On the April PGIM CIO 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 implications of the increased uncertainty in the macro environment for financial markets, the outlook for inflation and the impact of monetary policy tightening.
While economic growth remains strong, the inflation trajectory has ratcheted up even higher, pushing the Fed and other major central banks to double up their policy normalization efforts. Markets have benefited over the past month due to the easing of previously heightened risk aversion in the aftermath of the Ukraine invasion. However, the focus has now turned to central banks, especially the Fed, and their plans to normalize their ultra-accommodative policies. The Fed and ECB have signaled their resolve to bring inflation under control by hiking rates and Quantitative Tightening (QT). Meanwhile, the markets have front run the central banks and have penciled in significant rate hikes. If indeed the Fed implements all of the rate hikes that have been priced in by the market, we could see an excessive slowdown in the economy.
On the geopolitics side, Russia has abandoned its attempt to take Kyiv at least for the moment, focusing instead on the south and the Donbas region. While the war seems to be going Ukraine’s way at present, they still face long odds to defeat the Russian army. The US and NATO have been willing to supply defensive weapons, but not heavier weapons that would improve their odds to win. On the sanctions side, the impact on the Russian economy is seen as much more modest than originally thought, while the ruble is also back up to almost where it was before the war. With the impact from sanctions considerably lesser, Russia has the room to wage a protracted war with Ukraine. As an end game, the possibility of a negotiated settlement where Russia withdraws but maintains some of their gains in the south and the east is increasingly seen as less palatable by Ukraine and the West. Overall, it looks like the Ukraine situation will grind on for longer.
The global economy remains healthy in the near-term with strong underlying fundamentals. While the fallout from the Russian invasion of Ukraine is seen as contained, uncertainty in the medium-term economic outlook has increased. In the short run, the global economy still appears to benefit from strong demand. The US economy continues to be supported by pent-up demand, elevated savings, strong job growth, and rising wages. Domestic demand remains strong, but inventories and trade are expected to weigh on Q1 growth after boosting growth in late 2021. GDP growth is expected around 1.5% annualized in Q1 after a stronger 6.9% pace in Q4, but growth is expected to rebound in Q2 to above 3% as these temporary dislocations fade. The Fed embarking on policy normalization and recent yield curve moves have increased concerns about the possibility of a recession in the next 12-18 months. The upcoming monthly data on wages, home price appreciation, and inflation are likely to provide clues into the likelihood of a soft landing. (On Tuesday, the US Department of Labor said the consumer price index surged 8.5% in March.)
The Russian invasion of Ukraine has contributed to significant downgrades to Eurozone growth expectations, particularly in Q2 and Q3 as rising energy costs and sanctions disrupt supply chains. Eurozone GDP is expected to rise around 1.2% in Q1, before strengthening to a 2.8% pace in Q2. However, the current forecasts don’t anticipate energy sanctions and the possibility of a significant shutdown of energy imports from Russia. Such shutdowns will impose significant costs on Eurozone GDP growth outlook. Meanwhile, Emerging Markets growth expectations have been revised lower given the impact of the Ukraine war and slowdown in China. Emerging markets growth is expected to slow to around 3.6% YoY in Q1 and 4.1% in Q2 after growing around 4.3% in Q4 2021.
Global inflation expectations have further ratcheted higher in the past month since the Ukraine war started with global inflation expected to pick up to around 6.4% in Q2 2022 from 4.7% Q4 2021. The Russian invasion and the associated impact has boosted headline inflation worldwide from already elevated levels. US inflation climbed higher to 7.9% YoY in February, while core inflation increased to 6.4%. There is some evidence that US goods prices are peaking. However, there is broad upward pressure across inflation components, which is likely to keep inflation pressured higher in the short run. Eurozone headline inflation jumped to 7.5% in March, though it rose more modestly to 3% on a core basis. Upcoming inflation readings in both developed and emerging markets are expected to trend further higher in Q2 before easing from elevated levels in the second half of the year. Still, developed markets inflation is expected to remain well above central bank targets, averaging around 5.2%, by end of 2022 after peaking around 6.8% in Q2. EM inflation is seen as stickier, around 5.7% in Q4 after 5.9% in Q2. The rise in oil and commodity prices, and the step up in supply-chain disruptions are likely to keep inflation pressured higher near-term.
On the policy front, the Fed and other major central banks clearly see that policy is behind the curve. With near-term growth outlook remaining strong, the Fed is trying to front load rate hikes and at a faster pace in an effort to catch up. The Fed raised policy rates for the first time since 2018 by 25 bps in mid-March bringing the fed funds target range to 0.25% to 0.50%. The Fed has signaled that it plans to front load and step up the pace of tightening with a 50 bps hike in May now likely, alongside a more aggressive start to QT than in the last cycle. The consensus on the trajectory of Fed action is shifting rapidly. The ECB announced that it will accelerate its asset purchase taper but updated forward guidance saying that any hikes will be gradual and take place sometime after bond purchases end. The BoE raised rates for the third consecutive meeting and brings policy rates back to the pre-pandemic level of 0.75%. Central banks in EM have had to raise rates to rein in inflation as most central banks are facing inflation rates above their target range. With so many global central banks trying to front load policy normalization, it remains to be seen how much the global economy can take without tipping into recession. That may be yet another reason Fed tightening could fall short of what the market is currently pricing. The key challenge for the Fed, and the uncertainty for the market, is whether it will be successful in normalizing policy and be able to engineer a soft-landing for the economy.
Overall, call participants expect the increased uncertainty due to policy normalization and the impact on the macro outlook to keep risk assets volatile and drive bond yields higher. The expectation is that a modest level of exposure to risk assets should do well over the rest of the year, and outperform low-risk assets, despite the near-term volatility. Meanwhile, bond yields are likely to rise as the macro environment remains hot in the foreseeable future and inflation expectations remain elevated. However, the expected range for bond yields is wide, reflecting the broad range of possibilities for the economic outlook going forward, and the lingering potential for further geopolitical surprises.