PGIM Real Estate: Quarterly Insights
Read on to hear out how the current situation in global financial markets is affecting the outlook for each region.
Global markets started the year in a risk-off mood with high inflation proving persistent and the Fed’s hawkish pivot intensifying. Russia’s invasion of Ukraine made a difficult situation even worse for global central banks by adding a stagflationary shock to the mix. Equity markets corrected during the quarter, with some declines meeting the technical definition of a bear market. The S&P 500, NASDAQ, MSCI EAFE, Eurostoxx 50, and MSCI Emerging Markets indexes, for example, have experienced drawdowns from recent highs of roughly 13%, 22%, 18%, 20%, and 19%, respectively.
Moves in bond markets were also substantial, with yields repricing given the significant change in Fed policy expectations. The 10-year Treasury note yield began the year at 1.5%, breached 2% on February 10, and is now flirting with 2.5% (as of March 25). The move on the 2-year note yield, which is more sensitive to changes in the policy environment, was even more dramatic, reaching 2.3% (as of March 25) after starting the year at 0.73%.1 While it has been a rough start to the year for stocks and bonds, real assets such as commodities and gold shined, helping to hedge rising geopolitical and inflation risks.
In an environment of rising interest rates, stocks have experienced multiple compression from 2020’s highs. The forward P/E ratio on the MSCI World Index, for example, has fallen from 20.3 at the end of 2020 to 18.0 (as of March 25), a decline of roughly 11%.1 Most major equity markets, with the exception of the U.S. and EMEA, now trade at a discounted value to their 10-year average on forward earnings. Latin America and U.K. equities appear to exhibit very attractive value, with forward multiples significantly below their 10-year averages. Multiples could continue to be under pressure going forward as inflation runs hot and central banks hike rates, but a continued rise in corporate earnings should put a floor under stock market performance.
Assuming the war with Russia does not extend beyond Ukraine’s borders, we think the global economy will avoid recession, and U.S. and global earnings should still grow at a high-single-digit pace in 2022. While we expect equity markets to recover lost ground under this scenario, calendar-year returns are likely to be weak, though positive, in 2022, with higher interest rates continuing to weigh on valuation multiples.
Global bond markets have suffered steep losses since peaking last year. The Bloomberg Global Aggregate Index has fallen 11% from a high in January 2021. That’s the biggest drawdown since 1990, surpassing a 10.8% drawdown during the Global Financial Crisis.2 Rates could move higher from here given growth and inflation dynamics, but a lot of damage has been done to start the year. The yield rally may need to consolidate, similar to what we saw last year after a yield spike in Q1, before moving higher again. Still, we are bearish on sovereign debt on a longer-term horizon, and we think yields are likely to rise over the next few years.
We see a better risk-reward profile in fixed income risk assets than in government bonds. Emerging market (EM) debt has seen a sharper drawdown this year than U.S. stocks, falling 15% from last year’s peak. Spreads in EM hard currency debt have hit levels last seen during the depths of the COVID lockdowns, and the current yield of 6.5% looks attractive. Russian bonds currently make up less than 1% of the JP Morgan Emerging Markets Bond Index (down from 3.2% at the end of 2021) and will be removed from the index on March 31, 2022. In contrast, U.S. corporate high yield bonds have seen a shallower drawdown of about 5%, as U.S. companies are more insulated from the crisis in Ukraine. Spreads on high yield debt have also risen but are still below their historical average. However, overall yields still look enticing at 6.2%.1
We remain bullish on commodities. In prior commentaries, we’ve made the case for a structural bull market in commodity prices based on supply-demand imbalances that will not be easily remedied in the near term. Russia’s invasion of Ukraine strengthens the commodity bull case, adding both additional supply constraints and a demand boost. Russia, the second-largest commodity producer in the world, is a major supplier of energy, metals, and grain. Government sanctions and self-sanctioning among private actors have created a significant negative supply shock.
On the demand side, Russian aggression has reinvigorated NATO and strengthened the bonds between the U.S. and its allies. Germany has committed to military enlargement and energy diversification and is even considering shifting its stance on nuclear energy. These goals will take years to implement and will require significant commodity inputs. Higher military spending among NATO members increases the demand for oil, natural gas, steel, and other base metals. This will stress already tight inventories.
Commodities remain a stellar hedge against both inflation and a worse-than-expected outcome in the Russia/Ukraine conflict. We believe the bottom of the commodity cycle coincided with the beginning of the COVID pandemic, when oil hit negative $38 per barrel on April 20, 2020. In our view, a multi-year uptrend has begun. Commodities are up 109% since then but are still 56% below their 2008 high.1 If commodity prices eventually rise to their 2008 levels, we would see 77% appreciation from here, which is likely to occur over several years. Financial flows into commodities also have the potential to exacerbate any upward moves caused by deficits in physical demand.
1 FactSet, Bloomberg as of 3/25/2022. Past performance does not guarantee future results.
2 Global Bond Index Loses $2.6 Trillion in Record Slide from Peak, Bloomberg News, Ritchie/Flynn, 3/23/2022.
Bloomberg Commodity Index is composed of futures contracts and reflects the returns on a fully collateralized investment in the BCOM. This combines the returns of the BCOM with the returns on cash collateral invested in 13-week (3-month) U.S. Treasury bills. Bloomberg Global Aggregate Index is an unmanaged index of global investment-grade fixed income markets. Eurostoxx 50 is a market capitalization-weighted stock index of 50 large, blue-chip European companies operating within eurozone nations. MSCI EAFE Index is designed to represent the performance of large and mid-cap securities across 21 developed markets, including countries in Europe, Australasia, and the Far East, excluding the U.S. and Canada. MSCI Emerging Markets Index is an equity index covering 23 countries representing 10% of world market capitalization. MSCI World Index captures large and mid-cap representation across 23 Developed Markets (DM) countries.
NASDAQ is the market capitalization-weighted index of over 2,500 common equities listed on the Nasdaq stock exchange. S&P 500 Index is an unmanaged index of 500 common stocks of large U.S. companies, weighted by market capitalization. Indices are unmanaged and are provided for informational purposes only. Investors cannot directly invest in an index.
For Professional Investors only. All investments involve risk, including the possible loss of capital.
Past performance is no guarantee of future results.
The views expressed herein are those of PGIM Quantitative Solutions at the time the comments were made and may not be reflective of their current opinions and are subject to change without notice. Neither the information contained herein nor any opinion expressed shall be construed to constitute investment advice or as an offer to sell or a solicitation to buy any securities mentioned herein. Any projections or forecasts presented herein are subject to change. This commentary does not purport to provide any legal, tax or accounting advice. 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.
References to specific securities and their issuers are for illustrative purposes only and are not intended and should not be interpreted as recommendations to purchase or sell such securities. The securities referenced may or may not be held in the portfolio at the time of publication and, if such securities are held, no representation is being made that such securities will continue to be held.
In the United Kingdom, this financial promotion 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), and with respect to its Italian operations by the Consob and Bank of Italy. In the European Economic Area (“EEA”), this financial promotion may be issued by PGIM Netherlands B.V. or PGIM Limited depending on the jurisdiction. PGIM Netherlands B.V., with registered office at Gustav Mahlerlaan 1212, 1081 LA, Amsterdam, The Netherlands, is authorised by the Autoriteit Financiële Markten (“AFM”) in the Netherlands (Registration number 15003620) and operates on the basis of a European passport. In certain EEA countries, this financial promotion 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 in the UK who are professional clients as defined under the rules of the FCA and/or to persons in the EEA who are professional clients as defined in the relevant local implementation of Directive 2014/65/EU (MiFID II). PGIM Limited and/or PGIM Netherlands B.V. are indirect, wholly-owned subsidiaries of PGIM, Inc. (“PGIM” and the “Investment Manager”), the principal asset management business of Prudential Financial, Inc. (“PFI”), a company incorporated and with its principal place of business in the United States. 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. PGIM, the PGIM logo and the Rock symbol are service marks of PFI and its related entities, registered in many jurisdictions worldwide. PGIM Fixed Income and PGIM Real Estate are trading names of PGIM an SEC registered investment adviser in the United States. Jennison and PGIM Quantitative Solutions are trading names of Jennison Associates LLC, and PGIM Quantitative Solutions LLC, respectively, both of which are SEC registered investment advisers and wholly owned subsidiaries of PGIM. Registration with the SEC does not imply a certain level or skill or training.
In Singapore, this is a financial promotion issued by PGIM (Singapore) Pte. Ltd.), a Singapore investment manager that is registered with, and licensed by the Monetary Authority of Singapore. In Hong Kong, this is a financial promotion issued 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 of the Securities and Futures Ordinance (Cap.571).
© 2023 Prudential Financial, Inc. (“PFI”) of the United States and its related entities. PGIM and the PGIM logo are service marks of PFI and its related entities, registered in many jurisdictions worldwide.
For compliance use only 1059016-00001-00