By Robert Michele
Leaving aside fears about the end of the 35 year bond bull market, it’s still a good time to be a bond investor. Secular stagnation is inevitable and growth in much of the world is stabilizing at below historical levels – not a bad backdrop for fixed income.
Businesses are investing like they’re in a recession: the bulk of investment has not been in physical assets, but into the deadweight costs of security and control functions. These don’t drive productivity and growth (one could argue that they actually sap growth), although they may have contributed to an environment of lower volatility. And globally, disinflationary forces are in control.
As central bank policy loses its effectiveness, what’s needed is fiscal spending. However, fiscal policy, at best, will be incremental and not enough to replace other efforts. It’s hard to see fiscal spending happening in a meaningful way over the coming quarters, particularly in the US, where the presidential election makes compromise in Washington unlikely. It’s possible that we won’t see meaningful fiscal policies implemented until the next recession.
Longer term, at some point there will be a recession. In the U.S., lending standards continue to tighten and corporate profits are falling, but stabilisation—in the commodity markets, the dollar and China—suggests recession isn’t likely immediate or even imminent.
With global growth stabilizing at sub-trend levels and without any meaningful signs of inflation, we expect the Federal Reserve (Fed) to remain extremely slow and cautious. Its members don’t want to create an imbalance that would destroy the modest growth that exists. We expected the Fed to lower its future expectations, as it did on September 21; we expect one rate hike in December and a terminal rate for this cycle near 1%, and we believe that the US 10-year Treasury in a range of 1.25% to 1.75% is fair value. As a result, the dollar has likely peaked, but will probably trade in a noisy range and may be discounted as we move toward the US elections.
In the face of relatively stable global growth, albeit sub-trend, central bank actions—realised or expected—are driving the markets. Central banks are still in the driver’s seat and outside of the BoJ, they still have options. We expect a continuation of QE through 2017, with central banks adding, in aggregate, $500bn of new liquidity to the markets every quarter. The 35-year bull market is not dead yet; as long as the banks are accommodative, rates will remain low – a supportive environment for all fixed income sectors.
Emerging market local currency bonds, our best investment idea, has not been at the top of our list for some time. Stable commodity prices, a stable China, a stable rate market and a stable or falling dollar are all beneficial for the emerging markets and for emerging market currencies. At the same time, EM fundamentals—growth and earnings—are getting better. Yields look attractive, particularly in places with political stability, and even if FX doesn’t move, carry is attractive.
Credit sectors offer attractive carry, particularly in a stable rate environment. High quality US high yield benefits from an economy with modest growth and continues to be supported by retail flows and supply that is below historical levels. Modestly weaker fundamentals should improve with lighter headwinds from the dollar and commodity prices.
European high yield continues to benefit from the search for yield.
Fundamentals for the banks seem to be stabilising and foreign investors continue to be pushed into longer, lower-quality securities. We continue to like higher quality bank capital debt.
Central bank surprises and/or disappointments could lead to temporary periods of risk-off. We’ll look to these as buying opportunities. At these times, defensive trades—such as shorter duration securitized credit and extension-protected agency pass through mortgage-backed securities (MBS) — should also do well.
The ongoing failure by central banks to reflate the global economy and raise inflation expectations is frustrating to them as well as to most investors. As they begin to publicly second-guess the unconventional tools they have deployed, investors are left wondering what will happen to the economy and especially, to asset prices.
In the absence of meaningful fiscal stimulus, ideally in combination with structural reform, the post-crisis deleveraging will have years to run and ultimately, have to be underwritten by the central banks…reminding us that these unconventional tools have one unambiguous benefit: they make the debt burden sustainable. The magnitude of the ongoing accommodation is not something we are willing to fight. Asset price inflation continues.”
Robert Michele is global head of fixed income at JP Morgan Asset Management
