This is a sponsored article from J.P. Morgan Asset Management.
Investors are facing multiple considerations that can impact their asset allocation decisions, such as central banks’ normalising policies, rising inflation, the US interest rate hike cycle and elevated market volatility with the Russia-Ukraine conflict.
In this article
Our Global Fixed Income, Currency & Commodities (GFICC) group acknowledges the combination of a commodity price shock and central bank policy tightening presents a significant headwind for the global economy. While it is still possible for fiscal and monetary policymakers to thread the eye of the needle and engineer a soft landing, the eye of the needle just got smaller.
Our GFICC group believes that while the US economy will likely have to endure a prolonged period of high energy, agricultural and industrial commodity prices, the impact on Europe could be more severe. We expect European growth to slow sharply, but an outright recession is unlikely unless there is a material curtailment of gas supplies.
China represents an optimal case for a positive monetary and fiscal impulse. As the drag from the COVID-19 lockdown fades, policy appears to be shifting to growth stability, not deleveraging.
The central government has expressed their commitment to help stabilise financial markets and measures to support the property market and relax credit growth are being introduced.
Outside of China, we expect other emerging economies will continue to recover with economic reopenings. The group believes the greatest risk2 remains an escalation in the Russia-Ukraine conflict.
US interest rate hike cycle
For the first time since December 2018, the Federal Open Market Committee (FOMC) voted in March 2022 to raise the federal funds target rate range by 25 basis points (bps) to 0.25%-0.50%3. The Federal Reserve (Fed) also made it clear that further increases would be appropriate to tame inflation.
With housing and wage inflation showing continued signs of persistent strength, the GFICC group believes inflation will likely remain far above the Fed’s mandate for many quarters. We believe the Fed will likely hike rates by at least 25bps at each of the next six meetings bringing the policy rate to 1.75 – 2% by end-2022.
Andrew Norelli, portfolio manager for J.P. Morgan’s Income Strategy and a member of the GFICC group, shares his views on fixed income investing in the current market environment.
1. What are the implications for fixed income assets?
- 2023 becomes a critical year when wage growth catches up to the run rate of inflation, the economy could run into the risk of a wage-price spiral. When this happens, the Fed may potentially hike to a rate higher than 2% and this could slow down the economy.
- We have spent considerable time analysing how markets and economy will digest quantitative tightening (QT) and balance sheet reduction using data and information from 2018 when the last QT took place, and came up with a model on the three phases for the way that QT could evolve.
Source: J.P. Morgan Asset Management, as of March 2022. Provided for information only to illustrate team’s current process, not to be construed as research or investment advice.
- The first period is a volatile period for financial markets due to the bad correlation between risk assets and treasuries. The economy then enters the second phrase with weaker economic data and the third phase eventually leads to a dovish correction. With distinct events marking the boundary between each phase, we can look for signs when the correlation between risk and rates flips to determine and drive the rates positioning in our portfolio.
2. How are you adjusting your positioning for the Income Strategy4?
On duration5 positioning
- We believe inflation is an enemy of duration, not credit. We are looking to add risk to the portfolio while remaining short duration5. Currently, we favour a combination of corporate credit, both investment-grade and high-yield6, and short-duration securitised credit7.
- The macroeconomic environment is currently reflationary and nominal gross domestic product growth is relatively strong. The way we have positioned the underlying strategies is to focus on securities with larger rather than smaller cash flows, and for the overall portfolio be shorter rather than longer duration.
- We believe investors who are most impacted in an inflationary environment are holders of long-dated fixed income. We are generally underweight duration via shorts in US Treasury futures in the unconstrained portfolios. The short duration positions helped to mitigate portfolio drawdown as compared to the fixed income benchmark.
Active duration management across sectors
Source: J.P. Morgan Asset Management. Data as at 31.01.2022. The Strategy is an actively managed portfolio, holdings, sector weights, allocations and leverage, as applicable are subject to change at the discretion of the Investment Manager without notice. Provided for information only, not to be construed as research or investment advice. Investments involve risks and are not similar or comparable to deposits.
On high-yield credit6
- We believe there is room for high-yield credit spreads to tighten given the strong fundamentals and healthy balance sheets contributing to low defaults. The recent confluence of factors, such as the hawkish pivot from the Fed and importantly, the overhang on risk markets from the uncertainty in Ukraine has created quite a significant widening in high-yield markets.
- As part of the overall portfolio allocation, we believe high-yield corporate credit presents opportunities for returns on a default-adjusted basis.
On emerging market debt (EMD)2
- In mid-December 2021, as tensions began escalating, the Income Strategy reduced its exposure to Ukraine sovereign debt and added hedges on Russian sovereign credit risk debt and currency risk.
- Back in December, when Ukraine was one of our high conviction ideas from a long perspective, the team carefully assessed the geopolitical risk and the likelihood of an invasion. Upon discussing with the EM desks, our view was to add hedges to our Ukraine exposures with Russia shorts. Our rationale is we acknowledge that Ukraine’s creditworthiness is not that bad due to the massive international financial support. In our view, the default probability is low, but investors should expect volatility.
- On EMD, we do look diligently at the idiosyncratic risks. We have to be selective given the geopolitical uncertainties despite the valuations are quite attractive.
On securitised assets7
- We aim to invest in securitised assets where the collateral value is improved by a reflationary environment. The lowest-hanging fruit is in rental real estate, multi-family and single-family rental which is owned by a reputable company who manages these properties and securitises the pool of rental leases.
- The collateral quality improves significantly with rent increases. As we go through a period of rent inflation, the cash flows generated from the single-family homes or multi-family buildings are going up, which is helpful to the creditworthiness of the underlying assets. That is why we favour commercial mortgage-backed securities (CMBS).
- Agency CMBS interest-only (CMBS IO) are multi-family mortgages and they are insured by the US taxpayer. In the scenario of loans being refinanced, IO holders receive prepayment penalty immediately in compensation for the shrink in cash flows for the rest of the security tenor.
- What we try to do repeatedly and consistently in the strategies is pair together bonds that have varying sensitivity to different economic variables. Agency CMBS IO would do badly in an environment where multi-family buildings were defaulting everywhere. In that environment, we have single-family IO, which mortgage refinance would be really difficult to obtain, and they are inverse floaters. As LIBOR declines, the cash flow gets bigger. Although these risk profiles do not offset exactly you can envision scenarios in which they are not threatened at identically the same time. This approach has worked for us and we’ve been able to generate real portfolio-level risk management2 through that process.
- On the other hand, we do not prefer agency MBS pass-through securities against a backdrop of the Fed running down their balance sheets. We hold below 10% in pass-through securities for the Income Strategy and these are hand-picked for their favourable prepayment characteristics by our securitised team.
We believe a multi-sector fixed income portfolio presents opportunities as investors seek yield premium at a relatively attractive level, while maintaining a moderate level of risk.
We believe inflation risk could be more persistent than transitory, and that inflation is an enemy of duration, not credit. As such, we continue to seek exposures to quality corporates and securitised credit, while employing a flexible approach across the full fixed income spectrum to navigate market volatility.
As of 04/2022. 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. Yield is not guaranteed. Positive yield does not imply positive return.
1. Source: J.P. Morgan Asset Management’s GFICC Investment Quarterly Meeting (IQ Mtg). As of 09.03.2022. Opinions, estimates and forecasts may or may not come to pass. Provided for information only. These represent GFICC group’s views under normal market conditions subject to change from time to time.
2. The portfolio risk management process includes an effort to monitor and manage risk, but does not imply low risk.
3. Source: “Federal Reserve releases FOMC statement”, Board of Governors of the Federal Reserve System, 16.03.2022.
4. For illustrative purposes only based on current market conditions, subject to change from time to time. Not all investments are suitable for all investors. Exact allocation of portfolio depends on each individual’s circumstance and market conditions.
5. 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.
6. 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.
7. 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.
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This is a sponsored article from J.P. Morgan Asset Management.