18th May 2015
Every now and then, markets deliver a wakeup call to question consensus and shake out lazy positioning in our view, a shake out from extreme levels explains a good deal of the severity of moves in fixed income writes John Bilton, global head of multi-asset strategy at J.P. Morgan Asset Management…
At the margin, concerns over growth have challenged the consensus around the timing of the first U.S. rate increase at the same time as two-way risk on inflation has been reintroduced to the bond market.
Fundamentally little appears to have changed in the past month. We don’t think that the U.S. is heading into recession, given there is little evidence of the kind of economic imbalance that often precedes a contraction.
It is also doubtful that we are heading towards stagflation, given producer price indices (PPIs) this week surprised to the downside and wage inflation remains contained. Furthermore, we don’t think the U.S. Federal Reserve or the European Central Bank (ECB) are about to shift their reaction function, or make a policy mistake. Fed chair Janet Yellen remains “data dependent” and ECB president Mario Draghi has reiterated that policy stimulus continues.
Nevertheless, markets are, rightly, weighing the risks to these views – so our outlook needs to consider what the last few weeks have told us about growth, inflation and policy.
On growth, the U.S. slowdown in the first quarter succeeded in being well telegraphed and surprising at the same time. That forecasters have notorious difficulty seasonally adjusting for the, now traditional, first-quarter slump is well understood. What appears to have shaken market confidence is the scale of the weakness, limited evidence so far of a sharp rebound, and the inability to pin the soft patch to a specific factor.
Weak oil and a strong US dollar shoulder a lot of the blame for the first-quarter weakness. U.S. earnings revisions were cut to non-recession lows because of these factors. Yet, lower gasoline prices are usually viewed as a boost to real disposable incomes—so why the weak consumer? There are few satisfactory explanations, but we believe it is simple dumb luck that three otherwise minor factors coincided.
First, gas prices are a bigger slice of the weekly budget for lower income households. These consumers saw little of the benefit from quantitative easing as many are not asset owners. Hence the windfall boost to real disposable incomes from lower gas prices was an opportunity to improve household balance sheets and was saved rather than spent. Second, April is tax bill time and there is anecdotal evidence that new healthcare rules (Obamacare) may have prompted some modest overprovisioning, especially among the self-employed.
Finally, the strong dollar reduced import prices so even if volumes were stable, aggregate spending could have ticked down in dollar terms. If, arbitrarily, we assume each of these three factors has slowed retail sales growth by a tenth or two tenths of a percentage point, we can quickly explain the weakness. But crucially, the lack of a single cause creates a possibly misplaced sense of “broad based weakness”.
We expect U.S. growth to accelerate over the remainder of 2015. Initial jobless claims at the lowest level since 2000, robust payroll data, and better housing data are encouraging. So too is the generally sound state of consumer balance sheets. Moderation in dollar strength and the bounce in oil should also help corporate confidence and earnings expectations. Nevertheless, the next couple of months’ data will be closely scrutinised for signs that the worst of the slowdown has past.
On inflation, the deflation fears in Europe are fading and the global disinflationary impulse associated with the slump in oil prices has run its course. Nevertheless, excess capacity, labour market slack and wide output gaps in many regions persist—the deflation scare may be over, but it is premature to be priced for a v-shaped recovery in inflation data, in our view. PPI data from last week back this up. So, while the re-pricing of two-way risk into inflation and into bonds is reasonable, to extrapolate to either an inflationary or stagflationary end-game is unrealistic.
The stabilisation in the oil price is welcome, but here too we think extrapolation of recent price action is naïve. U.S. rig counts dropped sharply in response to falling crude prices, in turn slashing the rate of forecast supply growth. But with West Texas Intermediate (WTI) back towards $60/bbl the impetus to cut rig count is lower. We are also edging towards the breakeven price for many shale producers, which suggests that at current levels the market will not clear.
This is a problem given the level of inventories and supply and we see some risk that energy prices drift lower after the summer. On-land U.S. storage facilities are approaching 90% capacity in some cases, leaving oil markets sensitive to even modest upside in supply, or supply growth forecasts. But even if oil fell back to the upper-$40 range, this would be a much less dramatic re-pricing than took place in the second half of 2014. As a result, the effect of a subsequent drop in oil prices from here is more likely to manifest itself as slower inflation rather than outright disinflation.
Finally, on policy, we still see September as the likely Fed “lift off” date. The probability of a delay to December has ticked up, but we still believe that policymakers prefer “earlier and slower” to “later and faster” for a hiking trajectory. Crucially, we do not see any change to the Fed’s reaction function following the sell-off in bonds—it may even give them confidence that markets will price the cost of borrowing higher along the curve when they do finally raise rates.
With European net bond supply turning negative again over June, July and August, and inflation data remaining contained there is scope for global bond yields to drift lower once again this summer. But with two-way inflation risk now back into the long-end, bond bears are likely to be much more emboldened should yields drift too far. On balance, we are probably into “injury time” on the great bond bull market, but pricing for a surge in inflation, or fearing stagflation, is premature.