Economic & Market Update
Welcome to the 2Q 2021 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 13 Guide to the Markets slides.
There are 80 pages in the Guide to the Markets. However, we believe that the key themes for the second quarter can be highlighted by referencing just 13 slides.
DR. DAVID KELLY
CHIEF GLOBAL STRATEGIST
ECONOMIC & MARKET UPDATE: USING THE GUIDE TO THE MARKETS
TO EXPLAIN THE INVESTMENT ENVIRONMENT
1. The light at the end of the tunnel – herd immunity
Any discussion of the economic and investment outlook must start with an understanding of the human toll of the pandemic itself and the light at the end of the tunnel – herd immunity. This page looks at the 7-day moving average of new confirmed cases and fatalities of COVID-19. After surging in the winter months, the U.S. has begun to make considerable progress against the pandemic. Declining cases and fatalities beg the question: where are we on the road to herd immunity? The right hand side of slide 22 provides some color on this. Assuming that this accelerated pace of inoculations continues, growing immunity, along with better testing and therapeutic drugs, should allow the number of cases and fatalities to drop precipitously over the summer, allowing life to largely return to normal by the fall of 2021.
2. Massive fiscal support has boosted debt and deficits
A more realistic view on the federal budget over the next year suggests that the federal government will hit a new record high debt-to-GDP ratio by the end of fiscal 2021, even higher than in the aftermath of World War II. While we do not believe this will result in a fiscal crisis in the next couple of years, a failure to rein in deficits and debt monetization, once the economy accelerates in the wake of a vaccine, could lead to significant problems. In particular, a sharp rise in inflation could result in higher interest rates and higher taxes, and could ultimately set the stage for an economic relapse.
3. The economic recovery should accelerate in 2H21
The retreating pandemic coupled with new fiscal support is priming the economy for a surge over the course of 2021. Growth will be driven by pent-up demand and pent-up supply in those sectors that have been most impacted by the pandemic. We expect these to reopen very quickly, leading to high-single-digit economic growth in the second half of 2021 and going into 2022. This should push the economy closer to a full recovery, and growth thereafter may well retreat closer to the roughly 2% pace it saw in 2019 at the end of the last long economic expansion.
4. Job gains should follow as service sectors rebound in late 2021
While this partial recovery in the labor market is welcome, the pace of recovery has slowed. 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 continue to weigh on payroll employment. Moreover, the unemployment rate likely understates the degree of economic distress as almost 4 million people have dropped out of the labor force since the start of the pandemic, and are thus not counted among the unemployed. However, as the service sector rebounds strongly in late 2021 and early 2022, we expect very strong job growth and we believe that the unemployment rate should fall to between 4.5% and 5% by the end of 2021, and to between 3.5% and 4% by the end of 2022.
5. S&P 500 earnings poised to hit a new all-time high in 2021
The deep recession in the economy was mirrored in big declines in S&P500 operating earnings in early 2020. However, as shown on page 7 of the Guide, earnings have recovered substantially since then, and now look set to hit a new all-time high in 2021. This partly reflects the fact that some of the most important sectors of the U.S. equity market, including Technology, Communications Services, Health Care and Consumer Staples, saw few negative impacts from the pandemic and, in many cases, saw stronger revenues. In addition, the pandemic appears to have resulted in some degree of productivity improvement across the U.S. economy.
6. Inflation should rise, but not surge
The onset of the recession, combined with a collapse in oil prices, triggered a decline in already low inflation in 2020. Since then, inflation signals – such as oil – are getting hotter, with the potential to boost inflation going forward. It is important to note that though stronger growth is likely to be accompanied by higher inflation, the Federal Reserve views this outcome as transitory, and expects to maintain its accommodative stance for years to come. Consequently, we expect inflation, using both CPI and personal deflator measures, to edge over 2% by the middle of 2021 and stay at close to this pace into 2022.
7. The Federal Reserve remains 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 adding dramatically to its balance sheet.
In addition, in August, the Fed adopted an “Average Inflation Targeting” 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.
Although the Fed pledged to maintain its current asset purchases until “substantial further progress” has been made to achieving its inflation and employment goals, it is important to note that this timetable suggests that the Fed will reduce its bond purchases well in advance of any increase in short-term interest rates. This, in turn, suggests a steepening of the yield curve as the economy continues to recover in 2021.
8. Low for even longer
With the Federal funds rate at 0-0.25%, nominal Treasury yields have fallen to near-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.
9. Valuations are high for U.S. equities
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. Investors should recognize that earnings are likely to continue to grow quickly in the year ahead which should lead to some compression in these ratios. Moreover, a continuation of relatively low interest rates likely justifies some elevation of valuation measures above their historical averages. Still, rich valuations may constrain equity returns over the long-run. Consequently, investors may want to consider diversifying their equity exposure adding more to value stocks as well as reducing weightings to the very largest companies in the stock market.
10. The challenge of the 60/40 portfolio
The challenge to investors from high P/E ratios on stocks and low bond yields is illustrated on Page 77 which shows the earnings/coupon yield on a 60:40 bond/stock portfolios. The earnings yield on stocks, which is just the inverse of the P/E ratio should be a good predictor of future returns on equities. Bond yields should be a good predictor of the long-term return on bonds. The earnings/coupon yield is constructed by adding 0.6 times the S&P 500 forward earnings yield to 0.4 times the yield on the Barclays Aggregate bond index. This is now close to a record low and suggests that returns on a plain vanilla 60/40 portfolio should be very low in the next few years. This highlights the urgency of finding other ways to boost portfolio returns without taking on inordinate amounts of risk.
11. Value vs. growth
While growth has outperformed in recent years and, most notably, during the pandemic in 2020, value may do better over the next year or two. The left hand side of page 9 shows that, even after a good start to 2021, value appears to remain cheap relative to growth compared to long-term averages. The right-hand side of the chart shows that earnings in value sectors appear more likely to rise in the robust economic recovery that we expect for the next year.
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 in 2023 and growth stocks have traditionally outperformed value stocks in a slow economic growth environment.
12. International stocks offer long-term opportunities
Investors may also want to increase their holdings of international equities. East Asia appears to have had more success in subduing Covid-19 than the United States, while progress in Europe in resolving the Brexit standoff and increasing fiscal integration could benefit the region.
In addition, as we show on slide 58, both Emerging Market and Developed Country stocks outside the United States are selling at some of their cheapest levels relative to their U.S. counterparts in the last 20 years. This, along with the potential for a strong global post-pandemic economic rebound, lower trade tensions and the prospect of a lower dollar in the long run all argue for a greater allocation to international equities with a particular focus on East Asia and Europe.
13. S&P valuation dispersions points to active management
Finally, slide 11 shows S&P valuation dispersion over the last 25 years, illustrating that with the blessings of strong performance come the challenge of higher valuations. 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.
This quarter should be quite telling in regard to our collective success in ending the pandemic as well as the pace and shape of the U.S. and global recoveries from the social distancing recession. Given the uncertainties investors continue to face, it would be wise to maintain a somewhat defensive and diversified stance, taking advantage of active management as we impatiently approach the end of the pandemic.