Market Thoughts

The Trick Is Not to Blink

Richard Madigan, Chief Investment Officer
May 2017
 

In Brief

  • The world economy appears to be in a Goldilocks macro environment, where growth and inflation appear “just right” despite geopolitical risks
  • Valuations reflect underlying fundamentals and the Fed is likely to continue gradually hiking
  • In portfolios, we favor U.S. equity markets for their visibility and stable earnings growth
  • We favor European and developed Asian equity markets for their potential upside to earnings
  • We have reduced our target duration in fixed income and maintain exposure to credit markets

Introduction

Geopolitical tensions and a shifting policy landscape have challenged market participants’ outlooks so far this year. But, as long-term investors, we see the world economy as becoming better balanced and more stable today. Growth is improving, led by the United States and other developed markets (Figure 1). Emerging economies seem to be through the worst of the recent commodity crisis and are stabilizing–but with tremendous dispersion. In times like these, simple decisions seem difficult. The trick is not to blink.

Inflation expectations are rising globally, but not to a degree that central banks should be caught off guard. Energy prices have played a large part in the recent headline inflation bounce. In the United States, the Federal Reserve is on course for a steady tightening, while across other developed markets we continue to expect a bias to maintain accommodative policy. There are risks to our view, but a base case is important to start with. If we are wrong about the pace of rising U.S. interest rates–and it becomes more accelerated–markets may become unsettled. Currently, the economic data isn’t causing concern.

Putting policy, politics and geopolitical risks aside for a moment–I know that is asking a lot–what I’ve described as a base case outlook seems to be an almost “Goldilocks” macro environment. There is a market debate going on about current “soft versus hard” economic data. On the soft data front, expectations and sentiment have improved since the U.S. election as a parade of CEOs in and out of the White House has energized business confidence. Investor confidence, however, has remained more balanced.

With regard to hard economic data, the current macro landscape appears to be neither too hot, nor too cold. We are late cycle, but growth and inflation appear “just right.” Global fiscal stability is improving. Investors, however, seem to feel that there is a heightened risk of a market pullback or even recession. While absolute clarity is rarely possible, the easiest and most important decision to make as an investor is to separate long-term and short-term money. For long-term money, the key lies in clearly establishing appropriate investment goals, setting a risk tolerance and staying invested. Then it comes down to how much tactical investment risk to take in a portfolio, depending on where we are in the market cycle.

Anyone that walked away from markets in the first half of last year understands the point I am trying to make above. Human nature can make the simplest decisions seem the hardest. The trick is not to blink, which can prove to be difficult around volatile markets.

Politics, the Messy Art of Compromise, and Earnings

We expected politics to be a significant market distraction this year, and it certainly has been. Not only in the case of a new U.S. administration learning on the job, but the Netherlands, Turkey and France have offered political distraction, as will a June snap election in the United Kingdom. Geopolitical tensions also remain high. Unfortunately, that noisy backdrop isn’t going away soon.

Markets attached themselves too readily to what has alternately been dubbed the Trump- or reflation-trade, right after the November U.S. election. Deregulation, infrastructure investment, corporate and individual tax reform were supposed to happen almost instantaneously. We cautioned otherwise. Gravity is setting in as markets more realistically ground themselves on what can and can’t be politically accomplished, as well as the likely timing. I think it’s important to put current market choppiness in perspective. Expectations are normalizing; risks are still present.

The policy initiative that broad markets care most about from Washington is tax reform. Meaningful tax reform can make a difference for earnings growth over the next 18-24 months. In our portfolios, we favor U.S. equity markets for their visibility and stable earnings growth (Figure 2), with upside offered from potential tax reform. For non-U.S. equity markets, there is additional technical support as money that was sheltering in the United States continues to move into non-U.S. markets. We favor investment positions in Europe as well as developed Asian equity markets, including Japan, for potential upside surprise to earnings growth.

I think that arguments for any equity market being particularly cheap seem a little forced. Valuations across equity, not to mention fixed income markets, are full. But it’s important to recognize that they reflect strong earnings growth, low and relatively stable credit default risk, and a more resilient global economy.

Valuations are where they are because they reflect underlying fundamentals. That said, across small pockets of subprime debt such as auto loans, we are beginning to see modest pressure. According to TransUnion, subprime auto lending is about 15% of all U.S. auto loans and represents about $180 billion in loan balances. However, to put this in perspective, the amount of outstanding non-financial corporate bonds in the United States stands at over $5 trillion. We are watching the trend but are not currently concerned about subprime consumer debt.

Markets don’t move in straight lines. However, with a few pauses, global equity markets have essentially moved one way since the U.S. election: higher. But markets began to move up in the middle of last year because of improving fundamentals–particularly in earnings. The green shoots have been there since last June and, fundamentally, that is what is supporting current valuations.

Monetary Policy: Easy or Tightening?

Is developed market central bank monetary policy tightening or still easy? It depends on where you look. In the United States, it is very gradually tightening. In Europe and Japan, we believe the bias this year remains toward accommodative policy. And while the Bank of England continues to closely watch the inflationary pass-through from a weaker post-Brexit pound, we believe the bias is to remain on hold. In aggregate, developed market central bank monetary policy remains stimulative. That is an important backdrop for our current macro Goldilocks moment (Figure 3).

We came into this year saying that we thought the Federal Reserve would raise policy rates 2-3 times, and we continue to believe that to be the case. I personally thought the March Fed rate hike was masterful. While it wasn’t initially expected, the Fed got markets focused on the possibility of an early hike, and markets did the heavy lifting. That is how it’s supposed to work–no surprises.

What has been fascinating to watch is the current debate about whether the Fed pulled forward what was presumed to be a June rate hike because there was rising concern that inflation was getting ahead of monetary policy. Was the Fed being forced to play more reactive policy offense because it was behind the curve and had to move faster?

We believe the Fed, so far, is moving at the right tightening pace, and that the March hike was done proactively. Starting at such a low base policy rate, the faster the Fed can initially move from zero buys the Fed optionality in case it has to cut rates. However, that can work against it if it tightens too much, too quickly. Slow and steady wins this race.

The Fed indicated it may begin to reduce assets held on its balance sheet later this year. We see that as a positive signal. Also, it’s an additional policy lever the Fed will have to play with. We would expect a balance sheet roll-off to be phased in, and while reinvestments may stop, it doesn’t preclude the Fed from starting them up again. Going into the Global Financial Crisis, the Fed’s balance sheet held about $900 billion in assets. Today, that figure is around $4.5 trillion.

We think the Fed may hike policy rates again in June and/or September. We hold to our broad range of 2.5-3% for U.S. 10-year Treasury yields by year-end. Those yield guideposts are important to understand current portfolio positioning. For taxable portfolios in the United States, we recently cut target duration to 85% of our benchmark, and for portfolios that track the Bloomberg Barclays Global Aggregate Bond Index, we trimmed back duration targets to 80% of our benchmark.

We trimmed duration because we feel the bond market overreacted to weak first-quarter U.S. growth, which is likely to strengthen ahead. Also, government bonds benefited from a flight to safety around geopolitical tensions in North Korea, not to mention political headlines around the French elections.

Across portfolios, we remain significantly underweight core bonds and continue to favor credit. For portfolios that invest in global fixed income markets, we continue to tilt global bond allocations into U.S. core and credit markets. That may seem counterintuitive, as the Fed is the only developed market central bank we expect to see tightening policy this year. However, with interest rates relatively higher in the United States and rising, the yield differential in the United States offers a better cushion against rising rates (Figure 4).

The outlier that caught many investors off guard this year has been the U.S. dollar. The knock-on effects from the Fed raising policy rates, as other developed market central banks effectively eased, meant investors came into this year expecting a stronger dollar. We’ve seen the opposite. We do not expect developed FX markets–and in particular the dollar–to move much beyond a broad trading range for now. That is exactly what we’ve seen so far this year.

Straight Lines: The Trick Is Not to Blink

I mentioned earlier that markets don’t move in straight lines. As an investor, I anchor first on the macro landscape and on fundamentals. Right now, the fundamental backdrop continues to validate current market valuations–across equity as well as credit markets. Each of those remarks helps to qualify the amount of risk we are taking in portfolios.

We remain pro-cyclically positioned across portfolios because of a steady and a more balanced macro landscape. Because of where we are with both equity and credit market valuations, we aren’t overreaching for risk. Diversification matters more than ever in a market environment where we are late cycle and nothing stands out as inexpensive.

We expect to see pullbacks ahead, including the possibility of a more meaningful correction. We remain better buyers of risk assets on pronounced pullbacks. At the start of this year, as markets kept moving higher, one of the trading floor comments I kept hearing was that traders were “too scared to short” the reflation-trade. My sense is they are a little less scared. We can see that in rising volatility across equity as well as fixed income markets. Higher volatility inevitably creates opportunity. Remember how volatile the first half of last year was.

Markets last year made for a jarring investment journey. We saw what I would characterize as a systemic collapse in alpha across active managers globally–equity, fixed income and alternative assets alike. We took advantage tactically to reposition portfolios, riding though the storm.

Our strong portfolio performance over the last year is the proof statement for why staying invested is so important. I am saying this now as we undoubtedly will see market wobbles again. Like last year, we intend as a global investment team to take advantage of the bumps as presented. The trick is not to blink.

Biographies

 

Richard Madigan

Richard Madigan

Chief Investment Officer
J.P. Morgan Private Bank

Nancy Rooney

Nancy Rooney

Global Head of Managed Solutions
J.P. Morgan Private Bank

Michael E. Gray

Michael E. Gray

Head of Fixed Income & Credit, CIO Team
J.P. Morgan Private Bank

Learn more about our firm and investment professionals through FINRA BrokerCheck

 

Archives

Beginning of a Great Adventure
January 2017

 Download PDF

Change of the Guard
November 2016

 Download PDF

Follow the Leader
September 2016

 Download PDF

Opinions expressed are those of the author and may differ from those of other J.P. Morgan employees and affiliates. Neither J.P. Morgan nor any of its affiliates can represent that the statements or opinions expressed today will materialize.

Conflicts of interest will arise whenever JPMorgan Chase Bank, N.A. or any of its affiliates (together, “J.P. Morgan”) have an actual or perceived economic or other incentive in its management of our clients’ portfolios to act in a way that benefits J.P. Morgan. Conflicts will result, for example (to the extent the following activities are permitted in your account): (1) when J.P. Morgan invests in an investment product, such as a mutual fund, structured product, separately managed account or hedge fund issued or managed by JPMorgan Chase Bank, N.A. or an affiliate, such as J.P. Morgan Investment Management Inc.; (2) when a J.P. Morgan entity obtains services, including trade execution and trade clearing, from an affiliate; (3) when J.P. Morgan receives payment as a result of purchasing an investment product for a client’s account; or (4) when J.P. Morgan receives payment for providing services (including shareholder servicing, recordkeeping or custody) with respect to investment products purchased for a client’s portfolio. Other conflicts will result because of relationships that J.P. Morgan has with other clients or when J.P. Morgan acts for its own account.

Investment strategies are selected from both J.P. Morgan and third-party asset managers and are subject to a review process by our manager research teams. From this pool of strategies, our portfolio construction teams select those strategies we believe fit our asset allocation goals and forward looking views in order to meet the portfolio’s investment objective.

As a general matter, we prefer J.P. Morgan managed strategies. We expect the proportion of J.P. Morgan managed strategies will be high (in fact, up to 100 percent) in strategies such as, for example, cash and high-quality fixed income, subject to applicable law and any account-specific considerations.

While our internally managed strategies generally align well with our forward looking views, and we are familiar with the investment processes as well as the risk and compliance philosophy of the firm, it is important to note that J.P. Morgan receives more overall fees when internally managed strategies are included. We offer the option of choosing to exclude J.P. Morgan managed strategies (other than cash and liquidity products) in certain portfolios.

Risk

Bonds are subject to interest rate risk, credit and default risk of the issuer. Bond prices generally fall when interest rates rise.

As a reminder, hedge funds (or funds of hedge funds) often engage in leveraging and other speculative investment practices that may increase the risk of investment loss. These investments can be highly illiquid, and are not required to provide periodic pricing or valuation information to investors, and may involve complex tax structures and delays in distributing important tax information. These investments are not subject to the same regulatory requirements as mutual funds; and often charge high fees. Further, any number of conflicts of interest may exist in the context of the management and/or operation of any such fund. For complete information, please refer to the applicable offering memorandum.

Purpose of This Material

This material is for information purposes only. The information provided may inform you of certain investment products and services offered by J.P. Morgan’s private banking business, part of JPMorgan Chase & Co. The views and strategies described in the material may not be suitable for all investors and are subject to investment risks. Please read this Important Information in its entirety.

Confidentiality

This material is confidential and intended for your personal use. It should not be circulated to or used by any other person, or duplicated for non-personal use, without our permission.

Regulatory Status

In the United States, Bank products and services, including certain discretionary investment management products and services, are offered by JPMorgan Chase Bank, N.A. and its affiliates. Securities products and services are offered in the U.S. by J.P. Morgan Securities LLC, an affiliate of JPMCB, and outside of the U.S. by other global affiliates. J.P. Morgan Securities LLC, member FINRA and SIPC.

INVESTMENT PRODUCTS ARE: NOT FDIC INSURED • NOT A DEPOSIT OR OTHER OBLIGATION OF, OR GUARANTEED BY, JPMORGAN CHASE BANK, N.A. OR ANY OF ITS AFFILIATES • SUBJECT TO INVESTMENT RISKS, INCLUDING POSSIBLE LOSS OF THE PRINCIPAL AMOUNT INVESTED

In the United Kingdom, this material is issued by J.P. Morgan International Bank Limited (JPMIB) with the registered office located at 25 Bank Street, Canary Wharf, London E14 5JP, registered in England No. 03838766. JPMIB is authorized by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority. In addition, this material may be distributed by: JPMorgan Chase Bank, N.A. (“JPMCB”), Paris branch, which is regulated by the French banking authorities Autorité de Contrôle Prudentiel et de Résolution and Autorité des Marchés Financiers; J.P. Morgan (Suisse) SA, regulated by the Swiss Financial Market Supervisory Authority; JPMCB Dubai branch, regulated by the Dubai Financial Services Authority; JPMCB Bahrain branch, licensed as a conventional wholesale bank by the Central Bank of Bahrain (for professional clients only).

In Hong Kong, this material is distributed by JPMCB, Hong Kong branch. JPMCB, Hong Kong branch is regulated by the Hong Kong Monetary Authority and the Securities and Futures Commission of Hong Kong. In Hong Kong, we will cease to use your personal data for our marketing purposes without charge if you so request. In Singapore, this material is distributed by JPMCB, Singapore branch. JPMCB, Singapore branch is regulated by the Monetary Authority of Singapore. Dealing and advisory services and discretionary investment management services are provided to you by JPMCB, Hong Kong/Singapore branch (as notified to you). Banking and custody services are provided to you by JPMIB. The contents of this document have not been reviewed by any regulatory authority in Hong Kong, Singapore or any other jurisdictions. You are advised to exercise caution in relation to this document. If you are in any doubt about any of the contents of this document, you should obtain independent professional advice.

With respect to countries in Latin America, the distribution of this material may be restricted in certain jurisdictions. Receipt of this material does not constitute an offer or solicitation to any person in any jurisdiction in which such offer or solicitation is not authorized or to any person to whom it would be unlawful to make such offer or solicitation. To the extent this content makes reference to a fund, the Fund may not be publicly offered in any Latin American country, without previous registration of such fund’s securities in compliance with the laws of the corresponding jurisdiction.

Non-reliance

We believe the information contained in this material to be reliable and have sought to take reasonable care in its preparation; however, we do not represent or warrant its accuracy, reliability or completeness, or accept any liability for any loss or damage (whether direct or indirect) arising out of the use of all or any part of this material. We do not make any representation or warranty with regard to any computations, graphs, tables, diagrams or commentary in this material, which are provided for illustration/reference purposes only. The views, opinions, estimates and strategies expressed in it constitute our judgment based on current market conditions and are subject to change without notice. We assume no duty to update any information in this material in the event that such information changes. Views, opinions, estimates and strategies expressed herein may differ from those expressed by other areas of J.P. Morgan, views expressed for other purposes or in other contexts, and this material should not be regarded as a research report. Any projected results and risks are based solely on hypothetical examples cited, and actual results and risks will vary depending on specific circumstances. Forward looking statements should not be considered as guarantees or predictions of future events.

Investors may get back less than they invested, and past performance is not a reliable indicator of future results.

Risks, Considerations and Additional information

There may be different or additional factors which are not reflected in this material, but which may impact on a client’s portfolio or investment decision. The information contained in this material is intended as general market commentary and should not be relied upon in isolation for the purpose of making an investment decision. Nothing in this document shall be construed as giving rise to any duty of care owed to, or advisory relationship with, you or any third party. Nothing in this document is intended to constitute a representation that any investment strategy or product is suitable for you. You should consider carefully whether any products and strategies discussed are suitable for your needs, and to obtain additional information prior to making an investment decision. Nothing in this document shall be regarded as an offer, solicitation, recommendation or advice (whether financial, accounting, legal, tax or other) given by J.P. Morgan and/or its officers or employees, irrespective of whether or not such communication was given at your request. J.P. Morgan and its affiliates and employees do not provide tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any financial transactions. Contact your J.P. Morgan representative for additional information concerning your personal investment goals. You should be aware of the general and specific risks relevant to the matters discussed in the material. You will independently, without any reliance on J.P. Morgan, make your own judgment and decision with respect to any investment referenced in this material.

It is important to understand that alternative investments are speculative and involve a greater degree of risk than traditional investments, including: limited liquidity and limited transparency, among other factors. Alternatives should only be considered by sophisticated investors with the financial capability to accept the loss of all or part of the assets devoted to such strategies.

J.P. Morgan may hold a position for itself or our other clients which may not be consistent with the information, opinions, estimates, investment strategies or views expressed in this document.

JPMorgan Chase & Co. or its affiliates may hold a position or act as market maker in the financial instruments of any issuer discussed herein or act as an underwriter, placement agent, advisor or lender to such issuer.

References in this report to “J.P. Morgan” are to JPMorgan Chase & Co., its subsidiaries and affiliates worldwide.

“J.P. Morgan Private Bank” is the marketing name for the private banking business conducted by J.P. Morgan.

If you have any questions or no longer wish to receive these communications, please contact your usual J.P. Morgan representative.

Index Definitions

All index performance information has been obtained from third parties and should not be relied on as being complete or accurate. Indices are shown for comparison purposes only. While an investor may invest in vehicles designed to track certain indices, an investor cannot invest directly in an index.

Bloomberg Barclays Global Aggregate Bond Index

The Bloomberg Barclays Global Aggregate Bond Index tracks investment grade government and corporate bonds globally.

Bloomberg Barclays Municipal Bond Index

The Bloomberg Barclays Municipal Bond Index covers the USD-denominated long-term tax exempt bond market. The index has four main sectors: state and local general obligation bonds, revenue bonds, insured bonds and pre-refunded bonds.

DXY U.S. Dollar Index

The DXY U.S. Dollar Index indicates the general international value of the USD. It does this by averaging the exchange rates between the USD and major world currencies. The ICE computes this by using the rates supplied by some 500 banks.

JPM Domestic High Yield Index

The JPM Domestic High Yield Index is an index designed to track the performance of the investable universe of the U.S. dollar domestic high yield corporate debt market.

JPM Economic Activity Surprise Index

The JPM Economic Activity Surprise Index tracks growth perceptions by looking at the recent history of economic activity surprises from consensus estimates.

JPM EMBI Global Diversified Index

The JPM EMBI Global Diversified Index tracks emerging market sovereign bonds denominated in U.S. dollars.

JPM Global Composite PMI

The JPM Global Composite Purchasing Manager Index gives an overview of the global manufacturing sector based on monthly surveys of over 10,000 purchasing executives from 32 of the world’s leading economies.

JPM High Grade (JULI) Index

The JPM High Grade (JULI) Index provides performance comparisons and valuation metrics across a carefully defined universe of investment grade corporate bonds, tracking individual issuers, sectors and sub-sectors by their various ratings and maturities.

MSCI World Index

The MSCI World Index is a capitalization-weighted index that monitors the performance of developed market stocks from around the world.

S&P 500 Index

The S&P 500 is a capitalization-weighted index of 500 stocks from a broad range of industries. The component stocks are weighted according to the total market value of their outstanding shares.