While global growth is undoubtedly slowing, financial markets have recovered most of their 2016 loses. This seems like a disconnect. However, the extraordinary accommodation being provided by central banks is, in aggregate, staving off the next recession and providing a favorable backdrop for the sub-trend recovery to continue. In fact, a recent pickup in growth in the U.S., firming energy prices, and stabilization in Chinese economic and financial data have eased near-term risks.
LONG-TERM TROUBLES
Longer term, world trade growth is beginning to contract, and labor productivity is falling in both the developed and emerging markets. Economies are using leverage to create growth, essentially borrowing from the future. And good companies are having trouble generating top-line growth, foreshadowing the need to shrink their way to profitability by selling assets and cutting costs. Aggressive central bank accommodation is already beginning to realize diminishing returns; eventually, the onus will fall on governments to find an effective fiscal response, without which continued GDP growth in the U.S. and Europe will be hard to come by.
In the short-term, however, without growth and inflation to drive rates higher, and with the liquidity provided by central banks, the environment is supportive of fixed-income assets. The 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 a recession. But tighter lending standards, softening commercial real estate fundamentals and recent rental housing price weakness all suggest that inflation is not a threat. We expect the Fed will continue to struggle to get to 1%, and the U.S. 10-year Treasury will remain fair value at 1.50%-1.75% through year-end.
So where do we find value now? 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. While there has been no pain and losses have been limited — at least so far — we must monitor the risks.
OPPORTUNITIES
Our best ideas recognize the opportunities provided by central bank policy, balanced with the desire to hold assets that may provide a safe haven for the inevitable periods of risk-off and asset price correction. To reduce volatility and increase liquidity during episodes of market uncertainty, we favor “up in quality” assets.
This is a key investment theme across our portfolios:
• 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.
• High quality U.S. high yield, while no longer cheap, continues to be supported by strong retail flows, and modestly weaker fundamentals should improve through year-end.
• Leveraged loans are, by definition, higher quality and also can provide an element of defensive positioning.
• European high yield, adjusted for sector, ratings and duration, remains cheap to U.S. high yield. Furthermore, Europe is experiencing above-trend growth and is earlier in its recovery, providing the opportunity for credit improvement and potential ratings upgrades. Supply remains muted.
• Cash and the perceived safe haven of gold can be sources of liquidity during periods of market corrections.
Finally, given our views on global growth and leverage, we remain cautious with regard to U.S. investment-grade corporate credit, and we still prefer developed-market to emerging-market debt.
Bob Michele is chief investment officer and head of the global fixed income, currency and commodities group at JP Morgan Asset Management.
