Welcome to the 4Q 2021 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 12 Guide to the Markets slides.
There are 65 pages in the Guide to the Markets. However, we believe that the key themes for the fourth quarter can be highlighted by referencing just 12 slides.
ECONOMIC & MARKET UPDATE: USING THE GUIDE TO THE MARKETS
TO EXPLAIN THE INVESTMENT ENVIRONMENT
1. Progress on the pandemic has been bumpier than expected
After substantial progress in reducing cases and fatalities in the spring, the pace of vaccinations has slowed and the much more contagious Delta variant has caused a resurgence of the pandemic. That being said, we now estimate that between infection and inoculation, roughly 85% of the American people now have some immunity to COVID-19. This should allow cases and fatalities to fall in the months ahead. Further, while the pandemic isn’t over yet, many parts of the economy have adapted to operate in a pandemic environment. We hope the pandemic will fade as we move into 2022 but, whether it does or not, it should have much less of an impact in slowing the economy than it has over the last two years.
2. Massive fiscal support has boosted debt and deficits
The federal government has hit a new record high debt-to-GDP ratio, levels that have not been seen since WWII. The $1.9 trillion American Rescue Plan is still working itself through the system and will continue to support the economy through the end of the year and into 2022. Further, negotiations continue in Washington on additional spending aimed at infrastructure, child care and education, among other initiatives. However, new stimulus would be stretched out over a decade and at least partially financed by tax increases, providing much less stimulus to the economy than we have seen over the last two years. In 2022, the economy should be much healthier than over the last two years but it will also receive much less government support.
3. The U.S. economy should continue its rebound into 2022
The road to pandemic recovery has been bumpier than expected, with the delta variant and severe supply shortages cutting into consumer and business spending. However, we expect growth to reaccelerate late this year as reopening resumes and companies try to rebuild inventories. As we move into 2022, the economy should have fully recovered from the pandemic. Then, looking forward, a shortage of workers and much less fiscal and monetary stimulus should slow economic growth to its long-term trend of roughly 2% by the end of next year.
4. Unemployment has fallen and wage pressures are growing
With surging labor demand and a higher cost of low-wage labor due to enhanced unemployment benefits, employers have had to raise wages to attract workers. This slide shows that as unemployment has fallen, wage growth has been rising and is above historical trends. While recent employment reports have disappointed expectations, rising wages and indicators of robust labor demand suggest slower job gains are primarily an issue of labor supply. This should keep wages elevated as the recovery continues, and is critically important for the Federal Reserve, as higher wages should feed through to higher inflation, implying that the economy could reach “maximum employment” sooner than past economic cycles may suggest.
5. S&P 500 earnings poised to moderate after hitting an all-time high in 2021
Earnings have recovered spectacularly since the big declines in early 2020 and are now expected to hit a new all-time high in 2021. This reflects both stellar profits in sectors like technology and strong profits in health care throughout the pandemic, but also a rebound in many of the cyclical sectors that struggled the most last year. However, from 2022 on, slower economic growth, higher wage costs, higher interest rates and, potentially, higher corporate taxes could make further profit gains much more difficult to achieve.
6. Inflation has risen and should remain above the Fed’s 2% target
Inflation signals have heated up significantly as a surge in consumer spending continues to collide with supply shortages across major sectors of the economy. Some drivers of much higher inflation are beginning to abate and we expect inflation to moderate in 2022 as supply chain disruptions are ironed out and demand growth cools. However, strong wage growth, higher inflation expectations, a falling dollar and the lagged effect of higher home prices on rents should keep inflation more elevated than at the end of the last expansion.
7. Tapering is on the horizon for the Federal Reserve
While Delta poses a risk, the economic recovery has been robust and the Fed is keen to keep it on track. At its September meeting, the Federal Reserve gave markets an update on how it expects the broader economy to perform over the next few years. In general, the committee appears cautiously optimistic and still expects growth and inflation to run above historical trends, but cool down as we move into next year. Also, with companies paying more to attract workers, job growth should remain solid. While this is mostly good news, the Fed still wants to keep interest rates low for as long as possible, and may not begin raising rates until late 2022 or 2023. However, we continue to expect that they will begin to reduce bond purchases by year-end.
8. Interest rates likely to resume their ascent
The combination of very easy monetary policy and a recession has left 10-year Treasury yields at very low levels. Interest rates will likely move higher into 2022, against the backdrop of rising inflation, faster growth, and a less accommodative Fed as they begin tapering. There continues to be a place in portfolios for fixed income to provide diversification and protection in the case of an equity market or economic relapse, but investors may want to focus on shorter duration bonds to be well-positioned if long-term rates resume their ascent.
9. Valuations are high for U.S. equities
U.S. equities have trended higher during the course of the year, characterized by range-bound valuations and rising earnings expectations. Stock prices based on current forward P/E ratios still look elevated, although they have come in somewhat as earnings have played catch-up. Looking forward to 2022, returns will depend more heavily on profit margins. Rising wages, supply chain disruptions, and higher taxes could all negatively impact profit margins over the next few years. However, while elevated valuations may pose a speed limit for the market, the outlook for returns remains positive amidst strong fundamentals and corporate profitability.
10. Value could outperform in the short run
After multiple years of strong outperformance of growth stocks, most notably during the pandemic in 2020, value has begun to recover. The left chart shows that even after a good start to 2021, value appears to remain cheap relative to growth compared to long-term averages. Additionally, value generally tends to outperform growth during periods of above-trend economic activity and rising interest rates.
However, investors would be wise not to abandon growth stocks altogether as the economy is likely to slow down to a much slower pace of economic growth later in 2022 and into 2023, and growth stocks have traditionally outperformed value stocks in a slow economic growth environment.
11. International stocks offer cyclical and long-term opportunities
While the expected synchronized global recovery has been delayed, it has not been derailed, and vaccination progress overseas has gained speed with many countries now outpacing the U.S. We expect the global economy to continue to grow above trend over the course of next year and for robust earnings growth to be an important catalyst for international markets. In addition, valuations remain attractive with both emerging market and developed market stocks at some of their cheapest levels relative to the U.S. in the last 20 years. This, along with a global post-pandemic economic rebound, lower trade tensions and the prospect of a lower dollar in the long run argue for a greater allocation to international equities, with a particular focus on East Asia and Europe.
12. S&P valuation dispersions points to active management
This slide shows S&P valuation dispersion over the last 25 years, illustrating a widening valuation gap between the most and least favored stocks in the index. The current S&P 500 valuation spread is markedly higher than the 25-year average – this wide dispersion in valuations points to an opportunity for active management.
The U.S. economy has had a bumpier recovery than expected but is still on strong footing as we enter the fourth quarter, and further progress on the pandemic at home and abroad will continue to be a tailwind for the global economic recovery. Given the substantial growth markets have had thus far in the economic cycle, investors would be wise to focus on fundamentals and maintain a somewhat diversified stance as we move forward to a, hopefully, much better 2022.