Scenario probabilities (%)
Source: J.P. Morgan Asset Management. Views are as of December 13, 2017.
More of the same for the near term; going forward, it all comes down to inflation
Once again, nothing is cheap and valuations are less compelling. But for several quarters, we have been repeating the mantra “Don’t fight the Feds” as the world’s central banks, in aggregate, continued to perpetuate the Goldilocks environment of high growth and low rates that is supportive of risk assets. We expect this to continue for our forecast period (the next three to six months), although change is on the horizon. The question we asked ourselves at our most recent Investment Quarterly (IQ), held in December in New York, was: “As the central banks move towards policy normalization, are there risks building that could alter the benign trajectory of rates?”
Global growth is strong and shows no signs of abating. Economic data continues to improve across both the developed and emerging markets. Our own proprietary economic health indicator shows the G4 economies approaching pre-crisis levels. In the U.S., fiscal policy has the potential to provide additional stimulus to an already strong economy. As a result, we raised the probability that the markets will continue to price in Above Trend Growth from 65% to 70%. At the same time, we reduced the near-term probability of recession to zero (from 5%), recognizing that the flattening yield curve has been a function of low inflation and continued global quantitative easing, not imminent recession.
Despite strong growth, inflation has been stubbornly low. In the face of low inflation, the world’s central banks seem content to turn a blind eye towards the potential risks of ultra-accommodative policy. Markets are going up, unemployment is going down. Why do anything? On the other hand, central banks presumably want to be ahead of inflation, not behind the curve. What could tilt the central banks into a more aggressive tightening mode?
Inflation levels are caught in a tug-of-war between downward structural forces (technology improvements, price transparency) and upward cyclical forces (economic growth, tight labor markets), with the structural pressures continuing to deliver inflation print disappointments. But what if tightness in the labor markets finally leads to higher wage growth? Globally, investment growth is picking up, and it is broad-based. In the U.S., leading indicators suggest that investment momentum will continue, and could be further fueled by tax reform. Historically, investment growth leads to productivity growth. But what if it just leads to wage growth? Alternatively, we could get productivity, but the related gains could accrue to corporations, which would be even more inflationary.
If inflation starts to pick up, will the central banks remain complacent? We believe that it’s too early to tell—the data hasn’t tilted yet and we expect no change over the next three to six months. But if inflation does start coming in above target, we could easily see the Fed raise rates four times in 2018, not the three times the market is expecting. If both the European Central Bank and the Bank of Japan also start moving to higher rates at the same time that central bank balance sheet expansion turns negative (currently projected for around October 2018), then bond investors are not being compensated for the risks, volatility will rise and the second half of 2018 could be much more difficult for the markets.
U.S. rate expectations
For now, our view remains consistent with the Fed’s projections— growth will remain strong (despite the typical negative seasonality in the first quarter), inflation will stay contained and the Fed will remain on a gradual path towards normalized real yields by raising the fed funds rate three times. We believe that the yield on the U.S. 10-year Treasury will also rise modestly, ending 2018 at 2.75%–3.25%.
Risks to our forecast are continued sub-trend inflation prints, a significant correction in the equity markets or disappointing Chinese growth. All would lead to Sub Trend Growth and continued central bank accommodation. The probability of these risks is unchanged from last quarter (25%). Crisis, as always, is a risk, but we believe that risk remains small (5%).
For the next three to six months, consistent with our views on global growth, our best ideas continue to be in credit. In particular, we like those sectors that provide significant spread, room for tightening and good cash flow—all important attributes if rates start to rise.
Returning to its top spot among our best ideas is European bank capital (Additional Tier 1). Spreads are attractive, growth in Europe is strong and the banking system is healing: capital ratios are up and the possibility of equity conversion is remote.
U.S. high yield also remains a favorite. Global growth continues to support corporate profitability. Spreads in the mid-300s, while not wide, have room to compress; past end-of-cycle spreads have neared just 250 basis points. And while “high” yield may be a bit of an overstatement, spreads are more than enough to compensate for extremely low default rates.
Consistent with a tight labor market, the U.S. consumer is healthy. We like securitized credit, as the structures provide significant credit enhancement, attractive yields in the short end of the curve, and the benefit of quick amortization, which can provide a source of cash as rates rise.
While we like credit and credit spreads, we remain cognizant of the risk of higher rates. Given our view, we want to own the bonds and the positive credit convexity while managing the duration risks by shorting government bonds.
Since the first quarter of 2016, the markets have been flooded with the overly generous monetary accommodation of the central banks. Encouraged by a persistent global economic recovery, that excess liquidity has depressed market volatility and inflated asset prices. As the central banks continue with their normalization, we expect to see an inflection point in the level of volatility and valuation across markets in 2018. It is difficult to know when we will see the tipping point, but signs would include more volatility, deeper corrections and investors demanding more return potential before taking incremental risk. For our part, we will rely on our research and be sure not to become an inadvertent seller of liquidity.
SCENARIO PROBABILITIES AND INVESTMENT IMPLICATIONS: 1Q18
Source: J.P. Morgan Asset Management. Views are as of December 13, 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.
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.