Are bonds really back and for how long?
Tune in to hear Dr. David Kelly and Jordan Jackson, Global Market Strategist, discuss the outlook on the Federal Reserve and provide an overview on fixed income investing this year.
Welcome to Insights Now. A series of conversations designed to shine a light of clarity on the complex world of investing.
This episode kicks off our sixth season of Insights Now, entitled A Bonds Eye View of Investing.
We've decided to center this season around fixed income. With inflation coming down and the Fed very close to finishing the rate hiking cycle, we believe this is a great time to talk about fixed income investing. Over the course of eight episodes, I'm going to sit down with the slate of market strategists and portfolio managers and we'll try to cover all the important bases on bonds.
We discussed topics such as the outlook for the Fed and other global central banks, the outlook for the dollar, diversifying within fixed income, and how to think about bonds when positioning long-term investment portfolios. Stay tuned as we try to provide some insight in a pivotal time for the markets and economy.
On today's episode, we're going to start off with a broad overview of the fixed income landscape. As we record this episode, we've recently heard from the Fed at their February FOMC meeting, and markets remain volatile on monetary policy uncertainties and the potential for recession.
To discuss our outlook on the Fed and provide an overview of fixed income investing this year, I've invited my colleague, Jordan Jackson, Global Market Strategist for JPMorgan Asset Management and our in-house fixed income expert. If you'd like to learn more about our thoughts in fixed income, I also invite you to check out our latest publication entitled Bonds are Back, which I've linked to the show notes. Jordan, welcome back to Insights Now.
Happy to be here.
Let's start by setting the scene on fixed income in general. Last year was a really tough year to be invested in the markets with high inflation and the Fed's aggressive rate hiking campaign contributing to a deep market selloff in both stocks and bonds. Core bonds were their worst year of performance in almost half a century. In your view, what led to such a bad year for bonds?
Well, I think in part what led to the very challenging year in bonds last year was both the Fed as well as the markets were really caught off guard in terms of the persistence in inflationary pressures. Coming into last year, the markets only anticipated a 425 basis point rate increases to come from the Fed, and by the end of the year the Fed ended up delivering 1725 basis point rate increases. They effectively embarked on their fastest rate hiking cycle since the Volcker era tightening back in 1980. I think in an environment in which the Fed is aggressively tightening rates relative to market expectations, that very much contributed to the selloff in both stocks and bonds.
But one thing I would remind investors is typically bonds come under pressure in years when the Fed is actively tightening or communicating that they're tightening policy. If you look at the performance on the Bloomberg US aggregate, the standard core fixed income benchmark for the US, bond returns were negative in 1994, 1999, 2013, and 2018, all years in which the Fed was actively raising interest rates or communicating they would like they were in 2013.
I think coming in a year in which the Fed, again, is aggressively raising interest rates that certainly pose a significant headwind to both the stocks and bonds over the course of 2022.
We're less than two months now into 2023 and already this performance has turned around pretty quickly. What should investors expect this year from bond markets?
Well, we actually anticipate bonds can perform pretty well. I anticipate that bonds will return a roughly high single digit, potentially low double digit return year in 2023. And similar to the point that I just made, in years coming out of Fed tightening, so in year 1995, in year 2000, in 2014, and in 2019 that the average return on core bonds was about 11.5%. Again, as the Fed finishes and concludes their rate hiking cycle, that should allow, first, interest rate volatility to settle down, and that should provide some much needed stability in overall bond markets supporting strong returns through this year.
So bad years are usually followed by good years. To try to look at this more generally, moving from the bond market itself and talk about the overall investment environment, the macro environment is still clearly heavily influencing the bond market here. Where do you see things going on in terms of economic growth, jobs, and inflation?
Well, I think to some extent the first quarter might prove to be a bit of a pump fake from a growth perspective. When we look at broader growth, we do anticipate over the course of the year growth is likely going to slow. We could see a recession, if recession were to materialize a very shallow one, but the narrative is certainly developing that we could enter into a soft landing in the economy.
But specifically as we think about the first quarter, you are seeing a significant adjustment in social security payments for roughly 66 million Americans. You have already seen light vehicle sales, a surprise to the upside in the month of January. I do think there are certain elements that may be somewhat supportive of growth, some of the initial housing data that has come through as well. And I think, again, housing had got very, very depressed over the second half of last year. And now I think you're seeing just a little bit of bottoming out and reversal in some of the housing data.
Still there's a lot of breaking pressure being applied to the economy over the course of this year. Looking at the labor market, also, the January jobs report was particularly strong at the headline level, but again, I think this sort of masks some of the underlying weakness in terms of January typically being a very weak month from raw job growth, from a non seasonally adjusted perspective. I think this is more reflective of companies being scared to let employees go, much less companies going on an outright hiring binge in the month of January.
Given this very much still excess demand for labor in the economy, we do think that the unemployment rate is likely to bounce around between 3.4% and 4% over the course of this year as you continue to see that excess demand for labor continue to come down over the duration of 2023.
From an inflation standpoint, we are seeing clear signs that inflation is rolling over. In fact, most of the CPI components are actually an outright disinflation. It's really mainly food as well as shelter that sort of continue to run somewhat elevated relative to recent history. So we do anticipate that food inflation, other measures of real-time food inflation have started to roll over, looking at indices from the World Bank as well as the United Nations. And then when we look at shelter costs, we do think that shelter really will begin to peak out, shelter inflation will begin to peak out, sometime in the second quarter of this year and then begin to roll over by the back half. All that contributing to inflation, that could very well end the year between roughly 2.5% to 3% run rate.
So the consensus seems to be that the Federal Reserve is close to being done in terms of monetary tightening, but they certainly have maintained much of their hawkish messaging. In your opinion, how much higher do you think they'll go?
Well, I think as of today the Fed could probably squeeze out two more additional rate increases. And so as we know they've already increased rates by 25 basis points at their February 1st meeting. We do think that they will increase rates by another 25 basis points at their March meeting. And it does appear that markets are slowly coming up to speed with the potential for the Fed to raise rates at their May meeting as well.
I do think that's about just as far as the Fed can really get to in terms of just how much higher they can take the federal funds rate in this environment.
If we perhaps do get a May rate hike also, how long are they going to be able to hold rates at those levels if the economy's pretty soft and inflation's coming down?
Well, David, to be fair, I actually think that's the more important question. The reality is I don't think it really matters whether they go pencil in an additional rate hike in May. It's really a question of how long they intend to stay in restrictive territory. And that also is going to have a significant breaking power on the overall economy.
You'll now be in an environment in which consumers will have several quarters of a 19% credit card APRs. This is coming out of a period in which credit card APRs were sitting at 13% for almost a decade. In order to purchase that car or finance that next purchase, it's going to be a lot more costly.
Corporations are now going to have to tap the bond market at significantly higher rates after they've seen a lot of the borrowing that they've done at the outset of the pandemic, that very cheap debt being rolled over to much more costly debt.
Again, it really is a question of how much longer they will stay in restrictive. I think they're fairly committed to keeping rates in restricted territory through 2023 and they may be biased to begin to start reducing rates at their first meeting in 2024.
With all of that in mind, how do you feel about duration right now?
Well, it's really about what markets are currently anticipating and as of late you have seen a backup in interest rates in long-term yields and in short-term yields. I think this is a reflection of the strong jobs report and the market's getting more in line with what the Fed has been talking about here, and that's, again, lifting rates to north of 5% and keeping rates there for the duration of 2023.
Now if that does play out, I would argue that a US 10 year that is now sitting at close to 3.7% looks quite attractive in this environment. And so I do think that adding duration to portfolios makes a whole lot of sense. Within our portfolios on days and weeks in which yields back up, we are incrementally adding duration to many of our core fixed income strategies.
Looking at the other side of this, how do you feel about credit? I mean, should investors start looking as high yield or should they stick to high quality corporates right now?
It's somewhat of a tricky question because in an environment in which both inflation is going to come down and there is this growing consensus that we may be able to have a soft landing, that actually is a very, very good environment for credit. And as a result, you've seen credit spreads narrow pretty meaningfully over the course of this year.
Now very much we're biased towards investment grade credit, we still don't think you're getting enough compensation for high yield. One of the metrics that I like to look at that has closely tracked high yield default rates is the net lending standards in the senior loan officer survey that's conducted by the Federal Reserve.
Typically over the last three quarters, what we've seen is a net tightening in lending standards, and you have roughly a three quarter lag in which you start to see a pickup in overall defaults. Right now that relationship suggests that we could see high yield defaults in the range of around 4% to 5% in the back half of 2023 and into 2024.
Our current spread levels of about 430 basis points, we just don't think you're getting enough spread compensation by investing in lower rated credits at this stage. But we do think investment grade credits are providing a bit more opportunity.
Yes, investment grade credits spreads are narrow, but yields in investment grade corporate bonds are still giving you roughly 5% to 5.5% all in yield. So in that environment, I do think, from a technical standpoint, you are going to see still strong demand for investment grade corporate bonds, again, in an environment in which defaults can remain relatively contained in the high quality space.
After last year's selloff, bonds are sitting at some of the most attractive yields in a decade. Where do you see the most attractive opportunities now?
One of the areas where we're finding some of the most attractive opportunities is in the municipal bond market. If you actually look at the tax equivalent yield curve across municipal bonds, it is significantly steeper than that of the inverted nominal treasury curve. And so as we have had a discussion on adding duration to portfolios, for those investors who are in high tax states can actually use muni duration as a really attractive asset class to begin allocating towards, and increasing duration, in the broader bond market.
And then after, we do think that treasuries, again, around this idea of adding duration to portfolios. At a US 10 year of roughly 3.7% at time of recording, I do have a year end target for the US 10 year of 2.75% to 3%.
We do think that long dated treasury bonds can provide a healthy degree of insurance against equity market volatility and certainly an outright recession potentially hitting the US economy in 2023. Those are the two most attractive opportunities we're finding in the fixed income landscape.
Pulling back even further, if we look at the entire global bond market, I mean let's talk about some opportunities outside the US. Are we going to see the dollar come down this year, and do you think that makes international bonds look more attractive this year?
Well, as quickly as the Fed left 0, global central banks left negative by way of the ECB. I think global bonds are certainly looking a lot more attractive from an income perspective. But I'd argue that the ECB, and the Bank of England in particular, probably still feel as if they have a bit more work to do in squashing inflation than the Fed. And so the ECB and the BoE appear to be still hiking at 50 basis point increments versus the Feds 25. I do think ... We have seen the interest rate differential between global rates and US rates begin to narrow. And I do think this continues to support the notion that the dollar can continue its decline, again, in an environment which the Fed is closer to being done than the ECB versus the Bank of England.
That being said, there's still significant risk of the ECB and potentially the Bank of England doing too much in hiking rates more aggressively than what markets would like and that may suggest that global bonds could come under pressure, but I think the global landscape still looks fairly attractive after a decade in which you had a deluge of negative yielding debt.
Just getting back to one pretty basic question from last year. Last year we saw bonds and stocks sell off together, and these are two asset classes which classically have a negative correlation and the lack of that negative correlation, of course, meant that people ... It was just a miserable year for balanced portfolios. Do you think that that negative correlation will finally reassert itself this year and what do you think the risk is that it might not do so?
Well, I think it could. To a certain extent though, I think in a more immediate term we could still be in an environment in which that correlation remains positive, but to a benefit for investors. I mean if you think about last year, the Fed was raising rates very aggressively, inflation was high and rising, and both stocks and bonds sold off. Stocks didn't like the fact that the Federal Reserve was being aggressive and bonds didn't like the fact that inflation was running out of control.
Now we're in an environment in which inflation is coming down and the Federal Reserve may be turning the curve a bit sooner. I think we could see an environment, and we've already seen that play out in January, in which both stocks and bonds are positive. Investors, they don't like the positive correlation works against you and they seem to forget when the positive correlation works for you, which it has been over the course of January, and it could stay that way over the next couple of months.
But as, I think, we enter into a more normal environment, I do think that that negative correlation will reassert itself and bonds will be the zag to the equity market zig in portfolios.
Well, Jordan, this has been such a helpful summary of what's going on right now. I guess to summarize from an asset allocation perspective, how should investors think about positioning bonds within portfolios right now and what sort of levels of volatility or long-term returns should they expect?
I actually think investors should either be equal weighted bonds and stocks, so 50/50 allocation between stocks and bonds in portfolios, or potentially in overweight within bonds in 2023.
Again, I'd anticipate, just given a lot of the uncertainty about the economy, about what earnings are likely to do, I think stocks will deliver a roughly mid single digit return year, but I think, again, bonds might deliver a slightly better return year over the course of 2023.
And then from a volatility perspective, one of the things that we've highlighted in our outlook, that when the Fed is closer to the end of their hiking cycle, you tend to see interest rate volatility settle down, and that's exactly what has happened over the course of the year. If you were to look at the MOVE index, which is essentially the VIX as VIX is for equities, the MOVE index is for the bond market, you've actually seen the MOVE index decline by about 25% so far this year, so interest rate volatility really settling down pretty significantly relative to the movement that we've seen in rates last year. Again, I think this provides some much needed stability in the bond market. Bonds are back, is how I would sum up the conversation.
So a better year for bonds in 2023. Thank you for joining us, Jordan, and thank you all for listening.
Thank you for having me, David.
Please tune in to our next episode and until then, I invite you to read or listen to my notes in the Week Ahead podcast, where every Monday I share commentary on the latest in markets in the economy to help you stay informed for the week ahead.
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This content is intended for information only based on assumptions and current market conditions and are subject to change. No warranty of accuracy is given. This content does not contain sufficient information to support investment decisions. It is not to be construed as research, legal, regulatory, tax, accounting, or investment advice. Investments involve risks. Investors should seek professional advice or make an independent evaluation before investing. The value of investments and the income from them may fluctuate, including loss of capital. Past performance and yield are not indicative of current or future results. Forecasts and estimates may or may not come to pass. JPMorgan Asset Management is the asset management business of JPMorgan Chase & Co. and its affiliates worldwide.