Investment Strategy

The Fed is responding—quickly—to mounting pressure points

Apr 08, 2022

Prioritizing quality and reengaging on core fixed income may be the answer.

Our Top Market Takeaways for April 08, 2022.

Market update

Another week focused on the Fed

After a rocky start, U.S. stocks clawed back most of their losses heading into Friday. And while the “growthy” stuff such as technology led the declines, it also led Thursday’s rally.

Meanwhile, the ongoing war in Ukraine and subsequent global policy response continued to fuel oil price swings. WTI crude fell back below $100/barrel after a host of countries decided to release reserves from emergency stockpiles.

The U.S. dollar also climbed to the strongest it’s been in two years against a basket of other major currencies.

The big news of the week, though, came from the Federal Reserve. The central bank’s latest meeting minutes—which pull back the curtain from its March meeting—showed just how serious it is about confronting high inflation and a tight jobs market. Next week’s inflation print is expected to show 8.5% year-on-year headline inflation (an unprecedented reading over the last 40 years), and the gap between labor supply and demand is the largest since data has been publicly available. The bond market’s historically bad start to the year continued: 2-, 10- and 30-year U.S. Treasury yields are all at their highest levels since 2019, and the market is expecting policy rates to be well above 3% by the end of 2023.

This chart shows the ratio of job openings to unemployed workers in the United States from December 2000 to February 2022. The series begins at a job openings to unemployed ratio of 0.9 in December 2000. From here, the ratio falls to 0.33 in July 2003 and climbs back up to 0.74 in March 2007. At this point, the ratio falls off sharply to reach a series low of 0.15 in July 2009. After the ratio bottoms out here, there is a steady rise in the ratio over the next 10 years. The job openings to unemployed ratio first tops 1.0 in March 2018, and continues to climb from there to peak at 1.32 in June 2019. Then there is a slight decline to 1.16 in February 2020 before a sharp fall to 0.21 in April 2020 as the impact of COVID-19 struck the U.S. labor market. From here, the ratio recovered rapidly to the latest reading of 1.71 in February 2022, which is a series high.

The minutes signaled that policymakers see more than one 50-basis-point hike as warranted this year (markets are now pricing in such moves in both May and June), with the aim of quickly bringing policy rates into a “neutral” zone that neither speeds up nor slows down growth.

In tandem, the Fed will start reducing its massive balance sheet, a tool known as quantitative tightening (QT) that’s also aimed at taking off some of the economic heat. It works through allowing existing, maturing securities to roll off its balance sheet, rather than reinvesting the principal. Each month, it’ll allow a maximum value (the “cap”) of these securities to mature, and the lack of reinvestment ought to reduce demand for bonds. Judging from their plans to ramp up this pace over the course of three months or “modestly longer as conditions warrant,” this would be more rapid than the last cycle (when the Fed gradually ramped up QT over the course of a year).

If anything is clear, it’s that the Fed is responding—and quickly—to mounting pressure points. While it’ll be a narrow runway, we believe the Fed will be able to engineer a “soft-ish” landing (its words, not ours) and avoid ending the cycle in the year ahead. However, a growth slowdown does seem likely, which is why careful, quality selection across asset classes will be key as the cycle evolves. Today, we explore steps investors can take in portfolios to do so.

Spotlight

Quality: one of our favorite characteristics across asset classes

Last week, we explained how investors could prepare portfolios for slowing growth. Today, we expand on one of our favorite asset characteristics in the current environment: quality.

In equities, this might seem simple. Of course, investors should want to invest in the equity of high-quality companies, not low-quality ones. But it isn’t always that easy. For example, so far this year, the lowest-quality companies have outperformed the highest-quality ones by over 11%.

Quality companies tend to have strong balance sheets and generate high-quality earnings, have management teams that are reliable capital allocators, and are good partners to investors. One marker of such quality is consistent dividend growth. Companies that are dividend growers also tend to be less expensive than the broader market, have a higher absolute dividend yield, and typically come from the “defensive” sectors that are less sensitive to changes in economic growth. 

This chart shows the P/E ratio, dividend yield and percentage in defensive sectors of Dividend Growth and the broad market. - P/E ratio: 15.72x Dividend Growth and 19.18x Market - Dividend yield: 2.13% Dividend Growth and 1.74% Market - Percentage in defensive sectors: 35.3% Dividend Growth and 21.7% Market

All three of those characteristics seem attractive to us in the current environment. We want to be less exposed to economic growth as it slows. A growing dividend yield provides a cushion against higher inflation and discount rates because it provides equity holders with cash flows today, which are more valuable than cash flows in the future. Companies with higher valuations could still be in the proverbial penalty box while the market tries to find a ceiling for interest rates during the Fed rate hiking cycle.

But perhaps most importantly, quality companies should provide more certainty in what is an uncertain macroeconomic environment.

We haven’t been positive on investment-grade fixed income since the summer of 2020 for one simple reason: We thought interest rates could rise (remember, bond prices and yields move in opposite directions). That has turned out to be the right call. The U.S. Bloomberg Barclays Aggregate Bond Index (which tracks U.S. investment-grade fixed income) had its worst quarterly return since 1980.

This chart shows the quarterly performance of the Bloomberg U.S. Agg Index from 1979 to 2022. The best and worst performance in the following five-year time periods are: • 1980–85: +18.8%, -8.7% • 1985–90: +8.0%, -2.7% • 1990–95: +5.7%, -2.9% • 1995–00: +6.1%, -1.8% • 2000–05: +4.6%, -2.4% • 2005–10: +4.6%, -0.1% • 2010–15: +3.8%, -2.3% • 2015–20: +3.0%, -3.0% • 2020–22: +3.1%, -5.9%

But now, yields have risen to a level where investors are finally getting paid an adequate return for more certainty and recession protection if one does come to pass. You can make bonds very complicated or very simple. Here is the simple take: If you think the issuer can pay you back, and know when it will pay you back, you can be pretty clear on what you stand to earn from your investment.

Right now, there are a few highly rated municipal bond issues that are offering tax-equivalent yields of over 4% for the next few years. For reference, our Long-Term Capital Market Assumptions suggest that U.S. large cap equities will likely deliver something like 4.1% over the next 10–15 years.

In a recession, assuming 10-year U.S. Treasury yields fall back down to 75 basis points (bps) (from around 2.60% today), a portfolio of municipal bonds with maturities spanning 1–10 years could deliver something like an 8% total return over a year. If 10-year Treasury yields rise another 100 bps to 3.5%, the same portfolio would lose something like 2% over the next year. Further, we aren’t overly concerned about leverage in either the corporate or public sectors. Corporate interest payments as a percentage of revenues are at their lowest levels since the 1960s, and states and cities are still flush with cash from the stimulus programs of 2020 and 2021.

Meanwhile, lower-quality fixed income such as high yield bonds seems less attractive to us now because the relative valuations aren’t as compelling, and we can get a decent return from more creditworthy issuers. While there are some pockets of opportunity in the space, for the most part, the juice just doesn’t seem to be worth the squeeze in high yield. But the potential return profile of investment-grade municipal and corporate bonds seems attractive to us, as growth is set to slow.

Investment implications

Focusing on the bigger picture

Booming consumer demand, a tight labor market and high realized inflation have driven rapid progress through the business cycle. Now that the Fed has made its intentions to bring down inflation by any means necessary crystal clear, it seems reasonable to worry about the next recession.

But we still think it’s too early for that. Since 1975, the economy has spent about 20% of the time in what we consider “late cycle,” and risk assets tend to provide attractive returns during the period.

Further, trying to time investments based on when a recession may or may not come can be damaging to long-term returns. Of course, missing the worst months leads to better performance, but the risk of missing the best months is also costly. The S&P 500 has delivered a ~10% annualized return since 1900. Missing the best month of every year would reduce that return to less than 2% per year.1

Even if a recession does come sooner than we expect, remember that proper investment portfolios are designed to deliver adequate returns to investors through business cycles. We just try to make changes on the margin that can help smooth volatility and help investors stick to their plans. That is why we are reengaging on core fixed income, prioritizing quality in equity portfolios, and controlling what we can by reviewing our long-term plan.

For more on how we are guiding your portfolio through the market cycle, please contact your J.P. Morgan team.

1 Christian Mueller-Glissman, Goldman Sachs Global Investment Research. “Recession Obsession and Chasing Your Tail Risk.” April 8, 2022. 

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All market and economic data as of April 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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