Global Fixed Income Views 4Q 2023

In brief

• Recession and Sub Trend Growth are now our equal-weighted base cases at 50% each. Above Trend Growth remains at 0%, and we reduced the probability of Crisis to 0%.
• Growth and inflationary pressures have moderated to the point that the
• U.S. economy appears to be in a soft landing. But could the economy merely be mirroring a soft landing on the way to recession?
• The primary risk to our forecast is that inflation flares up and the central banks resume a prolonged hiking cycle.
• We believe high yielding front-end cash flows are the best place to wait out the next few uncertain months. Our top pick: short-duration securitized credit.

Not so fast!

Our September Investment Quarterly (IQ) was held in London amid a sea of central bank policy meetings. Given that most measures of inflation and growth have slowed considerably over the past year, our debate must have resembled many of the central bankers’: Has inflation come down enough for them to pause, or are further rate hikes needed? Can inflation be tamed without causing a recession? There is no doubt that investors are in an uncomfortable period of waiting to discover the impact of monetary tightening’s long and variable lags on the economy and markets. The prevailing market thinking for much of the year – that this phase will end in recession – has given way to the view that a soft landing can be achieved, as in 1995.

The group was admittedly perplexed that our expectations of a U.S. recession by year-end are fading. The resilience of businesses and households is running counter to the accumulating data that have historically been trustworthy indicators of recession. As the market swings between pricing in one scenario and then another, perhaps the Federal Reserve (Fed) and a growing number of central banks are right to say, “Not so fast!” It feels like time to pause for a quarter or so, in hopes of getting a more accurate read on those long and variable lags.

Scenario probabilities (%)

Macro backdrop

The group agreed that growth and inflationary pressures had moderated to the point that the U.S. economy appears to be in a soft landing. Core CPI on a three-month annualized basis has fallen to 2.4% from 5% over the past four months, while nonfarm payroll growth on a three-month rolling average has moderated to 150,000-plus from more than 300,000 six months earlier. But is the U.S. economy flattening out at these levels or merely mirroring a soft landing on the way to recession?

Historically, a yield curve inversion (three-month–10-year), tightening credit conditions and a contraction in temporary service jobs have all been reliable indicators of a U.S. recession. Add to that a consumer who is under pressure from the resumption in student loan payments, depleted excess savings, higher energy prices and increased borrowing at significantly higher financing rates, and recession seems inevitable. Lastly, Europe and the UK are on the verge of recession and adding fuel to the fire.

Nonetheless, growth remains resilient. The fiscal impulse coming from the ongoing spending from the CHIPS and Science Act, the Infrastructure Investment and Jobs Act and the Inflation Reduction Act is proving to be a healthy tailwind. Companies are investing in capex again, and the regional banking crisis has been dealt with through the Bank Term Funding Program. Away from U.S. shores, there is policy stimulus in China with the intent of achieving 5% real GDP.

On balance, a widespread slowdown in growth and inflationary pressures is genuinely underway. Whether the record amount of fiscal and monetary stimulus has been sufficiently muted by the equally impressive amount of central bank tightening to bring inflation to 2% remains a legitimate debate. Central banks will remind us that they may not have done enough, and we will be mindful that they may have already done too much.

Scenario expectations

Recession and Sub Trend Growth (soft landing) have become our equal-weighted base cases at 50% each. The probability of Recession was reduced by 5%, and Sub Trend Growth was increased by 10%. We must appreciate that over the next three to six months most central banks will be on hold and markets will likely flip between pricing in a soft landing and pricing in a recession as the impacts of the long and variable lags are measured via incoming economic data. In an average recession of -2% real GDP, nominal GDP in the U.S. would still be zero (assuming the Fed is at its 2% inflation target), which is not bad for a USD 27 trillion economy. Put differently, there would still be USD 27 trillion in annualized consumption of goods and services, making parts of the economy appear vibrant even in a downturn.

We reduced the probability of Crisis to 0% from 5%. In retrospect, the regional banking crisis showed us that a robust policy response would immediately follow any crisis, thus significantly reducing systemic risk. Currently, there are no notable warning signs.

Above Trend Growth was left unchanged at 0%. The central banks learned their lesson in 2021 and aren’t about to sow the seeds of the next surge in inflationary pressures.

Risks

The primary risk to our forecast is that inflation flares up and central banks must resume a prolonged hiking cycle. Perhaps the overwhelming fiscal and monetary stimulus cannot be sufficiently removed and is coinciding with the emergence of the millennial generation (and its surrounding cohorts) as the dominant earner, spender and saver. The shortage of labor and housing in the Western world may only worsen. And if China recovers fully from its pandemic malaise, the shortage in materials, commodities and goods could be significant.

Another meaningful risk is a normalization of monetary policy in Japan. As inflation stabilizes around current levels, the Bank of Japan may end yield curve control and negative interest rate policy, causing a repricing of the yield curve. Should that lead to a repatriation of capital, asset prices across markets could fall.

Strategy implications

The group felt that discretion was the better part of valor and that high yielding front-end cash flows were the best place to wait out the next few uncertain months. Short-duration securitized credit was the favorite market, given the yield and credit enhancement on offer.

Where there was some appetite to go further out on the yield curve, undervalued sectors included BBB rated corporate bonds and agency mortgage-backed securities.

In the extended sectors, emerging market debt had some supporters, but high yield was viewed as too expensive, with narrow credit spreads having completely priced in a soft landing.

Closing thoughts

A wait-and-see approach is a tough thing to accept when markets are in constant motion. But that is the environment put before us by the central banks. A soft landing and a recession are both good environments in which to own bonds. Yields typically fall after a central bank’s last rate hike, generating significant capital gains. The market will debate whether we have seen the last rate hike and what environment the economy is rolling into. But we believe the backup in yields over the past six months is a very good opportunity to buy bonds and unlikely to last as long as the Fed is telling us. Maybe we should go “not so fast” on determining where the economy is headed, but the time is right to buy bonds while they are on sale.

Scenario probabilities and investment implications: 4Q 2023

Every quarter, lead portfolio managers and sector specialists from across J.P. Morgan’s Global Fixed Income, Currency & Commodities platform gather to formulate our consensus view on the near-term course (next three to six months) of the fixed income markets.

In day-long discussions, we reviewed the macroeconomic environment and sector-by-sector analyses based on three key research inputs: fundamentals, quantitative valuations, and supply and demand technicals (FQTs). The table below summarizes our outlook over a range of potential scenarios, our assessment of the likelihood of each, and their broad macro, financial and market implications.

JPM Asset Management: Asset Class Views