Three Big Questions about the Post-Pandemic Economic Outlook

Recently, I was fortunate to spend 10 days in the interior of British Columbia, far from civilization and in the company of the mountains, grizzly bears and mountain goats.

The experience allowed me to unburden my mind from the ever-increasing number of distractions and demands that we all experience in daily life. This time enabled me to reflect on the complexities shaping today's markets, allowing me to focus on three pressing questions that shape our global economic outlook. The first question is: how we should think about the post-pandemic recovery. Understanding how we got here is important to understanding where the road might lead us in the future. The second question is why some developed economies like Europe are lagging behind the U.S. and last but not least, what are the risks to our global economic outlook?

How Should We Think about the Post-Pandemic Economy?

This is a big question and one that will be the subject of countless PhD theses to come. On the demand side, outsized government fiscal support (government spending) during the pandemic and in its immediate aftermath played a key role in sustaining consumer spending. This fiscal expansion manifested itself in several ways, including the “excess savings'' that were accumulated by households, and which have helped support spending over the past three years. With that said, while the pandemic served as a timely reminder of the power of fiscal policy in sustaining demand, it's possible to have too much of a good thing. The fiscal situation in most advanced economies is now unbalanced as budget deficits are too large and interest rates are too high. Advanced economies would be best served by rebalancing in favour of tighter fiscal policy and looser monetary policy (lower interest rates).

These observations are widely accepted among economists who have models that are oriented around analyzing shifts in demand. And, while there are clearly political challenges to overcome, most would agree that a recalibration between fiscal and monetary policy would be beneficial, not least in putting public finances on a more sustainable footing over the long run.

Yet the key to analyzing the post-pandemic economy lies in understanding developments on the supply side. In simple terms, the pandemic caused two things to happen: The first was that the dislocation caused by rolling lockdowns in advanced economies caused the supply of goods and services to decrease. At the same time, monetary and fiscal expansion - the lowering of interest rates and the increase in government spending to stimulate the economy during the pandemic - caused the demand for goods and services to increase. This moved economies to a new equilibrium where small changes in demand created large moves in prices rather than supply. This helps to explain the rise in inflation during 2021-22.

However, as the dislocation caused by the pandemic has faded, the supply of goods and services has normalized. In the U.S. and in Canada, this has been helped by a surge in immigration, which has increased the supply of labour. This has shifted the Canadian and U.S. economies to a new equilibrium, where the supply of labour is higher, and inflation is lower.

This is, of course, a simplified model of the economy, but it does help us to think through the various shocks and shifts that economies have experienced over the past five years. It also leads us to an important conclusion: the potential for a supply-side recovery raises the possibility that inflation can be conquered without crushing demand and tipping economies into recession. This supply-side recovery is crucial as it opens a path to the coveted “soft landing'', where inflation can be controlled without pushing the economy into a recession.

Supply-side recovery could lead to lower inflation without a recession, offering the potential for a soft landing.

Why Has Europe's Recovery Lagged the U.S.?

Despite global recovery momentum, Europe has struggled to match the U.S.'s pace of growth. The underperformance of Europe relative to the U.S. is clear in the data. Whereas the U.S. economy is now nearly 10% larger than it was pre-pandemic, euro-zone GDP is only 3.9% larger. This discrepancy raises important questions. One explanation we often hear is that the prevalence of long-term fixed-rate mortgages has shielded U.S. households from the effects of higher interest rates to a greater extent than in Europe. However, this narrative doesn't square with the data. Debt servicing costs for households have risen further in the U.S. than they have in the eurozone.

Instead, the underperformance of Europe is more likely due to a combination of different factors. For a start, fiscal support in Europe was generally smaller than was the case in the U.S. At the same time, while the U.S. saving rate has now fallen back to pre-pandemic levels, in Europe it has risen. In addition, the energy shock that followed Russia's invasion of Ukraine led to a huge deterioration in Europe's terms of trade that manifested itself in a hit to real household incomes. Since the U.S. is now a net energy exporter and does not import natural gas from Russia, it was not subject to the same shock. Crucially, the energy shock accelerated structural decline in sectors like German manufacturing, which had already been facing long-term challenges due to competition and an aging workforce.

Some of these pressures will ease over time. The surge in the household savings rate in Europe remains puzzling and may not be sustained. But structural headwinds will persist, particularly those facing German industry. Accordingly, we expect that the euro-zone economy will continue to experience extremely low rates of growth, and our expectations remain below that of the consensus. Moreover, the structural nature of this weakness will limit the ability of the European Central Bank to reinvigorate growth by cutting interest rates. Nonetheless, we continue to expect a relatively gradual pace of policy easing in Europe, with euro-zone interest rates lowered by 25bps each quarter to around 2.5% by the end of next year.

The European economy will continue to experience extremely low rates of growth, and our expectations remain below that of the consensus.

What are the Key Risks to the Outlook?

Risk #1: U.S. Hard Landing - Potential Recession if Consumer Spending Weakens

The biggest threat is a hard landing or recession in the U.S. However, while there are some signs of stress among lower-income households, our view remains that a soft landing is still the most likely scenario. Likewise, the U.S. election presents an obvious risk to the outlook, especially around trade, immigration, and fiscal policies, which could have significant negative implications for economic growth and inflation.

Risk #2: China Structural Issues - Faltering Growth, but no Global Systemic Collapse

One cannot ignore the concerns about China in the global economic outlook. However, while China's economy is clearly struggling, its problems are mainly structural in nature. China's recent pivot towards fiscal and monetary stimulus should support growth in the near term. But the economy continues to be propped up by investment, still elevated levels of construction, and the willingness of trading partners to allow China's producers to expand their market share. While unsustainable in the long run, we do not foresee a collapse that would severely impact the global economy.

Risk #3: Election Uncertainties - Impact of U.S. and Canadian Elections on Trade and Policy

On the home front, with the inflation battle all but won, weak GDP growth will force the Bank of Canada into more aggressive action, with a couple of 50bp interest rate cuts possible to end this year. We expect the Bank to adopt a more measured pace of loosening in 2025 until the policy rate reaches 2.25%. Looser monetary policy should support a recovery in GDP growth to 2.0% in 2025 and 3.0% in 2026, although elections in the U.S. this year and likely next year in Canada, as well as uncertainty about immigration policy, are risks to the outlook. These forthcoming elections present considerable uncertainty for businesses, particularly regarding international trade policy and domestic environmental regulations. It is still unclear whether potential U.S. policies to impose a universal import tariff would include Canada and Mexico, while the scheduled renegotiation of the terms of the United States of America, Mexico, and Canada Free Trade Agreement (USMCA) in 2026 is another potential flashpoint. With goods exports to the U.S. worth 20% of GDP, either tariffs or a breakup of the USMCA could be hugely disruptive.

Looking back over the past two decades there have been two types of shocks that have caused major economic disruption. The first has been non-economic in nature. The Covid-19 pandemic created huge dislocations on the supply side of the global economy, collapsing output and leading to a subsequent surge in inflation, while Russia's invasion of Ukraine caused a sharp rise in energy prices, particularly in Europe. These types of shock are by nature almost impossible to anticipate in advance. The Middle East is a constant source of risk but is only likely to cause significant consequences for the global economy if it leads to direct disruption to global oil supplies. Likewise, the risk of a confrontation between China and Taiwan continues to linger in the background but, while potentially catastrophic, could take many forms. Understanding the nature of these risks is more important than anticipating them in the first place.

On the macro-financial front, commercial real estate markets seem to be stabilizing. We were always sceptical that they had the potential to cause systemic problems for the global financial system. It is a reasonable assumption that there are risks lurking in pockets of private credit markets and shadow banks, but these are difficult to assess. We continue to anticipate the bubble in artificial intelligence (AI) and related stocks will inflate further, but when it pops the underlying technology won't disappear.

Risk #4: Ballooning Budget Deficits - Bond Markets Could React Sharply

Perhaps the biggest risk lies in shaky public finances across advanced economies. Budget deficits have ballooned, and public debt burdens are high and rising. The ultra-low-interest rate environment that helped to sustain fiscal positions in the pre-pandemic era has ended. The key lesson from the Truss debacle in the U.K. - a sell-off in the U.K. government bond markets triggered by the loose fiscal spending - highlights what's at stake: the tone and approach of policymakers are critically important. In addition to the forthcoming election in the U.S., national elections are due next year in Germany. Meanwhile, France's new government may struggle to pass a budget that delivers the fiscal tightening needed to put its public debt on a sustainable path.

If any of this gives rise to a sense of governments' lack of discipline on deficits - or, in the case of Germany's election, produces a result that threatens the integrity of the eurozone - then the situation in global bond markets could react sharply if governments' fiscal discipline falters. Sometimes the biggest risks are hiding in plain sight.

Key Takeaways

While the global economic landscape presents challenges, it also holds potential opportunities. The post-pandemic recovery is underway, with supply-side improvements fostering optimism for a soft landing, particularly in North America. However, Europe's structural headwinds and political risks, along with uncertainties surrounding U.S. and Canadian elections, pose risks of volatility that long-term investors should carefully consider without losing sight of growth opportunities. Key to navigating the road ahead will be the careful balancing of fiscal and monetary policies, as well as remaining vigilant to potential shocks—whether from geopolitical tensions, public debt concerns, or unexpected market disruptions. Agility and focus on long-term fundamentals will be crucial for navigating these uncertainties and seizing growth opportunities. Our portfolio management team remains vigilant, dedicated to safeguarding your investments and capitalizing emerging opportunities.

Our current positioning reflects the foregoing views and the balance of risks and opportunities. We believe that market participants continue to underestimate the degree and pace of rate cuts by the Bank of Canada and hence we remain overweight core Canadian fixed income. In addition, the artificial intelligence bubble we believe has additional room to run and the U.S. markets will continue to benefit from this positive market sentiment, as such, we are overweight large cap U.S. equities. We are underweight Canadian equities and neutral on international equities. The former as we believe that slowing global economic growth and investor sentiment will cause Canadian equities to lag and the latter because we believe that there is a significant dislocation in the pricing between U.S. and non-U.S. companies.

Sincerely,
A black and white drawing of a signature on a white background.
Corrado Tiralongo
Vice President, Asset Allocation & Chief Investment Officer
Canada Life Investment Management

PS:

Effective October 1, 2024, Counsel Portfolio Services Inc. amalgamated with, and continued under the name Canada Life Investment Management Ltd., serving as the manager, trustee, portfolio manager and promoter of the Counsel and IPC funds.''

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