On the September 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 the Delta variant on global growth, inflation, central bank policy and the prospects for global financial markets.
The global economy remains on a solid recovery path, although there are signs that economic activity is likely to take a modest hit from the COVID-19 Delta variant spreading around the world. Renewed lockdowns are pushing down growth projections from earlier expectations and from Q2’s torrid pace, but the net impact of Delta on growth is not yet clear. With widespread vaccinations weakening the link between infection and deaths and natural immunity rising, there have been fewer restrictions and lockdowns. However, airlines are reporting increased cancellations, businesses are pushing back return-to-office plans, retail sales have been weak and US jobs reports in early September were disappointing, to put it mildly.
All of these point to a negative effect of Delta. On the other hand, inventory rebuilding from current lean levels and increased Capex as firms beef up their digital capabilities could offset the slowdown in consumer spending. Inflation remains elevated although there has been a bit of moderation recently. Developed central banks maintain their accommodative policies even as the US Federal Reserve debates when to begin to taper their asset purchases. Risky assets continue to inch higher with the economy on recovery track and as strong profit growth and easy monetary policy provide support despite the COVID risks. The Call participants remain positive on the outlook for markets, but given the increased risks and elevated valuations, suggested keeping bets on risk assets modest.
Economic Outlook: Delta Casting a Shadow on Growth Expectations
Global growth remains solid, currently, but there are signs that economic activity is likely to take a hit from the spread of COVID-19 Delta variant, including in the US. While global industrial production is expected to strengthen to around 8% in Q3 from around 2% in Q2, retail sales growth has cooled a bit to around 5% from 13% in the previous quarter. Business confidence has moderated from the very strong levels in Q2 but still remains solid in Q3. However, as the Delta variant begins to subside and lockdowns globally are eased, growth is likely to reaccelerate heading into year-end.
US GDP is likely to see a modest slowdown in Q3 from the 6.6% annualized pace in Q2 due to the ongoing spread of the Delta variant. Retail sales declined in July, indicating that after flying high for months, consumer spending is falling back to earth. Further, households appear to be shifting spending away from goods to services. Rising concerns over the Delta variant pose downside risks to consumer spending in Q3 as services spending is likely to take a hit if mobility restrictions are reinstated. Nevertheless, the current wave has had a more limited impact on mortality due to widespread vaccination and natural immunity, resulting in fewer restrictions and lockdowns. Regardless, confidence indicators have pulled back, and July’s real personal consumption expenditure data was mixed. However, Ellen Gaske, a senior economist at PGIM Fixed Income, is of the view that inventory rebuilding from current low levels and increased Capex as firms beef up their digital capabilities could offset the slowdown in consumer spending. She expects the net result to be solid overall GDP growth well into next year. The US Congress is still working toward passing the infrastructure and reconciliation bills with a vote expected on the infrastructure bill likely in late September. Fresh public spending should also help support growth.
Eurozone GDP growth is expected to strengthen modestly in Q3 after rising 8% in Q2 as the impact of the Delta variant fades. European COVID-19 vaccination rates have increased significantly, which has helped prevent the Delta variant from becoming as widespread in Europe as it is in the US. The latest hard economic data from the end of Q2 was positive, particularly for Eurozone consumers. However, confidence indicators have pulled back modestly recently. Japanese GDP rose more than expected in Q2, up 1.3% annualized after declining -3.9% in Q1, with a recovery in consumer spending, improvement in Capex and public spending picking up. The recovery continues but Q3 growth is likely to be sluggish with ongoing lockdowns in several areas.
Among emerging economies, the Brazilian economy has demonstrated considerable resilience despite the latest Delta wave. The IBC economic activity index rebounded, and the services sector, which had lagged retail and industry earlier, is showing signs of picking up recently. Overall the Brazilian economy is set to rebound around 5% in 2021. In India, GDP posted a strong 20.1% recovery in Q2 aided by base effects, faster-than-expected lifting of lockdowns, rising vaccination rates, and a better-than-expected monsoon season GDP growth is expected to moderate to around 8% in the second half of 2021.
In China, the economy is expected to moderate in the second half of 2021 from the strong pace in the first half of the year. GDP growth came in at 8% in Q2 as expected after the very strong 18.3% in Q1. However, China’s July macroeconomic data showed a broad-based slowing in activity, including moderation in industrial production, overall fixed investment growth, and retail sales. The latest wave of the local Delta-variant outbreak started on July 20, and tighter mobility restrictions across a number of provinces are expected to be a drag on consumption and services through August. The economy is expected to post a slower but still solid 5-6% growth in the second half of 2021.
Price Pressures Remain Stubbornly Elevated
Global inflation remains elevated although there has been a bit of moderation recently. Global core inflation came in at 0.3% month over month in July after several months of 0.4% rise. In the near-term, inflation is likely to remain under upward pressure by transitory factors related to the pandemic shock. Goods price pressures, linked to supply chain bottlenecks and rising transportation and material costs, are behind this acceleration, but these effects are expected to ease in the coming months. However, the unwind is likely to be gradual in an environment of strong demand growth, lean inventory positions and a normalization of service prices that were depressed by mobility restrictions.
US inflation held at 5.4% year over year in July after rising strongly earlier in the year as the sharp rise in used car prices fade and base effects keep headline inflation contained. Core inflation edged down to 4.3% from 4.5% previously. Eurozone inflation jumped to 3% year over year in August, a ten-year high, from 2.2% in July with base effects and strong growth in French prices month over month. Core inflation jumped to 1.6% from 0.7%.
In Japan, nationwide inflation edged up to -0.3% year over year in July, from -0.5% in June (after revisions). Nationwide inflation ex fresh food and energy rose to -0.6% from -0.9%. In Emerging Markets, soaring food and energy prices have pushed inflation to high levels. In Brazil, consumer prices are up 9% year over year in July, more than twice the central bank’s target rate. In Russia inflation is 6.5%, well above the central bank’s target of 4%. Consumer inflation may tick higher in the near term after President Putin announced one-off social payments to pensioners and soldiers ahead of the September Parliamentary elections. Inflation in India, which had been high in 2020, rose above 6% in May-June, before easing modestly in July to 5.6%. China is the only EM where inflation remains low, coming in at 1% in July.
Central Banks Still Supportive but on Track to Taper in Q4
Developed central banks maintain their accommodative policies even as the Fed debates the timing of asset- purchase tapering against a backdrop of potential growth risk from the Delta variant and elevated inflation. Chairman Powell’s speech at the Jackson Hole monetary policy conference in late August warned of pulling back on monetary policy too early if inflationary factors prove transitory. He also noted that there is still room to go for the Fed to meet its maximum employment goal. However, consistent with the Fed’s July minutes, Chair Powell views the inflation goal as being met and that the Fed may need to slow asset purchases later in the year, likely in November.
The European Central Bank is set to meet in early September after last updating its forward guidance in late July. With preliminary August inflation coming in at its highest level in roughly ten years, there is some concern the ECB might start thinking about adjusting asset purchases. Nevertheless, when the ECB announced the changes to guidance in July, it noted that a transitory period during which inflation was above target was expected and that they planned to wait for these near-term effects to fade before significantly tightening policy. The next Bank of Japan meeting is scheduled for September. At the July meeting, the BoJ provided updated forecasts for GDP and inflation, trimming modestly on the 2020 GDP forecast but offset by faster growth in 2021 (2022 is unchanged) and raising the inflation forecast for both 2020 and 2021.
Among Emerging Markets, central banks remain divided between those hiking rates due to rising inflation amidst the recovery and others supporting their economies from virus-related downside risks. China left its benchmark interest rate unchanged in August for the 16th consecutive month, but that did little to dampen expectations authorities will boost stimulus to counter a slowdown in the economy. While expectations are that the Chinese government would boost fiscal spending and the People’s Bank of China will keep liquidity in the financial system ample, they are likely to stay clear of any aggressive monetary easing that could run the risk of creating asset bubbles.
The Bottom Line
While the global economy remains on a solid recovery path, there are signs that the economic activity is likely to take a hit from the COVID-19 Delta variant cropping up around the world. Renewed lockdowns are capping growth. However, the net impact of Delta on growth is not fully clear. The participants continue to watch inflation closely, which remains elevated, although there has been a bit of moderation recently. In the near-term, inflation is likely to remain under upward pressure by transitory factors related to the pandemic shock, but it seems unlikely that we will get persistently higher prices unless we have a wage-price spiral. Meanwhile, risky assets continue to grind higher with the economy on recovery track and with strong profit growth and easy monetary policy providing support despite the COVID risks. Developed central banks maintain their accommodative policies even as the Fed debates when to taper asset purchases. While the Call participants remain positive on the outlook for markets given the solid growth outlook and strong earnings, they recommend modest bets on risk assets given Delta risks, policy uncertainty and elevated valuations.