Weekly View from the Desk

May 23, 2022

Seeing Hints of Peak Bearishness

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As central banks ramped up their hawkishness in the face of escalating inflation, many market participants rushed to one side of the boat in anticipation of a stagflation scenario, thus keeping the door open for central banks to counter inflation in a Volcker-esque, recession-inducing fashion. We still take the under on the Fed’s projected tightening and think there are downside risks to holding an overly hawkish view; the market has yet to recognize that some of the more aggressive policy scenarios imply little reaction by corporates and consumers to financial conditions. We also believe that central bankers will likely slow the pace of hikes beyond the next few months to decide whether they need to induce a recession to bring down inflation.
Meanwhile, real household income remains strong due to solid ongoing hiring, though we recognize that the wealth effect, which had been a tailwind for consumer spending, is now shifting to neutral or even a headwind as individual-directed stimulus fades. Household and corporate balance sheets remain solid, suggesting healthy, economy-wide credit conditions that can moderate both the likelihood and severity of a recession.
Contrary to some longheld assumptions, we also think that demographics have become a possible upside risk to the outlook. The Millennial and Gen Z cohorts are sizeable population groups that are playing an important role in demand, perhaps leading to a mini version of the boomers-induced growth of the 1970s and 1980s. But these newer population groups are forming households later in life and are likely further along in their careers. We are also watching the recent expansion of temporary seasonal workers visas, which could help moderate some of the wage pressures this summer.
Since late last year, many of us have become cautious on the growth outlook as spreads had yet to price in the elevated tail risk of persistent inflation and stubbornly hawkish central banks, which may cause demand destruction, margin pressure, earnings downgrades, asset price deflation, loss of consumer and business confidence, and, ultimately, heightened recession probabilities. That said, recent sell-side research indicates that the market is pricing in between a 30% to 70% recession probability, which seems pretty close to peak bearishness. While the outlook has seldom been this uncertain, we are reminded of the old rule of thumb that it may be time to think about buying when most headlines appear negative.

On the margin, sentiment in U.S. Treasuries has improved compared to conditions three weeks ago. The Treasury yield curve bull-flattened while selloffs in U.K. and German rates continued. Market pricing for the path of the fed funds rate has also stabilized, which could reflect the higher probability of recession that market participants now expect and the lower terminal rate that a growth slowdown may lead to. We are also comforted by the return of the negative relationship between government bonds and risk assets, as the concurrent selloff of both in prior weeks called into question the traditional diversification role played by sovereign debt.
We are watching the quarterly Treasury futures calendar roll cycle closely this time for any signs of market functioning issues. To understand the significant size of the calendar roll, the current 10-year TY contract has around $400B equivalent of open interest, compared to the $42B of seven-year notes that will be offered at this week's Treasury auction. So far, the futures roll is going relatively smoothly and we think the recent stability in the cash market likely had a positive effect on futures. Overall, liquidity conditions in the Treasury market remains poor, and the ability to transact large amount of securities without moving the market has deteriorated substantially. JP Morgan's market depth indicator, which measures the price response of 10-year notes in reaction to a $100M transaction, is almost at 1 tick, compared to the pre-pandemic average of around 0.4 tick.
Agency mortgage-backed securities widened last week while both gamma and vega vols declined along with the overall decline in rates volatility. Lower 30-year coupons underperformed as overseas investors sold into the rates rally. A weaker outlook for the housing market and retail consumption added more fuel to the up-in-coupon trading theme.

The widening in U.S. IG spreads pushed them roughly 70 bps off the 2020 tights. As we think about potential scenarios that have been priced into spreads, we believe they reflect a 23-33% probability for a recession. At this point after the volatility, we believe spreads will likely remain within the 175 bps level, and we believe fair value for spreads in a non-recessionary environment is in the 115-125 bps range. With that backdrop, we continue to find money center banks attractive as they trade about 25 bps wide of their historical average and at a level we would equate with BBB industrials.
Retailers were at the forefront of last week’s volatility, and we certainly see a trend where consumers are moving away from virus-related goods (electronics etc.) due to reduced demand from lower-income consumers amid food and fuel inflation and challenging year-over-year comparisons. One sign of the squeeze is increased demand for private label products as opposed to brand names. However, spending on services remains relatively strong. The combination of factors point to a nuanced picture where consumers increasingly need to make spending choices. For reference, spreads on Target, Home Depot, Lowe’s, and Wal-Mart were wider last week by 15, 25, 25, and 7 bps, respectively.
After a stable start to the week, European IG bond spreads widened to 73 bps wider for the year to date, their widest level since the European sovereign debt crisis of 2009-2010. European bank bonds traded largely flat for the week, after their underperformance relative to corporate bonds in the year to date. As a further example: Credit Suisse priced two-year bonds, which were well-received by investors and priced around 12 bps tighter than its equivalent existing bonds. Utilities are an area of interest, since even those not exposed to Russian oil and gas have sold off substantially. An opportunity might exist to add to our portfolios some bonds issued by utilities that are recession-proof and lack exposure to Russia.
ECB President Lagarde's announced her view that the ECB's main policy rate will leave negative territory by the end of September. Since the ECB has stated before that it will stop buying corporate bonds before raising rates, the statement caused spreads to widen.

U.S. high yield posted another week of negative total and excess returns as the market continued to differentiate by quality. BB credits held in the best while CCCs declined the most as the lower quality tiers remained thinly traded and liquidity was limited. All high yield sectors posted negative returns, with super retail (-2.60%), healthcare (-1.17%), aerospace (-1.12%), and technology (-0.95%) performing the worst. The retail sector led the risk-off sentiment as several large retailers (Target, Wal-Mart, and Kohls) posted weaker-than-expected results. Issuance remained light as cruise line operator Carnival priced a $1B B1/B unsecured 8NC3 at 10.5%. The bonds traded down 1.5-2 points on the break but rebounded to trade down just a half-point by the end of the week. HY mutual fund outflows reached $2.6B, bringing YTD outflows to $36.4B.
Loans posted a negative return last week as loan mutual funds posted their largest weekly outflow since March 2020. The decline in loan prices remains largely technical in nature amid an ongoing buyers strike as CLO formation remains hampered by a lack of a bid for AAA paper. New issuance remained light, with just four loan deals pricing last week. As financial conditions tighten, we remain mindful of the impact that rising interest rates could have on leveraged loan issuers. That said, we believe most should be able to withstand even a meaningful rise in rates. Based on our analysis, we see leveraged loan interest coverage ratios declining from 3.9x to 2.3x, on average, should interest rates rise by 300 bps. Under a scenario where EBITDA declines by 10% and interest rates rise by 300 bps, we expect interest coverage to decline from 3.5x to 2.1x.
Taking a more bottoms up approach, we identified approximately 225 low-rated/highly levered loan issuers and overlaid the impact of higher interest rates over next two years (200 bps in year one and 125 bps in year two). Of those 225 names, we identified 16 issuers likely to generate negative free cash flow or where interest coverage slips below 1.0x.
In Europe, average yields rose but spreads tightened marginally last week. Despite the potential for positive news, our outlook remains cautious. We have adopted this wait-and-see position mainly because negative news on energy supplies to Europe may further weaken the continent's economic fundamentals. In addition, several profit warnings last week emphasised ongoing earnings deterioration, ECB officials increased their hawkish rhetoric, economic data from China continued to be weak, and equity market volatility continued.
That said, our bottom-up analysis of European high-yield bonds and their default expectations reveals a benign picture. Given 2.7% Eurozone growth in 2022, default rates in the next 12 months could fall to 0.33%. Even in our downside case of a 1% Eurozone contraction, that default rate would only rise to 1.73%. And despite the ECB's hawkish rhetoric, no more than a 0.5% rate hike is likely by the end of 2022.

A degree of de-globalisation and de-linking has affected emerging markets in recent years. For that reason, further deterioration of economic fundamentals in emerging markets is unlikely to trigger a systematic sell-off across EM issuers—unless that trigger is a downturn in China. We may, however, see deterioration in select countries with poor debt sustainability.
We remain cautious on EM hard-currency government bonds. Our projected default rates among EM hard-currency government bonds range from 2% to 3% (excluding Russia) to around 6% (including Russia). But this universe is broad: it ranges from AA-rated bonds to bonds in default, with spreads over US Treasuries from 192 bps for investment-grade EM hard-currency government bonds to 812 bps for their high-yield peers. This breadth offers us an opportunity to selectively include, for example, those Gulf Cooperation Council (GCC) countries that are benefiting significantly from higher oil and gas prices. Likewise, some sub-Saharan nations that export oil are of interest, particularly those that have put their economies on a sound footing.
Among EM corporates, we mainly hold bonds of issuers that are exposed to the commodities sector. Some of these EM corporate bonds are of better quality and, simultaneously, have wider spreads than their governments of domicile. Our default rate expectations in the EM corporate segment range from 2% (ex-Russia and ex-Chinese property) to 5% to 6% (including China's property sector).
We raised our allocations to EM local-currency bonds from underweight to closer to neutral. Some EM central banks started hiking rates approximately one year ago, but our analysis points to more rate hikes to come. Equally, among EM currencies, we mostly find value in those currencies that are commodity-related or from countries with hawkish central banks. We recently reduced our long US-dollar exposure somewhat. We're positioned to capitalise on unexpected turns of events, including a less hawkish Fed, slower inflation, and changes on the ground in Ukraine.

U.S. conduit AAA CMBS spreads widened another 5 bps last week as one conduit deal priced with the LCF coming at +158 bps (initial talk was +150) and the BBB- came at +540 (initial talk was +525), and there was widespread demand at the wider levels. We continue to recommend staying at the top of the capital structure as CRE fundamentals have increasing uncertainty from both monetary policy and geopolitical risk. SASB floater spreads widened another 10 bps, and SASB issuance remains steady as a $3B casino deal priced its AAA tranche at +220 bps. Non-agency RMBS spreads drifted wider last week. Generically, CRT M2s widened 5-10 bps and B1s 15-25 bps as real money bids waned.
U.S. CLO spreads continued to widen across the capital structure last week, and primary spreads remain roughly ~20-30 basis points tighter than where similar secondary trades are clearing. We believe spreads for benchmark issuers in the US are ~3M SOFR+165/250/290/415/795 for AAA/AA/A/BBB/BB, respectively, for 5-year reinvestment period deals. Total issuance across new issue, refinancings, and resets was ~$3B for the week, in line with the ~$3.3B the prior week. We saw spreads ~10 basis points wider as benchmark issuers began generally pricing in the 3M SOFR+150s. The level reflected above, 3M SOFR+165, is forward looking as we continue to expect spreads to widen further. European primary spreads persisted wider across the capital structure, and AAA spreads continued to lag the secondary widening as deals print in the 3E+120s, 20+ basis points tight to where secondary is pricing. Similar to the U.S., we expect primary spreads will converge wider towards secondary valuations.
Wider ABS spreads didn’t shut down primary issuance as a 3yr Discover credit card senior cleared at T+59bps (at price guidance), 2yr Carvana prime auto senior priced at T+150bps (+20 wide of guidance), and 2yr Oportun unsecured consumer senior placed at T+250bps (+25 wide of guidance). Secondary spreads remain soft, particularly unsecured consumer loan, as dealers remain risk averse.

Muni technicals remained weak but appear poised to improve on the net supply front. Demand reached $2.7B of outflows for the 19th consecutive week and a total of $58.6B. Supply was $5.6B, 74% of the five-year average. Performance was mixed as munis underperformed Treasuries five years and longer on the curve, while the tax-exempt market caught a bid in the latter part of the week with the first daily move lower in AAA yields on Thursday since April 9^th.

NOTICE: IMPORTANT INFORMATION

Source(s) of data (unless otherwise noted): PGIM Fixed Income as of May 2022

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U.S. Investment Grade Corporate Bonds: Bloomberg Barclays U.S. Corporate Bond Index: The Bloomberg Barclays U.S. Investment Grade Corporate Bond Index covers U.S.D-denominated, investment-grade, fixed-rate or step up, taxable securities sold by industrial, utility and financial issuers. It includes publicly issued U.S. corporate and foreign debentures and secured notes that meet specified maturity, liquidity, and quality requirements. Securities included in the index must have at least 1 year until final maturity and be rated investment-grade (Baa3/ BBB-/BBB-) or better using the middle rating of Moody’s, S&P, and Fitch.

European Investment Grade Corporate Bonds: Bloomberg Barclays European Corporate Bond Index (unhedged): The Bloomberg Barclays Euro-Aggregate: Corporates bond Index is a rules-based benchmark measuring investment grade, EUR denominated, fixed rate, and corporate only. Only bonds with a maturity of 1 year and above are eligible.

U.S. High Yield Bonds: ICE BofAML U.S. High Yield Index: The ICE BofAML U.S. High Yield Index covers US dollar denominated below investment grade corporate debt publicly issued in the US domestic market. Qualifying securities must have a below investment grade rating (based on an average of Moody’s, S&P and Fitch), at least 18 months to final maturity at the time of issuance, and at least one year remaining term to final maturity as of the rebalancing date.

European High Yield Bonds: ICE BofAML European Currency High Yield Index: This data represents the ICE BofAML Euro High Yield Index value, which tracks the performance of Euro denominated below investment grade corporate debt publicly issued in the euro domestic or eurobond markets. Qualifying securities must have a below investment grade rating (based on an average of Moody's, S&P, and Fitch). Qualifying securities must have at least one year remaining term to maturity, a fixed coupon schedule, and a minimum amount outstanding of €100 M. ICE Data Indices, LLC, used with permission. ICE DATA INDICES, LLC IS LICENSING THE ICE DATA INDICES AND RELATED DATA "AS IS," MAKES NO WARRANTIES REGARDING SAME, DOES NOT GUARANTEE THE SUITABILITY, QUALITY, ACCURACY, TIMELINESS, AND/OR COMPLETENESS OF THE ICE DATA INDICES OR ANY DATA INCLUDED IN, RELATED TO, OR DERIVED THEREFROM, ASSUMES NO LIABILITY IN CONNECTION WITH THEIR USE, AND DOES NOT SPONSOR, ENDORSE, OR RECOMMEND PGIM FIXED INCOME OR ANY OF ITS PRODUCTS OR SERVICES.

U.S. Senior Secured Loans: Credit Suisse Leveraged Loan Index: The Credit Suisse Leveraged Loan Index is a representative, unmanaged index of tradable, U.S. dollar denominated floating rate senior secured loans and is designed to mirror the investable universe of the U.S. dollar denominated leveraged loan market. The Index return does not reflect the impact of principal repayments in the current month.

European Senior Secured Loans: Credit Suisse Western European Leveraged Loan Index: All Denominations EUR hedged. The Index is a representative, unmanaged index of tradable, floating rate senior secured loans designed to mirror the investable universe of the European leveraged loan market. The Index return does not reflect the impact of principal repayments in the current month.

Emerging Markets U.S.D Sovereign Debt: JP Morgan Emerging Markets Bond Index Global Diversified: The Emerging Markets Bond Index Global Diversified (EMBI Global) tracks total returns for U.S.D-denominated debt instruments issued by emerging market sovereign and quasi-sovereign entities: Brady bonds, loans, and Eurobonds. It limits the weights of those index countries with larger debt stocks by only including specified portions of these countries’ eligible current face amounts of debt outstanding. To be deemed an emerging market by the EMBI Global Diversified Index, a country must be rated Baa1/BBB+ or below by Moody’s/S&P rating agencies. Information has been obtained from sources believed to be reliable, but J.P. Morgan does not warrant its completeness or accuracy. The Index is used with permission. The Index may not be copied, used, or distributed without J.P. Morgan's prior written approval. Copyright 2021, J.P. Morgan Chase & Co. All rights reserved.

Emerging Markets Local Debt (unhedged): JPMorgan Government Bond Index-Emerging Markets Global Diversified Index: The Government Bond Index-Emerging Markets Global Diversified Index (GBI-EM Global) tracks total returns for local currency bonds issued by emerging market governments.

Emerging Markets Corporate Bonds: JP Morgan Corporate Emerging Markets Bond Index Broad Diversified: The CEMBI tracks total returns of U.S. dollar-denominated debt instruments issued by corporate entities in Emerging Markets countries.

Emerging Markets Currencies: JP Morgan Emerging Local Markets Index Plus: The JP Morgan Emerging Local Markets Index Plus (JPM ELMI+) tracks total returns for local currency–denominated money market instruments.

Municipal Bonds: Bloomberg Barclays Municipal Bond Indices: The index covers the U.S.D-denominated long-term tax-exempt bond market. The index has four main sectors: state and local general obligation bonds, revenue bonds, insured bonds, and pre-refunded bonds. The bonds must be fixed-rate or step ups, have a dated date after Dec. 13, 1990, and must be at least 1 year from their maturity date. Non-credit enhanced bonds (municipal debt without a guarantee) must be rated investment grade (Baa3/BBB-/BBB- or better) by the middle rating of Moody's, S&P, and Fitch.

U.S. Treasury Bonds: Bloomberg Barclays U.S. Treasury Bond Index: The Bloomberg Barclays U.S. Treasury Index measures U.S. dollar-denominated, fixed-rate, nominal debt issued by the U.S. Treasury. Treasury bills are excluded by the maturity constraint but are part of a separate Short Treasury Index.

Mortgage Backed Securities: Bloomberg Barclays U.S. MBS - Agency Fixed Rate Index: The Bloomberg Barclays U.S. Mortgage Backed Securities (MBS) Index tracks agency mortgage backed pass-through securities (both fixed-rate and hybrid ARM) guaranteed by Ginnie Mae (GNMA), Fannie Mae (FNMA), and Freddie Mac (FHLMC). The index is constructed by grouping individual TBA-deliverable MBS pools into aggregates or generics based on program, coupon and vintage.

Commercial Mortgage-Backed Securities: Bloomberg Barclays CMBS: ERISA Eligible Index: The index measures the performance of investment-grade commercial mortgage-backed securities, which are classes of securities that represent interests in pools of commercial mortgages. The index includes only CMBS that are Employee Retirement Income Security Act of 1974, which will deem ERISA eligible the certificates with the first priority of principal repayment, as long as certain conditions are met, including the requirement that the certificates be rated in one of the three highest rating categories by Fitch, Inc., Moody’s Investors Services or Standard & Poor’s.

Palmer Square AAA CLO DM Index represents the discount margin of CLO AAA rated tranches in the Palmer Square CLO Senior Index, which is designed to reflect the investable universe of U.S CLO senior original rated AAA and AA debt issued after Jan 1, 2011.

Global Aggregate Bond Index is a measure of global investment grade debt from twenty four local currency markets. This multi-currency benchmark includes treasury, government-related, corporate and securitized fixed-rate bonds from both developed and emerging markets issuers.

U.S. Aggregate Bond Index: Bloomberg Barclays U.S. Aggregate Bond Index: The Bloomberg Barclays U.S. Aggregate Index covers the U.S.D-denominated, investment-grade, fixed-rate or step up, taxable bond market of SEC-registered securities and includes bonds from the Treasury, Government-Related, Corporate, MBS (agency fixed-rate and hybrid ARM passthroughs), ABS, and CMBS sectors. Securities included in the index must have at least 1 year until final maturity and be rated investment-grade (Baa3/ BBB-/BBB-) or better using the middle rating of Moody’s, S&P, and Fitch.

Euro Aggregate Bond Index is a broad-based flagship benchmark that measures the investment grade, euro-denominated, fixed rate bond market, including treasuries, government-related, corporate and securitized issues. Inclusion is based on currency denomination of a bond and not country of risk of the issuer.

Japanese Aggregate Bond Index The Japanese Aggregate Index contains fixed-rate investment-grade securities denominated in Japanese yen and registered as domestic bonds. The index is composed primarily of local currency sovereign debt but also includes government-related, corporate, and securitized bonds.

The S&P 500® is widely regarded as the best single gauge of large-cap U.S. equities. There is over U.S.D 9.9 trillion indexed or benchmarked to the index, with indexed assets comprising approximately U.S.D 3.4 trillion of this total. The index includes 500 leading companies and captures approximately 80% coverage of available market capitalization.

The DAX Index is a total return index of 30 selected German blue chip stocks traded on the Frankfurt Stock Exchange. The equities use free float shares in the index calculation. The DAX has a base value of 1,000 as of December 31, 1987. As of June 18, 1999 only XETRA equity prices are used to calculate all DAX indices.

The STOXX 600 Index is derived from the STOXX Europe Total Market Index (TMI) and is a subset of the STOXX Global 1800 Index. With a fixed number of 600 components, the STOXX Europe 600 Index represents large, mid and small capitalization companies across 17 countries of the European region.

The Nikkei 225 Index is a price-weighted average of 225 top-rated Japanese companies listed in the First Section of the Tokyo Stock Exchange. The Nikkei Stock Average was first published on May 16, 1949.

Shanghai Composite Index is a capitalization-weighted index. The index tracks the daily price performance of all A-shares and B-shares listed on the Shanghai Stock Exchange. The index was developed on December 19, 1990.

MSCI ACWI is a free-float weighted equity index. It was developed with a base value of 100 as of December 31 1987. MXWD includes both emerging and developed world markets.

FTSE 100 is a capitalization-weighted index of the 100 most highly capitalized companies traded on the London Stock Exchange. The equities use an investibility weighting in the index calculation. The index was developed with a base level of 1000 as of December 30, 1983.

MOVE Index is a yield curve weighted index of the normalized implied volatility on 1-month Treasury options. It is the weighted average of volatilities on the CT2, CT5, CT10, and CT30. (weighted average of 1m2y, 1m5y, 1m10y and 1m30y Treasury implied vols with weights 0.2/0.2/0.4/0.2, respectively).

VIX Index is a financial benchmark designed to be an up-to-the-minute market estimate of the expected volatility of the S&P 500® Index, and is calculated by using the midpoint of real-time S&P 500 Index (SPX) option bid/ask quotes.

Bloomberg Commodity Index Bloomberg Commodity Index (BCOM) is calculated on an excess return basis and reflects commodity futures price movements. The index rebalances annually weighted 2/3 by trading volume and 1/3 by world production and weight-caps are applied at the commodity, sector and group level for diversification. Roll period typically occurs from 6th-10th business day based on the roll schedule.

The U.S. Dollar Index indicates the general international value of the USD. The USDX does this by averaging the exchange rates between the USD and major world currencies. The ICE US computes this by using the rates supplied by some 500 banks.

2022-3507

Fixed income instruments are subject to credit, market, and interest rate. Emerging market investments are subject to greater volatility and price declines.

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Active Management Review

Active Management

Active Management Review

May 24, 2022

This presentation compares performance of active management across investment styles vs. corresponding indexes, illustrates how positioning by active managers may have driven quarterly outperformance or underperformance, and interprets results and relevance for due diligence teams.

Weekly Market Review

Markets

Weekly Market Review

May 23, 2022

In this recap, we summarize market performance and market moving news from the prior week.

GROWTH STOCK VALUATIONS HAVE SIGNIFICANTLY COMPRESSED

May 23, 2022

Equity valuations have reset for growth stocks, making now a potentially good entry point for long-term investors.

Weekly View from the Desk

In this Article

MACRO

Rates

IG Corporates

High Yield

Emerging Markets

Securitized Products

Municipal Bonds

Topics

You may also like

Active Management Review

Weekly Market Review

GROWTH STOCK VALUATIONS HAVE SIGNIFICANTLY COMPRESSED

Share

Share

In this Article

MACRO

Rates

IG Corporates

High Yield

Emerging Markets

Securitized Products

Municipal Bonds

Topics

You may also like

Active Management Review

Weekly Market Review

GROWTH STOCK VALUATIONS HAVE SIGNIFICANTLY COMPRESSED