Scenario probabilities (%)
Source: J.P. Morgan Asset Management. Views are as of March 2017.
From divergence to convergence
In the fall of 2016, a change in market sentiment (the proverbial unleashing of animal spirits) altered expectations for the sustainability of global growth and inflation, driving U.S. interest rates higher and allowing the Federal Reserve (Fed) to tighten for the first time in a year. In December, we dramatically increased our assessment of the probability that the market would price in Above Trend Growth over the near term—from 10% to 65%. As we gathered in New York in March for our second quarter IQ (Investment Quarterly), the Fed had just raised rates again.
What prompted the Fed’s March move? Has anything changed? Depending on one’s perspective, the answer is either a little—or a lot.
Sitting in the U.S., it appears that the markets are playing a waiting game and little has changed. Since the beginning of the year, the yield on the 10-year Treasury has bounced around in a fairly narrow trading range. The markets want to see the administration and Congress focus: focus on tax cuts, focus on deregulation and focus on the mechanism for getting fiscal spending into the economy. But when you broaden your perspective, you can see that a lot has changed. At the end of last year, it appeared that while the U.S. was beginning to normalize, the rest of the world was still awash in central bank accommodation, keeping rates low. What’s changed is that growth is now synchronized globally. And more important, so is monetary policy. No longer does the Fed appear to be going it alone. Central banks around the world are starting to dial down that accommodation; they are leaning into growth, inflation, better credit quality and more consumption. We are beginning a transition—a transition from monetary policy to fiscal policy.
Some pundits have suggested that higher rates cannot be sustained without the stimulus of fiscal spending. We disagree. We see the recent price action, in range-bound Treasury yields, as a pause, and just that. The U.S. is growing at 2% even without any fiscal boost; Europe and Japan are both growing above trend; China’s growth is stabilizing; and even the emerging markets are experiencing better-than-expected growth. We believe this synchronization signals a greater probability for the markets to price in Above Trend Growth over the coming three to six months; we raised our probability from 65% to 70%.
In the past, we’ve been concerned that divergence—rising rates in the U.S. vs. continued monetary accommodation in the rest of the world—would lead to a strengthening dollar, limiting the potential for global growth. With globally coordinated monetary policy, a stronger dollar is less certain. However, protectionist policies emanating from Washington or, conversely, a lack of policy action could still cause the markets to price in Sub Trend Growth; we put that probability at 20%, down from 25% last quarter.
We kept the probabilities of both Recession and Crisis at 5%. Continued risks are the upcoming European elections and the ever-present risk of a political misstep that threatens global stability.
U.S. rate expectations
Our rate view also remains unchanged from one quarter ago. At that time, we suggested that a near-term rally was possible, and we have experienced that. No path to higher rates is a straight line. We expect another three rate hikes this year and a 10-year Treasury bond that is 3% by mid-year and 3% to 3.5% by year-end.
We continue to find opportunities in those areas that benefit from the reflation trade, including credit across the board.
Opportunities also exist in areas that benefit from the prospects for higher growth:
- Our best idea is once again U.S. high yield. The sector offers attractive carry and, historically, high yield spreads are able to absorb some of the increase in rates. End-of-cycle high yield spreads are typically through 300 basis points; we’re not near that yet. Default rates continue to decline, as a lot of weak issuers have already defaulted out of the index.
- Shorter-duration securitized credit has been a favorite asset class for some time, as the sector offers attractive carry with limited duration risk. The consumer is in great shape, and wage gains are accelerating. With growth and inflation moving higher, credit quality should get better, not worse.
- U.S. leveraged loans, like their fixed rate counterparts, also benefit from the positive tailwind to credit. Carry is attractive, particularly on a duration-adjusted basis. Flows are positive, and every rise in Libor may be accretive to yield. The convexity profile of the sector, however, is less attractive. In portfolios where we have the flexibility, we like the option of owning high yield bonds while swapping out of the duration, creating synthetic leveraged loans.
Outside of the U.S., we continue to like emerging market local currency bonds. Both bonds and currencies look cheap. Typically, growth in the U.S. is supportive of growth in the emerging markets. Inflation is coming down, and in many cases currencies have gone through significant adjustments. Notably, the bonds now offer something that’s missing in some developed market government bonds—positive real yield. We prefer a basket of emerging market names, including sovereign-related credits, funded by a basket of low-yielding developed market currencies.
As central banks begin to raise rates, low yielding duration continues to look mispriced. Outright shorts in U.S. Treasuries, the eurodollar and European sovereigns are all ways to hedge against both rising rates and a faster pace of rate hikes.
As the post-crisis recovery ages, we believe that we are still in the middle innings of the ballgame rather than near the end. We are just beginning to see the transition from years of monetary policy support and stimulus to more meaningful fiscal policy stimulus. This does not suggest we should fear an economic and/or market collapse. It will take central banks considerable time to withdraw liquidity from the system. By our estimate, it will take the Fed about a dozen years to normalize policy, including running down the size of its bloated balance sheet. And, arguably, the European Central Bank and the Bank of England have not even begun the normalization process, while the Bank of Japan seems an eternity away. A long and gradual withdrawal of liquidity will allow policymakers to be more patient in developing coherent fiscal policies. If this turns out to be the evolving policy script, then the markets will easily be able to handle a gentle rise in rates and adjust without the trauma of previous tightening cycles.
SCENARIO PROBABILITIES AND INVESTMENT IMPLICATIONS: 1Q17
Source: J.P. Morgan Asset Management. Views are as of March 16, 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.
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.