Views on Global Fixed Income
Written by: Bob Michele, CIO and Head of Global Fixed Income, Currency & Commodities (GFICC), J.P. Morgan Asset Management
Themes and implications from the Global Fixed Income, Currency & Commodities Investment Quarterly meeting
- An environment of reasonable growth, low inflation and continued central bank accommodation should be supportive for risk assets in the near term.
- Given the strength of synchronized global expansion, Above Trend Growth remains our base case scenario (with a probability of 65%, down from 70% in Q2). However, continued low inflation would support a Sub Trend Growth scenario (with a probability of 25%, up from 20%).
- The biggest risks to this base case—a slowdown in China’s growth, an oil market collapse or an overly hawkish Federal Reserve (Fed) do not appear imminent. Both our Recession and our Crisis scenario probabilities are unchanged at 5%.
- U.S. rate expectations have been muted, but a rebound in U.S. growth later this year should allow 10-year Treasury yields to rise to between 2.50% and 3.00% by year-end.
- We see opportunity in European bank capital (Alternative Tier 1), leveraged loans, U.S. high yield bonds and emerging market (EM) local currency bonds.
- We anticipate an extremely challenging investment environment over the next 12 to 18 months as the unwinding of quantitative easing (QE) takes the central banks’ aggregate balance sheet from expansion to contraction.
Scenario probabilities (%)
Source: J.P. Morgan Asset Management. Views are as of June 2017.
EVERYTHING’S A PROXY FOR QE
“It’s the QE, stupid.”1 That’s the conclusion we came to at our third-quarter IQ (Investment Quarterly), held in Columbus, Ohio, in June.
We began by evaluating the outcome of our previous meeting. While we got some things right, we also got some things wrong. Growth is at least as strong as we thought globally, but inflation has disappointed. The potential for meaningful fiscal spending in the U.S. seems a distant memory. And we underestimated the pressure of continued global quantitative easing; central bank dynamics are stabilizing rates. We were correct, however, in our prediction that, despite the fact that everybody is suffering from valuation fatigue, credit, risk and emerging market currencies would all be strong performers.
Global growth is still synchronized. U.S. growth is forecast to rebound later in the year (and any fiscal stimulus would provide a surprise to the upside); Europe is growing above potential; Japan is growing way above potential; and the emerging markets, including China, are growing at potential. But there’s no inflation anywhere. The environment doesn’t fit neatly into one of our four scenarios. Nonetheless, the strength of global growth supports Above Trend Growth as our base case, albeit at 65%, down slightly from 70%. We raised the probability of Sub Trend Growth from 20% to 25%.
Key questions remain, among them:
- What is the path of inflation expectations?
- What does the flow of QE look like? And when does the tailwind of QE become a headwind?
Global slack is keeping a lid on inflation, and inflation remains stubbornly below target in the developed markets. Outside of modest growth in the U.S., there’s no wage inflation anywhere. We spent some time debating the drivers of inflation and inflation expectations. Certainly, an aging population that continues to work is one. But more important may be technology. Are the signals from telecom, from oil, from medical devices telling us that structural expectations for inflation need to be lower?
During our meeting, the Federal Reserve announced a rate hike and detailed the plan to partially unwind its balance sheet (albeit without specifying a start date). The Fed’s plan was more hawkish than we anticipated, reflecting its expectations of rebounding growth and inflation, but we believe the Fed is smart to go now, as continued purchasing by the Bank of Japan (BoJ) and the European Central Bank (ECB) cushions its actions. For now, the weight of cash being injected into the markets remains supportive. When will this change? We believe that the balance of flows needs to be negative before it really hits the market. Assuming the Fed embarks on its path later this year and both the ECB and BoJ begin to scale back buying at the beginning of 2018, we are looking at one more year of central bank dominance at a minimum.
Our concerns over China have risen, and we debated increasing the probability of recession. China has been borrowing and manufacturing its own growth, and may be running out of room to do so. Efforts to tighten should be closely monitored, as should the path of commodity prices. China may be a bubble, but it’s not about to burst in the immediate time frame.
Oil is also a risk. Will OPEC curb production to support prices, or will it attempt to break the back of shale once again, flooding the market with supply and trading lower prices for higher volumes?
Finally, an overly hawkish Fed could be a risk. As the Fed shrinks its balance sheet, it will be tightening financial conditions. The impact on growth could be quite suppressive, and we could see the seeds of the next recession.
Despite these concerns, we felt that the near-term risks were muted and we kept the probabilities of Recession and Crisis unchanged at 5% each.
U.S. rate expectations
In light of disappointing hard data, reduced expectations for fiscal stimulus in 2017 and continued QE from the ECB and the BoJ, we have muted our expectations for higher rates in the near term. We do expect, however, that growth in the U.S. will rebound later in the year, supporting another rate hike and the Fed’s desire to begin tapering, and allowing yields on the U.S. 10-year Treasury to rise to between 2.50% and 3.00% by year-end.
In the near term, the environment is as Goldilocks as it gets— reasonable growth, low inflation and accommodative central banks are all supportive of risk assets. Despite the fact that markets are suffering from valuation fatigue, our best ideas continue to center on credit and emerging market currencies.
The weight of cash in Europe exceeds that in the U.S., and European growth is strong. The credit fundamentals for banks continue to improve, cushioning European bank capital (Alternative Tier 1) and making yields attractive on a relative value basis vs. high yield and preferreds.
In the U.S., the revenue recession is over. In high yield, defaults are down and there’s still room for modest spread tightening. Leveraged loans, particularly given the flattening of the curve, offer attractive carry, but we must be cautious of structure and covenants, and we must recognize that we are ceding the upside. With bonds at today’s tight spread levels, we are cognizant of the fact that we are picking up pennies in front of a steamroller; we aren’t complacent, but for now, U.S. high yield bonds continue to be an attractive carry trade.
We are more cautious on growth in the emerging markets, but as a whole EM fundamentals are good and countries have better balance sheets with which to survive external shocks. Inflation is falling, and even though the Fed is tightening, the re-rating in the rest of the world keeps the dollar in check. The emerging markets offer something the developed markets don’t—positive real yields. We like emerging market local currency bonds, but are rotating away from commodity-based economies and toward manufacturing ones, away from Latin America and toward Central and Eastern Europe.
We believe the next 12 to 18 months will be among the most challenging investment environments in anyone’s career. As the central banks reverse their policies and their aggregate balance sheet goes from expansion to contraction, the impact is likely to be volatile asset prices. Further, central banks will be “normalizing” their balance sheets at a time when growth and inflationary pressures should still be muted. Add to that, there may or may not be policy stimulus coming out of Washington and there may or may not be a hard Brexit. We are about to find out how much quantitative easing and zero interest rate policy depressed volatility and inflated asset prices, if at all. We’ll be ready to expect the unexpected and will use our research-driven process to find value where we can.
SCENARIO PROBABILITIES AND INVESTMENT IMPLICATIONS: 3Q17
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 daylong discussions, we review 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.
Learn more about J.P. Morgan’s Equity ETFs here.
Source: J.P. Morgan Asset Management. Views are as of June 14, 2017.
Opinions, estimates, forecasts, projections and statements of financial market trends that are based on current market conditions constitute our judgment and are subject to change without notice. There can be no guarantee they will be met.
DM: Developed markets; EM: Emerging markets; FX: Foreign exchange.
1 Apologies to James Carville, who said, “It’s the economy, stupid.”
Investments in bonds and other debt securities will change in value based on changes in interest rates. If rates rise, the value of these investments generally drops. Securities with greater interest rate sensitivity and longer maturities tend to produce higher yields, but are subject to greater fluctuations in value. Usually, the changes in the value of fixed income securities will not affect cash income generated, but may affect the value of your investment. Credit risk is the risk of loss of principal or loss of a financial reward stemming from a borrower’s failure to repay a loan or otherwise meet a contractual obligation. Credit risk arises whenever a borrower is expecting to use future cash flows to pay a current debt. Such default could result in losses to an investment in your portfolio.
China's Push Toward Excellence Delivers a Global Robotics Investment Opportunity
Written by: Jeremie Capron
China is on a mission to change its reputation from a manufacturer of cheap, mass-produced goods to a world leader in high quality manufacturing. If that surprises you, you’re not the only one.
For decades, China has been synonymous with the word cheap. But times are changing, and much of that change is reliant on the adoption of robotics, automation, and artificial intelligence, or RAAI (pronounced “ray”). For investors, this shift is driving a major opportunity to capture growth and returns rooted in China’s rapidly increasing demand for RAAI technologies.
You may have heard of ‘Made in China 2025,’ the strategy announced in 2015 by the central government aimed at remaking its industrial sector into a global leader in high-technology products and advanced manufacturing techniques. Unlike some public relations announcements, this one is much more than just a marketing tagline. Heavily subsidized by the Chinese government, the program is focused on generating major investments in automated manufacturing processes, also referred to as Industry 4.0 technologies, in an effort to drive a massive transformation across every sector of manufacturing. The program aims to overhaul the infrastructure of China’s manufacturing industry by not only driving down costs, but also—and perhaps most importantly—by improving the quality of everything it manufactures, from textiles to automobiles to electronic components.
Already, China has become what is arguably the most exciting robotics market in the world. The numbers speak for themselves. In 2016 alone, more than 87,000 robots were sold in the country, representing a year-over-year increase of 27%, according to the International Federation of Robotics. Last month’s World Robot Conference 2017 in Beijing brought together nearly 300 artificial intelligence (AI) specialists and representatives of over 150 robotics enterprises, making it one of the world’s largest robotics-focused conference in the world to date. That’s quite a transition for a country that wasn’t even on the map in the area of robotics only a decade ago.
As impressive as that may be, what’s even more exciting for anyone with an eye on the robotics industry is the fact that this growth represents only a tiny fraction of the potential for robotics penetration across China’s manufacturing facilities—and for investors in the companies that are delivering or are poised to deliver on the promise of RAAI-driven manufacturing advancements.
Despite its commitment to leverage the power of robotics, automation and AI to meet its aggressive ‘Made in China 2025’ goals, at the moment China has only 1 robot in place for every 250 manufacturing workers. Compare that to countries like Germany and Japan, where manufacturers utilize an average of one robot for every 30 human workers. Even if China were simply trying to catch up to other countries’ use of robotics, those numbers would signal immense near-term growth. But China is on a mission to do much more than achieve the status quo. The result? According to a recent report by the International Federation of Robotics (IFR), in 2019 as much as 40% of the worldwide market volume of industrial robots could be sold in China alone.
To understand how the country can support such grand growth, just take a look at where and why robotics is being applied today. While the automotive sector has historically been the largest buyer of robots, China’s strategy reaches far and wide to include a wide variety of future-oriented manufacturing processes and industries.
Electronics is a key example. In fact, the electrical and electronics industry surpassed the automotive industry as the top buyer of robotics in 2016, with sales up 75% to almost 30,000 units. Assemblers such as Foxconn rely on thousands of workers to assemble today’s new iPhones. Until recently, the assembly of these highly delicate components required a level of human dexterity that robots simply could not match, as well as human vision to help ensure accuracy and quality. But recent advancements in robotics are changing all that. Industrial robots already have the ability to handle many of the miniature components in today’s smart phones. Very soon, these robots are expected to have the skills to bolster the human workforce, significantly increasing manufacturing capacity. Newer, more dexterous industrial robots are expected to significantly reduce human error during the assembly process of even the most fragile components, including the recently announced OLED (organic light-emitting diode) screens that Samsung and Apple introduced on their latest mobile devices including the iPhone X. Advancements in computer vision are transforming how critical quality checks are performed on these and many other electronic devices. All of these innovations are coming together at just the right time for a country that is striving to create the world’s most advanced manufacturing climate.
Clearly, China’s trajectory in the area of RAAI is in hyper drive. For investors who are seeking a tool to leverage this opportunity in an intelligent and perhaps unexpected way, the ROBO Global Robotics & Automation Index may help. The ROBO Index already offers a vast exposure to China’s potential growth due to the depth and breadth of the robotics and automation supply chain. As China continues to improve its manufacturing processes to meet its 2025 initiative, every supplier across China’s far-reaching supply chains will benefit. Wherever they are located, suppliers of RAAI-related components—reduction gears, sensors, linear motion systems, controllers, and so much more—are bracing for spikes in demand as China pushes to turn its dream into a reality.
Today, around 13% of the revenues generated by the ROBO Global Index members are driven by China’s investments in robotics and automation. Tomorrow? It’s hard to say. But one thing is for certain: China’s commitment to improving the quality and cost-efficiency of its manufacturing facilities is showing no signs of slowing down—and its reliance on robotics, automation, and artificial intelligence is vital to its success.
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