Podcast Summary
Focusing on risk-adjusted returns in uncertain markets: Investors should prioritize risk management over expected returns in volatile markets, such as the beginning of 2024 where stocks have underperformed and bond yields have risen.
Investors should focus on risk-adjusted returns rather than expected returns. The markets started the year with a downturn, particularly in big tech stocks like Apple, and bond yields have also risen. Despite this, it's important not to get trapped into maximizing expected value, but rather to consider risk management in uncertain markets. The beginning of 2024 has been a damp squib for stocks, with the 10-year yield moving closer to 4% after falling at the end of 2023. This unexpected turn of events leaves investors with questions about what to look for in these markets moving forward. It's crucial to keep risk in mind while navigating the markets in 2024. To delve deeper into managing risk in the face of uncertainty, tune in to PGIM's The Outthinking Investor podcast.
Long-term yields' impact on the economy: Long-term yields, influenced by inflation, Fed policy, and fiscal outlook, significantly impact the economic landscape in 2024.
The cost of long-term money is expected to remain elevated this year, despite recent declines from highs above 5%. While much focus has been on the Federal Reserve's short-term policy rate, the long-term yields at 10 years and longer will significantly impact the economic landscape in the coming weeks and throughout 2024. The inflation situation and the Fed's response to it are important factors, but they don't fully explain the rise in long-term yields. Inflation has come down significantly since its peak, but it remains higher than pre-pandemic levels. Additionally, the fiscal outlook, including record peacetime deficits and swelling government debt, is pushing up long-term yields as investors demand higher returns on their investments. Some market participants believe the soft landing has already occurred, as core PCE inflation, the Fed's preferred target, is at 1.9%, on target. However, the higher long-term yields may not decrease significantly even if the Fed declares victory and starts cutting. We're close to the target here. In summary, the long-term yield trend is an essential aspect of the economic narrative this year, and it's not solely driven by inflation and the Fed's policy rate. The fiscal outlook and the resulting demand for higher returns on government debt are significant contributors to the elevated long-term yields.
Government deficits and bond yields: Historically, larger gov't deficits lead to higher long-term yields due to bond issuance. But in 2021, term premium almost vanished despite increased spending, and bond-equity correlation started to trend positively, potentially harming diversification.
Higher government deficits typically lead to an increase in the issuance of government bonds, which can put downward pressure on bond prices and upward pressure on yields. However, last year, despite increased deficits due to pandemic spending, the term premium, or the additional yield long-term bonds must offer versus shorter-term bonds, almost completely vanished. This is surprising given historical precedent, where concerns over fiscal situations have led to higher long-term yields. Another key takeaway is the relationship between bonds and equities. Ideally, these two asset classes should have a negative correlation, meaning they move in opposite directions, providing portfolio diversification. However, in 2022, the bond-equity correlation started to trend positively, which could negatively impact portfolio performance.
The correlation between stocks and bonds turned positive in 2023 due to inflation concerns: When inflation is high or a concern, both stocks and bonds may underperform, but the correlation may not be as persistent as past inflationary periods.
The correlation between stocks and bonds, specifically the S&P 500 and long-dated treasuries, turned positive for the first time in November 2022 and stayed that way for most of 2023. This slow measure of correlation, which takes into account 500 trading days, indicates that when bond returns are doing poorly at the same time stock returns are, it's not a great sign for investors. The key factor driving this relationship is usually inflation. When inflation is high or the risk of inflation is a concern, the probability that neither asset class will perform well rises dramatically. However, it's important to note that the recent inflationary incident may not be as persistent or unstable as past inflationary periods, such as the 1970s and 1980s. The optimistic view is that inflation anxiety will die down, and the correlation between bonds and stocks will go negative again, allowing investors to return to their traditional 60/40 or 70/30 portfolios. However, the start of 2023 has not been great for most of the Mag 7 stocks, including Apple, which have all struggled in the few trading days of the year. The tech-heavy Mag 7 saw extreme volatility in recent years, with both sides of the spectrum being displayed. During the lockdown era, the Mag 7, led by tech stocks, went absolutely crazy. But once interest rates started to rise, they got crushed. The recent period has seen big tech become more defensive as inflation and interest rates leveled off.
The Enigma of the 'Magnificent Seven' Tech Stocks: These high-performing tech stocks offer a unique blend of current profitability and future growth potential, making them stand out from the crowd.
The "Magnificent Seven" tech stocks, which have significantly outperformed the market in recent years, remain an enigma for investors. Are they growth stocks, a momentum play, defensive, or an interest rate play? Their unique combination of high profitability today and plausible double-digit growth potential for years to come sets them apart from most stocks. Despite occasional analyst downgrades and concerns about peak growth, these companies continue to innovate and deliver returns. Meanwhile, Rob on Unhedged is feeling "short" commercial real estate, a call that would have paid off three years ago but is now late in the game. The market was underestimating commercial real estate risks in 2023. As we navigate the uncertainty and opportunities in the markets, PGIM's team of over 1400 investment professionals is here to help you pursue your long-term returns.
Real estate and tech concerns won't bring down the entire economy: Oversupply in certain real estate markets could lead to losses, while regulatory issues and operational missteps affect Alibaba, but these issues aren't expected to bring down the entire economy
Despite the recent sell-off in real estate ETFs and concerns about commercial real estate issues, these problems are not expected to bring down the entire economy. However, there are real concerns about oversupply in certain markets, particularly in Miami and the Sun Belt, which could lead to losses for investors. Meanwhile, Alibaba, the Chinese e-commerce giant, has faced significant challenges in recent years, including regulatory issues and operational missteps. While the stock has plummeted, some believe it may be oversold and that the company could make a comeback if the Chinese Communist Party softens its stance on tech companies. Overall, investors should keep an eye on these developments in the real estate and tech sectors.
