The latest global PMI measures remain at very high levels as the economic recovery continues. The sharp inflection upward in the European services sector shows the region is reaping the benefits of an accelerated vaccination campaign, while retracement in UK activities shows that the Delta variant remains a threat to the ongoing recovery. However, the U.S. picture may be more advanced—and less clear—as PMIs are levelling off, especially in the services sector. At this point, it's unclear whether the moderation reflects that the U.S. economy is continuing to work through temporary supply/demand imbalances or whether the peak of economic activity is already in the past.
The framework review also set out a roadmap to include climate change considerations in its monetary policy strategy. We see such initiative as a way to address the unintended consequences of market neutrality in the ECB's corporate-bond purchases considering that studies show that more than 60% of its holdings consist of carbon-intensive companies.Goldilocks Conditions Return for Secular Growth
Jennison Associates explains why they believe growth will regain market leadership and technology will lead the way forward.
PGIM Fixed Income Weekly View from the Desk
Jul 26, 2021
As Good as it Gets for GDP Growth?
Macro
The latest global PMI measures remain at very high levels as the economic recovery continues. The sharp inflection upward in the European services sector shows the region is reaping the benefits of an accelerated vaccination campaign, while retracement in UK activities shows that the Delta variant remains a threat to the ongoing recovery. However, the U.S. picture may be more advanced—and less clear—as PMIs are levelling off, especially in the services sector. At this point, it's unclear whether the moderation reflects that the U.S. economy is continuing to work through temporary supply/demand imbalances or whether the peak of economic activity is already in the past.- Indeed, our Q2 GDP estimate of 8.8% for the U.S. could be the high-water mark for the cycle. For example, if we hold the economic data at current levels through the end of Q3, it is possible to model quarter-over-quarter GDP growth of only 0.9%. Sell-side estimates place Q3 growth at 8.2%, but these forecasts have been gradually receding as well, and they currently indicate QoQ growth of 1.4% by Q4 2022. We see mounting downside risks to the consensus forecasts, which could potentially help explain the decline in yields we've seen of late.
- In Europe, the ECB held its first policy meeting following the completion of its framework review. One notable development was the update to the Committee's forward guidance, in which policy makers hardwired its tolerance for an inflation overshoot by linking guidance for interest-rate hikes to realized inflation data. While the change in forward guidance likely signals the ECB's willingness to stay accommodative for longer, European officials did not go as far as the Federal Reserve in implementing an average inflation targeting policy. We think their resistance stems from the fact that European inflation has been too low for too long, and imposing inflation targeting may effectively mean raising the ECB's 2% inflation target, which would have been unlikely to gain consensus among the governing council.
The framework review also set out a roadmap to include climate change considerations in its monetary policy strategy. We see such initiative as a way to address the unintended consequences of market neutrality in the ECB's corporate-bond purchases considering that studies show that more than 60% of its holdings consist of carbon-intensive companies.
Rates
- We do not expect any significant changes to the Fed’s policy stance at the FOMC meeting this week. The Fed's "transitory" narrative on inflation pressure will continue to come under sharp scrutiny, and we’ll continue to monitor for any signals regarding the timeframe for tapering asset purchases. Chair Powell may also be asked about the substantial bull flattening along the yield curve that occurred during the intermeeting period, which we partially attribute to the heavy positioning—and subsequent unwinding—of curve steepeners and rising-inflation trades in the rates market.
- As the dust from the rate rally settles, it's revealing to look at the new path of rate hikes as implied by short-term interest rates. The market continues to price in a first rate hike within 20 months, which has been largely unchanged since March. However, market pricing for subsequent hikes has been significantly reduced by around 50 bps since the beginning of July and now implies around two hikes a year for a terminal rate of 1.50%—as opposed to a terminal rate of more than 2.50% in March—once the Fed begins the rate hike cycle.
- The Treasury market has also been attentive to near-term supply dynamics, as many analysts have indicated the possibility of a reduction in issuance over the coming months. Most agree that the budget deficit will improve on the back of strong tax revenues and slowing fiscal stimulus spending and that the Treasury will mostly likely reduce issuance in the seven- and 20-year sectors. We think curtailing those tenors make sense since the two maturity points have been persistently undervalued compared to the rest of the curve, hence leading to a higher issuance cost for the Treasury.
- Mortgage-backed securities outperformed Treasuries in the past week, driven by stronger dollar-roll performance in higher coupons and the FHFA announcement to eliminate the Adverse Market Refinance Fee. So-called "up-in-coupon" trades done by some large real-money investors also likely contributed to the spread tightening. We remain underweight MBS due to continued concern over Fed tapering, and we think the FHFA announcement has richened OASs on the PGIM model by 1 to 4 bps across the coupon stack. The index OAS ended at Treasuries +8 bps and LIBOR +12 bps.
Corporates
- U.S. IG spreads were unchanged last week at 86 bps as the banking sector outperformed on less issuance than expected following Q2 reports while the pharmaceutical sector also outperformed on AstraZeneca’s one-notch upgrade to A-. The energy sector, particularly the crossover segment of the market, underperformed amid last week’s volatility in risk assets.
- The inflation and event-risk themes continued to play out last week. Spreads on Kimberly Clark’s 2.875% bonds due in 2050 traded about 5 bps wider on the month as the consumer products recently warned that rising input costs and reduced residential demand will reduce its full-year revenue and profit. VMWare priced a $6B multi-tranche offering that was well oversubscribed as industrial paper continues to draw strong demand as a diversifier away from financials. However, we shied away from most tranches as the issues priced with what we viewed as negative concessions from a company that is generally viewed as willing to lever up as needed. Finally, the extension trade continued as liability-driven investors sought to match long-term liabilities by moving out on the curve and adding spread duration.
- The big news in the euro IG market last week was that, after spending several weeks at 83 bps, index OAS finally moved—it widened by 1 bp to 84 bps. That said, the primary market was unusually quiet with only €1.2B pricing in what was likely the start of the market’s summer slowdown, so it may not be long before the index returns to its comfort zone of 83 bps.
Emerging Markets Debt
- Emerging market hard currency assets posted slightly negative returns on the back of U.S. yield volatility and spread widening. Local currency assets continued last week's positive momentum while EMFX retraced from last week's gains. EM hard currency returned 0.07%, EM corporates returned -0.01%, hedged local rates returned +0.13%, and EMFX returned -0.42%. EM hard currency spreads widened by +4 bps to +354 bps, with the investment grade portion of the index widening by +3 bps to 161 bps and the high yield portion widening by +7 bps to 601 bps. For reference, the spread of 312 bps between the EM high yield segment and the U.S. high yield is nearing the historic, pandemic wides of about 330 bps.
- Despite ongoing concerns around growth and uncertainty around U.S. rate policy, emerging market bond fund flows remained positive, totaling $1.08B. Hard currency funds saw inflows of $523M, local currency funds saw inflows of $685M, and blend funds saw an outflow of $129M. This brings year-to-date flows into EM bond funds to $35.37B, with hard currency, local currency, and blend strategies accounting for $14.08B, $15.62B, and $5.67B, respectively. EM equity funds saw $895M of inflows this past week.
- Within hard currency, the Ivory Coast, Venezuela, El Salvador, Argentina, and Hungary outperformed. Last week, Fitch Ratings upgraded the Ivory Coast to BB- from B+ citing a reduction in political risk, gradual fiscal consolidation, and GDP growth. Tunisia, Sri Lanka, Lebanon, Peru, and Suriname underperformed. While hard currency valuations are selectively attractive over the short and medium term, we foresee some fundamental challenges over the longer term, including economic growth in 2022, fiscal hurdles, and political risks.
- Within corporates, spreads widened by +5 bps as a sharp decline in the bonds of China Evergrande weighed on high yield property developers and, more generally, high yield Chinese corporates. While we anticipate near-term volatility to continue, we ultimately expect the Chinese government to step in to provide support, which should mitigate any significant contagion risk over the longer term.
- Within local rates, the index yield declined by 2 bps to 4.94%. Russia was the outperformer on the back of a widely expected 100 bp rate hike by its central bank, which also signaled it may be done hiking for the time being. Yields in Mexico and Brazil were 10-15 bps higher as inflation data came in above expectations.
- In EMFX, Latin American currencies generally underperformed while European currencies generally led. The Chilean peso, Israeli shekel, Russian ruble, Polish zloty, and Hungarian forint outperformed, while the Brazilian real, South African rand, Colombian peso, Mexican peso, and South Korean won underperformed. The Russian ruble strengthened slightly following news of the rate hike, it failed to rally substantially against the U.S. dollar, reflecting investors' current long U.S. dollar bias.
High Yield
- U.S. high yield returned +0.09% despite a decidedly risk-off tone to begin the week. Spreads widened +26 bps on Monday before tightening again throughout the week on the back of strong corporate earnings results. For the week, spreads widened by +4 bps to +322 bps while average yields declined by 1 bp to 3.92%.
- By quality, BBs (+0.14%) outperformed both Bs (+0.07%) and CCCs (-0.08%) for the third straight week as concerns over the Delta variant drove a solid bid for higher quality paper. For the year, CCCs have now returned +9.19%, significantly outperforming Bs (+3.34%) and BBs (+3.25%). High yield industry performance was mixed last week as healthcare (+0.53%), utilities (+0.39%), and cable (+0.31%) outperformed. Energy (-0.24%), retail (-0.07%), and gaming (-0.05%) lagged, weighed down by COVID concerns.
- U.S. high yield mutual funds posted $225M in outflows last week, bringing YTD outflows to $14.4B. Meanwhile, the primary calendar remained active, with seven deals pricing for $8.3B in proceeds. Last week's tally included a couple of $2B deals, one from cruise line operator Carnival and the other from DirecTV. Ba3/BB rated DirecTV priced $2.3B in six-year notes at 5.875% after garnering $10.7B in orders from more than 230 accounts.
- U.S. leveraged loans returned -0.06% after trading down in sympathy with equities to begin the week. New issue remained a focus with $20B in loans allocating last week. Among the largest was a new loan for DirecTV, which upsized the loan at the expense of the concurrent note sale. DirecTV's loan priced at L+500 bps with a 0.75% LIBOR floor and an OID of 99.
- Loan mutual funds saw the first outflow in 28 weeks, albeit a small one at -$67M. Nevertheless, loan technicals remain healthy with strong demand from CLOs coupled with an uptick in loan paydowns. Last week, American Airlines paid down a $1B short maturity term loan, causing the rest of the loan complex to trade up 2-5 points. Meanwhile, a number of other issuers are currently looking to prepay loan outstandings from IPO proceeds.
- In Europe, high yield bonds returned +0.03% following a volatile start to the week. By quality, BBs, Bs, and CCCs returned +0.02%, 0.02%, and +0.30%, respectively. Spreads widened +2 bps to 314 bps. Loans returned +0.06% as primary issuance tailed off ahead of the traditional August slowdown.
Securitized Products
- U.S. conduit AAA CMBS spreads finished last week unchanged after initially widening out in the beginning of the week. One conduit deal is expected to price this week with one more likely to follow. Private label supply has been increasing this year, although most of the increase is from SASB and CRE CLOs. We expect several SASB deals after Labor Day, and the conduit supply should stay limited for the rest of the year. We remain constructive on senior, well-enhanced CMBS tranches.
- U.S. spreads across the CLO capital structure remained relatively well supported this week as demand continued to emerge as supply hit the market. European nominal spreads were generally unchanged although the tone continues to be softer at the top of the capital structure as marginal supply tests market depth. We continue to see deals getting placed via large anchor investors in both the U.S. and Europe, although we’ve begun to see more deals, mainly for benchmark issuers, also go the syndicated route. Demand for CLO equity and mezzanine bonds continue to be very robust as market continues to seek higher yielding investments. U.S. CLO primary spreads for higher quality portfolios ended the week at about ~3L+112/165/195/300/620 bps for AAA/AA/A/BBB/BBs, respectively for 5-year reinvestment periods.
- ABS markets remained firm in aggregate as heavy new issuance was well absorbed. Supply YTD is $150 billion, well ahead of pandemic-impacted 2020 and 10% higher than 2019 as originators continue to take advantage of attractive funding levels due to the strong market. We remain constructive on higher value ABS, such as select issuers of unsecured consumer loans, top-tier subprime auto, and prime auto credit risk transfer.
Municipal Bonds
- Tax-exempt municipal bond technicals remained supportive, with inflows into municipal bond funds continuing and issuance remaining manageable. The 5 , 10-, and 30-year portions of the AAA-rated muni curve ended the week at 51.9% (down from 54.8% the prior week), 64.8% (down from 68.3%), and 70.8% (down from 73.4%). YTD, the high grade index has now returned +1.86% and the high yield index has returned +7.30%.
- Municipal bond funds saw another net inflow, totaling $1.7B. Long term, high yield, and intermediate funds saw inflows of $1.1B, $579M, and $132M, respectively. YTD net inflows total $68.1B, with municipal bond funds now having experienced inflows in 61 of the past 62 weeks for a total of $129.6B over that span. YTD gross supply totals $265B, which is 3.9% higher than the same period last year. This week's calendar remains manageable, with $7B expected.
Source(s) of data (unless otherwise noted): PGIM Fixed Income as of July 2021
PGIM Fixed Income operates primarily through PGIM, Inc., a registered investment adviser under the U.S. Investment Advisers Act of 1940, as amended, and a Prudential Financial, Inc. (“PFI”) company. Registration as a registered investment adviser does not imply a certain level or skill or training. PGIM Fixed Income is headquartered in Newark, New Jersey and also includes the following businesses globally: (i) the public fixed income unit within PGIM Limited, located in London; (ii) PGIM Netherlands B.V., located in Amsterdam; (iii) PGIM Japan Co., Ltd. (“PGIM Japan”), located in Tokyo; (iv) the public fixed income unit within PGIM (Hong Kong) Ltd. located in Hong Kong; and (v) the public fixed income unit within PGIM (Singapore) Pte. Ltd., located in Singapore (“PGIM Singapore”). PFI of the United States is not affiliated in any manner with Prudential plc, incorporated in the United Kingdom or with Prudential Assurance Company, a subsidiary of M&G plc, incorporated in the United Kingdom. Prudential, PGIM, their respective logos, and the Rock symbol are service marks of PFI and its related entities, registered in many jurisdictions worldwide.
These materials are for informational or educational purposes only. The information is not intended as investment advice and is not a recommendation about managing or investing assets. In providing these materials, PGIM is not acting as your fiduciary. Clients seeking information regarding their particular investment needs should contact their financial professional. These materials represent the views and opinions of the author(s) regarding the economic conditions, asset classes, securities, issuers or financial instruments referenced herein. Distribution of this information to any person other than the person to whom it was originally delivered and to such person’s advisers is unauthorized, and any reproduction of these materials, in whole or in part, or the divulgence of any of the contents hereof, without prior consent of PGIM Fixed Income is prohibited. Certain information contained herein has been obtained from sources that PGIM Fixed Income believes to be reliable as of the date presented; however, PGIM Fixed Income 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. PGIM Fixed Income has no obligation to update any or all of such information; nor do we make any express or implied warranties or representations as to the completeness or accuracy or accept responsibility for errors. All investments involve risk, including the possible loss of capital. These materials are 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 and should not be used as the basis for any investment decision. No risk management technique can guarantee the mitigation or elimination of risk in any market environment. Past performance is not a guarantee or a reliable indicator of future results and an investment could lose value. No liability whatsoever is accepted for any loss (whether direct, indirect, or consequential) that may arise from any use of the information contained in or derived from this report. PGIM Fixed Income and its affiliates may make investment decisions that are inconsistent with the recommendations or views expressed herein, including for proprietary accounts of PGIM Fixed Income or its affiliates.
The opinions and recommendations herein do not take into account individual client circumstances, objectives, or needs and are not intended as recommendations of particular securities, financial instruments or strategies to particular clients or prospects. No determination has been made regarding the suitability of any securities, financial instruments or strategies for particular clients or prospects. For any securities or financial instruments mentioned herein, the recipient(s) of this report must make its own independent decisions.
Conflicts of Interest: PGIM Fixed Income and its affiliates may have investment advisory or other business relationships with the issuers of securities referenced herein. PGIM Fixed Income and its affiliates, officers, directors and employees may from time to time have long or short positions in and buy or sell securities or financial instruments referenced herein. PGIM Fixed Income and its affiliates may develop and publish research that is independent of, and different than, the recommendations contained herein. PGIM Fixed Income’s personnel other than the author(s), such as sales, marketing and trading personnel, may provide oral or written market commentary or ideas to PGIM Fixed Income’s clients or prospects or proprietary investment ideas that differ from the views expressed herein. Additional information regarding actual and potential conflicts of interest is available in Part 2A of PGIM Fixed Income’s Form ADV.
In the United Kingdom, information is issued by PGIM Limited with registered office: Grand Buildings, 1-3 Strand, Trafalgar Square, London, WC2N 5HR. PGIM Limited is authorised and regulated by the Financial Conduct Authority (“FCA”) of the United Kingdom (Firm Reference Number 193418). In the European Economic Area (“EEA”), information is issued by PGIM Netherlands B.V., an entity authorised by the Autoriteit Financiële Markten (“AFM”) in the Netherlands and operating on the basis of a European passport. In certain EEA countries, information is, where permitted, presented by PGIM Limited in reliance of provisions, exemptions or licenses available to PGIM Limited under temporary permission arrangements following the exit of the United Kingdom from the European Union. These materials are issued by PGIM Limited and/or PGIM Netherlands B.V. to persons who are professional clients as defined under the rules of the FCA and/or to persons who are professional clients as defined in the relevant local implementation of Directive 2014/65/EU (MiFID II). In certain countries in Asia- Pacific, information is presented by PGIM (Singapore) Pte. Ltd., a Singapore investment manager registered with and licensed by the Monetary Authority of Singapore. In Japan, information is presented by PGIM Japan Co. Ltd., registered investment adviser with the Japanese Financial Services Agency. In South Korea, information is presented by PGIM, Inc., which is licensed to provide discretionary investment management services directly to South Korean investors. In Hong Kong, information is provided by PGIM (Hong Kong) Limited, a regulated entity with the Securities & Futures Commission in Hong Kong to professional investors as defined in Section 1 of Part 1 of Schedule 1 (paragraph (a) to (i) of the Securities and Futures Ordinance (Cap.571). In Australia, this information is presented by PGIM (Australia) Pty Ltd (“PGIM Australia”) for the general information of its “wholesale” customers (as defined in the Corporations Act 2001). PGIM Australia is a representative of PGIM Limited, which is exempt from the requirement to hold an Australian Financial Services License under the Australian Corporations Act 2001 in respect of financial services. PGIM Limited is exempt by virtue of its regulation by the FCA (Reg: 193418) under the laws of the United Kingdom and the application of ASIC Class Order 03/1099. The laws of the United Kingdom differ from Australian laws. In South Africa, PGIM, Inc. is an authorised financial services provider – FSP number 49012. In Canada, pursuant to the international adviser registration exemption in National Instrument 31-103, PGIM, Inc. is informing you of that: (1) PGIM, Inc. is not registered in Canada and is advising you in reliance upon an exemption from the adviser registration requirement under National Instrument 31-103; (2) PGIM, Inc.’s jurisdiction of residence is New Jersey, U.S.A.; (3) there may be difficulty enforcing legal rights against PGIM, Inc. because it is resident outside of Canada and all or substantially all of its assets may be situated outside of Canada; and (4) the name and address of the agent for service of process of PGIM, Inc. in the applicable Provinces of Canada are as follows: in Québec: Borden Ladner Gervais LLP, 1000 de La Gauchetière Street West, Suite 900 Montréal, QC H3B 5H4; in British Columbia: Borden Ladner Gervais LLP, 1200 Waterfront Centre, 200 Burrard Street, Vancouver, BC V7X 1T2; in Ontario: Borden Ladner Gervais LLP, 22 Adelaide Street West, Suite 3400, Toronto, ON M5H 4E3; in Nova Scotia: Cox & Palmer, Q.C., 1100 Purdy’s Wharf Tower One, 1959 Upper Water Street, P.O. Box 2380 - Stn Central RPO, Halifax, NS B3J 3E5; in Alberta: Borden Ladner Gervais LLP, 530 Third Avenue S.W., Calgary, AB T2P R3.
© 2021 PFI and its related entities. 2021-6013
Fixed income instruments are subject to credit, market, and interest rate. Emerging market investments are subject to greater volatility and price declines.
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.
Consider a fund’s investment objectives, risks, charges, and expenses carefully before investing. The prospectus and summary prospectus contain this and other information about the fund. Contact the PGIM Investments Sales Desk at (800) 257-3893 to obtain the prospectus and summary prospectus. Read them carefully before investing.
PGIM Investments LLC, is an SEC registered investment adviser and a Prudential Financial, Inc. company. PGIM Fixed Income is a business unit of PGIM, a registered investment adviser. PGIM is a PFI company.
© 2021 Prudential Financial, Inc. and its related entities. PGIM and the PGIM logo are service marks of Prudential Financial, Inc. and its related entities, registered in many jurisdictions worldwide.
1049739-00005-00 Ed. 7/2021
You may also like
Reopening and Reflation Continue to Support Cyclicals
QMA explains why they believe transitory inflation may last longer than desired and why value stocks may have more room to run.
Real Estate Rebuilds Demand and Rebounds
PGIM Real Estate discusses wide range of opportunities for real estate investors from improving sentiment and rebounding demand.