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.
Bond markets have endured one of their worst starts to a year in history. But after this sizeable decline, markets may be bottoming out and could be set up for a major rally in the coming year—particularly if rates crest and the Fed appears likely to rein in inflation. While it’s far too early to embrace this notion, we do expect volatility to drop over the short-to-intermediate term, providing a respite for bond yields and spreads over the next quarter or two. But the surprises we’ve seen over the last few months raise the risk of relying on market beta for returns. We’ll need to continually reassess the balance of geopolitics, growth, inflation, and policy risks. After the first-half volatility, valuations have improved with credit spreads back near pre-pandemic levels. Caution is still warranted over the near term with respect to interest-rate and credit risk, especially as recession risks rise.
Corporations have regained strength. Leverage ratios have declined, interest coverage has increased, profit margins remain strong, and share buybacks and dividends are rising. As such, credit quality has improved rapidly but appears to be approaching a peak, and strong improvement in credit fundamentals will likely moderate going forward.
Upgrades have sharply outnumbered downgrades, bolstering many rising stars (bonds moving to an investment-grade rating from below-investment-grade). This financial strength should enable corporations to better weather what comes next for the economy.
Higher interest rates have increased the income return to bond investors. Yield-to-worst (YTW) on the Bloomberg U.S. Aggregate Bond Index has increased ~2.4% since its pandemic low. As YTW has historically been a good proxy for future return potential, we expect better fixed income returns going forward.
Investors may benefit by positioning portfolios based on their expected outcome from Fed policy. Our base case for now remains a soft landing with notable fat-tail risks for stagflation and recession as downside risks remain elevated.
Fed raises faster to “catch up,” but economy absorbs higher
Lower duration to reduce interest rate risk via:
Fed engineers soft landing with positive growth and lower
Increase credit risk for better return potential via:
Fed gets overly aggressive and tips economy into recession
Reduce credit risk and focus on high-quality and duration-centric positioning via:
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.
© 2024 Prudential Financial, Inc. and its related entities. PGIM Custom Harvest, 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.
For compliance use only 1062796-00001-00