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A Bumpy Road to a Familiar Low-growth DestinationABumpyRoadtoaFamiliarLow-growthDestination

PGIM Fixed Income explains why it expects to see secular factors overtake cyclical trends as already-building headwinds slow the global economy.

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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.
Gregory PetersCo-Chief Investment OfficerPGIM Fixed Income

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.

 

The views expressed herein are those of investment professionals at PGIM Fixed Income 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. PGIM Custom Harvest does not provide tax, legal, or accounting advice. This material is for information purposes only, and is not intended to provide, and should not be relied on for tax, legal, or accounting advice. You should consult your own tax, legal, and accounting advisors before engaging in any transaction.

 

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.

 

Prudential Investment Management Services LLC is a Prudential Financial company and FINRA member firm. Jennison Associates, PGIM Custom Harvest, and PGIM, Inc. (PGIM) are registered investment advisors and Prudential Financial companies. PGIM Quantitative Solutions is the primary business name of PGIM Quantitative Solutions LLC, a wholly owned subsidiary of PGIM. PGIM Fixed Income and PGIM Real Estate are units of PGIM. © 2023 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.

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