Global Fixed Income Views: First quarter 2019
Themes and implications from the Global Fixed Income, Currency & Commodities Investment Quarterly
- We have lowered the probability of our base-case scenario, Above Trend Growth, from 70% to 50%, in light of potential congressional gridlock, worsening rhetoric around U.S.-China trade, Brexit and Italian politics—along with quantitative tightening and likely Federal Reserve rate increases (we expect two more hikes this cycle, after one in December 2018).
- Though economic headwinds are gathering, we expect policymakers and governments are incented, and have the tools at their disposal, to manage the risks.
- We have raised the probability of Recession to 10% from 0%; while we do not believe a recession is imminent, we acknowledge the potential risk (though not one we expect) of trade war escalation and/or central banks overtightening.
- Our best ideas include: short-duration securitized credit, which is tied to the strong U.S. consumer; high yield credit, as spreads appear attractive relative to expected defaults; and local emerging market debt, where 2018’s yield spread widening looks overdone.
SCENARIO PROBABILITIES (%)
RIGHT ON SCHEDULE
Well, the quarter we had all been waiting for finally arrived and gave risk-seeking investors a pretty good beating. Quantitative tightening (QT), another quarterly Federal Reserve (Fed) rate increase, trade battles between the U.S. and China, Brexit, ongoing Italian budget crises and plunging oil prices unsettled the markets and led to a dramatic increase in volatility. But perhaps the biggest change since our last Investment Quarterly (IQ) was the U.S. midterm elections, in which the Republicans lost the House of Representatives, handing President Trump a potentially gridlocked Congress. Taken together with a flattening yield curve, the markets began to fear an approaching recession. Such was the backdrop for our December 12 IQ, held in New York.
Simply looking at the markets would suggest that the global economy is headed into recession. Equity markets are now down on the year, with many having fallen 15%–20% from their recent peaks. Credit spreads have widened, the yield curve has flattened, and government bonds have rallied. However, while we agreed that the global economy was in a growth slowdown, we couldn’t see an impending recession. Certainly, a gridlocked Congress would mean no further fiscal stimulus (no Tax Reform 2.0 or infrastructure spend), and a trade war between the U.S. and China would mean less trade. But an adequate monetary policy response should have the ability to cushion the slowdown and assure a soft landing. Already, commentary out of the Fed suggests that it is nearing the end of a three-year journey to normalize policy. We think the Fed is headed to two more hikes (following one in December 2018) and a level of 2 ¾ %–3%. But the markets would certainly embrace a dovish hike … and what if the Fed also indicated a willingness to end the balance sheet rundown? Outside of the U.S., the central banks remain very accommodative. While the European Central Bank (ECB) has ended its balance sheet expansion, quantitative tightening or rate increases aren’t likely anytime soon. Further, the Bank of Japan (BoJ) doesn’t appear ready to slow its accommodation, and the People’s Bank of China may have to ease further to offset the impact of tariffs. Taking all these actions into account, we should see U.S. GDP growth slow from 3%-plus to 2%-plus, and the rest of the world hover at trend growth during 2019.
We brought down our base-case scenario of Above Trend Growth from 70% to 50%. While the U.S. midterm election was the major event since our last IQ, we also noted that the rhetoric around U.S.-China trade, Brexit and Italy had worsened since the first quarter of the year. Together with additional Fed rate increases and QT, economic headwinds are gathering. We lowered the probability of above-trend growth but kept it as our base case in expectation that there would be a policy response along the way.
We raised the probability of Sub Trend Growth to 35% from 25%. The data in the U.S., Europe and China are unambiguously pointing toward a growth slowdown. Perhaps after a decadelong expansion and three years of Fed tightening, it’s simply time for the economy to slow down. We also noted that companies seemed somewhat disinterested in investment and capex. For now, they seem content to buy back shares, raise dividends or make acquisitions. And, of course, the central banks’ balance sheet unwind creates its own liquidity headwind.
We also raised the probability of Recession to 10% from 0%. As the yield curve flattens and approaches inversion, it’s an ominous sign that soft landings are incredibly hard to engineer on a global scale. Recession may be a 2020 event, but it doesn’t seem like a 2019 event just yet. Of course, a full-blown trade war or overtightening by the central banks would bring forward that timeline.
Finally, we kept the probability of Crisis at 5%. Geopolitical risks are rising, but so far we have seen no evidence that a major policy error has been made.
Three very real risks to our somewhat optimistic bias are looming larger on the horizon:
1. Tariffs/U.S.-China relations. Further escalation of a trade war would damage growth and pull forward recession expectations. While each country has the tools to diminish the drags from a trade war, the hope is for compromise and de-escalation.
2. Central bank policy. The pressure is significant to return policy rates to something that looks normal on a real yield basis. But rate increases from the Fed, ECB and BoJ—on top of QT—are too much for the economy and the markets to absorb. The Fed may have to pause on the balance sheet runoff, and the BoJ and ECB may have to wait for the next cycle to raise policy rates.
3. Geopolitics. How the U.S. administration handles a gridlocked Congress will do a lot to shape the U.S. economy. Equally important will be how Europe handles Brexit, the Italian budget and the growing unrest in France.
For now, it’s our expectation that policymakers are incented to manage these risks and work toward their own soft landings.
While above-trend growth is now in question, a rapid deterioration should be averted—central banks and governments have many tools at their disposal, and much is at stake. Given the backdrop of still-solid growth, we are picking through some defensive and/or oversold credit markets for best ideas:
Short-duration securitized credit. A defensive amortizing security, it has limited duration and a yield advantage that is tied to a strong U.S. consumer balance sheet.
High yield credit. The sell-off has generated attractive spreads relative to expected defaults, in a reasonably strong U.S. economy.
Local emerging market debt. The yield spread widening of 2018 looks overdone relative to economic reality. Sentiment should benefit from a dovish Fed pause, a global soft landing— and possibly the end of the USD rally.
As a decade of quantitative easing proved to be more about asset price inflation than economic reflation, it stood to reason that quantitative tightening would cause some degree of asset price deflation. It is true that there are growing economic headwinds and a few risks to stability, but nothing of the magnitude reflected by many of the risk-loving markets (equities … ). As risks have become magnified and central bank policy responses underappreciated, we are using the increased volatility to find opportunities.
SCENARIO PROBABILITIES AND INVESTMENT IMPLICATIONS: 1Q19
Every quarter, lead portfolio managers and sector specialists from across J.P. Morgan’s Global Fixed Income, Currency & Commodities platform gather to formulate our consensus view on the near-term course (next three to six months) of the fixed income markets. In daylong discussions, we review the macroeconomic environment and sector-by-sector analyses based on three key research inputs: fundamentals, quantitative valuations and supply and demand technicals (FQTs). 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.
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