Good times did not last long. August ended the summer flirtation with bull market dreams. After strong recoveries in July, bond markets turned down once again in August, generating large negative returns.
10.10.2022 | 08:00 Uhr
Yields, spreads, and equities have not (at least yet) returned to their June nadir. Optimism for a soft landing in the economy has been seriously compromised. The S&P 500 index sold off more than 8% from August 16, while U.S. high yield spreads widened 75 basis points (bps). The culprits: energy prices in Europe, strong labor markets in the U.S. alongside a rebounding (compared to first half of the year) economy and newly credible central banks brandishing their hawkish wares. This has led to growing conviction of investors that markets will have to contend with sticky core inflation (if not headline inflation outside the U.S.), tight labor markets, particularly in the U.S., the risk of a wage price spiral, and irascible central banks for the foreseeable future.
If there were any doubts that central banks were prioritizing the inflation fight over growth they were put to rest in August. In his Jackson Hole speech, U.S. Federal Reserve (Fed) Chairman Powell laid out in no uncertain terms the Fed’s intention to take whatever actions were necessary to bring inflation back to target without delay, even at the cost of recession. Additional hawkish comments from the European Central Bank (ECB) and the Bank of England (BoE) made it clear that further, potentially aggressive, policy tightening could also be expected in the months ahead. Global monetary policy is going to be made restrictive and would stay restrictive until mission accomplished. The so called “pivot” the market thought was occurring this summer is dead; long live the pivot (towards the central banks’ views). The roller coaster continues.
The end result: By the end of the month, really starting in the middle of August, a mini bear market in bonds and stocks began as did a further upward surge in the U.S. dollar. U.S. 10-year Treasury yields rose over 50 bps; 10-year French government bonds rose almost 80 bps! Importantly, the rise in yields was due to a rise in real yields, suggesting tighter monetary policy expectations were to blame. In fact, the rise in real yields this year has been nothing short of breathtaking. U.S. 10-year real yields have risen approximately 200 bps. Normally inflation expectations and fluctuations in risk premiums generate most of the volatility in nominal yields. Not this year. Inflation expectations have been amazingly well anchored considering the inflation shock which occurred. The U.S. dollar’s rise is more complex as the complete collapse of current account surpluses in Europe and Asia with concomitant increases in capital flows hurt.
What does the future hold? Most likely more volatility. But, maybe with smaller tails. Central banks have forsworn forward guidance, becoming data watchers like the rest of us. We believe headline inflation should fall in the U.S. and many other parts of the world, but probably not Europe. The global economy is slowing down, while central banks continue their hawkish ways. The good news is that markets have embraced (or maybe more appropriately, grudgingly accepted) central banks’ guidance on the need for restrictive monetary policies, implying fewer, less frequent and smaller upward adjustments. Moreover, we think inflation should fall meaningfully next year (Europe a wild card), growth likely below trend and labor markets softer. Could we dare dream that we just might have a soft landing (from here)?
DISPLAY 1: Asset Performance Year-to-Date
DISPLAY 2: Currency Monthly Changes Versus U.S. Dollar
DISPLAY 3: Major Monthly Changes in 10-Year Yields and Spreads
Source: Bloomberg, JPMorgan. Data as of August 31, 2022
Fixed Income Outlook
August put paid to the idea that a soft landing in the economy and financial markets was around the corner. It does not mean one will not occur – only that we believe it is not going to happen this year, or probably in Q1 2023. Imbalances in economies remain too large to call all clear. The probability of a recession in the next 12 months has probably not been higher this year and rightly so, given the level and potential stickiness of inflation and potential -- and we emphasize potential -- that central banks will have to raise rates by more than currently expected.
While the U.S. economy is experiencing an upswing this quarter, the outlook for the rest of the non-energy producing world looks downbeat. Global manufacturing Purchasing Managers Indexes (PMIs) are in recession territory already. Asian economies are seeing a meaningful slowdown in export orders. China’s upswing has been smaller than expected, if not ending much sooner than expected, weighed down by Covid lockdowns, property woes, drought, a weaker global economy --particularly Europe’s -- and a lackluster policy response. While European hard economic data has held up surprisingly well, Germany’s annual natural gas bill will rise by 6% of GDP in 2022,1 a gigantic tax on the economy before potential rationing issues are factored in. Its resilience to this shock is likely to wan in the months ahead, leading to outright recession by Q4. But the unprecedented surge in energy prices will likely lead to continually higher inflation in the months ahead, unlike the slowdown that is unfolding in the U.S. With Europe unlikely to give into Russian demands, the reverberation of this shock has no end in sight.
In the U.S., resiliency in economic data contrasts with weakness elsewhere. The labor market is robust, GDP growth based on the Atlanta Fed’s nowcasting model is forecasted to be over 2.5% on an annualized basis. And goods prices are finally coming down as supply chains improve and demand shrinks. More importantly, gasoline prices are falling meaningfully. The implications of this may be underestimated. Consumer confidence has ticked up as pump prices fall, real incomes look better, and consumer spending could rebound nicely into the holiday season. Although falling gasoline prices (and maybe used car prices) will lead to lower headline inflation like in July, it may make the Fed’s job harder to bring down core inflation if households regain their spending habits, particularly on services. Given this, is it surprising Fed Chair Powell delivered such a hawkish message at Jackson Hole? Indeed, in September, this is what has happened already: Reserve Bank of Australia raised rates 50 bps, Bank of Canada raised rates 75 bps, central bank of Chile raised rates 100 bps; and the Polish central bank raised rates 25 bps. Later in September, the Fed and ECB have said they will raise rates 50 or 75 bps. It is not really important which amount they choose; less now means more later.
The good news is that yields and credit spreads are much more reasonably priced than a month ago. U.S. Treasury 10-year yields were 2.58% on August 1. This was too low and was about 100 bps lower than their June peak. Now, with 10-year yields back to around 3.25% this looks reasonable. Could we revisit the June highs of 3.5%? Absolutely. Will yields get to 4%? Unlikely, in our view.
European government bond yields also returned close to their June highs, making them look much more attractive. Could they go higher still? Of course, but we would not suggest getting more bearish near historical highs in yields. That said, it is premature to believe the bear market in rates is over. The inflation situation is not yet under control. Just because July data showed a slowdown does not mean it will continue, or assuming it does continue, it will be at a disappointing pace, keeping central banks hawkish.
Credit markets also retraced from their strong July performance, continuing their volatile pattern of returns. Given the dire state of European energy markets, we do worry more about euro issuers than U.S., especially given the ECB is likely to deliver as much or more rate hikes as the Fed for the remainder of the year. That said, euro investment grade (IG) credit is priced cheaper, compensating for at least some of the extra risk. But the much higher probability of recession in Europe makes European high yield corporates and securitized credit less attractive than U.S. alternatives.
All in all, given the likelihood of a mild recession sometime over the next 12 months, the need for restrictive financial conditions (including above average credit spreads) maintaining an upward quality bias in credit is preferred. It is hard to see a big rally with economies slowing; policy rates rising and potentially cheaper alternatives like equities. Selling strength, buying dips, towards June wides is our preferred strategy.
Of course, the hoped-for soft-landing is still possible, particularly for the U.S. economy. For this to occur, growth needs to slow and stay below trend for a meaningful period of time. Labor markets need to loosen, slowing wage growth (no sign of that yet), financial conditions need to stay restrictive (as of this month they will be), and inflation needs to decline a lot. There are signs that these conditions are being met. If there continues to be progress on these fronts, markets may become more sanguine about rates, spreads and equities. Since this is a non-trivial possibility, and markets have moved a long way to pricing themselves defensively, we do not advocate getting too defensive in portfolio positioning. Below average risk-taking still seems appropriate, but we are not likely to take aggressive actions from here. Particularly because any rallies in the near term loosen financial conditions, which are likely to be met with stern warnings from central banks if not with hostile rate hikes!
Developed Market Rate/Foreign Currency
August saw July’s rally in developed market rates reverse, with yields rising sharply over the course of the month as central banks made it clear that they were serious about tackling inflation. Consumer price levels were again elevated but appear to have peaked, at least in the U.S.; however, the case globally is still uncertain as further inflation highs could be in store, especially as Europe continues to face an energy crisis. Most economic data and indicators still depict a healthy economy, but one that is showing signs of slowing down.2
We find that the market’s current pricing for rates is close to fair, especially following Powell’s statement. With that said, we also believe that central banks will struggle to effectively lower inflation using their current tools and strategy. While the market has repriced rates higher, we still see risks that short-term rates will have to go even higher than the market is currently pricing in. As the energy crisis in Europe worsens, the situation remains especially problematic. Overall, the continuation of volatility appears to be the most certain prospect in a situation filled with uncertainty.
Emerging Market Rate/Foreign Currency
The summer rally for EMD was cut short following comments by U.S. Fed officials at the annual Jackson Hole Economic Symposium near the end of the month. Differentiation continued to be a theme as various growth and inflation profiles appear to vary widely by country. Performance was mixed for the three major EMD indices.3
Inflationary pressures remain, and corresponding central bank reactions for both emerging and developed markets will be important factors. In aggregate, EM inflation eased in August indicating that it may have peaked in some countries already and those central banks may consider adjusting monetary policy appropriately. Additionally, technical pressures on EMD may have hit a turning point as outflows have eased over the past couple months and segments of the market have received inflows. Differentiation among countries, credits, and currencies will be important for deriving value in the asset class.
In August, U.S. IG corporates outperformed Euro IG corporates. One notable feature of the month was the outperformance of BBB corporates versus A corporates. We believe the driving factors behind this were the impact of supply which was biased to higher quality financials and the unwinding of the European central bank (ECB) quantitative easing programme.4
The tone in the high yield market was initially strong in August. On average, earnings releases exceeded modest expectations and a positive stretch of inflows into U.S. high yield mutual funds, which began in July, continued for the first couple of weeks of August.5 The tone eventually soured amidst increased concern regarding Fed policy. As Treasury yields climbed and risk sentiment shifted, the average spread in the U.S. high yield market moved steadily higher. Default activity increased in August. The top performing sectors for the month were basic industry, energy and other industrial.6
Global convertibles held up relatively well during volatile markets in August. Despite finishing the month in the red, the Refinitiv Global Convertibles Focus Index strongly outperformed both MSCI Global equities and the Bloomberg Global Credit index.7
The senior floating-rate corporate loan market notched another positive month of performance in August – one of few capital market asset classes to do so.8
Looking forward the outlook is little changed. Spreads offer attractive valuations and carry that look inconsistent with the fundamentals we are seeing at the corporate level based on results to date.
We remain cautious on the U.S. high yield market as we enter September. Volatility returned in August, and we expect it to remain elevated over the near term. Liquidity and financial conditions are tightening, consumer sentiment in the U.S. is near a record low and the health of corporate fundamentals has likely peaked. Meanwhile, geopolitical risk remains elevated. August-end valuations appear somewhat attractive from a long-term perspective, but near-term risk appears to be skewed to the downside in light of the aforementioned catalysts as well as a general sense of risk aversion.
We remain constructive on the prospects for the loan market and believe this asset class is well positioned heading into the final four months of the year. Despite our ongoing conviction, the outlook is certainly clouded by a growing number of question marks compared with just a quarter or two ago.
August was almost an exact reversal of July: interest rates rose sharply, agency MBS spreads widened, and securitized credit spreads tightened. Agency MBS spreads widened in August above comparable duration U.S. Treasuries. U.S. non-agency RMBS spreads tightened meaningfully in August, as new issue and secondary supply declined sharply. U.S. ABS spreads also tightened in August, and new issue deals were generally over-subscribed. U.S. CMBS spreads also tightened in August, but AAA rated CMBS outperformed lower rated CMBS securities, as fundamental credit conditions remain challenging in many commercial real estate markets. European securitized markets remain under pressure and European securitized spreads were largely unchanged in August.9
Our fundamental credit outlook remains positive, and we believe credit spreads now offer attractive risk premiums for risk. Credit spreads for many securitized sectors remain at levels last seen at the depths of the pandemic, but credit conditions appear materially better today than during that period.