Prices Of Risk Assets Poised To Rise But Performance Could Be Constrained By High Valuations
On the November PGIM CIOs Call hosted by PGIM Quantitative Solutions, chief investment officers and senior investment professionals from PGIM’s international businesses, PGIM Fixed Income and PGIM Quantitative Solutions discussed the impact of global growth rates, inflation pressures, and central bank moves on the prospects for global financial markets.
The November PGIM CIO Call participants acknowledged that the global economy, after hitting a speed bump in Q3, is poised for a healthy rebound in the final quarter of 2021 with Covid-Delta fears abating, signs of global supply chains unclogging, and easing of China policy uncertainties and real estate fears. The Call participants noted that several variables driving markets—GDP growth, corporate profits, global supply chain disruptions and the era of ultra-easy monetary stimulus have either peaked or are peaking, while inflation and oil prices appear to be stubbornly elevated.
Global growth moderated in the third quarter of 2021, driven by a slowdown in China and the US, while some North Asian economies stalled. Europe was the only bright spot. The Chinese economy slowed sharply with a combination of supply chain disruption, a power shortage and uncertainty about the real estate sector with the Evergrande fireworks. However, economic indicators in early Q4 point to a global economic rebound in Q4. On the virus front, new cases have crept higher globally, especially with onset of cold weather in the northern hemisphere, but hospitalizations have been more modest due to widespread availability of vaccines.
Meanwhile, inflation remains elevated as energy and commodity prices continued to trend higher. Rising inflation expectations have led markets to fear that central banks might be behind the curve in implementing measures to tackle inflation. However, the Call participants noted that inflation hysteria appears to have peaked, although markets remain nervous that higher prices, supply chain disruptions, transportation costs, and higher wages are, perhaps, extrapolating a permanent change in the inflation regime.
Global central banks continue to tiptoe toward dialing back pandemic-era stimulus as stubbornly high inflation appears to have forced central banks to pull forward normalizing of monetary policy. While markets have raised their expectations of central bank tightening, especially in the US, the PGIM Fixed Income team believes these expected rate hikes might not be realized. In its view, doing so would be a policy mistake that would tighten financial conditions and ultimately could force central banks to unwind the rate hikes.
Overall, the macro backdrop remains supportive of risky assets given the anticipated growth rebound in the fourth quarter of 2021, continued strong profit growth, and the apparent abatement of COVID-Delta risks. Further, risk assets could also benefit from some easing in peak worries about inflation and central bank response to control inflation. However, the call participants also noted that risk assets have posted very strong gains year to date, and equity valuations are extended. On the China front, there are still lingering concerns that growth might decline more than expected. While the general consensus among the Call participants was that the macro backdrop remains supportive for risky assets, strong gains thus far in 2021 and extended valuations are likely to limit further gains by risk assets in the near term.
Economic Outlook—Global Economy on Track to Rebound from Third-Quarter Slowdown
Global growth hit a speed bump in the third quarter as supply chain disruptions and the spread of the COVID-Delta variant slowed economic activity in the major economies, including the US and China. However, economic indicators in early Q4 indicate that the global economy is on track to rebound in the final quarter of the year. The JP Morgan global GDP Nowcast is tracking at around a 3.1% annualized pace for Q3, compared to the 4.4% pace in the first half of 2021. The Q3 slowdown was driven by a contraction in China and a sharp slowdown in the US, as well as the stalling of North Asian economies. Europe was the only bright spot. From a sector standpoint, the Q3 contraction in global retail sales and US goods GDP, together with the slide in global factory output growth to just 1.4%, points to a demand rotation to services and away from goods. While global supply chain disruptions wreaked havoc on economic activity in Q3, evidence of a pullback in prices of containers from recent highs suggests some easing of the supply dislocations. Further, the supply chain constraints are actually seen as extending the ongoing cycle as demand gets pushed out into the next year.
The US economy slowed sharply in Q3 2021 with 2% annualized growth after 6.7% in Q2 due to supply chain disruptions that hit both consumption and investment spending. Consumer spending slowed to just 1.6% in Q3 from double-digit growth in Q2 (+12%) and Q1 (11.4%), as spending on durable goods fell -26% annualized. Further, with the end of enhanced unemployment benefits, Q3 personal disposable income contracted -5.6%, which took a toll on consumption spending. Business investment slowed to 1.8% annualized from 9.2% in Q2, as motor vehicle shortages affected fleet sales. Further, the ongoing decline in non-residential structures investment continued. Trade subtracted 1.1% from Q3 growth, as exports declined by -2.5%, while imports rose by 6.1%. Inventories added 2.1% to overall GDP growth, but this may be at the expense of future growth. As the supply disruptions ease, US growth is on track to grow by a healthy 5% in Q4.
Eurozone GDP rose slightly above expectations in Q3, rising 9.1% after 8.7% in Q2. Easing of COVID-19 restrictions was a major driver of growth, with consumption spending showing strong growth in the individual country reports.
The Chinese economy slowed sharply due to a combination of supply chain disruptions, a power shortage and uncertainty about the real estate sector. GDP growth slowed in Q3 to 0.2% quarter over quarter (4.9% year over year) from 1.2% quarter over quarter (7.9% year over year) in Q2.
Inflation Remains Stubbornly Elevated
Global inflation remains elevated and under upward pressure in Q4, with headline inflation expected to average around 4.3% in Q4 from 3.1% in Q2. Rising inflation is triggering anxiety around the world as a surge in demand following the easing of Covid-19 lockdowns has been confronted by supply bottlenecks and rising prices of energy and raw materials. US inflation edged back up to 5.4% year over year in September after easing to 5.3% in August from 5.4% in July. Eurozone inflation surged 4.1% year over year in October from 3.4% in September with ongoing strong gains in Germany and rising energy prices. In Japan, nationwide inflation rose to 0.2% year over year in September from 0.4% previously. Nationwide inflation ex-fresh food and energy held at -0.5%. Tokyo inflation eased to 0.1% in October from 0.3% in September. While current inflationary pressures are high, many of these inflation measures are beginning to level off, and these concerns have likely peaked.
Emerging Markets inflation remain under pressure due to soaring food and energy prices.
Policy Backdrop: The Fed Begins QE Taper and Other Central Banks Stop Refilling the Punch Bowl
Global central banks continue to tiptoe toward dialing back pandemic-era stimulus introduced in March 2020. Stubbornly high inflation across major economies appears to have forced central banks to move forward normalizing monetary policy. As widely anticipated, the US Federal Reserve announced the tapering of quantitative easing (QE) asset purchases at its November meeting. Acknowledging that the “substantial-further-progress” test for tapering has been met, the Fed announced it will reduce asset purchased by $15 billion per month starting in mid-November. Assuming a steady pace, the $120-billion asset purchase program will be wound down in June 2022. The Fed acknowledged that inflation remains “elevated” because of supply-demand imbalances, and it appeared less certain about the inflation outlook, stating “inflation is elevated, largely reflecting factors that are expected to be transitory.” Despite market expectations that the Fed will be forced to raise rates earlier than expected, the central bank maintained its guidance that the federal funds rate will remain at the current level, with liftoff unlikely until late 2022. However, there is the risk of a policy mistake with the Fed tightening too early in the face of supply-driven inflation.
Meanwhile, other developed central banks have started lift-off, with the Bank of Canada stopping its asset purchases and the Reserve Bank of Australia ending its yield curve control. The European Central Bank continues to make asset purchases at a moderately lower pace. The Bank of Japan left policy unchanged at its October meeting, as expected, with the policy rate at -0.1% and the 10-year Japanese government bond target at about 0%.
The Bank of England left policy rates and asset purchases unchanged at its November meeting. Given recent hawkish rhetoric from the BoE Governor and Chief Economist, markets were pricing in a November rate hike. Nevertheless, the BoE is likely to be one of the first central banks to start raising rates with the bank’s updated guidance that rate hikes would be needed “over coming months.”
Among Emerging Markets, the People’s Bank of China remains on hold and continues to provide liquidity, but some banks are hiking rates due to rising inflation amidst the recovery.
The Bottom Line
The November CIO Call participants discussed the outlook for markets amid signs of a global growth rebound, easing of peak inflation fears and the onset of central bank policy normalization. The call participants noted that supply chain disruptions may be easing, as seen in the pullback in prices of containers. Economic activity remains supported by pent-up demand due to high savings, continued inventory rebuilding and easing of supply dislocations. While inflation remains elevated, inflation hysteria has likely peaked. Global central banks continue to tiptoe toward dialing back pandemic-era stimulus. The Fed announced its much anticipated QE taper but insisted it was not a prelude to rate hikes. However, the call participants also cautioned that risk assets have posted strong gains thus far in 2021, and equity valuations are now extended. On the China front, there are lingering concerns that growth might slow much more than expected. The general consensus among the November CIO call participants was that risk assets should benefit from the Q4 growth rebound, continued strong earnings, easing of peak inflation fears and calming of rate hike anxieties. However, extended valuations, risk of a policy error with excessive tightening, and concerns about a slowdown in China all suggest the need to temper the optimism with some caution.
All data from PGIM Quantitative Solutions unless otherwise noted.
PGIM Markets will not publish the week of November 22nd for the Thanksgiving holiday. Look for the next issue of PGIM Markets the week of November 29th.