PGIM Fixed Income 2Q 2021 Outlook
PGIM Fixed Income's second quarter market outlook kicks off with “Next Phase for the Bond Bull Market: The Great Rotation,”.
After a 2020 rife with economic uncertainty, 2021 is shaping up to be a very different story.
A steady supply of COVID-19 vaccines, a $1.9 trillion COVID-19-related stimulus package and stronger earnings growth forecasts are driving great expectations for the U.S. economy. “2021 is likely to be a boom year for global and U.S. economic growth,” says Michael Collins, Managing Director and Senior Portfolio Manager, PGIM Fixed Income.
Of course, boom years often conjure images of central bankers pulling levers to cool an overheating economy. That’s a key reason why bond yields jumped over the last few months, with the yield on the 10-year Treasury note rising from below 1% in late December to over 1.7% by mid-March.
But Collins doesn’t expect a fast-growing economy to spur swiftly rising inflation and interest rates. To the contrary, he expects economic growth to moderate after a 2021 rebound, for reasons including an aging population, shrinking labor force and growing public- and private-sector debt.
That environment is likely to help keep inflation and interest rates in check, Collins says. As a result, he’s skeptical of the Federal Reserve’s long-term goal of 2.5% for the federal funds rate, its key short-term interest rate. “We think the Fed could get the fed funds rate to 1% or slightly above that over the next five years, but it would be difficult for them to hit their target of 2.5%,” he says.
If inflation and interest rates remain low for years to come, as Collins expects, then bond investors need to be diligent in their search for attractive fixed income opportunities.
Collins and his colleagues at PGIM Fixed Income have maintained low-rate, low-inflation projections for decades. He acknowledges that most of their peers on Wall Street don’t share their view. “We’re used to being the contrarians on this issue,” he says.
Collins is confident the Fed will move cautiously, given mounting levels of public and private debt. A jump in interest rates could lead to seismic levels of financial stress as the government, corporations and consumers face larger debt payments. “I think if the fed funds rate went to 2.5%, so much money would have to be allocated to servicing debt that it would cause a collapse in economic activity,” he says—and central bankers won’t take that chance.
Furthermore, Collins expects inflation to average less than the Fed’s long-term goal of 2%, pulled down by aging demographics and technological advances.
What’s more, institutional investors such as pension plans and non-U.S. investors should continue to drive demand for long-term U.S. bonds, which offer higher yields than bonds from other developed countries—some of which have even dipped into negative territory. The yield on the 10-year German bund, for instance, remains deeply in negative territory. That disparity should help hold down Treasury yields, Collins says.
With the fixed income markets pricing in forecasts for higher rates and higher inflation, Collins thinks bond investors may be able to lock in bargains. “Every cycle, you go through one of these periods where the market consensus points to a big increase in expected inflation and rates,” he says. “That sets investors up for really good buying opportunities.”
Collins is seeing opportunities in several areas of the bond market. They include securities with relatively long durations, which have priced in expectations for higher interest rates.” The 20-year area of both the Treasury and corporate bond yield curves are attractive right now,” he says.
The credit markets also offer opportunities to careful investors, Collins says. He notes that a challenging operating environment during the past 12 months has weeded out weaker companies and left many survivors with a more conservative and defensive approach to managing their balance sheets. “They’re concerned about the near-death experience they had,” he says. “So they’re changing their behavior to be more aligned with bondholder interests, rather than embarking on shareholder-friendly activities such as stock buybacks.”
In particular, Collins is finding opportunities among BBB-rated corporate bonds and the debt of larger banks. He’s also seeing value among high-yield bonds—even those issued by companies in industries hit hard by COVID-19, such as gaming, lodging and airlines. “We expect business volume in all of these areas to pick up,” he says.
Collins also sees good value in cyclical sectors such as automotive and homebuilding, because the pandemic has induced people to choose cars over public transportation and to quit urban apartments for suburban houses. “Those sectors are booming,” he says.
Certain parts of the securitized products market can produce opportunities as well, Collins says—particularly for investors who have the resources to dig deeply into the complexities of collateralized loan obligations or commercial mortgage-backed securities. “You can find diamonds in the rough if you do your homework,” he says.
Collins is prepared for a variety of risks that could limit these opportunities. For instance, stronger-than-expected economic growth could lead the Fed to reverse its accommodative stance. That’s why it’s de rigueur for Collins and his PGIM Fixed Income colleagues to constantly review their assumptions. “Over time, we’ve learned to emphasize the tail risks,” he says. Today, however, Collins stands firm on this lower-for-longer perspective.
This video is for informational and educational purposes only and should not be construed as investment advice or an offer or solicitation in respect to any products or services. Investing involves risk, including possible loss of principal. Fixed income investments are subject to interest rate risk, and their value will decline as interest rates rise. Past performance does not guarantee future results. Asset allocation and/or diversification do not assure a profit or protect against a loss in declining markets.
PGIM Investments and PGIM Fixed Income are affiliates.
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PGIM Investments LLC, is an investment adviser registered with the United States Securities and Exchange Commission. This is not an offer to any person in any jurisdiction where unlawful or unauthorized. PGIM Investments and Jennison Associates Prudential Financial, Inc. company. © 2020 Prudential Financial, Inc.
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1046136-00003-00 Ed: 04/2021
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