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

  • 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 (%)

 

Source: J.P. Morgan Asset Management. Views are as of June 6, 2018.

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.

Economic expectations

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.

Risks

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.

STRATEGY IMPLICATIONS

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%.

CLOSING THOUGHTS

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.

Source: J.P. Morgan Asset Management. Views are as of June 6, 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/SIPC.; 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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