Will Elevated Inflation and Supply-Chain Disruptions Derail Global Growth?
On the October 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, supply-chain bottlenecks and the prospects for global financial markets.
The global economy remains fundamentally solid, and the Covid-Delta fears are easing, but supply-chain disruptions have now emerged as a disruptor of economic momentum. Global growth slowed in Q3 due to the impact of the lockdowns to contain the COVID-19 Delta variant, the downshift in China’s growth due to supply chain pressures and the troubles at the country’s largest property developer, Evergrande. While the September purchasing managers indexes point to stabilization in business confidence, there are still concerns that global manufacturing continues to be impacted by widespread supply-chain issues. However, underlying fundamentals for the global economy remain solid with the October PGIM CIO Call participants highlighting healthy consumer income and savings, the need for inventory restocking, and increased business capex spending. On the virus front, the slowdown in new cases has been broad-based in both developed and emerging markets, while the pace of vaccinations has also steadily increased.
Less positively, inflation expectations remain elevated as a result of rising energy and commodity prices, and bottlenecks in the global supply chain. The participants acknowledged that the inflation unwind will likely be gradual with supply-chain repair taking longer and with the ongoing normalization of housing and other services prices. Central banks, acknowledging the persistence in inflation, have started laying the ground work to reduce monetary accommodation, perhaps faster than earlier expected. While developed central banks generally view this year’s inflation spike as transitory and are likely to proceed relatively gradually in policy normalization, some of the emerging central banks have had to start hiking or adopt a more hawkish stance. Overall, the backdrop remains supportive of risky assets with the economic recovery on track, profit growth remaining strong, developed market central banks maintaining accommodative monetary policy, and COVID-Delta risks easing. While the general consensus among the call participants was that the backdrop remains supportive for risky assets, a confluence of negatives is likely to keep markets volatile in the near term.
Economic Outlook—Global Economy Hits Soft Patch with Delta and Supply Disruptions
The global recovery appears to have hit a soft patch in Q3 with a slowdown in the US and China due to the spread of the COVID-19 Delta variant globally, supply-chain disruptions and risks from the Chinese real estate sector with the Evergrande debt crisis. The JP Morgan global GDP Nowcast is now tracking around a 3.9% annualized pace for Q3, down from around 4.3% a month back. The pace of vaccination is picking up, especially in Asia and Australia, keeping the recovery going. However, global manufacturing has been impacted by persistent supply-chain disruptions. Still, global capex spending remains strong and is expected to boost growth looking ahead.
US GDP growth should see a slowdown in Q3 from the 6.7% annualized pace in Q2. The Atlanta Fed’s GDPNow tracker is currently estimating 2.3% GDP growth in Q3. Retail sales rose 0.7% month over month in August slowing from -1.8%, signaling the cooling of consumer spending. Vehicle sales were disappointing in September as chip shortages hit automakers. The Q3 slowdown is unlikely to be the start of a growth downtrend, and the economy is on track to rebound in Q4 as consumer fundamentals remain solid. Ellen Gaske, a senior economist at PGIM Fixed Income, points out that wage and salary income have risen at a robust pace, while households also have a huge stock of savings and wealth to support their spending over the coming year. Further, business investment, including equipment and software, is also solid, and inventory rebuilding has become a key source of growth as businesses restock depleted shelves. Housing activity remains robust and is underpinned by strong fundamentals and demographics.
Eurozone GDP growth is expected to strengthen to a double-digit pace in Q3, after rising around 9% in Q2. European COVID-19 vaccination rates have increased significantly, which has helped contain the spread of the Delta variant in Europe. The latest hard economic data from the end of Q2 was positive, particularly for Eurozone consumers. However, confidence indicators have pulled back modestly recently. Supply- chain bottlenecks have hit European manufacturers, especially German automakers, which could dent growth. Japanese GDP rose more than expected in Q2, up 1.3% annualized. The recovery in Japan continues, but Q3 growth is likely to be sluggish. Expectations are for production to remain weak with supply-chain disruptions persisting. With the exception of autos, sales were down across the board, due to the impact of the widely expanded state of emergency in multiple regions. However, many large retail facilities, such as department stores, were not forced to suspend business.
In China, the economy is moderating in the second half of 2021 from the strong pace in the first half. The property market slowdown dragged down growth in Q3 as highlighted by the issues at Evergrande and its linkages to the economy. Supply-chain disruptions, such as power outages, and rationing, are likely to continue into Q4. The economy is expected to post around 5% growth in the second half of 2021 with a sharp slowdown in Q3 and a recovery in Q4.
The Brazilian economy was likely dragged down by weakness in industrial production driven by persistent supply disruptions. In Russia, recent activity data showed a loss of momentum in Q3 with industrial production slowing due largely to a plunge in auto. The Indian economy appears clearly on a mend, given the significant pace of vaccinations, lower infection rates, no third wave and better management of the economy through the second wave shutdown. GDP growth is expected around 8% in the second half of 2021.
Inflation Price Pressures Remain Stubbornly Elevated
Global inflation continues to pick up in Q3 with headline inflation averaging around 3.5% after 3% in Q2 and 1.5% in Q1. Inflation expectations are rising as a result of the recent rise in global energy prices linked to supply constraints across many commodity sectors, China’s de-carbonization policies and disruption in Europe’s natural gas supply. Global inflation remains underpinned by a surge in goods demand accompanied by disruptions in supply chains and labor markets related to COVID-19. While goods demand is now normalizing, and COVID-19 drags are waning, consumer fundamentals remain strong with pent-up consumer demand, and accommodative fiscal and monetary policies pointing to above-potential global growth absorbing excess slack in the economy.
US inflation eased to 5.3% year over year in August after 5.4% in July with the price pressures from earlier in the year easing. Core inflation fell further to 4% from 4.3% previously. Eurozone inflation rose to 3.4% year over year in September from 3% in August. Core inflation increased to 1.9% from 1.6%. In Japan, nationwide inflation edged down to -0.4% year over year in August from -0.3% in July. Nationwide inflation, ex fresh food and energy, edged up to -0.5% from -0.6%. Tokyo core inflation was unchanged at -0.1% in September.
Emerging Markets inflation continues to be pressured higher by soaring food and energy prices. In Brazil, inflation remains in double-digits, at 10% year over year, while core inflation came in at 6.5%. Russian inflation accelerated to 6.7%, its sharpest rise since August 2016 and well above the central bank’s target of 4%. Inflation in India eased to 5.3% in August from a peak of 6.3% in May driven partly by base effects, but rising global oil and commodity prices are likely to keep inflation under pressure. Chinese inflation remains well contained, coming in at 0.8% in August.
Policy Backdrop—Central Banks Prepare to Remove Punch Bowl
The US debt ceiling drama and debate about the infrastructure and reconciliation bills add fiscal uncertainty in the near-term. Global central banks are setting the stage to dial back stimulus, while emphasizing that policy will still remain accommodative. Central banks generally view the inflation spike as transitory, but their response to persistent inflation overshoots has varied. Developed central banks have largely maintained their accommodative policies even as Norway became the first developed central bank to hike since the pandemic began. The Fed adjusted its forward guidance at its September meeting, announcing that it will consider slowing its asset purchases in the future. The Fed is expected to announce tapering in November and begin shortly thereafter but is leaving itself lots of optionality. If inflation pressures persist, they may hike later next year, though our base case assumes they wait until 2023.
The European Central Bank met in early September and announced it would conduct asset purchases at a “moderately lower pace” in the future compared to the prior six months. It is likely to purchase around 60-70 billion euros in debt a month through the end of the year, down from the faster 80-billion monthly pace they had set in March. During the press conference, ECB President Lagarde stressed that this is in response to improved economic conditions. The ECB otherwise left the size of its asset purchase program and policy rates unchanged. The Bank of Japan left policy unchanged at its September meeting, as expected, with the policy rate at -0.1% and the 10-year Japanese Government Bonds target at about 0%. The BoJ will begin a green financing operation in December.
The Bottom Line
The October CIO Call participants discussed the confluence of negatives that interrupted the relentless rise in stock markets, including the growth slowdown in the US and China and extensive supply-chain disruptions that have dented growth while adding to inflationary pressures. In addition, they discussed the increased policy uncertainty with the US debt ceiling debate, revised expectations for a tighter policy backdrop in 2022 and rising bond yields. Finally, they noted that fears of contagion from the potential collapse of China’s largest property developer, Evergrande, is casting a shadow on markets.
While there was general agreement that the global economy remains fundamentally solid and that Covid-Delta fears are easing, supply-chain bottlenecks have now emerged as a disruptor of economic momentum. In addition, the participants noted that inflation remains stubbornly elevated with no end in sight. Central banks, acknowledging the persistence of inflation, have started laying the ground work to reduce monetary accommodation, perhaps faster than earlier expected. Finally, the US debt ceiling drama and fears of the destabilizing impact of Evergrande’s potential collapse on the Chinese economy and market are other near-term risks that are fueling market anxiety. While the general consensus among the call participants was that a bear market is unlikely, the confluence of negatives is likely to keep markets volatile, which warrants caution.
All data is from the Global Multi-Asset Solutions group at PGIM Quantitative Solutions unless otherwise noted.
