A resilient economy and unshakeable markets shouldn’t blind investors to an uncertain future, by Greg Peters, Co-Chief Investment Officer, Fixed Income, at PGIM
One lesson that investors have learned over the years is despite geopolitical tensions, fiscal deficits and monetary policy concerns, it’s difficult to shake the U.S. economy from its foundations. The same has held true for global fixed income markets recently, as the broad market wrapped up its third straight calendar year of solid returns. Amid this positivity, however, there are growing risks—with the range of potential outcomes as vast and wide as we’ve ever seen.
Our base case still holds that the major world economies will continue to ‘muddle through’ with steady but unspectacular growth across regions, shaped by fiscal dominance, productivity shifts and geopolitical challenges. These geopolitical issues include, for example, recent events in Iran.
We’re characterising the actions by the US and Israel as a maximalist and high-risk, high reward approach. From a market perspective, the rapid escalation in the situation has materially widened the uncertainty bands on both sides of the probability distribution, and, in the short-term, sentiment may skew to the downside amid the vast uncertainty.
Aside from geopolitical volatility, while most investors have mentally moved on from inflation, tariffs, combined with more accommodative policy, bigger fiscal packages, deregulation, and potential challenges to Fed credibility, remain as inflationary threats. Investors also face a gauntlet of emerging risks, including potential policy distortions in the Treasury market, hidden credit-market fragility, and AI driven overheating risks.
The wide range of possible outcomes is perhaps best illustrated by the AI story. If AI does truly unlock productivity gains, it could be a game changer for growth. A modest improvement in productivity could lead to a substantial reduction sovereign debt across developed economies, significantly improving fiscal projections for the future.
Also read: Layered Uncertainty: Conflict, Credit Stress, and AI
On the other hand, there’s a question of how long the enormous spend on AI lasts, and when companies will have to show actual results. Smaller players in this race face significant challenges in competing with industry giants. This competitive pressure, combined with the sheer size of debt issuance in the tech sector, raises the likelihood of deteriorating credit profiles. There is also huge circularity to the spending where one company’s investment is another’s revenue, a concerning dynamic if capital dries up.
This is not an environment where investors should be leaning heavily into credit risk. Investors should be selective rather than taking broad market exposure.
In this uncertain environment, curve steepening trades – betting that long‑term rates will rise faster than short‑term rates by purchasing short term Treasuries and shorting the long term – have been incredibly popular.. Investments closer to the front end are more connected to central bank policy and measurable data. Further out the curve, term premia and other hard to control factors dominate. This is especially important for sovereign‑debt investors, as surging government spending, shrinking fiscal restraint and mounting mandatory outlays are set to drive volatility.
High quality structured products offer a solid alternative for investors. CLOs, for example, consistently deliver a structural yield advantage, providing a persistent premium over Treasuries, with resilience through market stress without compromising credit quality. AAA and AA CLOs have not experienced a single default over their 30-year history.
Asset-backed finance is also seeing inflows from investors who are diversifying or complementing their corporate credit exposures. Prime consumer, commercial and residential subsectors are benefitting from demand for transportation, digital infrastructure, data centers, equipment financing and home improvement needs.
A few factors are readily apparent across global fixed income markets: the slow-going bull market remains in the sweet spot; attractive yield levels may translate into solid returns over the intermediate to longer term; and the unusual geopolitical backdrop and asynchronous central bank cycles should continue to create opportunities to add value through active management. The takeaway isn’t to run and hide, but rather avoid overpaying for risk.
