Weekly View from the Desk
PGIM Fixed Income shares their weekly views and outlook for fixed income markets.
The economic and geopolitical backdrop is creating significant uncertainty for policymakers and investors. The Fed’s plans to raise short-term interest rates meaningfully this year and the ongoing crisis in Ukraine are contributing to elevated risk aversion and dampening expectations for global growth, with a recession in Europe now considered a real possibility. Meanwhile, the Omicron variant of COVID-19 is forcing another round of lockdowns across China, with no clear path to near-term containment.
The U.S. economy remains healthy and should continue to generate stronger growth than other developed regions. However, with interest rates moving higher to combat persistent inflationary pressures, the pace of U.S. growth is set to moderate, even before factoring in the effects of the war in Ukraine. Signs of cooling have begun to emerge in the level of mortgage applications, housing turnover, and used car prices. With the fourth quarter earnings season coming to an end, it is clear that reported profit growth remained robust through 2021 and generally in line with forecasts.
Our forecasts for 2022 suggest a meaningful moderation in U.S. profit growth, following last year’s dynamic rebound from the worst effects of the pandemic. We also anticipate a passing of the baton from outsized demand for goods to services, particularly travel and leisure spending. Trends to date remain supportive of these expectations.
The inflationary pressures evident at year-end have persisted and have been exacerbated by spiking commodity prices, particularly crude oil, as a result of the war and sanctions. The Fed, while remaining data dependent, seems intent on cooling rising prices and, as such, is likely to continue to tighten steadily over the coming months.
Equity prices will continue to reflect the effects of higher rates and increased uncertainty from the war and its drag on economic activity and sentiment. So far, the conflict has revealed little about its longer-term impacts. Elevated stock market volatility is likely to endure as long as the conflict persists.
Our interactions with management teams since year-end have focused on the near-term effects that supply-chain challenges, inflation, and, more recently, the Ukraine conflict will have on their businesses—in the context of our longer-term outlook. Not surprisingly, these factors have weighed on valuations. Fundamentally, we are seeing little impact beyond what is factored into our expectations. We acknowledge that elevated uncertainty, while weighing on valuations in the short term, can also have real effects on growth prospects over the longer term, and we will continue to make adjustments, as needed, based on our fundamental analysis.
In the first quarter, Value outperformed Growth across all market-cap segments. Energy was the best-performing sector for the quarter and trailing one-year periods, benefitting from worries about shortages given Russia’s invasion of Ukraine. Growth sectors like communication services, consumer discretionary and information technology were the weakest sectors in the quarter.
In the first quarter, the Health Care sector of the S&P 500 Index declined 2.6%, which outperformed the overall Index, which returned -4.6%. Over the trailing 12-months, the health care sector rose 19.1% compared to the Index’s 15.7% gain. Since November of 4Q21, the appearance of the Omicron variant introduced new risks to the recovery story in the short term and ushered in a wave of volatility. But as we move into 2022, it is our view that the impact from COVID, coupled with many headwinds the sector faced in 2021, are subsiding. We believe the sector has begun to show signs of leadership again as investors place more emphasis on company fundamentals and the significant alpha-generating opportunity that broad innovation in the sector can provide. Furthermore, we remain hopeful that as we have finally received some clarity on drug pricing, the 6-year overhang on the drug industry, in particular biotech, can be lifted. We are pleased to see that the most negative elements of drug-pricing reform are now off the table and expect the final details of the reform to be manageable. More specifically, now that some “action” is being taken on drug pricing, the likelihood of any draconian changes that were potentially negative for the industry are off the table. A “no news” stance out of Washington, coupled with the announcement of an FDA commissioner, should position health care well into 2022.
The Financials sector posted modest gains and outperformed the broader market in the first quarter. With a tailwind from rising rate expectations early in 1Q, the sector outperformed the negative return of the overall market by over 500 bps early in the year. But then as the outbreak of war between Russia and Ukraine raised concerns about a dampening effect on the global economy, and possibly fewer rate hikes, financials lagged. The group returned -1.5% for 1Q22, outpacing the -4.6% return of the S&P 500 Index. Despite the modest return in the last three months, financials remain one of the best-performing sectors and have outperformed the S&P 500 by 1200 bps over the last five quarters.
Since the announcement of a COVID-19 vaccine in November of 2020 and subsequent start of the economic recovery, the sector has continued to be a strong performer on both a relative and absolute basis. Earnings continue to recover and cyclical tailwinds remain in place. While the sector is experiencing some inflationary pressure, this has been offset by the continued, albeit non-linear, economic recovery, better credit conditions, interest-rate-hike announcements, and the lingering effects of the second stimulus.
The current backdrop remains favorable for universal banks and brokers/asset managers as the capital markets are robust and expenses well-controlled. Scale has become a competitive advantage, and we are positive on business models with a broad reach along with higher profitability metrics. Also, higher interest rates translate into higher interest revenue and earnings for the regional banks, though this is largely priced into those stocks.
While Midstream Infrastructure has been a strong performer in the 16 months since the COVID vaccine announcement in late 2020, the group—and energy broadly—experienced outsized outperformance in the first quarter. Rising geopolitical tensions had been foreshadowing a potential invasion of Ukraine by Russia, which drove commodity prices and energy stocks higher at the start of the year. When Russia finally made its move at the end of February, prices—which had already seen strong increases—rallied further. Oil rose as much as 64% at one point in the quarter and the energy sector rallied 39%. While midstream was a laggard within the energy sector, the group significantly outperformed the broader market. For the full 3-month period, the Alerian MLP Index gained 18.72%, while the Alerian Midstream Energy Index, which includes a broader group of midstream infrastructure companies as well as MLPs, advanced by 23.9%. The midstream indices outperformed the S&P 500 index by more than 2300 bps and 2800 bps, respectively.
Midstream energy has been a sector in transition for several years. Most of the larger companies have taken decisive measures to conserve cash and “right the ship” during this global pandemic, and we believe this disciplined behavior will continue. Cash-flow metrics have improved across the board after companies reduced capex and growth spending over the last two years. Many larger companies are now free cash flow positive for the first time, an important inflection point reached in 2021. Added cost reductions and increased asset optimization should continue to fortify balance sheets, while offering management teams further opportunities to reduce debt levels as well as return cash to shareholders.
Prior to this quarter’s geopolitical shock, which has driven the sector significantly higher, improvements in fundamentals were finally starting to be reflected in stock prices. While a recovery is clearly underway, it will likely continue to be non-linear, as evidenced by the recent emergence of yet another COVID variant. While it is likely that we have seen the last of severe global economic shocks due to the pandemic, hiccups along the way—whether pandemic- or geopolitically induced—should be expected. However, as economic activity continues to ramp up, stocks should increasingly price in the long-term positive benefits from the significant transformational corporate reform that has occurred over the past few years. The group is well-positioned for performance beyond the cyclical recovery.
The global energy transition will require multiple sources of energy to be successful. Hydrocarbons will continue to have a role, driving future demand not just for the commodities but for the essential logistical systems that move them. With physical steel in the ground, midstream infrastructure companies have difficult-to-replicate asset networks with high barriers to entry, and whose adaptability to transport other energy sources is underappreciated. Management teams are increasingly aware of the role they will play in our energy future, focusing not just on the environmental impact of their operations but also on how their asset bases can and will be part of a greener future.
Following a rally that began in December of 2021, the Utilities sector continued to outperform the broader market in the first quarter, finishing up 4.8%, more than 900 bps ahead of the S&P 500. Despite relative outperformance throughout the quarter, the sector posted negative returns in the first two months of the period on persistent inflationary concerns before rallying sharply in March. Increased geopolitical tensions following Russia’s invasion of Ukraine, creating concerns about the potential spillover effect on global economic growth, drove investors to “safe haven” utilities. At the same time, the yield curve flattened in March, an added tailwind for the group. While the sector has seen a meaningful recovery in the last two quarters, utilities are still the worst-performing sector on a trailing 2-year basis, in spite of strong underlying fundamentals. In fact, even during this period of economic volatility, the group has continued to execute operationally and has been able to deliver strong earnings while also de-risking their portfolios. Continued solid execution, along with the potential growth opportunities from renewable energy investments, should help to drive the sector’s earnings going forward. In addition, geopolitical concerns as well as a flattening yield curve, remain macro tailwinds. The discrepancy between utility fundamentals and longer-term performance underscores both the attractive absolute and relative opportunity in the sector, especially given what remains a lower-than-average interest rate environment. Utilities represents a compelling defensive growth proposition for investors for several reasons in both sector-specific and macro-related terms.
Alerian Midstream Energy Index is a broad-based composite of North American energy infrastructure companies and is a capped, float-adjusted, capitalization-weighted index whose constituents earn the majority of their cash flow from midstream activities involving energy commodities. Alerian MLP Index is the leading gauge of energy infrastructure Master Limited Partnerships (MLPs) and is a capped, float-adjusted, capitalization-weighted index, whose constituents earn the majority of their cash flow from midstream activities involving energy commodities. S&P 500 Index is an unmanaged index of 500 common stocks of large U.S. companies, weighted by market capitalization. It gives a broad look at how U.S. stock prices have performed. S&P 500 Financials Index comprises those companies included in the S&P 500 that are classified as members of the Global Industry Classification Standard (GICS) financials sector. S&P 500 Health Care Index comprises those companies included in the S&P 500 that are classified as members of the Global Industry Classification Standard (GICS) health care sector. S&P 500 Technology Index comprises those companies included in the S&P 500 that are classified as members of the Global Industry Classification Standard (GICS) technology sector. S&P 500 Utilities Index comprises those companies included in the S&P 500 that are classified as members of the Global Industry Classification Standard (GICS) utilities sector. Indices are unmanaged and an investment cannot be made directly into an index.
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Past performance is no guarantee of future results.
The views expressed in this video are of Jennison Associates as of April 13th 2022 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.
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