PGIM Fixed Income Co-Chief Investment Officer Gregory Peters and Senior Portfolio Manager Michael Collins recently shared their views on uneven global growth potential, inflation concerns and fixed income opportunities that show promise amid current conditions.
Uneven and Asynchronous Global Growth. The global growth outlook continues to show signs of weakness but is still reasonably strong. We are in different growth cycles across jurisdictions and geographies. Banking stress, persistent inflation and heightened geopolitical risk present downside risk to growth in the U.K., U.S. and Europe, while Japan and China’s growth continues to tick upwards but does so more slowly than previously forecasted. We’ve reduced our recession probability estimate from 40% to 25%. Our concerns about the banking crisis and the debt ceiling have receded and labour markets continue to be strong, so underlying economic growth continues to be quite robust here, albeit at a slower pace. This environment presents opportunities for investors.
U.S. RATES & INFLATION
A Clearer Crest in the U.S. than Europe. Inflation continues to be the principal worry and concern, particularly in Europe and the U.K. where the consumer price index has risen above 8.5%, thanks to persistently high energy and food prices. When it comes to inflation, the U.S. seems to be in a better position than other developed countries, but core inflation numbers remain sticky, particularly service inflation. That said, when looking ahead, we think the opportunity set looks more favorable in the U.S. versus Europe.
Also read: US CPI: Brandywine Global Optimistic on Inflation
Closer to the End of the Tightening Tunnel. We are closer to the end than the beginning of the tightening tunnel. There might be some room left to increase rates another 25 or 50 basis points, but the key question is: Will this tightening create fundamental deterioration, and then, what does that mean for asset prices? The fact that these core CPI inflation rates remain highly elevated is a concern to central bankers and strongly suggests that they are not finished with their inflation-fighting campaign.
KEY POSITIONING FOR THE COMING QUARTER
The housing sector. Despite having caused problems in the past, the housing sector now is in great shape. It is not a levered sector, and lessons have been learned about mortgage underwriting; people are paying more cash for their houses, meaning the loan-to-values are high. We’ve ridden the wave of house-price appreciation, and just as house prices started to fall, they’ve stabilised and are moving back up. This is a function of very limited supply, not only of new homes, but of existing homes, and we still expect millennials to enter their home-buying years, which adds to the solid fundamentals we are seeing right now.
The auto industry. The auto industry remains plagued by supply issues. Indeed, auto production is just now getting back to where it was before COVID-19, after auto companies spent several years producing much less than they did on a run rate before COVID hit.
The private sector. The private sector is in good shape versus the public sector as the excess capacity and over leveraging that we’ve seen in past cycles which caused the big drawdowns are not really in play today. All of the debt has happened in the public sector, and it’s the big sovereigns in developed and emerging markets that have taken on all this debt. We anticipate seeing cracks in emerging market sovereigns as these countries cannot service their debt by printing their own currency.
The high yield market. We remain constructive on the high yield market versus the investment-grade market, which is running in the middle of its historical range at a lower level than it has been in past cycles. We continue to see credit downgrades, where bank loan issuers and leveraged loan companies that have low B ratings are starting to get downgraded to CCC. That trend is going to continue. The big increase in rising stars, high yield companies going to investment grade, is behind us. We are starting to see a handful of investment-grade companies downgraded from single A to triple B or from high-triple B to mid-triple B, so it is beginning to happen. This isn’t a time to load up on investment-grade corporate bonds or even on high yield bonds because of the deterioration that’s expected to come, but we see spreads widening, and this forms our base case, so we remain underweight in investment-grade corporates and hold a small overweight in high yield.
DURATION AND CURVE POSITIONING
We’re overweight the very front end of the yield curve and the very back end where you have the 20-year hovering around 4%, which seems attractive to us. We’ve been generating positive excess return over the last month or so from having this curve position. We remain short duration in the front end of the curve, and we’re adding duration tactically when appropriate.
PGIM Fixed income has AUM of $US793billion and a total of $US1.42trillion across the business as at March 2023.
