On the August Global Partners CIO call hosted by QMA, chief investment officers and senior investment professionals from PGIM’s international businesses, PGIM Fixed Income and QMA discussed the impact of the COVID-19 Delta variant on global growth, the inflation debate and the prospects for global financial markets.
The global economic recovery appears to have reached cruising altitude but is facing turbulence as the Delta variant of the COVID virus raises fresh risks to growth. At the same time, strong tailwinds of policy support are on track to wane. With the economic and earnings growth rates at or near peak, and valuation elevated, the consensus at the August CIO Call was that outlook for equity and credit markets is getting less rosy, while volatility is likely to remain elevated. Given the increased risks and uncertainties, the Call participants suggested reducing risk, while remaining positive on the outlook for markets.
Economic Outlook: Looking Beyond Peak Growth with Delta Risks
The global economy is soaring with solid Q2 GDP growth in the US, Europe, China, Taiwan, Brazil, India and several emerging markets. Current expectations are that global GDP is likely to remain solid over the second half of 2021 as economies continue to reopen globally. However, the growth pace is likely to peak in Q2 and Q3, and further acceleration seems unlikely as pent-up demand is exhausted and further policy stimulus appears unlikely, with the exception of the US. Further, the spread of the more contagious Delta variant across Europe, the US, and many parts of Asia is casting a shadow on the growth outlook. High vaccination rates in the developed economies have weakened the link between infection and deaths, which means that more draconian restrictions and lockdowns need not be imposed. However, in Japan and emerging markets where the vaccination rates are lower, fresh restrictions are being imposed, which could take a toll on growth. While the Delta variant may not derail the global recovery, it introduces fresh uncertainty to the growth outlook.
In the US, Q2 GDP came in below expectation, while Eurozone GDP beat expectations. US Q2 GDP grew a solid 6.5% annualized but below expectations of 8.4% growth. This brings the level of GDP above where it was prior to the pandemic, although it has still not recovered to its prior trend. However, while the headline number was a touch disappointing, the details were quite positive with strong aggregate demand reflected in private final domestic demand, which was stronger than expected at +9.9%. This was driven by strength in consumption and business investment, which grew at an 11.8% and 8.0% rate, respectively. The biggest drag on Q2 growth was bigger-than-expected inventory drawdown, which shaved more than 110 basis points (bps) from Q2 GDP growth. The inventory drawdown reflects supply-chains constraints. However, the need to rebuild inventories from currently very low levels should set up for a big inventory boost to GDP in coming quarters. Thus, the outlook for the second half of the year remains solid with Q3 growth tracking around +7% and Q4 around +5%. Looking ahead to 2022, Ellen Gaske, a senior economist at PGIM Fixed Income, expects GDP growth to be solid as consumer spending is likely to be boosted by consumers drawing down savings that were built up from government transfers, reduced spending during the lockdown and increased household wealth fueled by the rebound in equity and home prices. Further, federal transfers to state and local governments have been only partially spent, suggesting that the fiscal cliff might not be as steep as some expect. Gaske is positive on businesses and business investment spending as a catalyst for GDP growth going forward. The 5G rollout is likely to impact business models, potentially boosting business investment even further.
Eurozone GDP rose stronger-than-expected in Q2, up 8% annualized after -1.2% in Q1. There was strength across all components of GDP during the quarter. German growth had come in below expectations, but Spanish and Italian growth was a bit higher than expected. French growth was slightly above expectations. Expectations are for the Eurozone to post solid growth around +9.6% in Q3 and +5.2% in Q4.
In Japan, GDP growth for Q2 is set to be released in mid-August. Current expectations are for GDP to have recovered modestly, around 0.5% annualized after declining -3.9% in Q1. PGIM Japan CIO Seiji Maruyama points out that growth momentum is slowing due to the extended state of emergency imposed by the government in various regions, including Tokyo, to deal with the spread of the COVID-19 Delta variant. Overall Japanese GDP is expected to post solid growth in Q3, supported by the Tokyo Olympics, increased vaccination, and stronger global demand.
Among emerging markets, China’s growth is expected to moderate in the second half of 2021 from the strong pace in the past few quarters. Q2 GDP growth came in at 7.9% year-over-year, after strong 18.3% growth in Q1. The slowdown was driven by weaker industrial activity and slower real estate investment, while consumer spending improved. The economy is expected to slow further to a 5%-6% growth pace as industrial production continues to moderate. In India, the economy is expected to post a strong 19.4% recovery in Q2 aided by base effects, lifting of lockdowns, vaccinations rates continuing to pick up, and a better than expected monsoon season. GDP growth is expected around 7% in the second half of the year.
Taiwan’s Q2 GDP rose 7.5% year-over-year, much higher than consensus expectations of 6.6%, as strong exports offset weakness in consumer spending. The Russian economy continues to recover strongly with GDP expected to post around 10% growth in Q2 driven by rising oil prices. Trends in personal consumption and business investment spending have been strong. Growth is expected to remain solid, averaging around 3.25%, in the second half of 2021.
Inflation Debate: Jury Still Out as Price Pressures Remain Stubbornly Elevated
The inflation debate—transitory vs. persistent—remains alive as inflation remains elevated, with the June data pointing to a 0.5% month-over-month jump in core inflation globally. After bottoming late last year, core inflation has surged to a 3% annualized rate in the first two quarters of the year. The pandemic has impacted global supply chains, creating shortages and increased costs, while policy-fueled demand towards goods has also contributed to price pressures. US headline inflation rose further to 5.4% year-over-year in June from 5% in May with a narrow segment of COVID-19-impacted categories driving the bulk of the increase. Core inflation also jumped to 4.5% from 3.8% previously. Eurozone inflation rose to 2.2% year-over-year in July (preliminary) from 1.9% in June, largely due to base effects from last year’s German Value-Added Tax suspension falling out of the calculation. However, core inflation eased to 0.7% from 0.9% previously. In Japan, nationwide inflation rose to 0.2% year-over-year in June from -0.1% in May. Nationwide inflation excluding fresh food and energy was unchanged at -0.2%.
Policy Backdrop: Still Supportive but Inching Towards Taper
Developed central banks continue their accommodative policies even as they are balancing the potential downside risks from the Delta variant against an inflation backdrop in which prices remain stubbornly elevated. The US Federal Reserve left policy unchanged at its late July meeting, but it noted that some progress has been made toward its goals and that it will continue to assess at upcoming meetings, setting the stage to begin tapering quantitative easing later in the year. At the press conference, Chairman Powell specifically highlighted that the labor market is an area where there is “some ground to cover” for the Fed’s goals to be met. The Fed continues to maintain that inflation is transitory, and Chair Powell downplayed recent upside surprises to inflation.
The European Central Bank held a monetary policy review in July, when it adjusted its inflation target from a 2% ceiling to a symmetric goal and updated its forward guidance consistent with the review. It will likely wait to raise interest rates until inflation reaches the symmetric 2% target. ECB President Lagarde flagged the spread of the Delta variant as potentially holding back the Eurozone recovery, but she characterized the risks to the outlook as broadly balanced. The Bank of Japan left policy unchanged at its mid-July meeting, as expected.
Among emerging markets, central banks remain divided between those renormalizing policy and others supporting their economies from virus-related downside risks. The People’s Bank of China announced a 50-bps universal Reserve Requirement Ratio cut, applicable to most financial institutions, effective July 15. The Brazilian central bank hiked rates by an additional 100 bps to 5.25% in early August after raising its interest rate by 75 bps in June, hinting that it will continue raising policy rates until they are above levels considered neutral.
In Russia, the Central Bank of Russia increased the key rate by 100 bps to 6.5% in July, in line with expectations. The CBR has delivered front-loaded tightening to date, with 225 bps in hikes since March and has indicated that it will “evaluate the necessity” of further hikes at upcoming meetings, which implies that the bank will be much more data-dependent going forward. Meanwhile, the Reserve Bank of India (RBI) is nursing an economic recovering after a deadly second Corona virus wave. The RBI is expected to leave interest rates at record lows for a seventh straight meeting in August, but the markets are likely to focus on what it says about normalizing liquidity.
The Bottom Line
The August CIO Call participants discussed the risks to global growth from the spread of the Delta variant and the outlook for markets as the policy tailwinds are set to wane. The global economy is soaring at cruising altitude with solid GDP growth in the US, Europe, China, Taiwan, Brazil, India and several other emerging markets. However, the economies are likely at peak growth, and further acceleration seems unlikely. Further, the Delta variant has raised fresh risks to growth, especially in emerging markets where vaccination rates continue to lag rates in the developed economies. While the Delta variant may not derail the global recovery, it introduces fresh uncertainty to the growth outlook. In addition, the strong tailwinds of fiscal and monetary policy, which supported the economic recovery and fueled strong market gains, are likely to start waning in late 2021. Thus, while solid global growth and robust earnings continue to underpin stock markets, the fresh risks and uncertainties and rich valuation are likely to keep markets volatile, calling for caution.IN