18 March 2021
Our pro-growth outlook favours risk assets. While current spreads across fixed income sectors don’t offer obvious value, we see opportunities to collect carry in higher yielding parts of the market.
The result of our Investment Quarterly strategy meeting on 10 March was increased conviction in above trend growth as our base case scenario. This constructive outlook is driven by the combination of vaccines proving effective in the real world; upsized fiscal stimulus packages, particularly in the US; and the likelihood that excess savings will be spent, fuelling a recovery in services. As a result of these factors, we expect economies to experience a growth surge in the middle of this year. Our 2021 forecast for real GDP growth in the US is in excess of 7%—the highest level in 37 years. Furthermore, corporate fundamentals are on an upward trajectory, signalling a shift to the repair phase of the credit cycle. In particular, the ratio of companies being upgraded vs. downgraded has bottomed out, and we expect US default rates to fall from 6% currently to around 2-2.5% by year-end.
This pro-growth backdrop should drive interest rates higher, causing us to favour higher yielding markets that have scope to absorb a back-up in rates. For instance, US and European high yield (HY) spreads (373 basis points (bps) and 322 bps, respectively) are unlikely to widen in an environment of declining default rates. The front end of the HY market, in particular, offers cushion to any rate back-up: in the US, one- to three-year paper can withstand a 2.5% rise in interest rates before total returns are negative. The subordinated part of the capital structure in European credit also flags positively given that spreads are anywhere from 40 bps (for investment grade-rated hybrids) to 130 bps (for contingent convertibles) above their one-year tights. Within the emerging market (EM) space, our preference is also for higher carry opportunities such as high yield-rated hard currency sovereigns. These names register as cheap compared to competing markets such as US HY and EM investment grade-rated sovereigns. (Data as of 16 March 2021.)
High yield spreads are unlikely to widen in an environment of declining default rates
On the surface, the balance between supply and demand in some of these higher yielding markets may not appear to be favourable. Issuance has increased in US and European HY markets, as well as in European hybrids, and retail investor demand for HY, EM debt and investment grade credit funds has been lacklustre. However, flows into multi-sector strategies remain robust: aggregate funds have registered USD 4.3 billion of inflows so far this month, and unconstrained funds have received USD 2.1 billion. Inflows for aggregate and unconstrained strategies combined stand at more than USD 90 billion year to date. These flows indirectly benefit the various parts of the credit market as managers allocate across the fixed income spectrum. (Data as of 17 March 2021.)
What does this mean for fixed income investors?
An environment of accelerating growth, propelled by reopening economies and continued government and central bank support, is positive for risk assets. Given the impact that rising rates can have on fixed income investments, we favour markets with lower interest rate sensitivity and larger spread cushions.
About the Bond Bulletin
Each week J.P. Morgan Asset Management's Global Fixed Income, Currency and Commodities group reviews key issues for bond investors through the lens of its common Fundamental, Quantitative Valuation and Technical (FQT) research framework.
Our common research language based on Fundamental, Quantitative Valuation and Technical analysis provides a framework for comparing research across fixed income sectors and allows for the global integration of investment ideas.
Fundamental factors include macroeconomic data (such as growth and inflation) as well as corporate health figures (such as default rates, earnings and leverage metrics)
Quantitative valuations is a measure of the extent to which a sector or security is rich or cheap (on both an absolute basis as well as versus history and relative to other sectors)
Technical factors are primarily supply and demand dynamics (issuance and flows), as well as investor positioning and momentum