David Lebovitz: Welcome to the Center for Investment Excellence, a production of J.P. Morgan Asset Management. The Center for Investment Excellence is an audio only podcast that provides educational insights across asset classes and investment themes.

Today's episode is on Fed policy, inflation and more and has been recorded for institutional and professional investors. I'm David Lebovitz, global market strategist and host of the Center for Investment Excellence.

So it's been quite a start to 2022. Thinking back to the beginning of this year, things really started with concerns that inflation perhaps wasn't going to be as transitory as people originally thought. The Federal Reserve simultaneously came out in the month of January and made a quite aggressive and hawkish pivot relative to what people were expecting. And as we saw that inflation was going to be around for longer than people had penciled in and as we saw that the Fed perhaps was not going to be as tolerant of this above target inflation, we began to see markets become increasingly uncomfortable with the dynamic at play.

What really caught our attention and a lot of our clients' attention during the first quarter of the year was the shift in stock-bond correlations from negative territory into positive territory and again, somewhat eye-opening for a lot of investors to see their stocks and their bonds losing money in lockstep with one another.

We thought a lot about what was going on at that period of time. And taking a step back if you think about the equations for pricing a share of stock or a bond, the one common variable is interest rates.

And so the way that we think about it is correlations are unstable over time. We actually saw positive stock-bond correlations from the 1970s through the mid-1990s. And when inflation and monetary policy are in the driver's seat, that's when stocks and bonds tend to sell off together.

Obviously the bond market doesn't like the idea of a more hawkish Federal Reserve and higher rates. The equity market doesn't like the idea of a more hawkish Fed as well.

And so what's been interesting to observe is as we've watched concerns shift here, and I'll talk about this in just a couple of minutes, but as we've watched concerns shift from inflation to more of the impact of elevated inflation and more hawkish Fed on growth, we've seen that negative correlation snap back into place.

But I do think that investors need to be conscious of the risk that exists around correlations going forward, particularly given what developed in the month of March and unfortunately remains ongoing, which is the situation in Eastern Europe involving Russia and Ukraine.

The impact of all of that on commodity prices has been fairly spectacular. And while we do think that we've seen at least a local peak in commodity prices, we do recognize there is a risk of another shock, another like higher in commodity prices, which by our lights would bring that stock-bond correlation back into positive territory and investors not necessarily finding themselves with the protection that they thought they had.

And so it was a tumultuous start to the year. That's the bottom line. We have inflation that is stickier than expected, a more hawkish Federal Reserve, stocks and bonds selling off together and then the icing on the cake was very much the invasion of Ukraine by Russia at the end of February.

So with that as the way things started, let's shift gears and talk a little bit about how things are going. We can see the impact of what's going on, particularly the impact of higher food and energy prices on consumers and on consumption patterns.

More specifically one of the benefits to my seat is I'm able to look at data from the Chase side of our business. And we have seen a drastic shift in the spending across lower income cohorts, much greater focus on core, much less of a focus on discretionary. And we do think that that's going to persist for the foreseeable future.

And so we have consumers beginning to retrench a little bit as they're forced to spend more at the pump, forced to spend more filling up their fridges. We have a Fed that has come out and said that they are prioritizing controlling inflation over growth.

And so what started as a hawkish pivot and sticky inflation and Russia's invasion of Ukraine has now translated into a shift in consumption patterns, a shift in consumer behavior and a Fed that has come out and basically said, we're willing to let the economy roll over if it means that we can reign inflation back in.

So what is our expectation for the Fed here going forward? Well both the Fed and the market do see the Fed funds rate above 3% by the end of this year. And we would agree generally with the direction that markets are pricing Fed policy to move in.

We think that at least the 50 basis point hike in July is on the table in the cards. The risk there is undoubtedly to the upside. And we think that there is probably another 50 basis point hike coming in September as well. And potentially if things begin to cool off on the inflation front, we think that the Fed could return to a 25 basis points hiking cadence by the end of this year.

But, you know, the idea, and I think we might have talked about this in a prior episode, the idea that the Fed is going to take a meeting off before the end of 2022 is effectively off the table. No pun intended. And the key risk here is the same as the key risk at the start of the year, which is that the Fed over does it. And that risk is very much rising.

So we'll talk about recession risk given that backdrop. At any point in time in the United States economy, the risk of recession over the next 12 months is about 15%. We think that in the current environment that probability is closer to 40%, but we very much view this risk as being back loaded in 2022 and into the beginning of 2023.

The reality again is that the Fed is slamming on the brakes from a monetary perspective at the same time as fiscal policy is transitioning from being a tailwind to being a headwind.

And, you know, there is a lot that gets written, there is a lot that gets said about accumulated savings and $2 trillion of excess savings accumulated during the pandemic. That is going to allow the consumer to keep spending. That is going to allow the consumer to keep his head above water into year-end. But the question I'm asking myself today is whether the consumer actually decides to spend those funds.

One of the things that we've noticed again, not just in the Chase data but in the data from the Federal Reserve as well, is that the use of revolving credit is beginning to rise. We think that's frankly people continuing to sit on a little bit of extra cash and using their credit cards to fill their gas tanks and stock their fridges.

And so it does look like there is a recession on the horizon. Again we're not going to definitively make that call quite yet, but the probability is much higher than it was when we started the year. That begs the question of what a potential recession would look like.

And our expectation is still that any recession we see will be relatively mild. We always come back to the question of is there some sort of imbalance or are there some imbalances in the economy that could make a downturn particularly uncomfortable?

And we oftentimes look at the foremost cyclical sectors of the economy to really gauge that risk. And so on the consumer side, this is things like housing and autos. On the business side it is things like investment spending and inventories.

And frankly when we look at all four of those indicators today, none would suggest that there is an excess that has built up, which is going to be very painful to unwind. And pretty much across the board, with the exception of autos where auto sales remain below averages for reasons that are well understood, effectively everything else, whether it is non-residential investment as a share of GDP, inventories measured as of day of sale, residential investment as a share of GDP, these are effectively in line with their long run averages.

And so when recession comes, and we do see that risk as rising into the end of this year and the beginning of next year, we think that it's going to be relatively mild.

And we do get a lot of questions. You know, Atlanta Fed's GDPNow tracker is flirting with zero for the second quarter. We obviously had a negative print in the first quarter. Well a lot of people believe that two negative quarters of growth is what constitutes a recession and that's not necessarily the case.

It is actually up to the National Bureau of Economic Research Business Cycle Dating Committee. They are the official scorekeepers when it comes to recession. And so even if we were to see a negative quarter of growth in 2Q that would not guarantee that a recession had occurred. We need to wait for the guys in Cambridge to provide us with their assessment of the situation.

And so the bottom line here is that there are still a lot of questions that remain unanswered. What is the trajectory of inflation? What is Fed policy going to look like? When will the next recession materialize? But the path forward is becoming clearer.

That said people keep asking me what is it going to take to break the market out of this funk? And, you know, I think the reality here is that in absence of any new information, markets are going to continue to trade sideways for the foreseeable future.

So that new information, eventually we will get it. And it could be good. It could be bad. It could mean that markets begin to move higher. It could mean that markets take another leg lower.

What could go right? Let's start on a positive note. Well inflation could begin to surprise to the downside. The Fed could subsequently become less hawkish. Corporate profits, which there is obviously a lot of concern about, could prove to be more resilient than expected.

But on the flip side of that, what could go wrong? Well inflation could fail to cool as expected. That could lead the Fed to become increasingly hawkish. And as I mentioned earlier in some of my opening remarks, we could see commodity prices take another leg higher if there were some unforeseen shock to the global commodity complex more broadly.

So the reality is that everybody knows what's going wrong. What we need is something to go right. What we're dealing with is an absence of good news. But I do think that markets will become better behaved during the second half of this year.

It is also very important to remember equity markets peak before recessions start and they trough before recessions end. So just because the economy is struggling later on this year doesn't mean that things could begin to turn around in a more sustainable way when it comes to equity markets and potentially risk assets more broadly.

And so as we look ahead, how are we thinking about investing? There are a couple of themes that I would advise people to implement in portfolios as they think about navigating the back half of this year and into 2023. The first is that on the equity side, we continue to like those industries, sectors and companies that are able to generate profits in a robust nominal growth environment.

You know, if you are an industrial company, if you are an energy company, if you are a materials company, it is the nominal story that matters. If you are a tech company, it is the real story that matters.

And so we do continue to lean in to those more cyclical parts of the market, but we also recognize that given the selloff which has occurred in technology and growth more broadly, that some of these names, particularly the profitable names, are beginning to look more attractive from an evaluation perspective.

And so we're very much focused on owning assets that can provide growth at a reasonable price. We're not trying to bottom fish. We're not trying to overextend ourselves. We're trying to own companies that can generate earnings in the macro environment that we see playing out because effectively those earnings will be a safety net if markets were to take another turn lower.

On the fixed income side we continue to have a preference for securitized paper. We think that the backup in yields and spreads has created a variety of opportunities. We'd be leaning more into things like investment grade, given some of the risks that are building on the horizon. And then as always, we believe that investments in fixed income and equities should be complemented by investments in alternatives.

And core real assets, things like real estate and infrastructure, continue to look very interesting given the inflation protection, the income and the diversification that they can all provide. But we also believe there will be an opportunity for distressed and special situation investors at some point here down the road, particularly if the Fed overdoes it and knocks the economy into recession.

And so lots of continued crosscurrents here in the middle of 2022. Again, we're trying to see the forest for the trees. We recognize what's going wrong. We recognize that there is an absence of things going right. And we do think that recession risk has risen, which is really informing the approach to portfolio construction that we just covered here at the end of the conversation.

And so as always, thank you for joining us today on J.P. 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 June 22, 2022.

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