In brief

• Strong U.S. jobs report suggests a reduced likelihood of a deeper-than-expected cutting cycle, aligning with our soft-landing outlook and should support risk assets like stocks and bonds.
• Investors are advised to adopt a barbell strategy, with equities on one end while adding quality fixed income on the other end of their portfolios as a precaution against potential global economic downturns.
• Sector and country dispersion have been increasing, and the key to capitalizing on rate opportunities lies in the ability to flexibly allocate across different rate cycles globally.

Quality fixed income still deserves investors’ love

Last Friday’s unexpectedly strong September U.S. jobs report, along with a better-than-expected U.S. services Purchasing Managers' Index (PMI) reading and continued deceleration in inflation, has led to moderated expectations for easing, as the Federal Reserve (Fed) may not need to act as aggressively. Barring any further negative data surprises, the Fed appears on track to implement two additional 25 basis point cuts in November and December.

This robust payroll report suggests a reduced likelihood of a deeper-than-expected cutting cycle, aligning with our soft-landing outlook and indicating lower recession risk within the U.S. This should continue to support risk assets, including both stocks and bonds. Investors are advised to adopt a barbell strategy, with equities on one end while adding quality fixed income on the other end of their portfolios as a precaution against potential global economic downturns. Sector and country dispersion have been increasing, and the key to capitalizing on rate opportunities lies in the ability to flexibly allocate across different rate cycles globally.

Rates returns to be the bigger contributor than spread returns

Investors can break down fixed income total returns into two components: 1) rates returns (Treasury rate risk) and 2) spread returns (credit risk). The former is driven by a fall in Treasury rates, while the latter comes from spreads tightening.

Exhibit 1: U.S. investment grade return decomposition

Source: Bloomberg, FactSet, J.P. Morgan Asset Management. Bloomberg US Corporate Investment Grade Index is used. Data reflect most recently available as of 30/09/24.

Year to date, U.S. investment-grade bonds have generated a total return of 4.4%, where rates have been a more significant driver (2.4ppts) than spreads (2.0ppts), and we think this trend will likely continue.

• Regarding rates, medium- to long-term Treasury yields are around one standard deviation above long-term averages, indicating further potential for Treasury rates to fall, which would drive rates returns.
• On the contrary, U.S. IG spreads have been trading tight and are now around one standard deviation below the 10-year average. History suggests that spreads can remain tight for a long time, especially given the still-healthy credit fundamentals against a soft-landing growth backdrop. While we don’t see spreads widening significantly in our base case, scope for further tightening is limited. Thus, spread returns are less likely to drive future returns at current levels.

Looking beyond the U.S.: Europe and EM

As global central banks embark on a gradual easing cycle, idiosyncrasies within different economies’ inflation and growth progress result in cutting cycles of differing pace and magnitude. This underscores the importance of a global and dynamic fixed income allocation. With markets dialing back on Fed rate cut expectations after the strong September jobs report, there are still plenty of rate opportunities elsewhere, such as in Europe and emerging markets.

Europe Being Underpriced and More May Need To Be Done

The European Central Bank (ECB) has so far delivered two 25 basis point cuts in June and September. Policymakers have remained cautious, noting still-sticky domestic inflation and not displaying urgency for faster cuts. However, the string of disappointing economic data in Europe is starting to raise concerns over the health of the economy. The September Composite PMI showed the eurozone in contraction territory (48.9) for the first time in seven months. Germany’s manufacturing weakness persists, with the latest flash manufacturing PMI plunging to a 12-month low (40.3). The downside risks to the European economy enhance the urgency for more aggressive ECB rate cuts. At the same time, concerns over inflation should start to ease, with the September Euro area consumer price index falling to 1.8%, below 2% for the first time since 2021. Although the unemployment rate is still at an all-time low, there are signs of employment growth and wage growth cooling. Additionally, European companies often anchor wage decisions on the previous year’s inflation, so wage pressures should further ease in 2025.

Given the downside risks to growth and inflation in Europe, compared to the relatively well-balanced U.S. economy (where the Atlanta GDP Nowcast puts 3Q GDP at 2.5%), it might surprise some investors that the latest rate cut cycle expectations for the ECB and the Fed are actually quite similar, as seen in Exhibit 2. One can argue that the starting points of policy rates are different. However, given the drastically different growth backdrops, we see higher risks of dovish surprises from the ECB than the Fed, especially after the Fed’s September 50 basis point cut and the better-than-expected macro figures reducing the need for aggressive Fed action, absent a recession.

Exhibit 2: Market expectations of policy rates

Source: Bloomberg L.P., J.P. Morgan Asset Management. Expectations are based on overnight index swap rates. Latest expectation refers to October 7th expectations. Data reflect most recently available as of 07/10/24.

Fed Opening the Doors for Emerging Markets

Outside Europe, the start of the Fed’s easing cycle has also eased external constraints for emerging markets (EM). This could soften the strength of the U.S. dollar, reduce pressure on EM currencies, and thus open the doors for EM central banks to start cutting rates. This is especially a tailwind for “late cutters” within emerging markets that have already made sufficient progress on bringing inflation close to target. In late September, the Philippines and Indonesia started to ease, with India, Taiwan, and Korea expected to follow later in the year. Thus, whether in Europe or emerging markets, the current landscape presents a wide range of opportunities for a global rates allocation.

Investment Implications

Lower policy rates and an economic soft landing in the U.S. are likely to continue supporting a stock-bond portfolio that outperforms cash. Investors are advised to adopt a barbell strategy, with equities on one end and quality fixed income on the other, as a precaution against potential global economic downturns. Volatility is expected to remain elevated due to ongoing uncertainties related to the upcoming U.S. election, geopolitical risks in the Middle East, and the impact of China’s recent stimulus measures. Quality fixed income can help balance the goal of generating returns while managing these volatilities.

As multiple developed markets experience differentiated interest rate-cutting cycles, a diversified global exposure offers a broader investment opportunity set with greater flexibility to deliver alpha. While some investors may consider cash-equivalent assets as a hedge against a recession, holding large cash allocations entails significant reinvestment risk. Over the past 30 years, risk assets have significantly outperformed inflation, whereas cash has lagged behind rising prices. If history is any guide, investors should embrace quality fixed income and be cautious of falling into the cash trap.

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