INSIGHTS Global Bond Outlook Full circle, but which direction? December 211 PLEASE VISIT jpmorgan.com/institutional for access to all of our Insights publications. IN BRIEF Low levels of economic growth and high levels of debt are creating significant opportunities in global bond markets. Japan, which went through a similar low growth, low rate environment, may offer a roadmap for bond investors. The late 199s and early 2s, for example, turned out to be very supportive for both Japanese and western bond markets. Faced with what is likely to be a long deleveraging cycle and the current eurozone debt crisis, investors can still find value in today s bond markets. Attractive fixed income opportunities can be found in selected sovereigns (particularly Australia) and corporate credit (particularly high yield). The U.S. mortgage market provides a further good source of value for investors in both agency and select non-agency securities. Emerging market debt and emerging market currencies, particularly on a long-term basis, are also attractive although short-term dynamics are less supportive. Low levels of economic growth and high levels of debt are creating significant opportunities in global bond markets. J.P. Morgan Asset Management s international chief investment officer for fixed income, Nick Gartside, explains how the global economy has come full circle and why global bonds may continue to provide investors with attractive returns in the coming years. AUTHOR Nicholas Gartside Managing Director International Chief Investment Officer Global Fixed Income nicholas.j.gartside@jpmorgan.com Global Economic Outlook Japan Provides a Roadmap Global economic growth is below trend and the immediate outlook appears bleak (Exhibit 1). The reason why growth is so weak is that very high levels of public and private sector debt, particularly in the developed world, are set to continue to constrain government and consumer spending for some time to come. In this sense, the global economy has come full circle: economic weakness has led to increased government borrowing and high debt levels, while the austerity measures now being implemented to reduce these debts are only serving to further exacerbate economic weakness. FOR INSTITUTIONAL AND PROFESSIONAL INVESTOR USE ONLY NOT FOR RETAIL USE OR DISTRIBUTION
In the current economic environment, Japan may provide a roadmap for bond investors. Japanese growth collapsed in the late 199s at the same time as government debt levels rose sharply. The Bank of Japan reacted by cutting interest rates to zero and by introducing several bouts of quantitative easing the same policies now being pursued by western central banks. The low growth, low interest rate environment was very supportive for Japanese bonds. In fact, not owning Japanese bonds was the graveyard of bond investors in the late 199s and early 2s. As in Japan, returns from western bond markets may also continue to surprise positively. Bonds have two traditional enemies: inflation and interest rate rises. On both fronts the outlook is now benign, with low growth and ongoing deleveraging suggesting that inflation will ease and interest rates will fall. The European Central Bank (ECB) and several emerging market central banks are likely to cut rates in the coming months, while the Bank of England and Federal Reserve are contemplating further quantitative easing (QE) measures. Future global growth is set to be below trend EXHIBIT 1: DEVELOPED MARKETS LEADING INDICATORS 3 2 1 Future above trend growth governments to bring their debts under control. Deleveraging cycles have historically taken between five and ten years to complete. Given that we are no more than a few years into the current cycle, and given the high levels of debt and low levels of growth, the current deleveraging cycle is likely to be more like ten years than five years. The corollary of this long deleveraging cycle is that economic growth will remain lower for longer than previously expected. If deleveraging takes ten years, global economic activity may be anaemic for several more years to come. The developed world has too much debt EXHIBIT 2: WORLD DEBT age of GDP 6 5 4 3 2 1 Government Debt Household Debt Financial Debt Non-Financial Debt Total U.K. U.S. Germany France Japan Italy Canada Source: J.P. Morgan Asset Management, McKinsey. Latest available data. -1-2 Future below trend growth -3 Europe leading indicator G1 leading indicator -4 199 1993 1996 1999 22 25 28 211 Source: J.P. Morgan Asset Management, Bloomberg. Data as of November 211. Debt is Dominating the Economic Landscape Most major developed economies have too much debt, running total debt burdens of between 2% and 5% of GDP (Exhibit 2). Worries over the sustainability of these debts are leading to credit downgrades in the developed world: the U.S. has lost its AAA rating and other top-rated countries now look vulnerable, particularly France and the U.K. The reason credit ratings are coming under pressure is that the low growth environment is making it much harder for Eurozone Questions Remain Unanswered At the moment, the region facing the biggest challenge managing its debt burden is the eurozone, where several peripheral countries have borrowed too much and are now struggling to repay lenders. Despite its many complexities, the eurozone sovereign debt crisis comes down to two fundamental questions: 1. Who will suffer writedowns? 2. Who is injecting new capital to help indebted countries? Both of these questions remain unanswered. Investors do not know who will suffer writedowns on their peripheral eurozone bond holdings and they have no idea how much debt will ultimately have to be written off to return the region to a path of debt sustainability. This uncertainty is creating nervousness in the European banking system due to its large exposure to 2 Global Bond Outlook: Full circle, but which direction?
peripheral eurozone bonds, which in turn is having a detrimental impact on bank lending and economic growth. Meanwhile, it is clear that investors are reluctant to inject new capital into the eurozone without greater guarantees that they will get their money back. This means the attempt to leverage the eurozone s bailout fund, the European Financial Stability Facility (EFSF), is a non starter. Many investors would like to see the ECB step in and support eurozone peripheral debt using quantitative easing before they commit any money. Any injection of capital from the EFSF or the ECB (or a combination of the two) would help aid the deleveraging process and alleviate the crisis in the short term, but even that would not provide a long-term comprehensive solution. To avoid a future crisis, wide-reaching and fundamental reform is needed to address the serious structural imbalances that exist within the eurozone, in particular the lack of competitiveness of the region s periphery. Either way, the eurozone debt crisis has no quick-fix solutions. Finding Value in Today s Bond Markets In this deflationary, low growth environment, fixed income returns are likely to continue to provide positive surprises. Anaemic growth and record-low interest rates will also place an increased emphasis on the search for securities that offer attractive yields. As already mentioned, Japan may provide a roadmap for investors. The Japanese experience suggests that reducing exposure to global bond markets in the current environment could be costly. But where should bond investors be looking to put their money? At the moment, attractive fixed income opportunities can be found in selected sovereigns (particularly Australia) and corporate credit (particularly high yield). The U.S. mortgage market provides a further good source of value for investors in both agency and select non-agency securities. We also continue to like emerging market debt and emerging market currencies, particularly on a long-term basis, although shortterm dynamics are less supportive. Government bonds The weak global growth outlook is supportive for government bonds. However, given the deteriorating credit outlook in several large sovereign markets, we would suggest that investors focus on attractively valued bonds offering competitive yields that are backed by a high and stable credit rating. On a valuation basis, Australia stands out at the moment. Australian bonds benefit from the backing of strong public finances (the country has a low debt-to-gdp level and only a modest budget deficit), yet they offer a much higher yield than U.K. Gilts, U.S. Treasuries and German Bunds (Exhibit 3). Australia is also expected to continue to cut interest rates fairly aggressively given a weakening trend in domestic consumer data and concerns over Chinese demand for commodities. Australia stands out among sovereign issuers EXHIBIT 3: ENVIOUS OF AUSTRALIA: AN ATTRACTIVE REAL AAA 6.5 5.5 4.5 3.5 2.5 Corporate bonds Australia 1-yr U.S. 1-yr German 1-yr 1.5 2 22 24 26 28 21 Source: Bloomberg, as of November 3, 211. Following a recent widening in spreads over Treasuries, opportunities can be found in the investment grade and high yield bond markets. High yield offers particularly good value, from both a fundamental and a valuation viewpoint. High yield fundamentals are strong, with companies generating high levels of cash and benefiting from low levels of leverage on their balance sheets. Fundamentals are therefore radically different from those of 28, prior to the global financial crisis, when borrowing was high and cash flows were low. Therefore, companies are much better positioned to withstand any renewed economic slowdown. Furthermore, refinancing needs are relatively manageable for the next few years. From a valuation perspective, the current 9% yield offered by the high yield market is favourable compared to the negative real return available from cash and the low yield offered by other bond sectors. Current valuations also imply that default J.P. Morgan Asset Management 3
rates will rise significantly. With default rates at just 1% it is inevitable that they will rise at some stage, but we do not expect this to be dramatic and expect defaults to remain below the long-term average of 4%, again indicating current valuations are attractive (Exhibit 4). Mortgage-backed securities Agency debt (mortgage bonds backed by U.S. governmentsponsored agencies such as Fannie Mae and Freddie Mac) offer yields that are around 1.5-2% higher than is available from U.S. Treasuries, despite being implicitly backed by the U.S. government. As a result agency mortgage securities provide attractive value for investors. Non-agency mortgage bonds offer selected opportunities depending on structure and maturity, so individual security analysis is vital. The highest rated bonds that originated before the peak of the U.S. housing bubble (pre-26) can offer value. These bonds typically have a short average life of around a year, while yields are very attractive, at between about 6% and 9%. High yield valuations are attractive EXHIBIT 4: HIGH YIELD YIELDS AND DEFAULTS 25 2 15 1 U.S. Gov t Yield U.S. High Yield spread Default rate 12 1 8 6 4 supported in the long term by strong government finances, low levels of public sector debt and healthy economic growth rates. However, in the short term, the stress in western financial systems has translated into some fairly significant volatility in the emerging bond markets. Emerging markets have not decoupled in any meaningful sense, and therefore investors should remain cautious over emerging market debt, at least until credit conditions in the developed world stabilise and global risk appetite improves. Strategic Bond Investing: Seeking Out the Value in Global Bond Markets In the current environment it is perhaps more important than ever that bond investors are able to invest flexibly and strategically across global bond markets. Strategic bond funds can take a global view in search of the most attractive markets and securities, irrespective of any benchmark, adapting their fixed income allocations and duration exposures for the prevailing economic and market environment. This ability to adapt to changing conditions can prove vital for returns. Investors only have to look back at the volatility of the last 12 months to see the potential pitfalls of being stuck in a single-country or single-sector bond fund. Instead, investors need to be able to change their allocations and portfolio positioning in order to try and limit losses and seek out the most attractive valuations. With global bond market returns likely to continue to surprise in 212 and beyond, such a flexible approach could help investors to navigate these complex markets. 5 2 21 23 25 27 29 211 Source: J.P. Morgan Asset Management. Data as of September 3, 211. For illustrative purposes only. Emerging market debt Emerging market bonds are supported by falling inflation at the headline level and interest rates are likely to be cut by emerging market central banks as global economic growth continues to slow. Structurally, emerging market debt is also 4 Global Bond Outlook: Full circle, but which direction?
Nicholas J. Gartside, managing director, is the International Chief Investment Officer, within J.P. Morgan Asset Management s Global Fixed Income and Currency Group. He is responsible for leading and overseeing the activities of our international fixed income teams, as well as being the comanager of our multi-sector fixed income products and serves on the Currency Investment Policy Committee. Prior to this, Nick was at Schroder Investment Management for eight years, most recently serving as the Head of Global Fixed Income. Nick earned a B.A. in History and Politics from Durham University and an M.Phil. in International Relations from Cambridge University. Nick is a CFA charterholder and holds the Investment Management Certificate from the UK Society of Investment Professionals. This material is intended to report solely on the investment strategies and opportunities identified by J.P. Morgan Asset Management. Additional information is available upon request. Information herein is believed to be reliable but J.P. Morgan Asset Management does not warrant its completeness or accuracy. Opinions and estimates constitute our judgment and are subject to change without notice. Past performance is not indicative of future results. The material is not intended as an offer or solicitationfor the purchase or sale of any financial instrument. J.P. Morgan Asset Management and/or its affiliates and employees may hold a position or act as market maker in the financial instruments of any issuer discussed herein or act as underwriter, placement agent, advisor or lender to such issuer. The investments and strategies discussed herein may not be suitable for all investors. The material is not intended to provide, and should not be relied on for, accounting, legal or tax advice, or investment recommendations. Changes in rates of exchange may have an adverse effect on the value, price or income of investments. J.P. Morgan Asset Management is the brand for the asset management business of JPMorgan Chase & Co. and its affiliates worldwide. This communication is issued by the following entities: in the United Kingdom by JPMorgan Asset Management (UK) Limited which is regulated by the Financial Services Authority; in other EU jurisdictions by JPMorgan Asset Management (Europe) S.à r.l., Issued in Switzerland by J.P. Morgan (Suisse) SA, which is regulated by the Swiss Financial Market Supervisory Authority FINMA; in Hong Kong by JF Asset Management Limited, or JPMorgan Funds (Asia) Limited, or JPMorgan Asset Management Real Assets (Asia) Limited, all of which are regulated by the Securities and Futures Commission; in Singapore by JPMorgan Asset Management (Singapore) Limited which is regulated by the Monetary Authority of Singapore; in Japan by JPMorgan Securities Japan Limited which is regulated by the Financial Services Agency, in Australia by JPMorgan Asset Management (Australia) Limited which is regulated by the Australian Securities and Investments Commission and in the United States by J.P. Morgan Investment Management Inc. which is regulated by the Securities and Exchange Commission. Accordingly this document should not be circulated or presented to persons other than to professional, institutional or wholesale investors as defined in the relevant local regulations. The value of investments and the income from them may fall as well as rise and investors may not get back the full amount invested. 27 Park Avenue, New York, NY 117 211 JPMorgan Chase & Co. INSIGHTS_Global Bond Outlook FOR INSTITUTIONAL AND PROFESSIONAL INVESTOR USE ONLY NOT FOR RETAIL USE OR DISTRIBUTION jpmorgan.com/institutional