US, China and Global Markets: Investing Amid De-Risking and Divergence
The global economy has followed a seemingly unpredictable path. US growth accelerated in the third quarter—more than doubling its pace from the previous three months—despite elevated inflation and aggressive rate hikes by the Federal Reserve. China, which has long served as a catalyst for global growth, has struggled with a tepid recovery. In Europe, economic activity has weakened amid the region’s own battle with inflation. Geopolitical turmoil also threatens to curb growth around the world. To help investors capture returns and manage risk in this environment, PGIM gathered a panel of experts from its affiliates to discuss the state of the economy, the impact of higher rates across regions, and emerging opportunities in the technology sector. The following is a summary of the discussion.
- US and China divergence: The third-quarter GDP report confirmed that US growth was strong, driven by resilient consumer spending. Robust jobs growth and fiscal policy have also supported the US economy. However, a slump in activity may be on the horizon due to the lagging impact of higher rates. Tightening credit conditions make a case for downside risk, and surveys from the Fed show that banks are already imposing tougher lending standards. Although predictions for a recession have proven to be premature, the possibility of a downturn remains. If a recession does materialize, there are reasons to believe that it will be a shallow downturn, not a hard landing. The weaker corners of the economy are more likely to impact smaller banks rather than systemic banks, and economic indicators such as the labor market, consumption, earnings growth and business investment have been resilient against rate hikes. Meanwhile, China’s lackluster recovery has come amid a weak property market, demographic-related headwinds and trade tensions with the US. However, recent earnings growth upgrades have put China in line with expectations in the US, but with a much better valuations starting point. China and the US are following divergent economic and policy paths, as both economies seek technological superiority in key sectors like semiconductors and EVs.
- Globalization and the EM outlook: Near-shoring and re-shoring efforts, particularly in the US and Europe, likely mark the beginning of a new era for globalization, which will have broad implications for emerging markets. There is a path for EMs to grow even as globalization reorients. Policies designed to build greater supply-chain diversification present an opportunity for EM countries, particularly those that are rich in natural resources. Some countries will also be attractive for investors because of favorable foreign investment trends. US growth has helped EMs perform well relative to expectations, yet there are challenges going forward related to higher interest rates and a strong dollar. Rate volatility, a strong dollar and FX pressure will limit the ability of EM central banks to cut rates. Geopolitical turmoil in the Middle East may also add to inflationary pressures, further complicating the rate-cutting cycle. However, a diversified set of opportunities across the EM debt landscape will emerge once the Fed signals a more dovish stance. There will also be opportunities for EMs to restructure their debt.
- Investment strategies: Diversification continues to be an essential portfolio strategy to help investors navigate the current macro environment. Investors should spread exposures to different return drivers, looking across asset classes, regions, sectors and styles. The traditional 60-40 portfolio has had a difficult run, but valuations today offer a better starting point. Investors should also think about market expertise when managing their portfolio. There will always be sectors, themes and business models that outperform in a volatile market. Experts and active managers can help investors uncover these opportunities, as flexibility and nimbleness will be rewarded in this type of uncertain investing environment. Exposure to opportunistic strategies, such as absolute return or systematic macro strategies, can help mitigate downside risks and add greater diversification to the portfolio. Even in a higher-for-longer environment, there are many segments in fixed income that have attractive return outlooks following a rise in yields. Across EM sectors in credit, local bonds and FX, there are strategies to take advantage of the disperse valuations and vulnerabilities given the diversity of credit quality and risk in EM debt. It is important to remember that EM is not monolithic, and given tail risks, portfolios can be structured to do well in a multitude of scenarios.
- EV opportunities: One sector giving rise to new investment opportunities is the electric-vehicle industry. EVs create new avenues for manufacturers to monetize their relationship with customers after the initial sale through charging, insurance and wireless connectivity, which allows for over-the-air updates and the purchase of additional software features. EV penetration remains low, particularly in the US market where competition is limited compared with China and Europe. China’s EV industry has seen an influx of new startups and a fight for market share. Capacity has increased faster than demand, which has created greater price competition. EV prices in the US have also declined, but this has been largely driven by higher consumer borrowing costs. Over the long term, it is expected that EVs will offer more value but at lower price points than internal combustion engines because they can be cheaper to build at scale.