Risk assets have quickly rebounded from heavy losses in late 2018, in large part due to the pivot from global central banks. The Federal Reserve (the Fed) has paused further rate hikes, and the European Central Bank (ECB) has promised not to raise rates this year. Nonetheless, global growth has uniformly continued to slow, and inflation remains low. Furthermore, the yield curve has inverted, which historically has been a predictor of recession; we have taken another step from late cycle toward end cycle. Financial markets are pressing investors to answer one question, like it or not: Will a recession come to pass in the next 12–18 months? For now, we say no; but it’s a close call.

Three pillars define our second-quarter outlook:

PILLAR ONE. In October 2018, the Fed told us that that it was “a long way from neutral”; fast forward to 2019, and the Fed is going to be “patient” with the hiking process and cease unwinding its balance sheet. The abrupt pivot reflects concerns about slowing global growth and the Fed’s ability to convincingly achieve its 2% inflation mandate. In an attempt to combat these forces and anchor inflation expectations, the Fed is entertaining average inflation targeting—a regime change that so far hasn’t been deemed entirely credible.

Interest rates. The market is pricing the next move from the Fed as a cut, and we agree (but it’s a close call). As such, we revise lower our outlook for 2019 rate hikes to 0 (from 2 in our 2019 outlook), and our 10-year Treasury yield outlook to 2.65% (from 3.15% in our 2019 outlook). Importantly, we still view the distribution of outcomes on 10-year Treasury yields as skewed to the downside, despite the substantial move lower in yields over the last six months. 

The dollar. We continue to expect some of the U.S. dollar gains registered in 2018 to reverse, and we see the U.S. Dollar Index (DXY) depreciating modestly to 94.50 at year-end. On a trade-weighted, inflation-adjusted basis, the USD is overvalued (trading 12% higher than its 10-year average). Historically high valuations and U.S. late-cycle dynamics make further USD upside unlikely.

Gold and oil. Late-cycle dynamics are likely to reinforce gold’s traditional role as a safe haven asset and portfolio diversifier. Historically, when 12-month forward recession probabilities reach 50%, gold averages a positive return of nearly 1.5% per month. Elsewhere in the commodity complex, we expect OPEC to keep current production cuts throughout the year, inventories to continue to draw, and the market to remain in deficit for the second and third quarters. We expect to see WTI oil prices at $65/bbl at year-end 2019.

What can you do? Talk to your advisor about whether the duration/maturity structure of your fixed income portfolio is prepared for late/end cycle, and about tax-advantaged investments such as municipal bonds and preferreds. Also talk to your advisor about whether gold is right for your portfolio.

PILLAR TWO. In Europe, a lower for (even) longer euro area interest rate environment is likely. At its most recent meeting, in the face of slowing growth and persistently low inflation, the ECB pulled on the only two accommodative levers left in its toolkit: First, President Draghi promised to keep rates at the current level “at least through the end of 2019” (compared to “at least through the summer of 2019” previously), and second, he introduced another round of targeted longer-term refinancing operations (TLTROs) to keep cheap liquidity flowing to the economy.

European rates and the euro. Despite adding further accommodation, the ECB still expects inflation to stay below mandate-consistent levels through 2021. Given its significant trade ties to Asia, more powerful Chinese stimulus is a requisite for a notable shift higher in European growth. To date, we don’t view China’s easing initiatives as sufficient. We take the ECB at its word and expect no changes in interest rate policy this year, and revise lower our 10-year bund forecast to 25bps (from 75bps in our 2019 outlook). Pushing back ECB rate hikes at least until 2020 reduces some degree of support for the euro, and as a result, we have recently moved our year-end 2019 outlook down to 1.16 from 1.18 on EUR/USD.

What can you do? For clients who are waiting for a “better entry point” into euro area fixed income markets, they are likely to be waiting for some time. Like it or not, clients need to add interest rate risk, add credit risk, or find other non-traditional ways to achieve positive yields. Talk to your advisor about whether European bank debt, investment-grade credit and select extended credits are right for your portfolio. 

PILLAR THREE. We continue to live by our 2019 outlook mantra: Invest conservatively, but trade opportunistically. The sole purpose of this mantra is to encourage an open mind. Volatility breeds overshoots, and overshoots introduce opportunity. 

What can you do? Talk to your advisor about opportunities in select short-dated, high-yield and emerging market bonds that we expect may return principal even in a downturn. In typical late-cycle fashion, the new issue market is open, and bonds have been trading strongly after settling—take advantage of J.P. Morgan’s large syndicate footprint.

See below for an update to our views on interest rates:

Source: J.P. Morgan Private Bank Fixed Income, Currencies & Commodities Strategy as of March 29, 2019.
Interest rates table