A Bumpy Road to a Familiar Low-growth Destination
PGIM Fixed Income explains why it expects to see secular factors overtake cyclical trends as already-building headwinds slow the global economy.
Global markets started 2022 in a risk-off mood as high inflation persisted and various central banks turned increasingly hawkish. The fog of war in Ukraine continues to grip markets, adding a stagflationary shock to the mix. Globally, stocks, bonds, and real estate markets have all declined year to date, while commodity markets surged amid soaring crude oil and natural gas prices.
What happens next is very unsettling, because it’s been a long time since central banks have been this far behind the curve. It’s very difficult to achieve an economic soft landing at this stage, meaning the risk of recession is high. Today’s macroeconomic scenario mirrors that of the late 1970s and early 1980s. Inflation has remained higher and more persistent than central banks expected, compounded by geopolitical events. It’s clear that inflation expectations have become de-anchored and that central banks are behind the curve. In this situation, they may need to tighten aggressively and are signaling they will.
Central banks have few policy options as they can’t allow inflation expectations to be permanently de-anchored. This is starkly different from the economic landscape of the last 20 years when inflation was persistently low. Virtually every time financial conditions tightened and equity markets fell during that period, central bankers rode to the rescue. Today we’re faced with a situation where bond yields are rising because inflation is high and central banks are tightening, while equity markets are threatened by both higher interest rates and the prospect of a recession. This is a challenging environment for portfolios consisting of 60% stocks and 40% bonds, just as it was in the 1970s.
It’s rare for stocks and bonds to decline together, so the correlated fall of major asset classes this year poses a conundrum for the traditional 60/40 portfolio model. In this uncertain environment, the need for diversification is palpable. Portable alpha approaches are very well suited to today’s challenging investment landscape because of their low correlation to equities and bonds and their ability to generate returns in the neighborhood of cash plus 4%. So, the diversifying role these approaches can play in portfolios is to mitigate equity risk.
Given the wide variety of potential economic outcomes, it is especially important to remain agile and responsive to the evolving economic data. It is also necessary to remain diversified across asset classes, investment styles, and time frames, and to choose solutions with a low beta to traditional markets over a full market cycle. Agile strategies should deliver low average holding periods across positions and emphasize capital preservation. It’s also essential to consider taking both long and short positions in volatile, quickly changing market environments. Investors need to be more dynamic with their investment allocations and prepare their portfolios for the inflation scenario most likely to prevail. Including a global macro approach can be an attractive way for investors to gain both a wide investment universe and agility. Global macro has delivered strong absolute returns and relative returns versus stocks, bonds, and real estate this year, making it an attractive portfolio diversifier and alternate return source through rising rates and inflation.
*Global macro represented by Societe Generale Macro Trading Quant Index, Bonds represented by Bloomberg Global Aggregate Index, 60/40 represented by 60% S&P 500 and 40% Bloomberg U.S. Aggregate Bond Index, real estate represented by FTSE EPRA NAREIT Global Index, stocks represented by MSCI All Country World Index.
Risks—Investing involves risks. Some investments are riskier than others. The investment return and principal value will fluctuate, and shares, when sold, may be worth more or less than the original cost. Fixed income investments are subject to interest rate risk, and their value will decline as interest rates rise. Foreign investments may be volatile and involve additional expenses and special risks, including currency fluctuations, foreign taxes, and political and economic uncertainties. Investing in emerging markets is very risky due to the additional political, economic, and currency risks associated with these underdeveloped geographic areas. Investments in growth stocks may be especially volatile. Value investing involves the risk that undervalued securities may not appreciate as anticipated. It may take a substantial period of time to realize a gain on an investment in a small or midsized company, if any gain is realized at all. Real estate investment trusts (REITs) may not be suitable for all investors. There is no guarantee a REIT will pay distributions given the inherent risks associated with the market. A REIT may fail to qualify as a REIT as defined in the Tax Code, which could affect operations and negatively impact the ability to make distributions. There is no guarantee a REIT’s investment objectives will be achieved. Diversification and asset allocation do not guarantee profit or protect against loss. Investments in in Master Limited Partnerships (MLP) and MLP-related investments are subject to complicated and in some cases unsettled accounting, tax, and valuation issues, as well as risks related to limited control and limited rights to vote, potential conflicts of interest, cash flow, dilution, and limited liquidity and risks related to the general partner’s right to force sales at undesirable times or prices. MLPs are also subject to risks relating to their complex tax structure, including losing its tax status as a partnership, resulting in a reduction in the value of the MLP investment. Many MLP investments are in the energy sector and subject to a greater degree to risk of loss as a result of adverse economic, business, regulatory, environmental, or other developments affecting industries within that sector than investments more diversified across different industries. Diversification and asset allocation do not guarantee profit or protect against loss.
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