Taking the temperature of global bonds
By Bob Michele, Chief Investment Officer, Fixed Income, JP Morgan Asset Management and JPM Global Bond Opportunities Fund Portfolio Manager
As global bond investors, it has become increasingly clear that we may have underestimated the impact of a China slowdown on global growth. While the US and Europe (together 40% of global GDP), are forecast to grow slightly above‐trend, in the emerging markets (also 40% of global GDP), the trend itself is slowing, and growth is at below‐trend levels.
Rather than inflation, we’ve had shockingly disinflationary signs – oil, commodities, copper, financial services. It is still our primary expectation that modest global growth will prevail, but the risks are higher as signs of late-cycle behaviour have increased. Put another way, as the US Federal Reserve raises rates against a frail global economy, the odds of above‐trend growth recede.
It is reasonable for investors to wonder whether Fed’s December rate hike was a policy error. US data would suggest that the economy no longer needs the extraordinary accommodation that a zero policy rate provides. However, historically the Fed has raised rates because either growth or inflation was uncomfortably high.
This time is different – growth is slow; wage growth is limited; deflation is being imported. As the Fed actions drain liquidity from the system, rising rates and a stronger dollar are a headwind for future US growth.
The Fed has signalled a target rate of 2% (a real policy rate of 0%), but global policy divergence will restrain the Fed and global headwinds will keep rates in check. We think it’s possible that the Fed has trouble getting to 1%, and we expect no more than three rate hikes in 2016.
Furthermore, outside of the US, central banks from Europe to Asia continue to supply the global markets with abundant liquidity. In the face of these forces, the US ten‐year Treasury yield seems to be fair value/cheap at below 2.25%.
A cautious Fed and slowing global growth are supportive of the rates markets. Despite slowly rising short term rates, we do not expect a bear market for bonds.
At the same time, concerns raised by weakness in the commodity complex and in China have resulted in a re‐pricing of risk, particularly in the high yield market, where spreads significantly widened in 2015, and which we believe (ex‐energy, metals and mining) offers both attractive carry and significant compensation for increased volatility and default risks.
In the US, high yield companies are, for the most part, domestically focused, have healthy balance sheets, and are positioned to continue to benefit from economic growth. The key is to find those industrials that have the financials to survive a growth slowdown and that are committed to maintaining a strong balance sheet.