Mary Ann Ferraro, Client Manager: Hello, and thank you for joining PGIM Fixed Income's webcast highlighting our first quarter 2023 Macroeconomic and Fixed Income Market Outlook. I'm Mary Ann Ferraro, Client Manager for PGIM Fixed Income, and your host for today's webcast. Here with me today are two of my distinguished colleagues, Robert Tipp and Daleep Singh. Daleep, Robert, thank you for joining today.

Daleep Singh, Chief Global Economist, Head of Global Macroeconomic Research: Glad to be here.

Robert Tipp, CFA, Chief Investment Strategist, Head of Global Bonds: Yeah. Good to be here.

Mary Ann: Thank you. Daleep, as you lead the team responsible for formulating our firm's macroeconomic outlook as well as country views across both emerging and developed countries, I'm very interested and I'm sure the audience is, as well, to hear your latest outlook.

Daleep: Thanks, Mary Ann. So, in our modal scenario, we see a bumpy path ahead, which means global output will worsen in the first half of the year, including recession in most major economies before improvement takes hold. Why? Three main reasons. First, the shocks that buffeted growth this year will keep coming. Of course, it would be a fraught exercise to make predictions about precisely which shocks will hit and with what severity. But we judge that the cumulative probability of major disruptions remains well above 50%. It could be an intensification of Russia's invasion of Ukraine. It could be an escalatory tit for tat with China. Iran could develop a nuclear bomb. Russia could play a game of chicken with the G7 on oil supply. These scenarios are just illustrative. The most dangerous ones are those we can't even imagine, that we don't have in our collective memory. And the point I'm making is that, even without knowing precisely which shocks will hit and when, the likelihood is that the shocks will keep coming because they're symptomatic of durable structural shifts, shifts that we can identify and incorporate into our analysis, the most intense period of great power competition since World War II, unprecedented levels of political polarization, unnecessary but disorderly transition from fossil fuels to renewables, and a shift from global supply chains that prioritize efficiency to new arrangements that prioritize resilience and geopolitical alignment. The second reason for our pessimism is that, against this backdrop of structural drag, central banks will continue to apply cyclical restraint. Everywhere I look, central bankers are anxious, nervous, and fearful of losing hard-earned inflation fighting credibility that took generations to build. That's why we're hearing their determination to err on the side of slamming the brakes too much until the spot inflation data tell them it's okay to stop. Now, the problem is, if you wait that long, given the lags involved, for restrictive policy to cool inflation, there's a good chance that something will go wrong, especially since we've never had so many central banks tightening so much and so fast all at once. To say that last part differently, which rational and prudent policy for any individual central bank is less so at the global level when you consider the spillovers that transmit and compound globally. Our third reason for pessimism is a belief that the strength of the global economy consumption, especially in the US, will fade under the collective weight of cyclical headwinds, tighter financial conditions, negative fiscal impulse, the fading boost from reopening, and a looser labor market. Real disposable income flat-lined for most of this year in the US as fiscal transfers wore off and inflation took its bite. And as real income stagnates, lower- and middle-income cohorts are increasingly drawing down their savings and resorting to credit to finance spending. We don't think that's sustainable and expect cracks to emerge in the consumption story in the first half of next year, as the labor market softens towards other measures of aggregate demand. Now, getting into the specifics, for next year in the U.S., we expect growth to contract in the first half, roughly 4 percentage points peak to trough in the level of real GDP. And as the economy falls into recession, we see the unemployment rate rising to about 5.5% or 2 percentage points above the trough. For the nominal side of the economy, we expect inflation to converge towards but not all the way back to the Fed's 2% target, with core PCE falling below 3% on a three-month annualized basis by the end of Q1, mostly due to outright deflation in core goods prices and the beginning of disinflation in services prices, especially shelter. Against that backdrop, we think the Fed will deliver a final hike in January to a policy rate of 4.75%, with the balance of risk skewed towards further rate hikes in March to 5% or above. After reaching that peak, we expect a six-month pause before precautionary rate cuts begin in the second half of the year, likely 50 to 75 basis points in total, accompanied by a rebound of growth. In Europe, we expect a more drawn-out recession and more persistent inflation due to the structural shortfall of energy on the continent. There's certainly enough gas in storage to get through this winter, barring extreme cold. But next year is a different story. Even with higher LNG imports, conservation measures, and ramped up renewable production, there is an energy imbalance that will keep natural gas prices elevated. So, for the full year in the euro area, we expect a contraction of almost 1% in real GDP growth. As purchasing power is dented by energy prices and investment suffers from protracted uncertainty. Let's face it. The ECB is in an especially difficult spot. And after a 50-basis-point hike this month to 2%, we see the Governing Council likely hiking 25 basis points each quarter next year to bring policy rates to the 2.5% to 3% range by the end of 2023, again, with risk skewed towards faster and larger hikes to 4% if wages turn markedly higher. And when China where macro outcomes are especially sensitive to policy choice, we expect a rebound of GDP growth next year from 3% to roughly 5.5%, as the authorities appear set to shore up the property sector and lay the groundwork for exiting the zero COVID policy. But, over the medium term, we remain skeptical of the durability of the upturn in China due to the structural challenges in the growth story. The shrinking of the working age population will continue to impose a drag of at least a quarter of a percent on real GDP each year. The property sector still needs to be downsized. It represents 30% of GDP in China. And it's only the most prominent example of the need to deleverage from the credit fueled investment binge of the past decade, which pushed the debt ratio up in China above 300% of GDP. The rebalancing of the economic growth drivers in China towards consumption is also reversed in recent years. China's share of global exports has plateaued. And productivity, which is essential for China to escape the middle-income trap, remains flat at very low levels. Altogether, we expect China will do what's necessary to floor its own growth next year. But its impulse to global growth will remain modest. Now, Mary Ann, let me just close by repeating that what I've just outlined is only our modal scenario. With the state of the world as complex and uncertain as it is now, it's especially critical to think beyond our base case. In the U.S., for example, we assign a 40% probability to the recession scenario I just outlined. But it may be that the labor market remains tighter for longer, which means service prices will likely keep inflation above the Fed's comfort zone to contemplate a pause. And that would produce a stagflationary outcome, with much worse consequences for asset prices. We assign a 25% chance to that scenario. Conversely, there are brighter scenarios that cover the remaining 35% of the probability distribution. These could play out if global shocks dissipate, if we see continued resilience from consumers and corporates due to relatively healthy balance sheets, or if we get less of a drag from Europe and China due to fiscal support. The bottom line is this is an environment in which humility will pay off. It's a time to think across the probability distribution of possible outcomes, to pressure and probe our base case, to poke holes in assumptions, to unsettle our minds, and to help each other see our blind spots. The dark scenarios are important, but so are the bright ones.

Mary Ann: Thank you. So, one question, very much in line with your comments just now, is around tail risks.

Which kind of tail risk and events concern you the most and maybe keep you up at night the most?

Daleep: Yes. So, Mary Ann, I'm well aware that I sounded quite gloomy just now about the state of the world. Maybe too much so. And that's uncomfortable for me because I am an optimist. And so, actually, what keeps me up daydreaming are the positive tail risks. You know, as I said, I believe firmly that we're living through a period of intense competition among great powers. We need to be clear-eyed about that reality. But there is a branch of the probability tree in which this competition motivates a global race to the top with more public investments in R&D and infrastructure, more indigenous innovation and productivity, more labor force development, and stronger efforts to produce and attract talent and ideas. That kind of global competition would produce positive global spillovers that defuse across the world and underpin higher trend growth and low inflation, much like we saw in the 1990s. It's the basis for our roaring 2020s scenario, to which we currently assign a 5% probability. And I sincerely hope that's too low because this is a scenario that captures the world as it should be.

Mary Ann: Thank you, Daleep. You've covered a breadth of significant macroeconomic factors and pressures that are undoubtedly on the minds of investors, which we'll be monitoring, of course, going forward. So now turning to you, Robert, you are co-managing global multisector strategies, as well as responsible for global rates positioning across Core Plus, Absolute Return, and other PGIM Fixed Income strategies. So very interested to hear your latest bond market outlook.

Robert: Sure. Thank you. Well, in terms of the outlook, you know, despite that really wide range of possible economic scenarios, I think given the volatility that we've seen, probably a lot of the adjustment in the markets is behind us, certainly on the interest rate side. Interest rates are up several hundred basis points in many jurisdictions. And so, for example, in the United States, as we go up and top 4% on the Fed funds rate, we may have already seen the peak in long-term interest rates in 2022. To the extent, though, that the economy is a bit more durable, we may see long-term rates go back and challenge those highs or even top those by some margin in the U.S., in Western Europe, and so on. So, ultimately, where this peak in rates happens, how high, when in time is going to kind of follow the course of the central banks. But I think the highs that we've seen in interest rates in 2022 are representative of what might be a central tendency for as long as growth continues. After that, how quickly they fall, how much they fall will depend on the pace of deceleration and growth and how quickly inflation falls back down towards target. I think putting these tactical issues aside, though, I think the fact of the matter is, when we get five, ten years hence and look back at where we are now, growth will be more moderate. And growth has exploded after the depths of the pandemic. There's been incredible rate of growth that hasn't been seen for decades, probably will not be seen again for decades. And the same is true on the inflation side where it's spectacularly high rates of inflation. Five, ten years from now, we may not be back below target. But coming back down towards target will be incredibly lower relative to where we are now. So, as a result, interest rates will probably be lower as well. So, this is kind of like a mini 1980s reset. We're right in the vicinity of that kind of a secular high in interest rates.

Mary Ann: Thank you. So then, related to that, have we seen the peak in rates? And what about credit spreads?

Robert: Sure. So, I think, you know, we've seen the zone. But I think at this point in time we may have a little bit of a repeat of what we saw in the middle of 2022, which was after the markets had rallied, the long-term rates actually got lower than the Fed funds rate as they have been here in December. After the Fed hikes, then the rates sell off, and we kind of bear steepen to some extent and may see new highs, especially if the Fed gets up towards 5%. So, we'll have to see. But, generally speaking, I think we're in that zone. On the credit spread side, that one actually in the short-term is a little bit more difficult to thread the needle. If we get a moderation in growth, I think markets will like that. They will expect lower rates. Corporations are in pretty good shape. Collateral within structured products, certainly at the senior tranche levels are fairly secure. You'll begin to see a search for yield. You'll see spreads come in. So, it may be counterintuitive this spread product would do well in a mild slowdown. But we've seen that historically, 2019, 2017 periods of when growth moderated, spread product did very well. I think we could see that again. The problems are on the wings. In the near to intermediate term, it begins to look like the Fed is hiking too much. We're going into recession or spontaneously going into recession. Or we go back into an aggravated taper tantrum type environment where the Fed is going to have to hike a lot more. On those wing scenarios, we could see some near to intermediate term widening of spreads, maybe even reaching, or topping the levels we've seen in 2022. Bigger picture, though, I think if you look 12 to 24 months out, underlying fundamentals are pretty good. The things that usually really take economies down into very hard landings are largely absent. Banks are in fairly good shape. We haven't had incredible asset bubbles with aggressive lending. And so, I think the credit product 12 to 24 months out, once the central banks have turned the corner, are going to do well. So, big picture, you'll see us at a strategic, you know, favorable point in fixed income overall.

Mary Ann: Thank you, Robert. And thank you, Daleep.

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