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Welcome to our Quarterly Models and Markets Update – where we walk through key themes across our models, paired with Guide to the Market slides that you can use in conversations with clients. My name is Amy Moroz, and I am an investment specialist covering our J.P. Morgan Model Portfolios.
As we close the books on 2022, we can all acknowledge that it was an incredibly painful year. Looking at slide 63 of the guide – a balanced 60/40 portfolio drew down 16% – its worst performance since 2008, and the first time where both stocks and bonds sold off in tandem since 1974.
That painful backdrop has led to a dramatic reset of valuations across the board, which you can see on slide 62. This page gives a standardized view of valuations across asset classes versus their history – with anything above the line considered expensive to keep it simple. Looking at where things stood even just a year ago in the green diamonds – you’ll notice valuations have come down dramatically, creating a great entry point for investors. Looking at our long-term capital market assumptions, we’re now expecting the best returns for a balanced portfolio in over a decade – with a 60-40 mix expected to generate 7.2% annualized return over the next 10-15 years – implying investors could potentially double their assets over the next decade!
Now let’s zoom in and focus on the year ahead.. We expect many of the risks that plagued conversations over the last year likely to continue – though the balance of those risks has shifted - from runaway inflation and the impact on Fed policy – to slowing growth and risk of recession.
Looking first at inflation on slide 30 – inflation remained elevated throughout 2022, with headline CPI likely peaking in June at 9.1% YoY as shown on the left. We’ve seen relief in more volatile categories such as energy, vehicles, and food – which were hit hard by supply chain disruptions and worsened by the war in Ukraine. Meanwhile, other areas – like shelter and services, have remained stickier. Moving forward – we expect inflation to continue its path lower, though likely elevated above the Fed’s target in the year ahead.
Next, turning to slide 51 – this gives a picture of global economic momentum using our PMI heatmap which looks at manufacturing and services activity. Given elevated inflation and tightening financial conditions, we’ve seen global economic momentum slow meaningfully. Here green is good, red is bad, with numbers below 50 indicating contraction. Looking ahead, we anticipate growth to slow further as the Fed continues on its path of tightening, leaving the risk of recession elevated. Across portfolios – this backdrop leads us to remain underweight risk, and maintain an overweight to cash as we kick off the year.
Turning to fixed income – slide 34 looks at the Fed and interest rates. The Fed has remained persistent in its efforts to tame inflation with the fastest rise in rates since the early 80s, totaling 425bps in 2022. While there could be further hikes early this year, we believe we are far closer to the end of this hiking cycle than the beginning and expect policy to become less restrictive at some point this year, which would be a net positive for markets.
Slide 37 shows that while it’s been a painful year across fixed income with negative returns nearly across the board, we believe most of the pain is behind us. It’s hard to stomach with the Agg down 13% for the year, but as you look on the right as an example – if we were to see a 1% parallel shift upward in rates from here – that would result only in a 1.5% loss – given the extra cushion you get from higher yields today.
Across portfolios we are going back to basics in fixed income – and are now leaning into core bonds, which we feel offer the potential for diversification and attractive yield.
Switching gears to equities – last year was painful, with valuations under pressure as a result of rising rates. Valuations are now closer to long-term averages, but we feel there could be more pain ahead for stocks – driven by a decline in earnings, as a result of higher wages and slowing revenue growth. Slide 7 looks at corporate earnings with the right side of this slide showing the average amount analysts over or under-estimate earnings at different points in time. At the start of the year – analysts tend to overestimate annual earnings by an average of 5.5% - which is consistent with our perspective that the outlook for earnings is deteriorating and there is lower to go. We also anticipate for there to be broader dispersion across companies and sectors – making active management even more valuable.
As we zoom out further in equities – slide 49 looks at international earnings and valuations. Last year – with the dollar close to its highest rate since 1985 in real terms, investing internationally was a challenge. But looking ahead we could see interesting opportunities overseas as we anticipate the dollar to weaken, paired with the attractive valuations you can see on the right – particularly in areas like Europe, Japan or China. We’ll be keeping a close eye on key issues surrounding those regions. In Europe – the continued challenges with the war and its impact on energy, and in China with the easing of zero-covid policy.
Across portfolios – we are focused on high quality defensive names we feel can be resilient given further pressure on earnings and margins. We’re remaining well diversified across regions and styles and are leaning into active managers that can add value in this environment. We’re sticking to our mantra of remaining active – so we can focus on the short-term noise, and help clients stay on track towards their long-term goals.
That’s a wrap on our model themes this quarter, be sure to tune in again next quarter for our Models & Markets update.
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