Global Fixed Income Views 2Q 2022
Themes and implications from the Global Fixed Income, Currency & Commodities Investment Quarterly meeting
- Above Trend Growth remains our base case, but with a substantially reduced 50% probability, given the Russia/Ukraine war, central bank tightening and inflationary pressures. We raised the probabilities of Sub Trend Growth to 25%, Recession to 15% and Crisis to 10%.
- While the Federal Reserve appears committed to raising rates, we now expect half the increase (25, not 50, basis points) we expected previously; a path to 1.75%–2% seems most likely.
- Markets’ sharp repricing has given us an opportunity to add risk, with current valuations too compelling to ignore.
- We are looking to add risk while remaining short duration. A combination of corporate credit, both investment grade and high yield, is our favorite; short duration securitized credit is another top pick.
Scenario Probabilities (%)
2022 Will Be a Long Decade
Our March Investment Quarterly (IQ) was held in New York with 100% in-person attendance for the first time since December 2019. While it was terrific to see everyone again and engage in live debate, we confronted two enormous challenges facing the markets: the geopolitical fallout after the invasion of Ukraine by Russia, and central bank policy tightening as inflationary pressures escalated. There had already been a dramatic repricing across markets, with equities and credit much lower in value while commodities and safe haven currencies were substantially higher. We had to decide whether the repricing had gone far enough, presenting opportunity to dial up risk, or if the combination of an inflation shock and central bank tightening meant we should look for rallies to further reduce risk.
Once again, the consensus was anything but unanimous. But the group decided that the sharp repricing of markets was ultimately an opportunity to add risk, although our forecast was altered to reflect greater probability to the downside, including the risk of crisis. Simply put: current valuations were too compelling to ignore.
As the sadness of war in Europe dominated the meeting, the reality of sanctions and surging commodity prices – just as the global economy was emerging from the pandemic – loomed large. Prior to the invasion, there were already significant supply chain bottlenecks, labor shortages and rapidly rising prices for goods and services. These problems are only going to be exacerbated by the growing list of sanctions on Russia. While the U.S. economy will likely have to endure a prolonged period of uncomfortably higher energy, agricultural and industrial commodity prices, the impact on Europe could be more severe.
We expect European growth to slow very sharply, but we don’t expect an outright recession unless there is a material curtailment of gas supplies. To help offset the impact of higher energy prices, we’re expecting broad-based European government support to absorb some of the costs of higher commodity prices. There is also an increased likelihood of additional fiscal stimulus to address the energy transition, defense and the refugee crisis. Lastly, we expect that the European Central Bank will be more patient in raising rates, keeping the monetary cushion largely in place.
However, the Federal Reserve (Fed) still appears committed to raising rates at its upcoming March Federal Open Market Committee (FOMC) meeting. But we now expect a 25 basis point (bps) increase instead of the 50bps we were previously anticipating. A path to 1.75%–2% seems most likely, with 25bps increases at each of the next seven to eight meetings. We also expect balance sheet runoff to be announced at the July FOMC meeting and to commence in August. These policies should be well received by the markets, reflecting the Fed’s credibility in fighting inflation without throwing the economy into a tailspin as the commodity shock is digested.
China represents the best case for a positive monetary and fiscal impulse. As the drag from the COVID-19 lockdown fades, policy seems to be shifting to growth stability, not deleveraging. Measures to support the property market and relax credit growth are already apparent. Outside of China, the emerging economies should grow at around 4% as they recover on the continued post-pandemic reopening.
Above Trend Growth was reduced from 80% to 50%, while Sub Trend Growth (10% to 25%), Recession (5% to 15%) and Crisis (5% to 10%) were all increased. We had to acknowledge that the combination of a commodity price shock and central bank policy tightening presented a significant headwind for the global economy. It is still possible for fiscal and monetary policymakers to thread the eye of the needle and engineer a soft landing, but the eye of the needle just got a whole lot smaller. If, as we expect, the Federal Reserve raises the funds rate to 1.75%–2% this year, then what? Would that be sufficient to curtail inflationary pressures, or would the Fed need to keep going? At some point, would the Fed be forced to make a choice between rescuing growth or securing price stability? Hence, the 50-50 sum of upside/downside expectations.
We also had to acknowledge that war was still raging, and the situation could worsen. So, despite the best efforts of policymakers, the probability of recession and crisis had to rise.
Sadly, the greatest risk remains an escalation in the Russia/Ukraine war. Depending on what that may look like, the global economy and markets would be heavily dependent on a comprehensive policy response.
Near term, a commodity shock is occurring at a time when labor markets and manufacturing capacity are already tight, global commodity inventories are low and inflation is rising at a rate not seen since the early 1980s. A further, material acceleration in inflation that does not subside over the balance of the year should cause central banks to be more aggressive in tightening monetary policy, thus sacrificing economic growth in future years and potentially upsetting markets.
Our greatest concern is that the central banks are able to start the normalization process within reason over the next 12 months and the markets respond positively. But should the Federal Reserve get to 1.75%–2% over the next seven meetings and inflation is still a problem, it may start the next leg of tightening to 3%–4%. The markets are not and would not be prepared for that.
Finally, another risk may be that it is already too late: the escalating inflation shock may kill off aggregate final demand, and a recession may result in 2022, not 2023 or later.
In just the first nine weeks of 2022, public market assets have undergone a significant repricing, with fixed income securities now offering higher all-in yields from higher rates and wider credit spreads. Given our still optimistic (albeit far less so) base case, we are looking to add risk at these cheaper levels while remaining short duration.
A combination of corporate credit, both investment grade and high yield, was our favorite. For now, the corporate world seems prepared to absorb and pass along price increases without margins fully collapsing. While there was acknowledgment that the banking sector had weathered the storm and bank debt was undervalued, only a couple people were brave enough to step in now
Short duration securitized credit was also a top pick. Low interest rate sensitivity, an amortizing structure, credit enhancement and consumers with strong balance sheets in a tight labor market were very compelling reasons to add to our exposure.
The next 10 months are going to feel like a very long decade. While it is easy to draw up a path to a soft landing, believing that it can be accomplished despite an inflation shock and central bank tightening takes an enormous leap of faith. Perhaps it will be the grand global reopening from COVID-19 that will create enough aggregate final demand to see us through. Nonetheless, we appreciate any repricing in assets that will allow us to use our broad-reaching research to find opportunities for our clients.
Scenario probabilities and investment implications: 2Q 2022
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.
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