Economic & Market Update
Welcome to the 1Q 2023 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.
DR. DAVID KELLY
CHIEF GLOBAL STRATEGIST
ECONOMIC & MARKET UPDATE: USING THE GUIDE TO THE MARKETS
TO EXPLAIN THE INVESTMENT ENVIRONMENT
1. After a challenging 2022, calmer waters lie ahead for markets.
Volatility was a defining feature of the markets in 2022, as higher interest rates and inflation, Russia’s war in Ukraine, and recession fears sent markets tumbling. The Asset Class Returns page of the Guide to the Markets shows a sober picture of recent performance, with significant losses in both global stocks and bonds and only commodities posting significant gains. However, calmer waters should lie ahead for investors. Inflation is falling, the Fed is nearing the end of its tightening cycle, and much of the expected weakness in economic growth is already reflected in market valuations.
Moreover, as investors consider this performance, it is important to take a longer-term view. In particular, it is worth noting that a broadly diversified portfolio could have risen by more than 30% between the end of 2018 and the end of 2022. Even after losses this year, many investors are well ahead of the game in their long-term plans and, after this year’s global reset in valuations, they are being offered a much broader menu of investment opportunities and higher potential returns than existed a year ago.
2. The U.S. economy is teetering on the edge of recession.
Entering the first quarter of 2023, there is a growing danger that the U.S. economy could slip into recession. While the U.S. consumer has been largely resilient so far, higher interest rates have weighed on home-building, trade and business investment.
In particular, higher inflation is squeezing consumer wallets, cutting the personal saving rate to 2.3% and boosting credit card balances. While excess savings from the pandemic supported spending in 2022, this stock is now drying up and it is unlikely consumers will see further aid from the federal government.
In addition, mortgage rates have more than doubled since the start of the year, contributing to continued declines in home building, home sales and consumer spending associated with setting up new households. Moreover, the dollar rose by roughly 9% in 2022, even after a late-year sell-off. This very high exchange rate, combined with weakness overseas, will likely boost imports and curtail exports thus dragging on overall economic growth. As the economy confronts these challenges, it is likely to see very weak real GDP growth with a greater than 50% chance of tipping into a recession by the end of 2023.
3. The labor market is showing early signs of cooling.
The labor market continues to be a bright spot in an otherwise gloomy environment, with the unemployment rate at 3.7% as of November, just 0.2% above its 50-year low in 2019. However, the economy is now losing momentum, even in the labor market. Job openings have come down and will likely fall further, as businesses reel back hiring efforts in the face of slower demand and higher costs. Initial and continuing jobless claims have also begun to trend higher, although they still sit below historical averages.
However, there is also a limit to how much weakness we may see in employment going forward, as U.S. businesses still face a structurally smaller labor force than prior decades. Diminished legal immigration, particularly over the course of the pandemic, and baby-boomers reaching retirement age have left the economy very short of workers.
This will somewhat resolve itself as higher wages and a higher cost-of-living lure some workers back into the labor market, allowing the economy to see additional months of solid job growth and low unemployment. As such, the unemployment rate may only nudge slightly higher in the year ahead. Wage growth has also moderated and will likely slow further, providing some relief to businesses and inflation.
4. S&P 500 earnings continue to be challenged by slower growth.
Following a spectacular 2021, in which S&P 500 operating earnings per share (EPS) rose by 70%, profits came under pressure amidst higher costs and receding demand in 2022, leading operating EPS to decline by an estimated 4% over the year. Looking forward, consensus expectations for a double-digit gain in earnings in 2023 look too optimistic, and we expect earnings will more likely be flat-to-down relative to 2022.
Rising costs, rather than deteriorating sales, have caused weakness in earnings and pricing power should continue to differentiate winners and losers in 2023. Energy companies will continue to benefit from high margins, while businesses that provide essential goods and services should be supported. Elsewhere, rising labor costs, higher interest rates and slowing nominal sales growth should bite into profits. In addition, a much higher dollar poses a headwind for companies with overseas sales and recession concerns could cause management teams to further reel in spending and investment.
A recession would lead to a further decline in profits and lower inflation tends to coincide with lower corporate profit growth, posing an additional headwind in the year ahead. However, if a recession that eventually leads to less wage pressure and easier monetary policy materializes, it could set up a better long-term environment going forward.
5. Inflation has peaked and should gradually fall.
2022 was undoubtably a year of very high and rising inflation with headline CPI inflation peaking at a 9.1% y/y gain in June. The good news is that there are convincing signs that a sustained inflation downtrend is underway. Most recently, consumer prices rose just 0.1% m/m in November, and just 0.2% when excluding food and energy. As we show on page 29, a modest pace of monthly inflation has been mostly sustained over the last five months.
Moreover, when looking at the components of inflation, the major hotspots of inflation from earlier this year have now simmered down. After Russia’s brutal invasion of Ukraine sent global commodity prices soaring early in 2022, energy prices declined in the second half of the year. Further, easing supply constraints, combined with lower consumer demand, have allowed inflation to simmer across core goods categories. While shelter inflation remains elevated, we expect it will soon peak and decline to reflect cooling rental markets. The remaining problem for inflation, therefore, is services prices outside of shelter, which are highly correlated with labor market dynamics. Fortunately, easing labor market tightness should also allow for services ex-shelter inflation to come down.
High and rising inflation caused pain for consumers and markets in 2022, but inflation is set to ease over the next few years to much more manageable levels, regardless of whether the economy falls into recession.
6. Global economic momentum has also slowed.
Elevated inflation and tighter financial conditions have become a global phenomenon with weakness broad-based in the global economy. Page 51 displays a composite PMI heatmap of the world. Red represents weakness across manufacturing and services while green represents strength. Clearly, economic momentum declined in the second half of 2022.
In particular, the Eurozone economies and the UK have been hindered by higher energy prices and energy shortages due to the Ukraine war, resulting in slumps in consumer confidence and spending. In addition, inflation has risen sharply across Europe and caused central banks to adopt more hawkish policy positions. Key policy rates of the ECB and the Bank of England began the year at -0.50% and +0.25% respectively. Today, they have risen to 2.00% and 3.50% respectively and are both set to move higher in the months ahead even amidst recession risks.
While growth was particularly weak in China in 2022, it should improve in the coming years. Actions taken by policymakers, such as the easing of zero-Covid policies, liquidity injections for the real estate sector and efforts to ease geopolitical tensions should act as economic tailwinds. Given this, we expect growth in China will accelerate in 2023 and normalize back to trend in 2024.
7. After soaring in 2022, the dollar should find its footing.
The U.S. dollar soared in 2022. As seen on page 31, the dollar is now trading near a 20-year high in nominal terms. In real terms, once inflation is considered, the dollar is close to its highest level since 1985. The dollar’s strength has been a function of weak overseas growth, geopolitical and macroeconomic uncertainty, and the Fed’s aggressive tightening cycle compared to other central banks.
This high dollar has contributed to a worsening current account deficit, now amounting to roughly 4% of GDP. Due to lagged effects, this is likely to widen further over the next year, undermining the competitiveness of U.S. manufacturing and diverting U.S. demand towards overseas producers. The rising dollar has also undermined returns on international equities.
Over the long run, we expect economic forces to gradually drive the dollar down. In the near term, macroeconomic uncertainty and the Fed’s persistent hawkishness may continue to support the dollar. However, the dollar could peak as the Federal Reserve nears the end of its tightening cycle and global central bank tightening narrows the gap in interest rate differentials.
8. The Federal Reserve is nearing the end of its tightening cycle.
2022 was also a year of aggressive monetary tightening, with the Fed hiking rates by a cumulative 4.25% throughout the year. Despite signs that the labor market and inflation are easing, the Fed has maintained its hawkish stance on monetary policy. At its December meeting, the Fed increased the federal funds rate by a reduced pace of 0.50%, following a series of 0.75% hikes, and remained firm on its higher-for-longer messaging.
The Summary of Economic Projections signals further rate hikes from the Fed ahead. The median expectation among FOMC members indicates that rates will rise to a range of 5.00% to 5.25% by the end of 2023. Meanwhile, the Fed will continue quantitative tightening, reducing their massive bond holdings at a maximum pace of $95 billion per month.
The Fed’s updated economic projections showed a perplexing picture of higher inflation, slower growth and higher unemployment compared to previous projections. The current median FOMC expectation for the annual core PCE inflation rate is now higher for 2022, 2023 and 2024 versus its September projections, despite recent evidence that inflation is easing. Other revisions suggest that the Fed believes below-trend growth and an increase in unemployment will be necessary to combat inflation, but that a soft landing is still possible.
Interestingly, futures markets disagree with the Fed’s forecast for the federal funds rate for 2023. Despite Powell opposing the idea of rate cuts, futures markets have priced in rate cuts for the second half of 2023, reflecting the concern that overly aggressive Fed action could tip the economy into recession.
9. Valuations have come down significantly across asset classes.
Elevated inflation and tighter financial conditions across the globe sparked a global reset in valuations that spared few asset classes. That said, the sell-off in markets this year has presented investors with attractive opportunities. As investors assess positioning in the new year, it’s important to assess both the remaining risks on the horizon as well as a new menu of investment opportunities in the aftermath of this year’s performance.
Page 62 shows 10 major asset classes and styles and their valuations, expressed as z-scores versus their respective 20-year history. Using z-scores allows us to illustrate how normal, or abnormal, current valuations are compared to history. Most asset classes are much cheaper today compared to the end of 2021. In particular, the sharp rise in yields have left U.S. Treasuries and core fixed income about 1 standard deviation below their average valuation levels. While other asset classes may not be as cheap compared to their historical levels, they have fallen from the lofty valuations seen at the end of 2021. This is not to say the year ahead won’t face further challenges in the markets, but with inflation receding and a Fed pivot forthcoming, the worst of the volatility is likely done. With careful risk management, there is plenty of opportunity for investors as we start the year.
10. The inverse stock-bond relationship should reassert itself.
Performance in 2022 was particularly unique because the bear market in stocks was accentuated by a bear market in bonds. A portfolio with 60% invested in the S&P 500 and 40% in the Bloomberg U.S. Aggregate Bond index fell 16% in 2022, marking the second worst year for a 60/40 portfolio since 1974. Rising inflation combined with rising yields contributed to deep selloffs in both stocks and bonds this year. However, a negative correlation between stocks and bonds is still overwhelmingly the norm. As shown on page 63, most drawdowns in equity markets have been offset by gains in fixed income. Moreover, as investors assess performance going forward, large drawdowns in both stocks and bonds have never repeated themselves the next year. Indeed, past years of underperformance were often followed by years of strong performance.
11. Don’t let how you feel about the economy overrule how you feel about investing.
For many Americans, 2022 was a very disappointing year with sharply rising inflation and interest rates, falling stock prices and the shock of Russia’s brutal invasion of Ukraine. These factors drove consumer sentiment down to its lowest level on record in June and has only staged a modest rebound since then.
When investors feel gloomy and worried about the outlook, their natural tendency is to sell risk assets. However, history suggests that trying to time markets in this way is a mistake. This slide shows consumer sentiment over the past 50 years, with 8 distinct peaks and troughs, and how much the S&P 500 gained or lost in the 12 months following. On average, buying at a confidence peak returned 4.1% while buying at a trough returned 24.9%.
Importantly, this is not to suggest that U.S. stocks will return anything like 24.9% in the year ahead, as many other factors will determine that outcome. However, it does suggest that when planning for 2023 and beyond, investors should focus on fundamentals and valuations rather than how they feel about the world.
