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The U.S. economic outlook

The first half of 2022 saw the U.S. economy buffeted by multiple shocks including further pandemic waves, significant fiscal drag and the impact of both China’s “zero-COVID” policy and the Russian Ukraine conflict. In considering how the economic and financial landscape might evolve over the rest of 2022 and beyond, we look at these shocks one by one and then consider what they might mean for U.S. economic growth, jobs, inflation, Federal Reserve (Fed) policy and the U.S. dollar (USD). 

Shocks to the U.S. economy

After more than two years of the pandemic, most Americans are now returning to normal activities providing a significant boost to aggregate demand in the short run. Conversely, demand is being reduced by a fast-falling federal deficit. According to the latest estimates from the Congressional Budget Office, the federal deficit could fall from USD 2.8trillion or 12.4% of gross domestic product (GDP) in fiscal 2021 to just USD 1.0trillion or 4.2% of GDP in fiscal 2022. This would mark the single largest decline in the budget deficit relative to GDP since 1947 and reflects an end to a host of government benefits, many of which were particularly significant for low- and middle-income consumers, who now face a sharp rise in the cost of living. 

We do not expect any further significant fiscal stimulus from the current term of Congress, or the next one. Without this aid, we expect consumer spending, particularly on basic goods and services, to grow more slowly through 2022 and into 2023.

Inflation has soared over the past year partly because of strong demand and partly because of supply chain difficulties arising from the pandemic. These problems are being extended in 2022 with the outbreak of the Omicron variant in China and the Russia-Ukraine conflict. On the former issue, we expect China’s government to maintain a “zero-COVID” policy for most of 2022. While this may have prevented an immediate surge of fatalities, it has resulted in rolling lockdowns that have disrupted both domestic economic activity and exports.

On the latter issue, the Russia-Ukraine conflict has evolved into a protracted situation in the east of Ukraine. Disruption from the conflict itself along with sanctions on Russia have resulted in further increases in food and energy prices. However, provided there is no further escalation, global producers and consumers will likely gradually adapt to the situation. High commodity prices will likely play their normal role of promoting more supply and less demand, allowing global commodity prices to generally move sideways, or down, in the months ahead.

Lower demand meets constrained supply

The U.S. economy contracted in 1Q 2022 as the Omicron wave created genuine economic weakness. While we expect activity to rebound in the second quarter, it is also becoming evident that growth will drift lower in 2H 2022 as demand is hit by fiscal drag, a high USD, rising mortgage rates and lower consumer confidence.

What we do not expect is for demand to collapse, as there appears to be strong pent-up demand for vehicles, houses and consumer products that have been in short supply throughout the pandemic. Spending should also be buoyed by pent-up demand for travel, leisure and entertainment.

Another source of resilience will be pent-up demand for labor. At the end of March 2022, there was a record 11.55 million job openings, equating to almost two jobs for every unemployed worker (Exhibit 1).

Exhibit 1: Ratio of job openings to job seekers
JOLTS job openings* divided by unemployed persons, JOLTS lagged 1 month

Source: Bureau of Labor Statistics, J.P. Morgan Asset Management.
*JOLTS job openings from Feb. 1974 to Nov. 2000 are J.P. Morgan Asset Management estimates. Data are as of June 3, 2022.

Even if slowing economic momentum reduces job openings in the months ahead, the excess demand for labor when supply is restricted could see the unemployment rate fall closer to 3% by the end of 2023. 

Very low unemployment should contribute to strong wage gains, which in turn creates stickiness in the underlying level of inflation. We do expect some transitory forces, such as high energy prices, the semiconductor shortage and government aid, to wane in the months ahead. However, the effects of higher wages, higher housing costs due to the lagged impact of rising home prices and higher inflation expectations are expected to linger (Exhibit 2). For this reason, we expect that inflation rates will be slow to roll over and that the core consumption deflator, the Fed’s preferred inflation measure, will be above the bank’s 2% target at the end of this year and at the end of 2023. 

Exhibit 2: Contributors to headline inflation
Contribution to y/y % change in CPI, non seasonally adjusted

Source: BLS, J.P. Morgan Asset Management. Contributions mirror the BLS methodology on Table 7 of the CPI report. Values may not sum to headline CPI figures due to rounding and underlying calculations. “Shelter” includes owners equivalent rent and rent of primary residence. “Other” primarily reflects household furnishings, apparel and medical care services.
Guide to the Markets – U.S. Data are as of May 31, 2022.

One crucial assumption in our outlook is that the Fed will be patient in trying to guide inflation back to target. No doubt the Fed would prefer inflation to come down quickly, but will be aware of the significant braking power being applied to the economy by falling budget deficits, a higher USD and rising mortgage rates. Because of these economic risks and the long-term forces that should reduce inflation in the years ahead, we expect the Fed’s rhetoric to turn more dovish in the months ahead. In the near term, we expect the Fed to remain focused on controlling inflation and driving policy rates toward 3% by end-2022. In 2023, we expect some slowdown in the pace of tightening, raising rates by 0.25% only in every second meeting, although continuing the gradual reduction of its balance sheet.

The combined effects of slowing growth and a more dovish Fed will put some downward pressure on the USD, alleviating some of the strain on U.S. exports and increasing the overseas profits of American corporations and USD returns on international financial assets.

How will the U.S. midterm elections impact markets?

U.S. midterms are often a referendum on the current administration, and the president’s approval ratings are low. Therefore, a divided government seems to be the most likely outcome.

However, investors needn’t be too overly concerned over a divided government as it is the most common political configuration. Through divided governments since World War II, the U.S. economy has grown at a 2.7% pace on average, and market returns were 7.9%. This underscores a critical point for investors: Don’t let how you feel about politics overrule how you think about investing. Voters had very strong opinions about the prior two presidents, but average annual stock market returns during the Trump and Obama administrations were nearly identical at 16.0% and 16.3%, respectively.

Markets do not like uncertainty, so we typically see higher volatility and lower returns in the lead up to elections. However, election results provide the clarity that allows volatility to settle down and markets to settle up.  

International economy: Can China normalize, and can Europe avoid a recession?

As the year began, the global economy displayed solid momentum, with even brighter prospects due to expectations of both a surge in services activity, as pandemic restrictions were lifted, and a rebuilding of inventories, as supply chain stresses slowly eased. The combination of an improving supply chain and an easier base of comparison for energy prices was expected to reduce elevated global inflation levels after the first quarter.

This view was partially correct; global services momentum did pick up meaningfully outside of China by the middle of the first quarter as mobility improved. Since then, however, compounding shocks have led to downgraded economic growth forecasts and upgraded inflation expectations. The lockdowns in China now mean a second quarter economic contraction is likely and supply chains remain stressed. Meanwhile, surging commodity prices largely due to the conflict in Ukraine are creating an energy crisis for Europe. The outlook for the global economy crucially depends on whether China can normalize and Europe can avoid a recession.

China

Officials in China face an unfavorable trilemma of pursuing the “zero-COVID” policy, deleveraging the housing sector and achieving a 5.5% growth target for 2022. These conflicting goals are clearly impacting the policy response and the ability to support the economy given the severe restrictions on mobility. The question is not whether the economy has contracted as a result of the restrictions, but whether April marked a bottom and what the roadmap out of the pandemic looks like.

We see the following conditions as necessary for a more sustainable growth outlook:

Implementation of a pandemic strategy that permits a sustainable peak in lockdowns. Shanghai’s reopening experience in the weeks ahead will serve as a nationwide test for how China can find a balance in its policy objectives. The roadmap involves: 1) ramping up vaccinations, especially of the more vulnerable, 2) setting up large-scale testing and monitoring to control case numbers, 3) implementing “closed loop” work systems in factories and transportation hubs and 4) focusing on community transmission as the metric to ease individual mobility restrictions.

Laying the groundwork with large-scale policy stimulus. Concerns around leverage and capital outflows constrained officials’ willingness to ease policy at first. However, subsequent policy measures are aimed at improving both the supply and demand side of the economy. The stimulus package announced in late May had a broad remit covering fiscal and monetary policy and energy policies, as well as improving supply chains.

Weak credit demand could hinder the impact of policy easing, implying a strong focus on facilitating consumption and demand in the housing market. Such policies are in line with lifting consumer demand such as tax cuts on car purchases and lower mortgage rates for existing and new homeowners. However, a lift in demand as the economy reopens without matching supply would create its own issues. Officials are ensuring supply by supporting companies through payment deferrals on loans to small- and medium-sized enterprises (SME), social security payments and tax cuts as well.

The drop in flight and freight activity illustrates the impact on both domestic and international supply chains (Exhibit 3). Measures to ease travel restrictions from low-COVID-19-risk areas will be helpful, as will lending to the aviation industry. However, the possibility of rolling restrictions across China, should case numbers again rise, poses a risk to alleviating pressures in the supply chain, and we expect only slow improvement. 

Exhibit 3: China’s pandemic strategy will determine how sustainable May’s improvement in activity is
Index 2019 = 100, 7-day moving average

Source: OAG Schedules Analyzer, Our World in Data, Oxford University, Wind, J.P. Morgan Asset Management. Data are as of May 31, 2022.

Confirmation that the regulatory cycle has moved from “introduction” to “status quo.” China’s economy had already slowed before the rise in COVID-19 cases in March, due to the uncertainty generated by the introduction of new regulations in pursuit of “Common Prosperity” goals. Increased clarity and predictability around the implementation and enforcement of the new regulations would give companies confidence to expand, while moderating investor concerns on heightened regulatory risks. Regulators’ words have shifted to emphasizing “normalized supervision,” and we believe that we have passed the peak in regulation. But greater clarity on the current suite of changes as well as a lull in further announcements may be needed to temper investor concerns.

Europe

Europe is not unaccustomed to conflict or crisis, but the situation in Ukraine and ensuing energy crisis came at a time when the region was tipped for a period of strong growth. The region is currently eking out positive growth (the May Eurozone Markit Composite PMI of 54.9 is consistent with 2% GDP growth), but the deterioration in both consumer and business confidence may be enough to see Europe flirt with recession later this year. Thus far, current activity has been supported by solid corporate and household balance sheets, a record low unemployment rate and fiscal transfers from national governments.

Should the worst of the energy price pressures soon pass, the region may be able to weather this latest challenge. This depends on whether the European Union is able to transition away from Russian fossil fuels over time (as currently seems to be the case)—or whether it ends up doing so suddenly as a result of sanctions and/or counter sanctions. Should energy prices continue to stabilize, price pressures may be able to peak mid-year, while confidence may find a bottom and activity stays resilient. 

Global central bank policy

Lingering commodity and supply chain issues and strong services spending imply the peak global inflation outside of the U.S. may not occur until the third quarter. While global central banks have already hiked rates 81 times this year, further tightening is expected across both developed and emerging markets in response to inflationary pressures (excluding China and Japan). Central banks across Asia are likely to lag the Fed in its aggressive policy path, but will gradually raise interest rates. The lower starting point for inflation in many Asian markets suggests less urgency, while better current account positions suggest that some policymakers won’t have to act to defend their currencies. Rising food prices pose a risk given that a higher proportion of household income is spent on food in emerging economies compared with developed ones. The risk is greatest to emerging markets outside of Asia. 

Given the quick repricing of the Fed’s rate hike path at the beginning of the year, the USD surged over 5% from February to April. However, global yields have also moved higher, with the share of negative yielding debt falling from 12% of global bonds in March to 4.5% in May. The USD’s more recent leg of 2% appreciation seems to be more driven by global growth fears in the U.S., China and Europe. For the USD to sustainably peak (and eventually embark on its expected structural downtrend), investors will need to regain confidence that the U.S. can see a soft landing, China can normalize and Europe can indeed avoid a recession. 

Exhibit 4: Eurozone’s current activity remains resilient, but sentiment has taken a tumble

Source: Markit, J.P. Morgan Asset Management. Data are as of May 31, 2022.

Fixed income: How are yields and interest rates impacting core fixed income?

The hawkish pivot from the Fed has sent shock waves through the bond market, and interest rate volatility has spiked higher as a result. Investors are increasingly concerned about the trajectory of monetary policy and, crucially, if the Fed will be patient in raising rates rather than be overly aggressive in its efforts to quell inflation at the risk of slowing growth. While policy uncertainty remains elevated, particularly for 2023, the Fed has solidified its hiking path this year, suggesting it will lift the target range for the federal funds rate to 3% by year’s end.

From a performance standpoint, the first half of this year will be one of the worst on record for core fixed income. That said, most of the detrimental impact is likely behind us assuming that the full repricing of this year’s rate hikes are fully configured into bond yields. Importantly, given the Fed’s transparency, it is likely that rate volatility will fall in 2H 2022 and into next year. As we show in Exhibit 5, since 1983, interest rate volatility as measured by the MOVE index has been highest (outside of recessionary periods) in the first half of a rate-hiking cycle and comes down meaningfully in the second half. This makes intuitive sense; a decision to remove accommodative policy tends to be jarring for investors, but as a steeper trajectory for rates is priced in, rate volatility settles down. 

Exhibit 5: Outside recession, rate volatility tends to be highest when the Fed first starts hiking
Average level of the MOVE index in different policy cycles, 1983-present*

Source: Federal Reserve, Haver Analytics, J.P. Morgan Asset Management. Cutting/recession periods are calculated from the first rate cut to the last rate cut or recession end, whichever occurred last. *From Jan. 1983 - Apr. 1988 (inception of MOVE index), a regression model is used based on a
30-day standard deviation in daily changes in the U.S. 2-, 5-, 10- and 30-yr. Treasury yield; the r-squared = 70%. Data are as of May 31, 2022.

As interest rate volatility settles down, bond yields should be better behaved, and investors should look to take advantage of the dramatic repricing year-to-date. The move higher in rates and credit spreads has led to some of the most attractive yields/valuations seen in recent years. Exhibit 6 shows current yields for major fixed income assets relative to the past 10 years. It is evident that core bonds are at their highest yields relative to recent history, and given the very tight relationship between current yields and subsequent performance, bond investors can expect relatively attractive returns from these assets over the next few years. 

Exhibit 6: Yield-to-worst across fixed income sectors
Basis points, past 10 years

Source: Bloomberg, FactSet, J.P. Morgan Credit Research, S&P, J.P. Morgan Asset Management. Indices used are Bloomberg and S&P except for emerging market debt and leveraged loans: EMD ($): J.P. Morgan EMIGLOBAL Diversified Index; EMD (LCL): J.P. Morgan GBI-EM Global Diversified Index; EM Corp.: J.P. Morgan CEMBI Broad Diversified; Leveraged loans: JPM Leveraged Loan Index; Euro IG: Bloomberg Euro Aggregate Corporate Index; Euro HY: Bloomberg Pan-European High Yield Index; U.S. Treasuries: Bloomberg U.S. Aggregate Treasury Bond Index. All sectors shown are yield-to-worst except for Municipals, which is based on the tax-equivalent yield-to-worst, and Leveraged loans, which is based on Yield to 3Y takeout.
Guide to the Markets – U.S. Data are as of May 31, 2022.

Even though yields have moved a lot already, we are still biased to higher yields in the later half of this year. We anticipate the nominal U.S. 10-year Treasury yield will end the year between 3.00%-3.25%, suggesting a modest move higher in long rates for a few reasons:

1. The Fed’s balance sheet reduction (quantitative tightening) and possible consideration of outright mortgage-backed security sales in 2023 should put upward pressure on long-term interest rates,

2. While realized inflation should come down for the remainder of the year and next, it may not come down fast enough to satisfy policymakers, increasing the risk of further aggressive policy rate hikes in 2023, and

3. As the Fed lifts short-term rates more aggressively than other developed market central banks, the appetite for long-dated U.S. Treasury debt from foreign investors should weaken given the rise in hedging costs.

Investors who are outright short duration and have embraced lower-quality credit in portfolios should consider edging back to a more neutral position and increase the quality of bonds they own. Moreover, an active approach to fixed income is critical at this juncture; rates will not move in a straight line and active managers have a broader ocean of bonds in which to fish.

U.S. equities: The importance of profit growth in a rising rate environment

Markets have been under pressure since the start of 2022 as elevated inflation, a more hawkish Fed, slower growth and geopolitical tensions have all weighed on both valuations and investor sentiment. In fact, the S&P 500’s forward price-to-earnings (P/E) ratio has declined to 15.8x from a peak of 20.9x in early 2022, and now sits below its 25-year average.

Exhibit 7: Equity volatility has been driven by a re-rating in valuations
S&P 500 price return decomposition

Sources: FactSet, Standard & Poor’s, J.P. Morgan Asset Management. Data are as of May 31, 2022.

With the Fed set to continue normalizing monetary policy over the coming months, equity market volatility will likely persist and valuations will likely remain under pressure, leaving corporate profits as the primary driver of returns. Although 1Q 2022 earnings were better than expected and consensus earnings estimates have steadily risen so far this year, the outlook for profits rests on the ability of companies to defend margins.

There are three levers that companies can pull to offset margin pressure: reduce costs, pass costs along in the form of higher prices or focus on automation and efficiency. In the current environment, businesses seem inclined to embrace all three. We have seen hiring freezes and layoffs in sectors like technology, whereas costs are likely to be passed on in the industrial, energy, material and consumer staples sectors. Across the board, we expect a greater focus on productivity, which could potentially be supported by some of the investment spending we have observed so far this year. Margins will decline from their 2021 highs, but should stabilize in the mid-12% range, barring a more significant downturn in the economy.

Exhibit 8: Margins will decline from all-time highs, but seem unlikely to collapse
S&P 500 operating profit margin

Source: Compustat, FactSet, Standard & Poor’s, J.P. Morgan Asset Management. Past performance is not indicative of future returns. *1Q22 operating margin is an estimate from Standard & Poor’s based on 97.1% of the S&P 500’s market cap having reported results. Data are as of May 31, 2022.

From a size and style perspective, we have a preference for large caps but believe there are opportunities across both value and growth. On the value side, greater operating leverage should support earnings and cheaper valuations should be less sensitive to any further rate increases. At the same time, the sell-off so far this year has left valuations in the more profitable parts of the growth complex looking attractive, and we anticipate that investors will rotate back into these names as interest rate volatility subsides and economic growth begins to slow. At the end of the day, we are inclined to focus on those sectors and industries that are able to continue growing profits in the macroeconomic growth environment we project, while simultaneously being mindful of valuations given elevated inflation and hawkish central banks.

Europe equities

Headwinds from geopolitics, higher bond yields, elevated inflation and recessionary fears continue to weigh on the market. However, the current European reporting season has been coming through surprisingly well. Having said that, the weakening macro environment may put more pressure on earnings growth going forward, especially as companies may be less well placed to pass on higher costs, given potential weakness in consumers’ disposable income. The tail risk of energy supply shortage may also remain an overhang. 

Nevertheless, European equities continue to provide opportunities for diversification and return generating potential with sector and company selection remaining key. Another reason for active management when investing in European equities is the role of environmental, social and governance (ESG) investing in Europe. ESG investing is already much better established in Europe, and this implies companies that have low ESG ratings could face a greater risk of being excluded in portfolios. This factor may not be properly represented in traditional equity benchmarks. On a more positive note, the same applies to some of Europe’s “green technology” leaders that could contribute positively to reduce greenhouse gas emissions.

Asia equities

Asia performance so far has been dragged by valuation de-rating and margin underperformance. At a >30% discount, Asia now trades at close to the largest discount compared to the U.S. However, Asia equities fared better than developed markets year-to-date given the increasing expectations for improving economic fundamentals in Asia. The MSCI Asia Pacific ex Japan index fell 15.1% this year compared to the -20.8% for MSCI Europe (total returns in USD) or -21.1% for the U.S. S&P 500. The improvement in COVID-19 development, coupled with gradual re-opening of more Asian economies should provide a significant boost to domestic services consumption. In particular, tourism-dependent Asian economies will continue to benefit from the return of people flow, as seen by the outperformance of the Association of Southeast Asian Nations (ASEAN) (-8.7% year-to-date).

Moreover, net commodity exporters like Indonesia and Malaysia have been relatively more insulated from higher oil and gas prices. 

Looking ahead, the earnings upgrade should be concentrated in these regions, especially for cyclical sectors serving their domestic markets. Asian economies are less vulnerable compared to 2013-2014, with healthier current account balances capable of withstanding capital outflow. Most of the Asian central banks have also been preemptive in their rate hikes, which limits the widening of rate differentials and thereby limits the weakness of their currencies. Inflation readings over the next few months will be key in calibrating the degree of policy tightening within Asia, but we expect the Asian central banks to hike in an unhurried manner given relatively higher real yields relative to the U.S.

China equities

Crucially, for Chinese equities to sustainably escape their recent correction, investors need to regain conviction and confidence about the China market. Investor conviction and confidence will be restored when more detailed policy implementation plans and a clear pandemic-exit roadmap are laid out, which should help unlock equity market performance. On regulations, the government will have to demonstrate being predictable and transparent when making changes in real life, and this could take time. Financial performance in the quarters ahead would help investors determine how these rule changes will impact their long-term earnings potential.

The +50% recent correction saw MSCI China’s multiple contract 37% from the January 2021 peak, leaving current valuations below China’s 20-year average. This de-rating means investors have not had an opportunity to buy Chinese equities at such a discount since the late 2018 correction. Relative to other markets, Chinese equities now offer a near-record discount to U.S. equities of 39% (nearly double its average discount of 23%). Given the global regime change in monetary policy, valuations matter again and investors are starting to be enticed by discounted Chinese valuations (in addition to its higher potential long-term returns). 

There may be more earnings downgrades in the period ahead and around the 2Q 2022 earnings season. However, opportunity will emerge once the current round of earnings downgrades are largely done. We remain constructive on sectors with policy tailwinds such as renewable energy and decarbonization, as well as consumer goods and services that benefit from stronger income growth for the lower income group.

Alternatives: How are alternatives continuing their transition to an essential portfolio allocation?

The first quarter of the year saw stocks and bonds sell off in lockstep, as fears of inflation and a hawkish pivot by the Fed sent yields higher and equity valuations lower. While both fixed income and equities have come off from stretched valuations, alternative assets, whether infrastructure, real assets or hedge funds, can still provide valuable attributes such as income generation and diversification benefits. 

Exhibit 9: Stock-bond correlations are unstable over time
S&P composite, 10-year UST yield, 12-month rolling correlations, 1900 - present

Source: Robert Shiller, Yale University, J.P. Morgan Asset Management. Data are as of May 31, 2022.

Core real assets are in focus, such as real estate, infrastructure, timberland and transportation, which have all historically provided investors with both inflation protection and income. While there are lingering concerns about some parts of the real estate market—particularly the office sector—activity has been resilient. Importantly, when it comes to the real estate market more broadly, tenants are not shying away from higher rents. 

Private equity activity has cooled against an uncertain macro backdrop, with general partners focusing less on traditional buyouts and more on add-ons, platform creation and growth equity. Furthermore, we have seen an increasing focus on the middle market as well as on the old economy sectors that stand to perform well in an environment characterized by a tight labor market and elevated inflation.

In private credit, direct lending and mezzanine debt strategies remain attractive. At the same time, we are increasingly seeing investors discuss committing to distressed or special situation funds, as there is an expectation that a backdrop of slower growth and higher interest rates may lead to an expansion of this opportunity set.

Finally, hedge fund performance should continue to improve, especially macro funds and those strategies that are agnostic to the direction of markets. Macro strategies in particular have proven to be a port in the storm given they tend to traffic less in traditional stocks and bonds, while relative value credit and equity long/short strategies have been able to take advantage of lower correlations and elevated return dispersion. In general, our work has shown that environments of greater macroeconomic volatility tend to translate into elevated capital market volatility; in these types of environments hedge funds tend to outperform traditional long-only equity and fixed income strategies.

Exhibit 10: Hedge funds tend to outperform in environments of elevated rate volatility
Hedge fund performance by MOVE quartile

Sources: Bloomberg, FactSet, HFRI, Merrill Lynch, MSCI, J.P. Morgan Asset Management. Data are as of May 31, 2022.

At the end of the day, however, we still believe that alternatives require an outcome-oriented approach. Furthermore, we recognize the ability for manager selection to make or break an allocation to alternatives. As a result, we believe that having a framework for allocating to these assets and strategies is imperative, as traditional portfolio construction methods may not be an optimal approach when constructing portfolios of alternative assets.

Cyclical location and asset allocation: How should investors position through growth deceleration?

As investors consider the rest of this year, it is clear that the backdrop for investing has changed from the beginning of 2022. Moreover, much is still uncertain, and investors face a wall of worries.

Cyclical positioning remains the foremost concern, and it should be noted how unusual this cycle has been. However, halfway through the year, the concerns have changed: no longer are investors worried about the length of the runway; instead, they are worried that the runway has disappeared. Still, investors would do well to step back from near-term concerns and focus on the bigger picture.

The impact of the pandemic on the economy continues to fade as the U.S. government shifts policy away from COVID-19 eradication and toward “cohabitation”; a high probability of divided government in the U.S. following midterm elections suggests that future fiscal stimulus will be limited; and due to upward wage pressure and ongoing supply chain constraints, higher inflation will likely linger. This economic landscape is impacting corporations, which face weaker demand alongside higher costs and a normalizing Fed. Meanwhile, the re-acceleration in global economic momentum, which once looked promising, is now rolling over very bumpy terrain. 

Despite the changes in the backdrop, there is still room to run for cyclicality and quality in portfolios.

Ongoing U.S. monetary policy tightening has pushed yields sharply higher, resulting in one of the worst years for bond investors in recent memory. However, given the possibility of a Fed “balk” in the face of deteriorating economic data, investors may consider taking a more neutral stance on duration while taking advantage of widening spreads by increasing allocation to lower-quality debt instruments.

From an equity perspective, investors should look primarily toward profitability. This favors an allocation both to quality and to some value sectors. China’s economic growth is more likely to accelerate than decelerate, even though Beijing’s stringent strategy to manage the pandemic is still a potential challenge. Nonetheless, less confusion over regulatory reform and better growth momentum should support Chinese equities. For the rest of Asia, earnings momentum from strong exports should be joined by recovering domestic demand and services sector, as more Asian governments adopt a more tolerant approach toward COVID-19. The relative valuations between the U.S. and Asia also makes Asian markets an attractive proposition. 

This changing backdrop may also push investors to further diversify portfolios. Correlations have worked in the wrong way so far this year, suggesting the need to consider a heartier allocation to alternatives, which are typically uncorrelated to public markets.

All told, the investing landscape is challenged. Given the nature of the global recovery and the shifting pockets of opportunity, the best way to approach asset allocation is to broadly diversify and work with active managers.

Exhibit 11: Investor allocations
Trailing 12-month allocation, April 2022

Source: J.P. Morgan Asset Management. Data are as of May 31, 2022.

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