Economic & Market Update
Welcome to the 1Q 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 11 Guide to the Markets slides.
There are 75 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. The pandemic continues to surge
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. The path of the pandemic impacts the level of economic activity, and fluctuations cause a lot of uncertainty. After surging and retreating in the spring and the summer, the pandemic has worsened in recent months and will likely continue to surge in the first quarter. However, the approval of several very effective vaccines in the U.S. should allow for the inoculation of roughly 150 million people in the first half of 2021, allowing life to largely return to normal by the fall of 2021.
2. The economic recovery should accelerate in 2H21
After suffering the most severe recession since WWII resulting in the worst quarterly GDP print on record in 2Q20, economic growth surged in the third quarter, notching the best quarterly GDP print on record in 3Q20. However, despite this strong surge, economic activity has only partially recovered from the collapse and remains far below the trend suggested by economic growth at the end of the last decade. This reflects the dominance of the service sector in the economy and the inability of it to recover fully in a pandemic.
The renewed pandemic will put further pressure on these industries and this, combined with a delay in getting extra fiscal support to the U.S. economy, is leading to a sharp deceleration in economic activity with growth likely slowing to a very low single-digit pace in early 2021. Thereafter, however, growth should surge due to both pent-up demand and pent-up supply in those sectors that have been most impacted by the pandemic.
3. Job gains should slow until broad vaccine deployment
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 more gradual, as the pace of job gains has already 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 could weigh on payroll employment. However, once the vaccine is broadly deployed, service-sector jobs could have a healthy rebound.
4. Profits have turned a corner
The deep recession in the economy was mirrored in big declines in S&P500 operating earnings in early 2021, pushing profits into recession. Analysts are expecting profits to recover 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. However, in 2021, areas hardest hit by the pandemic, like energy, financials, and industrials, could experience solid earnings rebounds, while areas like technology and health care should continue to hold up well.
5. Higher inflation is a risk down the road
The onset of the recession, combined with a collapse in oil prices, 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 fiscal stimulus, the continuing extra costs of operating during a pandemic and the likelihood of an economic surge following the distribution of a vaccine. 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.
6. 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.
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 at the onset of the pandemic. Pending further fiscal support and possibly infrastructure spending, the budget deficit could further increase in 2021, but will likely still be below 2020 levels. However, the national debt as a share of GDP will continue to grow to the highest levels since WWII. 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. This suggests that eventually, the government will have to make some tough choices on tax hikes and spending cuts.
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. 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.
11. Risks ahead call for diversification
Given the extraordinary disruption to the U.S. and global economies in 2020, it is remarkable how resilient financial markets have proven to be.
However, investors should recognize that the blessing of strong performance brings with it the challenge of higher valuations. The next few months should answer many questions with 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 all the uncertainties surrounding these and other questions investors would be wise to maintain a somewhat defensive and very diversified stance after one of the most difficult and unusual years in modern history.