Robert Michele
The V-shaped volatility in the first quarter of this year set Janet Yellen and the US Federal Reserve back on their heels, prompting a surprisingly dovish stance and switching their reaction function from proactive to reactive. In indicating that they are willing to be behind the curve and accept the risk of higher inflation in light of the tenuous global growth picture, Yellen changed the tone for the markets and softened US dollar strength.
The spigot of liquidity that just keeps pouring from central banks is acting as a pillar of support for bond markets. For example, it’s hard to describe the recent actions of the European Central Bank as anything short of extraordinary. They are throwing the kitchen sink at reviving Eurozone inflation and stimulating credit growth. Even the Fed’s inaction is a form of easing. We expect at most only a single rate hike from the US Fed during the remainder of the year, and the ten-year Treasury should end the year between 1.75% and 2.00%. Meanwhile we anticipate near-term stabilisation in China, as stimulus measures support growth.
Against this backdrop, the near-term probability of economic recession is debateable (we’d argue it’s rising but not imminent), although a growth slowdown is certainly underway. Weaker productivity and aging populations are constraining trend growth rates in the developed world and it’s only a matter of time before levels of emerging market leverage creep to unsustainable levels and have to be unwound, a process that will take decades.
But it’s not as if slightly disappointing growth is bad news for bonds – on the contrary. One could argue fixed income finds itself in something of a ‘sweet spot’ – low economic growth, low global inflation, continued highly accommodative central banks with no evident or immediate catalyst for core government bond yields to inch higher.
That said, there are both near-term opportunities and long-term risks embedded in this current confluence of bond friendly factors.
High quality duration – long government bonds and US agency mortgages – can benefit in the near term from central bank accommodation and in the longer term can provide stability in a risk-off environment. Likewise, gold can benefit from a variety of scenarios.
In the near term, corporate credit continues to provide attractive carry and can continue to benefit from the central bank liquidity gusher. European high yield remains our top idea. Yields may seem low, but spreads on a credit by credit basis are comparable to those in the US and are poised to tighten as investors search for yield. European growth is also supportive of improving fundamentals and potential upgrades. In the US, while the spread widening that we saw in January and into February has been completely reversed, we still think that high yield spreads (ex-energy, metals and mining) more than compensate us for potential defaults, increased volatility and bond market illiquidity.
For example, US high yield was recently trading on a spread of 700 basis points over government bonds – indicating investors can get an 8.5% average yield. In our view, default risk has been priced into the market and investors are being well compensated. European high yield is even more attractive on a fundamental basis and is yielding approximately 5%, which is all spread if you consider that the risk free rate in Europe is effectively negative. European high yield has outperformed its US counterpart market for the last 4 years and it remains earlier in the credit cycle.
The key with high yield, as with other credit sectors, is to know when to take your chips off the table. As we move through the year, we are increasingly sensitive to signs that exuberance has taken hold and that downside risks are beginning to outweigh upside opportunities. In some of our more risk-averse strategies, that time may be sooner rather than later.
We remain cautious on US investment grade credit, given the companies’ slowing top line growth, potential margin compression, and increasing leverage. And we’re still wary of emerging markets debt.
Without question it’s going to be an increasingly challenging year to invest in the bond market, as central banks continue forcing us to be more dependent on policy. But as long as global growth is cooling and large pools of cash are searching out a home with positive yield, fixed income is still poised in a sweet spot.
Robert Michele is global head of fixed income at J.P. Morgan Asset Management
