationary pressures may begin to intensify. The extent of job creation in the leisure and hospitality sector, following the recent improvements in high-frequency mobility data, may give us some clues on the strength of the upcoming growth pickup. In the euro area, energy base effects should push headline inflation higher, but core inflation is likely to stay quite low and very far from the European Central Bank’s inflation target.

Daniele Antonucci | Chief Economist & Macro Strategist