Credit Markets Favor Alpha Over Beta
PGIM Fixed Income discusses reasons for its near-term caution but long-term optimism and where to find opportunities for different economic scenarios.
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.
We are moving through the business cycle at an aggressively compressed rate, with markets feeling more pronounced shocks along the way. The good news is that this could mean that we’ll come out on the other side faster. Of course, the unpredictable course of the Ukraine conflict, the global response, and the associated impacts on the world’s geopolitical order and financial system will continue to drive market dynamics in the near term.
As inflation has become more broad-based and remains stubbornly high, central banks have ramped up their hawkishness, with many investors anticipating a stagflation or recession scenario. In the U.S., the Fed appears to be behind the curve raising downside risks for the economy. Given that supply-chain disruptions are easing and markets expect long-term inflation expectations to come down, there is still opportunity for the Fed to engineer a soft landing by becoming more aggressive quickly. If inflation does not show signs of moderating as expected in the coming months, we think any “Volcker” moment of more aggressive Fed action would likely come late this year or early next year.
Speeding to Neutral
With the Fed confirming its goal to frontload rate hikes to get inflation under control, higher (50 basis points or more) rate hikes are likely in the second half of the year. The Fed is shrinking its balance sheet, letting U.S. Treasury and mortgage-backed securities roll off at a faster pace than during its previous quantitative tightening cycle in 2017-2019.
Source: Bloomberg as of 6/15/2022.
Source: PGIM Fixed Income as of June 2022.
Secular forces will overtake cyclical trends
Cyclical trends overwhelmed secular factors in the first half of 2022. In the coming months, we expect to see the prevailing effects of already-building headwinds, including tighter financial conditions, a fiscal rollback, high energy and food prices, lagging wages, and a slowing global economy. Interest-rate-sensitive sectors of the economy will likely respond in coming quarters to tighter financial conditions and companies’ dissipating pricing power as workers’ wages continue to lag. Real earnings, which spiked early in the pandemic, are now back down to their pre-COVID levels. We expect to see other economic gauges follow suit. Longer term, we expect secular forces to overpower cyclical trends.
While rates on the short end of the yield curve may remain volatile given the near-term uncertainty, it’s possible the long end of the curve may be nearing a peak as expected growth slows.
Inflation: As the impact of policy runs through the system, we expect inflation to recede from its four-decade high before falling toward more benign trend-like levels by the end of next year. Longer-term technology and labor-saving innovation/automation will act as deflationary forces.
Economic Growth: Aging demographics, high debt, and deficits will curb economic growth, forcing GDP growth back towards trend levels.
Interest Rates: While rates on the short-end of the yield curve may remain volatile given the near-term uncertainty, it’s possible the long-end of the curve may be nearing a peak as expected growth slows as well.
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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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