Global Fixed Income Views 4Q 2021
Themes and implications from the Global Fixed Income, Currency & Commodities Investment Quarterly
- Above Trend Growth is still our base case, but reduced to an 80% probability, given central bank normalization, the expiration of U.S. unemployment benefits and the persistence of COVID-19. We raised the probability of Sub Trend Growth to 10% from 0% because the growth peak has passed and downside risks have risen. The probabilities of Recession and Crisis remain at 5% each.
- The Fed is likely to wait a bit before making its first rate hike in mid-2023. The inflation trajectory over the next two years—and how far rates need to rise—may determine how disruptive this round of tightening will be.
- Though supply disruptions are pushing inflation higher for longer than expected, we expect them to fade. More persistent inflationary pressures are building up in some economies (U.S., UK); anecdotal evidence from companies suggests cost pressures have been passed through to the consumer, protecting corporate margins.
- Corporate credit remains our favorite sector. Our top picks are U.S. and euro high yield, leveraged loans and bank additional tier 1 (AT1) securities. We also like non-agency securitized credit.
SCENARIO PROBABILITIES (%)
Don't overthink it
Our September Investment Quarterly (IQ) came on the heels of another very good three-month period for markets. Nearly every asset class and market sector had appreciated in price, driven by the ongoing recovery, the relentlessness of central bank (over?) accommodation and the probability of further fiscal stimulus. Other than a bit of a misstep in local emerging market debt and currency, it was hard to find anything in the markets to be disappointed with.
This is not to say that everything has gone, and will continue to go, perfectly. Quite a number of issues and concerns are starting to accumulate. The reopening growth surge has appeared to peak, and there is some debate as to where U.S. and global GDP will settle. The Delta variant health care challenges have proven to be more material than originally hoped. Supply-side constraints are still evident and limiting growth. The U.S. is about to transition away from enhanced unemployment benefits, China is dealing with both lockdowns from its 0% infection rate policy and the impact of increased regulation, office tower occupancy rates in the U.S. hover around 20%, the Northern Hemisphere is about to roll into fall/winter with people moving back indoors, and the central banks are about to begin the normalization process by tapering their large-scale asset purchases.
As if that wasn’t enough, we also had to assess the ongoing surge in inflation and the seemingly expensive valuation of markets—ours and others. It made for a spirited day, a willingness to not overthink things and a bias to ride the asset price momentum a bit longer.
There is little doubt that the supply-side constraints and spread of the Delta variant have slowed U.S. GDP. We modestly lowered our 2021 forecast to 6% while forecasting a still buoyant 2022 outlook at 4.5%. This is still well in excess of the economy’s long-term potential. We acknowledged that even with the infrastructure and reconciliation bills in the pipeline, U.S. fiscal policy will be materially less supportive in 2022. Consequently, the consumer must be ready to take the baton from the fiscal handoff. Our look at accumulated savings over the pandemic and current savings rates gave us confidence that the consumer is in a healthy position to do so.
Similarly to the last quarterly debate, we spent some time looking at inflation. While supply disruptions are pushing inflation higher for longer than expected, we expect them to eventually fade. More persistent inflationary pressures are building up in some economies (U.S., UK); anecdotal evidence from the companies we cover suggests cost pressures have been passed through to the consumer, thus protecting corporate margins. Labor shortages and the potential for durable wage increases present more upside risks: The Beveridge curve (job openings vs. the unemployment rate) reflects a challenging and potentially more persistent mismatch for employers looking to hire in record numbers but seemingly unable to do so. This context represents a novel challenge for the central banks in their path toward policy normalization.
The Federal Reserve (Fed) has already well telegraphed its intention to start tapering its large-scale asset purchases. Details are expected to be announced in November or December, with the taper starting in December or January. Consensus is that the Fed will reduce Treasuries by USD 10 billion/month and mortgages by USD 5 billion/month, resulting in a full exit from the USD 120 billion/month quantitative easing program within eight months. The Fed is then likely to wait a few quarters before the first rate hike, in mid-2023. Other than some modest upward pressure on bond yields, we expect this normalization path to be very palatable for markets. Importantly, the inflation trajectory over the next two years, and how far rates need to ultimately rise, will determine how disruptive this round of Fed monetary tightening will be.
The Bank of England also looks set to end its quantitative easing program by year-end, with a first rate hike in 2Q 2022. The European Central Bank should end its Pandemic Emergency Purchase Program (PEPP) in March 2022, but maintain market support through the general Asset Purchase Program (APP), with no rate hikes on the horizon. Lastly, the Reserve Bank of Australia has indicated further taper in February 2022, with the bond-buying program to end by 3Q 2022 and a first rate hike in 2024.
Overall, the aggregate monetary, fiscal and health care response of the last 18 months has been effective and has led to a broad-based recovery. The economic trajectory going forward may not be perfect, but with inflationary risks building, it’s time for central banks to begin removing some of their emergency policies and begin the long journey to a more “normal” policy environment.
Above Trend Growth remains our base case but has been reduced from a 90% probability to 80%. Growth is still there, but so is the growing list of issues. At the top of the list are the central bank policy normalization, the expiration of U.S. enhanced unemployment benefits and the persistence of the virus. Nonetheless, policymakers are likely to ensure that monetary and fiscal support remain a tailwind, albeit somewhat less intense.
We raised the probability of Sub Trend Growth to 10% from 0%. We acknowledge that the growth peak has passed and that risks to the downside have risen. In addition, supply disruptions and inflationary pressures could have a greater impact than we are anticipating.
We left the probabilities of Recession and Crisis at 5% each. Policy error and the potential aggressive, premature withdrawal of monetary and/or fiscal support are key risks … but tail risks at best.
The biggest risk to our outlook remains a non-transitory surge of inflation: Input cost pressures could get pushed through to the price of finished goods and services, and wage pressures could become more persistent. We are reminded of Milton Friedman famously saying that “inflation is always and everywhere a monetary phenomenon.” The cash resulting from monetary policy is still very much present.
Until the central banks are well into the tapering process, yields are unlikely to move materially higher. We expect 10-year U.S. Treasury yields to drift up to 1.875%, but not much higher.
Corporate credit remains our favorite sector. Corporate profitability looks terrific, and default rates continue to evaporate. U.S. and Euro high yield, leveraged loans and bank additional tier 1 (AT1) securities are our top picks.
We also like non-agency securitized credit, as the consumer balance sheet looks very strong.
Emerging market debt was noticeably absent from our top picks this quarter. Concerns on the efficacy of the health care response to COVID-19 and the slowdown in China weighed on the participants.
From an economic perspective, growth has crested and the path forward is a bit bumpier but still above trend.
From a central bank perspective, the field has long been tilted in favor of the borrower at the expense of the saver, although central banks are about to embark on a multi-year rebalancing of that dynamic.
From a markets perspective, everything looks expensive, but the past buildup of liquidity is looking for an entry point.
From our perspective, keep an open mind, but don’t overthink it. The recovery continues, driven by the abundance of policy support … and that is asset price friendly.
Scenario probabilities and investment implications: 4Q 2021
Every quarter, lead portfolio managers and sector specialists from across J.P. Morgan’s Global Fixed Income, Currency & Commodities platform gather to formulate our consensus view on the near-term course (next three to six months) of the fixed income markets. In daylong discussions, we review the macroeconomic environment and sector-by-sector analyses based on three key research inputs: fundamentals, quantitative valuations and supply and demand technicals (FQTs). The table below summarizes our outlook over a range of potential scenarios, our assessment of the likelihood of each and their broad macro, financial and market implications.
Please be aware that this material is for information purposes only. Any forecasts, figures, opinions, statements of financial market trends or investment techniques and strategies expressed are, unless otherwise stated, J.P. Morgan Asset Management’s own at the date of this document. They are considered to be reliable at the time of writing, may not necessarily be all-inclusive and are not guaranteed as to accuracy. They may be subject to change without reference or notification to you. JPMorgan Asset Management Marketing Limited accepts no legal responsibility or liability for any matter or opinion expressed in this material.
The value of investments and the income from them can fall as well as rise and investors may not get back the full amount invested. Past performance is not a guide to the future.