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 Q3 Review and Outlook for Global Liquidity investors using slides from the Guide to the Markets.
In the first half of 2022, already high inflation became even more elevated, the Fed became progressively more hawkish, and risk assets sold off. On the one hand, valuations are now at much more attractive levels than earlier in the year, but on the other hand, the forward looking picture becomes further complicated with increasing recession risks on the horizon. For liquidity investors, the key to the market remains a sober view on the path of the Fed’s monetary policy decisions. For this, we consider:
- The current state of growth (page 19)
- The implications of elevated inflation (pages 28 and 29)
- The Fed’s hawkish path of monetary tightening (pages 33 and 36)
Right now, Fed watchers are divided into primarily two camps: the recessionist doves who think the Fed will blink in anticipation of a softening economy and the inflationist hawks who think the Fed will stay firm on monetary tightening to tame pricing. To flesh out this debate, we will start on p. 19 of the Guide, where we will look at US GDP growth.
- As you can see on the left, the US economy through the end of 2021 had essentially recovered from the pandemic, with the solid actual output line just about touching the dotted 2% trend growth line.
- This year, without stimulus, however, growth has lost momentum, and Q1 GDP growth came in at -1.6%. Q2 and Q3 GDP growth should partially recover due to a still strong labor market, but we only see growth at about 1% for both quarters, which is below trend and below consensus.
- Unlike last year, each of the components of GDP (listed on the right chart) are coming under attack:
- Exports are facing a stronger dollar
- Support for consumption from savings drawdowns is fading. It is not on this chart, but nominal personal consumption grew a mere 0.2% (or 2.4% on an annualized basis) in May. To be fair, this is only a single monthly data point, but this data series is unadjusted for inflation, which means that consumption in May actually shrunk MoM on a real basis (Bloomberg: US Personal Consumption Expenditures Nominal Dollars MoM SA)
- Congress no longer has the appetite for large stimulus programs, thus limiting gains in government spending
- Capital expenditures and residential construction (i.e. investments) will be hampered by higher debt costs
- Exports are facing a stronger dollar
- While we would agree that these factors raise the likelihood of an outright downturn, we do not see the Fed blinking in the near term. Case in point, waning growth momentum this year, including negative GDP in Q1, has done very little to slow inflation, which means the Fed will have to put their inflation fighting credibility to the test.
We next turn to p. 28 of the Guide, to look at inflation itself.
- Drawing your attention to the blue line on the chart, Headline CPI is running at 8.6% YoY, which is the highest inflation we have seen since December 1981
- Although we do think inflation will come down eventually due to base effects, it will likely remain stubbornly high in the near term due to curtailed capacity in global food and energy production and rising US housing costs.
- In fact, we see headline CPI persisting in the 7-8% range for Q3, which is why we believe the Fed will remain hawkish. By these numbers, inflation technically has peaked, but we note that a drop to 7-8% will not be much relief to the average American.
- With inflation at 7-8%, the Fed will have little choice but to continue tightening monetary policy. Also remember that today’s 1.5% Fed Funds Rate (lower bound) is still well below current CPI of 8.6% and even below neutral, which we believe is 3% for this cycle.
While inflation may have peaked, looking at the components of inflation growth, which are depicted on p. 29 of the Guide (shelter and food in particular), we see inflation remaining painful this year:
- On shelter: the Richmond Fed is forecasting imputed owner’s rent to increase just over 5% this year YoY; this forecast is from late May and already incorporates the effects of higher mortgage rates. ( https://www.richmondfed.org/research/national_economy/macro_minute/2022/mm_05_24_22 )
- On food: the FDA is predicting prices of food at home to increase 8.5-9.5% and prices of food away from home to increase 6-7% this year ( https://www.ers.usda.gov/data-products/food-price-outlook/summary-findings/ )
- On energy: although some commodities, including oil, may be below their local peak prices, the YoY change is still very high
- As an example, the national average price of gasoline in the US was $5.01/gallon mid-June, which was the highest in history. It is now about $4.82/gallon; even if gas prices were to drop to $4.00/gallon for Q3, which would still be the highest national gas price since the Global Financial Crisis (GFC), Q3 gas prices would be up 28% YoY (Bloomberg - Daily National Average Gasoline Prices Regular Unleaded, AAA) – energy prices are notoriously very difficult to forecast, but it illustrates the point that Q3 YoY energy inflation numbers can be strong even if commodities continue to come off their recent highs.
- The only relief we have seen is on used car prices, which are down 5.7% YTD (Bloomberg, Mannheim US Used Vehicle Value Index SA)
- Of these components, shelter and food prices tend to be sticky which is why we think inflation will remain in the 7-8% range for Q3. It is also why we think the new longer-term neutral rate is 3% and no longer 2%.
This bring us to our call on the Fed. To visualize this part of the discussion, we turn to p. 33 of the Guide
- Our Fed call in JPMorgan Global Liquidity, is for a 75bps hike in July, a 50bps hike in September, and a peak Fed Funds rate of 3.75% in 2023H1; within this, we see a risk to higher rates in both the September FOMC meeting and the peak rate due to the inflation outlook.
- This is largely in line with the Fed’s own Summary of Economic Projections (SEP), but more hawkish than the market is currently pricing.
As you can see on p. 36. in the middle column, fixed income performance in H1 2022 has been very challenging.
- In fact, the Aggregate Bond index in H1 2022 experienced the 3rd worst half year performance in modern US dollar denominated bond market history.
- As we enter Q3, we see some more pain headed for longer duration fixed income as the Fed strives to control inflation.
- On June 30th, the 10 year yield was 3.02%. We see a continued bear flattener on the rates curve as the Fed hikes the Funds Rate towards 3.75%
- Although the recessionist doves appear to have the upper hand as we begin Q3, we believe the inflationist hawks will win out by the end of the quarter.
- Money market and ultra-short strategies have had some of the best performance amongst a number of investment options for Q1 and Q2, and we see that continuing for Q3
This brings us to our summary:
- In Q3, we estimate below trend GDP growth of 1% as the headwinds from a stronger dollar, depleted savings, a drag on government spending, and higher capital costs work against the still strong labor market
- At the same time, we see inflation persisting in the 7-8% range due to sticky shifts in shelter and food prices, forcing the Fed to remain hawkish
- Our call on the Fed Funds rate is a 75bps hike in July, a 50bps hike in September, and a peak rate of 3.75% in 2023.
- As such, despite much higher rates vs. the beginning of the year, there is still some more pain in fixed income markets further out the curve
- Unlike many other investment strategies, money markets and ultrashort duration are well positioned to benefit from monetary tightening; the key is managing investment time horizons
- To explore these topics further, please reach out to your J.P. Morgan Asset Management representative. Thank you for listening.
Asia Pacific Quarter in Review: China’s zero-Covid policy weighed on economic growth expectations
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.
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 the Asia Pacific region during the second quarter of the year and the outlook for the rest of 2022.
Starting with China: Economic growth slowed sharply during the second quarter as multiple Covid outbreaks across the nation provoked protracted lockdowns – which discouraged consumption, exacerbated the property downturn and disrupted production.
First quarter GDP was actually stronger than expected at 1.3%q/q, helped by solid trade data and robust infrastructure investment in January and February. However, the recovery in the annual growth rate to 4.8%y/y disguised economic weakness triggered by Covid inspired lockdowns, initially in Shenzhen and then for an extended period in Shanghai, while smaller outbreaks in other cities, including Beijing, necessitated additional local restrictions.
Key economic data in March and especially April was much weaker than expected with industrial production and retail sales plunging to the lowest levels since the start of the pandemic in early 2020 at -11.1%y/y and -2.9%y/y respectively. Fixed asset investments also weakened while unemployment jumped to a two-year high. Meanwhile, the pace of exports moderated as supply disruptions, higher prices and a global shift from goods to services as markets reopened weighed on demand.
In contrast to the rapidly rising prices witnessed in many Western markets, Chinese inflation remained muted throughout the quarter, averaging 1.9%y/y as declining food prices offset higher fuel prices.
Despite the significant economic impact of the lockdowns, the government remained committed to its zero-Covid policy. Fortunately, it did acknowledge the escalating risks to growth and committed to implementing additional stimulus measures to support the economy including tax refunds, social security payment deferrals and SME loan support.
Responding to the risk of a sharp economic downturn, the People’s Bank of China (PBoC) cut the reserve requirement ratio by 25bps in late April, leaving the weighted average ratio at a historic low of 8.1%. Subsequently, in May, the central bank announced the floor for mortgage rates would be cut by 20bps, while the five-year loan prime rate, ostensibly set by commercial banks, but approved by the PBoC was cut by 15bps to 4.45%. These actions were intended to support lending, especially in the property sector – although their size and impact was modest.
Chinese government bond yields edged slightly higher during the quarter and the curve steepened as investors contemplated the risk of additional bond issuance to stimulate the economy. In contrast, short tenor SHIBOR yields declined sharply across the curve to two-year lows, in anticipation of additional PBoC rate cuts. Meanwhile, stock exchange and inter-bank repo yields were broadly stable and lower as the central bank focused on ensuring ample liquidity.
Despite the lockdown disruptions and ongoing property market weakness, onshore corporate spreads tightened during the quarter as investors searched for yield. Finally, the Renminbi witnessed its largest ever monthly decline in April as lower growth expectations prompted international investor’s outflows, although the currency stabilized later in the quarter to end the term approximately 5% lower during a period of broad based USD strength.
By the end of the second quarter, China appeared to have successfully quashed the Covid outbreaks in Shanghai and Beijing, allowing the resumption of normal economic activity. High frequency data shows widespread signs of recovery, although the pace of the rebound is significantly slower than in the second quarter of 2020. Weak employment and muted property sales also remain a concern, as does the risk of further Covid outbreaks as the government remains committed to its zero Covid policy – although the recent easing of quarantine and travel restrictions should be positive for domestic consumption.
While the government has pledged to support the economy, the fiscal policies implemented during the quarter are modest at best, stabilizing rather than boosting growth, suggesting it will be very difficult for the authorities to achieve their 2022 GDP target. Meanwhile, we believe the PBoC will be reluctant to cut rates again given the aggressive rate hikes implemented by the US Federal Reserve, implying that short tenor interest rates are likely to remain at their current low levels for the foreseeable future.
Beyond China, inflation and growth concerns dominated investor’s focus, with hawkish central banks front loading rate hikes to curb rapid price rises.
In Australia, economic data remained broadly robust with first quarter GDP increasing by a stronger than expected 0.8%q/q as domestic consumption rebounded. The unemployment rate declined to a 48-year low of 3.9% in April while wage prices increased further, boosting retail sales and consumption. Second quarter exports and industrial production were boosted by solid commodity demand, which was also reflected in elevated business confidence readings. In contrast, house prices started to moderate, declining in May for the first time in almost two years, although they remain close to record highs. Consumer confidence also weakened as higher prices and interest rates weighed on sentiment.
Inflation, which is only published quarterly and was previously muted, jumped to a 22-year high of 5.1%y/y in the first quarter on broad based prices increases. This triggered a hawkish pivot by the Reserve Bank of Australia (RBA), which hiked its overnight cash rate (OCR) by 25bps to 0.35% at its May meeting. This was the first hike in over a decade and lifted rates from their pandemic emergency lows. Noting that higher energy prices, supply chain disruptions and the negative impact of the Russia-Ukraine conflict meant that inflation was higher than they had earlier anticipated and likely to increase further, the RBA hiked again in June, by a larger 50bps, taking the OCR to 0.85%.
Australian BBSW and bond yields moved sharply higher and the curve steepened further during the second quarter as the market anticipated faster and more front loaded rate hikes. We believe future inflation data will remain the critical determinant of RBA’s monetary policy over the coming quarters.
Singapore economic growth also remained strong in the second quarter as key export, industrial production and domestic consumption data rebounded. First quarter GDP increased by 0.7%q/q, pushing the annual rate to 3.7%, as the easing of travel restrictions boosted tourist arrivals and spending. Although subsequently the government did suggest full year growth would likely be at the lower end of its official 3% to 5% range due to increasing global headwinds.
Inflation continued to trend higher throughout the quarter, hitting a decade high of 5.6%y/y in May on elevated food, housing and transportation costs. In response to the escalating inflation pressures, the Monetary Authority of Singapore (MAS) re-centered the mid-point and increased the slope of the Singapore dollar nominal effective exchange rate at their semi-annual policy meeting in April. This represented the third hawkish hike by the MAS and was more aggressive than expected as the central bank revised up its core inflation forecast and acknowledged that inflation was likely to pick up sharply in the coming months.
In response to global and local central bank actions, Singapore bond and money market yields moved sharply higher and the curve steepened further during the quarter. With solid local demand likely to offset any moderation in exports, the Singapore economy is expected to remain robust for the remainder of 2022. Combined with more aggressive Federal Reserve rate hikes and the likelihood of additional MAS hikes, we believe Singapore money market yields will likely continue to trend higher over the coming quarter.
Thank you all for joining the conversation today. Should you have any questions, please reach out to your J.P. Morgan Asset Management representative
UK & Europe Q3 2022 in Review and Outlook: The road to future rate hikes hit by growth speed bumps
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.
If Q1 2022 was all about inflation and Central Banks waking up to the reality that they were behind the curve and needed to act and fast, well … Q2 was the quarter where the Fed and Bank of England cracked on with their tightening cycles at ever faster clips and the European Central Bank preannounced a July lift off for their own normalisation of policy … and the first steps to move away from negative interest rates.
As we approached the end of the quarter, mixed economic data increasingly fuelled the markets concerns surrounding the potential for economic slowdown and recession and, in a rather violent manner, the heightened expectations for future rate increases moderated meaningfully.
To choose one word to sum up Q2 , we would call it VOLATILE. Daily swings in 2 year government bonds of up to 10 or 20 basis point have become commonplace, adding a dimension to markets largely absent in the years of quantitative easing and forward guidance, … where the central banks largely snuffed out any material volatility from many risk markets.Well volatility is back, and if July 2022 is anything to go by, with a vengeance!
Q2 witnessed rates curves trend higher (although latterly exhibiting more volatile characteristics), credit spreads widen and equities also suffer. So the first half of 2022 has been pretty brutal for both stocks and bonds, there have been very few investors actually making money year to date.
As we look forward into the second half of the year we expect this market volatility to continue based on our view that the inflation versus growth debate is not over and the economic data will continue to paint a rather mixed picture. One thing we will say with conviction is the central banks will continue to hike, potentially aggressively for the remainder of the year, increasing the yields in our portfolios, despite our very conservative fund positioning.
After almost a decade of ultra-low rates, this is at least something for our clients to cheer, especially in Europe where we will soon revisit positive yields and hopefully stay there!
With Central Bankers making it clear that they believe restoring price stability is currently more important than the risks of harming the economy due to higher rates. They are basically telling us, in the near term at least, they will need to continue to hike and potentially aggressively.
It’s noteworthy how far we have come though, moving on from low rates … forever, just a matter of a few months ago .. to … will the ECB move in clips of 25 basis points or 50 basis points, just like we have seen from the Fed and Bank of England?
So COVID … and war … are clearly inflationary. Neither were forecast nor planned for. For Europe especially, the inflationary outlook changed significantly post the 24th of February, with the Ukraine crisis. The ECB now needs to combat this and do everything in their power to stop inflation from becoming embedded in the system .. but that being said, the market is now increasingly concerned they will probably tighten us into recession - lots of things for a fund manager to think about … so, what does all of this mean for our funds positioning and strategy?
For many months now … we have been increasingly worried about ECB repricing, and the risk they will need to play catch up, to ALL THE OTHER central banks “playing catch up” to their inflation realities ... like the Fed or Bank of England ... … We are certainly seeing that now.
For the ECB … well Similar to US, the debate has now shifted from maybe hiking in 25 basis points to probably moving in 50 basis points, at least in some meetings
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 ….. as you can be losing money in even 6 month maturities as rates expectations repriced more and earlier hikes.
On the Euro portfolios, despite recent volatility, market pricing is expecting either 25 basis points or 50 basis point hikes at each of remaining 4 ECB meetings we have this year. So July , September, October and December.
So by year end the market is pricing the deposit rate at POSITIVE 85 basis points (we are currently negative 50 basis points) … This feels like a fair assessment of what the ECB can achieve, however in this back drop of central banks focusing on inflation and expected 25 basis points hikes morphing to 50 basis points as inflation continues to trend higher .. we remain wary that the front end of curve could reprice further .. this keeps us a LOT CLOSER TO CASH than we previously would be in portfolios and WAMs and WALs are near historic lows.
It’s a similar story in the UK, although concerns about the squeezed consumer have been front of mind for some time and the Bank of England themselves have voiced concerns about the prospect of a slowdown. Having said that, we are currently pricing at least another 150 basis points of tightening before year end with rates expected to hit 3% by March next year! Despite the pain .. rates appear to be going higher … everywhere!
For terminal rate for Europe – well looking out the Overnight Index Swap curve – market is pricing rates to peak at 1.8% in December next year. Whether this is enough or not remains to be seen … lots of reasons for inflation to stay stickier and rates to peak higher. Some of these include:
- Wages – workers are demanding more money – the union are looking at double digit inflation and saying a 2% salary rise simply won’t cut it . There are now risks of doctors, teachers and bin men striking by the summer in the UK … Similarly the .. IG metal union in Germany – so the German metals and engineering sector are asking for around 8% pay increase. We will be monitoring very closely trends in wage inflation.
- 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 distraction.
So, perhaps not surprisingly, our current strategy is to remain cautious in our strategies until our conviction levels pick up.
On the bright side we will be achieving yields not seen in over a decade very soon by sitting in cash. Our focus is on managing portfolio volatility and minimising losses on our strategies, 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 2 years in curve, is at or near historic highs.
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 technical’ s 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 quantitative easing and ultra-low rates forced riskier credit spreads towards historic tights and 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 quantitative easing, 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. This is not a fluke, 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 second half of 2022.