The bond investor dichotomy
Investors are struggling with a fundamental disconnect. Global growth is slowing, yet financial assets have recovered most of their 2016 losses.
The World Bank recently reduced its forecast for global growth from an already anemic 2.9% to 2.4%. And inflation is muted across the globe, leading to weak nominal growth. World trade growth is beginning to contract and labour productivity is falling in both the developed and emerging markets.
At the same time, leverage is rising – in the developed markets, it is government debt; in the emerging markets, it is corporate debt. Economies are using leverage to create growth, essentially borrowing from the future. Rising leverage, when combined with weak nominal growth, is a massive headwind, as debt affordability will eventually reach the breaking point.
All the while, extraordinary central bank accommodation keeps staving off the next recession, providing a favourable backdrop for the sluggish recovery to continue. A recent pick-up in growth in the US, firming energy prices, and a stabilisation in China have eased near term risks.
Even with modest growth, good companies are having trouble generating top line growth, and may have to shrink their way to profitability by selling assets and cutting costs. Eventually, those job cuts will result in weaker jobs data in the back half of this year. Aggressive central bank accommodation is already beginning to realize diminishing returns; eventually the onus will fall on finding an effective fiscal response, without which continued GDP growth in the US and Europe will be hard to come by.
There is a pattern of recovery fatigue every eight to ten years. While recession is not imminent, the probability increases as we near year end.
Meanwhile, the US Federal Reserve is caught between the desire to create more inflation and the recognition that lower rates are punitive to an aging population that needs to save. If we see wage pressures, the Fed may be forced to raise rates, which could trigger recession, but tighter lending standards, softening commercial real estate fundamentals, and recent rental housing price weakness all suggest that inflation is not a threat. Likely the Fed will continue to struggle to get to 1%, which means 10 year US Treasuries at 1.4% actually look good value.
Clearly market levels are being driven by investors’ unwillingness to fight the central banks, which appear to be committed to doing whatever it takes to stimulate growth. However, imbalances are increasing at a greater speed.
Bond investors therefore face a dichotomy. Chase assets benefitting from central bank policy, or hold safe haven assets for the inevitability of risk off corrections?
Solving for that contradiction, a central theme that’s emerged for us as investors is a preference for high quality holdings. For example, many US securities look attractive given the strong demand coming from Japan and the Eurozone, where negative interest rates are forcing investors to go cross‐border. While dollar denominated investments may not look attractive on a hedged basis, the higher yields in the US market provide a lot more room for capital appreciation.
High quality, long duration government debt benefits in the near term from central bank response and potential easing and provides stability during periods of risk off. Higher rated, higher yielding securities, such as US high yield, European high yield, provide attractive carry and may continue to benefit from quantitative easing and the on‐going search for yield. US high yield, while no longer cheap, continues to be supported by strong retail flows, and modestly weaker fundamentals should improve through year end.
In the dog days of summer, its worth remembering that the same things usually recur: the days are long and hot, and the markets are illiquid and volatile. High quality debt had already entered the summer season with a tailwind from the combination of slower global growth and flows emanating from central bank quantitative ease. Brexit will likely increase both of these factors.
Robert Michele, global head of Fixed Income, JP Morgan Asset Management