Man with surfboard

In brief

  • A 70% probability of Sub Trend Growth, and a soft landing, remain our base case. While smaller businesses and lower income households struggle with higher prices and interest costs, financial conditions have eased, private sector balance sheets are strong, and many U.S. industries continue to benefit from fiscal programs. 
  • Tail risks remain balanced: We see a 15% risk of a downturn resulting in a Recession (10%) or Crisis (5%) and a 15% risk re-acceleration to Above Trend Growth. 
  • Soft landings are notoriously difficult to engineer but we expect the labor and inflation data to allow the Federal Reserve to cut rates in September, to take the pressure off households and businesses. 
  • The biggest risk: Elections around the globe, combined with the potential for a populist shift toward widespread fiscal stimulus.  
  • With considerable money on the sidelines that could flood into the market and drive spreads narrower, we like carry-oriented ideas: bank loans, AT1s and contingent convertibles, securitized credit, and some local emerging market sovereigns.

Our June Investment Quarterly (IQ) was held in Columbus, Ohio, a day after what should have been a non-event Federal Open Market Committee (FOMC) meeting. Instead, we had to deal with a data-dependent Federal Reserve (Fed) that largely opted to ignore new and important inflation data from the May CPI report, sticking with their original and outdated forecasts.

Happily, that was not the case for the IQ participants. We spent eight hours combing through data and balancing the mixed signals we were seeing across the global economy. Would the Fed put more emphasis on the moderation in inflation and signs of labor market weakness or would policymakers focus on the tailwind to growth from strong corporate fundamentals and the fiscal spending associated with spending on infrastructure, data centers, artificial intelligence (AI), the energy transition, etc.?

Ultimately, the timing of any rate cuts would be determined by the FOMC’s understanding of real-time data that is, admittedly, conflicting—at least for now.

Summer vacation

The more we drilled into the soft landing narrative, the more we saw equal and opposite forces. While soft landings are notoriously difficult for central banks to engineer (1995 was the only U.S. soft landing in the last 50 years), the Fed may just have been able to do so by achieving the holy grail of central banking, which is noninflationary growth. Perhaps we should all watch the data over the next couple of months, embrace the current soft landing until the September FOMC meeting and enjoy a well-deserved summer vacation in the meantime. Summers don’t normally play out this way, but one can aspire to some relaxation in what has been a very eventful year-to-date in markets.

Macro backdrop

 At the core of the group’s conversation was the mixed picture in the labor market. We saw some catalysts for continued strength in non-farm payroll growth. But we also took note of the rise in unemployment and moderation in wages consistent with falling voluntary quits and job openings. The Bureau of Labor Statistics’ (BLS’s) latest establishment survey (or Current Employment Statistics, CES, survey) derived from businesses paints a picture of a strong labor market, with a three-month moving average of approximately 250,000 net new jobs created and average hourly earnings rising 4.1% year-overyear (y/y)—still above pre-COVID levels.

But the BLS’s household survey (Current Population Survey, CPS) shows some moderation. The unemployment rate has risen to 4%, from a cycle low of 3.4%, and the increase in unemployed workers (532,000) over the last year exceeds the increase in employed workers (376,000). Several other metrics seem to confirm the weakness in the household survey and reflect more fragility. These include small business survey data on jobs hard to fill, compensation and hiring plans; measures such as the quits and openings rate and consumer survey responses of jobs easy vs. hard to get.

But our group also heard from our corporate bond teams that corporate America had stabilized, with EBITDA improving as many industries were benefiting from the support of various fiscal programs still distributing cash. Our municipal bond team confirmed that of the USD3.9 trillion in Federal stimulus from laws enacted (ARPA, IIJA, IRA, CHIPS1), only up to a half may have already been spent. Overall, the group believed that the labor market may be more balanced than any set of data would imply on its own and ultimately, supportive of the soft landing narrative.

The disinflation trend appeared entrenched to us. Granted, we had the benefit of just-released CPI and PPI reports confirming the ongoing moderation. Strikingly, those reports’ details were even more encouraging. The transition from goods disinflation to services disinflation seems to be well underway. One of the stickiest elements of inflation—namely, housing—looks to be on the verge of moderating, as the lagged impact of weaker rents over the last year flows through the data.

In addition, existing home sales remain sluggish and additional supply in multi-family housing should moderate owners’ equivalent rent. Immigration data showing 3.3 million annual U.S. border crossings highlights the capacity building in the labor market and provides another tailwind for wage and scenario disinflation. We also felt that China coming fully back online was adding manufacturing capacity to the global economy, also relieving inflation pressures. Again: supportive of a soft landing.

The Fed is at an interesting inflection point. The longer the central bank leaves policy at a historically high real fed funds rate, the deeper the ultimate downdraft is likely to be. Waiting until inflation is fully at its 2% target seems too risky, as the long and variable lags will likely be hitting the economy in earnest. The key to the 1995 soft landing was bringing down the fed funds rate by 75 basis points, which was just enough to take the pressure off businesses and households. We expect they will do the same in this cycle and to see the first rate cut in September. 

Scenario expectations

Despite considerable debate, we left our scenario expectations unchanged. Sub Trend Growth/Soft Landing (70%) is how the economy is currently running, with its fate in the hands of central bankers. While small to middle market businesses and lower-middle income households are struggling with higher prices across the board, and the higher interest costs to finance those higher prices, financial conditions have eased and there is evidence across larger businesses that strong private sector balance sheets persist.

The tail risks also remain equally balanced. The 15% left tail risk—Recession (10%) and Crisis (5%)—reminds us that a policy error from the central banks would come with considerable downside, given the magnitude of rate hikes since 2022. And, of course, the coming elections in the U.S. and globally create geopolitical uncertainty. The 15% right tail risk—Above Trend Growth (15%)—recognizes that businesses and households may have done a better job absorbing the monetary policy tightening than we think. As more of the fiscal stimulus monies are spent, employment and wage growth may lead to stronger top-line growth for businesses and start an economic reacceleration.

Risk

The combination of elections globally with the potential for a populist shift toward widespread fiscal stimulus has become the greatest risk to our soft landing expectation. A U.S. government unified behind either a Biden or Trump presidency would seemingly incorporate tax cuts and fiscal spending. The supply of government debt to fund the spending, and the acceleration in growth and inflation metrics, would both certainly push bond yields substantially higher. The same concerns are starting to emerge in Europe, where snap elections have been called in the UK and France. Perhaps it’s that Modern Monetary Theory is now just a generally accepted tool. The use of tariffs by parties in political power also continues to loom large.

Underestimating the strength of the ongoing recovery is a risk we constantly debate. The consumer has remained resilient, inflation has remained above central banks’ targets and there is plenty of fiscal spending yet to come. A wage-price spiral would surely cause the Fed to put rate hikes back on the table.

Strategy implications

An economy gliding to trend growth and 2% inflation has always been good for credit risk, and this time should be no exception. While we wish credit spreads were wider, we appreciate that there is considerable money on the sidelines that should flood into the market and drive spreads narrower. Carry-oriented ideas dominate our picks: bank loans, AT1s and contingent convertibles (CoCos), securitized credit, and some local emerging market sovereigns. We also believed the yield curve would dis-invert and gradually steepen with the risk that yield curve steepening could be more aggressive in tail scenarios. While the 10-year U.S. Treasury appears to be pricing in a terminal fed funds rate of around 3.75%–4%, we acknowledged that yields could fall through 4% as money comes into bonds. We believe the U.S. dollar’s exceptionalism will continue until the first rate cut.

Closing thoughts

Everything is in place for the continuation of the soft landing. A couple more months of data watching should give the Fed plenty of cover to begin cutting policy rates. For now, the best thing to do is fill portfolios with carry, enjoy a summer vacation and come back in September when the Fed should be ready to cut rates.

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1 American Rescue Plan Act (ARPA), Infrastructure and Jobs Act (IIJA), Inflation Reduction Act (IRA) and Chips and Science Act (CHIPS). 
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