David Lebovitz: Welcome to the Center for Investment Excellence, a production of JP Morgan Asset Management. The Center for Investment Excellence is an audio podcast that provides educational insights across asset classes and investment themes. Today’s episode is on the economic reopening and has been recorded for institutional and professional investors.
I'm David Lebovitz, Global Market Strategist and host of the Center for Investment Excellence. With me today is Jared Gross, Head of Institutional Portfolio Strategy for JP Morgan Asset Management. Welcome to the Center for Investment Excellence.
Jared Gross: Thanks for having me. So David let’s start with the bullish reopening story which seems to rest on two foundations, vaccinations and stimulus. The news on the vaccination front is quite positive, nearly a majority of adults have had their first shot and a significant number have had two. We are hearing anecdotally about the pace slowing down but nonetheless a number of large cities are moving to end restrictions on indoor activity as Covid cases decline significantly, so that’s the first piece and a very positive one.
We also are seeing the effects of the Biden Administration’s Covid Relief Bill and there are aggressive plans for further stimulus via infrastructure spending though of course that still has to make its way through the congressional meat grinder. One could almost forget that we are also still getting massive monetary stimulus from the Federal Reserve at the same time, so that’s the second piece.
Maybe we'll just start with your outlook for the economy for the remainder of 2021 and into 2022. Is there a lot left in the tank at this point or do you think growth is going to stave later in the year?
David Lebovitz: In terms of the story here in 2021 I think you’re going to see economic activity continue to accelerate over the course of the next couple of months and arguably into the end of this year and the beginning of next year as well.
We do recognize that there are limits to how long the economy can really grow at an above trend pace given constraints related to productivity and demographics, but the combination, Jared, as you’ve noted, of an economy that’s opening back up, people that are getting vaccinated and a significant tailwind from both monetary and fiscal policy, it’s really tough to fight the reopening story and we do think that this could be the best year for economic growth in the United States since the early 1950s.
Now what I'll say about the rest of the world, you know, Europe is lagging the US in terms of vaccination and emerging markets are obviously in somewhat of a tough spot, particularly places like India and Brazil. We do think that the European story is delayed rather than derailed and we will see that economy begin to fire on all cylinders into the end of this year. The EM story may lag a bit beyond that but generally spillovers from the United States to the rest of the world are far more impactful than spillovers from the rest of the world to the US. And so I do think that there’s an element to all of this whereby a very robust US economy brings everybody along for the ride and we do think that by the time we get into the first quarter of 2022 we'll be in an environment of fairly synchronized global growth.
But the road ahead of us is not without bumps and twists and turns. I think last week’s jobs report serve as a reminder here that things aren’t necessarily going to proceed in an uninterrupted fashion and serves really as kind of a checkpoint for investors in the sense of they need to recognize that GDP is bouncing back very quickly, employment is going to lag that to an extent and more broadly that the capital markets are very different from what we're seeing in the real economy.
And we got a string of very positive economic reports over the past couple of weeks. We've gotten some very good corporate profit data for the first quarter. The markets aren’t really reacting to that and a lot of clients have been asking us why. I mean the reality of the situation is that there’s already a lot of very good news in the price.
I would go as far as to say that what we've seen over the past 12 months in terms of the pricing of risk assets, the repricing of risk assets as we've worked our way through the pandemic is really pricing in what we're seeing today. And I do worry a little bit about what markets might sniff out here as they look at 2022 and look at 2023 but in general we are of the view that the economic recovery is still very much on track.
Jared Gross: Okay so the economic backdrop is looking very constructive. I think you’re spot on there. If there is a potential fly in the ointment it may be the widespread signs of emerging inflation. So spend a minute breaking down what we're seeing and I think it’s important to try and separate anecdotal evidence from potentially more worrisome long term underlying trends. So give us a flavor of what you think about inflation right now.
David Lebovitz: Exactly it’s really a question of cyclical versus structural. And, you know, the way that I think about cyclical inflation is it’s kind of like economic sweat. If you go to the gym and you run on the treadmill for 20 minutes chances are you’re going to perspire. If you’re an economy like the US that’s capable of growing it 2% in the long run and you grow by more than 7% in a given year you would expect a little bit of inflation to materialize.
And so, you know, the inflation that we're starting to see here in the United States and really across the developed world and we do think inflation will pick up over the remainder of 2021, you know, a lot of this is the function of mismatches between supply and demand.
Obviously we see what’s going on with goods pricing and bottlenecks. There’s some really interesting work that’s been done which basically says look if you used to spend $100 a month and you split that $50 on services and $50 on goods because you haven’t been able to consume services at the same case during the pandemic you’ve consumed goods, you spend $100 on goods.
And so a lot of this does feel like it’s transitory and there are really four big things that we think have weighed on inflation from a more structural perspective over time and very well could weigh on inflation here going forward. And those are things like demographics, income inequality, globalization, technological adoption, the way that we've embraced technology in order to continue working over the past 12 months arguably could lead to a boost to productivity going forward and help some of those more cyclical transit inflation run their course. But again, you know, absent the implementation of more progressive policies by the government a real retrenching on the globalization front, we don’t really see how this inflation that we expect over the course of the next 12 months proves to be anything more than transitory.
But there was something that caught my attention in the jobs report last week that I think is worth teasing out, wage growth was very robust and it does look like employers are being forced to kind of entice workers to come back into the labor force by paying higher wages. Actually if you look at on a year over year basis while controlling for sector MIPS wage growth was something to the tune of 8% in the month of April. That’s obviously a number that we haven’t seen in quite some time.
And I do think that another risk that we need to monitor as it pertains to the more structural outlook for inflation is really what happens with wages here going forward and particularly what happens with policies around a minimum wage in the tune of $15 in the United States.
So our base case view here is that inflation is going to be transitory. We would agree with the Federal Reserve but we also recognize what has held inflation back over time and we're watching all of those things very closely because we begin to see a shift in that broader dynamic that may suggest that inflation is a bit more persistent than what a lot of people have currently penciled in.
And so that’s the view from our vantage point, growth should be pretty good, we're going to see some inflation but it’s not necessarily going to be a return to what we saw back in the 1970s.
Jared maybe turning things over to you, we know that most forecasting whether it’s capital markets or economics really grounds itself in views on growth and inflation but obviously the key variable that kind of links those two things together is an outlook for the central bank.
And so the inflation question is one that I get all the time. The first derivative of that is what does it all mean for the Fed and so how are you thinking about the Fed’s current policy stance? How are you thinking about their reaction function as it pertains to inflation and what do you think the impacts will be on markets when the Fed eventually does start a signal that it’s getting ready to move to the exit?
Jared Gross: Yes thanks David. From a financial economics perspective inflation is usually priced into financial assets. And so what we worry about as investors is surprises to the expectation, either to the upside or to the downside that could reprice assets. And we don’t have a lot of history to go on with a Fed that is actively trying to encourage inflation. That is really a new feature.
And I think starting with Yellen’s recognition that the 2% target was somewhat flexible and now the more kind of fleshed out Powell doctrine that they’re willing to let the inflation rate run well above the 2% for a period of time in order to get the economy going, we're starting to get some clarity around how the Fed is thinking about this.
In the near term what investors care about most is the path of interest rates. Most investors don’t own a lot of inflation-sensitive assets, they don’t have directly inflation-sensitive liabilities and so you really have to filter this through what does this mean for my portfolio and the first sign of impact is going to be on fixed income assets.
And right now you’ve got the Fed using its policy levers to put a sum on the scale to keep rates low and sort of increase the value of fixed income assets, reduce yields across a wide spectrum of the fixed income market. So on one level you look at the inflation expectations, you look at the level of yields and you say something is mispriced here but of course that’s an intent, that’s the Fed’s policy as we say, it’s a feature, it’s not a bug.
What you then have to consider is what does the unwind look like. Will the Fed be able to engender a calm and measured unwinding of current policy and avoid the sort of elephant in the room which is the Taper Tantrum 2 and will something of that nature occur a second time.
As of now the markets are pretty calm, about where Fed policy stands. I think to your point there is going to be a spike in inflation, some of that is from base effects last year, some of that is from a legitimate move upward in commodity prices and wages and so forth. And so as we kind of get more data on that we're going to have to assess the Fed’s stance relative to that data and they are currently projecting the kind of spike in inflation that comes back down and they’re willing to hold the line with rates where they are and that’s going to be tested.
And you’re starting to see a little bit of fissures developing even within the FOMC and within the broader Fed Board of Governors. And you had fissure from Dallas make some relatively hawkish comments more recently balanced by Evans and Kashkari making more dovish comments. Obviously the unified message coming out of Washington from Powell and Clarida it’s pretty clear that they expect to remain on hold.
But this overall mix of policy has driven investors towards riskier assets which is partly by design and is intended to be a stimulative movement within the economy. So that then again brings you back to what happens as this starts to unwind.
The first phase of the unwind which I think most people project into late this year or next year is going to be some sort of a tapering of purchases along the yield curve assuming that growth and employment continues to improve and see some signs of stability in the economy. That’s going to have a hopefully modest effect on those specific asset pools that they’re buying into, potentially credit, mortgages, treasuries and they’re probably going to start further out on the curve and kind of walk it back in.
What you’d be concerned about is if the expectation is that the Fed is behind the curve on inflation if rates rise meaningfully and that starts a broader repricing of risk assets not just within fixed income but within equities and potentially even into more sort of private alternative assets classes that rely on low cost financing and leverage and so forth.
So right now I think it’s steady as she goes. I think as an investor you probably want to be a little underweight duration. Credit looks fairly stable at this point with a lot of liquidity in the system but there are reasons to be concerned that the Fed is at least positioning itself to wind up a little bit behind the curve and they may feel like that’s almost by design but the markets may ultimately say otherwise.
David Lebovitz: I think that that’s right. And I think you mentioned some of the divisions beginning to emerge out of the Fed. Let’s not forget what everybody’s favorite Chief Market Strategist Yellen said last week about the need for rates to rise here going forward. I thought that that was an interesting statement that you then saw her kind of try to walk back.
But nonetheless Jared you made a really good point which is that the Fed is banking on the idea that inflation is not going to be a problem. And the Fed is also banking on the idea that if inflation becomes a problem they have the tools that they need to get things back to where they’d like it to be. And I think that those are fair assumptions, they are significant assumptions and that makes them significant risks to the outlook.
And so what we really need to think about is what might a Fed mistake look like. In the times that I've been doing this job the Fed has never really gotten it quote-unquote right. You know, they’ve either been behind the ball, they’ve been a little bit ahead of things, they haven’t been in line with the market. And so I think the risk here is that you one, see continued division in the messaging from the Fed and that makes it increasingly difficult for investors to gauge really what the direction of travel is.
And taking it one step further forward guidance is the only thing that they have left. I mean there are very few arrows that the Fed still has in its quiver, I don’t think they want to move rates into negative territory. I don’t think that they want to ramp up asset purchases further and so it’s really about sending that reassuring message that’s going to be what dictates the efficacy of Fed policy here going forward.
And so, you know, I think it’s important that they really try to hold their ground as much as possible and present that unified view because there is going to be an angle of all of this where the pockets of inflation you’re seeing, you know, those stories, those anecdotes really could begin to gain momentum.
And you could hear other parts of the government begin to try to get involved in Fed policy, we obviously saw that under the prior administration. I don’t think it would necessarily look exactly the same but even just what Yellen said the other day, I mean it’s very, very strange for a treasury secretary to be commenting on Fed policy in that way.
And so I think the base case view here is that they start tapering at the beginning of next year, they hike rates at the beginning of 2023. Again that’s a little bit more dovish than the market, a little bit more hawkish than the Fed but if they can telegraph that timeline I think that markets will be able to take it in stride.
The risk is that investors get nervous about inflation and the risk is that investors begin to question what the Fed can and cannot do going forward. And so to me I think we got a little bit of a preview of what a taper tantrum might look like earlier on this year when you saw long term rates move sharply higher in February and March.
The risk during the back half of this year is that the story around reopening is so positive and you continue to see prices rise on the back of this mismatch between supply and demand and the Fed becomes a little bit uncomfortable in that dynamic and you see markets begin to price in what they expect is going to happen rather than what the Fed is telling them is going to happen.
So really watching that alignment or lack of alignment between what investors believe and what the Fed is suggesting is actually going to do. And so if we saw something like that I think that it calls into question how to think about asset allocation in an environment where that is very clearly a risk we haven’t even really touched on the subject of asset prices.
The Fed has acknowledged that risk assets look expensive and I think to your point earlier Jared, you know, some of that is by design but that obviously means when assets are expensive there’s less room for a mistake.
And so last year was a year in the sense that the economy was in a really, really bad place but markets were willing to look through that, how are you thinking about asset allocation in 2021 where effectively it’s the opposite, the economy’s really good, markets are fully priced and the risk that the Fed makes a mistake is arguably at its highest level in at least the past couple of years. So how do you kind of square that circle from a portfolio perspective?
Jared Gross: Yes it’s interesting, you know, your comments I find a little amusing that it was Governor Brainard who made this point about the markets being stretched and valuations being high and, you know, I think the Fed likes to point that out without acknowledging their own responsibility for causing these types of asset price bubbles.
But nevertheless where are we? We are at a point in the markets where asset prices really across the board are fairly rich. Certainly in any sector where the Fed has a direct ability to influence markets and obviously in sectors that are broadly sensitive to declining interest rates that’s going to be a major impact on pricing.
So you’ve got the forward looking returns for a diversified public market portfolio are pretty dismal right now. You know, you’re talking about a 60/40 portfolio returning somewhere between 4 and 4-1/2% on a forward looking basis. That’s a long term nominal return, clearly well below history, clearly well below what many investors want or need and, you know, that’s going to drive people to look for other solutions.
But if you break that down into its components fixed income right now, interest rates are still incredibly low by historical standards. Obviously they’ve normalized a little bit off the lows from mid-2020 but still trading I think well below expected inflation across most of the yield curve and there’s clearly room for those rates to rise further in the event that the positive reopening story and the inflation story takes hold so hard to look at traditional fixed income sectors as being particularly attractive at this point.
There’s a question as rates move higher, as bond yields move higher at what point does that start to become a drag on other risk assets either from a sort of more bond love perspective that higher interest rates are just sort of bad for economic activity or from more of a portfolio perspective which is simply that the draw of higher yields will pull capital out of other categories of investment and into fixed income.
Right now the Barclay’s aggregate or the Bloomberg aggregate is still trading below 2%. I think until you get north of that number it’s probably hard to see a lot of strong pull from fixed income assets relative to other forms of investment but that’s something to be mindful of. There will come a point where fixed income becomes relatively speaking more attractive and prices elsewhere will adjust and usually they adjust downwards.
Stocks right now are rich, current P/E ratios in the mid-20s are not indicative of strong future returns. And despite the sort of relatively benign economic forecast and the relatively strong corporate profitability that we've seen a lot of that is priced in as you said. Asset prices have risen aggressively off the bottom of last year and so you have to wonder how much of that is already in the price.
And if we do start to see persistent inflation and higher wages for sure that could put a crimp in corporate profitability as well. So those things are not conducive to strong portfolio returns going forward so what do you do in response to this?
Well across the traditional liquid markets asset management is essential, cap weighted fixed income is usually a bad idea and passive bonds are going to just expose you to the most indebted, most issued names. There’s a lot of opportunity still within certain sectors.
I think particularly as you go outside the more traditional spaces into things like preferreds, convertibles, high yields, and more into sort of the mezzanine parts of the capital structure if you’re talking about structured credit there’s some very attractive opportunities there to go outside the traditional fixed income space.
On the equity side I think certainly going global there’s a lot more opportunities. I think it’s a very persistent argument over time that Europe always looks cheap to the US and somehow it always does but I think there are real opportunities globally and I think that’s very fertile ground for active management.
I think with respect to alternatives there has been a lot of attention paid to alternatives over the last 5, 10, 15, 20 years. I think what’s starting to change is a pivot away from just the high long term total return sleeves, you know traditional private equity and real estate to asset classes that offer more moderate returns but much lower equity correlations and much higher income.
You know, you think about core real assets, real estate, infrastructure, transportation, these are asset classes that are driving enormous amounts of investment in the real economy and they have return and risk characteristics that are fundamentally different than those liquid market beta exposures and some of the more traditional private exposures that investors have relied on for very concentrated high returns.
I mentioned some of those things in the middle of the capital structure, hybrid investments in the mezzanine space and high yield. You can also look at derivative implementation, hedged equity programs where you’re giving away a little bit of upside to get some downside protection or increase your income.
So there’s a lot of interesting places to allocate capital right now. It’s a challenge to reach historical return targets, we often use 7% as kind of a guidepost for asset allocation and in this current environment that’s a real stretch. I mean it does require investors to think outside the box about their strategic asset allocation, about the nature of which investment categories they view as critical to move capital into, how much liquidity they want to hold in return for excess return.
It’s a very interesting environment. We talked a lot about the Fed today and what the Fed’s impact will be. I think as this move towards growth and inflation and interest rate normalization kind of ripples through the markets, again it’s going to be less about the classic kind of 60/40 categories and more about true diversification across stocks, bonds, alternatives, core real assets, hybrids and the use of active management everywhere you can to squeeze excess return out of your portfolio.
I think maybe I'll conclude it there but David anything else you wanted to add?
David Lebovitz: No I think that’s great. I think the question is do investors take advantage of the full color palette that they have when it comes to building portfolios here going forward because as you noted, you know, 60% stocks, 40% bonds is not going to cut it at the end of the day. We're going to be just thinking outside perhaps where we spend a lot of our time thinking over the course of the past couple of decades.
So Jared as always it was a pleasure. Thanks for joining us today.
Jared Gross: Thank you for having me, it was great.
David Lebovitz: Thank you for joining us today on JP Morgan’s Center for Investment Excellence. If you found our insights useful you can find more episodes anywhere you listen to podcasts and on our website, thank you. Recorded on May 10, 2021.
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