Economic & Market Update - J.P. Morgan Asset Management
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Economic & Market Update

“There are 65 pages in the Guide to the Markets. However, we believe that the key themes for the third quarter can be highlighted by referencing just 10 slides.”

DR. DAVID KELLY, CHIEF GLOBAL STRATEGIST
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Economic & Market Update: Using the Guide to the Markets to explain the investment environment

1. The economic expansion is continuing at a slow but steady pace

LEFT: This has been a slow but resilient expansion

This economic expansion has been like a healthy tortoise – slow but steady. In fact, as of December, the expansion is in its ninth year, making it the third longest expansion since 1900. Growth accelerated in the third quarter after firming in the second, and rebuilding following a series of natural disasters, alongside tax reform, should add to growth. That said, U.S. growth may be limited moving forward by structural constraints.

RIGHT: The economy should grow faster moving into 2018

Growth should accelerate and stabilize through the end of 2018, reflecting a pick-up in exports, inventories, government spending and fiscal stimulus through tax reform. Stronger investment spending and an improving global economy should also be tailwinds, with some give-back from a weaker-than-expected first quarter likely. Regardless, weak productivity and labor force dynamics should prevent sustained growth at 3.0%, with growth likely slowing to 2% or less in 2019 and beyond.

Economic growth and the composition of GDP

Unemployment and wages

2. Unemployment continues to fall, which should drive up wages

While the economy maintains a slow-but-steady pace of growth, the labor market has continued to tighten. This reflects two key trends: low productivity growth, which implies most GDP growth has to come from employing more workers, and low labor force growth, which means that much of the job growth has come from re-employing the unemployed rather than new workers entering the labor market.

Solid GDP growth in 2018 should cut the unemployment rate further, perhaps to 3.5% by the end of 2018, having already fallen to its lowest level since December 1969. While wages have been slow to react to a tight labor market so far, extra pressure to find workers spurred by tax cuts could finally boost wage growth by the end of the year.

3. Earnings headwinds should be behind us, but future growth may be muted

LEFT: Corporate earnings are rebounding from a weak 2015

After falling 11% in 2015 due to a high dollar and losses by energy companies, S&P 500 operating earnings per share have continued to rise this year. However, earnings growth could be more muted in 2019, though a positive impact from tax reform should provide a boost for the rest of this year, so long as the stronger growth offsets higher wages and interest rates on corporate income.

TOP RIGHT: The dollar should be less of a drag on earnings in the near future

With over 40% of S&P 500 revenues coming from abroad, a weaker dollar will boost foreign sales, particularly in 2018.

BOTTOM RIGHT: Margins may start to come under pressure

Corporate margins are at near record-highs, meaning companies in the S&P 500 are more efficient than they’ve been in some time. This will not last forever, though: as wage pressures start to build and interest rates rise, corporate margins may start to slip, eroding profit growth slightly in 2019 and beyond.

Corporate profits

Inflation

4. Inflation should rise gradually

The weakness in inflation in 2017 appears to have been largely transitory, and inflation looks set to continue to edge up through the end of 2018, helped by a weaker dollar, higher oil prices and tightening labor and housing markets. That said, the use of information technology around the world has empowered buyers of goods and services, a powerful structural force that has put downward pressure on inflation globally in recent history. This force will likely remain in 2018 and beyond, which should temper the rise of inflation moving forward.

5. The global economy is growing everywhere but booming nowhere

After two years of very mediocre growth and various setbacks over the last decade, the global economy started to show signs of life at the end of 2016. So far in 2018, though some countries have reported slowdowns, it does not appear that the broader global growth story will end any time soon.

The Eurozone is growing particularly fast, thanks to a still undervalued currency, rising confidence and considerable pent-up demand, while other developed markets like Japan, Canada and the U.S. continue to accelerate. The UK appears to be weathering the impact of the Brexit vote better than many had feared, thanks to more competitive exports on a weaker currency. Meanwhile, a rebound in demand for commodities continues to be a general positive for Latin America, Canada and Australia, while Chinese contribution has ebbed slightly as authorities try to restrain financial speculation. All-in-all, the global economy is growing everywhere but booming nowhere, something that adds a certain stability to future growth.

Manufacturing momentum

The Fed and interest rates

6. The Fed should feel comfortable about raising interest rates

The global economy is generating fewer worries than in recent years and the U.S. is approaching or at many long-term targets, like unemployment and inflation, making it clear that interest rates are still too low. The decision to increase rates again in June reflected this conclusion, and barring any significant negative shocks or fiscal stimulus, we anticipate the Fed to further raise rates by 0.25% two more times in 2018. In addition, the FOMC’s plan to reverse quantitative easing, the start of which was announced at the Fed’s September 2017 meeting and commenced shortly after, demonstrates that the central bank is committed to raising interest rates across the yield curve.

7. Rising rates will make fixed income investing more difficult

Long-term interest rates remain very low, especially compared to historical averages, despite a clearly improving global economy and Fed tightening. However, in 2018, some forces like further hikes in the federal funds rate, stronger economic growth and lessening accommodation by other central banks should push yields higher. This back-up in rates should result in weak total returns on Treasuries and some high-quality corporate bonds, suggesting that investors may want to consider investing in other fixed income sectors, like high-yield debt or emerging markets, or shifting their portfolio allocation to underweight bonds relative to other asset classes.

Interest rates and inflation

S&P 500 valuation measures

8. U.S. stocks are slightly expensive relative to history, but not relative to bonds

Despite a very long and powerful bull market, the case for an overweight to U.S. stocks over bonds persists. As it currently stands, many valuation measures show the U.S. equity market to be slightly expensive relative to history, with both forward P/E and Shiller P/E ratios trending higher than long-term averages. That said, valuations have recently moved more in line with average, thanks in part to improving analyst estimates of 2018 earnings in the face of tax reform.

Regardless, the most important ratio on this slide is the comparison between the earnings yield on stocks and yield on BAA bonds (the yield of the average debt rating of S&P 500 companies) – this is, in essence, an adjusted risk-free rate, incorporating credit risk. Looking at this metric, it would still appear that owning the equity of a company is a better investment than owning the debt. Put more simply, relative to bonds, stocks still look cheap. That said, bonds, like stocks, look expensive, and rising interest and wage costs may put pressure on margins, underscoring the importance of diversification outside of the most traditional asset classes.

9. International stocks may offer better opportunities

Over the last 20 years, both U.S. and international markets moved sideways. However, come 2011, U.S. markets took off while international markets remained stuck. Recently, international markets have started to perform well, too, leaving many investors to wonder if they’ve missed the boat on international investing. Thanks to lower-than-average valuations, higher dividend yields than U.S. stocks and a falling U.S. dollar, which should amplify returns on international investments, it appears that there are still opportunities available for overseas exposure.

U.S. and international equities at inflection points

Asset class returns

10. Higher valuations and uncertainty underscore the need for broad diversification and careful portfolio management

Despite continued political turmoil in 2017, risk assets produced generally positive returns, as indeed they have been on average over the past 15 years despite the global financial crisis and many other economic, geopolitical and financial disruptions. In 2018, cash is still paying close to nothing and global economic momentum and reasonable global stock valuations suggest that this is still a time to be overweight risk assets.

Having said this, it should be noted that many asset prices are higher than they were a year ago. Because of these higher valuations and potential dangers from policy mistakes or geopolitical risks, it will be even more important for investors to maintain well-diversified portfolios and be willing to make adjustments in response to changing valuations or the investment environment.