Economic research firm Capital Economics released a note on Monday, in which it has identified three major questions shaping the global economic outlook: the post-COVID economy, Europe’s economic underperformance, and the key risks ahead.
1) ‘How Should We Think About the Post-COVID Economy?:’ According to the note, fiscal support played a significant role in sustaining consumer demand during the pandemic, with excess savings boosting spending in the years that followed. However, the policy mix in many advanced economies is currently unbalanced.
“Budget deficits are too large and interest rates are too high,” the note highlights. A rebalancing towards tighter fiscal policy and looser monetary policy is considered necessary to restore stability.
On the supply side, the pandemic caused significant dislocations, shifting the aggregate supply curve inward.
At the same time, monetary and fiscal expansion shifted the demand curve outward, leading to the inflation seen in 2021-22.
As these dislocations have faded, economies like the US have benefited from increased immigration, which boosted labor supply. That shift has allowed for higher output with lower inflation, raising the possibility of a soft landing, where inflation can be controlled without tipping economies into recession.
2) ‘Why Has Europe Lagged the US?:’
In the report, Capital Economics points out a clear underperformance of Europe compared to the US.
Since the pre-COVID period, the US economy has grown by nearly 10%, while the eurozone has expanded by only 3.9%.
One common explanation is the prevalence of fixed-rate mortgages in the US, which have shielded households from rising interest rates more effectively than in Europe. However, Capital Economics argues that the data doesn’t fully support this, pointing instead to smaller fiscal support and the energy shock following Russia’s invasion of Ukraine as the key reasons for Europe’s struggles.
In addition, the structural weaknesses in key industries, particularly in Germany, are expected to persist.
“Accordingly, we expect that the euro-zone economy will continue to experience extremely low rates of growth and our GDP forecasts remain below that of the consensus,” the note writes.
The European Central Bank is anticipated to gradually ease rates, but this may not be enough to significantly stimulate growth in the region.
3) ‘What Are the Key Risks to the Outlook?:’
Capital Economics identifies several risks that could disrupt the global economic outlook. The biggest concern is a potential hard landing or recession in the US, though the firm still believes a soft landing is the most likely scenario.
Political risks also loom large, with the US election posing uncertainty. Measures floated by Donald Trump during his campaign could “reduce US GDP and raise inflation,” although the note suggests that these proposals may be diluted in practice.
China’s economic struggles also present a potential risk, but Capital Economics emphasizes that these problems are structural, and a sudden collapse in China’s economy is not anticipated. Moreover, the threat of geopolitical shocks, such as a conflict between China and Taiwan or disruptions in the Middle East, cannot be ignored.
Finally, rising public debt in advanced economies is viewed as a significant long-term risk.
“Budget deficits have ballooned, and public debt burdens are high and rising,” the note warns, particularly in light of upcoming elections in the US and Germany. Any perception of fiscal drift could cause turmoil in global bond markets.
“Sometimes the biggest risks are hiding in plain sight,” the report concludes.
