David:  2022 so far has been a tough year for investors, but the market itself has also brought valuations back to much more reasonable levels. The economy is dealing with very high inflation and a more hawkish Fed right now and is increasingly threatened by recession later this year or in 2023. However, any recession should be relatively mild and short and arguably much of the bad news may already be priced into markets.

 

This being the case, investors may well want to position portfolios for the expansion that emerges after the current strong cyclical forces fade. For our last episode of this season, I'm very glad to be joined by my colleague, Jack Manley, global market strategist for JP Morgan asset management for an important conversation on market performance, asset allocation, and investing in the long run. So Jack, welcome back to Insights Now. Thank

 

Jack: Thank you David. It's good to be here.

 

David:  So let's start by talking about what's happened so far this year, the S&P 500 is down about 20% year to date. And while bonds typically provide balance to a portfolio in down markets, the Bloomberg aggregate bond index is also down about 10% year to date. So lots of bad things have happened so far this year. What do you think have been the key drivers of this performance?

 

Jack:  There's a laundry list here when it comes to all the problems that we're dealing with as an economy and when it comes to our capital markets right now. I think top of mind, of course, for a lot of people is the red hot inflation that we've been experiencing. CPI print the other day of 9.1% strongest one we've seen in over 40 years and what of course that may do to the federal reserve and monetary policy, because we know that monetary policy influences of course benchmark interest rates and benchmark interest rates are going to influence what's going on, not just in the bond market, but also in the stock market.

 

But you put those concerns aside. You have other problems. We have war in Europe for the first time in a long time, we have a continued pandemic that while we'd like to think is over, isn't really, truly over and beyond that this economy is set to slow down. We just don't have as much of a fiscal push as we had over the last couple of years, growth is cooling with or without Fed intervention. You put all these things together, it results in just a perfect storm. And when you look at what's gone on with inflation, when you look at what's gone on with growth, when you look at what's gone on with interest rates and interest rate expectations, it is no surprise that it has been such a troubling year for capital markets, particularly here in the US.

 

David:  But really with the federal reserve, I think is kind of the center of this. I agree with you in all of those issues are affecting markets and market sentiment, but I guess one of the key questions, maybe the key question right now is what's your base case scenario for the economy? Do you think the federal reserve is going to actually manage to achieve a soft landing or are they going to overdo it and put us in recession here?

 

Jack:  Well, one of the problems is that when it comes to talking about Fed policy, it is really important to separate what you think they should be doing and what you think they actually will be doing. Because unfortunately, as we've seen over the last six months, at least from where I sit, I don't think they've been doing what they probably should have been doing, but that of course is not influenza the overall trajectory of policy. So let's put that to the side for a moment.

 

The other thing that's important to remember right now is that given the fact that there are no clear instances of excess in this economy. You look at residential investment as a percentage of GDP. You look at inventories as a percentage of GDP. If we do end up in a recession, for whatever reason, perhaps driven by confidence, perhaps driven by an overly aggressive Fed this is not going to be a financial crisis style recession. It's not going to be a COVID style recession. This recession is going to be short and shallow and relatively painless as far as recessions typically go.

 

 So that ultimately comes down to David your question, what is sort of the base case here? And right now, if we look at what markets are expecting, markets are expecting the Fed to overdo it. We're seeing a Fed funds rate peaking by the end of this year, and then moving down next year in terms of those expectations, which is a suggestion that the markets clearly think that the Fed over tightens and will be forced to cut. I'd like to think that isn't necessarily the base case, but I think it is becoming increasingly more likely that we do end up seeing the Fed slam too hard on the brakes and be forced to retrench.

 

Now, that means that we will likely see interest rates move higher for the rest of this year but it also means that we may start to see a tailwind from interest rates starting at some point next year. If the rates actually do end up moving lower, if the Fed actually does decide to cut rates, that all of a sudden starts to make a little bit more sense from a duration perspective, that all of a sudden starts to help the equity market. So perhaps almost paradoxically, there is a silver lining even to this this not so great case of recession leading to rates moving lower.

 

David:  Yeah. And I was looking at the Fed funds futurist markets and you're right. The market is assuming that the Fed's going to overdo it and have to cut rates next year. I mean, if you look at the last Fed meeting dot plot, they said, they'd raise rates to between three and a quarter and three and a half percent by the end of this year. And then they'd raise rates by another roughly 50 basis points next year, before they cut in 2024. So the Fed officials seem to think they're going to achieve a soft landing. The market is saying they'll cut but actually, as of right now, the market's only saying they're going to cut by 50 basis points next year.

 

So in some ways the market is hedging its bets. And of course, what that really means is there's a lot of divergence of opinion within the market that some people think, yeah, we're going to ahead for recession, some people think, "Well, they're going to kind of get a self landing," and what's ending up being priced in the middle here. But I do think that it's unlikely that the federal move rates all the way up to three and a half to 4% by the end of this year and then only because by 50 basis points next year. That's kind of an unusual scenario here. If we end up in a recession, I just think we should make it clear to people. If we end up in a recession and inflation does fade, the federal reserve is probably going to have to do a much more dramatic reversal and cut rates more dramatically in 2023.

 

Jack:  I think that's absolutely right. And even on top of that, let's say that inflation, the Fed recognizes that inflation is largely outside of its control. So much of it as supply side driven, maybe the Fed just decides it needs to under deliver anyway. And in that case, you see markets sort of repricing expectations off of that as well. So I'd agree with you, David.

 

David:  All right. So getting back to the issue of markets, it's been a very rough time for both the bond market and the stock market so far this year. Do you think that they have priced in all the bad news here?

 

Jack:  I think say the price in all the bad news may be a little bit hopeful. That may be a little bit of wishful thinking because I think you're begging for something bad to show up out of nowhere, if that's what you say. But I would say that most of the bad news has already been priced. And most of the problems that we're facing with have already been incorporated and digested by both the stock and the bond market. If we see a meaningful slip in employment gains, if we see a meaningful slip in GDP growth, that may be a shock that is not necessarily anticipated but directionally, I think the stock market, the bond market know exactly where this economy is going which is slower for longer in the aftermath of this sort of post COVID bounce back kind of having run its course.

 

And so when we think about markets moving forward from here, if most of the bad news has already been priced in, then I don't think we should necessarily expect another six months of minus 20% on the stock market. Another six months of minus 10% on the bond market. I think the back half of this year looks a little bit different from the first half because touch wood there isn't a whole lot more bad news that this market has to digest.

David:  Okay. Well, let's try and move away from a very ugly, fundamental story right now. And talk a little bit about valuations, because I always believe valuations are half the story on any asset price and valuations have, of course rerated significantly across the board. And in particular over the course of the pandemic high growth stocks and the biggest growth stocks were really the all stars of performance. But if you had an extra chip to put in the market right now, do you think that this is... Would you put it in growth or value right now or how do you see that?

 

Jack:  Yeah, if you're going at it from a purely valuation perspective and you're just looking at where things are versus where things have been over the past, first of all you're right, David. There has been an incredible rerating in valuation so far this year. And in fact, the S&P 500 is now trading more or less in line with its long-term average if not a little bit cheaper than that which is remarkable when you consider sort of the trend that we've seen over the last five to 10 years, the fact that stocks look this cheap at face value is I think very interesting.

 

Of course, when you're looking at say something like value versus growth right now, growth stocks are still trading at a premium relative to value by a pretty significant margin. Value stocks trading at roughly a 40% discount or so to growth. Also, if you look at say the 15 year average valuations, growth stocks are trading richer than those long term averages, whereas value stocks are trading at a pretty healthy discount.

 

But I think it's also important to remember that it's hard to compare where we are right now and where we likely will be over the long run to where we've been over the last 20, 30, 40 years. I think personally, the interest rate environment is fundamentally different. The idea of the Fed funds rate get into six, seven, 8%, I don't think we're going to see that happen in our lifetimes. And so if the trajectory for interest rates is lower for longer, I think that's a net tailwind, probably a little bit more of a powerful tailwind for growth equity than it is for value equity, because those borrowing costs stay lower and growth companies can continue to grow.

 

I'd also make the case that growth and particularly technology and tech adjacent names. Those are long term secular trends. They came into this year, very expensive at an index level. I don't think anybody can argue in good faith that technology is going to be less important in 10 years than it is at the moment. So I like that tech story. I like that growth story, but what I think we have to be really careful about is distinguishing within that growth bucket, the sort of quote, unquote smart growth versus the silly growth. You come into this year with some valuations that were completely out of whack on companies that did not have physical products that were in high growth mode that were extremely cash hungry, had no defendable market share.

 

You compare those to some of the other, what I call almost blue chip growth stocks, high quality growth stocks companies that have a long track record, proven innovation, physical products, defendable market share. They've been caught up in this deluge as well. Indiscriminate selling in the marketplace resulting, and I think valuation and balance that exists across the growth spectrum. So if we're intelligent about where we're allocating to growth and we only look for that higher quality growth, that's where I'd put my last poker chip.

 

David:  Well, that makes a very strong and reasonable argument for growth and particularly blue chip growth as you've put us. And I think that makes a lot of sense. And I also think that it's really important to think about the role of interest rates here. If we reverse to a low, long term real interest rate environment the thing about growth stocks is they depend upon cash flows, which are going to be earned for decades and decades into the future. It's really much more about future earnings wealth and current earnings. And that's when interest rates become really important. So low interest rates do help growth over value, but is there any aspect given that values is still looking cheap relative to growth based on recent history. Is there any story that you would tell... Can you take that as sort of devil's advocate's perspective here and look at why might you favor value over growth?

 

Jack:  Sure. I think you can make a couple arguments in that favor. And of course the valuation story is a big, big part of that. Value stocks right now are extremely cheap, not just relative to history, but also to growth equity. And if you are looking for a good deal in today's market value is where it's at. But even if you look at it at a sector by sector level, you get a little bit more nuance. I think in that story. Energy has been the darling thus far this year of the equity market. It has done extraordinarily well. Earnings are up double if not triple digit percentages this year, because we know what's going on with fuel prices. Oil prices are very high. Gas prices are very, very high and so profitability in these companies has been highly elevated.

 

Now, you can make the argument that gasoline prices are going to stay higher for longer because there's not necessarily enough refining capacity out there. That's going to make a refining sort of crude products into something you can actually fill your pump up with or fill your tank up with rather a longer term problem, which not really good news necessarily from an inflation perspective, not really good news from say a consumption perspective, but if you're looking at crude oil the stuff that actually comes out of the ground, there is an enormous amount of incentive for global producers for US producers to produce more of this stuff.

 

So I do anticipate seeing crude oil prices move lower in the not so distant future as more capacity comes online. And that means that this energy story is a little bit shorter lived. Maybe you can strike while the iron's hot but trying to time the bottom on that is really complicated.

 

The story that I like a lot more actually in the value side of things is financials. And I like the large financials, the big banks, the diversified players, the universal players right now. They have been indiscriminately sold off this year as well. Valuations are trading at a pretty steep discount, but there is a lot of money to be made in these large diversified banks, particularly from banking services. A lot of attention is paid to the shape of the yield curve and we know that as the Fed hikes and as the Fed tightens, the yield curve typically flattens and Hey, a flatten yield curve is not good for net interest margins. Well, we don't pay enough attention I don't think to this lesson that a lot of large banks learned in the aftermath of the financial crisis, which is that they don't have to pass on those higher rates to depositors.

 

David, I don't know where you bank, but I can guarantee you're not getting one in three quarter percent on your savings account. That is not the case. You're getting two or three basis points and you are grateful for it because it's up from where it was six months ago. Meanwhile, you want to take a mortgage out right now it's north of 5%. There is a lot of money to be made in financials, a strong valuation argument. I think banks in general are in very good shape right now relative to where they were say 10 years ago. And so beyond that sort of broad based valuation argument you can make in value stocks, I think you can point to certain sectors like financials and say there's longer term growth potential here.

 

David:  Well, if there was one, I guess, area of financial markets that has been less loved and has underperformed longer than value equities, it's got to be international. International equity valuations still look very cheap relative to US valuations. For long term investors, do you see an investment case for international right now?

 

Jack:  I think for long term investors, I do but you have to be really careful about where you're allocating overseas because the valuation story you mentioned David, certainly things now are worse than they've been in a very long time, but international stocks have been cheap for a while. And there's a good income argument to be made for international investing. We look at the dividend yield and international stocks, it's considerably higher than what you get out of the domestic equities. And if you're struggling to find income in today's world, Hey, international stocks may be a good place for that. But that story was true five, 10 years ago also. Those things hadn't made a difference because there's been a lot of headline risk, a lot of political risk, a lot of social risk in a lot of these foreign countries that have interrupted the fundamentals.

 

What we were missing was some sort of catalyst. And at the beginning of this year, I know we were all really excited about international investing because that catalyst had finally shown up. We are now in the early innings perhaps of the post COVID cyclical upswing. It's not just the US recovering from COVID the whole world's recovering from COVID. And unlike the US which has been more or less open for business for the last year and a half some of these places around the world look at what's going on in Europe, in Canada, in Japan, in China, certainly have been locked down with severe mobility restrictions up until very recently. Younger cyclical position, longer cyclical runway, and a composition of those markets that is much more cyclical in nature. More financials, more industrials, more in energy, more materials. That was the story for out performance over there. You add on top of that, those incredible valuations you add on top of that, the income stream you add on top of that, the fact that the dollar must decline at some point.

 

It's just too overvalued right now. All of this makes the case for international investing over the long run. But I do think you have to be careful as I said, because those headline risks, they still exist. Look at what's going on in the UK right now, political turmoil, something that we weren't necessarily expecting a few months ago, it is back front and center in the news. And so when we approach international investing, yes, the valuations are important. The cyclicality is important. The income stream is important. The dollar strength is important, but it's also about figuring out what these markets do better than anybody else.

 

And if I were to pick on let's say Europe for an example, what is Europe known for? They're known for luxury goods. You want a nice car, a nice watch, a nice bottle of wine, a nice handbag, chances are they're made in Europe. Europe does that well. And that's a highly cyclical position. You also think about broader trends like ESG, energy transition, moving away from fossil fuels into renewables. Europe does that better than almost anyone else. So you can get exposure to foreign markets. You can get exposure to that, theoretically falling dollar without taking on broad political, social headline risk. I think it really makes the case David, more than anything for active investing in that space.

 

David:   Yeah. You mentioned the dollar and of course the dollar in real terms is now at its highest levels since the 1980s. What is your outlook for the dollar and how do you feel about its impact on international investments going forward?

 

Jack:  Well, it's great if you're a tourist because you look at what's going on with Euro dollar parody, you look at what's going on with CAD dollar parody or pound dollar parody. We're all approaching these things in the Europe. In Europe we've already hit that. But from an investment perspective, it has very clearly been a challenge, very clearly been a challenge because a strengthening dollar works against our US dollar denominated assets overseas. Now, you can make the argument at the moment that the dollar is overvalued. The fact that Euro dollar parity exists is incredible. First time that's happened in around 20 years. And you can say that well, okay, if the Fed does end up pivoting and we see interest rates moving lower and we see growth pick up overseas, that's a very strong case for short-term dollar weakness.

 

The problem though in predicting short-term moves in the currency is that fundamentals don't matter as much as the bigger sort of shocks to the system. So much of what's attributable or so much of dollar strength is attributable yes, of course, to the sort of widening out interest rate differentials. It's also attributable to the war and the uncertainty that that has caused and the global flight to quality that has caused. What I'd much rather focus on is the longer term story. And from that perspective, I think it's clear as day that the dollars overvalued. The US trade deficit is the widest it has ever been on record.

 

And what that in effect says is that we are pumping the global economy full of dollars, and we're buying those fancy cars and watches and wine and handbags, we're pumping the economy full of dollars. We're swapping them out for that respective for currency. The world's a wash and dollars right now. And supply demand very basic situation. It tells you that prices should move lower. The dollar should devalue.

 

And so if we take more than say like a six month time horizon, if we're looking 5, 10, 15 years, that dollar is going to be moving lower. And as it moves lower, it's going to be a net tailwind for investments overseas because that dollar weakness will help to sort of add to the kicker. It's also going to work against our domestic performance, particularly for those larger cap companies, I think further widening out that international opportunity set.

 

David:  Okay. Let's leave international there and talk about something else which has been, I think it's been easy to make a case for international for a long time. Even if it hasn't worked out. One thing that's been hard to make a case for, for a long time is fixed income. For a long time, rates have been at extremely low levels. We haven't got much income. We haven't had much diversification benefits from bonds. Haven't worked out very well so far this year with the bond market falling along with the stock market. But it has been a difficult first half of the year valuations look better. So do you think now is the time to step into fixed income?

 

Jack:  Yeah. If you're worried about fixed income and you're thinking of selling, you should have been having these conversations six months ago. I think now it's just too late for that story and we have to keep looking forward. And so much of this as everything else that we've really talked about, David hinges on what the Fed is going to do. And if indeed the Fed under delivers whether that means delivering fewer rate hikes than they expected delivering smaller rate hikes than we're expecting, or actually flat out cutting rates, which may happen next year if we were to enter a recession, all of these things are going to be positive for duration. It should result in yields moving lower.

 

 So if you're looking for that correlation benefit, that balance that insurance policy in a portfolio, I think fixed income does still very much play a role. It's the income side of things that is a little bit more challenging especially if the Fed does under deliver on interest rate hikes, especially if inflation stays relatively elevated, especially compared to where it was pre COVID. It's going to be hard to generate meaningful, real income out of bonds unless you are willing to take a whole lot of credit risk.

 

And frankly, on my end, if I'm taking all that credit risk, I'd much rather be in the equity market where I get the growth and the income potential. So bonds make sense in portfolios, maybe it's not the 40 and your 60, 40 anymore. Maybe you don't use them for income in addition to ballast, but as an insurance policy, as something that's going to zig, when everything else is zagging, I think we are entering a period where correlations start to work in our favor and fixed income will be that balance in a portfolio. Should things go south from an economic perspective?

 

David:   Well, the first half of 2022 has been a lot of zigs and a lot of zags. And frankly, I think a lot of investors are feeling pretty dizzy. And given that I know there's a temptation for investors to sit in cash until the outlook improves. Do you think there's a case for a larger holding in cash in portfolios right now?

 

Jack:   A larger holding maybe, but a big holding I wouldn't say so. When you think about investing quote unquote in cash right now, it's one of the few assets that you can invest in quote unquote that guarantees a loss. At least in real terms. If you look at the annualized yield on a six month CD, right now it's around 30 basis points. Meanwhile, headline inflation came in at 9.1%. The other day, you are losing big money in real terms. Most investors cannot afford to hold that much cash.

 

You always want to have cash on the sidelines. You want that rainy day fund. You want that emergency fund. You want that money for when you need immediate liquidity. But if you are worried about current market conditions, rather than sitting on the sidelines, I think you just have to be more thoughtful about how you're allocating. It brings that story all the way back to that active management play that we were talking about earlier. If you're thoughtfully allocating in the sectors styles, themes that have long term growth potential that have long term opportunity, you can actually do fairly well in a portfolio in today's challenging environment and not lock in those losses that you would be getting otherwise by sitting in cash.

 

David:  So you mentioned inflation earlier on, of course we just saw the highest reading on inflation since the 1980s. Headline CPI rose 9.1% year over year, not seasonally adjusted in the month of June. Given that high level inflation, a lot of people saying, "Okay, how do I protect myself against inflation?" Do you think this is a time to put inflation protection in place? And what sort of hedges should or shouldn't investors look at?

 

Jack:  Trying a time, whether or not you should be putting in inflation protection in place is really challenging because as we can all kind of relate to a year ago, we were talking about this inflation being transitory. And very clearly it hasn't been transitory. So trying to time the end of all this is tough. The way this works out, I'm sure I'll say, yeah, we should all go into tips and then inflation cools back off the 3% next month. I hope that is the case. I don't think that will be the case, but much more realistic I think when it comes to having conversations about inflation is how you would protect against it if you think that this inflation regime is here to stay for longer. There are certain fixed income instruments like treasury inflation, protected securities tips.

 

There are i-bonds that you can invest in that have their coupons linked directly to inflation rates. But I think it also means, first of all, you cannot afford to be in cash for those reasons that we just discussed. And more to the point you need to invest in something that's going to get you over that extremely high hurdle whether it's got a nine handle on it, an eight handle on it, a seven handle on it, whatever that number may be. You got a high hurdle to clear when it comes to investing in assets right now.

 

 I think that makes a very compelling case for equities, whether that's on the growthier side of things, where you're just looking for capital appreciation or the more inflation resistant parts of that market. Things like utilities, things like real estate investment trusts, parts of the market that typically pass on those higher costs to the end users. And that's another way that you can help to hedge against inflation. So I think you have to have a view on where inflation is going. Do you think it's going to stick around for a while? Do you think it's going to cool off sooner rather than later, that'll help you to decide whether or not you want to put inflation protection in your portfolio, but in terms of protecting your portfolio, if you do decide to go that way, there are a few different options across both stocks and bonds that will likely satisfy those needs.

 

David:  Wise advice. Okay, I'm going to ask you for one more piece of advice. Just to wrap up here, if you had a single key piece of advice for investors right now, what would it be?

 

Jack:  I would say right now, looking at the stock market, looking at what's gone on with recent performance, equities have sold off so much so far this year, and so much bad news is priced. And that you really have to ask yourself a very simple question as an investor right now, are we ever going to get back to where we were in January of 2022? The answer is no, you got bigger problems. But if the answer is yes, then it's just a question of time. How long is it going to take. If you were to buy into the market right now, and you think things are going to improve back to where they were in January over the next 12 months, you're looking at a 25, 30% upside. Let's say, you think it's going to take two years. Now, you're looking at a 15% you're so annualized upside three years, 10% annualized upside.

 

These are numbers that I would not sniff at. And so when it comes to allocating right now, I think we need to consider the upside potential at least as much as the downside risk. Frankly, I would consider it more. I would weigh it more in my thought process and realize that as long as we are longer term investors with that sort of positive mindset, you don't have to worry about what happens to the markets tomorrow or next week or next month because you're walking in those strong recovery gains over the next 12, 24, 36 months looking forward.

 

David:  Well, thank you Jack. And thank you all for listening to Insights Now. This concludes our fourth season of the Insights Now podcast. And thank you to all our listeners who have joined us along the way. We'd love to hear your thoughts and any suggestions you may have on our podcast as we plan for our next season. You can reach out to our team market insights at MI.questions@JP morgan.com.

 

We'll also provide the email in the show notes for this episode. Our next season is slated to begin in September. So stay tuned for more and enjoy the rest of the summer. Other than I invite you to read or listen to my notes in the week ahead podcast where every Monday I share commentary the latest in the markets in the economy to help you stay informed for the week ahead. For even more timely insights, you can also follow and subscribe to my content on LinkedIn.

 

Speaker 3:  This content is intended for information only based on assumptions in current market conditions and are subject to change. No warranty of accuracy is given. This content does not contain sufficient information to support investment decisions. It is not to be construed as research, legal, regulatory, tax, accounting or investment advice. Investments involve risks. Investors should seek professional advice or make an independent evaluation before investing.

 

The value of investments in the income from them may fluctuate, including loss of capital. Past performance and yield are not indicative of current or future results. Forecasts and estimates may or may not come to pass. JP Morgan asset management is the asset management business of JP Morgan Chase and Company and its affiliates worldwide.