- Our base case sees continued moderation of inflation and growth but also acknowledges the underlying resilience of the U.S. economy. In this environment we favor carry trades, relative value positions and manager selection alpha above bold directional calls.
- With rates set to remain high for an extended period, scope for bond yields to decline meaningfully is more limited. But current yield levels support a modest duration overweight, and we see diversification potential in the UK and Europe where growth is slower, and in Australia where carry is less of a headwind.
- With risks of imminent recession easing, and rates volatility likely to decline as the hiking cycle pauses, we find value in credit. Our preference is up-in-quality but we see opportunities right across the credit complex.
- We maintain a neutral view on stocks and prefer developed markets over emerging markets. Strong cash generation supports U.S. stocks, rerating potential favors Japan, and valuations point to UK equity, while the sluggish global goods cycle still weighs on Europe.
The divergence of the economy and policy in 2023 wrong-footed many investors. The year started with the fastest pace of rate hikes in a generation and moved quickly to yield curve inversion and then banking stress, but it is ending with the U.S. economy proving more resilient than many expected.
As the fiscal impulse and surprisingly robust consumer activity of 2023 start to fade, growth will likely moderate. But it remains unclear whether the cycle, having slowed, can extend or whether the most widely anticipated recession in history finally materializes.
Cooling inflation, combined with slower but positive growth, probably keeps rates on hold for some time and gives few clear directional signals for markets. Such conditions favor carry trades, relative value positions, manager selection alpha and an emphasis on portfolio diversification much more than bold directional calls.
Convention dictates that restrictive rates for a prolonged period will eventually cause something in the economy to break. However, the imbalances that often help trigger recessions are notable by their absence or at least by their heterogeneity – stresses in one sector do not necessarily cause the dominoes to fall elsewhere.
The result is that, broadly, the economy is less interest rate sensitive than many had assumed. At a more granular level, various stresses pass sequentially from one sector or region to another, leading to divergences in margins, earnings and valuations. In turn, this is generating relative value opportunities across assets and across securities but failing to deliver the synchronized slump so many had feared.
Yields have risen to levels that have surprised many investors – especially as inflation began to reverse from mid-year. But with more evidence of moderating growth, the case for lower yields and lower rate volatility is building. This calls for a modest overweight to duration and diversifying a core U.S. Treasuries position with other regions. We favor UK Gilts and core European bonds – where the growth picture is distinctly less robust – and Australia, where curves are not inverted and the carry penalty to owning bonds is reduced.
Unusually, interest rate volatility jumped this year, while equity and credit volatility declined. Since firms had termed out their liabilities in the aftermath of the pandemic, the transmission of volatility from policy to credit and equity markets was weakened. Refinancing cliffs will eventually loom closer but remain manageable for much of next year. And with policy on hold, we see rate volatility declining. This creates a favorable environment for carry assets such as credit.
By and large, we play credit with an up-in-quality bias, but this is not a simple matter of investment grade over high yield. The differing impact of higher rates by sector and by country leads to a richer opportunity set in which to express our preference to be overweight credit. Credit may also be a preferable means of adding beta to a portfolio rather than adding equities, particularly for those with an income objective.
Although we continue to take a neutral view on stocks, the recent sell-off in equities is bringing market levels closer to a more attractive entry point. But for now within the asset class, we focus on increasing opportunity for relative value positions. Bulls and bears alike tend to agree that margins are elevated. We also note significant variance in margins – and in turn earnings – by sector and by region. At a regional level, we see further rerating potential in Japan, strong cash flow generation in the U.S. and cheap access to high dividends in the UK.
Meanwhile, Europe and emerging market (EM) ex-China equities are held back by continued slowing in the goods cycle. Chinese equities stand out as cheap and unloved, but while the potential for a short squeeze persists, the fundamental picture does not yet support a long position. Sector exposures add further nuance: U.S. cyclicals appear underheld in a region that could undergo an inventory restocking cycle, while European defensives look inexpensive in a region facing ongoing manufacturing weakness.
In sum, we believe that the sharp rise in rates has created asset market distortions that are more compelling to trade than simply trying to predict or time a recession. True, recession odds are modestly elevated, but not so elevated as to suggest an outsize defensive stance. Equally, the path toward an extension of the cycle is not yet sufficiently clear to call for a large risk-on tilt.
Instead, we believe that collecting carry in credit as volatility declines, leaning into the better earnings and cash flow outlook in the U.S. and Japan compared with Europe and emerging markets, and diversifying bond overweights into slower growth regions provide ingredients for a resilient portfolio in today’s less certain environment.
Multi-Asset Solutions Key Insights & “Big Ideas”
The Key Insights and “Big Ideas” are discussed in depth at our Strategy Summit and collectively reflect the core views of the portfolio managers and research teams within Multi-Asset Solutions. They represent the common perspectives we come back to and regularly retest in all our asset allocation discussions. We use these “Big Ideas” as a way of sense-checking our portfolio tilts and ensuring they are reflected in all of our portfolios.
- Growth and inflation cooling but still see rates high for an extended period
- Fragilities in parts of the economy do not trigger widespread slowdown
- U.S. economy more resilient, EU and China mired by sluggish goods cycle
- Supports a modest duration OW, but limited scope for large dip in yields
- Credit becoming attractive for carry as rates volatility falls
- Favor up-in-quality credit plays and see value in higher quality securitized
- Equities neutral, but see growing scope for RV in sectors and regions
- Prefer U.S. equity given cash generation and Japan given rerating potential
- Key risks: sticky inflation leads to further hikes, corporate caution extends, sharp additional tightening of credit conditions
J.P. Morgan Multi-Asset Solutions manages over USD 255 billion in assets and draws upon the unparalleled breadth and depth of expertise and investment capabilities of the organization. Our asset allocation research and insights are the foundation of our investment process, which is supported by a global research team of 20-plus dedicated research professionals with decades of combined experience in a diverse range of disciplines.
Multi-Asset Solutions’ asset allocation views are the product of a rigorous and disciplined process that integrates:
- Qualitative insights that encompass macro-thematic insights, business-cycle views and systematic and irregular market opportunities
- Quantitative analysis that considers market inefficiencies, intra- and cross-asset class models, relative value and market directional strategies
- Strategy Summits and ongoing dialogue in which research and investor teams debate, challenge and develop the firm’s asset allocation views
As of June 30, 2023.