Economic & Market Update
Welcome to the 1Q 2024 J.P. Morgan Asset Management economic and market update. This seminar, presented by Dr. David Kelly, highlights the major themes and concerns impacting investors and their clients, using just 11 Guide to the Markets slides.
There are 65 pages in the Guide to the Markets. However, we believe that the key themes for the first quarter can be highlighted by referencing just 11 slides.
ECONOMIC & MARKET UPDATE: USING THE GUIDE TO THE MARKETS
TO EXPLAIN THE INVESTMENT ENVIRONMENT
1. A soft landing is in sight, but recession risks remain.
The U.S. economy saw impressive resilience last year, with the first three quarters showing above trend real GDP growth. Easing inflation and improved prospects for growth have helped fuel optimism for a soft landing. However, a quick look across each sector of the economy tells us that economic momentum in the year ahead is set to be moderate, at best.
Business spending held up better than expected last year despite tighter lending standards, supported by increased spending on intellectual property with greater emphasis on building and integrating artificial intelligence capabilities. Tailwinds from AI spending as well as federal government support for semi-conductor manufacturing should persist in 2024. However, increased caution among lenders and slowing corporate profits could still constrain growth in capital expenditures.
Consumers have remained resilient, supported by a tight labor market and rising real wages. That said, there are some signs of weakness. While revolving credit as a share of disposable income does not look overextended, delinquencies are rising, and younger households are showing signs of increased financial stress. As labor market conditions continue to loosen and lending standards remain tight, consumer spending should grow at a slower pace from here.
The housing market appears to have stabilized, albeit at low levels, as tight housing supply and steadying mortgage rates are signaling that the worst is behind us. Trade should be a mild drag on the economy as a still-strong dollar and sluggish global growth weigh on exports. Meanwhile, government spending growth should slow as gridlock in Washington limits further stimulus.
Overall, the U.S. economy should continue to grow at a moderate but slowing pace from here. That said, a slower-moving economy will be increasingly sensitive to shocks. Whether it be the U.S. election, higher policy rates, significant geopolitical tension or something else entirely, risks remain that could push the economy into recession in 2024.
2. The unemployment rate should remain low until we see a recession.
After a red-hot labor market sent wages higher and brought unemployment down from a pandemic peak of 14.7% to a 50-year low of 3.4%, the labor market is now getting back to normal. Unemployment remained at 3.7% in November, despite swift declines in job openings, and has hovered between 3.4% and 4.0% since December 2021. However, cooling labor market conditions are evident in private sector wages, which have moderated from a peak of 5.9% y/y in March 2022 to 4.0% in November. While still above its long-term average, wage pressures are receding with quits falling and businesses reeling back hiring efforts in the face of slowing consumer demand. Moreover, while strikes have made headlines in the last year, less than 6% of the private sector workforce is represented by a union, down from over 20% in the 1980s.
On balance, we aren’t worried about wages contributing to higher inflation and in the absence of a recession, unemployment could remain stable. U.S. businesses still face structurally slower labor force growth than in prior decades, with Census projections showing the population aged 18-64 will rise only 0.1% in 2024. Tight labor markets could encourage more immigration or further gains in labor force participation, but excess capacity may be limited.
Overall, a combination of subdued job growth and slowing wages should give the Federal Reserve further confidence that inflation is sustainably coming down.
3. Sustainable earnings will differentiate winners and losers against a backdrop of slowing growth.
Resilience in the U.S. economy has also been shared by Corporate America with earnings growth surprising on the upside last year. Revenues were the largest contributor to earnings, with consumer strength and pricing power allowing companies to boost sales. Margins, however, have detracted from earnings as companies grappled with higher input and labor costs. Still, companies have been active in defending margins by cutting costs and adopting more efficient digital capabilities, helping margins stage an impressive recovery in the third quarter.
Looking to 2024 and 2025, expectations for double-digit earnings growth seem too optimistic as defending profit margins will become increasingly difficult in an environment of slowing economic growth and waning pricing power. However, high-quality companies with strong balance sheets, ample cash balances and sustainable earnings should perform well relative to the broader index.
4. Inflation is steadily trending back to target.
After inflation reached 50-year highs in 2022, the inflation heatwave met a cold front in 2023. Headline CPI eased to 3.1% y/y in November, well below the 9.1% peak reached in June 2022. While still above the Fed’s target, the underlying components of inflation provide us with confidence that this downtrend has room to run.
Core goods prices trended lower in 2023 as supply chain distortions related to the pandemic and Russia’s invasion of Ukraine continued to fade. Meanwhile, the more volatile components, mainly energy and food prices, also provided an important source of disinflation amidst slowing demand. Absent any supply shocks or unexpected surges in demand, these categories should continue their descent in the coming months. Lastly, shelter inflation, which accounts for a third of the CPI bucket, is predictably falling as the rollover in market rents gradually flows through the data.
The remaining problem for inflation, therefore, is core services prices outside of housing, which the Fed has honed in on when referencing persistent inflation. However, as we show on the right-hand side of slide 28, inflation in this measure is mostly driven by “transportation services,” which includes auto insurance and auto repair costs. Going forward, the rollover in vehicle and auto part prices should feed through to this category and, combined with easing wage pressures and cooling consumer demand, services inflation should fall further in the year ahead.
Overall, inflation made impressive progress towards more normal levels in 2023. While we are not quite back to the Fed’s target, 2% inflation by the middle of 2024 is attainable even without a recession. This should give the Fed assurance that inflation is under control as they debate easing policy.
5. The Federal Reserve is near the end of its tightening cycle.
The Federal Reserve has hiked rates by a cumulative 5.25% since the beginning of 2022 to combat inflation. However, with inflation steadily trending towards their 2% target and labor market conditions easing, the July rate hike was likely the last of this cycle. At their December meeting, the Fed voted to leave the federal funds rate unchanged at a target range of 5.25%-5.50% and strongly hinted that rates are at their cycle peak. Fed Chairman Powell did not push back against easing financial conditions or the idea of rate cuts, as he has done in the past, and forward guidance was decisively dovish.
Specifically, the Fed’s “dot plot” suggested that rate cuts may occur faster than initially expected, with the median FOMC member expecting a year-end federal funds rate of 4.6% in 2024, implying three cuts next year. Updates to the Summary of Economic Projections showed lower inflation forecasts for 2023, 2024 and 2025 without material revisions to the growth or employment forecasts. With these revisions, the Fed is acknowledging that inflation is falling faster than expected and appear to be forecasting a soft-landing scenario.
Overall, the Fed is likely at the end of its hiking cycle, which means investors are now more interested in the timing and extent of eventual rate cuts. If the economy remains afloat, the Fed may only deliver minor policy cuts. However, if the U.S. economy enters a recession, the Fed may be forced to cut rates more aggressively to try and stimulate the economy. Either way, it is increasingly likely that rates will move lower in the year ahead, but they may settle at a higher level compared to previous policy easing cycles.
6. Divergent global growth should converge in the year ahead.
Despite the negative headlines, the global economy proved to be more resilient than expected in 2023, but some countries clearly did better than others. The Eurozone, UK, Canada and China struggled, while the U.S., Japan and emerging markets outside of China were stronger, as evidenced by their composite PMIs remaining above 50 for much of last year.
In China, depressed consumer and business confidence continues to challenge growth, while the full effects of stimulus measures from policymakers have yet to be realized. China’s weakness also spilled over to Europe, which is similarly experiencing weak domestic consumption and elevated manufacturer pessimism. Activity is now showing signs of stabilizing, albeit at low levels, and there is hope for a modest reacceleration in Europe as falling inflation boosts real incomes. Elsewhere, India continues to see strong growth, supported by its growing middle class and government support for private businesses and digitalization.
Global growth should be less divergent in 2024, with the US economy slowing down and China’s economy stabilizing. However, the key question is how much this gap will close, and whether it is driven by a U.S. slowdown or a pickup in overseas growth.
7. Despite the recent bond market rally, yields still look attractive.
In bond markets, volatility was a defining feature of 2023 as investors grappled with resilient economic data, a hawkish Fed and various technical factors. The yield on the 10-year Treasury climbed by nearly 170 bps from early April to late October, before expectations for a soft landing and an end to tightening helped drive the yield lower by more than 100 bps in less than two months. Even with this move lower, current yields across the fixed income landscape still offer investors much better income and total return opportunities than existed a year ago.
Slide 37 shows yields across fixed income sectors relative to the last 10 years, and nearly all sectors are trading well above their 10-year median yields. Simply sticking with core fixed income provides attractive yields above 5%, while leaning into riskier asset classes, like high yield, can provide yields north of 8%. Moreover, with peak interest rates likely behind us, bonds also offer the potential for price appreciation in the event of lower rates and diversification benefits as lower rates coincide with recession. This potential for asymmetric return in bonds may not last long, underscoring the importance of leaning into fixed income while yields are at these elevated levels.
8. Broadening U.S. equity market performance will create opportunities for active management.
After a very troubled year for investors in 2022, U.S. equities rallied in 2023, largely recovering their losses in the prior year. This performance owes to a combination of better-than-expected consumer spending, resilient corporate profits and enthusiasm around the advancements in AI. However, equity market performance was not broad-based, with the largest stocks in the index by market-cap accounting for the majority of gains.
On the left, we show stock market performance since the start of 2023, and the top 10 stocks have accounted for roughly 90% of price returns, leaving them about 1.4 times more expensive than the broader market. Meanwhile, the remaining stocks are only up by low-single-digits and are trading more in-line with broader index.
Indeed, index concentration is not a new phenomenon as the weight of the top 10 stocks in the S&P 500 has been rising since 2016. The earnings contribution from those stocks, however, hasn’t kept pace and hardly budged last year despite strong price appreciation. The fact that the top 10 stocks make up a third of the index but only account for a fifth of index earnings suggests significant mispricing in the stock market.
In 2024, if economic growth remains positive and technological advancements yield significant productivity gains, markets could still perform well. That said, gains should broaden out beyond the largest names. In environments like these, active management is best suited to identify those companies with sustainable, high-quality earnings that are being overlooked by the markets.
9. There are attractive opportunities across international markets.
Strong equity market performance in 2023 was not only a U.S. phenomenon. International equities also experienced impressive growth, with the MSCI All Country World Index climbing more than 10%. Taking a quick trip around the globe, Japanese equities had a very strong year, rising roughly 16% in dollar terms, as an improved interest rate backdrop and corporate governance reform propelled new enthusiasm from investors. Elsewhere, promising fiscal reforms and strong economic momentum bolstered the case for Indian equities, which similarly rose over 16%. In Europe, markets also saw strong performance in the first half of the year as the end of negative interest rates supported banks and economic activity stabilized from Russia-induced energy shortages.
Looking ahead, while the global growth backdrop looks set to slow, there are still strong opportunities outside of the U.S. for long-term investors, and at better valuations. Indeed, international equities continue to trade at a steep discount of over 30% compared to U.S. equities, near 20-year lows. International equities also offer greater income, with dividend yields trading at a 1.8% spread above that of U.S. equities.
Combine this attractive entry point with structural tailwinds, attractive relative fundamentals and a weakening dollar, and the year ahead could be a much more favorable environment for U.S. based investors investing overseas looking to diversify and add exposure to important global secular trends and themes.
10. Alternatives can help investors reach their strategic goals in challenging market environments.
Regardless of what happens to the economic backdrop, investors are still looking for consistent outcomes across alpha, income and diversification. The challenge is that you can’t get all those outcomes from the same assets. However, when you expand the opportunity set outside of public markets, investors can leverage a range of different alternative assets to reach their desired outcomes. Indeed, as we show on slide 55 of the Guide, alternative assets can offer low correlations to public markets, diversified income streams and enhanced long-run returns.
For instance, real assets shown towards the left, such as real estate, infrastructure and transport, tend to be less correlated to a traditional 60/40 portfolio while providing robust income. Private equity and venture capital, towards the right, provide much higher total returns but come with higher correlations to public markets and little-to-no income generation.
The classic 60/40 stock-bond portfolio still looks attractive, but adding a sleeve of alternatives can help long-term investors achieve strategic goals through higher alpha, better diversification and enhanced income.
11. While peak cash yields may look attractive, holding too much cash can be costly. .
Policy tightening from the Fed has pushed yields on cash-like instruments to their most attractive levels in over a decade. With yields north of 5% and minimal risk, many investors have decided to allocate more heavily to cash.
However, history shows that staying parked in cash after the peak in interest rates usually leaves money on the table. In the last 6 rate hiking cycles, the U.S. Aggregate Bond Index outperformed cash over each of the 12-month periods following the peak in CD rates, while the S&P 500 and a 60/40 stock-bond portfolio outperformed in 5 of these periods.
This is not to say that investors should abandon cash altogether, as liquidity is an important allocation in any portfolio. However, there is an opportunity cost in holding onto too much cash, and investors should put long-term money in long-term assets. Following a peak in interest rates there has always been a better asset than cash to deploy capital.