« The uncertainties that made us cut our risk OWs to small have not gone away and merit hedging. The biggest one comes from an early end to the cycle caused by the lack of productivity growth. Inflation will be the warning sign and should be hedged. »
Another good read from Jan Loeys and team at JPMorgan…
Bond and equity markets are largely unchanged on the week with credit spreads a few bp’s wider. The dollar is down, while commodities rebounded from previous losses. Economic data were broadly supportive for risk assets, but lingering concerns about Greece and bond illiquidity are keeping uncertainty higher than before.
We retain a portfolio allocation with only small overweights of risk assets ― equities, credit and commodities ― and have hedges through inflation and swap spread wideners. One could call it cautiously optimistic, if that were not somewhat a contradiction. We have yet to turn neutral or underweight risk assets as risk premia still seem sufficient relative to the medium-term economic and event risks we see for the year. But this is becoming a closer call. The main risks to us come from Greece, bond illiquidity, and a miscalculation by central banks and markets on how much excess capacity there is in global economies.
The Greek drama continues. At its core, this is a country that now has way too much debt relative to its ability ever to repay it. If Greece were a company, this would simply be a case of bankruptcy and reorganization, aimed at maximizing value for stakeholders. However, claims on Greece are now concentrated among public-sector authorities that are ruled by political rather than economic objectives. EU voters outside Greece find debt relief unfair, and Greek ones fin reform plus austerity without debt relief even more unfair, if not unbearable. It makes the obvious solution of debt relief in exchange for reform much harder to achieve and increases the odds of a value- and people-destroying default, if not an EU exit. In the event, contagion will likely be controlled by the rest of the Euro area pulling closer together and painting Greece as the black sheep. Still, markets seem eerily calm in front of this risk.
Bonds pulled back from the yield highs scored mid-week. Much of this is happening without fundamental news, aside from a growing realization that we are simply three months away from the Fed. Three months is indeed the average time before past instances of a first Fed hike when bonds have started selling off. Next week’s FOMC will likely see lower dots for both this year and the next ones, lower growth forecasts and a lower neutral funds rate (below and Feroli, FOMC preview, June 12). The FOMC meeting may thus well be bullish for bonds, keeping us neutral duration at the moment. Still, we do not see a large rebound in bond prices as the risk of liquidity suddenly disappearing when most needed remains acute. This is also quite possibly a contributing factor to the inability of credit spreads to tighten on rising bond yields. We have, therefore, raised our credit spread forecast (see below).
The third, more medium-term, but also more dangerous risk is that major central banks and investors misjudge how far we are in the cycle . To us, this is equivalent to miscalculating how much excess capacity there is in world economies. We have discussed at length here the growing global productivity crisis with labor productivity growth―the gap between GDP and jobs growth―falling dramatically over the past three years in both DM and EM.
Most economists and central banks agree only that we do not know the cause of this decline, but still expect that productivity growth will rebound with improved global demand. The major impact of productivity growth failing to rebound is that the world economy is then much closer to capacity and higher inflation (see our Market implications of low productivity growth , May 22).
The chart shows that the faster the US economy grew versus potential in postwar expansions―the excess speed―the shorter the expansion lasted. The US economy has grown at a 2.2% pa pace this expansion. The consensus view of 2.25% potential growth implies the output gap has not shrunk: this expansion could thus last well over a very long one, say 10 years. Our view of only 1.75% potential still implies several more years before the recession. The last four years has only seen about 1% labor force and productivity growth, though. If that does not improve, US excess growth speed is over 1%, and we would be on the verge of creating higher inflation, faster Fed hikes and an early end to the cycle, both for the US economy and world risk markets. How will we know? Inflation will tell us which view is right . Hence the inclusion of inflation hedges in our portfolios. We like inflation breakeven wideners (or OW inflation linkers). We also retain an OW of commodities, even as that is more a view on oil demand. Gold is probably also worth including even as it has protected only against very high or rapidly rising inflation.