Figure 1: Peak-to-trough GDP drops 2020

Source: Deutsche Bank, Macrobond

“What we saw across the world was economies building in resilience to restrictions that came in over last winter,” he continued. In the UK, for example, during lockdown in November 2020, GDP did not contract. And in Q1 2021 during the three-month lockdown, a further contraction of between 3% and 5% was anticipated by analysts – but output only dropped by 1.4%. Consumers and businesses had learned how to adapt to the restrictions which is why the steep GDP drop seen in Q2 2020 was indeed not repeated. The other contributor to the “huge jump in GDP” was involuntary/excess savings – in other words savings arising from restrictions that prevented individuals from spending their cash. As this built up – with the US hitting almost 8% of GDP during 2020 (see Figure 2), economists and central bankers were very optimistic, said Raja, about a significant recovery and assumed “unprecedented levels of demand and household expenditure flowing through various economies”.

“While we knew that the jump in GDP was never going to last, the pace of that slowdown was not quite what we were expecting.”
Sanjay Raja, UK Economist, Deutsche Bank Research

Figure 2: Household involuntary saving levels

Source: Deutsche Bank

However, the anticipated growth bonanza did not happen, said Raja, but “while we knew that the jump in GDP was never going to last, the pace of that slowdown was not quite what we were expecting.” The US Purchasing Manager’s Index (PMI) is an economic indicator built from monthly reports and surveys from private sector manufacturing firms based on five main data sets: new orders from customers, speed of supplier deliveries, inventories, order backlogs and employment levels. As can be seen in Figure 3, the PMI Index demonstrates how output expectations were rising earlier this year but just after the summer they started to dip – and faster than anyone expected.

Figure 3: PMIs dropped quickly over the summer of 2021

Source: Deutsche Bank, Macrobond

In the UK, restrictions were eased on 19 July (dubbed ‘Freedom Day’) and crowds flocked to Wembley Stadium for the Euro 2021 football matches. However, while the event should have contributed to stellar economic growth in July this did not materialise, and instead a slowdown was underway, recalled Raja. The excess savings were concentrated among high earners and the bottom decile had in the meantime got themselves into more debt.

During the pandemic, both manufacturers and retailers deleveraged and ran down inventories as “nobody knew what the post- pandemic world would look like”. Going into 2021 and with the talk of growth surging, everyone restocked at the same time. Supply chain disruptions increased massively. “It was difficult to get goods across China and Asia to come into the developed world,” said Raja. He added that the TS Average Global Container Price Index shows how shipping prices have risen 50% since the end of 2020 and the US Freightos Freight Pricing Index tracked US West Coast Freight costs rising than 3.5 times since the start of the year. Supply constraints have put pressure on producer prices (see Figure 4) “you can see price pressures building through the economy,” he added.

Figure 4: PPI output prices over three months, year-on-year

Source: Deutsche Bank, Macrobond

Figure 5: Participation rates below pre-pandemic levels

Source: Deutsche Bank US Economics, Haver Analytics LP

In the UK, the labour force has contracted by around 500,000. “One thing that shocked me was how slow people were coming back into the labour market, despite the introduction of vaccines and business sentiment improving materially,” Raja recalled. In the US, he explained, the Federal Reserve monitors the prime age labour force participation very closely along with the employment/population ratio (see Figure 5) and “you can see the gap we were at pre-pandemic to where we are at the moment in the US”. Unsurprisingly, the industries with the largest drops are those with high contact and the corresponding risk of contracting the virus – such as retail, leisure and hospitality and healthcare. In addition, female participation is pronounced in the US because of childcare problems and restrictions with schools and education. Over-55s who left the labour force during the pandemic returned in very small numbers (now representing less than 20% of the labour force against 41% before).

As a result of this contraction, businesses are struggling to find qualified applicants for their roles, which puts pressure on wages as the competition for talent intensifies. In the UK, added Raja, Brexit is also taking its toll with 200,000 EU nationals leaving the labour market at the height of the pandemic and only half of them since returning. “The UK not only has Covid to contend with but a second supply shock in the form of Brexit.” In other words, a smaller workforce usually means lower production levels. He pointed out that what we are seeing as we come out of the deepest recession since 1706–09 is that the lowest income earners are getting some of the largest pay rises.

Figure 6: Deutsche Bank US inflation forecasts

Source: Deutsche Bank

Central banks are cautious, said Raja, about the trade-off between economic growth and inflation, and the current light touch, based on the assumption we have transitory inflation, is far from reliable. The risks are again helpfully summarised by the Bank of England’s Haldane, “There is a tangible risk that inflation proves more difficult to tame, requiring monetary policymakers to act more assertively than is currently priced into financial markets. People are right to caution about the risks of central banks acting too conservatively by tightening policy prematurely. But, for me, the greater risk at present is of central bank complacency allowing the inflationary (big) cat out of the bag.”

“The boom is over and it’s all about supply constraints now,”
Sanjay Raja, UK Economist, Deutsche Bank Research

Is it possible that a 1970s-style period of stagflation – when rapid inflation and high unemployment resulted from the oil price shock – could return? Raja thought this was unlikely, nor could he imagine the central banks would stand by and let this happen. On 18 October, after the ITFA event, he wrote in his UK Economic Notes paper, “the continued burst in inflation should leave the [Bank of England Monetary Policy Committee] MPC in a more uncomfortable position heading into the November meeting. Worries around household and business inflation expectations becoming dislodged are likely to rise over the next two quarters, adding some pressure on the MPC to lift the Bank Rate from its historic low more immediately.”³

“The boom is over and it’s all about supply constraints now,” Raja said in conclusion of his ITFA presentation. In short, the labour market recovery “will be bumpy” and inflation looks set to be more “sticky”.

This article was first published by the ITFA on 27 October 2021 following the 47th Annual International Trade and Forfaiting Conference in Bristol, 6–8 October 2021