Where the bond market leads, the stock market follows | Bob Michele, JP Morgan

Bryce: [00:00:15] Welcome to another episode of Equity Mates, a podcast that follows our journey of investing, whether you're an absolute beginner or approaching Warren Buffett status. Our aim is to help break down your barriers from beginning to dividend. If you are joining us for the very first time, welcome and thank you for becoming an equity mate. If you're still getting up to speed with the basics, check out our Get Started Investing podcast. But let's crack on. My name is Bryce. And as always, I'm joined by my equity buddy, Ren. How are you going? 

Alec: [00:00:41] I'm very good. Bryce is very excited for this interview we have. There's a saying in financial markets where the bond market leads, the stock market follows. And we have one of the best bond investors, fixed income investors in the world. Joining us today to give us a sense check of where the bond market is and where the stock market might be going.

Bryce: [00:01:02] That's right. It is our absolute pleasure to welcome you to the Equity Mates studio. Bob Michele, Bob, welcome. 

Bob: [00:01:07] Hey, guys. I'm glad to be here. I love the intro. You're right. Bonds are at the top of the capital structure always. 

Bryce: [00:01:16] So Bob is the chief investment officer and head of the Global Fixed Income Currency and Commodities Group at JP Morgan Asset Management. And a big thank you to Jp morgan Asset Management for supporting this episode and Ren. As we said at the top today, we're going to be exploring fixed income, a topic that we haven't spoken much about and we're going to try and answer the question, is the bond market back? But Bob, before we jump into the made of the episode where we're going to be talking a lot about bonds today. So to contextualise this conversation and for investors who have just joined us, what is the bond market? 

Bob: [00:01:54] So you guys are really smart not to have talked about bonds for a long time because you're right, it didn't make sense. It's repricing that that really happens. You have to think about a bond as a loan. You think that you're taking out a mortgage, you go to your bank, they give you a loan, and then they expect you to pay it back with some interest. We're in the market. What we're doing is we're taking client money. You may have money that you want to invest in bonds. You give it to us. We look for borrowers, we look for governments, we look for corporations, and we lend them your money and we set terms with them. We want a reasonable rate of interest. For example, today, if you gave us your money and we like ten year Australia government bonds, we're getting just below 4% on that. We give them your money, they start paying us 4% a year until we take your money back. 

Alec: [00:02:50] And a lot of new investors don't realise this, but the global bond market is actually bigger than the global stock market and just doesn't get as much airtime in the financial press.

Bob: [00:03:00] It's big and it's growing. And if you think about it, if you own a business and you're looking to get additional financing, if you go to the bond market, you borrow money for a certain number of years, whatever you like, but then you pay it back with some interest and hopefully your business has grown. It's just the cost of borrowing that money for a short period of time. If you give somebody equity in your company, then it's gone right then. Then you now have somebody else who owns shares of your company. You may never get back. So a lot of businesses, a lot of households, a lot of governments prefer to get financing through the bond market so they don't have to give up any ownership of their franchise.

Alec: [00:03:50] Now, Bob, 2022 was a bit of a disaster for bond markets. And let's start with what? 

Bob: [00:03:59] Thank you for bringing that up. It was Early. 

Alec: [00:04:02] So I guess give us the overview of what happened last year and then let's move to what you're saying in 2023. Is it going to be more of the same or will it be different?

Bob: [00:04:10] In the measured history of the bond market, there's never been a year as bad as last year and most bond markets, and it's going to vary, but they were down about 15%. So I think the best bond markets were only down about ten. And the ones that were the most challenged were down over 20%. The problem is that we came into 2022 with interest rates very, very, very low. And in a lot of parts of the world, they were about zero. Look, we got there because we had to. We had a pandemic which could have killed a lot of us. There was an emergency response by governments to, first of all, put a lot of fiscal stimulus, supply money and aid packages into the system. And then central banks lowered the cost of funding that recovery so that it was affordable and they brought interest rates down. Now, happily, we're emerging through the other side of the pandemic. It's time for the central banks to begin. Normalising interest rates and they started about 12 months ago and they've been hiking rates ever since. Of course, as interest rates go up, the existing interest rate in the bond market looks too low, so bond prices have to fall to accommodate that. That's simply what happened. But after a year, we're thinking we're coming towards the end of that. 

Bryce: [00:05:38] And so what's the general outlook for 2023? 

Bob: [00:05:42] Well, the general outlook for 2023 is the central banks are telling us inflation is still sticky. It's still a bit of a problem. A lot of the money from the fiscal aid from the government expenditures that helped get us through Covid are still sloshing around in the system. They want to make sure they're thorough and starting to pull that out so that inflation doesn't become a lasting problem. One way to do it is to keep raising interest rates so that the cost of financing anything goes up to a point that you have to think twice about it. And I know in this market, when people buy a home, sure, a couple of years ago, they got a very low interest rate every two or three years. It's going to roll over their mortgage and it's going to go to a higher interest rate. And because of that, it's going to make everyone rethink about what else they spend money on. Once people pull back their spending in economic terms consume less, then that starts to bring inflation down because there's nowhere for higher prices to go. When you listen to the Reserve Bank of Australia, the Federal Reserve and the U.S. European Central Bank, they're all saying the same thing. We've done a lot. There's a bit more to go, but we're getting towards the end of that cycle. So I think blue skies are ahead. 

Alec: [00:07:03] Yeah, we are. We have a macroeconomics podcast, Canadian versus economist in the Equity Mates network here, and they were speaking about the wage data that came out in Australia, I think this week or last week, and they were talking about how it was really positive for the inflation story, not super positive for workers, but we're not really seeing evidence of like a wage price spiral. And that's a good sign that perhaps inflationary pressures aren't as bad as people thought. I say that and I'm touching word as I say.

Bob: [00:07:34] Well, well, you know, the old that when you're talking about wage pressure, on one hand, all of us would like our wages to go up. On the other hand, if everyone else goes up, then the price of everything goes up. You know, the classic definition of recession, when your neighbour's laid off, it's a recession. When you're laid off, it's a depression. 

Alec: [00:07:57] I like that. So, Bob, we're talking about a market that globally is, I assume, over $100 trillion, the global bond market. And you mentioned that there are a number of different segments in the bond market. I guess, you know, the government bonds are corporate bonds. You often hear about junk bonds. Are we here? Are we saying these different segments of the market respond differently to the rising rate environment? 

Bob: [00:08:23] So we don't call them junk bonds anymore? Michael Milliken was in prison and that got cleaned out. We now call them high yield or below investment grade. 

Alec: [00:08:34] By good guys. 

Bob: [00:08:37] So they're all repricing and they all have to reprice because when you look at where central banks have moved interest rates and we think by the time they're done, the Reserve Bank of Australia will have raised rates about 400 basis points, 4% to 4.1%. The Federal Reserve will have raised rates from 0 to 5%. That's a lot of repricing that has to happen across the bond market. And then you start thinking of some of those borrowers that are not governments. A lot of the corporations that you talk about, whether they're investment grade companies or below investment grade companies or some of the mortgage providers out there that securitise their mortgage loans in the US and then go to the market. Those have gone up and goes a little bit more because in a higher rate environment the probability of recession grows and you want a little extra yield to cushion yourself from any potential defaults in borrowers outside of government. It's a very small risk, but in the bond market we just like to build that. 

Bryce: [00:09:46] Are there any other parts of the market that kind of concerning you or that you're that you're worried about a steering clear of at the moment? 

Bob: [00:09:53] Yeah, there are a couple of areas. One is in the below investment grade area at the high yield area. When we look at that market, yes, in a lot of places in the US it yields 9%. Not too long ago it yielded just about 5%. So the yield has gone. A lot. But our work shows that the bottom in that market or the highest yields that you can buy in the high yield market occur during recession. And and we believe that the central banks, unfortunately, only have one solution to high inflation, and that's to raise rates high enough so that the economy goes into recession, washes out a lot of the the unsustainable excesses that have built up over the last couple of years. They're pretty much telling us that they don't. Sure, they'd like to engineer a safe, soft landing. It's too hard this time because of all the money thrown in the system. But if we wind up in recession, then the yield on those bonds should go from about 9% to something like 12%. I'd rather be patient and wait and then go in at that point in time. 

Alec: [00:11:07] Are there any parts of the bond market that are getting you on Jp morgan excited or just the market as a bond market as a whole? Like where are funds flowing at the moment? 

Bob: [00:11:18] I started out by throwing you guys sort of a backhanded compliment that you weren't, and I can see you too. I'm sure you got a lot of backhanded compliments, but you're smart not to talk about the bond market for the last couple of years because it was so manipulated by the central banks. It was always expensive. Now, clearly in Australia this week, I've come from New York. I travelled across the U.S. through the Asia Pacific region to Europe to visit clients, and I've seen a lot of clients in the wealth management platforms. A lot of the individual investors who tune in for these podcasts and a lot of institutions. And the one thing they're telling me is they haven't allocated to bonds in a long time, but they're looking to do it and they don't want to miss it. The interesting thing is, in a long time they don't mean the last couple years. They mean going back to the financial crisis. So we looked at the global government bond market and we looked at the yield you can get in the global government bond market relative to inflation. We call that the real yield. Are you getting a yield above the level of inflation and how much are you getting the highest real yield in government bonds since 2007? That's six years ago. That's a generational repricing in the bond market. And that's what's got investors interested in coming into this market. And when they sense that the central banks, whether it's the RBA or the Federal Reserve, are at the end of their hiking cycle, that money's going to come in in a big way. I think it's smart money, it's going to go into government bonds, but it's also going to go into investment grade corporate bonds where you can pick up another percent, 2% and a half above the yield of government bonds. 

Alec: [00:13:19] You're right on that point around it being a generational shift, because I think about my investing journey. You know, I was in high school during the GFC and started investing while I was at uni and bonds never were really part of the conversation or part of my thought process. And you know, you read all investing books from some of the greats over the years, and there's a lot of talk about the 6040 portfolio, 60% equities, 40% bonds. That was the sort of staple portfolio. But for people of the most recent generation, that's sort of seen as quite archaic. And you know, you say financial media talk about the 6040 portfolio being dead. But now that bonds are back, interest rates are rising. I guess the question is, is the 6040 portfolio back again? 

Bob: [00:14:12] Yeah, but that's a really good question. The answer is yes, it is. And it's back in a big way. And you're right, there's a lot of confusion in the marketplace and maybe we can unravel some of that. I think we also have to remember over the last couple of years, coming into 2020 to call it 2020, 2021, once central banks brought rates down to zero and kept them there in the bond market was too expensive. The term I heard a lot was Tina. Tina. There is no alternative and people are saying go into the equity market because the yield, the dividend yield on stocks is higher than bonds. That's now completely repriced. You could put money into a general bond fund, and if it's domestic in Australia, get a yield of about three and a half percent. If it's global, you're looking at a yield of closer to 6% and it's all investment grade. Now that's real competition. You can leave money in a money market account and you're probably going to get it. Close to 4% over the next couple of months. That makes a tremendous amount of sense to me. What's confusing people is they thought 6040 protects them in all environments. That in periods of time when equities drop, bond prices go up. So you're compensated. Well, that didn't happen last year. So that's really confusing people because they expected, well, when equities go up, then my bond prices will drop. I can live with that as long as it goes the other way. And that's called correlation. They expect the bond and equity market to be correlated where, as I said, equities go down, bond prices go up. They are, but it depends on what central banks do. And we haven't had central banks move interest rates in a long period of time. So here's a simple way to think about it. Yes, what should happen is equity and bond prices should move opposite to each other, but only when central banks aren't changing interest rates. That's normal. When central banks are raising interest rates, they're raising the discount rate applied to every asset class. And asset class prices have to drop. That's capital asset pricing model theory. So what have the central banks done? They've raised rates at the most aggressive pace since 1980, and you're seeing exactly what the textbook tells you. All asset prices should drop. That's the correct correlation. Rising rates. Now we're getting to the end of this. We think we're going to be in a recession over the end. And then you should expect around that time central banks to start cutting rates. And what should happen when central banks cut rates? Well, the discount rate applied to all asset classes should drop or their value should go up. So long story short, 6040 makes sense. Be aware of the correlations. Just understand you have to know whether central banks are hiking rates, cutting rates, or leaving them unchanged. The markets behave exactly as they should. We've been through the worst. There's probably a little volatility ahead, but the trend is upward. And then, as I said, there's a lot of blue sky ahead for 60/40.

Bryce: [00:17:40] Compliant with the 6% yield.

Alec: [00:17:43] It is just it sounds so far and for the last ten years that we've been investing mean.

Bryce: [00:17:48] I know although my portfolio certainly doesn't reflect a 6040 Bob that's for Sure. 

Bob: [00:17:55] When I started in the business in the US, you could put money on deposit with banks and get 26%. And by the way, we didn't think that was high enough.

Alec: [00:18:07] Oh yeah, yeah, yeah. Look, we probably don't want to try to go back to those days because that will mean.

Bryce: [00:18:17] Well, let's turn to unpacking the central banks a little bit more, because you said a couple of times there that there's been some pretty aggressive right moves by both the Federal Reserve and the RBA here in Australia expectations this year that there's a few more at least to come. Do you think that they've gone too far? Have they got it bang on? And what happens realistically if the Fed does actually continue and have to go higher than they've had sort of advised the market?

Bob: [00:18:44] As I had said earlier, I think we just have to accept we had a pandemic. The policy response was what it had to be. You throw as much at it as you could on the fiscal side. On the monetary side, it worked. We survived. And now it's time to take all that stimulus out of the system. And if you go back 18 months, we knew when that day come it wouldn't be painful. Now we can debate, did the central banks leave the liquidity in there too long? Well, yeah, because look how high inflation has gotten. It's by most minute measure, it's a minimum of 5%. A lot of measures close to 10%. The only way to bring that down is to drain liquidity from the system through quantitative tightening, which they're doing. They're running down their balance sheets, they're destroying money and raising rates so that it discourages you from financing new purchases. And that's starting to bite hard. So I stepped back and I said, and I think I knew we would be at this point in time, I don't want to stand in front of it and fight it. I want to let the central bank tightening inflation wash through the market, get to the end of it, see where the market is, and then start to invest. And I think we're getting to the end of it. Does it matter if the Fed pauses at 5% or has to go to 6%? Maybe a little bit. But the bond markets are already pricing in a five and a half percent Fed funds rate. So if they pause at 5%, 110% of the rate hikes are priced in. If they have to go to 6%, 90% of the rate hikes are priced in. That's a pretty good spot to start putting money into the bond market. And the same thing with the RBA. The market's expecting 4.1%. I don't know if they have to go, you know, to something like 4.6% because China reopening is creating more stimulus within the Australian economy. But even then, 90% of the pricing has washed way through. I think last year we could have pointed a finger at the central banks. I think this year we have to say they're doing their jobs. Cleaning inflation out of the system will be long term healthier for the economy and for us as investors. We're coming through to the end of it. So start thinking about where you deploy capital.

Alec: [00:21:21] So, Bob, there's a cottage industry of financial experts that go on to financial media and make predictions about where interest rates are going to end up. And they've been doing a roaring trade in 2023 because everyone's wondering what their mortgage rate will be and the like you mentioned there. You can say what the bond market is pricing in for people whose ears picked up at that and were wondering how they could not listen to the talking heads on TV, but rather look at what the bond market is telling us. How do you actually say what the bond market is pricing in? 

Bob: [00:21:56] Yeah, there are things called futures market, and a futures market is effectively placing a bet on something. And if you think about, you know, if you buy a physical bond or a physical stock, you basically take in cash and bought the valuation. Today, futures is like betting on the outcome of a match. You could win or you could lose. And you see where is all the money? Gone have two thirds of the batteries expected to win or lose. And we do the same thing in the bond market. You could look at the Fed fund futures market and see where are people expecting the Fed funds rate to go. They're putting a lot of money on it right now. That's five and a half percent. And a year ago, frankly, it was about 2%. So the bet, the smart money lost a lot of money because it blew right through 2% and went through five. So those are the kinds of things we look at. I'm sure if you Google that Fed Funds Futures market, you'll come up with a nice chart. 

Bryce: [00:23:06] Like chart not. Speaking of futures, Bob, let's move to sort of beyond 2023 24. What is your view on the longer term outlook for rates over the next two, three years? 

Bob: [00:23:20] So one of the things that I look at is the composition of our fixed income platform and we manage over $700 billion. We have a lot of smart people there. I look at the 37 year old and I know this is going to cut close to home, but the 37 year old is super bright. They have families, they have homes. They have a mortgage. A lot of them are managing directors and run big businesses for us. But the only world they know is the world when they exited uni in 2008. And that's the post financial crisis world. So they think yields belong at 2%. That zero is legitimate. And the reality is that's a result of the great financial crisis and the last hurrah of the baby boomers who overbuilt the property market, then crashed it and then wiped it out. I think what your listeners have to understand is that the last 15 to 20 years weren't normal. We're going back to what I'll call the old normal, where there is a healthy economy, there is competition for capital. There's going to be a cost for capital. So, yeah, you may not be able to get a mortgage at the rates you got a couple of years ago, but you'll be able to invest in the fixed income market and higher yields than you've ever seen. And companies will continue to pay higher dividends than they did in the past. So I think we're getting to an environment where a realistic Fed funds rate is about 4%. The Reserve Bank of Australia, a realistic rate is probably in that 3 to 4%. An area. We're not going to go back to 0% unless in an extreme emergency. And because we've now shot past those levels, because we're trying to remove an incredible amount of stimulus. There has been a painful adjustment in the market. So we're actually coming from above those yields down to it. That's a nice tailwind for bond prices and bond returns. So as I said, maybe there is a little volatility over the next quarter. So when the central banks get to the end of the tightening cycle. But as I look out over the next 2 to 3 years, I'm looking at what I think will be double digit returns in some bond funds.

Bryce: [00:25:54] Wow. So it's 37 years olds. Not that we are. We're getting close to it. We should be thinking a little bit more about getting bonds into the portfolio. 

Bob: [00:26:02] Right. I'm just past my 37th birthday. 

Bryce: [00:26:05] Nice. 

Alec: [00:26:07] So, Bob, I guess if rates normalise at, I guess a bit more of a long term average of around three or 4% and the 37 year old is, I was about to say, in for a rude awakening, but I actually think it's the opposite. I think it's like our worlds open and there's a whole other asset class that we can invest in and we're given more choice. And hopefully it also means that savings accounts rise from that 0.01% interest they were paying. I started this episode saying where the bond market leads, stock markets follow, and I guess if rates normalise around that long term average of three or 4%, if bonds, if there's competition for capital and if bonds can give investors a meaningful return going forward, what is what are the flow on effects to the stock market, do you think? 

Bob: [00:26:56] I think unfortunately for the equity market, it all comes down to whether the central banks can engineer a soft landing or whether we wind up in recession. And if you look at the greatest inflation shocks since 1980, the greatest interest rate hikes since 1980 and consequently the greatest rate shock passing through the system since 1980, it seems very aspirational to hope for a soft landing. I think you have to prepare for recession, which we believe is necessary to wash out some of the excesses in the system. So it's going to happen much like the high yield bond market which bottoms during recession. We see the same thing in equity markets they bottom during recessions. So if investors can maintain their discipline and some patience and wait until we get into recession, then you're buying at a generational low in relative value for equity. So that's what I'm doing in my personal account. I'm buying bonds in here and I'm going to be patient and look at equities as a back end of 2023 trade. 

Bryce: [00:28:16] Those that are listening at home, thinking about where they can put money in the bond market. If you had to pick an investment, what would you be picking right now? 

Bob: [00:28:25] Yeah, so and I'm just going to tell you where I'm putting my own money. We run an income fund, Jp morgan income fund. It's looked at across the global bond markets for the best value and we're trying to optimise yield. So where it makes sense to buy government bonds, we'll buy them. We're getting paid to own corporate bonds will hold them where we feel that it does make sense to own some high yield below investment grade bonds. We'll buy them. We've got a yield on that fund of over 6%. I think it's pretty conservative priced and I think it's conservatively invested. When I look out over the next couple of years, that's the kind of fun I'm expecting to generate double digit returns. 

Bryce: [00:29:17] Well, Bob, that does bring us to the end of the interview in the episode today. We've thoroughly enjoyed chatting to you. As we said at the top, it's an asset class that we haven't really had, not the opportunity but the the need to talk a lot about. So I'm glad we could get someone with such expertise in the studio with us. So it was great. We do finish with one more question though, and every year Equity Mates holds the Equity Mates Awards, which is where we celebrate products, platforms and people that are really making markets accessible for us and our community. And as an expert, you are now in the running for the highly coveted trophy expert of the year that is voted for by our community to help them pick out Expert of the Year. If you were to win it, where would you put the trophy?

Bob: [00:30:06] I would put it in a place of honour out on our trading floor in New York.

Alec: [00:30:15] The J.P. Morgan, New York trading floor. That is somewhere that we need to be. That's very, very enticing. 

Bob: [00:30:23] You guys have been awesome. Thanks for having me on. Hopefully, I've earned the chance to come back some time.

Bryce: [00:30:30] Absolutely. And thank you to J.P. Morgan Asset Management for supporting this episode. And if you'd like more information or are interested in finding out more about what the fund was that Bob was talking about there it was the JP. Morgan Income Fund. But, Bob, absolute pleasure. Thank you very much. Hope to catch up soon.

Bob: [00:30:48] Great. Thanks, guys. Good luck in the markets to all your listeners. 

Alec: [00:30:53] Thanks, Bob.