CIE PODCAST DECEMBER

TRANSCRIPT

00:00:19:20 - 00:00:45:06

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 podcast that provides educational insights across asset classes and investment themes. Today's episode is on the outlook for 2024. I'm David Leibowitz, global strategist, Multi-Asset Solutions and host of the Center for Investment Excellence. With me today is Arjan Menin, also a global strategist in our Multi-Asset Solutions business for JPMorgan Asset Management.

00:00:45:17 - 00:00:47:06

ARJUN MENIN

Arjun, thanks for joining me today.

00:00:47:20 - 00:00:49:02

Speaker 2

Thanks for having me. Great to be here.

00:00:49:11 - 00:01:16:21

Speaker 1

Well, I'm excited to have the. I'm excited to have this conversation. Obviously, 2023 didn't shake out quite the way people had expected. Much better than expected, particularly from a risk asset perspective. A lot of questions about 2024 people seem to be embracing the idea of Goldilocks or perhaps a soft landing. People are very bullish on risk assets. You've seen relative stability and interest rates, although things have backed up here over the past couple of days.

00:01:16:21 - 00:01:41:07

Speaker 1

And so what I'm particularly excited about doing today is unpacking not only the macro economic outlook and the interest rate outlook, but then bringing you into the conversation to talk a little bit about what we're seeing across global equity markets in particular. And what I would say about our outlook for 2024 is, you know, it's relatively constructive. We we don't necessarily find ourselves in the Goldilocks camp.

00:01:41:07 - 00:02:06:18

Speaker 1

We think that getting inflation back down to 2% with above trend growth is is frankly going to be quite difficult. And if we do see that, I'm not sure that the Federal Reserve will ease the way that markets are currently pricing. But we very much see a soft landing as being in the cards and to us, what a soft landing is, is a continued deceleration in the overall pace of inflation and a move in economic growth to somewhere around, if not below trend.

00:02:06:18 - 00:02:26:14

Speaker 1

And that should allow these disinflationary forces that we've seen over the course of the past 12 months continue to play out, eventually giving the Federal Reserve some room to ease policy. When we think about the rest of the world, the outlook, unfortunately, is not quite constructive. But we are looking for a handful of things which would lead us to become more constructive.

00:02:26:14 - 00:02:46:02

Speaker 1

Really, when it comes to Europe and the emerging markets, we're looking for a turn in the good cycle, in the manufacturing cycle. If we begin to see that, we will become more constructive on the outlook for growth in those parts of the world. I'd say the one caveat there is, is around China, where, frankly, you know, Chinese equity markets have sold off quite a bit.

00:02:46:02 - 00:03:09:05

Speaker 1

They you know, if nothing else, they certainly look cheap in the current environment. But what we would really want to see out of China to become more constructive on the outlook for risk assets. There is some sort of more material stimulus coming from the government. Up until this point, it's been very piecemeal and frankly, that's led to a little bit of an inability or failure to launch for the Chinese economy.

00:03:09:10 - 00:03:33:03

Speaker 1

Growth wasn't bad last year. We got some numbers out of China last night, but not necessarily as robust as what we've seen in the past. And so where that leaves us again is with a view that if the U.S. can continue to march forward, the rest of the world should frankly be along for the ride, albeit they will likely see somewhat softer growth than what we get here in the United States from an investment perspective.

00:03:33:03 - 00:03:53:09

Speaker 1

Turning more to markets. Where does that leave us? We still see value in what we've been referring to as the financial conditions trade. That's an environment where you can lean in to both equities and duration. Now, importantly, we think the role of duration is going to shift over the course of this year. Right now we're looking at things like ten year treasuries.

00:03:53:16 - 00:04:12:10

Speaker 1

We frankly like them for the carry. We think a little bit about the role that Treasuries will play in a portfolio going forward. And we do think that as growth slows here and investors become more focused on the outlook for growth itself, that duration position may evolve into more of a hedge against a more material deterioration in growth.

00:04:12:10 - 00:04:37:04

Speaker 1

So taking bonds for the income today, but owning those high quality bonds as a hedge against weaker than expected growth. As we look ahead over the remainder of 2024 and more so into 2025 when it comes to carry assets, we think investment grade looks relatively rich from a valuation perspective at the current juncture, but continue to see value in things like high yield parts of the emerging market debt complex as well.

00:04:37:07 - 00:05:00:21

Speaker 1

And really owning those assets. We're not looking for significant capital appreciation more so owning them for the carry in. That's particularly the case when we look at U.S. and European high yield. The elephant in the room, though, after a very, very good year for U.S. equities is what lies ahead. You know, a lot of times at the beginning of the year, people talk about their expectation being for mid-single digit returns.

00:05:01:07 - 00:05:20:19

Speaker 1

That actually never materializes. Right? You end up with very good years, some lackluster years, the average shakes out there. But those years are very rare. So let's dive in and talk a little bit about what to expect from equities. I want to start with the U.S. and then move on to the rest of the world. Much better than expect, much better than expected year in 2023.

00:05:21:11 - 00:05:29:18

Speaker 1

What's your outlook for U.S. equities in 2024? In particularly, what's your outlook for corporate profits, which seem to be on the up and up over the course of the past couple of quarters?

00:05:30:18 - 00:05:57:00

Speaker 2

Yeah. David, Absolutely right. I mean, it was a very optimistic November and December post CPI. We saw equities rally very sharply towards the end of the year. In our view, going from pricing in a soft landing to going to more of a Goldilocks type of environment. But overall, we think in 2024, our forecast is for the S&P to be around the 5000 to 5100 level.

00:05:57:09 - 00:06:18:13

Speaker 2

So that implies about high single digit total returns. I know you said that sort of where the average turns out, but when we break it down in terms of the framework that we use for equities, that's that's how we get there, where we have four different pieces in our equity framework. So we have earnings, we have valuation, we have positioning and sentiment, and then we have technicals.

00:06:19:01 - 00:06:45:23

Speaker 2

So when we look at the earnings piece, we think earnings are really going to be the biggest driver of returns in 2024. So what we saw in 2023 was that valuations contributed to the most of the returns. And so in 2024, we think it's going to be earnings driving returns and we don't see huge earnings upside. But given our forecast of a soft landing, we do see positive earnings growth in 2024 and that's going to be driven by sales.

00:06:46:09 - 00:07:07:06

Speaker 2

So our forecast is for 7% EPS growth this year and that's going to be driven around 5% from sales, a little bit from buybacks. And our expectation is for margins to be flat and happy to go into that in a little bit more detail. But on the valuation side, as I said, you know, that was really the biggest driver in 2023.

00:07:07:11 - 00:07:36:12

Speaker 2

But where we are today is the market already looks quite expensive to us both in absolute terms and relative to interest rates. So we think that valuations from here should be relatively flat. So it's really driven by a handful of stocks that really take that absolute number to the very elevated levels. If we look at the equal weighted index, it's not as expensive as in the aggregate, but overall we think the valuation trade is really behind us in terms of positioning in technicals.

00:07:36:12 - 00:07:57:19

Speaker 2

We think there's a little bit of a risk there in the near term. Positioning was quite stretched coming into the start of the year. Given that we saw that rally at the end of 2023. We've seen that roll off a little bit in the past couple of weeks to a little bit more neutral levels. But still on the positioning and on the technical side, we think that could be a little bit more consolidation over the next couple of weeks.

00:07:58:22 - 00:08:04:11

Speaker 2

But overall, in the in the sort of 6 to 12 month horizon, we still think equities can go quite high from here.

00:08:04:22 - 00:08:24:18

Speaker 1

So I want to double click on something you mentioned, and that's the issue of margins. Margins have obviously been in focus not only last year, but very much so as we look ahead to 2024, a lot of people are saying, look, top line growth is going to slow, partially because inflation's coming down, partially because real activity is decelerating.

00:08:24:18 - 00:08:43:01

Speaker 1

At the same time, wage growth is still north of 4% here in the United States. It sounds like you're not wildly bullish on margins, but you're constructive on margins and you don't necessarily feel like they need to come in all that much. Can you talk a little bit more about your margin view? And furthermore, are you seeing any differentiation at the sector level?

00:08:43:01 - 00:08:50:01

Speaker 1

Anything that jumps out at you is maybe a spot where there's room for margin expansion versus areas where we may see margins continue to contract?

00:08:50:17 - 00:09:13:05

Speaker 2

Sure. Yeah. I mean, we've heard a lot that margins still need to come down. I hear that argument a lot. But looking at what we saw in 2020 to the margin contraction we saw two years ago was actually greater than what we saw during the COVID period. So there was almost 300 basis points of margin contraction already. And this is looking at the core S&P 500 margins, excluding some of the more volatile sectors.

00:09:13:14 - 00:09:32:03

Speaker 2

So we did see margins come back a little bit in 2023, but now we're basically back to those pre-COVID levels. So there was quite a bit of a rollercoaster ride to get back to where we are today. But again, margins don't look elevated to us relative to where we were in the macro environment prior to what we had during COVID.

00:09:32:13 - 00:09:57:10

Speaker 2

And so in terms of moving forward, there's two ways in which we looked at margins. First, from a top down perspective and then secondly on sectors and costs. So when we look from a top down perspective, if we look at our assumptions for soft landing, for GDP growth, for interest rates for oil and for the dollar, we come out with our forecast of 7% EPS growth, which again implies flat margins from here.

00:09:57:19 - 00:10:23:08

Speaker 2

But we took another look at margins in in a different way to get a little bit deeper into the sector level and also the cost structures of these companies. And so even though index level margins are back to pre-COVID levels, when we look at the sector level, it's really those high growth air exposed sectors that margins have expanded relative to pre-COVID, whereas other sectors are actually still below their pre-COVID levels.

00:10:23:08 - 00:10:44:17

Speaker 2

And so we think those margins for those sectors are actually justified. And going into 2024, we think those sectors will continue to deliver that earnings growth and drive returns for the overall market. Now, if we look at the cost structure, there is some differentiation where we look at standard costs and interest costs are not quite where they were at pre-COVID levels.

00:10:44:20 - 00:11:10:21

Speaker 2

But then when we look at, say, refinancing costs for companies this year with their debt maturing in 2024, or we look at the impact of wage acceleration, we don't really see those costs being a major headwind to margins. So a modest headwind, but we also forecast positive positive sales growth. And in that environment, because companies have operating leverage, positive sales growth usually translates into margin expansion.

00:11:11:05 - 00:11:35:07

Speaker 2

So if we look sort of down the income statement, we see a positive impact on margin from sales. Some headwind from SGA costs and interest costs. And so we end up from a top down perspective and from a sort of sector cost structure perspective that margins can stay at these levels where they are now. And if we look see relative to consensus or some other sell side strategists, we're actually not that optimistic.

00:11:35:07 - 00:11:48:22

Speaker 2

So we're seeing margin expansion forecasts from bottom of consensus from sell side. And so our forecasts are sort of flat to slightly higher margins from here we think is very much achievable in 2024.

00:11:49:04 - 00:12:10:20

Speaker 1

So it sounds like there's a little bit of a tug of war there where on the one hand, some of the supply side issues in terms of moving raw materials and physical goods around the world in some sectors that's begun to abate. And I know there are other sectors where it's still a little bit of a headwind. And then furthermore, kind of pushing the other way, you have these SGA costs, you have the interest costs, but all things considered, flat margins aren't necessarily bad.

00:12:10:20 - 00:12:34:21

Speaker 1

Again, with wage growth north of 4%. I want to look outside of the U.S. for a couple of minutes. And, you know, FAA has been a frustrating and disappointing trade for a lot of investors over the better part of the past, you know, not just this cycle, but the prior cycle as well. We talked a little bit about what we want, what we want to see to get more constructive on Europe in terms of turning in the good cycle.

00:12:34:21 - 00:12:43:08

Speaker 1

But when you think about Europe versus Japan, do you have a preference between the two regions? And furthermore, you know, I'd love to get a sense of of why that may be the case.

00:12:44:10 - 00:13:09:14

Speaker 2

Yes. Another question that that we've gotten a lot over the past couple of months, especially, you know, given Japan's outperformance in 2023. So we hear a lot of optimism on Japan and we would agree going forward because again, when we break down sort of the drivers of returns, when we look at fundamentals, valuation, positioning and technicals, Japan just screens to us as as much more attractive than Europe.

00:13:09:14 - 00:13:33:19

Speaker 2

So starting off with the fundamental piece, our forecast is for above trend Japanese GDP growth in 2024, which is really in contrast to our forecast for other regions. And so when we have that domestic growth that should support Japanese companies earnings, but also there's an upside risk from the reflation trade. And so we'll get results on the wage negotiations over the next couple of months.

00:13:33:23 - 00:13:59:16

Speaker 2

And so if we do have that reflation story in 2024 actually come to pass, that would boost earnings even more than what GDP would suggest. So that's on the earnings side. Now, if we look at valuation, I'd say, you know, the valuation trade for the U.S. was over in 2023, but I'd say that's pretty similar to most other equity regions around the world, where valuations expanded a lot last year.

00:13:59:22 - 00:14:24:07

Speaker 2

So if we look at Europe and we look at Japan, valuations are pretty much back to average to slightly above average levels. But from here to see valuation expansion, I think the story in Japan is a lot more ripe because of corporate governance. And so what we saw last year is that corporate governance actually boosted companies that responded to the TSC a lot more than the overall market.

00:14:24:07 - 00:14:51:03

Speaker 2

So if that continues to happen in 2024, there could be that valuation upside for Japanese equities. Even though we saw that expansion in 2023, whereas in Europe we don't really see that upside case for valuations. And then finally, on positioning. So even though sentiment on Japan is quite positive and as I said, we've heard a lot of optimism on Japan recently, we haven't really seen that flow into the actual data on positioning.

00:14:51:03 - 00:15:12:10

Speaker 2

So if we look at institutional investors, if we look at retail investors, if we look at foreign investors, we are not seeing those real flows into Japanese equities, especially relative to previous times of optimism around corporate governance. And so if we do see that real money start to flow through, we think there's a lot of upside there to Japanese equities.

00:15:12:10 - 00:15:37:20

Speaker 2

And then finally, on the technical side, we've seen Japanese equities break through some key resistance levels over the past couple of weeks. It's outperformed a lot so far this year. And so we think there is continued upside for Japan relative to Europe, where, as you said, we need to see a real pickup in the manufacturing and good cycle to see that earnings benefit, especially if valuations are not at very cheap levels at the moment relative to history.

00:15:38:02 - 00:15:54:08

Speaker 1

Well, clearly, Japan is going to be in focus for for those of you who tuned into the last episode, you'll remember I had a portfolio manager on from our international equity group and he was painting a little bit more of a bearish case for Japan. And so continuing that theme of tug of war, you know, it sounds like there are things working in favor of Japan.

00:15:54:08 - 00:16:11:18

Speaker 1

There are some things that may be working against Japan, if nothing else. I think that this is going to be a key area of focus for investors over the course of the next 12 months. And, you know, finally, maybe bringing our conversation to a close, I want to touch on on m And, you know, China has sold off aggressively, as I mentioned at the outset.

00:16:11:18 - 00:16:25:16

Speaker 1

If nothing else, Chinese equities are currently looking cheap. How are you thinking about M What are some of your expectations for this year? And, you know, similar to the case around Europe, what would you want to see to get more constructive on that asset class?

00:16:26:09 - 00:16:49:22

Speaker 2

Sure. Yeah, I totally agree on the cheapness of of especially of Chinese equities and positioning looks extremely light at the moment. But in terms of what would get us excited about Chinese equities in particular is we're looking for a catalyst at the moment and we're just not seeing that come through at the moment. So there's three potential drivers of a of a catalyst for Chinese equities this year.

00:16:50:10 - 00:17:16:21

Speaker 2

First is policy easing and we really haven't seen enough policy easing so far even to support the 5% growth target for 2024. And so we really need to see more money flow through into the Chinese economy as a potential catalyst this year. The second would be a stabilization in the property market. So the data, the data have continue to be quite weak property accounts with 25% of Chinese GDP.

00:17:17:00 - 00:17:37:22

Speaker 2

And so if we see a stabilization there that could potentially support a rerating of Chinese equities or the last could be a sustainable improvement in earnings. And so that would come from the manufacturing cycle or the good cycle, which again, we we've seen some stabilization in the macro data, but we haven't really seen that flow through the earnings data yet.

00:17:37:22 - 00:18:15:18

Speaker 2

So we'd have to see that sustainable improvement in earnings for us to get a little bit more excited, particularly on Chinese equities. Now EEM ex China is starting to look a little bit more interesting to us because some of those secular policy worries that we have for Chinese equities particularly is doesn't fully apply to China. And so if we do have again, more sustained earnings improvement in the same ex China region and we've seen some improvement on the tech cycle, semiconductor export exports have, you know, started to improve there and so if we see that continue to flow through this year, I think we'd get a little bit more optimistic on M Ex China.

00:18:15:18 - 00:18:31:08

Speaker 2

But you know, if we compare that to the U.S. and Japan, you know, our preference is still very much for U.S. equities given that fundamental strength and Japanese equities given some of those more secular drivers. And so we're still overweight those two regions relative to. Yeah.

00:18:31:17 - 00:18:55:20

Speaker 1

I think that makes a lot of sense. And all I would add on on the China front is not only do we have a lack of sufficient easing, we have a policy that continues to crack down on certain parts of the economy and that has created an additional headwind. There were some articles flying around this morning that allude to this really leading the Chinese equity markets and the economy to a certain extent, to really struggle to re accelerate to the levels that I think a lot of investors are looking for.

00:18:55:20 - 00:19:15:04

Speaker 1

So Argent, first of all, let me just thank you. This was fantasy tech and thank you all for joining us today on JPMorgan's Center for Investment Excellence. If you found our insights useful, you can find more episodes anywhere you listen to podcasts on our website or on our Jp morgan Asset Management YouTube channel recorded on January 17th, 2020 for.

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