This is a sponsored article from J.P. Morgan Asset Management.
The pause before the pivot
Federal Reserve (Fed) officials and market participants seemingly agree on one thing in their outlook for 2024: they expect interest rates to decline. While both parties agree on the general direction of interest rates, they disagree on the pace at which this could happen. Market participants appear to be discounting an earlier and more aggressive rate cut cycle, while the Federal Open Market Committee (FOMC) favours a gradual decline as evidenced by the dot plot from their December meeting.
By and large, the combination of slowing growth, retreating inflation and restrictive monetary policy suggests that we could be at the end of the Fed’s rate hike cycle. The median projection from the December FOMC meeting indicates as much, with Fed officials pencilling in three cuts of 25 basis points each in 2024. Crucially, in a near-unanimous decision, 17 of 19 Fed officials project interest rates to be lower by the end of 2024.
At this stage of the economic cycle, the balance of risks for monetary policy appears asymmetric. In the pursuit of a soft landing, policymakers would be more inclined to cut interest rates in the face of growth risks as opposed to hiking rates to curb inflationary pressure. Slowing growth and enduring disinflation trends could increase the willingness of policymakers to calibrate the current restrictive stance in monetary policy, even if inflation has not reached the target level. Moreover, material recession risks triggered by financial market stress and deteriorating consumer and private sector balance sheets could easily bring forward the rate cut cycle.
The path forward is uncertain and much will depend on the cumulative and lagged economic impact of tight monetary policy as well as the evolving outlook for inflation.
Bonds: ready for prime time
While the path to policy easing in 2024 could be bumpy, it still provides a rather constructive backdrop for fixed income.
From the outset, yields typically fall after a central bank’s final rate hike, which has historically coincided with meaningful capital gains for fixed income. Furthermore, with yields across many fixed income sectors hovering near decade highs, it could be opportune to lock in elevated yields as central banks approach the end of their rate hike cycles. Higher starting yields tend to be a good indicator of forward returns and more importantly, present an income buffer to cushion against potential capital losses should interest rates rise or credit spreads widen.
Starting yields have increased significantly across various fixed income sectors.
Source: Bloomberg, FactSet, J.P. Morgan Credit Research, J.P. Morgan Asset Management. Data as of 30.11.2023. US Treasuries: Bloomberg US Treasury Index; US IG: Bloomberg US Corporate Index; US MBS: Bloomberg US Mortgage-Backed Securities (MBS) Index; US ABS: Bloomberg Asset-Backed Securities Index; Europe IG: Bloomberg Euro Aggregate Corporate Bond Index; USD EMD: J.P. Morgan Emerging Market Bond Index (EMBI) Global Diversified Index; Local Emerging Market Debt (EMD): J.P. Morgan GBI-EM Global Diversified Index; EM Corporates (Corp): J.P. Morgan Corporate Emerging Market Bond Index (CEMBI) Broad Diversified Index. Europe HY: Bloomberg Pan European High Yield (HY) Index; US HY: Bloomberg US Corporate High Yield Bond Index. All sectors shown are yield-to-worst. Yield-to-worst is the lowest possible yield that can be received on a bond apart from the company defaulting. Past performance is not indicative of current or future results.
These factors suggest that some allocation to bonds in a diversified portfolio, based on an investor’s investment objectives and risk appetite, could create a meaningful impact from a total return perspective.
Finding the sweet spot between quality and value
While the field of fixed income opportunities is wide and diverse, several sectors present relatively attractive risk-reward.
- Duration1: The last two years have been especially volatile for interest rate markets in view of the significant shifts in both inflation and monetary policy. Yet, over the last seven rate hike cycles since 1981, duration tends to outperform after interest rates peak, as illustrated below2. Furthermore, the high correlation between stocks and bonds in 2022 has moderated somewhat, potentially allowing the useful diversification properties of duration to reassert itself. While short-duration assets continue to play an important role in portfolios given higher front-end yields and volatile market conditions, investors should calibrate their short-duration allocation as the potential for policy easing comes into view.
Duration tends to outperform after the Fed’s last rate hike
Source: Bloomberg, J.P. Morgan Asset Management. Data as of 30.11.2023. Cumulative returns for US Treasury Indices from 1981, 1984, 1989, 1995, 2000, 2006, 2018. Past performance is not a reliable indicator of current and future results.
- Agency mortgage-backed securities3 (Agency MBS): Agency MBS – pools of securitised residential mortgage loans that are issued or guaranteed by US government agencies – can present a high quality income stream for bond portfolios, especially against a softening macro backdrop. These assets are typically investment grade, tend to exhibit lower credit risks and are generally very liquid. Amid elevated credit spreads, valuations of the sector look relatively attractive, in our view. Moreover, new issuance of agency MBS has been muted amid a general dearth of new mortgage origination and refinancing, largely driven by higher interest rates. This typically translates to greater cash-flow stability.
- Commercial mortgage-backed securities (CMBS)3: There are pockets of opportunities in the CMBS sector. While office commercial real estate debt remains under pressure, residential rental real estate debt continues to be supported by decent fundamentals. In particular, rents have remained relatively resilient on the back of high mortgage rates that have discouraged buying and kept many people renting – market dynamics that continue to support the sector.
Stay selective. Stay active.
While valuations of the broader fixed income market look relatively attractive, it is not the case across all bond sectors. For instance, credit spreads in some sectors such as US high yield4 do not fully reflect the risk of a recession and could widen should economic data disappoint. Furthermore, a recession, even a shallow one, could potentially push default rates higher. This underscores the importance of judicious bottom-up credit selection to differentiate opportunities and separate the wheat from the chaff.
In addition, volatility may remain a feature of the rates market in view of the expected incoming supply of US Treasuries to help finance the US government’s significant fiscal deficits. Coupled with the loss of price insensitive buyers like the Federal Reserve due to quantitative tightening, the increase in supply of government debt could stoke more volatility in US rates. Active duration1 management will be key in navigating this fast-evolving and volatile environment.
Unconstrained, flexible, bottom-up
Currently, fixed income presents a wide opportunity set for some investors to lock in relatively higher yields for longer. Yet challenges remain, spanning market volatility and recession risks. Ultimately, this underscores the importance of adopting an active, unconstrained and flexible approach to seek out enduring opportunities for yield and harness the income potential across both traditional and extended fixed income sectors.
At J.P. Morgan Asset Management, we strive to construct stronger bond portfolios with robust risk management5. We manage over US$2.8 trillion in assets, with around US$710 billion in fixed income6. Our fixed income solutions span the risk spectrum and are underpinned by the deep resources and rigorous research of a truly global platform.
As of December 2023. This information is based on current market conditions, subject to change from time to time without prior notice. Provided to illustrate macro and asset class trends, not to be construed as research or investment advice. Investments are not similar or comparable to deposits. Investors should make independent evaluation and seek financial advice. Risk management does not imply elimination of risks. Forecasts/ Estimates may or may not come to pass.
Diversification does not guarantee investment return and does not eliminate the risk of loss.
- Duration is a measure of the sensitivity of the price (the value of the principal) of a fixed income investment to a change in interest rates and is expressed as number of years.
- For illustrative purposes only based on current market conditions, subject to change from time to time, and are not to be construed as offer, research or investment advice. Not all investments are suitable for all investors. Exact allocation of portfolio depends on each individual’s circumstance and market conditions.
- Securitisation is the process in which certain type of assets, such as mortgages or other types of loans, are pooled so that they can be repackaged into interest-bearing securities. Examples of securitised debt include asset-backed securities and mortgage-backed securities.
- High-yield credit refers to corporate bonds which are given ratings below investment grade and are deemed to have a higher risk of default. Yield is not guaranteed. Positive yield does not imply positive return.
- The portfolio risk management process includes an effort to monitor and manage risk, but does not imply low risk.
- Source: J.P. Morgan Asset Management, data as of 30.09.2023.
The views contained herein are not to be taken as advice or a recommendation to buy or sell any investment in any jurisdiction, nor is it a commitment from J.P. Morgan Asset Management or any of its subsidiaries to participate in any of the transactions mentioned herein. Any forecasts, figures, opinions or investment techniques and strategies set out are for information purposes only, based on certain assumptions and current market conditions and are subject to change without prior notice. All information presented herein is considered to be accurate at the time of production. This material does not contain sufficient information to support an investment decision and it should not be relied upon by you in evaluating the merits of investing in any securities or products. In addition, users should make an independent assessment of the legal, regulatory, tax, credit and accounting implications and determine, together with their own financial professional, if any investment mentioned herein is believed to be appropriate to their personal goals. Investors should ensure that they obtain all available relevant information before making any investment. It should be noted that investment involves risks, the value of investments and the income from them may fluctuate in accordance with market conditions and taxation agreements and investors may not get back the full amount invested. Both past performance and yields are not reliable indicators of current and future results.
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This is a sponsored article from J.P. Morgan Asset Management.