Insights
Who Let the Hawks Out?
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Global Fixed Income Bulletin
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October 15, 2021
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Who Let the Hawks Out?
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October 15, 2021
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Who Let the Hawks Out?
Who Let the Hawks Out? |
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Having enjoyed a decade of equity and bond prices generally rising together, investors have more recently had to deal with the less pleasant situation of both bonds and shares going down together. The reason for this is the growing concern that central banks, for a long time perceived as a backstop to financial markets, may have to start tightening policy, even as the economy weakens, because inflation risks are rising and need to be brought under control. Stagflation, a bad environment for most assets, is increasingly discussed as a possibility.
While there might be some truth to this narrative, it is not entirely true, or at the very least glosses over a lot of nuances. Yes, the acceleration in economic growth is slowing; yes, central banks are clearly planning to reduce monetary accommodation; and yes, higher inflation may lead them to tighten policy quicker and further than they might otherwise would. However, the global economy is still expected to post above-average growth this year and next, so stagflation (depending on how you define it) seems unlikely. Central banks are moving to tighten policy (the Norges Bank and Reserve Bank of New Zealand (RBNZ) have already raised rates), but this is more a removal of extraordinary monetary accommodation, implemented due to the COVID crisis, rather than a desire to make policy restrictive. And central banks have been at pains to emphasize that they see the current surge in inflation as largely transitory rather than something they are responding to. So, while central bankers might be sounding less dovish than they did before (unsurprising given the quicker than expected economic recovery), it generally doesn’t sound fair to describe them as hawks either.
However, there is a risk that monetary policy normalization may happen quicker than in the past. In the 2010s, central bankers with faster growing economies (e.g., the Federal Reserve and the Bank of England) were held back from raising rates as much as they might by other central banks which were not tightening (e.g., the European Central Bank (ECB) and Bank of Japan). This was due to the FX markets: central banks which raised interest rates saw their currencies appreciate, which tightened monetary conditions and reduced the need for further rate hikes. Some analysts named this the “central bank peloton” because, as in cycling, individuals found it very difficult to break away from the pack. This time around, though, with economies recovering in a synchronized fashion following COVID lockdowns, the entire peloton is turning less dovish at the same time, meaning central banks wanting to tighten will be less constrained by their peers. It also suggests that currency markets may be more difficult to read, as interest rate and growth differentials are less pronounced.
On balance, we expect central banks to proceed slowly and with caution, but this could still lead to volatility in markets, depending on what investors expect. Even though markets have priced the beginning of rate hiking cycles, they are expecting slow and low cycles, stopping well below previous highs in policy rates. If investors change their mind on this, for example because higher inflation appears to become more entrenched and the economy remains resilient, bond yields might need to rise considerably. In credit markets, spreads are still below long-term averages; this seems justified given the benign economic outlook, and stronger corporate and household balance sheets, but even a minor deterioration in credit conditions could impact valuations, and there are concerns about how markets will cope once central bank support programs end. In short, we believe the risks stem more from investors assuming very benign conditions will persist rather than central banks being very aggressive. Of course, the “central bank put” could still come into play, with tightening measures delayed or cancelled if markets wobble too much, but the pace of normalization will primarily depend on the state of the economy.
In terms of our market views, we have generally been reducing portfolio risk given the uncertain outlook. We remain long risky assets (corporate credit, securitized credit, emerging markets) because of the positive economic outlook and strong fundamentals, and in spite of credit spreads being tight relative to history. We expect government bond yields to drift higher as we move towards tighter monetary policy.
Note: USD-based performance. Source: Bloomberg. Data as of September 30, 2021. The indexes are provided for illustrative purposes only and are not meant to depict the performance of a specific investment. Past performance is no guarantee of future results. See disclosures section below for index definitions.
Note: USD-based performance. Source: Bloomberg. Data as of September 30, 2021. The indexes are provided for illustrative purposes only and are not meant to depict the performance of a specific investment. Past performance is no guarantee of future results. See disclosures section below for index definitions.
Note: Positive change means appreciation of the currency against the USD. Source: Bloomberg. Data as of September 30, 2021.
Note: Positive change means appreciation of the currency against the USD. Source: Bloomberg. Data as of September 30, 2021.
Source: Bloomberg, JPMorgan. Data as of September 30, 2021.
Source: Bloomberg, JPMorgan. Data as of September 30, 2021.
Fixed Income Outlook
September turned out to be a far less benign month for financial markets than August, with both government bond yields rising and equities selling off. The price action has continued so far in October, with notable weakness in corporate credit and emerging markets. As is typical, given the price action, the U.S. dollar has appreciated on a trade-weighted basis. The reason for this weakness in financial markets is easy to identify: economic growth surprises have turned negative while inflation continues to surprise to the upside. This spells a potentially unfriendly scenario for markets: central banks tightening monetary policy just as the economy starts to slow. Indeed, in addition to several emerging market central banks tightening policy, the Norges Bank and RBNZ have both recently implemented their first rate hikes since the COVID epidemic struck. While none of these banks are big enough to significantly affect global liquidity conditions, their behavior is indicative of the direction in which the larger central banks are moving, given central banks tend to move together. Some of the more gloomy analysts are already talking about a stagflation.
We think some of these concerns are overstated. In particular, stagflation (an environment of high inflation and low growth or recession), still seems unlikely as the economic data still point to exceptionally strong global growth in 2021 continuing into 2022. Yes, economic data are no longer (on average) surprising to the upside, and economies are not accelerating further. However, timely indicators of growth, such as business survey indices, remain consistent with above average growth rates, so there is little evidence of a slowdown, and it was always going to be difficult for growth to keep on accelerating as it came out of lockdown. One point of concern is the state of the Chinese economy and the risk of defaults in its real estate sector, but so far it would appear the authorities are maintaining their typical tight control of the situation.
However, inflationary pressures are growing stronger. The most recent surge has come from higher energy prices (especially European natural gas prices), but the pressure is more broad-based: many other commodities (e.g., food, a particular concern for EM central banks) are also at multi-year highs; COVID-induced bottlenecks continue to cause shortages in many consumer goods supply chains, and there are widespread reports of labor shortages across developed economies. It is currently unclear just how persistent, or permanent, many of these issues are, but what is certain is that the current surge in inflation is expected to last longer than previously thought, with economists now forecasting it will only return to more normal levels towards the end of 2022.
So far developed economy central banks have remained adamant that the inflation surge is transitory and is not something to respond to, although some (such as the ECB) have said they will remain vigilant to it causing “second round effects” and a more persistent increase. Medium term inflation expectations have risen, but are still only returning to levels which suggest investors and households think central banks will achieve their inflation mandates. So, there is little need for them to go into inflation-fighting mode just yet, but the inflation data clearly introduces a hawkish risk to policy. Emerging market central banks are already tightening, given the risk inflation poses to their economies through the currency markets, but they now face the risk of choking a still nascent, weak recovery.
Bond investors are clearly rethinking just how accommodative central banks will be. One factor to consider is that, while no developed market central bank has sounded extremely hawkish, they are all clearly moving in the same direction. This is important because, to use the cycling analogy, monetary policy in recent years has been like a peloton of cyclists from which it is very difficult for an individual bank to break free and set tighter monetary policy (because this would lead to a stronger currency and remove the need to tighten). However, if all are moving in a tightening direction, then it is easier for individual central banks to end their COVID crisis programs and start raising rates.
Central banks are still communicating a slowly-slowly approach, which we think the markets have priced appropriately. However, the risk to bond valuations comes more from the length of the hiking cycle and the eventual terminal policy rate. At present investors seem to think the tightening cycles will be short, lasting only a few years and not taking policy rates back to historical levels. But if they start expecting a more normal central bank cycle, then yields could rise further. Credit investors have also become more nervous recently, causing credit spreads to widen; we think this is mainly reflective of how tight spreads had become rather than any meaningful increase in default risk.
Where does this leave our views on markets? In general, we remain overweight the riskier, cyclical sectors but we have been reducing portfolio risk. On government bonds, we expect yields to drift higher and have been reducing duration exposure. We have also reduced our underweight to U.S. dollar with not a strong conviction on direction in the short to medium term. We remain overweight corporate credit and securitized credit. We are overweight emerging markets, for idiosyncratic reasons rather than a general preference for the asset class.
Developed Market (DM) Rate/Foreign Currency (FX)
Monthly Review
In September, we saw bond yields rising globally along with risk assets selling off. On the back of weakness in risk sentiment, the U.S. dollar rose against both developed market and emerging market currencies over the month. While growth surprises have turned negative, inflation continues to surprise to the upside globally. Central banks started reducing excess accommodation instituted last year, by raising interest rates or signaling a shift towards less easy policy as economies normalize. Norges Bank became the first developed market central bank to hike policy rate this year.
Outlook
During the final quarter of 2021, policy is still expected to be a dominant driver of asset performance, but the recovery in the economy to date means that policymakers are eyeing how they will dial back emergency support measures without threatening the economic recovery. We expect global central banks to continue removing excess accommodation as growth and inflation outlook improves over the coming months.
While we do not expect a dramatic sell-off in government bond markets, we think the risk is skewed to yields rising, as markets price in the path to monetary policy normalization. We expect inflation to remain high for some time, with year-over-year rates only declining in 2H22. It is still our view that the surge is mainly transitory, due to technical factors, higher commodity prices, and temporary bottlenecks in the economy.
In terms of currencies, we expect U.S. dollar to remain range bound against developed market and emerging market currencies and don’t have a strong conviction on direction in the short to medium term. We have been reducing the U.S. dollar underweight against developed market and emerging market currencies.
Emerging Market (EM) Rate/FX
Monthly Review
EM debt returns were negative in September. Hard currency sovereigns, as represented by the JPM EMBI Global Diversified Index, delivered negative returns, driven by wider spreads and yields. EM Corporate returns were also negative for the month with high yield underperforming investment grade corporates (proxied by the JPM CEMBI Broad Diversified Index. Local currency bonds, represented by the JPM GBI-EM Global Diversified Index posted negative returns, primarily due to weaker EM currencies versus the U.S. dollar.
Outlook
The outlook for EM debt in the weeks ahead looks challenging, as the asset class faces multiple disruptive forces. The prospects of Fed tapering as early as November and its impact on real yields and the USD may weigh on EM asset performance. We remain cautious on risk in the near term, despite valuations being generally attractive. We are biased towards EM High Yield credits with positive idiosyncratic stories and/or exposed to higher oil prices (and similarly, in EMFX). In rates, we prefer yield curves that are already pricing in aggressive monetary policy tightening.
Credit
Monthly Review
Credit spreads over the month were broadly unchanged in Europe and tightened slightly in the U.S. Sector and corporate news in the month remained dominated by M&A and higher costs driven by structural shortages in both labour and transportation. Global convertibles, as measured by the Refinitiv Global Convertibles Focus Index, held up in difficult markets in September, outperforming both equity and credit.
Outlook
Looking forward, we see credit as fully valued but likely to consolidate at current levels supported by the four pillars of: (1) expectations that financial conditions will remain easy supporting low default rates (2) economic activity that is expected to rebound as vaccinations allow economies to re-open (3) strong corporate profitability with conservative balance sheet management as overall uncertainty remains high (4) demand for credit to stay strong as excess liquidity looks to be invested. We expect good ability to earn attractive carry but see limited opportunities for capital gains from spread tightening.
Securitized Products
Monthly Review
Market activity increased in September both in terms of new issuance and secondary trading. There was nearly $50 billion of new issue activity across Residential Mortgage Backed Securities (RMBS) Mortgage Backed Securities (MBS), Commercial Mortgage Backed Securities (CMBS) and Asset Backed Securities (ABS) markets, highest volume of the year, but supply was comfortably absorbed. Agency MBS performed well in September, as bank buying increased with the steeper curve and Fed buying continued. U.S. non-agency RMBS spreads were essentially unchanged in September. U.S. ABS spreads were slightly tighter again in September while U.S. CMBS spreads were largely unchanged. European RMBS, CMBS and ABS activity also increased in September as much of Europe returned from holiday. European securitized spreads continued to tighten in September, despite talk of the ECB potentially reducing its asset purchases.
Outlook
We believe the securitized market offers a unique combination of low duration, attractive yields, and solid credit fundamentals. We expect securitized new issuance and secondary activity to remain robust in October. Rates volatility will likely remain elevated, but credit fundamentals should remain very solid, especially for residential and consumer assets.
RISK CONSIDERATIONS
Diversification neither assures a profit nor guarantees against loss in a declining market.
There is no assurance that a portfolio will achieve its investment objective. Portfolios are subject to market risk, which is the possibility that the market values of securities owned by the portfolio will decline and that the value of portfolio shares may therefore be less than what you paid for them. Market values can change daily due to economic and other events (e.g. natural disasters, health crises, terrorism, conflicts and social unrest) that affect markets, countries, companies or governments. It is difficult to predict the timing, duration, and potential adverse effects (e.g. portfolio liquidity) of events. Accordingly, you can lose money investing in a portfolio. Fixed-income securities are subject to the ability of an issuer to make timely principal and interest payments (credit risk), changes in interest rates (interest rate risk), the creditworthiness of the issuer and general market liquidity (market risk). In a rising interest-rate environment, bond prices may fall and may result in periods of volatility and increased portfolio redemptions. In a declining interest-rate environment, the portfolio may generate less income. Longer-term securities may be more sensitive to interest rate changes. Certain U.S. government securities purchased by the strategy, such as those issued by Fannie Mae and Freddie Mac, are not backed by the full faith and credit of the U.S. It is possible that these issuers will not have the funds to meet their payment obligations in the future. Public bank loans are subject to liquidity risk and the credit risks of lower-rated securities. High-yield securities (junk bonds) are lower-rated securities that may have a higher degree of credit and liquidity risk. Sovereign debt securities are subject to default risk. Mortgage- and asset-backed securities are sensitive to early prepayment risk and a higher risk of default, and may be hard to value and difficult to sell (liquidity risk). They are also subject to credit, market and interest rate risks. The currency market is highly volatile. Prices in these markets are influenced by, among other things, changing supply and demand for a particular currency; trade; fiscal, money and domestic or foreign exchange control programs and policies; and changes in domestic and foreign interest rates. Investments in foreign markets entail special risks such as currency, political, economic and market risks. The risks of investing in emerging market countries are greater than the risks generally associated with foreign investments. Derivative instruments may disproportionately increase losses and have a significant impact on performance. They also may be subject to counterparty, liquidity, valuation, and correlation and market risks. Restricted and illiquid securities may be more difficult to sell and value than publicly traded securities (liquidity risk). Due to the possibility that prepayments will alter the cash flows on collateralized mortgage obligations (CMOs), it is not possible to determine in advance their final maturity date or average life. In addition, if the collateral securing the CMOs or any third-party guarantees are insufficient to make payments, the portfolio could sustain a loss.