NN Investment Partners

The outlook for the second half of 2021 depends heavily on the question of how the Federal Reserve and markets deal with the high inflation prints in the US. Our three “New Future” scenarios provide the most likely outcome in our base case and explore two alternative outcomes.

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Our base case, which we call the “Cruise Control” scenario, presupposes that the strong recovery of the developed economies remains intact. We assume it will take a few months before we see signs that inflation is in transition, and that the Fed is moving towards tapering. This should create an environment in which equities have some moderate upside left and rates should then rise gradually. And while this overall trend might be gradual, markets may be volatile along the way due to the strong macroeconomic dynamics and the nervousness always attached to monetary tightening.

In our “Full Throttle” scenario, we describe an alternative future in which the global economy overheats. Inflation lasts well into next year and forces the Fed to tighten prematurely. The third scenario, “Idling Engine”, takes us into a different market environment, in which the current strong stimulus is followed by a push back from fiscal hawks. In this case, consumers decide to hoard their saving and new virus mutations could lead to an increasing number of smaller setbacks.

Our three “New Future” scenarios provide the most likely outcome in our base case and explore two alternative outcomes. In this update, we publish projections for the rates and returns consistent with each scenario (see Table 1).

Inflation spike is transitory in our base case

This update concentrates on three questions: Are the high inflation prints in the US transitory or persistent? Which path will the Fed take in the coming quarters? And how will markets process this information? The updated scenarios include different answers to these questions. 

We believe that US inflation will peak towards the end of this year. Various inflationary pressure appear transitory: many supply chain disruption should unwind in the coming months, OPEC is likely to agree to increase supply, pent-up demand is a finite boost and the expiration of the US relief package will force workers back to the job market.

For inflation to be persistent, general wages will need to rise sharply once the temporary forces have passed. This would imply that workers need to gain substantial bargaining power. Even though it is a realistic risk factor for inflation in the coming years, we do not expect it to unfold over the coming quarters.

 A fundamental assumption embedded across the scenarios is that central banks have the tools to tackle high inflation, even at high costs, but are struggling to generate inflation. This is another reason why it is hard to imagine inflation remaining high beyond 2022, let alone a stagflation scenario.

 In a world of transitory inflation, we would expect the Fed to continue on the path of talking about tapering for now and to defer the rate hikes to 2023. In this environment, there is moderate upside potential for rates in the US and, to a lesser extent, in Europe. However, we cannot rule out market nervousness as high inflation prints continue in the coming months.

“Full Throttle” scenario probes the possibility of sticky inflation

But what if US inflation remains high? Given the uncertainty due to reopening, strong stimulus, and supply chain disruptions, the Fed would take a while to change its current course. If the Fed is forced into action to catch up with inflation dynamics, it may have to raise rates to 2% over several quarters to re-establish price stability.

The tightening would be a temporary shock to markets, but we are confident that the Fed would choose a strategy that prevents the economy from sliding into a recession. While the sequence of these events is plausible, it is hard to time each phase. In Table 1, we assume that the first 50 basis points would be added in 2022 and the Federal Funds Rate would stand at 2% at the end of 2023.

There is a good reason why the discussion is so focused on the US. Inflation and growth dynamics are much weaker in Europe. The welfare system helped European countries weather the crisis with less fiscal stimulus; however, the growth numbers are also much more muted. In addition, the ECB has been struggling for years to reach its 2% inflation target due to the structure of the EU economy, which gives European leaders much less room to manoeuvre.

Meanwhile, China has been able to overcome the Covid crisis with a mix of effective restrictions and limited stimulus. The Chinese Communist Party should be able to steer the economy on a solid growth path in the range of 5-6% in the coming years. The outlooks for the other emerging markets diverge widely, due to the broad range of policy responses and economic outcomes.

Clearly, inflation dynamics are a key structural uncertainty that defines the outcomes of the scenarios. Our approach to scenarios is to build on a limited set of such key structural uncertainties, or unknowns. We adapt three more unknowns from the previous update: the vaccine rollout, animal spirits and fiscal stimulus (see

We continue to assume that the developed economies will focus on rolling out various vaccines throughout the year to reach or exceed the herd immunity of about 70%. Although we made limited changes to this assumption, we recognize that the question of how many people want to be vaccinated will be more important in the coming months. At the moment, we do not assume that a new virus variants will have a major impact on the global economy, but there will be more virus mutations and more local lockdowns. Moreover, developing countries will continue to struggle with the health crisis until the vaccines finally arrive.

Another unknown is the presence of animal spirits amongst investors, which is our wild card to describe irrational exuberance. The massive monetary and fiscal stimulus led to the rise and fall of various social media-driven “meme” stocks, strong inflows into special purpose acquisition companies, and the roller-coaster ride of cryptocurrencies. In our base case, we take the stance that high liquidity might lead to temporary rallies and dislocations but will not distort markets permanently. In the “Full Throttle” scenario, this unknown might lead to wilder swings when the Fed decides it needs to step in to contain inflation.

In the “Idling Engine” world, investors shift towards muted market expectations after experiencing various setbacks. The third unknown, fiscal stimulus, is one of the starting points for this last scenario, which we describe next.

The global economy weathered the worldwide shutdowns of 2020 reasonably well through a mix of massive monetary and fiscal stimulus in the US and, to lesser extent, in Europe. In 2021, the US Congress passed another relief bill and is surprisingly close to approving another package aimed at infrastructure and some social reforms in the coming years. In the Eurozone, the EUR 750 billion recovery plan is only starting to gain speed in terms of rollout and financing. This pipeline makes us confident that a recession is rather unlikely at this stage across the various scenarios.

As the economies reopen, the fiscal debate moves from emergency measures to long-term visions. The risk at this point is a return of the fiscal hawks in the US and Europe. This is one of the assumptions that is embedded in the idling engine scenario. Fiscally conservative countries like Germany, Austria and Finland could increase the pressure to end the ECB’s asset purchases. As we saw in the early 2010s, such a mindset could lead to lower growth and deflationary pressures.

Another major risk factor in the idling engine scenario is consumer behaviour. The relief packages led to high household savings, especially in the US. Whereas much of the savings is turned into pent-up demand in our base case, the consumer would be far more cautious in the “Idling Engine” scenario and continue to hoard cash. The outlook for growth assets would be more muted and there would be little scope for rates to rise.

Scenarios help in constructing portfolios

How do scenarios help to construct portfolios? We think that our “Cruise Control” base case is a good starting point to form expectations. The rates and returns in Table 1 are meant as midpoints; risk measures like standard deviations measured over a long horizon provide an idea about the range of typical outcomes around these midpoints for the regime described by the base case.

All three scenarios are based on unknowns, which encompass our view of the most relevant factors spanning the range of possibilities. The alternative scenarios, Full Throttle and Idling Engine, explore alternative paths for the unknowns and tell consistent stories about relevant markets scenarios.

We believe investors should think through the possibility of persistently higher inflation, even though it is not the most likely outcome in our view. Our discussion has shown that the Fed would most likely be able to fight inflation, though at a high cost, and we believe that it is important to consider possible factors that could undermine the recovery assumption. Fiscal policymakers and consumers are key players to watch, and the existing stimulus should help avoid recession at this stage.

We will never be able to cover all possible scenarios, but we believe that our alternative scenarios help in understanding the range of possibilities and add value to the base case. Investors can use the rates and returns in Table 1 to test their portfolios in the event that the alternative scenarios play out, and check whether they can afford the risk of structural breaks.

Another way of using scenarios is to find patterns that are robust across scenarios. These robust patterns tend to be rare, but when they occur, they send a strong signal. In the current set of scenarios, sovereign bonds have very limited upside and equites are more attractive. This does not mean equities are without risk; but if you can bear the volatility over a longer horizon, you have a good chance of outperforming on a risk-adjusted basis.

Political battles are looming

Another aspect of upcoming normalization is likely to impact our scenarios updates in the coming quarters. Politicians in the US, Europe and in many other regions decided to fight the Covid crisis with massive stimulus. In the coming 15 months, voters will decide whether this was a good choice. Germany’s general elections are in September, and next year, France’s presidential contest in April will be followed by the US Congressional mid-terms in November. In addition, Fed Chair Jerome Powell’s term expires next year. All these events are important signposts of whether we see a progressive era in the 2020s, and whether we need to change our unknowns.

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