10 February 2023
Too fast, too furious?
Investors have begun reducing the probability of a recession in 2023 but have markets come too far, too fast?
Driven by a combination of improving growth prospects and more dovish tones from central bankers, the Bloomberg US Aggregate Index returned 3.1% in January, registering its best start to a year since 1988. While challenges remain, investors have taken heart from Federal Reserve Chair Powell’s suggestion that policymakers have returned to being ‘data dependent’ when judging the pathway for further rate hikes. However, reading the runes on inflation is tricky. As discussed in last week’s bulletin, recent inflation prints suggests that some key components such as shelter and energy prices are beginning to moderate. In contrast, the US labour market remains remarkably robust. The January payrolls print came in at 517k, shattering analyst estimates of 187k. Unemployment fell to 3.4%, its lowest level since May 1969. While layoffs have crept up in recent months, the relative tightness of the labour market is likely to trigger further wage pressure. Central bankers will be keen to avoid prematurely declaring victory over inflation and the resiliency in the labour market may warrant further rate hikes, pushing up the terminal rate for this cycle. However, the ability of the global economy to weather one of the most aggressive tightening cycles in history has led investors to start lowering expectations of a recession in 2023. While the economic data has been resilient, there is some need for caution. The full effect of rate hikes can take some time to ripple through the economy and therefore it may not be fully felt until later in 2023.
The Bloomberg US Aggregate is not the only index having a strong start to the year. The Bloomberg Global Aggregate benchmark has also participated in the rally, as have credit markets, most notably investment grade credit. As investors adjust to this ‘data dependency’ environment, they are likely to enter a holding pattern as we await upcoming inflation prints and digest any further comments from policymakers. In the long-term, there remains a structural opportunity in fixed income markets. However, this ‘wait-and-see’ economic environment may see market valuations remain somewhat range-bound in the near term as investors seek to consolidate their gains.
A rosier outlook and the possibility that a recession may be avoided in 2023 has left investors questioning whether now is the time to be overweight duration. Portfolio positioning surveys suggest that investors had built up a slight overweight to duration in January but have subsequently returned to being underweight moving into February. For long term investors, there should be a bias to be overweight duration particularly if equity-bond correlations turn negative again. Historically, there has been a positive relationship between equities and bonds when inflation has been elevated. But if inflation uncertainty begins to recede in the coming months and investors’ focus returns to growth, it is likely that the equity-bond correlation will once again turn negative. The takeaway is that if pricing pressures continue to moderate, high quality duration may once again offer protection during periods of equity sell-offs.
What does this mean for fixed income investors?
Investors are right to acknowledge the improving growth outlook, which explains much of the quick start to 2023. Despite this rally there is still a strategic case for fixed income however, in the near term there is some need for caution as investors consolidate recent gains. For long-term investors, the improving economic outlook justifies the need for more credit risk in portfolios but the possibility of defaults suggests that investment grade is better positioned than high yield at this stage in the cycle.
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.
include macroeconomic data (such as growth and inflation) as well as corporate health figures (such as default rates, earnings and leverage metrics)
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)
are primarily supply and demand dynamics (issuance and flows), as well as investor positioning and momentum