Scenario probabilities (%)
Source: J.P. Morgan Asset Management. Views are as of March 31, 2018.
On schedule: the journey to higher rates
Over the first quarter of 2018 the macro environment played out much as we anticipated. Positive growth fundamentals, strengthened by tax reform and fiscal stimulus in the U.S., supported higher yields globally, yet the risk-on environment fell slightly short of our outlook. During our most recent Investment Quarterly (IQ) held on March 21 in New York, we spent time focusing on the slow journey to higher rates. While it is true that we are still in an environment where central bank quantitative easing and current economic conditions have kept rates from rising materially higher, storm clouds continue to gather. The reduction in central bank liquidity will soon come to the forefront as the European Central Bank ends its buying program before year-end and the Bank of Japan maintains yield curve control and considers a higher rate target for the 10-year government bond. In truth, yields have been rising painlessly for over two years: the Fed first raised rates in December 2015 and Treasury yields have been rising since the Brexit referendum low in July 2016. The question we asked throughout the day was, “Are we approaching a tipping point?”
What was clear is that global growth is strong and that continues to be the familiar narrative. Our proprietary measure of key economic indicators for the G4 shows that economic health continues to make new highs and wage growth has stabilized at higher levels. Confidence surveys remain elevated, confirming our proprietary models which suggest that consumer and business spending will increase through 2018.
Turning to the U.S., favorable financial conditions and stimulative fiscal policy should support economic momentum… although the economy may not need such a large boost at this stage of the cycle. For now, the market seems unfazed by the need to finance a deficit that will exceed 5% of GDP by 2019. As rates rise to attract capital, net interest expense will also rise—creating its own headwind. Inflation is also beginning to show signs of life as cyclical upward pressures (less slack in labor and manufacturing) begin to outweigh the structural downward pressure (technology efficiencies).
Taken together, sustained growth, reemerging inflation, U.S. fiscal spending and a constructive view on China support a greater likelihood that markets will price in Above Trend Growth as the central scenario over the next three to six months. As a result, we raised the probability of our base-case scenario, Above Trend Growth, from 70% to 75%.
Our rate view remains consistent with our base case: the Fed will engineer a gradual normalization path with four rate hikes in 2018 and the U.S. 10-year Treasury will end the year at 3.00%–3.50%. A sustained break above this level is still unlikely unless inflation rises above our expectations or Japan abandons yield curve control.
There is some possibility that potentially disappointing inflation prints, slowing growth out of China and a significant equity market correction could lead to a Sub Trend Growth scenario. However, corporates are benefitting from a lower tax rate and a strong operating environment, mitigating the impact of the increased borrowing and leverage that has been incurred to raise dividends and buy back shares. Consequently, we believe the probability of Sub Trend Growth to be less than last quarter and reduced it from 25% to 20%.
We left the probability of Recession unchanged at 0%. It’s a scenario that’s hard to envision when most economies are growing above trend, when most central banks are running accommodative monetary policies and when the U.S. is about to unleash significant fiscal stimulus.
The discussion on Crisis was more interesting. Although we left it as a 5% probability, we acknowledged that the potential could be much higher. If the U.S. becomes overly aggressive or clumsy in its use of tariffs, the escalation into a full-blown global trade war would have serious consequences. Both the global economy and the capital markets could become casualties.
In an environment of sustained global growth where inflation is beginning to drift higher, select sectors within credit should do well, with room for additional spread compression and an ability to absorb a portion of rising rates.
Securitized credit was our favorite. Similar to last quarter, our view on the consumer remains strong as confidence is near all-time highs. With its limited duration risk, incremental yield and credit enhancement, the sector offers an alternative to corporate credit.
U.S. high yield spreads remain attractive relative to current and expected defaults of 1%–2%. After some volatility in February, spreads remain range-bound in the mid-300 basis points (bps) and have the ability to tighten modestly toward end-of-cycle lows of about 250bps. European high yield looks good as it trades at about the same yield as U.S. high yield, after adjusting for credit quality and cross-currency basis. Similar to high yield bonds, U.S. leveraged loans remain a good carry trade and their floating rate structure can mitigate the impact of rising rates.
European bank capital (Additional Tier 1) also remains popular, supported by both positive fundamentals and technicals. European banks continue to benefit from positive operating trends, strong capital ratios and a low chance of equity conversion. Structure does matter and positioning favors issues with better protection against extension risk.
EM local currency bonds also made our buy list. Solid global growth and the weaker U.S. dollar (USD) trend continue to support EM FX. History has shown us that emerging markets can continue to perform during a Fed hiking cycle, specifically when it is gradual and well-telegraphed. We continue to favor markets with high real yields and commodity-based economies and remain cautious on countries with high external financing needs.
Overall, the central bank backdrop continues to support risk assets in the near term. Nevertheless, as rates begin to rise, we remain cautious on duration and will look to manage this risk with underweights to sectors that are long in duration and low in credit spread.
Be careful what you wish for! We wanted more volatility and greater opportunity to move positions around and to generate higher alpha. The wind up of QE, the rundown in central bank balance sheets and a rise in geopolitical risks are causing market volatility to revert to that higher and more normal mean. That doesn’t mean we should derisk our portfolios and hide in cash. What it does mean is that we must thoroughly understand the dynamics in play this year and position our portfolios to benefit from them. Our Investment Quarterly (IQ) gave us two very clear views:
- The normalization (rise) in rates has a long way to go. The price-insensitive support of the bond market is slowly being removed at a time when growth is accelerating, inflation has firmed, fiscal stimulus is being applied and U.S. Treasury issuance is growing.
- Parts of the credit markets, domestically and internationally, will do well. Choose the markets and sectors (securitized credit, high yield, EM debt) that will benefit from stronger growth and higher inflation while avoiding those sectors (U.S. investment grade?) that will try to take advantage of the environment by applying too much leverage in an effort to accelerate revenue.
Let’s embrace the higher volatility with strategies that deliver results!
Scenario probabilities and investment implications: 2Q18
The table below summarizes our outlook over a range of potential scenarios, our assessment of the likelihood of each and their broad macro, financial and market implications.
SCENARIO PROBABILITIES AND INVESTMENT IMPLICATIONS: 2Q18
Source: J.P. Morgan Asset Management. Views are as of March 21, 2018.
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.