Global Fixed Income Views: Third quarter 2018
Themes and implications from the Global Fixed Income, Currency & Commodities Investment Quarterly meeting
- Our base-case scenario, a 75% probability of Above Trend Growth, remains unchanged, underpinned by global economic strength, evidenced by growth in U.S. and global corporate profits, along with stable to improving credit card receivables and municipal tax receipts.
- We expect the Federal Reserve (Fed) to continue its gradual hiking cycle, with the fed funds rate ending the hiking cycle at around 3%.
- A significantly stronger dollar remains a risk to global markets, especially within emerging markets.
- Volatility across markets is likely to increase as the market transitions from quantitative easing (QE) to quantitative tightening (QT).
- We continue to own credit: Short-duration securitized credit remains our favorite market, given the strong U.S. consumer. The leveraged credit market (bonds and loans) is attractive as the corporate market benefits from expected revenue growth. We remain cautious on U.S. rates, with the increase in supply potentially weighing on the market as the Fed unwinds QE.
SCENARIO PROBABILITIES (%)
A VOLATILITY SURGE AND MIDWESTERN SENSIBILITY
The disconnect between the financial markets and the real economy continued in the second quarter. The U.S. dollar rose, emerging market debt and currencies plummeted, Italy and peripheral Europe came under pressure, and equity markets saw intraday downdrafts of more than 3%. Yet relative stability prevailed in the broader economy. While it is true that the U.S. experienced its typical first-quarter slowdown and European growth slowed from its torrid rate, it was also hard to find a region of the world operating below trend. Such were the complexities of the macro backdrop that we tried to reconcile at our most recent Investment Quarterly (IQ), held on June 6 in Columbus, Ohio. It was just what we needed: a dose of Midwestern sensibility.
A deep dive into the data told us that the global economy was just fine. The U.S. should likely post about 4% GDP growth in 2Q and 3.5% over the balance of 2018, with the labor market likely to be especially tight. Within the eurozone, economic activity indicators have already started to show signs of a reacceleration in growth, benefiting from a weaker euro. And China, the anchor of the emerging markets, looks committed and capable of generating sustained 6.5% GDP growth.
In short, we believed the volatility across markets had less to do with the real economy and more to do with the transition from quantitative easing to quantitative tightening. It wasn’t really a surprise—it just seemed to happen five months ahead of schedule.
We kept our base-case scenario, Above Trend Growth, at a 75% probability—but not without considerable debate. There was a strong view that we are closer to the end of the cycle than the beginning and, consequently, need to reflect that with a 5% reduction in our base case’s probability. However, while the Fed has been raising rates for 2 ½ years, and will likely end the hiking cycle in 12 to 18 months with the fed funds rate at about 3%, the impact of U.S. tax reform and fiscal stimulus has yet to be fully felt. We drilled down into the underlying performance of different parts of the global economy and saw a lot of positives. Revenue and profit growth in corporate America looked very strong. Although leverage has risen for investment grade companies, overall default rates for high yield companies were only about 2%. The European corporate market also looked strong. Companies were loath to leverage up their balance sheets and were enjoying good revenue and profit growth. We then looked at credit cards and saw strong performance in the underlying receivables. The same story was true in the municipal market: All forms of tax receipts had turned sharply higher since the start of the year.
An area of some concern was the emerging markets, where a significantly stronger dollar could cause growth to slow. But we had difficulty seeing prolonged problems there in light of higher commodity prices, accommodative central banks and stability in China.
Slightly confounding our optimistic forecast was inflation’s continued failure to become more evident. This was especially true in wages, even though labor data is uniformly strong across regions and economies. Consequently, we kept Sub Trend Growth at a 20% probability. We also recognized that the path to monetary normalization and a stronger USD will create headwinds to global growth.
We spent a lot of time discussing the probability of Recession, ending by leaving it at 0% for now. Low global real rates, U.S. stimulus and a stable global banking system don’t seem to be the ingredients of recession. We did estimate that a recession could occur between the fourth quarter of 2019 and the end of 2020. If the Fed finishes raising rates in mid-2019, a recession about 12 months later would be typical.
We left the odds of Crisis at 5%. Although the trade and tariff front and geopolitical risks remain in flux, perhaps the biggest risk to the market will occur in 4Q, when the Fed finishes transforming QE to QT and the aggregate central bank balance sheet shifts from net expansion to contraction. Then we will see if QE was more about asset price inflation than price inflation.
Given our expectation of sustained global growth, our preference to continue to own credit was not surprising.
Short-duration securitized credit remains our favorite. Strong consumers, attractive yields, credit enhancement and little interest rate sensitivity are all very appealing attributes.
High yield and leveraged loans are also quite attractive. Whether it is the expected revenue growth of U.S. companies or the conservative balance sheets of European issuers, both sectors offer very good default- and duration-adjusted yield.
Shorting U.S. duration also garnered support. The supply-demand dynamic in the U.S. Treasury market looks appalling. At a time when the price-insensitive buying of central banks is ending, the Treasury is ramping up supply by over $1 trillion per annum. Who is the next best buyer? While we expect 3.5% 10-year Treasury yields at the end of 2018, our quantitative models are still flashing 4%.
The growth slowdown and increased market volatility have caused many investors to rethink their strategies. Certainly, we expect market volatility to escalate further the closer we get to QT. But for us, this isn’t the time to be shaken out of the market. It’s the time to embrace that volatility, do our research and invest where the value has been created. What could be more sensible than that?
SCENARIO PROBABILITIES AND INVESTMENT IMPLICATIONS: 3Q18
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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