Strengthening your core: The case for fixed income
The environment is uncertain—but there are still high-conviction themes to consider for your portfolio.
Our Top Market Takeaways for September 9, 2022
Market update: Same as it ever was
Markets returned from the Labor Day holiday and picked up right where they left off. This week though, non-U.S. markets drove most of the narrative.
The European Central Bank raised interest rates by 75 basis points in an effort to get their policy position to a more appropriate stance. With the move, overnight cash rates within the Eurozone are positive for the first time in around 10 years. The primary driver of the inflation problem that the monetary union is dealing with is soaring energy costs. In Germany, contracted power and natural gas prices are nearly 13-times higher now than they were in January 2020. The shutdown of the Nord Stream pipeline that supplies Europe with Russian natural gas raises questions about how the European economy will avoid energy rationing over the winter, and how damaging the cost of living squeeze will be to households and the economy. We expect growth in the region to be stagnant at best for the rest of the year, especially now that the summer tourism season is behind us.
Meanwhile, in Japan the currency has weakened to its lowest level against the U.S. dollar since “Titanic” and “Saving Private Ryan” were the biggest movies in the world. The Bank of Japan and the People’s Bank of China are the only two major central banks that aren’t raising rates to fight inflation, and currencies are getting hurt for it. For Japan, currency weakness could result in an unwanted form of domestic inflation because imports are so much more expensive, while for China it is more of a commentary on growth consequences of a rebalancing property sector and continued Zero-COVID policies.
The irony is that the rest of the world’s problems help to solve the inflation issue in the United States. Due to demand concerns, crude oil prices are at their lowest levels since the beginning of the year. That should help consumption, headline inflation readings, and consumer inflation expectations. A strong dollar helps curb inflation from imports, and reduces global manufacturing activity. Shipping costs are down almost 65% from their highs, used car prices have peaked, and market expectations for inflation over the next year are below 2.5% for the first time since March 2021. The labor market is showing no signs of strain, despite the headlines around workforce reductions at many technology firms. Initial jobless claims have fallen for four straight weeks and remain at levels entirely consistent with expansion.
But that strength in the labor market is the reason why the Fed will probably raise interest rates by 75 basis points at their meeting in two weeks. They are still not convinced that they have done enough to solve the inflation problem, but the latest data and market indicators suggest that they are well on their way. We think that after their September meeting they will be within striking distance of where they will stop raising interest rates for this cycle. That will mark a critical pivot point for global markets.
Spotlight: The case for core fixed income
If you have been following our commentary, it probably won’t surprise you that investment grade fixed income is one of our top investment ideas. In fact, we think investors could potentially earn equity-like returns through a diversified portfolio of fixed income assets. In today’s note, we want to address the two most common concerns that we hear.
The first is, "I think the Fed is going to continue hiking rates. Why would I buy longer dated bonds while we are in a hiking cycle?"
The first thing to remember is that interest rates already embed the expectation that the Federal Reserve raises rates to almost 4%. The actual rate hikes therefore won’t be enough to push long-term rates materially higher. Second, we think the Fed is very close to the end of the hiking cycle. Interest rates are already slowing activity in the manufacturing and housing sectors and inflation markets have already reverted to levels that are consistent with the Fed’s mandate. Finally, the yield curve is deeply inverted. In the last three rate hiking cycles, inversion of the 2-year – 10-year yield curve has preceded the end of the Fed’s tightening cycle by an average of four months. We are two months in this time.
The second is, "Why would I want to own corporate and municipal bonds when we are heading into recession and defaults will rise?"
This one is critical because we believe that investment-grade corporate and municipal bonds would be some of the best assets to own in the event of a recession. We are focused on the highest quality pockets of both spaces where default risk is extremely low. Credit spreads would widen in a recession, but investors should remember that these events tend to be short lived and that falling risk-free rates tend to offset wider spreads, which helps keep the lid on yields and supports prices. Finally, current entry yields are close to the peaks of the last 10 years, which to us represents a compelling entry point that supports solid forward-looking returns.
Investment takeaways: High conviction investments in an uncertain economic environment
In today’s global investments backdrop, conviction is a rare commodity. The global economy remains challenged heading into the fall. The housing and manufacturing sectors are slowing substantially, China is still mired in the zero-COVID labyrinth of their own making, and the energy crisis in Europe shows no signs of abating with winter looming.
In times of uncertainty, we focus on what we have confidence in. Right now, we think that:
- A recession isn’t inevitable, but the risks of one over the next year are elevated.
- Central bank tightening is causing volatility across asset classes and reduced capital market activity.
- Investing in assets with valuation support and behind secular trends is attractive.
Those three views translate into what we are most focused on from an investment perspective. Adding portfolio buffers like core fixed income and focusing on quality and defensive characteristics in equities should benefit while recession risks are elevated. Investors can take advantage of capital scarcity by providing capital to businesses that need it for a premium price, and they can use volatility to tailor more certain return streams or to extract excess yield from markets.
Finally, mid-cap equities are presenting an interesting opportunity based on current valuations and energy transitions, real assets, digital transformation and health care innovation offer exciting long-term investment potential.
While the outlook may be murky, we feel that investors are being presented with many opportunities that may help them reach their financial goals. Please reach out to your J.P. Morgan advisor to hear more about how any of these dynamics may impact your plan.