Economic & Market Update
Welcome to the 4Q 2020 J.P. Morgan Asset Management market and economic 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 73 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.
Dr. David Kelly
Chief Global Strategist
ECONOMIC & MARKET UPDATE: USING THE GUIDE TO THE MARKETS
TO EXPLAIN THE INVESTMENT ENVIRONMENT
1. This slide tracks the progress and trajectory of COVID-19
Any discussion of the economic and investment outlook must start with an understanding of the human toll of the pandemic itself. This page looks at the 7-day moving average of new confirmed cases and fatalities of COVID-19 over time. The path of the pandemic impacts the level of economic activity, and fluctuations cause a lot of uncertainty. Therefore, economic activity is likely to remain below pre-pandemic levels until the broad distribution of a safe and effective vaccine, likely in 2021.
2. The economy is emerging from recession into gradual recovery
The economy has likely emerged from one of the deepest, but also one of the shortest, recessions over the last century. Because of how severe the recession was, and the fact that we do not have a more permanent solution to the virus yet, the economic recovery should be gradual. Economic output may not reach its 2019 peak level until late 2021.
Part of the reason for this is consumption drives nearly 70% of the economy, and with many service-oriented businesses only reopened partially, and with high unemployment reducing households’ ability to spend, the engine of the economy impaired. Some areas of the economy, however, like housing and autos, have been able to rebound strongly, while others, like hospitality and leisure, may continue to struggle until there is a vaccine.
3. The second half of the labor market recovery is likely to be slower
After reaching a 50-year low in February of 3.5%, the unemployment rate spiked to 14.7% in April, as 22 million people lost their jobs. Although there has been a sharp recovery in jobs thus far, the second half of the labor market recovery is likely to be much slower. This is highlighted on the right, looking at some of the hardest hit industries. Much of the remaining employment decline from the pandemic is in sectors that will have a hard time reopening while the pandemic continues, including the leisure, hospitality, travel, retail and food services industries. In addition, state and local government cutbacks, the layoff of over 250,000 temporary census workers and continued job losses in the energy sector should weigh on payroll employment.
4. Profits should gradually improve from here
The deep recession in the economy was mirrored in big declines in S&P500 operating earnings in the first half, pushing profits into recession. Analysts are expecting profits to recovery in 2021, but past earnings recessions have typically lasted 2-3 years, and given the severity of the plunge in profits and the gradual economic recovery, it is likely that profits will not surpass their 2019 peak until 2022.
5. Higher inflation is a risk down the road
The onset of the recession, combined with a collapse in oil prices, has triggered a decline in already low inflation. Although inflation normally troughs after the end of a recession, things may be a little different this time around, particularly given the potential for further economic stimulus after the election, the continuing extra costs of operating during a pandemic and the likelihood of an economic surge post-pandemic..
6. The Federal Reserve has committed to remaining accommodative
In the first half of 2020, the Federal Reserve took very strong action to support the economy including cutting the federal funds rate to a range of 0-0.25%, opening or expanding a very wide range of facilities designed to support different parts of the bond market and doubling its balance sheet.
In addition, in August, the Fed adopted an “Average Inflation Targeting” operating strategy, by which they will aim to achieve inflation of above 2% for some time to make up for years of undershooting this target. In order to achieve this they have pledged to hold the federal funds rate at its current 0-0.25% target range until inflation is at 2% and on track to moderately exceed 2% for some time.
Critically, the Fed’s willingness to buy almost unlimited quantities of Treasuries is enabling the Federal Government to deploy the most aggressive fiscal stimulus since World War II. Assuming that this continues, the Fed may well achieve its above 2% inflation goal within the next few years.
7. Massive fiscal support has boosted debt and deficits
The heart of the economic damage is with consumers and businesses, so the U.S. government delivered a multi-trillion dollar fiscal package to mitigate permanent economic damage.
This legislation provides very significant but temporary help to individuals, companies and state and local governments, but it hasn’t prevented the economy from falling into a sharp recession, in terms of lost output and higher unemployment. However, it should allow both households and companies to avoid the worst effects of recession until a vaccine has been developed and the economy can embark on a robust recovery. A follow-on package is expected at some point as many provisions of early packages have expired, but could come after the election.
Needless to say, however, this stimulus has come at a very high fiscal price, leaving the economy with the highest debt to GDP and deficit to GDP since World War II.
8. Short-term election volatility should not disrupt investment plans
Markets are likely to experience increased volatility around the upcoming November election. That is because markets do not like uncertainty, but the outcome of an election always reduces uncertainty. Even if we do not have results on Election Day, the interim volatility or the eventual outcome should not disrupt investment plans because markets rely on fundamentals, not politics. And investment time horizons extend far beyond election cycles or presidential administrations.
This page show S&P 500 returns and real GDP growth during periods of Republican, Democrat, or divided government control. We define Republican control, for example, as a Republican president with a Republican-majority Senate and House of Representatives. Over time, markets have enjoyed solid returns and the economy has continued to grow under all configurations of government.
9. Low for even longer
With the Federal funds rate at 0-0.25%, expectations for low rates for long again, and challenges to growth ahead, nominal Treasury yields have fallen to historic lows and real yields are negative. In this low rate environment, investors will continue to hunt for yield. Although spreads had widened in riskier fixed income, they have come in meaningfully, making risk-return dynamics less attractive. However, despite unattractive yields, high quality fixed income will continue to play an important role in providing investors with downside protection and diversification.
10. U.S. equities have recovered significantly
U.S. equities have recovered significantly from the March lows, and at record speed. However, as markets look through the virus and the downturn to the recovery, valuations are well above historical averages. However, investors should recognize that any valuation based on earnings over the upcoming year will look high given the unusually deep recession. Valuations look much closer to normal levels based on lagged earnings. While markets may experience volatility ahead with risks such as a resurgence of the virus or election uncertainty, ultra-low rates and support from the Federal Reserve provide meaningful support to equities.
11. International stocks offer long-term opportunities
Both U.S. and international stocks sold off at the height of the COVID crisis, but the valuation gap between U.S. and international stocks that persisted throughout the recent expansion still persists today. However, this dynamic could shift in the next expansion.
The long-term growth prospects of EM economies still look better than for the U.S., valuations remain cheaper overseas, and the dollar has been retreating, which amplifies the return on international equities. Europe, which has been long unloved, may have a catalyst for turnaround with more promising efforts towards fiscal integration.
12. Risks ahead call for diversification
Despite a rebound in markets, the economic, labor market, and earnings recoveries will likely be much slower. With additional risks ahead such as a resurgence of the virus and the election in November, investors would likely benefit from a focus on quality in equity and fixed income, with a balanced approach to confront a range of outcomes.