Inflation: How We Got Here And Where We’re Going
PGIM Quantitative Solutions discusses the historical background of past inflation episodes, why inflation is high now, and what the path forward could be.
PGIM Quantitative Solutions 4Q21 Outlook: Stay the Course for Now
Oct 14, 2021
PGIM Quantitative Solutions’ 4Q 2021 Outlook explains why despite a few speed bumps, moderate pro-risk positioning remains supported by a robust global recovery.
2021 has generally been a “risk-on” year with developed market equities delivering strong performance that has beaten the returns on global bonds by a large margin. With a strong US recovery—in both the economy and corporate earnings—low policy rates, and ongoing asset purchases by the Federal Reserve, US equities have been particularly strong performers with both US REITs and broader US equities leading among the major market indices.
Commodity Strength Should Persist
Commodities have also exhibited strong performance due to the strength of the global economic rebound from COVID-19, continued supply chain bottlenecks, and tight capacity stemming from a decade of minimal investment given last decade’s commodity price bust, environmental regulations, and the influence of ESG investing. Commodity performance has also been bolstered by the rising trend in global inflation, given the assets’ historical record as an effective hedge against unexpected inflation. We think the strength in commodities prices should persist looking forward, and we remain overweight the segment in our multi-asset portfolios.
Rising China Risks
In contrast, Chinese equities have been significant underperformers, with much of the damage happening in the latest quarter, due to the Chinese government’s unprecedented regulatory crackdown on a range of sectors, including big tech, data security, and after-school education. In addition, there have been several policy interventions addressing social matters, including climate change, property prices, and health care. The speed and breadth of these changes have created uncertainty among investors, leading some to question whether Chinese stocks are still investable. Given that Chinese stocks have the largest weight—about 40%—in the MSCI Emerging Markets Index, they have been the most significant contributor to this year’s underperformance of emerging market stocks relative to developed market equities.
The latest China-related risk to unsettle markets is a looming default by the massive and overly leveraged real estate developer, Evergrande Group. This situation was exacerbated by the Chinese government’s tightening of restrictions on leverage in the property sector. While some have warned that this could represent a “Lehman moment” for China, most observers have dismissed the analogy, noting Evergrande’s less central position in the global financial system compared to Lehman, and the expectation that the Chinese government will take proper steps to prevent the property giant’s crisis from destabilizing the wider financial system and economy. Whether or not this situation escalates into a bigger problem for financial markets is still unknown. At a minimum, however, any default could be a deflationary shock resulting in a hit to economic growth, motivating a pivot toward policy easing in China, which is already underway, even if wider financial market contagion is avoided.
Reasons to Buy the Dip
Until the most recent turbulence sparked by China risks, U.S. and global stocks had been experiencing a relentless rise on low average volatility and only very limited drawdowns so far this year. Could a credit event like an Evergrande default spark an overdue correction in global stock markets? With a near doubling in U.S. and global stocks since the 2020 COVID-19 low and the elevated level of stock market valuations, this remains a distinct possibility. However, should stocks experience a notable drawdown linked to this event, we think this would be a buy the dip scenario given the underlying strength in the economic and earnings recovery and the low odds of an economic recession.
The strong economic rebound from the COVID-19 recession has sparked an impressive rebound in corporate profits. U.S. companies are expected to grow earnings by 46% this year while Eurozone, U.K., Japanese, and emerging market firms are expected to deliver calendar-year 2021 earnings growth of 60%, 77%, 29%, and 64%, respectively, according to MSCI.1 Rapid earnings growth has led to a moderation in elevated valuation ratios despite continued gains in global stocks. All major regions have seen P/E ratios fall from 2020’s end. U.S. and European stocks still trade at a notable premium to their 10-year average forward multiple, while emerging market and Japanese stocks sport valuation multiples more in line with their historic averages. U.K. stocks, in contrast, trade at a discount to their historic average due in part to the uncertainty related to Brexit.
We’re overweight stocks, commodities, and real estate relative to fixed income and cash as economic growth is likely to reaccelerate into year-end and global monetary policy conditions stay accommodative.
Stick to Moderate Pro-risk Positioning
With economic growth likely to reaccelerate into year-end as the economic impact of the Delta variant recedes and global monetary policy conditions stay accommodative, we are sticking with a moderate pro-risk investment strategy: Overweight stocks, commodities, and real estate relative to fixed income and cash. The recent rise in inflation is unlikely to provoke a significant policy shift at this stage. While the Fed is on track to taper its asset purchases later this year, the policy rate should stay near zero well into 2022. Monetary policy will likely stay accommodative as the Fed is willing to tolerate inflation overshoot in pursuit of its maximum employment goal.
Bond yields should rise back toward the levels seen earlier in the year as Delta variant risks peak and decline. However, rates should stay historically low, at least for now, anchored by structural trends and central bank policy. Stock markets exhibit high, though improving, valuation ratios but macro conditions, corporate performance, and low interest rates continue to support solid performance. Value, cyclical, and small cap-stocks have faced a setback in recent months but remain attractively valued. These segments could see renewed outperformance as economic growth stays strong and risks from the Delta variant fade.
You May Also Like
Short-duration high yield can mitigate rate, credit, and equity risks
Short-duration HY bonds can help mitigate interest and credit risk while providing strong, less volatile, return potential than equities and broad HY bonds.
Stronger returns likely to follow recent high yield bond declines
The recent high yield bond selloff may present an attractive buying opportunity and be a potential prelude to stronger returns in the 12 months to come.
1 Source: FactSet as of 8/31/2021.
The views expressed herein are those of PGIM Quantitative Solutions at the time the comments were made and may not be reflective of their current opinions and are subject to change without notice. This commentary is not intended as an offer or solicitation with respect to the purchase or sale of any security or other financial instrument or any investment management services. This commentary does not constitute investment advice and should not be used as the basis for any investment decision. This commentary does not purport to provide any legal, tax, or accounting advice. PGIM Investments LLC is a registered investment advisor with the U.S. Securities and Exchange Commission.
Certain information in this commentary has been obtained from sources believed to be reliable as of the date presented; however, we cannot guarantee the accuracy of such information, assure its completeness, or warrant such information will not be changed. The information contained herein is current as of the date of issuance (or such earlier date as referenced herein) and is subject to change without notice. The manager has no obligation to update any or all such information, nor do we make any express or implied warranties or representations as to the completeness or accuracy. Any projections or forecasts presented herein are subject to change without notice. Actual data will vary and may not be reflected here. Projections and forecasts are subject to high levels of uncertainty. Accordingly, any projections or forecasts should be viewed as merely representative of a broad range of possible outcomes. Projections or forecasts are estimated, based on assumptions, subject to significant revision, and may change materially as economic and market conditions change.
This material is being provided for informational or educational purposes only and does not take into account the investment objectives or financial situation of any client or prospective clients. The information is not intended as investment advice and is not a recommendation. Clients seeking information regarding their particular investment needs should contact their financial professional.
PGIM Quantitative Solutions, Jennison Associates, and PGIM are registered investment advisors and Prudential Financial companies. PGIM Quantitative Solutions is the primary business name of PGIM Quantitative Solutions LLC (PGIM Quantitative Solutions), a wholly owned subsidiary of PGIM. PGIM Fixed Income and PGIM Real Estate are units of PGIM. © 2021 Prudential Financial, Inc. and its related entities. Jennison Associates, Jennison, PGIM Real Estate, PGIM, and the PGIM logo are service marks of Prudential Financial, Inc. and its related entities, registered in many jurisdictions worldwide.
1053343-00001-00 Ed: 10/2021