My name is Harveer Bhalla, and I am a portfolio manager on the ultra-short duration team at J.P. Morgan Asset Management. I am pleased to present the 2022 Q2 Guide to the Markets for Global Liquidity investors.
Needless to say, the first quarter of 2022 was an eventful one for the US. We saw a dramatic surge then recovery from the omicron variant of Covid-19, inflation reaching a 40 year high, war breaking out in Ukraine, and the Federal Reserve (Fed) hiking interest rates for the first time since the global pandemic began.
We expect Q2 to be no less eventful. In this commentary, we will explore:
- The path of monetary tightening (p. 32)
- The Fed’s balance sheet (p. 33)
- US GDP growth (p. 18)
- Oil prices and inflation (p. 29 and p. 26)
- Fixed income performance (p. 36)
We begin our discussion about Q2 by talking about the Fed’s path of tightening monetary policy. To facilitate our discussion, we turn to p.32 of the Guide.
- On March 16th, the Fed took several steps to tighten monetary policy:
- It raised the Federal Funds (Fed Funds) rate by 25bps for the first time since 2018 bringing the target range to .25 - .50%
- It published its Summary of Economic Projections (SEP), which includes a forecast of the Fed Funds rate and is on the chart in blue. You’ll notice that the forecast points to the Fed Funds rate reaching 1.90% by the end of 2022 and 2.75% by the end of 2023.
- They also signaled that Quantitative Tightening (QT) could begin after the next Fed meeting.
- The JPMorgan Global Liquidity view is for an additional 200bps of hikes in 2022, within that – a 50bp hike in May, a terminal rate of 3.0%, and approximately $3 trillion of Quantitative Tightening (QT) over the next few years. The Fed is clearly in inflation fighting mode, and these views reflect that.
- For several months, the market was pricing in 2% as the terminal Fed Funds rate. We disagreed with the market, which is why we have been cautious on extending maturities. Now that the terminal rate is priced above 3.0%, we are becoming a bit more constructive on yields and duration.
- The removal of stimulus injected into the system to counter the effects of the pandemic will include normalizing the size of the Fed’s balance sheet. The minutes of the March FOMC meeting on April 6th should provide further details on balance sheet reduction or what is otherwise known as Quantitative Tightening.
- As seen above on page 33 of the Guide, the Federal Reserve’s balance sheet expanded by more than $4.8trn through the pandemic and currently stands at $8.9trn.
- It is unlikely the balance sheet returns to pre-pandemic levels and we could foresee approximately $3 trillion in balance sheet contraction over the next few years, with a more rapid pace of runoff than in the last Quantitative Tightening cycle (2017-2019).
- Estimates vary, but the shrinking of the balance sheet could have the effect of an additional 1-2 hikes for 2022.
- In his January press conference Chairman Powell indicated that the “federal funds rate is the primary means for adjusting monetary policy”, and that reducing the size of the balance sheet “will occur over time in a predictable manner primarily through adjustments to reinvestments”. As a result we would expect balance sheet reduction to occur passively through bond maturities but would not rule out sales if necessary.
For 2022, we expected strong economic growth to continue, supported by wage gains, excess savings, and pent up demand for services. Our forecast was for US GDP growth of about 3.5% in 2022.
- Higher food and energy prices, exacerbated by the war in Ukraine, and a more hawkish Fed pose risks to that view.
- The yield curve (2year/10year) has begun to invert signaling that markets believe a soft landing may not be possible with the FOMC in inflation fighting mode.
- However, we believe the US economy, bolstered by a very tight labor market, should be able to weather these shocks without a recession in 2022 and we expect US GDP growth of 2.5% for the year.
- Geopolitical events are not to be ignored, but the direct linkages between the US,and Ukrainian and Russian economies are limited. To analyze this, we turn to p. 18 of the Guide.
- Ukraine and Russia are relatively small trading partners of the US: in 2021, US goods trade with Ukraine and Russia were $639mm and $23.3bn, respectively (census.gov). As you can see on the top right chart, the total US economy in nominal dollars was $24trn for 2021. Therefore, US trade with Ukraine and Russia represents less than 10bps of GDP.
- Although we recognize the headwinds to growth, higher commodity prices and inflation is where the US economy will be impacted most. Inflation fighting will be the Federal Reserve’s number one concern.
At this point, we will explore energy prices. For some thoughts on the oil markets, we turn to p. 29 of the Guide.
- With Russia accounting for roughly 11% of global oil supply, as seen in the chart on the top left, the conflict has pressured oil prices higher, with West Texas Crude hitting a multi-year high of $123 barrel on March 8th.
- For the average person, it is easier to think of inflation in terms of gasoline prices rather than oil prices. Since the Russian invasion of Ukraine, US national gas prices have increased about $0.80/gallon or about 20%.
- From a macroeconomics standpoint, for every $2/gallon increase in gas prices, it shaves 1% off of real GDP, which means that the $0.80/gallon increase we’ve seen so far is shaving about 0.40% off of real GDP.
- Now, how concerning is inflation? To frame our views on inflation, we turn to p. 26 of the Guide
- Last month, headline CPI printed at 7.9% year over year, which is the highest inflation in the US in 40 years
- This 7.9% figure does not even include the effects of 20% higher gasoline prices in March that we discussed on the prior page.
- I would not be surprised to see inflation comfortably above 7.9% for the month of March given the increases in energy and other commodity prices.
- In China we are now seeing an uptick in Covid cases, causing the health authorities to shut down major metropolitan areas, which is negating some of the supply chain gains in Q1
- The net effect of both of these situations in Ukraine and China is inflationary, pushing up our 2022 year end estimate for headline CPI to 5-6% from 4% a couple months ago.
- This was concerning enough for the Fed to turn decidedly more hawkish; in fact, after the FOMC release on March 16th, 2 year US Treasury yields have sold off by almost 60bps, taking their YTD sell off to 170bps!
As mentioned, we’ve seen a dramatic selloff in interest rates year to date. If you bought 2 year US Treasuries on December 31st, your return by the end of March would have been -2.54%. You can see that in the middle column on the left side of p. 36 of the Guide. And even more dramatic are the negative returns out the curve with 5 year US Treasuries returning -5.16% and the US Aggregate index down 5.93%
- We believe the Federal Open Market Committee (FOMC) has just begun what may prove to be one of the most aggressive hiking cycles in an effort to fight inflation, however, the market is now pricing in a terminal rate of over 3% with yields significantly higher than they were at the beginning of the year.
- With 2 year treasuries yielding over 2.4% and the average yield of a managed reserves portfolio of approximately 1.5%, we have come a long way and are more comfortable with yields and duration in the front end of the curve.
- The market is thawing, and we are starting to recommend that clients with available risk budget think about extending out of money market funds and into ultra-short strategies.
- With inflation at a 40 year high and events in Ukraine and China putting further upward pressure on prices, it is clear that the Fed are in inflation fighting mode.
- We expect a further 200bps of hikes in 2022 and a terminal rate of 3%.
- US growth is less likely to be directly impacted by what is happening in Ukraine, however, the indirect effects of higher commodity prices has led to our real GDP growth estimate for 2022 being revised down to 2.5%.
- Global Liquidity portfolios are well positioned to capture the uplift in overnight rates. Our money market funds will quickly reset a significant portion of their portfolios to higher yields due to the substantial positions held in overnight and weekly maturities.
- The hawkish shift from the Fed has led to negative performance in most fixed income portfolios YTD. That said, higher interest rates will benefit cash products going forward. For clients with a longer investment horizon, now may be a good time to step into the ultra-short space to capture those higher yields whilst still limiting duration risk.
To explore these topics further, please reach out to your J.P. Morgan Asset Management representative. Thank you for listening, and we look forward to speaking with you.
Hi, I’m Jeff Schill, portfolio manager for our international ultra-short duration portfolios.
What a difference a few months and even a few weeks can make. The start of the first quarter of 2022 was dominated by the resurgence of a more transmissible strain of Covid-19 and continued concerns over stickier inflation. However, as Omicron cases started to wane and nearly all Covid restrictions were rolled back in the UK and the rest of Europe, a new headline emerged to dominate markets, the Ukraine crisis.
While tensions were already high due to a build-up of Russian troops along the Ukrainian border in 2021, the war brought on a new wave of global uncertainty that rattled markets. As investors, what we will cover here and in meetings is the potential impact on global markets.
Global central banks were already beginning to articulate a concern for stickier inflation pre-crisis and the resulting spike in energy prices led to a further pricing-in of sustained high inflation prints and a hit to growth projections. Consensus growth estimates for the eurozone in 2022 were revised down by 1-2 percentage points since the start of the year. As a result, the market found itself at a crossroads, having to pick which narrative would drive volatility – stickier inflation or uncertainty stemming from war in Eastern Europe.
Throughout the quarter we got a mix of both – credit spreads widened due to concerns on war escalations but snapped back sharply. As all-in yields climbed higher, 1-3 year euro credit traded well into positive territory and led to an increase in demand from certain buyers. This increased demand drove spreads tighter following the risk-off events. Euro 1-3 year credit option adjusted spread (OAS) started the quarter at 68 basis points (bps) and ended around 97bps. The tightest level was 66bps and the widest came in early March at 135bps. Sterling 1-3 year credit OAS widened 34bps from the start of the quarter to 124bps. The tightest level was 86bps and the widest came in early march at 175bps.
As with any periods of market stress, fundamental credit analysis is crucial to how your portfolio can weather the turbulence. Direct or indirect exposure to the conflict region led to a divergence in spread widening across corporate credits, which highlights the importance of deep research teams and the ability to act quickly.
As we noted in our last quarterly update, one constant theme that developed towards the end of the year was the shift in central banks’ tone around inflation and that certainly continued during the first quarter of 2022 as monetary conditions were tightened. First up was the Bank of England (BoE). The BoE’s Monetary Policy Committee (MPC) raised the Bank Rate from 0.25% to 0.50% in a split 5-4 vote with dissenting members calling for a 50bps hike. The tone from the BoE and notion of front loading more than just a 25bps hike fuelled expectations of more hawkish sentiment in the March meeting. On 17 March, the MPC did raise the Bank Rate another 25bps to 0.75% but the hawkish tone from the February meeting evaporated. A complete see-saw back to a dovish stance was mainly driven by concerns over the war’s impact on household incomes and overall growth outlook.
The February European Central Bank (ECB) meeting shifted to a more hawkish stance as President Lagarde acknowledged that “things have changed” in regards to inflation. This was seemingly her first public acknowledgment that inflation may be much more sticky than anticipated. In March, the ECB continued to build on its hawkish sentiment despite acknowledging the large amount of uncertainty brought on by the war. The main takeaway from this meeting was the decision to accelerate the taper of asset purchases under Asset Purchase Program (APP). The acceleration pointed to the ECB’s desire to end net purchases under APP at the end of Q2 and then begin to raise interest rates.
There was a time in the not-so-distant past where economists were left wondering if the eurozone would ever come out of negative interest rate policies. Here we are now in March 2022, the Overnight Index Swap (OIS) curve is pricing in about pace of 25bps hikes per quarter from Q2 and reaching 1%. This implies that the market is pricing in a base rate of above 0 by the end of the year. This seems very reasonable as a base case – although it can certainly move higher and quicker if we continue to see inflation prints at current levels.
The Federal Reserve (Fed) rounded out the eventful first quarter of global central bank activity. The Federal Open Market Committee raised the fed funds rate target by 25bps for the first time since December 2018. Out of the three main global central banks, (BoE/ECB/Fed) the Fed seems to have expressed concerns over inflation more vocally – leading to a number of potential 50bps hikes in 2022.
So where does all of this activity leave us? Rates are clearly rising across the UK, Europe and the US as inflation expectations and market participants are testing central bankers’ desire to fend off high inflation without driving economies into recessions, and all with the backdrop of a war in Eastern Europe.
In a rising rate environment, we must remain disciplined in our approach to adding duration at current all-in yields. With seemingly attractive yields in fundamentally sound credits, future rate hikes must be considered along with breakeven analysis before adding products with interest rate risks. That being said, this is a great opportunity for clients in the front end of fixed income markets to finally take advantage of higher yield and return possibilities in the very near future.
The first three months of 2022 were packed with market and geopolitical activity driving uncertainty around growth, inflation, and the safety of the world as we have known it for a number of decades. While it is very challenging to predict what comes next, it is safe to say we will continue to be discussing stickier inflation and how aggressively central banks will adjust policy. Our themes have continually shifted over the last few quarters but the stickier inflation narrative is here to stay and the next debate will be around how far central banks can go before we enter a recession.
Source for all data is J.P. Morgan Asset Management and Bloomberg as at 31 March 2022
Welcome to J.P. Morgan Global Liquidity’s audio commentary. My name is Aidan Shevlin, I am the Head of the International Global Liquidity Fund Management Team, and today I will be discussing the economic and interest rate developments in China and other parts of Asia Pacific during the first quarter of the year and the outlook for the rest of 2022.
Starting with China – economic growth slowed in the fourth quarter of 2021 as regulatory reforms and property restriction continued to restrain activity while consumer sentiment and spending remained weak. In contrast, January and February data surprised on the upside, benefitting from robust exports and an easing of fiscal and monetary policies. However, a new Covid outbreak in late February, triggering additional restrictions and lockdowns across multiple provinces including Shanghai, casting doubt on the sustainability of the rebound. The government’s 2022 growth target, announced at the National People’s Congress, was regarded as ambitious, suggesting further fiscal and monetary policy stimulus would be required, although the People’s Bank of China (PBoC) left key interest rates unchanged throughout the period while bond yields edged lower and the curve steepened slightly.
Fourth quarter GDP recovered to 1.6%q/q, although the annual pace slowed to a new post-Covid period low of 4%y/y as multiple headwinds negatively affected industrial spending and consumer confidence. Therefore, investors were surprised when the combined January/February key activity data was stronger than expected, with industrial production rebounding on robust exports and the easing of energy constraints while retail sales was supported by online sales. Property activities continued to weaken, but at a slower pace, aided by a slight easing in lending restrictions, although the government remains committed to deleveraging the sector and discouraging risky borrowing activities.
A new Covid outbreak in late February rapidly spread to numerous provinces, triggering multiple lockdowns and mobility restrictions. With a significant portion of China’s GDP impacted by Covid restrictions; economic activity, especially in the service sector, slowed.
Headline inflation remained muted throughout the quarter, declining to 0.9%y/y as lower food prices offset higher energy prices. The producer price index also moderated to an 8-month low as energy and supply bottlenecks eased.
The National People’s Congress announced a 2022 GDP target of “around 5.5%” for China, this is relatively low by historic standards, but regarded as ambitious given the current economic backdrop. In subsequent comments, Premier Li acknowledged it would be challenging to achieve the government’s growth target, suggesting further fiscal support, including tax cuts, rebates and additional infrastructure spending was likely. The government also reiterated its commitment to dynamic zero Covid cases, although it did make adjustments to procedures to cope with rising local outbreaks, focusing on targeted lockdowns to minimize the economic impact.
Concurrently, the PBoC confirmed its commitment to supportive monetary policies to ensure economic growth remains within a reasonable range. The central bank maintained adequate liquidity throughout the quarter via open market operations, although investors were disappointed the PBoC did not cut its medium term lending facility or reserve requirement ratio in response to the weaker economic outlook.
Finally, in response to a significant increase in market volatility triggered by weak economic growth and geopolitical risks, the State Council’s Financial Stability and Development Committee issued a rare statement reiterating the government’s accommodative policy stance and focus on maintaining the stable operation of capital markets, designed to ease investors’ concerns.
Chinese government bond yields declined slightly and the curve steepened during the quarter as investors weighted the strength of the latest economic data relative to the likelihood of additional monetary policy support. In contrast, short tenor Shibor yields declined across the curve, while repo yields were broadly stable as the central bank focused on ensuring adequate liquidity.
Corporate spreads widened during the quarter as the property sector weakness continued to weigh on the broader market. Meanwhile, despite broad based USD strength on expectations of U.S. Federal Reserve interest rates hikes, the Renminbi was the top performing Asian currencies, declining only marginally versus the USD.
By the end of the first quarter, economic growth appears at risk of further slowdown as multiple headwinds, including, geopolitical risks, the largest Covid outbreak since early 2020 and continued property restrictions negate the benefit of brisk online retail sales and surprising industrial and infrastructure strength. Robust exports remain a bright spot and a source of currency strength, nevertheless additional fiscal policy support will be necessary to achieve the government’s economic targets.
Meanwhile, the PBoC has turned decisively dovish and lower inflation gives it the capacity to cut rates further, but the central bank appears reluctant to ease aggressively, especially given expectations of rapid Federal Reserve rate hikes. This suggests short tenor interest rates are likely to continue to edge lower – albeit gradually.
Beyond China, inflation concerns, Covid reopening plans and central bank policy pivots dominated investor focus during the first quarter of 2022.
In Australia, fourth quarter 2021 GDP rebounded to a 46-year high of 4.2%y/y as the economy reopened following Covid lockdowns. First quarter 2022 economic data was also stronger than expected with housing, industrial and domestic consumption data all trending higher. Employment numbers were particularly robust with four months of positive job creation pushing the unemployment rate down to a multi decade low of 4% in February, although lagging wage prices and fourth quarter 2021 inflation remained muted.
The Reserve Bank of Australia left overnight cash rate unchanged throughout the quarter, although they did end their quantitative easing program. Initially, RBA Governor Lowe continued to stress patience regarding rate hikes until they obtained greater clarity on inflation, the pandemic and the strength of the recovery. Although, notably, in subsequent speeches the Governor admitted rate hikes were plausible later this year.
In anticipation of continued economic rebound, rising inflation and increasingly hawkish comments from other major central banks, Australian BBSW and bond yields moved sharply higher and the curve steepened during the quarter. We believe future employment and inflation data will be the critical determinant of the RBA’s monetary policy over the coming quarters.
The Singapore economy also witnessed a potent economic rebound, with fourth quarter 2021 GDP printing at 6.1%y/y as robust manufacturing and construction activity offset weaknesses in services. First quarter industrial production, exports and domestic demand remained solid as the Omicron outbreak did not derail growth, allowing the government to ease Covid restrictions and commit to reopening the travel and tourism sectors.
In late January, the Monetary Authority of Singapore surprised the market by announcing a pre-emptive, off-cycle tightening of its monetary policy by increasing the slope of the SGD nominal effective exchange rate by an estimated 0.5%. The MAS explained the hike was based on expectations that GDP and inflation would be above trend this year.
As headline inflation hit a 9-year high of 4.3%y/y in February, short tenor and bond market yields increased sharply and the curve steepened further. With the US Federal Reserve increasingly hawkish and investors anticipating additional MAS hikes at their upcoming policy meeting in April, Singapore money market yields are expected to continue trending higher for the foreseeable future.
Thank you all for joining the conversation today. Should you have any questions, please reach out to your J.P. Morgan Asset Management representative.