Investment Strategy

Choice: A new luxury amid the sell-off

Sep 30, 2022

During the last cycle, there were few alternatives to equities–but opportunities are now appearing across the risk spectrum.

Our Top Market Takeaways for September 30, 2022

Market update

Breaking points


There has been one question for investors to consider this year: What would it take to break inflation?

The hope at the beginning of the year was that a combination of interest rate hikes and natural resolution of pandemic-related imbalances would conspire to cool down consumer spending, labor markets and price increases.

Even though there are some signs of progress, it hasn’t been convincing to central banks. Last week, the Federal Reserve reiterated its commitment to not only aggressively hiking rates, but also to keeping rates elevated until the Fed can declare victory.

During most hiking cycles, weak links emerge. We are now starting to see more and more of them piling up.

The U.S. housing market has been under pressure all year. Higher mortgage rates are meant to slow down activity, and they are working. Pending home sales are down over 22% relative to this time last year, which is the most drastic slowdown since COVID-19 and the Global Financial Crisis. That slowdown is trickling through to the labor and financial markets.

Aggregate payrolls of employees in the real estate lending industry are down -14%. Homebuilder and housing-related stocks are trading at a 50% discount to their average valuations. With the 30-year mortgage rate hitting a new high this week, there isn’t much impetus for near-term improvement.

This chart shows real estate credit: aggregate weekly payrolls, YoY change from 2007 to 2022, as well as recession bars. Payrolls started at -0.6% and fell to -39.4% in November 2007, the start of the recession. They rose to -3.5% by July 2009 at the end of the recession and 14.7% by December 2019. They dipped, then rose to 32.2% in December 2012. They fell to -12.2% by December 2013 before rising again to 10.2% in March 2018. They dipped, then rose to 24.5% in February 2020, the start of the second recession in the series. They ended at 28.1% in May 2020. They then rose to a series high of 37.8% in January 2021 before falling to -14.2% in July 2022.

Capital market activity is non-existent. Before Porsche’s relatively successful IPO this week, only 32 companies have gone public this year for a paltry $2.5 billion raised. The only worse year for IPOs in the last 25 was 2008. Debt issuance too is challenged. New debt issuance has fallen by 77% so far this year, and the banks that underwrote the leveraged buyout of Citrix Systems had to take a deep haircut to entice investors to buy the loans.

The global economy is under increasing pressure from the U.S. dollar, which is supported by higher interest rates and the relatively decent growth prospects in the United States. Countries such as the United Kingdom are having a harder time attracting foreign capital. No matter what you think of the benefits of new Prime Minister Liz Truss’s economic plans, the market has spoken. Investors will require a higher return to help finance tax cuts for an economy already facing a material inflation problem and the largest current account deficit among G-10 economies. UK 10-year sovereign bond (gilt) yields surged to their highest level since 2008, and the pound fell to all-time lows relative to the dollar.

This graph shows the United Kingdom 10-year gilt yield and the pound sterling/U.S. dollar exchange rate from 1983 to 2022. The gilt yield began at 10.7% and rose slightly to a series high of 13.2% in April 1990. It then began a steady decline to reach 3.9% in June 2003 and 0.2% in December 2020 before ticking up to 4.3% at the end of September 2022. Meanwhile, the exchange rate began at 1.5 and fell to 1.04 by February 1985. It rose to 2.0 in February 1991, then dipped to 1.4 in July 2001. It rose again to 2.1 in November 2007 before falling to 1.4 in March 2009 and 1.1 in September 2022.
Fixed income and currency volatility are quickly becoming untenable. The Bank of England was forced to step in on Thursday to stem the surge in longer-dated gilt yields due to potential pressure on pension fund assets. China reportedly intervened to support its own rapidly weakening currency, and the Bank of Korea announced several measures meant to limit volatility in currency, fixed income and equity markets. Last week, another Asia exporter—Japan—unilaterally intervened for the first time since 1998. U.S. Treasury market volatility and illiquidity have only been worse during the height of the COVID crisis over the last decade, and President Biden is posting on Twitter about meeting with his economic team for briefings on financial markets.
This chart shows the U.S. Government Securities Liquidity Index and the Move Index from 2010 to 2022. Treasury liquidity began at 2.1 and fell to 0.4 in November 2012. It rose to 2.5 in December 2015 before falling to 0.7 in May 2019. It spiked to 3.1 in March 2020, then fell back to 0.6 in June 2021. It then rose to 2.9 by September 2022. Meanwhile, the MOVE Index began at 113 and dipped to 49 in May 2013. It rose to 118 in July 2013 before falling again to 45 by March 2019. It spiked to 164 in March 2020, fell to 37 in September, then rose again to 158 in late September 2022.

After this week, bond yields are close to their cycle highs, while equity markets are making new lows.

The only thing that seemingly isn’t breaking is the labor market (jobless claims keep falling) and inflation (the August core PCE deflator came in at a still-hot +0.6% MoM pace), which gives the Fed the green light to keep pushing.

In the near term, it seems like things may have to get worse for the economy before they start getting better.

Investment implications

Luxury of choice


If there is an upside to the current market environment, it is that investors who have capital to deploy have the luxury of choice.

We are focused on three areas.

  1. Bonds. You can lend money to the U.S. government for the next three months and yield more than 3% for the first time since 2007. If you do think the Fed will have to cut rates eventually, you can lock in a close to 4% yield for the next five years. U.S. taxpayers can do even better lending money to states and municipalities. Pre-refunded, short-dated municipal bonds have federal tax–equivalent yields of nearly 5%. If you are willing to lend money for longer (think ~10 years), you can achieve tax-equivalent yields in the high single digits. The only questions to really ask are: (1) Are you willing to hold them to maturity; and (2) will the issuer pay you back? If the answer is yes to both, then you don’t have to worry as much about interest rate volatility and the potential mark-to-market impact. In the portfolios we manage, we are moving into longer-dated bonds that would do better if interest rates fell.
  2. Structured equity and credit. Investors can also fill the financing gap caused by closed capital markets. Companies still need access to debt and equity financing, and those with capital can potentially charge a higher premium to provide it.
  3. Mid-cap equities. While large-cap equities are trading at just a slight discount to longer-term averages, mid-cap equities are at a 30% discount. We feel we are being compensated properly for the risk that earnings fall, and would suggest adding to a space that has a good chance of representing the leadership of the next cycle.

During the last cycle, investors had no alternative to large-cap stocks. Today, at least for a moment, they are able to generate compelling potential returns across the risk spectrum and capital structure.

Please reach out to your J.P. Morgan team to hear about how these ideas could fit into your overall financial plan.

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U.S. Government Securities Liquidity Index is a measure of prevailing liquidity conditions in the U.S. Treasury market. This index displays the average yield error across the universe of Treasury notes and bonds with remaining maturity of one year or greater, based off the intra-day Bloomberg relative value curve fitter.

All market and economic data as of September 2022 and sourced from Bloomberg and FactSet unless otherwise stated.

We believe the information contained in this material to be reliable but do not warrant its accuracy or completeness. Opinions, estimates, and investment strategies and views expressed in this document constitute our judgment based on current market conditions and are subject to change without notice.

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