♪ jonathan: from j.p. morgan's asset management trading floor, i'm jonathan ferro. with 30 minutes dedicated to fixed income, this is "bloomberg real yield." ♪ jonathan: goldilocks dominating 2018 again. central banks say yes, predicting high-growth and low inflation. tax negotiators hours away from a congressional compromise. uneasy calm hangs over treasuries. is this the year credit fails to match a massive rally in equity? we begin with the big issue, high-growth and low inflation in 2018. janet yellen: real gdp growth is a little stronger.

the unemployment rate is a bit lower, and inflation is essentially unchanged. mario draghi: the strong cyclical momentum in the significant reduction of economics gives grounds for greater confidence that inflation will converge towards our inflation aim. yellen: i want to see it move up to 2%. most of my colleagues and i do believe it is being held down by transitory factors, but there is work undone there. draghi: an ample degree of monetary stimulus therefore remains necessary for underlying inflation pressures to continue to build up and support headline inflation developments over the medium-term. jonathan: joining me today from j.p. morgan asset management is bob michael, the global head of fixed income. lisa coleman, the firm's global head of investment grade corporate credit. great to have you with us on the

program. it is your turn to grill me. bob: don't you worry about that. jonathan: let's talk about goldilocks growth next year. we have experienced this for so long. high-growth, low inflation, and central banks staying in the game, and it is positive for risk. does that change next year? bob: what is not to like about it? i love the central banks this week. they acknowledge the higher growth. they acknowledge moderate inflation. when it came to policy, they are looking the other way. you have got very benign rundown of the balance sheet. almost no rating increases except for the fed. it is great for asset prices. certainly the first half of next year. you throw in any sort of policy stimulus out of washington with tax reform, you have got to go with it. lisa: i agree. from my perspective, what is not to like? you have got accommodative conditions. you have great growth. central banks are not raising

globally at a rapid pace. you have the fed outlining what they are going to do. i think it is ideal conditions. jonathan: it makes sense for high yields to perform? it happens. -- hasn't. why not? lisa: we have had some very sector specific issues going on, whether it is in the retail sector, people are concerned. when you take a step back and look over at where defaults are, look at the positive benefits we will see from the tax plan. double with good growth, we are in a good environment for high-yield. bob: it is not that high-yield has performed poorly. it has been ok. there is a lot of rotation and -- into equity now. if you're going to own the top of the capital structure of the company, you have to like the bottom. if you have some stimulus from washington coming through, you have to own the bottom. i think that is what we are seeing. jonathan: i spoke to someone from morgan stanley thinks credit might be topping. they think high yields might b12 -- topping and that is a warning

for the fx market. is that is something you are thinking about? bob: i don't see it. i look at credit spreads, at 370 basis points over look pretty generous for the default rate that's about 1%. if you think about some of the tailwind we will see in corporate america next year with tax reform, the reduction in the the tax rate down to 21%, that is really nice for corporate profitability. i think we have a while to go. you typically see high-yield spreads come in through 300 towards 250. jonathan: i spoke to you last time a couple of weeks ago and you sounded less bullish. what is behind the? -- what is behind that? bob: i recognize that. 570, that's a bit worrisome. we've had a good run for a number of years. the central banks are definitely taking the punch bowl away. it is a question of how much longer do i want to ride it? i think the next couple of quarters for sure. jonathan: if you think about the returns people need, 5.5% will not do it in high-yield. will they keep going down?

if you look at the capital structures and you think the financials will be ok, why be at the top of the stack? lisa: i get the point on equity, but i'm a fixed-income investor. jonathan: you've got to be somewhere. lisa: you got to be somewhere. i like high-yield. you know what i like more? a k-1's in europe. you have got an improving europe, growth is great. banks have built up capital. think about where we have come from the banking sector in europe from the crash back in 2008. you have capital ratios just under 15% for the banks we cover. why not come down in capital structure? jonathan: cocoas have had a great year. do we have more to go? lisa: i think it is the weight of money. if you think about where we are in terms of negative yields. you have a large swath of the market trading at negative yields. probably about 18%. even if you look at the central banks starting to correct that policy, we have looked at forward rates.

maybe in the worst case you have another 3% that is no longer negative. where do people go? they are looking for yield. go to the area you get the best opportunity, which is banks in europe. jonathan: a lot of people have been more constructive about europe. the economy has improved. the ecb is still in the game. when i think about how difficult it has been to push that positive asset classes across europe, yields just stay low 30 basis point on the german 10-year, multiple expansion in the xp market. it has been a difficult place to actually push through a positive view. bob: people have got it wrong. i am going to horrify you. we have been adding european high-yield in the last couple days. you know what the total yield is? 2.5%. because when you swap it back to dollars, you are getting the yield of just over 5%. i look at that. i look at what i could do in the dollar high-yield market of

equivalent credit quality. i might as well take some european high-yield backed up 50 basis points, swap it back to dollars. i have got the ecb with a dovish view underwriting the next few quarters for me. jonathan: from your perspective this is not a total return story, this is exclusively about yields. bob: i think we are going to see credit spreads back down toward 2%. i will pick up a couple percent on that. then i am going to collect the 5% carry. i have been saying all year you cannot be greedy. if you wait for these pullbacks to be greedy, you're going to miss it. we have had a pullback. that is enough. jonathan: we have had a massive rally in the last couple of years. is it not greedy to be chasing it? bob: we have had a tremendous rally in all asset classes for a while. but the ecb is the one central bank that is telling us they may extend qe beyond when they said the taper would end.

they do not foresee raising interest rates anytime in the near future. you think about the -.4%. you have got to go with it. jonathan: there might be a reprice in bunds. you have to recognize there is interest rate risk in the corporate debt market because of this method asset purchase program the ecb has conducted. you are not concerned at all about european credit? given that the ecb is stepping back not stepping up. , lisa: think about those negative yielding assets. until that point happens, you still have to find a place to go to get positive yield. it is corporate credit. the other thing to carry on from that, think about japan. japan has been the big story and continues to be the big story for us. japanese investors still can find value, albeit less than it was over the past couple of years, but they can find value by buying u.s. corporate bonds, hedged back into japanese yen. jonathan: is 2018 the year they

get away from the front end? bob: i think so. i actually think the growth looks wonderful in europe. it will put pressure on the ecb. i think you will see inflation drift a bit higher on the core rate than their 1.1% expectation. i don't know they will be able to do a continued qe in the last months of the year. three i think the focus by midyear will turn to when are they going to raise rates? jonathan: bob michele and special thank you to lisa coleman. next up we focus on emerging markets as china follows the fed's lead and tightens monetary policy. this is "bloomberg real yield." ♪

♪ jonathan: from new york city, i am jonathan ferro. this is "bloomberg real yield." at j.p. morgan asset management headquarters here in new york city for the year that was and the year ahead. in 2017, it was definitely the year for emerging markets. we have seen em credit rip higher. with us is bob michele, global head of fixed income, and joining us is pierre-yves bareau, the head of emerging-market debt. when you think about the things to fear in 2017, one of them was emerging markets. we were all thinking about this relationship between the united states and china, the potential for trade wars, and the idea you want to stay clear of em in a big way. that was a bad call. what happened? pierre-yves: growth is good for em. people forget that. when you look at history, it's

always good. in 2018, it seems it is very conducive. growth is good. moderate inflation is good. commodities is in good shape, and china is doing well. it is a good environment for em. jonathan: did investors overestimate the impact of politics? pierre-yves: it's something we need to care about in 2018. i think we should have headwinds coming to em from politics. a lot of countries, 40% of the em countries will be going through political transition. the second challenge will be the central bank normalization of the main central banks. jonathan: it was just treasury yields staying stubbornly low and the dollar was weakened and everyone ended up disappointed, and that helped drive em returns. it wasn't about em. it was about elsewhere. bob: there was some of each in those statements. emerging-market teased us all year long. it had the high real yield when

we had zero real yields in the developed market. coming out of the trump victory, the emerging-market currencies were a bit undervalued. you can pick up high real yield and get a tailwind. i think actually we did not get the trump stimulus. that was clear by the end of the first quarter. the dollar came off and emerging-market debt looks pretty attractive. jonathan: i want to tease out your review on treasuries. -- you are in view for next year on treasury. the 10-year will not come through. are you still looking for that next year? bob: we go back and forth on this, don't we? you can point to the 30-year as rallying over 35 basis points this year. i can point to the entirety of outstanding treasuries -- that is the funding rate of the u.s. government raising 30 basis point. it surprised us that yields in the long end have not gone up a bit more this year. i think certainly when there was a failure of the administration to get stimulus at the start of the year we had a revised -- had to revise our expectations.

the fed is committed to raising rates at least three more times. we will see what happens when qe winds down and we go from balance sheet expansion to contraction, and the buyers exit the market. i think you will see a bearish steepening of the yield curve next year. jonathan: can you be a treasury bear and an em bull? bob: it is the pace. right now, the developed market central banks are being overly cautious in how they normalize policy. pierre-yves: in the past two years, the fed has been hiking quite a bit, even with expectations. em has done very well. as long as central banks are telegraphing what they are doing, we need to keep in mind they have balanced the books a lot. jonathan: where do you have the most conviction around em? surprising things for a lot of people this year might have been

emerging-market europe, eastern europe. latam not great, southeast asia mixed. how are you looking at things regionally? pierre-yves: we see three big opportunities next year. we think high-yield in emerging-market. we are more or less away from the 10-year average. that is the value trade in our portfolio. we are targeting the countries where there is upgrading. south africa is part of that, and central america as well. the second opportunity is countries that are growth related. central europe and asia. we think that carry will be more of a challenge next year. carry will be less appealing. but gross is the central case. jonathan: in terms of the sector breakdown in credit, a story is technology. technology in emerging markets is something people might not have valued enough. when a lot of people think about

commodities, the story is energy and mining. is that something you are focused on? pierre-yves: that is why we are big on china. contrary to market expectation which is downbeat on china. the reason why we think this slowdown is much more solid in terms of growth. one of the reasons is this industry upgrading. the fact that more than 50% of the capex in china is going to technology oriented sectors, which makes growth in china much more robust than the market thinks. jonathan: there has been a bond route in china. why has that not bled to em? pierre-yves: i think people miss that is good news. it is news that it is happening. there is tightening, more defaults, and we think that is good news because leveraging is finally happening. china is rebalancing into the newer sectors we were talking about. it is rebalancing from the supply model to a demand oriented model. consumption is now 70% of gdp growth in china. that is the reason why with those drivers china is a much

better footing than people think. jonathan: i should be bearish on old economy china exposure? pierre-yves: china is a big factor for em. being more optimistic on china makes us very comfortable with em in general. not everything in em. we are coming to a tighter level right now. the big thing next year will be differentiation. one factor will be politics. you have the big value opportunities in local markets. a lot of countries are beyond 10% of the yield. the election will matter. it will differentiate winners from losers. jonathan: i'm assuming you share his confidence around emerging markets? bob: i do. by the way, i'm impressed with the way china policymakers have handled things. we want them to rein in credit a bit. we did not talk about the way the pboc snuck in a decorative rate hike on the heels of the fed. they are doing all the right

things. if they are doing the right things, and you got this stimulus coming out of the developed central banks, you are going to have a pretty good environment for emerging-market debt. jonathan: i believe a number of years ago they delivered a rate hike on christmas day as well. bob michele, pierre-yves bareau, thank you for joining us. next up, we have a look ahead to 2018. before we get there, a check on where bonds have been this week. twos, tens, and 30's. it is a flatter yield curve on the front and and rally the long end. bob give us the annual bond market awards next from j.p. morgan asset management. this is "bloomberg real yield." ♪

♪ jonathan: from the new york city, for our audience worldwide, i am jonathan ferro. this is "bloomberg real yield" at j.p. morgan assets trading floor. it is time for the final spread. coming up over the next week,

there will be a slew of u.s. economic data released. including housing and personal spending. you will have bitcoin futures. we won't deal with that right now. a boj decision, regional elections in catalonia, and all eyes on washington for a tax vote and a potential government shutdown. what i want to do with bob michele is something he does every year, the bond market awards. i think it is absolutely brilliant. bob: we are going to have some fun now. jonathan: we're going to rattle through them. you chose bond of the year. can you walk me through bond of the year? bob: in distorted markets you have to look for something that is most distorted. i went with the violia zeroes, a three-year triple-b rated issue. forget about the fact that they borrowed money for three years. they actually got lenders to pay them money to take their money.

it had a yield of -3 basis points. if that is not a sign of distorted markets, i don't know what is. jonathan: you took a pass? bob: we did. jonathan: lifetime achievement award? bob: got to give it to janet yellen. i actually think she is a really cool lady. she got into the fed. she helped normalize policy, and she is also the fed chair in 40 years to have a term without a recession happen. jonathan: comeback player of the year? bob: lots of potential candidates. it has got to be developed market government bonds. every time i am on, you keep telling me they have not gone up in yield. we have not had the bear market i said we were going to have. they should have. don't they know growth is where it is accelerating? jonathan: is it going to happen next year? bob: certainly by this time next year it will because the distortion by the central banks is not going to be there.

central bank balance sheet expansion turns to contraction. jonathan: unsung hero? bob: another good one. it is the yield curve. it has to be. the front end of the market went up in yield. if you're a short-term investor, it is the yield curve. looks great. what about if you're a long-term investor? you made some money. jonathan: most valuable player of the year? i want to spend a little bit of time on this. bob: most valuable player, i went with quantitative ease. jonathan: still. bob: there is a number of ways to look at it. if this were january 1, 2017, we could've put all the sectors and asset classes on the wall, throw darts at them, and the portfolio would have been up in value. are we just good dart throwers? or is there something bigger going on? the fact that central banks keep printing money, $160 billion a month. it comes into the market, ripples through. it means you don't get corrections. it is why the equity market has not corrected more than 3% this year.

jonathan: are we approaching an inflection point next year as far as qe is concerned? and its impact on markets? or is the size of the balance sheet still going to remain powerful? bob: it will remain powerful, but because the inflow will turn the way the central banks have laid it out with the ecb doing $30 billion over the next nine months, the fed stepping up its rundown to $20 billion a month in january, and it steps up every quarter. we will see with the bank of -- what the bank of japan does. balance sheet goes from expansion to contraction. when you have a correction in the market, say the summer of 2018, you will not have that big pool of money being printed that

is going to come in and support bonds and then spillover into everything. jonathan: when we do this this time next year, the two-year in germany will not be yielding -70 basis points? bob: i don't believe it will. it may still be negative. jonathan: we are going to cut this and clip it and plant next year. my special thanks to j.p. morgan asset management's bob michele, lisa coleman, and pierre-yves bareau. that does it from j.p. morgan asset management. my special thanks to them for letting us do a full hour for bloomberg radio and on bloomberg tv right here from new york. i will see you next friday at 12:30 p.m. new york time. 5:30 in london. this was "bloomberg real yield." this is bloomberg. ♪ cannot live without it.

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