The recession dilemma: Why J.P. Morgan Asset Management isn't playing the 'if' and 'when' game

For most investors, regardless of whether they have a local or global focus, the potential for a US recession is the number one risk right now.

Aside from an unknowable, black swan-type event, a US recession is the event that will have the most profound impact on economies, investment opportunities, and portfolios.

By some estimates, the US should have been in a recession months ago. But the proverbial can keeps getting kicked down the road and debate remains rife about if and when said recession will occur.

Whilst the ‘if’ and ‘when’ game can be an amusing pastime, J.P. Morgan Asset Management's head of global aggregate bonds, Myles Bradshaw, isn’t particularly interested in playing it. He and his team readily acknowledge that they can’t know for sure if or when a recession will land, so they don’t try to guess. Instead, they are building portfolios to position appropriately, in the most cost-effective way.

"If the recession takes place, central banks will cut rates and the yield curve will steepen. So, you get your return not from necessarily owning 30-year treasuries, but from owning two-year treasuries," Bradshaw says.

"That's how we are building our portfolio. We've got trades on that would benefit from dramatic rate cuts. We're not betting on the timing of those rate cuts, per se. We're taking them longer out."

For investors such as Bradshaw, the challenge is to do this in the least expensive way possible. In the following wire, he shares his knowledge from almost 30 years in markets and provides his long-term outlook for the global economy and fixed income. He also explains his belief that this time, bonds should provide suitable protection in any potential downturn.

Where are we now?

Bradshaw unequivocally states that “we’re late cycle” and “that means we’re at the late stage of the expansion”.

Without specifically calling for a recession, Bradshaw goes on to explain that “the hard part is the timing of [a potential] recession."

"Recessions are usually a non-linear event. They don’t happen very predictably. They happen very unpredictably."

Coupled with such unpredictability is the pricing in the bond market today, which Bradshaw describes as “unusual” and has comparisons to the 1980s, “where market interest rates peaked below where the Fed fund's rate peaked."

Bradshaw notes that, in every market cycle, the peak in the Fed funds has coincided with a widespread view that rates will continue to climb. That contrasts with the current environment, where the peak has occurred while the market anticipated rate cuts.

He believes the macro data would need to deteriorate at “quite a rapid pace” from here to see rate cuts this US summer – the market is pricing in the first rate cut in May.

How to position accordingly

If the macro data does deteriorate and a recession ensues, Bradshaw posits that “central banks will cut rates dramatically and the yield curve will steepen”.

As noted earlier, Bradshaw emphasises that in the above scenario, investors will get their return from bonds not from necessarily owning 30-year treasuries, but from owning two-year treasuries.

“From a positioning point of view, you want your portfolio to be earning more duration than it used to because interest rates have gone up substantially," he says.

"They're now at the near the peak in the cycle. We know inflation is coming down. We know the income you get from bonds is attractive. You want to be building portfolios that, if the recession occurs, are going to make excess returns."

For Bradshaw and his team, this is reflected in their yield curve positioning. 

And in terms of adding interest rate risk more broadly, he says they are trying to do this opportunistically, when the market provides cheaper opportunities, "rather than chasing the market."

Why is this time different?

Whilst Bradshaw has a playbook for recession, and bonds typically provide protection in times of economic turmoil as other asset classes tank, that wasn’t the case in 2022. Quite the opposite, in fact, with the bond market suffering a meltdown and delivering the worst performance in history.

So, why will this time be different?

Bradshaw sees “inflation” as the main reason.

“You can look back at the correlation between bonds and equities over the last 50 years, and they tend to be positively correlated when core inflation is above 2.5%," he says.

"Where inflation is above that level, central banks are raising rates to slow economic activity. That's bad for equity's earnings and it's bad for bond yields because rates are going up."

Bradshaw believes that an inflation level below 2.5% provides central banks with the flexibility to respond to weaker earnings growth and weaker economic growth by cutting rates.

"And you get that negative correlation. We think we are there, or thereabouts at that point in time, because inflation is coming down quite rapidly," he says.

"It has not reached the Fed's target of 2%, but if you have slowing activity and a recession on the horizon, the forecast will be for inflation to go down to that 2% level, which enables the Fed to cut rates, and that supports the bond market."

Is this the worst of it?

While the last two years have been historic for bond markets, they’re not the most volatile Bradshaw has seen.

He cites the Global Financial Crisis in 2008/2009 and the European Sovereign Debt Crisis in 2012 as periods with more volatility.

That said, he has been paying close attention to an “unusual” feature of the current market that he has observed, particularly over the past three months. For Bradshaw, the fact that macro data isn't driving the volatility is the most unusual observation over the last three months.

“We've had very high levels of the intraday volatility without much new information," Bradshaw says.

"If we go back to the Sovereign Debt Crisis in Europe or the Great Financial Crisis, there was new information. You knew they were deleveraging portfolios that were causing asset prices to fall sharply.

"It's not obvious there's a deleveraging process. There's a lack of market depth, which is resulting in very large intraday moves”.

The opportunity for investors

It’s the level of curiosity displayed above, looking for key features and outliers, and comparing and contrasting to history, that keeps Bradshaw motivated – even after almost 30 years.

“You're always learning something new... whether it's the economy, whether it's the oil market, whether it's COVID - the intersection of fundamentals on the economy and macro, with the technicals. It is very appealing”.

That desire to keep learning and improving is reflected in the portfolio that Bradshaw oversees, the J.P. Morgan Global Bond Strategy which includes the JPMorgan Global Bond Fund as well as the JPMorgan Global Bond Active ETF (Cboe: JPGB), which has a three- to five-year investment horizon and has historically delivered returns around 100 basis points above the benchmark, whilst delivering similar levels of volatility.

And while Bradshaw oversees the portfolio, he’s keen to point out that there is a large team, numbering more than 300 analysts and portfolio managers, that scour the globe for the best opportunities. That team researches the fundamentals of every single security, “and that's the foundation of our process”, adds Bradshaw.

The other key part of the process is that they think very deliberately about portfolio construction, using multiple risk tools to help ensure the robustness of their portfolios.

"Not only to make money in the scenarios we think are likely, but also to think about the scenarios that we think are possible. And we don't want to be losing lots of money in those scenarios," Bradshaw says.

But for now, it seems those low-probability scenarios aren’t particularly likely. At the start of our conversation, I suggested to Bradshaw that it must be a nice change not having to reach for risk anymore, instead getting paid appropriately for the risk he is taking.

Emphatically, Bradshaw said, “Finally, we’re back”.

“It’s great to be able to build portfolios that offer capital preservation, good income, and diversification - those are the key features that we get from our bond portfolio. They're back now”.

Quality fixed income matters in uncertain markets

Investing in a global portfolio of higher-rating bonds means opportunities for diversification while managing volatility.

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