2022 Q3 Capital Market Assumptions
PGIM Quantitative Solutions shares its quarterly update for 10-year expectations for widely-held asset classes.
Macro
- While all eyes are on the Federal Reserve, officials at the BOE, BOJ, Riksbank and the Swiss National Bank—to name a few—are all slated to make important policy decisions this week. Except for Japan, most central banks are expected to implement forceful rate hikes to tamp down inflation, and Sweden’s Riksbank followed through with a full percentage point hike on Tuesday, leading to another leg higher in developed market rates. In the U.S., last week’s highly disappointing CPI report suggests the Fed will likely follow through on its hawkish rhetoric. The 0.5% MoM rise in core goods prices shows just how strong the demand for goods, particularly durable goods, remains (see accompanying chart). While we've seen sequential growth in goods expenditures soften, the overall level of spending in this category is still above pre-COVID trends.
- Furthermore, the much-heralded rotation from goods to services spending has yet to reach a tipping point as U.S. consumers find themselves in a bit of a sweet spot with gasoline prices well off their highs and winter heating bills yet to kick in. Although household’s freed- up purchasing power becomes available for other spending categories, the strong demand may have contributed to last month’s high inflation readings in cases where supply-demand balance remains constrained. Given the latest high inflation prints and the Fed’s likely reaction function, we view 2023 U.S. GDP growth at about 0.8% vs. 1.5% previously. The risks of a recession have risen further given the combination of continued Fed rate hikes into even more restrictive territory and the risks from rising energy prices as winter approaches in the Northern hemisphere.
- The world's second biggest economy is also facing headwinds, and we lowered our 2022 GDP forecast for China to 3% from 4% after its latest economic data (excluding exports) came in only moderately above estimates, dashing our hopes of a robust rebound. That said, the policy direction is proceeding with increasingly widespread and substantial stimulus. For example, the recent, positive surprise in industrial production was driven mainly by autos and infrastructure, which are both benefiting from the scaled-up stimulus. Structurally, however, our pessimistic view remains intact: there is very little growth dynamism outside of exports and government stimulus. While last year’s policy decision to deflate the property bubble appears to be a major policy error (as we thought it would become at the time), leading to a huge adverse GDP shock, the property market is still hemorrhaging and will need stabilization in order to prevent the broader economy from breaking down further.
- Geopolitically, the recent Putin-Xi meeting appears to have been a subdued affair relative to what some expected. Readouts contained none of the euphoric "no limits" partnership that characterized their joint statement right before the invasion of Ukraine in February. Putin's statement suggests that not everything is great on the Russia-China partnership, contrary to what some may believe. Beyond the perfunctory commitment to support each other diplomatically—China supporting Russia's claims about NATO with Russia recognizing China's policy on Taiwan—there was nothing to suggest that China will provide military assistance to Russia. On the trade front, however, the readouts make it clear that trade relations will strengthen, with Putin stating that he expects bilateral trade to increase by another $60 B to $200B vs. last year.
Rates
- Global bond yields continue to march higher with the Treasury two-year and 10-year yields rising to multi-year highs on Tuesday of 3.98% and 3.60%, respectively, and the yield curve again teasing with historical inversion. In light of the latest CPI print—and especially the reacceleration of shelter/services inflation—we revised our terminal rate forecast to around 4.25–4.5% by next spring. The forecast is roughly consistent with fed funds futures pricings, which indicate another 75 bp hike in November and an increase of about 50 bps in December from the current effective rate of 2.3%.
- Meanwhile, MBS spreads are at multi-year wides and continue to look attractive to us versus Treasuries. We expect higher interest rates and slower housing seasonals to begin to take hold, possibly providing the sector with a technical tailwind.
IG Corporates
- Last week’s negative total returns in U.S. IG corporates came amid a subdued primary market with issuance of $19B, which was short of expectations given the market volatility picked up and selloff in rates. On average, order books were 3.4x covered and deals priced 27 bps through initial price talk with average concessions of 3 bps. Syndicate desks are calling for $20B in supply this week.
- Last week’s top performing sectors included Supermarkets, Diversified Manufacturing, Airlines and Wireless. The bottom performing sectors included Cable Satellite, Wirelines, Other Utility, and Railroads. On the demand side, corporate-only High Grade funds saw inflows of +$270M last week consisting of -$100M in outflows from short strategies as well as +$52M in inflows to intermediate and +$318M in inflows to long corporate strategies.
- In contrast, the European primary market remained busy last week with €23B of supply including a €3.5B quadruple tranche deal from Medtronic. Orderbooks remain healthy with deals from German Grids' Amprion and Viergas more than six times covered, highlighting the demand for strong credits pricing with attractive concessions despite Germany’s worsening energy crisis.
- We also had opportunistic “off-cycle” deals from U.S. banks Citi and Goldman Sachs, hinting that some treasurers' may fear that market access could become more challenging in the coming months. The performance of the new issues has mirrored that of the broader macro tone with most closing Friday wrapped around re-offer quotes. The top performing sectors included Midstream, Packaging, Airlines, and Refining. The bottom performing sectors included Healthcare, Finance, Banking, and Restaurants.
High Yield
- U.S. high yield bond prices declined in each of the last four days of the week amid renewed economic concerns as a result of more restrictive rates. By quality, all rating tiers declined with CCCs underperforming. By industry, Energy (-1.43%), Containers (-1.76%), and Paper (-1.77%) outperformed, while Telecom (-2.98%), Super retail (-2.97%), and Cable (-2.76%) underperformed.
- Fund flows were positive for the reporting week ended Wednesday, totaling $734M. However, based on daily data, outflows totaled $1.7B last week. Meanwhile, primary issuance remained light, with just one $500M refinancing deal pricing. For the full-year, high yield gross issuance now stands at $84B, down 78% from the same period last year. Of that total, $42B is attributable to refinancing activity, down from $246B from the same period last year as higher yields have disincentivized issuers from refinancing existing debt.
- While U.S. high yield issuers have largely chosen to remain on the sidelines amid 2022's volatility, record refinancing activity in 2020 and 2021 has largely pushed out high yield maturities. Per Credit Suisse, the maturity wall appears relatively benign over the next couple of years with just $34B of maturities among B or CCC issuers coming due before 2025.
- Loan prices held in better than high yield bonds last week and are now posting a modest decline for September, with BB loans outperforming both Bs and CCCs. For the week ended Wednesday, loan funds reported $954M in outflows, which reduces the YTD inflow to $5.0B. Still, technicals remain somewhat supportive as supply remains light, with YTD gross loan issuance down 68% from the same period in 2021.
- In Europe, risk sentiment saw a modest improvement amid easing gas prices and the expected announcement of fiscal support in the EU, even as the higher-than-expected U.S. CPI print weighed on the market toward week's end. Last week saw the first high yield deal since mid- July, with Lottomatica bringing a €350M secured bond at 9.75%. For context, a comparable bond from the issuer priced with a 6.25% coupon back in July 2020.
Emerging Markets
- The slight negative total return in EM hard currency saw some resiliency from Ukraine, Tunisia, Iraq, Senegal and Namibia, which were the top performers. The bottom performers were Sri Lanka, Armenia, Ghana, El Salvador and Hungary. EM local-rates also posted a slight negative total return with bonds from Hungary, Czechia, South Africa, Chile and Turkey outperforming, while Mexico, the Philippines, Brazil, Colombia and Poland lagged. Given the negative return in EM currencies, the Argentine peso, Indian rupee, Turkish lira, Czech koruna, and Peruvian sol were relatively resilient and outperformed. The weakest currencies were the Chilean peso, Hungarian forint, Brazilian real, South African rand and Thai baht.
- Last week, EM hard-currency funds registered outflows of $787M, EM local-currency bond funds posted outflows of $532M, and EM blended funds $277M. This brings year-to-date outflows from EM bond funds to $59.97B, of which EM hard-currency outflows make up $20.60B with EM local-currency outflows totalling $31.10B and EM blended strategies notching $8.09B of outflows.
- In terms of sector developments, Argentina hiked its key rate to 75% last Thursday in an effort to stem inflation that is predicted to end the year at an annualized rate of 100%. Elsewhere in South America, Moody’s downgraded Chile from A1 to A2, amid fears of higher spending and lower growth. In Brazil, President Jair Bolsonaro’s last minute campaign push has failed to win support, as current polls show favorite Luiz Inácio Lula da Silva ahead with 45% of the first-round vote.
- In the quasi-sovereign new issue market, the Private Department of Sheikh Mohamed bin Khalid Al Nayan, a property developer in the United Arab Emirates, issued a $300M 3-year bond priced to yield 8.75%. In the government bond market, Bulgaria issued a €1.5B 7-year bond priced to yield 4.125% and a €750M 12-year bond priced to yield 4.625%. In the corporate market, China’s KWG Group Holdings issued a $795M 2-year bond priced to yield 6.00%, while Shangyu State Investment Operation issued a $300M 3-year bond priced to yield 5.2%, Korean Air Lines issued a $300M 3-year bond priced to yield 4.75%, and mining company Anglo American Capital issued a €745M 10- year bond priced to yield 4.75%.
Securitized Products
- U.S. conduit 10-year AAA CMBS spreads were generally unchanged last week, and 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.
- Levels remained mixed across the U.S. CLO capital structure last week. We believe spreads for benchmark issuers are ~3M SOFR+195/275/375/500/835 for AAA/AA/A/BBB/BB, respectively. Given dealers focus on clearing warehouses from their balance sheet, we expect issuance to persist at varying spread levels. We continue to believe there are opportunities for an anchor investor to negotiate favorable all-in economics given elevated warehouses on dealers’ balance sheets. We remain guarded around the relative value of some junior mezzanine tranches as we do not believe the market is fully pricing in potential for higher impairment rates in the underlying collateral.
- ABS spreads were generally unchanged last week and we remain highly selective around additions. Fundamentals are stable in aggregate, aided by continued strength in the labor market, though ABS collateral performance is expected to trend negatively as the impact of stimulus programs wane and inflation affects affordability, particularly for lower credit cohorts.
Municipal Bonds
- Last week’s increase in Treasury rates and continued muni outflows placed longer-dated munis under pressure. The steepening in the muni yield curve put the 10s20s and 10s30s muni index curves at multi-year highs. With long-dated muni/Treasury yield ratios well above 100%, the tax-exempt market may start to generate some interest from crossover investors. However, the belly and the front end may not appear as attractive at current ratios.
- In terms of technicals, last week’s issuance reached $9B and estimates place this week’s issuance at $3B. Municipal mutual funds recorded outflows of about $1.4B (compared with $1.1B of outflows the previous week), which places net year-to-date outflows at about $86B.
NOTICE: IMPORTANT INFORMATION
Source(s) of data (unless otherwise noted): PGIM Fixed Income as of August 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.
2022-6000
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.
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