Scenario probabilities (%)
Source: J.P. Morgan Asset Management. Views are as of June 2017.
EVERYTHING’S A PROXY FOR QE
“It’s the QE, stupid.”1 That’s the conclusion we came to at our third-quarter IQ (Investment Quarterly), held in Columbus, Ohio, in June.
We began by evaluating the outcome of our previous meeting. While we got some things right, we also got some things wrong. Growth is at least as strong as we thought globally, but inflation has disappointed. The potential for meaningful fiscal spending in the U.S. seems a distant memory. And we underestimated the pressure of continued global quantitative easing; central bank dynamics are stabilizing rates. We were correct, however, in our prediction that, despite the fact that everybody is suffering from valuation fatigue, credit, risk and emerging market currencies would all be strong performers.
Global growth is still synchronized. U.S. growth is forecast to rebound later in the year (and any fiscal stimulus would provide a surprise to the upside); Europe is growing above potential; Japan is growing way above potential; and the emerging markets, including China, are growing at potential. But there’s no inflation anywhere. The environment doesn’t fit neatly into one of our four scenarios. Nonetheless, the strength of global growth supports Above Trend Growth as our base case, albeit at 65%, down slightly from 70%. We raised the probability of Sub Trend Growth from 20% to 25%.
Key questions remain, among them:
- What is the path of inflation expectations?
- What does the flow of QE look like? And when does the tailwind of QE become a headwind?
Global slack is keeping a lid on inflation, and inflation remains stubbornly below target in the developed markets. Outside of modest growth in the U.S., there’s no wage inflation anywhere. We spent some time debating the drivers of inflation and inflation expectations. Certainly, an aging population that continues to work is one. But more important may be technology. Are the signals from telecom, from oil, from medical devices telling us that structural expectations for inflation need to be lower?
During our meeting, the Federal Reserve announced a rate hike and detailed the plan to partially unwind its balance sheet (albeit without specifying a start date). The Fed’s plan was more hawkish than we anticipated, reflecting its expectations of rebounding growth and inflation, but we believe the Fed is smart to go now, as continued purchasing by the Bank of Japan (BoJ) and the European Central Bank (ECB) cushions its actions. For now, the weight of cash being injected into the markets remains supportive. When will this change? We believe that the balance of flows needs to be negative before it really hits the market. Assuming the Fed embarks on its path later this year and both the ECB and BoJ begin to scale back buying at the beginning of 2018, we are looking at one more year of central bank dominance at a minimum.
Our concerns over China have risen, and we debated increasing the probability of recession. China has been borrowing and manufacturing its own growth, and may be running out of room to do so. Efforts to tighten should be closely monitored, as should the path of commodity prices. China may be a bubble, but it’s not about to burst in the immediate time frame.
Oil is also a risk. Will OPEC curb production to support prices, or will it attempt to break the back of shale once again, flooding the market with supply and trading lower prices for higher volumes?
Finally, an overly hawkish Fed could be a risk. As the Fed shrinks its balance sheet, it will be tightening financial conditions. The impact on growth could be quite suppressive, and we could see the seeds of the next recession.
Despite these concerns, we felt that the near-term risks were muted and we kept the probabilities of Recession and Crisis unchanged at 5% each.
U.S. rate expectations
In light of disappointing hard data, reduced expectations for fiscal stimulus in 2017 and continued QE from the ECB and the BoJ, we have muted our expectations for higher rates in the near term. We do expect, however, that growth in the U.S. will rebound later in the year, supporting another rate hike and the Fed’s desire to begin tapering, and allowing yields on the U.S. 10-year Treasury to rise to between 2.50% and 3.00% by year-end.
In the near term, the environment is as Goldilocks as it gets— reasonable growth, low inflation and accommodative central banks are all supportive of risk assets. Despite the fact that markets are suffering from valuation fatigue, our best ideas continue to center on credit and emerging market currencies.
The weight of cash in Europe exceeds that in the U.S., and European growth is strong. The credit fundamentals for banks continue to improve, cushioning European bank capital (Alternative Tier 1) and making yields attractive on a relative value basis vs. high yield and preferreds.
In the U.S., the revenue recession is over. In high yield, defaults are down and there’s still room for modest spread tightening. Leveraged loans, particularly given the flattening of the curve, offer attractive carry, but we must be cautious of structure and covenants, and we must recognize that we are ceding the upside. With bonds at today’s tight spread levels, we are cognizant of the fact that we are picking up pennies in front of a steamroller; we aren’t complacent, but for now, U.S. high yield bonds continue to be an attractive carry trade.
We are more cautious on growth in the emerging markets, but as a whole EM fundamentals are good and countries have better balance sheets with which to survive external shocks. Inflation is falling, and even though the Fed is tightening, the re-rating in the rest of the world keeps the dollar in check. The emerging markets offer something the developed markets don’t—positive real yields. We like emerging market local currency bonds, but are rotating away from commodity-based economies and toward manufacturing ones, away from Latin America and toward Central and Eastern Europe.
We believe the next 12 to 18 months will be among the most challenging investment environments in anyone’s career. As the central banks reverse their policies and their aggregate balance sheet goes from expansion to contraction, the impact is likely to be volatile asset prices. Further, central banks will be “normalizing” their balance sheets at a time when growth and inflationary pressures should still be muted. Add to that, there may or may not be policy stimulus coming out of Washington and there may or may not be a hard Brexit. We are about to find out how much quantitative easing and zero interest rate policy depressed volatility and inflated asset prices, if at all. We’ll be ready to expect the unexpected and will use our research-driven process to find value where we can.
SCENARIO PROBABILITIES AND INVESTMENT IMPLICATIONS: 3Q17
Source: J.P. Morgan Asset Management. Views are as of June 14, 2016.
Opinions, estimates, forecasts, projections and statements of financial market trends that are based on current market conditions constitute our judgment and are subject to change without notice. There can be no guarantee they will be met.
DM: Developed markets; EM: Emerging markets; FX: Foreign exchange.
1 Apologies to James Carville, who said, “It’s the economy, stupid.”
Investments in bonds and other debt securities will change in value based on changes in interest rates. If rates rise, the value of these investments generally drops. Securities with greater interest rate sensitivity and longer maturities tend to produce higher yields, but are subject to greater fluctuations in value. Usually, the changes in the value of fixed income securities will not affect cash income generated, but may affect the value of your investment. Credit risk is the risk of loss of principal or loss of a financial reward stemming from a borrower’s failure to repay a loan or otherwise meet a contractual obligation. Credit risk arises whenever a borrower is expecting to use future cash flows to pay a current debt. Such default could result in losses to an investment in your portfolio.