Navigating the opportunities in global bonds
Tune in to hear Dr. David Kelly and Iain Stealey, International CIO for the GFICC group, discuss the outlook for global monetary policy and the opportunities in international fixed income.
David Kelly:
Welcome to Insight Now a series of conversations designed to shine a light of clarity on the complex world of investing. So far this season, we've talked about the bond market from a number of different angles, and in this episode we want to emphasize that fixed income is a global asset class. We've recently launched our second quarter Guide to the Markets, and on page 42 we have a chart that shows that the U.S. share of global debt has fallen from 60% in 1990 to less than 40% today.
So there's a lot more than just the U.S. when thinking about fixed income. Moreover, the Fed has not been the only central bank hiking rates, and global central banks are also facing the challenge of combating inflation in an environment where financial conditions are tightening globally. On today's episode, I'm joined by Ian Stealey, CIO for our international global fixed income currency and commodities group here at J.P. Morgan Asset Management to dive into the outlook for global monetary policy and what all of this means for opportunities in international fixed income. So Ian, welcome to Insights and app.
Iain Stealey:
Thanks for having me, David.
David Kelly:
So far in this season of Insights Now, we've talked about the big opportunity in fixed income markets at the start of 2023, but of course it's not just about the United States. So where do you see opportunities outside the United States, and how does the story differ around the world?
Iain Stealey:
I think that's a good point, because it definitely has been a global phenomenon. This has been an environment where it's not just been the Federal Reserve raising interest rates. If I look around the world, you've seen Canada take rates up by 425 basis points, the Bank of England over 400 basis points, Australia, 350 basis points, and a similar move from the European Central Bank. And really, it's that move by the European Central Bank, which I think has been most interesting from a global standpoint, because what that has allowed to happen is the removal of the $18 trillion worth or so of negatively yielding bonds that we had prior to this round of monetary policy tightening. I think that's made a big difference and created a lot of opportunities within the global bond market.
If I just look at the Bloomberg Global Aggregate Index today, it's yielding around three-and-a-half percent. Now, remember, this index was yielding below one percent on average just a couple of years ago, so there has been a huge repricing. Actually, that yield you're now getting of three-and-a-half percent, that is the highest. I mean, it has come down a little bit over the last couple of weeks or so, but it really is still the highest level of yield that you've had since June of 2009, so before the great financial crisis. Really, for people who haven't wanted to invest globally within the fixed income markets for the best part of over a decade now, finally we're getting yields that are attractive. We're not seeing negatively yielding bonds. It feels like zero interest rate policy or negative interest rate policy is behind us, and suddenly people are getting excited about fixed income again. I say it's not just a U.S. phenomenon. It is a global phenomenon.
David Kelly:
So if I finally had time to get excited about global fixed income, but of course in recent weeks the headlines have been dominated by backing turmoil start in the United States, and has implications of the fed's pathway going forward. And actually, we discussed this with Kelsey Berro last week, but I wanted to turn to the situation in Europe, and particularly given the buyout of Credit Suisse. Are there similar concerns about the European banking system?
Iain Stealey:
It's interesting, because obviously Credit Suisse happened pretty much straight after Silicon Valley Bank, and obviously you are going to be thinking about what is the knock on impact, and are we likely to see more of this? Now, we don't think this is 2008 all over again. We do believe that Credit Suisse was more of an isolated event here over in Europe. I mean, it's a bank that was struggling from a profitability standpoint for a number of years, so I think we should put Credit Suisse to one side and just look at the overall banking sector in Europe today. When we compare how we look now versus how we looked prior to the sort of financial crisis, we actually see the banking sector in Europe looking pretty healthy.
If you think about all the regulatory reform that has happened over the last decade since that period, it's all been about creating stability in the banking system, trying to avoid a repeat of what happened. Firstly, from a capital buffer standpoint, the regulation means that they need to be a lot higher than they were prior to the financial crisis, so I look at the core equity tier one ratio over here in Europe, and that's the measure of a bank's capital against the assets it runs. We're up about 15% at the moment. Prior to the financial crisis, that number would've been more like 7%, so that's a significant shift in capital in reserves that they've got in place.
We've also had some very harsh stress tests from both the European Banking Association and the European Central Bank, and showing how solid these banks now are. So that's the first thing I would point out that is a big positive. The second thing is really the non-performing exposure or the non-performing loans that a lot of people were concerned about, particularly in some of the peripheral banks post the financial crisis. A lot of that has been cleaned up. Those numbers, again, have been reduced significantly. I think that's a good thing, and then the other thing that we look at is, are there comparisons between the European banking system and the U.S. banking system?
Obviously, I think we've all heard about the differences between the big money center banks in the U.S. and the regional banks and what their requirements are. When you look at it from a European bank standpoint, they do need to market all of their available for sale portfolios. So that is a difference to what happened to SVB, and additionally in Europe, we've also got less concerns over sort of deposit outflows, given we've got pretty low concentration risk, but also there's a lot sort of weaker competition within Europe from money market funds as an alternative investment. So I think, again, what's been happening in the banking system has, you would argue it has been driven by the tightening in monetary policy, but when we do look at the overall sector, we do believe that it is in a much better place than they were prior to 2008.
David Kelly:
Well, I know that most of our listeners lived through 2008, so it's very comforting to hear that the banking system, both in the United States and particularly in Europe, as you point out, is in just a much better condition, a much stronger condition right now, so I think that is clearly a big positive. But nevertheless, given all this banking stress on both sides of the Atlantic in recent weeks, do you think that that has some implications for the Bank of England or the European Central Bank in terms of their policy going forward, particularly if this amounts to some sort of global tightening of financial conditions?
Iain Stealey:
If I listen to what the Bank of England and the European Central Bank have been saying since the banking turmoil has occurred, they've been very clear. They are monitoring the banking situation. They are ready to step in, and support the system if they believe it is going to become an issue that would ultimately disrupt financial stability, but I think you'd argue that both the Bank of England and the European Central Bank have been very clear that they do believe, as we've said, the banking system is sound, very well capitalized. For both those central banks at the moment, their focus remains on bringing down inflation, particularly from the European Central Bank.
They're in a bit of a different situation to the Federal Reserve, where there is clear evidence that core inflation is slowing, maybe not as quickly as the Federal Reserve would like you to be slowing, but it's definitely slowly. That's not the case in Europe at the moment, and they are committed to getting inflation back down under control. Obviously, the evidence of that is highlighted by the fact that they continued to tie it to policy. They raised rates by 50 basis points, sort of almost during the banking turmoil, indicating again their resolve to try to get price stability back where it should be. So I think that's how they would focus on it. That said, I would argue that there has been evidence over the last few months or so that, if things do really start to break, then actually the central banks are willing to step in.
So we've had a really good example here the UK with the Bank of England and the pension crisis that we had during the third quarter of last year, where the Bank of England did step in, they did intervene in the market, really to ensure that financial stability remained as we were seeing a big selloff in the GILT space. What they were very keen to stress was that there can be a difference in response between keeping financial stability under control and not disrupt what they were trying to do from a tightening standpoint when it comes to monetary policy. I think that was good evidence that, at the moment, I think both the European Central Bank and the Bank of England do believe that, they say the banking system is solid and that they need to continue to fight inflation. If that does become more of a systemic problem, they will be willing to step in and support, as the authorities in the U.S. and in Switzerland did
David Kelly:
As you point out, still a lot of monetary tightening over the last year, and more monetary tightening to come. I guess one of the questions for investors is what does this mean for global growth? How much can the global economy take? Is this really going to slow down global growth?
Iain Stealey:
Now, I think that that's a really interesting question, because up until just a few weeks ago, we were having this debate as to how the exceptional monetary tightening that we'd seen over the last year or so, how it hadn't actually been impacting or it didn't appear to have been impacting global growth. We'd been very impressed by the way that global growth had held up, whether it was down to, I'm sure you've discussed previously around the level of consumer savings that are in the system, how healthy corporations are. We've obviously had a reopening in China, which has been a big support at the beginning of this year, and then over here in Europe, the much milder winter meant that there wasn't the concerns around elevated energy prices and the drawdown that would have on economic activity.
So I think we have been in quite a supportive environment, and I would argue that's really due to the very accommodative policy that we had for such a long period of time post-COVID, and the fact that the central banks were a bit late to the party when it came to tightening policy, but obviously what we've then since seen over the last couple of weeks is we are starting to see cracks in the system, obviously starting with the banking sector within the U.S. Our expectation is that, actually, those long and variable lags that we've discussed and at length, long and variable lags that were occur following the tighter tighten of monetary policy, they are starting to show through.
Although we might well have reasonable growth coming out of the first course, maybe even the second quarter of this year, we do start to feel that it's going to be an impact as we move into the second half of this year, particularly the third and fourth quarter. As we sat down, even prior to the banking turmoil that we've just witnessed, as we sat down prior to that during our investment quarterly strategy meeting, our base case was still that we would be seeing a recession in the global economy over the next, call it, 6 to 12 months. I think that has probably been reinforced by what's going on at the moment. It is having an impact on global growth, and I think the interesting thing now is how do central banks react to that with slowing activity but yet still inflation. It's probably a little bit higher than they would like it to be.
David Kelly:
Of course, one of the really key questions is not just how do central banks, in general, react, but do they react in exactly in sync, or do we have a situation where the Federal Reserve is done or almost done with its tightening, and the ECBs got some more tightening to go? Given that, if the ECB keeps tightening as a Fed and nears the end of its rate hikes, what do you think that means for the dollar, and how do you manage foreign exchange risk, given that in your portfolios?
Iain Stealey:
Over the last 12 months or so. We did, at the beginning of that period, have a very positive view on the dollar, and really for two reasons. Firstly, as you mentioned, the Fed was leading the way in tightening policy. It started earlier than a number of the other central banks and was a bit more aggressive than particularly the European central banks. That gave U.S. assets a very attractive yield advantage, and then secondly, we were in a world of what I would term wrong way correlation last year, where all assets were struggling. So we had stock markets going down, but at the same time as bond yields were going higher and bond prices going down. So you weren't getting that diversification benefit from bonds, so really for sort of a multi-asset portfolio or someone who was looking to put protection to portfolio, one of the only areas that you could do that was through buying the U.S. dollar.
I think both of those situations are fading at the moment. The repricing in yields to the movement higher, particularly in U.S. treasury yields, has meant that they are now a diversifier. They will and they should perform well if we have a slowdown, so they can be that ballast of a portfolio. You no longer need to own the dollar for that. Then, as you mentioned, we are starting to see economic activity slow, more so in the U.S. than maybe other parts of the developed markets. We're also seeing inflation coming down faster in the U.S. than in other parts. That will allow, we believe, the Federal Reserve to pretty much be done. Maybe they've got another 25 basis points in them. But the reality is, as I mentioned earlier, is that the ECB are still laser focused on bringing core inflation down, and ore inflation in Europe isn't coming down. We haven't even peaked yet. We're still going through a whole load of wage negotiations.
That really means that we are going to see a convergence of yields, we believe, between the U.S. and Europe, which means the attractiveness of a U.S. dollar or to invest in the US dollar isn't to the same extent as it was last year. But when we look at long-term averages or long-term valuations from the U.S. dollar, it still looks reasonably expensive to us, not as expensive as it did a few months ago, but it does still, from a long run basis, look expensive. That means, to us, you want to be underweight the U.S. dollar, at least relative to, I would say, high quality major currencies like the Euro, like the Yen. Given the backdrop though of more of a slowing global environment and, as I said, base case of recession later this year, that probably means you don't want to stretch for the higher bee to the higher octane non-dollar positions. You want to be more conservative around that, but I say we do see weakness in dollar relative to Euro's, relative to Yen as we move through this year.
David Kelly:
Given what you just said about the dollar, and also the fact that negative yields in Europe are gone and gone for a while now, do you think those investor flows are going to return to Europe?
Iain Stealey:
I think the simple answer to that is yes. It's quite difficult to figure out the exact amount of flows that moved out of Europe. I know, from talking to clients, that a lot of people just couldn't get their heads around investing in negatively yielding bonds. That just was a concept that they couldn't really, really agree with. They were effectively shifting their allocations away from European fixed income into other areas around the world, and we've looked at a number of different ways.
One of the calculations that we've looked at is that you could argue close to $3 trillion worth of assets moved away from European fixed income, trying to avoid those very low or negative yielding bonds. I would expect that to reverse. Now, that's not, obviously, all going to reverse overnight. That will take time. Asset allocators, big sovereign wealth funds, they take time to move their assets around. But over the next, let's call it 12 to 24 months, I would expect that shift to reverse people to look back towards Europe and reallocate there. And again, that's going to be a big support for the Euro relative to the dollar.
David Kelly:
All right, so let's move away from Europe for a bit to, I guess, the longest story ever told in finance, which is low inflation and negative interest rates in Japan. We've had years and years of negative rates in Japan, and years in which they were just trying to push the inflation rate up, but the inflation rate does seem to finally be showing some signs of life. Do you think the back of Japan is going to stay uber doveish here, or are we finally going to see some sort of pivot, and when's that going to happen?
Iain Stealey:
I definitely think they should pivot. Making an expectation of when that's going to happen is much more challenging, and we've witnessed that over the last few months from the Bank of Japan. But you are completely right. I mean, the Bank of Japan is certainly an outlier at the moment. It's the only major central bank to still have negative interest rate policy. They haven't tightened rates this cycle. They're actually still doing yield curve control, so that's fixing the yield on 10-year bonds, and it just doesn't really make sense to us at the moment. Now, we haven't seen the real spike higher in inflation in Japan that we've seen around the rest of the world, whether it be the U.S. or the Eurozone.
But inflation is definitely kicking up, and it's definitely showing signs of life. If you look at the Tokyo inflation, X food and energy, it's currently running around 3.4%. It's well above the Bank of Japan's 2% target. It's the highest level that we've seen since the early 1990s, and we are also starting to see a lot of wage negotiations go on in Japan as well, so negative interest rate policy, yield curve control does look dated to us, and it looks like they need to get out of it. The question is how do they do it? I think the way I would describe it is it's a bit like ripping off the bandaid. You've got to just make a sudden decision to do it. Otherwise, the market is going to push you.
We've seen that already, to some extent, in December. There was no expectation that they were going to shift a yield curve control band, and they made the decision to move it from 25 basis points up to 50 basis points against market expectations. Then, in January of the meeting, there was expectations that they might do some further tweaks to it, and they didn't. I think it's really a case of when they do it, not if they do it, but it's very difficult to put an exact time around that. I think what's quite interesting now though is we are obviously seeing a change in command in Japan, so Governor Kuroda is being placed by Kazuo Ueda on the 9th of April.
I think one of the first things that the new governor will be doing is looking at the yield curve control, and basically doing a comprehensive review of the monetary policy, under the view that actually it isn't favorable. It is impacting market functionality of the JTP market, and it does need to be changed. That's difficult to say an exact date, but our expectation is that, over the coming months, yield curve control will be removed, and then there's going to be a question as to whether we do start to, for the first time in a long time, see the Bank of Japan actually raising interest rates.
David Kelly:
And staying in Asia and just moving a few miles away, let's talk on China. Do you see an opportunity in Chinese bonds?
Iain Stealey:
So if you'd asked me this question at the beginning of last year, I would've been pounding the table saying, saying, "Yes. There was a big opportunity in Chinese bonds." That was a period where the 10-year government bond in China was yielding around 2.75%, and you compare that to the 100-year treasury at the time was around 1.5%. Obviously, as a house, we had the view that the Federal Reserve would be tightening policy, and we still had zero COVID policy in China, and the PBOC would be accommodative. 15 months ago, it looked like a really good investment, but obviously everything has changed since then.
If you fast-forward to today, Chinese 10-year yields are still hovering around 2.75%, maybe a little bit higher than that, but they're significantly less than 3%, yet we've seen this big repricing around the rest of the world, whether it's in the U.S., the Eurozone, or most of the other major developed markets out there. On a relative basis, Chinese government bonds no longer look as attractive as they did. Then, actually, when you think about what's happening in China at the moment, we're obviously having the reopening in China that we experienced a couple of years ago in the rest of the world, and it is supporting economic activity.
We're seeing the high frequency economic data. It's very encouraging. Actually, one of the PMIs that came out today rose to the highest level since November of 2020. We're seeing positive numbers around property sales, up 40% year over year in March, box office tickets up. In a way, we are seeing the activity that we experienced around the rest of the world now occurring in China. It's unlikely that we're going to see easier policy and lower yields in China, at least in the near term. At the moment, our portfolios are actually underweight Chinese government bonds, and much preferring to invest in the areas of the market where we've seen big tightening, and we think the central banks are getting towards the end of the monetary policy tightening cycle.
David Kelly:
Okay. That makes sense. Finally, Ian, how about emerging markets outside of China? Should investors be looking at EM debt?
Iain Stealey:
Definitely, and I think one of our favorite trades at the moment is looking at emerging markets and, in particular, local emerging market bonds. And again, this shows the benefit of active management, because you do have to group China into emerging market bonds. There are definitely some areas of the emerging markets you probably want to avoid, but there are definitely some areas that we do like. I think one of the ways that we look at emerging markets is that their central banks were much more proactive than the developed market central banks. There was a lot of criticism push towards the developed market central banks, that they were very late to the tightening party. They did not get ahead of the curve in an attempt to bring inflation down under control. That can't be said for all the emerging market central banks. We saw a number of emerging market central banks aggressively raising rates back in 2021 and getting them to quite elevated levels.
What that now means is that as the global economy slows, those central banks that have already done a lot of the heavy lifting, they will be able to reverse that tightening. They'll be able to at ease pretty aggressively, in some cases, to support their economies. If they can ease aggressive, that should be very supportive for the local bonds. I think, again, it's a case of looking at country by country, and not just buying emerging markets as a basket, but there are definitely some real gems out there, and particularly when we look at some of the real yields on offer. I'm thinking areas like Brazil, where you're getting a yield today of close to 12.5%, and we've got inflation running at 6%. Now, I do understand there's some political noise in Brazil at the moment, but that's a very attractive real yield. In places like Mexico, you're talking a 2% real yield. Somewhere like South Africa, close to a 4% real yield.
Those are much more attractive real yields in the emerging space than you are seeing in the developed markets. The pushback I would get at times is, we are going into possibly a global recession or at least a global slowdown, and that's not normally a favorable environment for the emerging markets. But I would say that the emerging markets have developed a lot over the last years. If you think about EM as a whole, the asset class has been unloved for a long time. There's not a lot of, what you might call fast money or tourists sitting in emerging markets. A lot of people got out of out of emerging markets and haven't ventured back in. A lot of the local bonds in EM are held domestically. Again, I think that's much more of a supportive. I think, actually, and this is an environment where emerging markets this time around, if we do get a slowdown in the rest of the world, emerging market local bonds could still give you some very attractive returns.
David Kelly:
Interesting. Well, so plenty of opportunity in emerging market debt and, really, plenty of opportunity in global fixed income in general. So listen, thank you so much for joining us, Ian, and thank you all for listening. Please tune into our next episode, where I'll be joined by fixed income portfolio manager, Andrew Norelli, for conversation on credit versus duration, and where investors may want to spend the risk budgets and portfolios. I invite you to read or listen to my Notes on the Week Ahead podcast, where every Monday I share commentary on the latest in the markets and economy to help you stay informed for the week ahead. For even more timely insights, you can also follow and subscribe to my content on LinkedIn.
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