Every quarter, J.P. Morgan's Global Fixed Income, Currency & Commodities team, led by Bob Michele, CIO, meets to discuss and debate macro-economic trends and sector developments. The team then determines its fixed income outlook for the next three to six months and identifies its best investment ideas.

IN BRIEF

  • We have reduced our base-case scenario, Above Trend Growth, to a 70% probability in response to escalating tariff battles and the potentially negative impact on trade; otherwise, the global economy is in very good shape.
  • The Federal Reserve (Fed), seeing 3-4% GDP growth and low unemployment, can continue marching toward normalization, suggesting a 3% fed funds rate and further balance sheet rundown.
  • We consider the stronger dollar unsustainable and expect it to correct as we enter 2019.
  • We continue to like carry and credit. Favorite sectors include U.S. and European high yield and leveraged loans, as U.S. consumers enjoy the strongest balance sheets in decades; short-duration securitized credit; and emerging market debt, where potential trade wars and a strong dollar appear to be priced in.

SCENARIO PROBABILITIES (%)

 

Source: J.P. Morgan Asset Management. Views are as of September 13, 2018.

SEA OF DIVERGENCES

As we approach year-end, the calm heading into 2018 is now a distant memory. Instead, we are awash in a sea of divergences: economic growth, interest rates, trade, monetary policy and politics. Investors will now have to grapple with these issues as they decide how to allocate capital. What is different this time is that they will have to do so without the backstop of the central banks. Quantitative easing (QE) is evolving into quantitative tightening (QT), so that sea of cash that indiscriminately supported all asset prices will not be there to cover up “mistakes” going forward. This doesn’t mean that there won’t be opportunity. It just means that investors will have to once again roll up their sleeves, do the detailed research and uncover the treasures from the trash. Such was the backdrop for our September 13 Investment Quarterly (IQ), coincidentally held in London, the site of another pending divergence, Brexit.

MACRO/MARKET BACKDROP

Once again, we noted that the global economy looked fine. The U.S. continues to chug along at a 3%–4% GDP growth rate, with low unemployment and rising wages. While a lot of this growth has been driven by fiscal policy, the Federal Reserve (Fed) has met its dual objectives and can continue its march toward normalization. For us, that means a 3% fed funds rate and further balance sheet rundown. But the U.S. and the Fed do seem to be going it alone. European and Chinese growth have slowed a bit, and their central banks are responding with caution. The European Central Bank (ECB) has indicated it will be at least another year before it begins to raise rates from -0.40% and the People’s Bank of China (PBoC) has cut rates and let the currency drift lower as it seeks to offset some of the impact of the tariffs scuffle with the U.S. All of this has led to a stronger dollar-unsustainably so, in our view. Entering 2019, we expect the dollar to correct as global growth and interest rate expectations stop diverging.

Economic expectations

We spent a fair amount of time discussing whether to leave our base-case scenario of Above Trend Growth unchanged at a 75% probability or to lower it in response to the escalating tariff battles. Ultimately, we felt increased tariffs would lead to less trade and consequently reduced our base case to a 70% probability. Outside of the tariffs, the global economy is in very good shape. Almost all regions are growing above trend, and the central banks are reluctant to normalize policy at a meaningful pace. As long as inflation remains moderate, they can stay behind the curve, perpetuate the distortion, and support with bloated balance sheets and negative real policy rates.

We raised our probability of Sub Trend Growth from 20% to 25% to acknowledge the potential impact of broad tariffs. It was noted that China had already begun to slow from its 6.5% growth rate, as planned deleveraging was underway. While we appreciated that PBoC easing and a weaker currency could offset most of the initial impact of tariffs, it would be a lot for the Chinese economy to absorb tariffs on the entire (approximately $500 billion) of exports, or tariff rates rising from 10% to 25%. In the worst-case scenario, we could see Chinese GDP falling to 4.5%. There would also be a broader knock-on effect to the rest of the emerging markets.

Risks

We left the probability of Recession at 0%. Fiscal stimulus in the U.S., a well-capitalized global banking system, strong U.S. consumer balance sheets and central banks that are overly cautious in restoring normality to the system are on the growing laundry list of reasons not to expect a recession any time soon. There was some discussion about the flattening U.S. yield curve, which has historically been a reasonable indicator of approaching recession. We felt the monetary distortions present in this cycle were a meaningful difference accentuating curve flattening. We’ll see how the next couple quarters play out for the curve as QE gives way to QT and the tax reform incentive for U.S. plans to contribute to their pension funds ends.

We also kept the probability of Crisis at 5%. A potential trade war, QT, rising interest rates and geopolitics should not be so quickly dismissed. It’s too early to worry that the next crisis is in the offing, but all these issues bear keeping a watchful eye on.

STRATEGY IMPLICATIONS

We continue to like carry and credit. We continue to believe that the zero/negative real yields of developed market (DM) government bonds are a reflection of the ongoing distortions created by global central banks. Our favorite investments for the coming three to six months are:

High yield. We like U.S. and European high yield, as well as leveraged loans. Companies continue to enjoy top line growth, cost discipline and accelerating earnings. Our high yield team remarked that this is the first time since the global financial crisis that the market felt normal.

Short-duration securitized credit. Short duration, yield and credit enhancement are an irresistible combination. Further, U.S. consumers are enjoying their strongest balance sheets in over 40 years.

Emerging market (EM) debt. Emerging markets are the one market/sector that has gone through a painful correction. The market looks to have fully priced in potential trade wars and a strong dollar. It’s time to scale in.

CLOSING THOUGHTS

This is the quarter we have all been waiting for: QE becomes QT, U.S. fiscal stimulus accelerates, Treasury supply mushrooms, Brexit is a reality, and trade wars loom. There will be increased volatility. There will be markets that become overbought or oversold. Our high yield team is right—for the first time since the financial crisis, things are starting to look normal. Let’s remember what that looks like and take advantage of it in our portfolios!

SCENARIO PROBABILITIES AND INVESTMENT IMPLICATIONS: 4Q18

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.

Source: J.P. Morgan Asset Management. Views are as of September 13, 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.




Important Disclaimer

The views contained herein are not to be taken as an advice or a recommendation to buy or sell any investment in any jurisdiction, nor is it a commitment from J.P. Morgan Asset Management or any of its subsidiaries to participate in any of the transactions mentioned herein. Any forecasts, figures, opinions or investment techniques and strategies set out are for information purposes only, based on certain assumptions and current market conditions and are subject to change without prior notice. All information presented herein is considered to be accurate at the time of production, but no warranty of accuracy is given and no liability in respect of any error or omission is accepted. This material does not contain sufficient information to support an investment decision and it should not be relied upon by you in evaluating the merits of investing in any securities or products. In addition, users should make an independent assessment of the legal, regulatory, tax, credit, and accounting implications and determine, together with their own professional advisers, if any investment mentioned herein is believed to be suitable to their personal goals. Investors should ensure that they obtain all available relevant information before making any investment. It should be noted that investment involves risks, the value of investments and the income from them may fluctuate in accordance with market conditions and taxation agreements and investors may not get back the full amount invested. Both past performance and yield may not be a reliable guide to future performance.

J.P. Morgan Asset Management is the brand for the asset management business of JPMorgan Chase & Co. and its affiliates worldwide. This communication is issued by the following entities: in the United Kingdom by JPMorgan Asset Management (UK) Limited, which is authorized and regulated by the Financial Conduct Authority; in other EU jurisdictions by JPMorgan Asset Management (Europe) S.à r.l.; in Hong Kong by JF Asset Management Limited, or JPMorgan Funds (Asia) Limited, or JPMorgan Asset Management Real Assets (Asia) Limited; in India by JPMorgan Asset Management India Private Limited; in Singapore by JPMorgan Asset Management (Singapore) Limited, or JPMorgan Asset Management Real Assets (Singapore) Pte Ltd; in Taiwan by JPMorgan Asset Management (Taiwan) Limited; in Japan by JPMorgan Asset Management (Japan) Limited which is a member of the Investment Trusts Association, Japan, the Japan Investment Advisers Association, Type II Financial Instruments Firms Association and the Japan Securities Dealers Association and is regulated by the Financial Services Agency (registration number “Kanto Local Finance Bureau (Financial Instruments Firm) No. 330”); in Korea by JPMorgan Asset Management (Korea) Company Limited; in Australia to wholesale clients only as defined in section 761A and 761G of the Corporations Act 2001 (Cth) by JPMorgan Asset Management (Australia) Limited (ABN 55143832080) (AFSL 376919); in Brazil by Banco J.P. Morgan S.A.; in Canada for institutional clients’ use only by JPMorgan Asset Management (Canada) Inc., and in the United States by JPMorgan Distribution Services Inc. and J.P. Morgan Institutional Investments, Inc., both members of FINRA.; and J.P. Morgan Investment Management Inc.

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Robert Michele

 








Chief Investment Officer and Head of the Global Fixed Income, Currency & Commodities Group








John Bilton


 

Head of the Global Strategy Team for the Multi-Asset Solutions Group.


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