In Brief

• Our global economic outlook remains generally downbeat while central banks remain resolutely on their tightening paths. We expect below-trend growth and elevated recession risk over the coming year for the U.S.

• Government bond yields continued rising over the month and set the tone for markets in October. Volatility in fixed income is set to continue for a while until there is more visibility on the peak of inflation and hence the peak in policy rates.

• For our outlook to turn more positive on duration we are looking for slowing employment growth, stability in market pricing of policy rate hikes and less core bond volatility.

• Our multi-asset portfolios remain underweight equities, neutral on core duration currently – but we are starting to reevaluate a more positive stance – and underweight credit with an up-in-quality bias.

Portfolios remain underweight risk assets

With the U.S. and other major developed market economies still overheating and China facing headwinds relating to pandemic policy and the housing sector, we maintain our generally downbeat global economic outlook.

We expect a below-trend pace of growth through the end of 2023 and see elevated recession risk over the next year. Inflation continues to run well above central bank targets and has not yet shown convincing signs of deceleration, prompting rapid monetary policy tightening that is pressuring broader financial conditions.

We do expect a modest improvement on the inflation front in coming months and think interest rate hikes may conclude around the first quarter of 2023 – but see significant uncertainty around these forecasts.

In the U.S., we have observed some tentative signs of rebalancing in the labor market. Vacancies have declined significantly in the past few months and some measures of wage inflation are cooling modestly. Job growth, though, is still running at a pace consistent with downward pressure on the unemployment rate over time, which is inconsistent with what the Federal Reserve (Fed) wants. Meanwhile, consumer price inflation is running higher than expected, due largely to services categories where prices are typically sticky.

Overall growth has held up fairly well, however. We expect a 2%-plus rate of U.S. GDP growth for the third quarter that will likely benefit from volatile foreign trade flows; other indicators of underlying growth remain in positive territory.

All this suggests that the Fed has more work to do, and that the policy interest rate will likely rise about 200 basis points (bps) by March 2023, putting it around or slightly above 5%. 

Outside the U.S.: Headwinds continue

The outlook elsewhere appears similarly challenging. The euro area and UK are dealing with a severe energy price shock due to reduced flows of natural gas. Fiscal policy will likely offset some of those costs – but in the UK to a lesser extent than the government had (until recently) intended. Falling real household incomes already appear to have put the UK economy into contraction. Private sector surveys in the euro area also signal very weak growth or an outright downturn. With inflation pressures fairly broad-based, though, we think the European central bank and the Bank of England will continue tightening into that weakness.

Japan’s economy is a partial exception, for now: Monetary policy remains stimulative as the economy enjoys the benefits of a relatively delayed post-pandemic reopening, and with inflation still below the Bank of Japan’s target. But signs of deterioration in the global goods cycle pose downside risks to Japanese exporters – a phenomenon we have long expected, as household spending rotates back toward services and inventory rebuilding runs its course.

Meanwhile, China’s economy continues to struggle with intermittent COVID-19 related lockdowns and a deflating property sector. Fiscal and monetary policy are pushing in the other direction, but modestly. We now expect a vigorous recovery to take hold only in the second half of 2023.

Fixed income volatility continues to set the tone

Bond yields continued rising in October, with core government bonds setting the tone across asset classes. The U.S. 10-year yield surged nearly 100bps since the start of September and is now above 4%. Central bank hawkishness, and the resilience of both inflation and growth, have pushed yields higher across other major markets, too.

At the same time, volatility in UK fixed income markets, sparked by the government’s announcements of stimulus, spilled over into other markets and further exacerbated fixed income volatility. It is hard to see how this volatility lets up in the near term while inflation continues to surprise to the upside and central banks remain resolutely on their tightening paths.

The drive higher in core government bond yields is starting to make bonds attractive. U.S. 10-year yields above 4% (nominal) and above 1.5% (inflation-adjusted) should start attracting liability-aware investors.

What would make us to turn more positive over the medium term on duration, and specifically U.S. Treasuries? We would like to see some of the following:

Slowing employment growth: U.S. unemployment fell steadily over the last year, to below 3.6%. It is hard to see bond yields stabilizing with such a tight labor market, employment still expanding strongly and wage growth continuing to be robust.

Stability in the market’s pricing of Fed hikes: In a related point, strong employment growth coupled with persistent service-driven inflation supports the market’s pricing of large Fed rate hikes. At the time of writing, market pricing for the terminal fed funds rate was above 5%, after a few months of rising steadily.

Less volatility in core fixed income: The MOVE index (a measure of volatility in fixed income option pricing) is up more than 30bps since September and sits more than 2 standard deviations above its long-term average. Unusually, the MOVE has led equity volatility thus far in the rate hiking cycle.

Bond market volatility will likely continue while the Fed calibrates where to pause tightening – and determines what a plausible rate would be. This is hard to predict. Market participants are left to largely infer it over time by the reactions of employment and inflation data to policy tightening, keeping volatility elevated.

In the coming months, we expect slowing global growth to refocus investor fears from inflation to recession risks, which should ultimately drive a pickup in bond demand. Central to this view is our expectation that core inflation peaks in coming months across major markets and then starts falling gradually back to central bank targets. For now, though, we are wary that markets remain hyper-focused on increasingly hot inflation and hawkish central bank guidance. Also for now, this keeps us neutral on duration.

U.S. large cap stocks: Closely linked to our view on duration

Given these circumstances, we are assessing the role of U.S. large cap stocks within our equity exposure. The U.S. large cap market can be considered defensive in several ways:

•Sector composition: It has greater exposure to defensive sectors, on average, than global equity indexes. The U.S. index is underweight financials and materials stocks, and overweight health care and software stocks, whose earnings we expect to be less sensitive to changes in the economic cycle. This should support the attractiveness of the U.S. index if growth slows.

•Quality: U.S. large caps are particularly profitable, with a higher equilibrium profit margin, and return on equity, than peers. While earnings expectations for large caps look too high, their quality may offer support amid a broader earnings slowdown.

•The U.S. economy: In recent history, the U.S. economy has proved more resilient than many of its peers. Today it is less exposed to the impacts of the Russia-Ukraine war and to some of the tail risks associated with the energy crisis. While we are hardly optimistic about U.S. growth, we expect outright recession in Europe and the UK this year, making U.S. assets relatively more attractive.

•The U.S. dollar: Given the U.S. dollar’s outperformance this year, currency exchange has been an important consideration for equity investors. In local currency terms, U.S. stocks have performed in line with global averages. But large caps have significantly outperformed when global equity returns are translated back into U.S. dollars (Exhibit 1). For dollar-based investors unable to access local currency returns, the attractiveness of the U.S. dollar also supports U.S. assets.

U.S. large cap stocks have been just average this year, but the impact of FX has lifted performance in USD

Exhibit 1: U.S. large cap vs. ACWI (in local and USD currency) earnings per share

Source: Bloomberg, J.P. Morgan Asset Management; data as of October 19, 2022. 

In this year’s trading environment, higher interest rates have reduced the P/E ratios of expensive stocks, especially in the tech sector – making it difficult for the U.S. index’s software exposure to prove defensive. But as we begin to warm up to duration, and approach what we think will be the end of a series of hawkish surprises from central banks, the tech sector’s defensiveness should re-emerge.

Asset allocation implications

Our multi-asset portfolios remain underweight equities, consistent with our expectations for below-trend growth in the U.S., recession in Europe and the headwinds facing Asian economies. We are currently neutral on core duration but with the rise in yields over the last few months, we are starting to evaluate taking a more positive stance. We remain underweight credit overall in the near-term and have an up-in-quality approach, expecting that decelerating global growth will widen spreads and create better entry points in the months ahead. Our conviction here, though, is offset by the high carry foregone, and notably depressed issuance since September. 

Exhibit 2: MAS Asset Class Views

The tick chart and views expressed in this note reflect the information and data available up to September 2022.

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