Positive Catalysts Create Relative Value in Fixed Income
PGIM Fixed Income’s senior portfolio manager, Michael Collins, CFA, explains why bond ballast comes back and how to prepare for evolving conditions.
Greater Clarity on Fed Policy Improves Bond Market Outlook
Dec 8, 2022
PGIM Fixed Income’s co-chief investment officer, Greg Peters, shares his interest rate outlook and resulting implications for bond markets in 2023.
TRENDING TOWARDS RECESSION
Recent deceleration in U.S. inflation levels notably changed expectations for economic outcomes related to monetary policy. While inflation moderation supports markets, we do not believe that the full economic impact of the Federal Reserve’s tightening efforts is sufficiently priced in. Stagflation expectations are falling, with markets pricing in a shift toward the kind of moderation associated with a soft landing. Our market implied-probabilities framework suggests investors believe that the probability of a soft landing is close to 75%. Still, recession remains our base-case scenario.
NEARING A TURNING POINT FOR THE FED
We expect a peak in the Fed’s short-term interest rate hikes in early 2023, possibly even January. After that, we believe the Fed will pause a few months and wait for data to show whether the aggressive tightening has worked. If we get supporting data confirming economic contraction with higher unemployment, lower inflation and core PCE trending closer to 3.5%, we think the Fed will pivot sharply with precautionary rate cuts in the second half of the year to save the economy from falling into a deep recession. This would be a boon for bond markets after a brutal year with negative returns.
RATES REVERT TO LOWER LEVELS OVER THE LONG HAUL
While the current environment has been tough, we may be on the cusp of a new long-term bond bull market. The economic backdrop seems destined to return to a configuration more like pre-COVID conditions. Secular factors, such as an aging demographic and high debt burdens, are likely to drive a return to moderate growth and inflation, which should contribute to a lower interest rate environment—albeit with some variation in the Eurozone market.
Given today’s higher yields and potential for future capital appreciation as rates decline, now may be an attractive entry point for long-term investors.
GREGORY PETERS
Co-Chief Investment Officer of PGIM Fixed Income
RELATED INSIGHTS
The Macro Picture and Market Implications
Daleep Singh, Chief Global Economist at PGIM Fixed Income, looks forward to the Fed reversing course on interest rates as part of his global economic outlook.
2023 Investment Themes
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.
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