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.
Credit Markets Favor Alpha Over Beta
PGIM Fixed Income discusses reasons for its near-term caution but long-term optimism and where to find relative value opportunities for different economic scenarios.
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.
CREDIT FUNDAMENTALS RETURN TO PRE-PANDEMIC LEVELS
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.
Source: JPMorgan and BofA Merrill Lynch Global Research as of 4/30/2022.
Source: Bloomberg, Morningstar as of 5/31/2022. Past performance does not guarantee future results.
BETTER RETURNS TO FOLLOW HIGHER INCOME
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.
The current backdrop may render beta an ineffective generator of returns, reinforcing the need for an expanded focus on bottom-up research and relative-value positioning as a reliable way to alpha.
INVESTING FOR DIFFERENT ECONOMIC SCENARIOS
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.
Scenario |
Strategy |
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Stagflation Fed raises faster to “catch up,” but economy absorbs higher rates
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Lower duration to reduce interest rate risk via:
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Soft Landing Fed engineers soft landing with positive growth and lower inflation
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Increase credit risk for better return potential via:
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Recession Fed gets overly aggressive and tips economy into recession
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Reduce credit risk and focus on high-quality and duration-centric positioning via:
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EXPLORE MORE THEMES
Outlook Improves for Growth Stocks
Jennison Associates explains why growth stocks are likely to regain investor favor and how lower valuations may present an attractive entry point for investors.
Real Assets Outshine if Inflation Persists
PGIM Quantitative Solutions explains why inflation may linger longer this time and how adding real assets to portfolios can help mitigate inflation risks.
Real Estate Poised to Perform Going Forward
PGIM Real Estate discusses how real estate is well-prepared for what comes next and can help investors mitigate both inflation and interest rate risks.
Inflation and Demand Tailwinds Buoy Midstream Energy
Jennison Associates explains short-and long-term tailwinds that should continue to support the midstream energy sector, such as surging demand for natural gas.
Agile Alternatives Diversify Amid Macro Uncertainty
PGIM Wadhwani explains why portable alpha approaches with low correlations to stocks and bonds are well suited to today’s challenging investment landscape.
Volatility Boosts Tax Loss Harvesting Potential
PGIM Custom Harvest discusses how tax loss harvesting strategies can help investors turn volatility into opportunities to increase after-tax return potential.
The Great Balancing Act
PGIM asset managers assess key trends shaping the investment landscape and where to find opportunities for different economic scenarios.
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.
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