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.
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.
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.
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.
Co-Chief Investment Officer of PGIM Fixed Income
PGIM asset managers assess key trends shaping the investment landscape and where to find opportunities for different economic scenarios.
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