IN BRIEF

  • Above Trend Growth remains our base case, with global growth at its strongest since the recovery and cyclical inflation potentially poised to move higher. As continued aggregate central bank balance sheet expansion keeps risk-free rates range-bound and risk-asset spreads tight for the near term (notwithstanding the Federal Reserve’s anticipated taper), don’t fight the Feds.

  • We anticipate only a gentle rise in rates. In the near term, we expect the Federal Reserve (Fed) to raise rates in December, supported by higher growth and inflation. We expect only a modest rise in 10-year U.S. Treasury yields, to between 2.25% and 2.75% by year-end.

  • With real rates compressed and asset classes fully priced, we seek relative value. We believe in prudently adding carry, until leading indicators tell us inflation is rising much faster or growth is slowing.

  • We still like U.S. high yield and are bullish on Europe, particularly European bank capital (Additional Tier 1). Emerging market local currency bonds remain a favorite, funded with a basket of low-yielding developed market currencies.

 
Scenario probabilities (%)
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Source: J.P. Morgan Asset Management. Views are as of September 14, 2017.

Don't fight the FEDS

Last quarter, I began by saying, “It’s the QE, stupid.” Then, we had an environment of stretched valuations and central bank dominance. This quarter, I could just as easily say, “Ditto.” That’s the easiest way to describe the outcome of our fourth quarter IQ (Investment Quarterly), held in London in September.

For the third time in the last four quarters, our base case is Above Trend Growth (unchanged at a probability of 65%). We also kept the probability of Sub Trend Growth unchanged (at 25%). Global growth is arguably even stronger than three months ago, and is the strongest since the recovery. Not only are the big four—the U.S., Europe, Japan and China—all growing above trend but over 80% of countries have GDP growth that is higher than one year ago.

And inflation, which has been stubbornly stuck at low levels, may be poised to move higher. Cyclical inflation, that is. In the U.S., a weaker dollar should help, as should the strong labor market. While wage growth remains muted, our analysis shows that the Phillips curve1 is alive—maybe not well, but alive. Structural inflation, on the other hand, will likely remain low for some time, as technology investment continues to rise, pushing prices lower, and as changes in the online marketplace lead to further disinflation.

Risk-free rates have been range-bound and risk-asset spreads remain tight. Both are results of continued central bank balance sheet expansion. And that expansion is forecast to continue until the middle of 2018, notwithstanding the Fed’s anticipated taper.

Why didn’t we increase the probability of Above Trend Growth? While J.P. Morgan Asset Management’s leading indicators remain positive, they have fallen from their strongest levels, perhaps indicating that the dysfunction in Washington is impacting Main Street. Plus, we are that much further into the cycle and that much closer to the shift from quantitative easing (QE) being a tailwind to a headwind.

Risks

Past risks - a slowdown in China and a collapse in the oil market— no longer seem imminent. The end of QE, however, is nearing and it’s impossible to fully predict the impact of central bank tapering. We’ve never been through this before. How will central banks normalize and prevent asset prices from imploding? That’s the challenge they are facing. Nonetheless, over the near term, balance sheets will continue to expand.

Geopolitical risks also increased over the quarter, but seemed a bit diminished when we met.

We kept the probabilities of Recession and Crisis unchanged at 5% each.

U.S. rate expectations

Longer term, we do not expect a balance sheet run-off tantrum, but instead, we expect a gentle rise in rates. One of the reasons that U.S. rates are unlikely to move that high—or that quickly—is the Bank of Japan (BoJ). Its yield-curve control policy means that every time U.S. or global rates move higher, the bank is forced to intervene in size, to print money to stem rising bond yields. That money, in turn, buys Treasuries.

In the near term, we do expect the Fed to raise rates in December, supported by both higher growth and higher inflation. For the 10-year U.S. Treasury, the same forces that kept rates range-bound over the last three months are still in play. We expect only a modest rise in rates, to between 2.25% and 2.75%, by year-end.

Strategy implications

We, like most investors, continue to suffer from valuation fatigue. The real effect of quantitative easing is that real rates are compressed and every asset class is fully priced. So the question is not “Where is there value?” The question is, “Where is there relative value?”

We still like U.S. high yield. Corporate profitability looks quite good; so do earnings. Even though yields are low, spreads are attractive when measured through the lens of defaults, which are nearing just 1%. No one more than I would like to buy credit at a wider spread and a higher yield, but we can’t. As with last quarter, we are cognizant that we are picking up pennies in front of a steamroller. But if you sit on cash too long, the next pool of money is created, and you start to lag. I don’t want to fight the Feds.

We are also bullish on Europe. We see a lot of growth and we see a lot of value from a currency that has re-valued; corporate profit is high. In particular, we continue to like European bank capital (Additional Tier 1). The banking system is healing and spreads are attractive, particularly when compared with U.S. high yield.

Emerging market (EM) local currency bonds also remain a favorite. Yields are relatively high, and in many countries inflation is coming down, allowing central banks to ease. Most important, the emerging markets offer something that the developed markets don’t: positive real yields. Uncertainty regarding the path of the dollar, however, means we prefer to finance our EM currency longs with a basket of low-yielding developed market currencies.

Closing thoughts

Don’t fight the Feds. We are unhappy with valuations, but global imbalances have lessened, economic volatility is low and there is little indication of impending recession. Investors continue to have above-average cash allocations and that condition will worsen with each additional month of money printing. Until there is a change in this situation-a sign from leading indicators that either inflation is rising much faster or growth is slowing-we believe that prudently adding carry remains the right strategy. There is no doubt the next 12 months will be incredibly challenging as the central banks begin to unwind the distortions they have created.

SCENARIO PROBABILITIES AND INVESTMENT IMPLICATIONS: 4Q17
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Source: J.P. Morgan Asset Management. Views are as of September 14, 2017.

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.

1 The Phillips curve illustrates the inverse relationship between unemployment and inflation.

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.

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