Asia Pacific Quarter in Review: Diverging inflation paths shape Asian interest rates
Aidan Shevlin, Head of International Liquidity Fund Management, discussed the economic and interest rate developments in China, Australia and Singapore during the past quarter and outlook.
My name is Kyongsoo Noh, 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 Q4 Review and Outlook for Global Liquidity investors using slides from the Guide to the Markets.
The first half of the year in the US saw high and accelerating inflation and a full labor market getting even tighter. In the second half of the year, we see some reversals: high but decelerating inflation and a full labor market getting softer.
For liquidity investors, the key to the market remains an educated view on the path of monetary policy. Despite the expected reversals in the inflation and the labor market, the Fed still has more work to do. For this quarter’s review and outlook, we will analyze:
The current state of growth (page 19)
Inflation and the labor market (pages 29, 30, and 27)
The Fed’s continuing path of monetary tightening (page 34)
We start on p. 19 of the Guide to talk about US growth
We see positive real growth in Q3 and Q4 of this year, primarily due to two things:
Although it is decelerating, a still strong labor market will support a modest amount of consumption growth
Improving supply chains will help accelerate inventory buildup for the remainder of the year
Numbers-wise, we see Q3 GDP growth at 1.5% and Q4 at 1%, which will offset the -1.6% for Q1 and the -0.6% for Q2, summing to about 0% GDP growth for full year 2022.
A real YoY GDP growth rate of 0% is certainly underwhelming, but it is still not going to be slow enough to bring down the current Headline CPI of 8.2% to the Fed’s target of 2% by the end of this year
Monetary policy typically works with a lag, and next year in 2023, we do expect the US to enter a recession as our base case; however, we anticipate a more traditional rather than a deep recession because:
The shortage of workers in the US will limit fallout in the labor market (we will touch upon this first point later)
The consumer is healthy and consumer leverage is benign
Overshoot in cyclical activity that normally precedes recessions (specifically, residential construction and corporate capital expenditures) is pretty non-existent
To continue our discussion, we turn to p.29 of the Guide, which shows various measures of inflation
As seen on this chart, Headline CPI is running at 8.2% YoY, which is off the recent peak but still some of the fastest price increases in the US in 40 years
Due to base effects, stabilizing commodities markets, and supply chain improvement, we expect inflation to slow down to 6.5% by year-end
Near term relief beyond that will prove elusive, in our view, because of the stickier shelter component of inflation in particular
For a deeper dive into inflation, we turn to p.30 of the Guide where on the left, we can see contributions to CPI growth by component category.
It is not explicit on this page, but shelter makes up about one third of CPI; this sizable proportion makes sense because for the average person, their mortgage or rent payment is their largest monthly outlay; another couple things to note about shelter costs are that they are not typically volatile and they tend go up (in other words, they are sticky with positive bias)
The shelter portion of CPI is up 6.3% YoY, well over the 20 year average of 2.7% (US CPI Urban Consumers Owners Equivalent Rent of Residences YoY NSA, Source: Bloomberg), and unfortunately this figure is still climbing; since shelter makes up about a third of CPI and it grew 6.3%, its weighted contribution to overall CPI growth was about 2% by itself (see the bottom of the stacked column for August on the left); remember the Fed’s target for inflation is 2% and as of now, shelter generates that on its own
Eventually, shelter inflation will abate but it will likely take a recession to get there; until that point, shelter will remain a support to elevated inflation and push the Fed to remain hawkish
You may ask: aren’t home prices softening today? The answer to that is yes -the S&P/Case-Shiller U.S. National Home Price Index is down slightly from the peak in June 2022 (Source: Bloomberg); however, shelter inflation is a reflection of monthly payments not home prices; through that lens, rents are rising as are payments on newly originated mortgages
Now we switch gears and turn to p.27 of the Guide, where we have three different charts on the labor market.
We are off the extremes of job openings, quits, and layoffs but these indicators are still pointing to near all-time strength in the employment sector
It is not on this page, but one big reason labor demand is strong is because the US has a worker shortage
The US labor force was 159 million workers in December 2019 prior to the pandemic
That figure troughed at 133 million in April of 2020 during the beginning stages of the pandemic shutdowns, but has recovered back to 159 million as of August 2022 (US Employment Total in Labor Force SA, Source: Bloomberg)
The problem is that the overall US population is currently growing by about 0.5% per year (Source: US Census Bureau), which means that the labor force should be about 2 to 3 million workers higher today than what it was at the end of 2019, all else being equal
There are two implications of this worker shortage or “anti-slack” in the labor market: (1) when we do get a recession, this anti-slack will soften some of the economic hit and (2) for now, it makes it easier for the Fed to remain hawkish if inflation is high, but people still have jobs
It is also not on this page, but unemployment is 3.7% today, and we see it ticking up to 3.9% by the end of the year. So the labor market has peaked, but it remains strong and still points to tighter monetary policy
This brings us to the Fed, and for this part of our outlook, we turn to p.34 of the Guide.
Synthesizing what we have said so far:
We are seeing some small reversals: inflation and labor are coming off their peaks, but they remain elevated (we see inflation dropping to 6.5% and unemployment ticking up to 3.9% by the end of the year)
This means that the tightening by the Fed so far is working, but it also shows that the Fed’s work is far from done; remember the Fed’s stated goal is to bring inflation back down to 2%
We also see US GDP growth at 1.5% for Q3 and 1.0% for Q4
All of this points to a continued green light for the Fed to hike further, and our call in Global Liquidity is for a 75 bps hike in November, a 50 bps hike in December and a 25 bps hike in February, taking the Fed Funds target range to a peak of 4.50% to 4.75%
This is in line with the Fed’s Summary of Economic Projections (SEP), but about one hike above current market consensus, which warrants continued caution in the rates markets
And now for our final thoughts:
Early in Q4, we are seeing a rally in rates due to fears of a deep recession both in Europe and the UK, an escalation of the Ukraine Russia war, and short covering.
Eventually, there will be an attractive entry point on US rates especially considering our view of a recession next year, but we believe this rally in early Q4 is premature.
In light of our views on the Fed, we continue to be wary of duration even in the liquidity part of the curve; for money market strategies, this means continued use of repo, healthy amounts of weekly liquid assets, and letting longer positions roll down; for ultrashort strategies, it means reducing curve risk and holding higher amounts of outright cash.
To explore these topics further, please reach out to your J.P. Morgan Asset Management representative. Thank you for listening.
UK & Europe Q4 2022: The quarter of "Mini" budgets, JUMBO hikes and new Kings
Neil Hutchison, lead portfolio manager for our international ultra-short duration funds, provides an update on the current market environment in UK and Europe and how it impacts investment strategy.
Hi, I’m Neil Hutchison, lead portfolio manager for our international ultra-short duration portfolios.
Q3 2022 will go down in the annals as once of the most eventful quarters in history. It had a bit of everything … in the UK we got a new PM and a new King ….. in the same week, …. we witnessed central banks, globally, making increasing hawkish squawks …. and then following up with increasingly large rate hikes, …. We witnessed extreme volatility playing out in the rates markets ……….. the cost of living crisis in Europe got even worse due to high costs of energy and food ……. forcing governments to step in with support measures … that ultimately have to be paid for, so more near term government borrowing .. pointing to even higher yields! The new UK government decided to take this a step further and announced a radical new Growth Plan that ultimately almost broke the gilt market, and this is without mentioning further escalations in Russia/Ukraine and a new far right government in Italy. Definitely lots of news flow for us all to digest.
So where do we start…let’s start with the good news …. well at least for some of Global Liquidity’s clients!
The ECB … eventually … crashed the rate hiking party in July – hiking the deposit rate by 50bps to 0%. A momentous move for all of us investing in front end markets, as it closed the chapter on their Negative Interest Rate Policy experiment . An experiment that has shaped our front end investment universe for almost 10 years!
The ECB told us that this is the first of several hikes and promptly followed up the July move by hiking by an even more aggressive 75bps in September and looking forward, the market is expecting JUMBO 75bp moves to remain on the table for the remainder of the year.
Inflation and inflation expectations are a problem globally …. and with the ECB one of the last to act ….. it appears they have a bit of catching up to do in order to keep inflation expectations in check.
Whilst higher (and positive) cash yields are certainly welcomed by our clients , this current environment of jumbo rate hikes and heightened volatility is very challenging to navigate for investors.
Central bankers are telling us they are now “data” dependent and have dropped forward guidance , this has certainly increased volatility in the markets. Especially as the “data” in the UK and Europe is pointing towards recession.
But more importantly for central bankers at this point in time … “the data” is also pointing to the risk that inflation becomes embedded in the system.
So for the growth versus inflation debate, the central banks ALL seem to be in agreed on one thing right now, and that is they, the need to focus on the RISKS of INFLATION becoming more structural in nature or to put it another way, interest rates WILL need to go higher despite the risks of recession.
So the front end of the rates curve is anything but boring and predictable right now… concerns about structural inflation have forced the global central banks to move more aggressively in tightening monetary policy.
25bps no longer seems enough, even 50bps hikes, that seems excessive a few months ago, now would underwhelm expectations, as we look forward into the remaining central bank meetings for 2022 the market as of early October is expecting the Fed to hike 75bps on 2 November and another 50bps on 14 Dec, this will take cash rates to around 4.25% by the end of the year.
Similarly in Europe we are expecting the ECB to hike 75bps on 27 October and almost the same again on 15 December, so the deposit rate above 2% by year end.
In the UK, dealing with the fall out of the disastrous and developing Fiscal policy blunder, well market pricing is no longer expecting inter meeting hikes, but we still expect around 1% on 3 Nov and probably another 1% on 15 December. This will take year end pricing to around 4.75% .
Focusing on the UK, the fallout from the mini budget has been extreme, but perhaps the most concerning of all, considering recent developments, is market credibility in the new government and their policies is now severely damaged, and may be very hard to rebuild.
With their policies deemed inflationary, fiscal discipline largely absent and an increasing government debt mountain dependent on international investors seeing value (or the “kindness of strangers”) .. there are a lot of reasons to remain cautious with respect to UK risk.
Volatility surrounding UK rates markets has been compared to Emerging Markets, and with uncertainty and sentiment still challenged we expect this to remain an issue for the near term.
The Bank of England, is now between a rock and a hard place, with inflation forecasts now higher and the value of Sterling lower against the dollar (which is also inflationary) , they now need to hike even more. Looking at terminal rates the Bank is currently expected to hike until they hit 5.75% in the middle of next year. This is more than a percent higher than the expected peak rate in the US, and 3 % higher than where the market is pricing for Europe… such high rates are obviously a concern for the consumer with both 2 and 5 year mortgages now showing rates of at least 6%...so more pain ahead for the UK consumer. The only questions that remains is how deep and how long will the recession be? … and considering the growth versus inflationary challenges, will the BoE be able to hike all the way to almost 6% next year?
For liquidity investors monitoring the front end of the rates and credit markets, maintaining an exceptionally short duration position has been critical to protect performance, considering the pivot from normal 25bp hikes into JUMBO 75bp or higher, has made cash the most attractive asset class of the past few months. With such dramatic repricing of front end curves investors can be losing money in investments as short as 6 months, as markets reprice rate expectations for larger and quicker hikes. Building a war chest of cash has been helpful for ballast as well as total return in recent months.
For terminal rate for Europe, also dealing with heightened uncertainty , mainly around energy security, …. well looking at forward curves – the market is now pricing rates to peak at 2.75% in September next year. Whether this is enough or not remains to be seen .. we are increasingly concerned that inflation could stay stickier and rates may need to peak higher and remain higher.
1) We remain very focused on Wage inflation – unions across Europe are looking at double digit inflation and saying a 2% salary rise, for example, simply won’t cut it . Train strikes in the UK are now commonplace, and its not just the rail union, industrial action is at a generational high in the UK and increasing across Europe
2) Then themes like food security, energy security, supply chain – friend shoring, green revolution . .. well that is all in some way inflationary. So …. for neutral rates – who knows? But the risks are they could be higher, irrespective of recession and demand destruction.
So, perhaps not surprisingly, our current strategy is to remain cautious in the funds until our conviction levels pick up. We value outsized cash positions in volatile market environments , so we continue to focus on very short and high quality investments.
On the bright side we will be achieving yields not seen in well over a decade very soon by sitting in cash. Our focus is on managing portfolio volatility and minimising losses on the fund, and in our opinion, the pain trade for front end rates , could have more to run.
Another reason to remain cautious is the volatility we are feeling in rates markets – our clients, in ultra-shorts are looking for incremental return and not volatility .. current volatility even at 1 years in curve is at or near historic highs, certainly in the UK markets recently.
With uncertainty levels high and conviction levels low, we expect this volatility to remain a theme for the remainder of the year.
For credit, spreads have been widening steadily this quarter as deteriorating fundamentals and technicals are being reflected in valuations. We are also witnessing a trend where lower quality credit widening at a faster rate than higher quality. We would class this “decompression” as healthy normalisation of credit tiering. Central bank QE and ultra-low rates forced riskier credit spreads towards historic tights we are seeing a reversal of that now. We are certainly mindful of this in portfolio positioning and have been operating an up in quality portfolio approach for much of 2022 so far.
In an rate rising environment , fixed income investors should beware of blindly adding duration into their portfolios. It’s critical to monitor breakeven and consider what is already priced with respect to expected future hikes before adding any investment with interest rate risk. Similarly , with concerns surrounding recession rising by the week , and central banks no longer engaging in QE, active management with respect to credit investment is also key . Having a team of analysts monitoring the competitive and economic landscape for names on our buy list is critical as owning the wrong name could cost you in terms of negative returns. Active management is therefore key and having a blinkered focus on yield may actually come at the cost of lost returns.
So in conclusion, it’s been a tough year so far for global markets but our conservative positioning and active management have allowed our portfolios to deliver high liquidity, low volatility and benchmark performance. The Global Liquidity strategies, ranging from liquidity funds to ultra-short duration portfolios, are designed to perform relatively well in an environment of rising rates and we believe our solutions will continue to help both corporate treasurers as well as term fixed income investors through the final quarter of what has been a rather challenging 2022.