David Lebovitz:    ...Investment Excellence, a production of JP Morgan Asset Management. The Center for Investment Excellence is an audio podcast that provides educational insights across asset classes and investment themes. Today's episode is entitled, "Is this the time for offense or defense?", and has been recorded for institutional and professional investors.

I'm David Lebovitz, Global Market Strategist and host of the Center for Investment Excellence. With me today is Jared Gross, Head of Portfolio Strategy for JP Morgan Asset Management. Welcome to the Center for Investment Excellence.

Jared Gross:    Thanks for having me. It is great to be back on the podcast. And these are interesting times indeed. I'm really excited to hear your thoughts on the economy and the markets, as we endure this two-month span between FOMC meetings. It certainly feels like the September meeting is a long ways away. So let's just say you have the floor to tell us where we are and where we are going. Simple.

David Lebovitz:    Absolutely. It is kind of funny how quickly summer goes, but how far September feels. And frankly, you know, we've gotten a lot of very important data points here over the past couple of weeks. But we're going to get even more important data over the course of the weeks to come. So just taking stock of where things are, you know, the things that have kind of caught my attention are obviously around inflation and employment.

We do think that inflation has peaked here. I think it's important to recognize that even though the headline figured cooled from 9.1% to 8.5%, we still have inflation of 8-1/2%. You're generally seeing the inflation data if you take a broader swath of it, beginning to roll over. We think that PCE is going to begin to decline here, which is obviously the Fed's preferred measure of inflation. But the question to me about the inflation narrative, really has to do with not so much what happens at the headline level, but what happens at the core level going forward, you know, the core of it was unchanged on a year over year basis, in the month of July. And we're seeing housing provide a fairly significant contribution to that core inflation figure.

And so I am looking for some signs that house price appreciation isn't necessarily rolling over but is potentially beginning to slow, as that should then filter into the inflation data over the course of the next call it six to nine months, and allow that upward pressure around core, to begin to subside. Against this backdrop where inflation is cooling, we have a labor market that continues to look pretty hot, at least according to the July employment figures.

But I do think it's important to take stock of what we've seen in the (JOLTS) report, what we've seen in the claims data. Again, it does look like some of the higher frequency labor market indicators are beginning to suggest that the employment situation is cooling off. And so we're going to be watching very closely, to see whether or not that plays out over the course of the coming months.

You know, when it comes to consumers and businesses, consumers continue to look okay. You know, the balance sheets are still relatively healthy. We have seen some deterioration kind of in the middle income segment over the past couple of weeks. We've seen an increase in revolving credit use and card utilization more broadly. We think that a lot of this has to do with food and energy prices that have, to an extent, come off the boil, but still remain elevated. And as consumers are paying these higher prices, businesses have been able to defend their margins relatively well.

But commentary from, you know, a lot of the big S&P 500 companies does suggest that the earning situation is going to be a bit challenging as we look over the coming months. And so I'd say that we're kind of in a middle gear. Parts of the economy are clearly slowing. The labor situation continues to look relatively solid and bubbling in the background. We have the issues of slower growth in China, the risk of a recession in Europe, obviously commodity issues stemming from the geopolitical situation in each Eastern Europe, and that is very much an overlay to what we're seeing.

But all of this data really comes together and helps us try to unpack what the Fed is going to do over the course of the next couple of meetings. And you have a market that is pricing in, a Fed that continues to hike through the end of the year and then begins to cut in 2023. You have a Fed that is pricing in rates to continue to rise, the forecasting that rates continue to rise through year-end. And then they actually continue raising rates over the course of the coming year.

When we think about who's right and who's wrong here, I frankly think that we need to recognize we're probably going to split the difference. I'm not sure that the Fed is going to be able to continue hiking for all that much in 2023. Maybe they sneak a hike or two in there at the beginning of the year. But I think frankly, they're going to get the job done by the end of 2022. But I'm not so sure that if the economic data is beginning to soften, that they turn around and begin to cut. I frankly think that the Fed will hold rates where they are until they're confident that the inflation genie is really going back into the proverbial bottle.

And so all of this kind of dovetails into a conversation around whether the market has it right or wrong after a big rally in July, which has continued into August. You know, stocks have rebounded strongly, spreads have tightened aggressively. Long term rates have fallen as have commodity prices. And so in general, what we've actually seen is a loosening in financial conditions, which is not necessarily what the Fed is looking for. And I think that this may be a little bit of a false dawn.

I do think that we could see equities pull back a bit as we get additional details on inflation, and additional details on the outlook for the Fed, and additional details on the outlook for activity data at large. And so there's a lot going on here from a macroeconomic perspective. And Jared, I'd love your opinion and your reaction to all of this, and what you think it might mean for institutional investors.

Jared Gross:          Yes. This is a really interesting and complex environment. And there's sort of a mixed message in here. And I don't mean that you're giving a mixed message, David. I mean the markets are giving us a mixed message. You know, I think as you said, the macro data is probably starting to turn, particularly around inflation. You know, as you said, the headline numbers are coming off a little bit, core still remains elevated, but we are far from out of the woods.

And the market seems to be saying, with its price movements over the last few weeks, that they are expecting a shorter Fed cycle, a terminal rate that is significantly below the current Fed expectations for the terminal rate, a relatively rapid decline in rates thereafter, yet with no recession or a mild recession that appears to be pricing in sustained consumer activity, corporate profitability, and credit health. So that is a more or less Goldilocks scenario that, you know, at least from where I sit, and I think I'm probably representing your views as well here, there's a pretty narrow path to getting that just right.

And so the questions are, what is the probability of that happening; and what are the other paths that we might go down? If we have a higher and more extended inflation period than we currently seem to expect is the Fed going to have to hike more? Is that going to be ultimately more recessionary? Or is there a more bullish case as well? You know, it's a really interesting environment right now. So I'll sort of throw it back to you a little bit, and just say as you think about this mixed message, which element of the current market pricing seems most off base to you?

And is there a particular data point that you're focused on that's going to help guide us to which path? Is it that Goldilocks path down the middle, or is it a more inflationary and ultimately more recessionary response? Or is it a more benign and bullish response?

David Lebovitz:    I'd say that it's more the latter, and less the former. I think what's interesting about the current environment, particularly from a marketing perspective, is you could well see equities continue to rise because positioning among a lot of the systematic strategies and the trend-following strategies, is still relatively low. So, you know, putting it differently, there's probably some additional gas in the tank for this rally to continue. But when I think about what's going on in the equity market at large, the technicals are looking a bit better. But there are still some questions around participation and the share of equities that are above their various moving averages.

With the run we've seen over the past few weeks, we can no longer say that equities are cheap, right? I think that was a big part of the thesis that got things moving in a more positive direction. Back at the beginning of July, 2023 earnings estimates are still too high. Interesting to see some of the big retailers hold guidance firm. But obviously they downgraded their guidance at the beginning of the year. And so I do think that there's going to be another shoe to drop as analysts began to focus more on the next calendar year.

And it's not clear to me that the market ever really flushed. It never really had that feeling of capitulation and, you know, things are just - they can only get worse. It felt like they began to turn around, again as a little bit of a false dawn. And so I think what's going to happen here and this is kind of a perverse statement. But I think recession is becoming increasingly inevitable. And if you look back over time, really the only way to get inflation back under control, is to have a period of economic contraction.

But you look at the health of the consumer, you look at the health of businesses, and one could argue that if the Fed is going to cause a recession for the purposes of putting inflation back into the bottle, now is frankly a pretty good time. And so I'd be more in the camp of mild recession, but I think markets have already priced a decent amount of that in. As recession shows up, I wouldn't be surprised to see markets pulled back a bit, maybe to some of the lows that we're seeing earlier this year.

But I do believe that a recession is what the market would like to see. And so what I'm watching most closely is what happens with jobless claims. I think that that's going to give us the best read on what's happening in the labor market in real time. And if claims to move above say 300,000, that would signal to me that recession is closer than a lot of people may believe it to be. And so with that kind of as my view from a capital markets perspective, Jared I'm going to put you on the spot here. How should investors respond, particularly long term investors who may not be as focused on kind of day to day tactical adjustments to their asset allocation?

Jared Gross:          So let me take a bit of a long way around to answering that question. You know, at the very most basic level, investors are in the business of putting capital at risk to generate returns. And we always want to be as thoughtful as possible about how we do that. But the reality is that there are simply times when risk taking works in your favor, and times when it doesn't. And the first half of 2020 was clearly one of the bad times. No one has a crystal ball, no one can anticipate market selloffs with any degree of confidence. And so you have to take your lumps when they come sometimes.

Now, we'll come back to this later, I'm sure, but one of the more concerning elements of the 2022 selloff was the failure of traditionally defensive assets, particularly fixed income, to deliver protection to portfolios. This led to losses in diversified strategies that were in excess of what most allocators had expected, and it should, going forward, lead to some critical examination of top down portfolio construction and risk model. And then again, we'll come back to that. It's not completely unexpected, however.

Many people, myself included, had commented over not just the last few months, but the last few years, that if we get to a point where market valuations are extremely rich and forward looking returns are low, and bond yields are extremely low, the power of diversification inside portfolios has diminished. And it was also not outside the scope of our historical awareness that periods of high inflation tend to be moments where these correlations reverse, and that effect can be greater. So we sort of knew coming in that there was a risk of this. How do we respond today?

I mean, first of all, as you said, asset allocation is a long term exercise. But it also has to be responsive to current market conditions, at least to some degree. After all, the long term is a series of short terms. And you have to formulate strategy at points along the journey, not simply over the sort of average of all future tomorrows. And so, where are we now? Looking forward from today, the prospects for higher long term returns are genuinely improved across most major markets. I mean that's the inevitable result of a selloff.

And that's good news to some extent, but there are some important caveats. First, we lost a lot of money in the process of getting here, so the higher returns going forward are really just going to restore what's been lost. And we also have to be kind of humble enough to realize that the investment strategy that worked for the last 40 years of disinflation and falling rates, are not likely going to work as well going forward. So we have to be open to some degree of flexibility and new thinking as it relates to the asset allocation process.

David Lebovitz:    So when it comes to flexibility and kind of that new thinking, obviously we've talked on this podcast before about the growth in the opportunity set in alternatives and the importance of incorporating risk assets. So maybe pushing you a little bit, how do you see things tilted? I think your point about the long run not necessarily being an average of the short term outcomes is particularly important. And so given that it's not a simple average, what direction do you see things leaning in? And again, how do you think people can respond with this growing toolkit, that has evolved over the course of the past couple of years in particular?

Jared Gross:          So getting back to your original question - what do investors do? So here's a quick list of thoughts. First, de-risking after the selloff is counterproductive. The time for being defensive was last year; it's not now. So we do need to be in the mindset of a pivot towards putting risk on. We want to do it patiently, selectively for sure. But failing to take on some risk when markets are cheap is a truer path to underperforming long term objectives.

Now it's complicated by the fact that traditional rebalancing is less compelling when both stocks and bonds are down together. There's no obvious trade between the two in sort of the liquid public markets. And pulling capital from private strategies for rebalancing into public markets, is generally inefficient both because of higher transaction costs, but also many of those private strategies are built around long term value creation that you're going to short circuit if you yank that capital back. And there's no guarantee that that's going to deliver higher returns in the public markets than you would have received if you had just left the money working.

Now dry powder to the extent you have it, is incredibly valuable right now. And that's true whether it's in the form of cash in the asset allocation, or some source of external contributions. And as we think about where that dry powder should flow, adding risk in the public markets probably is the right first step for a variety of reasons. First, public valuations as you noted, have adjusted more rapidly. So there's an entrypoint value that you can access there. Private market valuations conversely, they do lag, and they probably still don't fully reflect current conditions.

And it's going to take a while for that to flow through the private markets in a way that will have visibility and confidence that it's an attractive entrypoint. Further, many private managers have dry powder already. And so they should be allocating that dry powder to find opportunities and adding more capital may not be the highest priority right now. And then lastly, public markets also preserve liquidity at a higher level. And so if we are in a dynamic environment and we see swings in the future that we want to take advantage of, having a slightly higher bias to liquid assets as opposed to illiquid assets, can make sense.

So adding capital to public markets makes sense. We have to be selective. And we have to think about sequencing a little bit. So I think it should look a little bit like the following, and I'll be curious to get your feedback on this. As headline inflation peaks, probably the first place to start to add risk is in duration. Now you want to be thoughtful about where you do that. You know, the curve is not normally shaped right now. It is significantly inverted.

And so moving from cash to shorter maturities and even toward core sectors, probably makes sense, because you're going to capture higher yields; you're going to get the roll down from that steepness in the curve at the front end. But the long end of the curve absent some need to hedge along liability, probably is less appealing. A second phase is going to be increasing exposure to spread sectors. So you're locking in the higher yields, both higher rates and spreads, and allowing yourself to sort of earn those returns over an extended period of time.

It's important to note though, we are certainly not done with credit risk or a credit cycle. And if we do go into a recession, and it happens to be more severe than we might hope, the credit cycle will reemerge. And so we have to be willing to use active management and particularly diversified multi sector approaches that allow managers to move across sectors as opportunities present themselves, and not be narrowly allocated to very small slices of the credit markets where that volatility can really hurt.

And then the last step is as we get clarity on recession and the impact on corporate earnings, that's really where equity allocations are going to start to look more attractive, and we'll have more confidence about pushing capital back into equities. And I think as you would probably agree, there's a lot of dispersion in equity valuations right now. And so it certainly is a stockpicker's market to a large degree. And active management will be very helpful there.

David Lebovitz:    I couldn't agree more. And I think your point about fixed income is important. We are comfortable taking on more duration, but we are cognizant of credit risk. And to just put it bluntly, high yield probably gets cheaper before it gets materially more expensive. If you assume that we have some sort of default cycle, some sort of credit cycle, which coincides with a downturn in the economy.

And so I think intermediate duration makes a lot of sense; taking some credit risk, particularly in investment grade makes some sense; and when it comes to equities, I think you're spot on. Given the dispersion in valuations, we're looking for growth at a reasonable price. We want to own things that are going to be able to generate profits in the macro environment that we see playing out. But we don't necessarily want to buy things simply because they're cheap. We also don't want to overpay for cashflows that may or may not materialize at some point down the road.

And so this is what's so interesting about the current environment, is a lot of us have never been here before. And it doesn't mean that there are no opportunities. It just means that some of the opportunities are in different places than they were over the prior cycle. And so the one thing that I think is on everybody's mind, is the topic of diversification. And we talked a little bit about how adding some duration may help with that going forward.

To me, obviously stock/bond diversification didn't really work in the first quarter. But to your point earlier, that's because the Fed and inflation were in the driver's seat. As we've seen growth concerns come back into the market, we've seen that negative correlation beginning to take hold. And so how are you thinking about diversification? I know you alluded to it a little bit earlier in the context of an inflationary environment. But how are you thinking about building portfolios, particularly if the value of stock/bond diversification may be diminished as we deal with this inflation issue?

Jared Gross:          It's a great question. History suggests that you're correct and that the value of stock/bond diversification is going to be diminished in a higher inflation environment. And obviously, we have to recognize that the first half of 2022 was a little bit unique, just because we were starting from such an incredibly low point in the interest rate cycle, that the bond market was almost uniquely unable to do what it traditionally has done.

But it's also an interesting question and one that we don't really have an answer to yet is, is this effect of the results of the direction of inflation? You know, is it going higher or going lower? Or is it the level of inflation; just high in absolute terms or lower in absolute terms? And we don't really have clarity on that yet. But to some extent, regardless of the answer, I think there are a couple of logical responses in terms of how we evolve asset allocations.

So first, we can, to some extent, sidestep the problem. And that's by continuing to add diversified alternative assets to a portfolio in lieu of stocks and bonds and public markets brought. Now there are limits to how far we can go down that path. But it's important to recognize that the size and diversification of alternative asset classes continues to grow. And that allows investors to design and implement alternative allocations that offer very tailored risk return and liquidity characteristics along with potentially higher returns.

So there is a very strong long term structural argument for holding more alternative asset classes broadly. In particular, poor real asset strategies across real estate, infrastructure, transportation - these offer a very compelling response to an inflationary environment. And without going into too much detail, it's basically because they are able to capture the effects of inflation in their revenue stream and pass it on to investors in the form of higher income. And that's an almost unique characteristic that these asset classes share.

So that's the first approach, which is simply to spend less time on stocks and bonds, more on alternatives. The second approach is to maintain or add equity exposure, essentially recognizing that the purpose of fixed income, at least to some extent, was to provide that diversification; to provide the insurance. And if it's no longer as good at doing that, then you don't need as much of it, or you should try and find something that does it a little bit better.

Now, may be easier said than done, but there are strategies that limit drawdown risk, or strategies that provide tail hedging. And through that tail hedging offer, sort of mark to market protection of the portfolio level, and also what we would call conditional liquidity in the event of a selloff. All things that are extremely valuable in the real world to investors, and that don't rely on fixed income as the pure or the only source of risk diversification.

So what would those look like? Well, hedged equity strategies - certainly those that are designed and implemented carefully are a very interesting way to maintain an equity allocation at its target size, without taking on undiversified downside risk. So I think that's a really interesting path. Another one is if market volatility normalizes a bit more, if we see say the VIX come down a little bit, then as an entrypoint for the purchase of portfolio protection, that could be interesting. And substitute for some of what we used to get from bonds.

So to wrap it up essentially, the bottom line here is that the toolkit that investors have access to, is incredibly diverse. And it offers many more paths to reaching specific risk and return objectives than sort of traditional strategies allowed for. You know, used to be well, if it's not 60/40 it's 70/30 or 65/35, or maybe 80/20. That's no longer the sum of the opportunity set. And so we have to be open to this kind of full expression of what the market is allowing us to invest in. And I think regardless of what inflation environment we're in, regardless of what correlation environment we're in for stocks and bonds, we can get to our goals; we just have to be more flexible.

David Lebovitz:    I think that's spot on. You know, painting with a broader color palette if you will. I think that's the name of the game here. So Jared, as always, thank you for joining us. And we're looking forward to having you back again soon.

Jared Gross:          This was great, David. Thank you so much.

David Lebovitz:    Thank you for joining us today on JP Morgan's Center for investment Excellence. If you found her insights useful, you can find more episodes anywhere you listen to podcasts and on our Web site. Thank you. Recorded on August 17, 2022.

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