By Greg Peters, Co-Chief Investment Officer, PGIM Fixed Income
This time last year, Chairman Jerome Powell and the U.S. Federal Reserve were attempting what nearly everyone agreed was impossible: bring down inflation without anything bursting. Yet, even as the Fed hiked interest rates faster than any time in recent memory, the U.S. economy remained strong and inflation cooled. Contrary to all expectations, higher rates have brought sanity to the market, not a bloodbath. For fixed income investors, that’s a very good thing.
Barring unforeseen events, it looks as if 2024 will finally end a dark era for global bond investors and the world economy—a regime led by zero and even negative interest rate policies that forced investors and savers to take on uncomfortable amounts of risk. With rates higher but likely not rising any further, presents something of a goldilocks scenario for fixed income. Finally, “yield is destiny.” In other words, while we can always expect periods of volatility, long-term fixed income investors should see elevated yields manifest as elevated returns, with little to fear from interest rate risk eating away at their positions.
How should investors think about repositioning themselves for a goldilocks scenario?
Despite the bond rally in late 2023, attractive values can still be had in a number of areas, with yield characteristics quite attractive overall. That’s where individual security selection matters.
The commercial mortgage-backed securities market (CMBS) has been tainted by concerns around commercial real estate since the pandemic broke out. But ever since the global financial crisis, CMBS structures have tightened up, with subordination reducing credit risk and providing investors with a quicker path to being repaid in the event of defaults. While worries persist about the immediate future of office space in a world where many more people are working from home, the asset class is trading at an attractive discount and the worst predictions of lasting damage to the commercial market seem overblown. In general, there’s value in high quality structured products.
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Financials are another area that stand to benefit from stable or falling rates in this new regime. While there was much hand wringing about the health of the banking system—especially regional banks—after Silicon Valley Bank’s collapse in March 2023, deposit outflows have since stabilised. Banks have been able to rebuild capital, and should soon see increased stability with Basel III Endgame, a new set of banking regulations, on the horizon. These new regulations would increase capital buffers for the biggest banks in the banking system and guard against the issues that caused the collapse of the U.S. regionals.
There are also significant tailwinds for emerging markets, who were first to raise rates in response to inflation and will likely be the first to cut. Favorable developments for emerging markets include fierce competition between the U.S. and China for hegemony in the global south; the movement of supply chains out of China and growing foreign direct investment in other emerging markets; and the rising demand for commodities like lithium and copper to build out new technologies and green infrastructure. With inflation in emerging market countries falling faster than developed markets, the beginning of a rate cutting cycle would greatly benefit emerging market growth as real rates remain positive. Of course, not all emerging markets are the same—investors should look at countries such as Indonesia, India and Mexico that are growing rapidly and benefitting directly from the shift in supply chains.
Geopolitical headwinds, such as the threat to shipping lanes in the Middle East and the war in Ukraine, may strain supply chains and further elevate prices. These factors will likely keep the Fed from a dovish turn in the near term.
While a recession could necessitate rate cuts sooner than expected, we place the odds of a U.S. recession at only 25%. Self-inflicted wounds, however, such as a Federal government shutdown, may change that calculus. Historically, for each week that the government is closed, current quarter real GDP contracts by 20 bps on average.
In the big picture, however, rates hitting a plateau is the ideal time to invest in bonds. Once the Fed and central banks across the globe start cutting rates, we should expect to see even more investors pare back on stocks and cash holdings, and return to more traditional portfolio allocations, which means a massive shift into bonds, and a subsequent fall in yields. Investors who fail to lock in higher rates now may end up losing out in the long run.
