- While recession remains our base case scenario, we’ve lowered it slightly to 55%, given that policymakers need time to work through years of policy stimulus. We raised the likelihood of Sub Trend Growth to 40%; our Crisis and Above Trend Growth scenarios are unchanged at 5% and 0%, respectively.
- In our view, the Federal Reserve would need to see core inflation near 2% and unemployment rising toward 4% before cutting rates. While we are skeptical that inflation can return to target without a recession, it is unlikely to start before 2024.
- The chief risk to our forecast is that central banks lose patience in waiting for monetary policy to take hold, and tighten policy well beyond market expectations.
- Agency mortgage-backed securities are our top pick. We plan to use any backup in yields to add high quality duration to portfolios.
“Box box … box box”
Our June Investment Quarterly (IQ) was held in Columbus, Ohio, a week after the Federal Reserve (Fed) delivered a very hawkish pause. After 10 consecutive rate hikes totaling 500 basis points (bps), the central bank decided it was time to pause and evaluate whether the much-discussed long and variable lags of tighter monetary conditions were starting to bite and further slowing growth and inflationary pressures. The Fed’s infamous Summary of Economic Projections (and accompanying dot plot) indicated two additional 25bps rate hikes are anticipated later this year. Clearly, policymakers are uncomfortable with the stickiness of core inflation and unwilling to again assume it will be transitory.
The group spent a considerable amount of time drilling into data and trying to make sense of the macro backdrop. Consistent with late cycles, data and views were mixed. While there was a growing list of indicators that registered levels never seen other than in recessions, unemployment and inflation were reminders that the Fed had more work to do. In the end, perhaps policymakers were right to pause and wait a few months to gauge what the cumulative and lagged impact of monetary tightening has been. Federal Reserve Chair Jerome Powell apparently has decided it’s that time, when the economy needs monetary policymakers to do some critical end-of-cycle fine-tuning – like a pit crew calling a fast-moving Formula 1 race car in for speedy, expert track-side adjustments. It’s an often make-or-break moment in a race known as a “box box.” What that might be and how the economy and markets will react were the focus of our meeting.
With hindsight, had we known that the central banks would engineer the volume of rate hikes that have occurred (cumulatively, ~5,000bps in the developed markets and ~28,000bps in the emerging markets since January 2021) along with significant quantitative tightening, we would have thought the global economy would be in recession by now. Throw in the UK pension crisis last September and the U.S. regional bank crisis in March, and we would have believed that the central banks would be cutting interest rates. Instead, job growth is still firm, core inflation remains sticky, and central banks are intent on raising rates even higher.
It does not seem to matter that yield curves have been inverted for multiple quarters, recession models are flashing red, and input costs are plunging. The Fed has reiterated that success cannot be declared until core inflation is at 2%—which seems distant. It appears the consumer is continuing to drive the U.S. economy. Although the jobless claims data have turned up, unemployment remains low and consumer excess savings is still above 2019 levels in aggregate. Further, the housing market has stopped weakening, suggesting that the consumer remains resilient. Outside of the U.S., the picture is no different, and in some cases it is worse. Inflation remains high in the UK and Europe, and both the Bank of England and the European Central Bank are signaling significant rate hikes ahead.
While we cannot dismiss the delayed impact of monetary tightening, we can take the central banks at their word that they are committed to bringing inflation down to 2%. We are skeptical that inflation can be brought back to target without a recession, but that does not seem imminent. We believe recession is likely by the start of 2024. Though the Fed typically cuts rates before the start of a recession, that may not be the case this time. Like the 1981 experience, with inflation high and the Fed’s credibility threatened, policymakers may wait until recession is clearly in the cards before having conviction that inflation is under control and rates can be brought down. Some combination of core inflation near 2% and unemployment rising toward 4% is, in our view, what the Fed would need to see before cutting rates.
The common denominator of all previous recessions has been the removal of an overabundance of cheap funding. Given the overwhelming fiscal and monetary policy response to COVID-19, the removal of abundant, cheap liquidity is simply taking longer than we had anticipated. The rate of change in a slowdown is there, but the overall level of activity is still too high.
Recession remained our base case, but the probability was lowered to 55% from 60%. While the central banks are committed to bringing inflation down to 2% and willing to sacrifice the economy to get to that level, the group appreciated that it is taking longer to work through several years of accumulated policy stimulus. The leading indicators with reliable and long track records continue to suggest recession is ultimately most likely.
Sub Trend Growth was raised to a 40% probability from 35%. The period from last rate hike to recession takes about a year, on average. During that period, it will feel and look as though a soft landing has been engineered. We expect that to happen this cycle once the Fed signals that it has concluded its tightening cycle. A soft landing seems aspirational, but the markets may price that in on the way to recession.
Crisis at 5% and Above Trend Growth at 0% remained unchanged. Policymakers showed us during the regional banking crisis that they will quickly step in and arrest the downside during dislocations. On the other hand, there is absolutely nothing in the data that points to a sharp reacceleration in growth.
The primary risk to our forecast is that the central banks lose patience in waiting for the long and variable lags in monetary policy to take hold, and tighten policy well beyond market expectations. The single-minded focus on bringing inflation to 2% ignores that growing volume of data suggesting the global economy is already in or rapidly approaching recession. Overtightening policy runs the risk of not only bursting the unsustainable excesses that had formed (crypto, meme stocks, growth at any price, SPACs, etc.) but also unleashing a range of unintended consequences (e.g., regional banks).
We are also keeping an eye on three significant stress points. While the regional banking system has been stabilized, its problems have not been solved. We are also concerned about high vacancy rates in the central business district office space. Lastly, there are more signs that the volume of floating rate borrowing in corporate America (bank loans, private capital, etc.) is creating operating pressures and bankruptcies.
We spent time discussing whether we should embrace risk assets in general and high yield bonds specifically.
We felt that, at current levels, high yield was priced for a soft landing and did not adequately protect us if a recession occurred in the time horizon we expected. Our overwhelming bias was to use any backup in yields to add high quality duration to portfolios.
Agency mortgage-backed securities were our top pick. While the technicals of Fed balance sheet runoff, FDIC selling and lower bank demand are challenging, valuations are at their cheapest level since the height of the global financial crisis.
Local emerging market debt also attracted attention. Despite its good performance year-to-date, the sector seems to be unloved and under-owned by crossover buyers.
The last three months should have been no surprise. After months of aggressive monetary tightening, there was a regional banking crisis followed by a meaningful policy response resulting in a sense of relief that caused a subsequent rally in risk assets. With the banking system managed for now, central banks have renewed their focus on inflation. Nonetheless, the signs of recession are mounting, although the eventual timing may be pushed into 1Q 2024. Adding risk here appears to be the equivalent of picking up nickels in front of a steamroller.
Scenario probabilities and investment implications: 3Q 2023
Every quarter, lead portfolio managers and sector specialists from across J.P. Morgan’s Global Fixed Income, Currency & Commodities platform gather to formulate our consensus view on the near-term course (next three to six months) of the fixed income markets.
In day-long discussions, we reviewed the macroeconomic environment and sector-by-sector analyses based on three key research inputs: fundamentals, quantitative valuations, and supply and demand technicals (FQTs). The table below summarizes our outlook over a range of potential scenarios, our assessment of the likelihood of each, and their broad macro, financial and market implications.
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