On the May PGIM 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 diverging economic growth rates across the globe and the debate as to how long spiking prices are likely to last.
The May CIO Call participants remained positive on the outlook for stock markets underpinned by solid, albeit uneven, economic growth and strong earnings rebound. The news on the pandemic front has been mixed with positive developments in the developed economies tempered by surging cases in some emerging markets, such as India, Thailand and Brazil, and slower vaccine rollout in most emerging markets. This is likely to delay the economic recovery and render the rebound uneven. Inflation, which was off investors' radar for a long time, has now emerged as a fresh concern. While policy remains supportive for now, the rise in inflation is prompting some central banks to begin signaling the end of the global easing cycle.
The global economic recovery is unfolding as expected but remains uneven in Q1 2021 with solid GDP growth in the US, and growth contraction in the Eurozone, UK and Japan as renewed restrictions on activity dampened growth. US GDP grew 6.4% annualized in Q1 2021, strengthening from 4.3% growth in Q4 2020, driven by strong growth in consumption, business investment spending, residential investment and government spending. Consumption spending surged 10.7% and contributed 7% to Q1 growth while government spending rose 6.3%, adding 1.1% to growth. Business investment rose a solid 9.9%, while residential investment rose 10.8%. Q1 GDP growth would have been 2.6% higher but for the drag from inventories.
After the strong Q1 growth, US GDP is now just about -1% below the previous high in Q4 2019. Looking ahead, US GDP growth is expected to accelerate in Q2 to more than 8%, with risks to the upside, as consumers are awash with cash and vaccinations are allowing for continued easing of virus-related restrictions. Spending on services, which remains nearly 6% below pre-pandemic levels, still has plenty of room to recover, while other components, such as non-durables spending, business and residential investment components, are expected to continue their strong pace.
The Eurozone economy fell into technical double-dip recession with Q1 GDP contracting -3.6% quarter over quarter annualized in Q1 2021after declining -2.8% in Q4 2020 as renewed lockdowns and restrictions depressed spending. By country, there was a significant decline in Germany (-6.6%), driven by household consumption, after rising in Q4. Spanish and Italian GDP also declined modestly. However, French GDP rose slightly (+1.6%), helped by a big increase in construction investment, as households put some of their savings into the housing market. While the Eurozone suffered a second technical recession in more than a year, the economy is on track to a solid rebound as increased vaccination administration allows governments to lift restrictions. Eurozone GDP growth is expected to rebound 1.7% in Q2 and remain solid over the rest of the year, assuming no further significant lockdowns. However, the Q1 GDP contraction leaves the Eurozone economy 5.5% below its pre-crisis peak, a much wider gap than that of the US. Hence, even if the economy starts to rebound, it is likely that it will take at least until mid-2022 to regain its pre-crisis level.
UK GDP growth is estimated to have contracted -6.6% annualized in Q1 but is on track for double digit growth in Q2 with progress on vaccines and the reopening of the economy. The Bank of England upgraded its 2021 growth outlook for the UK to 7.25% (up from February forecast of 5%), slightly above consensus expectations (5.5%). The Japanese economy is also likely to have contracted in Q1 (-4.5% annualized expected), following the solid 11.7% annualized growth in Q4 2020. New COVID-19 restrictions on activity were a negative in Q1, as were natural disasters in February, which disrupted production. However, the economy is on track to rebound with easing of restrictions, and the summer Olympics also likely to give a modest boost.
China's growth remains solid, but Q2 GDP growth is on track to moderate to 8% year on year after Q1 GDP rose 18.3%. In Taiwan the economic backdrop remains strong with strong export growth and a recovery in domestic demand. Export growth remains strong on robust demand from China and strong chip demand as higher prices and fears of supply shortages have customers stocking up. PGIM SITE Taiwan CIO Bevan Yeh and the Taiwan team expect 2021 GDP growth to come in much stronger than the official forecast of 4.6% year over year. India was on track to double digit GDP growth in 2021 but the growth forecasts have been trimmed by between 0.5% and 2% as the new wave of infections has forced renewed restrictions. As such, Q2 growth is on track to weaken substantially.
The Inflation Debate
Inflation, which was off investors' radar for a long time, has now emerged as a fresh concern after decades of low inflation and deflation fears in 2020. Headline inflation has risen in 2021 across most developed markets, primarily due to rising energy prices and base effects from declines in 2020. Headline inflation rose 2.6% year over year in the US in March and 1.6% in the Eurozone in April. However, core inflation is more mixed, rising in the US (to 1.6%) but edging lower in the Eurozone (0.8% from 0.9%). By contrast, inflation in Japan remains weak with nationwide CPI down -0.2% year over year in March.
Looking ahead, inflation is expected to peak in April as that was the lowest level of decline in 2020. Thereafter, base effects will have an offsetting impact, limiting the rise in annual inflation. Policy makers at the US Federal Reserve and the European Central Bank thus believe that much of the recent increase in inflation is transitory and that weaker monthly price growth will contribute to an inflation reversal later in the year and into 2021. However, a growing number in the marketplace are concerned that elevated inflation may persist longer than what the central banks believe. Ellen Gaske, a senior economist at PGIM Fixed Income, and QMA Portfolio Manager Ed Keon agree that the temporary rise in inflation may persist a little longer than originally anticipated, mainly due to the shortages that will likely persist for some more time, particularly in key components, such as semiconductors. It could take anywhere from 12 to 18 months to resolve these supply bottlenecks. Further, the US has undertaken significant fiscal stimulus, and the Fed's new average inflation targeting framework and comments from Chairman Powell and other Fed officials suggest that the Fed will allow an overshoot of inflation and will delay any monetary policy tightening. If markets perceive that central banks are behind the curve, then inflation expectations may become unmoored, requiring even sharper interest rate hikes later to bring inflation in line.
The Policy Backdrop
After aggressive rate cuts in 2020, with global central banks delivering around 207 rate cuts in total and remaining on hold in early 2021, central banks have now started to reduce the stimulus and signal the end of the global easing cycle. The rate hikes started in eastern Europe with rate hikes in Armenia, Tajikistan, Belarus and Ukraine as inflation picked up in the region. Other major emerging markets central banks, such as Brazil's, Russia's and Turkey's, have joined in hiking rates amidst rising inflation expectations as the global recovery droves up the prices of energy and other commodities in addition to continued increases in food prices. More rate hikes are expected in the coming months as inflation concerns are causing central banks in emerging markets to shift to a more hawkish stance.
Among developed markets, Canada's central bank became the first major central bank to signal an end to the high levels of monetary accommodation initiated in 2020. At its April meeting, the Bank of Canada said it would scale back purchases of government debt by C$0.25-3 billion and possibly accelerate the timetable for rate hikes. The Bank of England also started slowing their weekly quantitative easing (QE) asset purchases from £4.4 billion to £3.4 billion per week. In contrast, the US Federal Reserve reaffirmed its commitment to keep policy rates low and continue QE asset purchases. PGIM Fixed Income's Gaske expects the Fed to be the last to start the taper process, potentially beginning to taper at the end of the year, but she doesn't see the Fed hiking rates until 2023, potentially in the latter half of the year.
The Bottom Line
The general consensus at the May CIO Call was that the stock markets are likely to remain in an uptrend after the gains thus far in 2021, underpinned by solid, albeit uneven, economic growth and strong earnings rebound. However, while progress in vaccinations in the developed economies is a positive, surging COVID cases in some emerging markets and slower vaccine rollout are likely to be a risk for the recovery. Further, concerns about inflation (whether it is transitory or more long-lasting), and central banks' response (ending the global easing cycle or remaining behind the curve) are other uncertainties that are likely to keep markets volatile in the near-term.