An Opportune Time for Active Fixed Income
The paradox of the unprecedented volatility in the bond markets is the tremendous opportunities being created for selective fixed income sectors.
Rate Reset May Fuel A New Bond Bull Market
Jun 15, 2023
PGIM Fixed Income Co-Chief Investment Officer Greg Peters shares his outlook for why he believes we’re in the early innings of a new bond bull market.
THE ONSET OF “WEAKFLATION”
Aggressive central bank rate hikes and the resulting bond bear market in 2022 were extremely painful for investors. With 2023’s banking crisis adding to a backdrop already at risk from the hikes, economies must now cope with the frictions and long tail of the crisis. We see a material slowdown in GDP growth in major western economies. In light of the recent shocks and the Fed's constrained ability to contain a broader crisis, our base case calls for "weakflation," i.e., weak growth and inflation of more than 2%, but falling. We've also significantly reduced the odds of a recession given the ongoing strength in the labor market. Consistent with these adjustments, the shock has reduced the likelihood of a soft landing (moderate growth and inflation) or a roaring 2020s scenario (high growth and low inflation). Our base case for the Eurozone also calls for a weakflation scenario. By contrast, China’s growth should reaccelerate this year.
CURRENT CONDITIONS MAY FORCE A FED PAUSE
Before the banking crisis, reducing inflation was the top priority of central bankers. Now they may be more balanced in their efforts to tamp down inflation given their newfound appreciation for unforeseen risks.
While moderating inflation also gives central banks some breathing space, diverging economic data are leading to diverging expectations for central bank rates. The Fed has a better chance of downshifting compared to the ECB and has already signaled a rate-hike pause. The key question is when and for how long. Inverted yield curves are indicating recessions in 2023. With the already-brewing credit crunch likely to contract the U.S. economy in the second half of the year, we expect the Fed to deliver one more hike before sitting on the sidelines for the rest of the year.
Despite the difficult path markets have taken, there are periods when negative developments can be market positive. For instance, there has historically been a narrow window between a Fed tightening cycle ending and an easing cycle beginning, with nine months as the average time between the two based on the past four rate hike cycles. The 12 months after rate hike cycles ended have been beneficial to fixed income investors, broadly speaking.
SECULAR TRENDS SIGNAL LONG-TERM MOVE BACK TO LOWER RATES
The current macroeconomic backdrop likely will revert to pre-COVID-19 conditions over the longer term. Secular factors—such as aging global demographics, high debt levels and deleveraging, and mounting geopolitical competition—are likely to lead us back to subdued growth, moderate inflation, and lower central bank policy rates.
We are firm believers that the game is still on for bonds and that we are in the early innings of a new bond bull market.
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Gregory Peters
Co-Chief Investment Officer, PGIM Fixed Income
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