04 November 2021
Compared to rates markets, risk markets have held up fairly well in recent weeks. We outline why we think this situation is likely to persist and look at where the opportunities currently lie in fixed income markets.
Central bank rhetoric has dominated headlines recently, leading to volatility in rates markets. We’ve seen hawkish shifts from the Bank of Canada and the Reserve Bank of Australia, but the key central banks to watch will be the ones with most clout, namely the Federal Reserve (the Fed), the European Central Bank (ECB) and the People’s Bank of China (PBoC). We don’t expect a meaningful near-term shift from the PBoC, while the ECB has pushed back on market pricing of 2022 rate hikes, but only gently. The Fed, meanwhile, has announced a gradual reduction in its asset purchases, but has also stated that the criteria for interest rate increases will be more difficult to satisfy given elevated unemployment and lacklustre labour force participation. Therefore, we still believe that global monetary policy will tighten gradually, which should enable the expansion to continue and support a robust outlook for corporate earnings growth. In contrast to central bank signals, corporate fundamentals have been far less volatile. With more than half of listed companies having now reported their third-quarter results, earnings estimates have been exceeded by roughly 10% in both the US and Europe. This strong earnings growth feeds through to improved credit metrics, such as lower leverage, which is in turn being reflected in positive rating trends. Importantly for credit and high yield markets, default rates remain benign at 0.9% in the US and 1.5% in Europe. We expect defaults to continue to fall and will end 2022 at around 1%.
Most of the recent market volatility has manifested itself in developed market government bonds, especially at the front end of curves. The US two-year government bond yield now stands at 0.45%, having moved 17 basis points (bps) higher so far in the fourth quarter. Canada and Australia have seen even larger moves, of 52bps and 67bps, bringing two-year yields to 1.05% and 0.72% respectively. Risk markets on the other hand have been slightly more subdued: while the S&P 500 continues to reach all-time highs, the high yield market has seen some spread widening, but a modest amount compared to front-end rates. US and European high yield spreads stand at 323bps and 333bps respectively, having increased by 7bps and 28bps this quarter. The rebound in Europe has lagged the US as the region has been dragged down by its real estate exposure, while Europe has also not benefited as much as the US from the rebound in the price of oil, as Europe’s exposure to the energy sector is lower, at roughly 2% versus 14% in the US. (All data as of 2 November 2021.)
Front-end government bond yields have seen more volatility than high yield spreads
Demand for risk assets is certainly helping to prop up the performance of risk markets despite the volatility in rates markets and uncertainty about future policy changes from central banks. While high yield fund flows have been negative over the past couple of months, there is evidence to suggest that there is ample demand from institutional buyers, who continue to be faced with little alternative with almost 20% of the global aggregate bond market trading with a negative yield. Central banks may be discussing dialing back their ultra-accommodative policy, but while major bond buying programmes remain in place, investors are continuing to be pushed down the credit risk spectrum. Equity demand, meanwhile, has remained positive, with US equity funds receiving inflows of about $64 billion over the past three months. The new normal for global asset allocators appears to be to reduce equity exposure to neutral rather than to underweight when equites fall out of favour. (All data as of 31 October 2021.)
What does this mean for fixed income investors?
The momentum is building for developed market central banks to withdraw their easy policy. However, we are still of the view that tightening will be incremental and is unlikely to disrupt the economic recovery, while we think inflation is unlikely to significantly impact corporate bottom lines, as companies will be able to pass on higher costs given consumers are currently in a position to cope with price rises. Nevertheless, some investors may be looking for a risk hedge in the event that we see volatility pick up. We would argue that investors would be better off with a short US duration position rather than giving up credit risk. If major central banks, such as the Fed, were to signal a more aggressive policy tightening then perhaps risk markets would be rattled, but this doesn’t appear likely in the short term based on the most recent Federal Open Market Committee meeting.
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