The V-shaped volatility in the first quarter of this year has set the U.S. Federal Reserve back on its heels, prompting a surprisingly dovish stance and switching its reaction function from proactive to reactive. In indicating that the central bank is willing to be behind the curve and accept the risk of higher inflation in light of tenuous global growth, Fed chair Janet Yellen changed the tone for the markets and weakened the U.S. dollar.
The spigot of liquidity that just keeps pouring from central banks is 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. It has thrown the kitchen sink at reviving euro zone inflation and has stimulated credit growth. Even the Fed’s inaction is a form of easing. We at J.P. Morgan Asset Management expect at most only a single rate hike from the Fed during the remainder of the year, and the ten-year Treasury to end the year between 1.75 and 2 percent. We also anticipate near-term stabilization in China, as stimulus measures support growth.
Against this backdrop, the near-term probability of recession is debatable — we would argue it’s rising but not imminent — although a slowdown in expansion is certainly under way. Weaker productivity and aging populations are constraining trend growth rates in the developed world. It’s only a matter of time before emerging-markets leverage levels creep up 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 that fixed income finds itself in something of a sweet spot: conditions of low economic growth, low global inflation and continued central bank accommodation. That said, there are both near-term opportunities and long-term risks embedded in this confluence of bond-friendly factors.
High-quality duration such as long government bonds and U.S. 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 inflows of central bank liquidity. European high-yield remains our top recommendation. Yields may seem low, but spreads on a credit-by-credit basis are comparable to those in the U.S. and are poised to tighten. European growth is also supportive of improving fundamentals and potential upgrades. In the U.S., although the spread widening that we saw in January and into February has been completely reversed, we still think that high-yield spreads (excluding energy, metals and mining) more than compensate for potential defaults, increased volatility and bond market illiquidity.
U.S. high-yield was recently trading on a spread of 700 basis points over government bonds — indicating that investors can get an 8.5 percent 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 percent, which is all spread if you consider that the risk-free rate in Europe is effectively negative. European high-yield has outperformed its U.S. counterpart market for the past four years, and it remains behind 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 will be 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 U.S. investment-grade credit, given 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 investors 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 will still be in a sweet spot.
Robert Michele is chief investment officer and head of the global fixed income, currency and commodities group at J.P. Morgan Asset Management in New York.
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