COVID-19 is definitely still with us, but the economic impact is fading.

The pandemic continues to rage in some parts of the world, defying the comforts of high vaccination rates and confounding pronouncements that we may be nearing the exit. Europe is in the midst of its fourth COVID-19 wave, with the incidence skewed toward those countries and regions where effective vaccination is lightest; some lockdowns have been re-imposed.

The regional late summer surge in the U.S. has passed although the trough was higher than the previous wave and a new uptick has begun. Some countries in Asia-Pacific have begun to open up, although China retains a strict zero COVID policy. And a new omicron variant has been identified in South Africa, and it's spreading at a faster pace than delta.

While the spread of the virus has not been brought fully under control, its economic impact has clearly weakened. There are two elements to this story. First, for a given level of infections, measures restricting mobility have eased. This reflects governments having a higher degree of tolerance overall for COVID-19 infections, as well as being able to more precisely target and curtail certain types of activities.

As an example, skewing measures against unvaccinated parts of the population. Second, for a given level of mobility restrictions, the impact on consumption has declined (see chart 1). Households have redirected their spending power away from activities that are "locked down" (food and entertainment) and towards those where spending is still possible (durable goods). While the offset is not one-to-one, the reduction in consumption in mid-2021 was much lower and flatter than in 2020.

Chart 1

S&P Global Ratings believes the new omicron variant is a stark reminder that the COVID-19 pandemic is far from over. Although already declared a variant of concern by the World Health Organization, uncertainty still surrounds its transmissibility, severity, and the effectiveness of existing vaccines against it. Early evidence points toward faster transmissibility, which has led many countries to close their borders with Southern Africa or reimpose international travel restrictions. Over coming weeks, we expect additional evidence and testing will show the extent of the danger it poses to enable us to make a more informed assessment of the risks to credit. Meanwhile, we expect the markets to take a precautionary stance in markets and governments to put into place short-term containment measures. Nevertheless, we believe this shows that, once again, more coordinated, and decisive efforts are needed to vaccinate the world's population to prevent the emergence of new, more dangerous variants.

2021 Legacy: Robust Rebound And Record Growth

Macro performance has generally exceeded expectations in 2021. The pattern has been driven by a combination of fiscal support, vaccinations and economic "gravity." These provide a useful lens through which to view the rebound. The first two of these factors tend to favor the advanced economies while the third has a larger influence on emerging markets. As we will argue below, the robust recovery has led to concerns about inflation.

Europe has been the latest strong performer, posting 9% annualized GDP growth in the third quarter (July to September). This reflected a Grand Re-Opening on the back of a strong vaccination push, fueled by the release of pent-up demand and rising confidence. This was not unlike the U.S. outturn in the second quarter of the year when vaccinations and confidence rose, although regional surges in COVID-19 and supply bottlenecks pulled down U.S. growth to just 2.1% in the third quarter.

In contrast, Chinese growth has slowed appreciably over the course of the year as fiscal support has been modest, and high intolerance for the virus has curbed mobility and kept services spending weak. However, countries linked to China's investment and durable goods sector have seen steady export demand that has helped to boost growth. Overall, we continue to see a high degree of unevenness in activity across both countries and sectors.

Never Mind The Rebound, Here's Inflation

The macro focus of the recovery has shifted to inflation. The original thinking was that there would be a modest and temporary rise in inflation in early 2021 as economies re-opened; however, events turned out differently. Price pressures have persisted and broadened more than expected. And the debate is now whether inflation is transitory and will gradually ease, or whether it is persistent and requires an earlier-than-planned policy response.

Turning first to the majors, the U.S. personal consumption expenditure index, the Federal Reserve's preferred measure, rose at a three-decade high of 5.0% on a year-on-year basis in October 2021 (see chart 2). Meanwhile, the eurozone harmonized index of consumer prices, the ECB's preferred measure, is expected to hit 4.9% in November, an all-time high. While eurozone inflation is more narrow and driven mainly by energy prices, in both economies inflation momentum (the most recent three monthly readings, annualized) is rising again.

Chart 2

The inflation picture is more concerning outside of the majors, and central banks across emerging and advanced economies have begun to raise rates and remove monetary accommodation. In EMs, inflation (and expectations) has continued rising, most recently reflecting energy prices. The central banks of Brazil, Chile, Colombia, Mexico, Russia, Poland, and South Africa all hiked rates in their most recent meeting, with more hikes expected into 2022 (Turkey is the only major EM country that has lowered interest rates). These policy responses reflect in part a weak anchoring of medium-term inflation expectations. But central banks in the advanced countries have begun to tighten as well. Monetary authorities in Norway, Korea and New Zealand have hiked rates in recent meetings, with Australia, England, and Sweden tapering asset purchases.

Inflation pressures from oil and supply chains--which have been driving inflation dynamics in many countries--show initial signs of easing. This gives some weight to the transitory view. The price of WTI crude oil per barrel has come off its recent peak of $85 per barrel, roughly double the price of a year earlier. Our oil analysts note that the combination of increased U.S. shale production next year and the likelihood of some deal with Iran mean that prices are forecast to decline in 2022. While this will eliminate oil price inflation (since prices will no longer be rising), the high level of prices could still cause strains for oil consumers. On supply chains, the Baltic Exchange dry index has fallen by around one-half since early October, suggesting some easing of logistics costs; although our sector analysts do not foresee a clearing of production backlogs in high-demand sectors such as microchips until mid-2022.

Revised Forecasts

Our baseline GDP forecasts are little changed from the previous forecast round. We have nudged global GDP growth down to 5.7% this year and 4.2% in 2022 before declining closer to trend of around 3.5% in 2023-2024. Amongst the major economies in 2021, growth in Japan was taken down 40 basis points to 1.9% and Brazil was taken down 30 basis points to 0.8%, both reflecting weaker-than-expected third quarters and slowing prospects ahead. For 2022 Brazil, the U.K., the U.S. and China will all see lower growth (in that rank order), while forecasts are flat to higher in 2023-2024.

Table 1

As we have noted in previous reports, the levels of GDP matter in addition to the rate of growth given the size of the COVID shock. Comparing the latest level of output to the last quarter of 2019 (the last pre-pandemic quarter) remains a useful exercise, China regained its pre-pandemic GDP level last year and the U.S. was able to achieve this feat in the second quarter of 2021. Our current forecast for the eurozone has that block regaining its pre-pandemic output level in the final quarter of this year.

The story is very different for emerging markets. Many countries in this group remain well below end-2019 GDP levels and will suffer a "permanent" output loss. This means that EM economies will not get back to their pre-pandemic GDP path; they will be on a lower path. The main cause of this outcome was the lack of fiscal space and spending, which led to the loss of non-replaceable expenditures. India was hit particularly hard, where we see permanent output losses on the order of 10% of GDP.

Regional Economic Summaries

United States.   Economic activity has started to pick up pace again after a slowdown in the third quarter. The delta COVID-19 wave is behind us and there are signs that supply bottlenecks are starting to ease. Inflation remains a top risk, with the October consumer price index (CPI) and personal consumption expenditure (PCE) price measures running at 6.2% and 5.0% year on year, respectively, well above the Fed's average target (for the latter) of 2%. In addition, the labor market is struggling to match workers with jobs, leading to a shift in the Beveridge Curve (see chart). Even with the slowdown in growth, our 5.5% forecast for 2021 growth will be a 37-year high, before drifting toward potential over 2022-2024. With inflation still rising and looking less transitory, the Fed has been moving up its tightening schedule. We now expect faster tapering and a policy rate liftoff in the third quarter of2022.

Read our latest U.S. macro update here.

Chart 3

Europe.   Following a strong economic performance in the third quarter with annualized GDP growth of 9.3%, Europe is once again the center of the pandemic. The virus is surging more in countries where vaccination has increased least in recent months. The unknown is whether consumers will be more hesitant about social contact, and real-time indicators show few signs of self-imposed restrictions so far. While industrial production remains hampered by bottlenecks, consumer confidence in the eurozone is well above the historical average, fueled by a smooth labor market recovery and excess savings. Although growth should slow in the final quarter of the year, we see a pickup in 2022. Inflation has risen sharply in recent months, but this has been driven mainly by energy prices, which are levelling off. Longer-term inflation expectations remain well anchored, and the ECB should be on hold until early 2024 in terms of interest rate policy.

Read our latest eurozone and U.K. macro updates here and here.

Asia-Pacific.   The region continues to underperform relative to the U.S. and Europe as lockdowns crimp domestic demand and generate an overreliance on exports for growth. On the pandemic, some countries have begun to step away from the "zero-tolerance" approach that has held back growth (China is an exception), adding some needed momentum to activity. Of note, the region has largely escaped the inflation scare seen in other parts of the world, although central banks in Australia, Korea and New Zealand are withdrawing accommodation. In contrast to their global peers, emerging market central banks are generally on hold. Our macro forecasts over 2022-2024 remain broadly unchanged from the previous quarter with China now below 5% growth and India slowing to 6%-6.5%.

Read our latest Asia-Pacific macro update here.

Emerging markets.   New COVID-19 cases are high in Central and Eastern Europe, but low elsewhere. Third-quarter GDP outturns were mixed but generally weak as supply disruptions held back growth. Brazil and Mexico were particularly hard hit, and Russian output declined slightly while Poland outperformed. Inflation continues to surprise to the upside, in large part due to the recent surge in energy prices, and expectations continue to rise, in many cases surpassing central banks' targets. The market has priced in policy rate increases across a swathe of emerging markets next year. Turkey continues to defy market with policy rates cuts. Looking ahead, we have marked down GDP growth in Latin American over our 2022-2024 (especially for Brazil) while outturns in EM-EMEA and EM-APAC will be mixed.

Read our latest emerging markets macro updates here and here.

Macro Risks Shift Sharply Toward Near-Term Inflation

Our top and rising risk is a misreading of inflation dynamics by major central banks. In this scenario, inflation pressures turn out not to be transitory and central banks need to step in earlier and more forcefully than currently expected to remove monetary accommodation. This would likely result in a period of rising rates and spreads, de-risking and volatility, and slowing growth as markets reprice and adjust the cost of borrowing. Realizations of this risk are most likely in the next six to 12 months.

In contrast to inflation risks, we see the macro risks from any future COVID-19 outbreaks as declining. While we cannot make a call on the likelihood and severity of any future outbreaks, the data show that for a given rise in serious infections the impact on consumption would be measurably lower than earlier in the pandemic. In an extension of this risk, the trade-off between infections, mobility restrictions and economic costs has improved, which could lead policymakers to respond less heavily to any outbreaks. The recent emergence of the highly contagious omicron variant of COVID-19 could provide a next test.

The largest risk to our outlook over the next two to three years is the economic path of China. The combination of China's 2025 "Common Prosperity" goal and the ongoing crackdown on the property sector are aimed at transforming the model toward more domestically driven, more financially sustainable and more equitable growth. The exact policy objectives are unknown, but it seems clear this juncture that there is more tolerance for slower GDP, less tolerance for speculation and more emphasis on supporting the middle class. The role of the private sector--which has driven growth over the reform period--is unclear. A less vibrant (and productive) private sector will affect not only China but the rest of the world through slower growth and export demand.

Continued Progress, But Much Macro-Credit Work Remains

Even assuming that the end of the pandemic is nearing, there is much work to be done before we can declare a return to normal macro-credit conditions.

First, governments have taken on significant additional debt in the COVID era to provide a cushion to hard-hit sectors and, more recently, lay the foundation for longer-term and greener growth. While this was the correct policy response, we need to put economies onto a path of fiscal sustainability.

Second, central banks have much work to do to restore balance sheets to their post-COVID normal size, which has yet to be full articulated.

As we noted in our recent research, tapering is only the beginning of the end. Trillions of U.S. dollars (or equivalent) government assets and corresponding excess bank reserves are sitting on balance sheets, holding down yields, and distorting credit decisions. It will take years to unwind these, and guidance as to how this will be done has been minimal at best.

Third, the structure of economies has changed owing to COVID, not least the shift from services to durable goods and the reimagining of work. Identifying the transitory versus the structural and measuring it properly will take time.

Finally, awareness of sustainability has surged during the pandemic, including in the area of economics. The discipline will reposition thinking on growth to include natural capital and environmental sustainability, which will remain front and center for the foreseeable future.

Related Research

• Economic Outlook Emerging Markets Q1 2022: Recovery Isn't Yet Complete While COVID-19 And Inflation Risks Remain Front And Center, Nov. 30, 2021
• Economic Outlook EMEA Emerging Markets Q1 2022: High Inflation And COVID-19 Threaten To Slow Recovery, Nov. 30, 2021
• Eurozone Economic Outlook 2022: A Look Inside The Recovery, Nov. 30, 2021
• Economic Outlook U.K. Q1 2022: Onward And Upward, Nov. 30, 2021
• Economic Outlook U.S. Q1 2022: Cruising At A Lower Altitude, Nov. 29, 2021
• Economic Research: Asia-Pacific: Ghosts Of COVID Past Hover Over 2022, Nov. 29, 2021