J.P. Morgan Asset Management is pleased to present the latest edition of Quarterly Perspectives. This piece explores key themes from our Guide to the Markets, providing timely economic and investment insights.

THIS QUARTER’S THEMES

Building resilience against higher bond yields and inflation worries

Overview

• Investors are bracing for higher inflation as the global economy recovers from the COVID-19 pandemic. Alongside sizeable fiscal stimulus in the U.S., central banks are also likely to keep their monetary policies loose to further support the economic recovery.

• We expect U.S. Treasury (UST) yields to gradually normalise in the next 12-24 months. This would be driven by both a rise in real yields consistent with economic recovery and inflation consistent with the Federal Reserve’s (Fed) target.

• Rising yields coincide with stronger growth at this phase of the economic cycle, and this should be constructive for equities. Fixed income investing could become more challenging with the potential price decline from duration risk.

Better growth prompts higher inflation expectations

The economic outlook of the U.S. is improving because of vaccination progress and supportive fiscal measures.

• The U.S. is on track to vaccinate about half of its population by this summer. This should provide impetus for the economy, especially the services sector, to reopen and deliver faster rates of growth. The USD 1.9trillion fiscal package adds fuel to the economy just as it’s re-awakening.

• The combination of these factors is prompting investors to focus more on the possibility of higher inflation. Despite the Fed’s ongoing commitment to keep monetary policy easy, growing scepticism is pushing UST yields higher, forcing the yield curve to steepen.

• Even though the global economic outlook is improving, delays in vaccination progress in some other regions could lead to the U.S. and China becoming the economic outperformers in 2021.

Inflation rising from a low level should benefit risk assets

Investors are right to question the outlook for inflation. However, historical data has shown risk assets can still outperform when inflation is rising from a low level.

• Risk assets, such as equities, higher-yielding corporate bonds and EM fixed income, could deliver positive returns as bond yields and inflation rise from a low level. The positive earnings growth associated with this environment should have a stronger influence than the withdrawal of liquidity from higher yields.

• Admittedly, investors should also take into account the prevailing valuations of these risk assets since some segments, such as technology (tech) and corporate credit, started this recovery with expensive valuations.

• The outlook for DM government bonds and high-quality corporate credit is challenging. Their low yields would struggle to provide an adequate buffer against price declines as UST yields rise.

In fact, some inflation could help boost earnings

Moderate inflation could help to enhance corporate earnings and improve profit margins.

• With valuation re-rating driving much of the equity rally over the past year, corporate earnings will need to do more of the heavy lifting to deliver return to investors. Globally, earnings reports have been encouraging.

• With profit margins at a low point, expanding profitability will be an important driver of earnings growth, as stronger economic activities should boost revenue.

• A modest pick-up in inflation should help improve businesses’ pricing power, especially for downstream retailers. However, too much sustained inflation could pose a challenge in controlling costs, undermining earnings. Active management is needed to understand which sectors or companies are in a strong position to control costs when this happens.

Investment Implications

• Equities have historically delivered positive return to investors when yields are rising from a low level. Despite potential volatility in the months ahead, market corrections are opportunities for investors to build equity allocation in portfolios.

• For fixed income, given tight credit spreads, coupons will likely be a key buffer against the risk of falling prices as yields rise. Developed market (DM) government bonds and investment-grade (IG) corporate debt, with their low yields, could still face headwinds in the months ahead.

• Short-duration high yield (HY) corporate debt and emerging market (EM) fixed income can still serve the purpose of providing some diversification benefits to a portfolio. Investors can also consider alternative real assets (real estate, infrastructure, transportation) to look for income opportunities and lower correlation with equities and risk assets.

Fixed income: Managing inflation risk

Overview

• The effectiveness of monetary and fiscal policies in responding to the COVID-19 pandemic has created a credible risk, which bond investors have not faced for many years—higher inflation.

• The rise in core government bond yields from a low starting point limits the appeal of owning these assets in the near term, but they remain a key source of diversification within portfolios. Credit and EM debt can still offer an income solution.

• Investors may wish to consider a dynamic allocation to fixed income markets to traverse the uncertainties of the bond market.

Don’t fear inflation

The effectiveness of the 2020 policy response to the COVID-19 pandemic has created an inflation risk that bond investors have not faced for many years.

• In the years after the global financial crisis, the extraordinary policies of central banks failed to create inflation but helped to avoid persistent deflation.

• Now, the combined effect of coordinated monetary and fiscal policies changes the narrative, with higher inflation being a real risk. 

• A risk does not need to be feared, but does need to be managed. Being short duration rather than long means bond holders can re-invest at higher yields. Tilting towards credit over government debt also means investors can use the positive inflation environment to their advantage as corporate fundamentals improve and credit risk declines.

Credit tights

The support of both the government and Fed policies led to a sharp retracing in spreads, with U.S. IG credit spreads back at their pre-COVID-19 levels by January 2021. Many other segments of the credit market experienced a similar, but less dramatic, market movement.

• Further narrowing in credit spreads is unlikely and, as such, coupons will make up a greater proportion of returns. This suggests allocating to the segments of the market with the highest yield, namely EM debt, and the higher beta parts of the HY bond market.

• Improving corporate health and earnings recovery is supportive of credit markets in the same way it supports equities, minimising the potential for significant spread widening.

• Investors will have to be mindful of the impact of rising UST yields and may opt for a more dynamic approach to fixed income markets as yields rise.

Finding balance

Owning government bonds has been relatively unappealing with the low level of income and high valuation. But rising yields may change this dynamic.

• The initial rise in bond yields implies large capital losses when yields are low. But as yields rise, investors may start to rotate back into government bonds.

• The relative valuations argument to equities and other risk assets could start to narrow, and investors who have benefited from rising equities over the last year may wish to rebalance their portfolios.

• This rebalancing may actually cap, or at least stem, some of the rise in bond yields, limiting the potential for losses. However, the rotation may not gain momentum until there is more clarity on the strength of the rebound and central banks’ responses.

Investment Implications

• Rising inflation is traditionally the enemy of the bond investor, and rising yields certainly limit the appeal of longer duration fixed income assets in the near term.

• With uncertainty over how persistent the inflation threat will be, or how fast and high core government bond yields may go, investors should take a dynamic approach to bond markets, allowing for a shifting allocation across fixed income segments.

• Positioning in shorter duration assets limits the impact of the inflation risk and allows for re-investment amid better valuations as yields rise.

• The rise in yields will likely come in waves, but eventually bond yields will reach a level where they are once again appealing for both portfolio income and diversification.