The global economic picture in the first quarter has been as we expected. In terms of year-on-year growth, the economy is moving up steadily since bottoming out in the second quarter of 2020, when countries around the world started locking down to fend off the coronavirus.
Rising economic activity is reflected in confidence indicators, purchasing managers' indices (PMI), retail sales and industrial production, as well as GDP and labour market data. These reflect a new round of economic stimulus, especially in the US, and the steady progress of vaccinations globally, especially in the rich world.
Nevertheless, the recent rise in daily cases as new Covid variants emerge in Latin America, India and Europe is a cause for concern and needs to be monitored closely.
The combination of three positive factors -- the economic rebound, huge US stimulus and progress in global vaccinations -- has led to what some may believe is a "too good to be true" condition. This in turn has fed a boom in stock markets and subsequently brought back the fear of inflation.
Funds now flowing into the US economy from the $1.9-trillion stimulus programme will not only help America but will fuel global growth by way of increased demand in the US and from the US to the rest of the world. That's why some people are beginning to fear high demand will lead to rising prices. US borrowing costs and commodity prices have already returned to pre-crisis levels in recent months.
INFLATION EXPECTATIONS
As a consequence, rising inflation expectations have led investors to believe that central banks, notably the US Federal Reserve, will have to tighten their loose stance in order to curb inflation. With bond yields rising, a broad-based rise in financial costs -- from government finance to higher mortgage rates to higher private sector borrowing costs -- is inevitable.
Consequently, rising bond yields are the indicator we need to monitor most closely. We forecast the direction of the US 10-year yield by studying the interrelationship between oil, inflation, inflation expectations and bond yields. Oil prices are a major contributor to inflation, which in turn influences future inflation expectations. The rise (or fall) in expectations will eventually lead to the rise (or fall) in bond yields.
From our model workup, demand for oil will gradually increase based on three factors: the recovery of economic activity following the decline in Covid cases; widespread inoculations and the arrival of herd immunity; and the Biden administration's stimulus package. As a result, we see global oil demand rising from 93.4 million barrels per day (bpd) in the fourth quarter of last year to 95 million in the current quarter, and gradually going up to 97 million in the fourth quarter. That's still about 3 million bpd below the end-2019 figure.
On the production side, we expect production to increase gradually after the Opec+ alliance, especially Saudi Arabia, increases production to pare down member states' budget deficits and in response to increasing global demand. Production volumes will gradually increase from about 92 million bpd in the fourth quarter of last year to 97 million in the fourth quarter of this year.
We believe the oil demand surplus will peak in the first quarter of this year at 3 million bpd, easing gradually to 1 million bpd in the fourth quarter. This will put the price of Brent crude at $62 a barrel in the first quarter, before a slight fall later in the year, with an average of $60.30 forecast for the full year.
Though oil prices are expected to be fairly stable this year, year-on-year rates of change will be significant given how prices collapsed in 2020. Brent sank below $20 and West Texas Intermediate futures actually turned negative in April last year. The annualised changes will thus range from more than 100% in the second quarter, before dropping to around 30% in the second half. Factoring in such a big jump in the fuel component would push up the US consumer price index (CPI) to about 2% in the second quarter of this year, from around 1.5% in the first quarter.
As inflation numbers jump from the low base, inflation expectations will increase in the next two months and lead bond yields up to 2% or higher, from around 1.6% now.
But with inflation projected to subside in the second half, the 10–year Treasury yield will be lower, and should settle at 1.5% by year-end.
WILD CARDS
Having said that, there are a number of factors that could cause real numbers to deviate from the projection.
If, for example, Opec+, especially Saudi Arabia, decided to continue to maintain oil production capacity at the current level of around 9.1 million bpd, and the Saudis disregard the need to lower their budget deficit from 12% of GDP, it is possible oil prices may continue rising. This would keep inflation climbing and subsequently bond yields.
On the other hand, if the Fed decides to explicitly or implicitly "manage" the yield curve to lower financial costs, the 10-year yield may be lower and smoother in the second quarter.
The conclusion of our analysis is that although the economy is benefiting from three positive factors and will continue to grow robustly, higher risk due to rising financial costs could appear on the investment horizon. The risk is, however, skewed to the second quarter and is projected to subside in the latter part of the year.
Apart from this, other risk events could include a rise in the number of new Covid cases in more countries, a possible financial crisis in emerging markets, and a possible rise in US corporate tax rates, something Biden administration officials have hinted at.
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Piyasak Manason is senior vice-president and head of the wealth research department at SCB Securities, email piyasak.manason@scb.co.th