Just as investors were coming to terms with the threat of relentless inflation, Russia’s invasion threw a wrench into an already difficult investing environment. For us, the most salient question at this juncture is whether global central banks will succeed in engineering a soft landing by simultaneously fighting inflation and mitigating the negative consequences of war. Given the immense difficulty in achieving such a feat—as depicted by the simple matrix in Figure 1—we think the market volatility is far from over.
Key to our thinking is the realization that the threats of inflation and Russia’s assault on Ukraine together exacerbate, rather than offset, their impact on many asset classes, such as corporate bonds and commodities. In the weeks and months leading up to Russia’s surprise invasion, the prospect of rising inflation and continued supply chain constraints already forced central bankers to change policy course abruptly, leading to mounting losses in fixed income and triggering concerns that aggressive tightening will result in central bank policy errors. Furthermore, beneath the uncertainty of war and a generational surge in prices, our unease is underpinned by the near certainty that U.S. economic growth will slow this year due to drastically reduced monetary and fiscal support, removing another factor that supported asset valuations during the pandemic.
Our Geopolitical/Central Bank Matrix
PGIM Fixed Income
The interplay between inflation and escalating conflict will likely extend the current risk-off tone in the market, a departure from the past when military conflicts created dip-buying opportunities. Stuck between Scylla and Charybdis, we think the priority for the Fed and other central banks is taming inflation, and officials will have no choice but to stick with their current hawkish trajectories even if conflict in eastern Europe further drives up prices of goods and commodities while simultaneously pushing down economic growth. We think it is a low probability that central banks can succeed in pulling off a soft landing, and all of this raises the spectre of stagflation in the U.S., a scenario that we previously thought was overblown but seems increasingly tangible at this point.
While the market weakness is, to us, far from over, we are largely maintaining our positions in emerging market fixed income, specifically Russia and Ukraine. Even though many investors have become forced sellers of these nations’ assets in recent weeks, we have maintained our overweight in Ukrainian sovereign bonds as we don’t see a high risk of default given its ample FX reserves, and our mostly short-duration position has experienced limited price impact so far. The Ukrainian economy is also much stronger and its financial needs are much more manageable than during the Crimea crisis in 2014. We have also maintained our neutral position in Russia as we think the macro fundamentals remain solid, and even though sanctions will continue to escalate, U.S. investors will likely be allowed to continue trading Russian securities and receive payments from Russia even if the West imposes further sanctions and cuts off Russian access to SWIFT, the international payment network.
Looking beyond emerging markets, the selloff in developed market assets has also been sizable. That said, we have yet to see the bottom in certain markets, such as U.S. high-yield bonds, as valuations are still rich by historical standards. But relative-value relationships are increasingly dislocated, and we see ample alpha-generating opportunities ahead. One opportunity we are watching closely is in European high yield, particularly in B-rated companies (Figure 2), which has sold off disproportionately versus its U.S. peers in recent months even with a superior growth outlook and more generous policy support.
The Gap Between European and U.S. “B” Spreads Reach Historically Wide Levels
PGIM Fixed Income and Bloomberg
While the scale of conflict that transpired this week was nearly unpredictable just a few months ago, we now find ourselves being increasingly cautious on the outlook for risky assets given the challenging economic reality we just laid out. While waiting for the maelstrom of Scylla and Charybdis to clear, we see some compelling relative-value opportunities ahead.