Finding growth in a slow-growth environment - J.P. Morgan Asset Management

Finding growth in a slow-growth environment

Contributor Robert Michele
Low rates and extreme monetary accommodation will be with us for a while

As we approached fall, the Federal Reserve (Fed) and financial markets awoke to the fact that an engine of global growth—it had been China—may be sputtering, and they both blinked. Against a backdrop of increased volatility and global stock market corrections, both the Federal Open Market Committee (FOMC) and lead investors from across our Global Fixed Income, Currency & Commodities platform gathered to discuss their economic and market outlooks.

Slowing global growth

Never before have global markets been so integrated nor as dependent on emerging markets, which now comprise over 40% of global GDP. Growth is slowing in over 60% of the emerging markets (Exhibit 1), productivity is down, and world trade remains subdued. Our base case outlook calls for sub-trend global growth, that is, below a 3.75% threshold. Given our focus on China, the obvious threat to our outlook is a hard landing in China, which would ripple through the global economy. Furthermore, continued weakness in commodity prices could drive instability in selected emerging markets.

In the U.S., we expect that the first Fed rate hike in almost ten years will happen this year. We caution, however, that real policy rates have fallen around the world (Exhibit 2) and a stronger dollar and increased market volatility may make it difficult for the Fed to decouple too much from its global counterparts. Against that backdrop, rates may actually decline over the next three to six months, as investors come to recognize the reality of slowing global growth. In the face of a stronger dollar and modest expansion, we expect global monetary policy to remain accommodative.

A cautious approach to risk markets

A deliberative Fed and slower global growth are positives for rates markets. Without an abrupt withdrawal of liquidity, people will be more patient in holding bonds, and yields look attractive. However, given our expectation for slower global growth and potentially higher volatility, we approach risk markets carefully.

Investment implications

Over the past year we have experienced a significant re-pricing of credit – spreads are 60% wider than they were just one year ago, and, we believe, offer significant compensation for default and liquidity risks. That’s particularly true for corporate high yield (ex-energy, metals and mining), where it looks like buyers are being over- compensated for both defaults and potential volatility. U.S. high yield companies are, for the most part, domestically-focused, have healthy balance sheets, and are positioned to benefit from above-trend growth.

Likewise, European high yield fundamentals benefit from above-trend economic growth and ongoing ECB easing. We like European financials, specifically hybrid bank debt, but we are cautious about banks with emerging market exposure. Alternative Tier I securities (these receive top short-term ratings from any two Nationally Recognized Statistical Rating Organizations) are attractive in the face of regulatory pressure to improve bank balance sheets; however, we prefer the securities of banks who have completed their financing needs.

We are more guarded in our approach to U.S. investment grade corporates, as many are dependent on global demand. Furthermore, continued easy money increases the opportunities for investment grade issuers to re-leverage. Ongoing new issue supply, especially if paired with outflows as investors move to high yield, would also put negative pressure on spreads.

As an alternative, we like commercial mortgage-backed securities (CMBS). Spreads are attractive when compared with both U.S. investment grade corporates and agency MBS. Like the high yield market, CMBS is poised to benefit from U.S. growth and further strength in the housing market.

Finally, given our concern over slowing global growth, we are quite selective in our emerging market investments. Commodity prices present a major headwind; the effects of a strong U.S. dollar have yet to be fully priced in; and the specter of a Fed hike may increase the risks of emerging market crises. Differentiation among markets is key, and we’re focused on countries that have less borrowing needs; that are commodity importers, not exporters; and that are addressing market-friendly structural reforms.

Although the Fed tried to walk back its decision in the days following the FOMC meeting, its lost credibility was damaging and still reverberates through the markets. Nonetheless, as we look for deeper value, we view this as a further opportunity to search markets for investment opportunities. What we have learned is that the Fed (and other major central banks) will be overly cautious in normalizing policy; low rates and extreme monetary accommodation will be with us for a while.

International investing bears greater risk due to social, economic, regulatory and political instability in countries in "emerging markets." This makes emerging market securities more volatile and less liquid developed market securities. Changes in exchange rates and differences in accounting and taxation policies outside the U.S. can also affect returns.

Securities rated below investment grade are considered "high-yield," "non-investment grade," "below investment-grade," or "junk bonds." They generally are rated in the fifth or lower rating categories of Standard & Poor's and Moody's Investors Service. Although these securities tend to provide higher yields than higher rated securities, they tend to carry greater risk.

CMOs are collateralized mortgage obligations, which are issued in multiple classes, and each class may have its own interest rate and/or final payment date. A class with an earlier final payment date may have certain preferences in receiving principal payments or earning interest. As a result, the value of some classes may be more volatile and may be subject to higher risk of nonpayment.

Related funds

Global Bond Opportunities Fund
Broaden the borders of your bond portfolio. The Fund provides flexible, high-conviction exposure across more than 15 fixed income sectors and 50 countries.
Strategic Income Opportunities Fund
Complement your core. With an absolute-return-oriented approach to fixed income investing, invests flexibly across a diverse set of fixed income strategies, taking advantage of the best opportunities across all market environments.
Core Bond Fund
Quality at the core. A value-driven approach that emphasizes intermediate bonds of the highest quality, the Fund serves as a foundation for investors seeking a well-diversified portfolio.