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. U.S. growth is set to decelerate in 2H19

LEFT:  This has been a slow but resilient expansion

The economic expansion enters its 11th year in July, making it the longest expansion since 1900. This economic expansion has been like a healthy tortoise – slow but steady. However, growth is set to decelerate further, and resume its expansion average pace of roughly 2%. 

RIGHT: Consumption is the foundation of GDP

Consumption comprises 70% of GDP, and appears resilient for the second quarter. However, business fixed investment has weakened, and stronger net exports and a build-up in inventories that bolstered 1Q growth is likely to fade throughout the year.

Economic growth and the composition of GDP

Unemployment and wages

2. Employment gains will likely be at a slower pace

The unemployment rate is like a playground slide: it rises steeply during a downturn, and falls steadily during a recovery and expansion, similar to the shape of a playground slide. However, at the end of every playground slide is a leveling off at the end to slow momentum. After reaching multi-decade lows, the unemployment rate is likely to now experience that leveling off and fall only modestly from here to 3.2-3.5%. After all, employment lags GDP growth by one to two quarters, so as growth decelerates, so will gains in employment.

Although wages experienced a modest acceleration, that is also likely to plateau from here as companies continue to resist raising wages, workers have limited bargaining powers given the decline of trade unions, and wages are pushed down by a wave of retiring baby boomers.

3. Corporate profits should achieve low to mid-single digit growth

Profit growth was extremely strong in 2018, but slowed considerably in the final quarter, rising just 3% year-over-year after three quarters of 25%+ year-over-year growth. 1Q19 growth was relatively steady from the previous quarter at 4%, despite initially very pessimistic analyst expectations. From here, earnings growth should continue to achieve low to mid-single digit growth for the rest of the year.

Sources of earnings per share growth

Inflation

4. Inflation will likely remain subdued through 2019

Almost 10 years of monetary stimulus, economic growth and falling unemployment have succeeded in boosting home prices, bond prices and stock prices. However, they have not had a meaningful impact on consumer prices. Oil’s collapse brought headline inflation down, and despite a temporary rebound in oil prices, it failed to lift inflation. The Fed has acknowledged this persistently low inflation by lowering its projections for year-end inflation to just 1.5% on the PCE deflator.  

Information technology continues to make consumer markets more competitive and this, along with likely only modest wage growth from here, suggests that CPI inflation will hover at just under 2% year-over-year over in 2019, with inflation as measured by the personal consumption deflator likely undershooting the Federal Reserve’s 2% target.

5. The global economy has slowed but not stalled

Amid global trade tensions that have intensified this spring and remain unresolved, along with political turmoil across Europe and a slowing China, the global economy is facing a slowdown. We have seen manufacturing activity, as measured by PMI data, dip into contractionary territory (below 50) in many regions, most notably China, Germany, the Euro Area, Taiwan and Korea. Services PMI, which has held up better than manufacturing, is also beginning to deteriorate. Still, the global economy is not likely to stall in 2019.

Manufacturing momentum

The Fed and interest rates

6. The Fed may cut rates this year

Although the labor market is strong and growth has been solid, concerns about slowing growth ahead and negative impacts from the ongoing trade tensions between the U.S. and China have global central banks considering easing measures. The Federal Reserve is likely to cut rates at least once, but possibly multiple times, in 2019 as economic conditions deteriorate. Although the labor market is strong, growth prospects are in question and inflation remains subdued. The Fed has abandoned “patience” and “will act as appropriate to sustain the expansion.” Consequently, we expect two rate cuts in 2019.

7. Careful fixed income positioning is necessary in a changing environment

Long-term interest rates remain very low, especially compared to historical averages. Investors enjoyed a long bull market in bonds after rates peaked in the early 1980s, resulting in very low yields that were brought down further by extensive quantitative easing and rate cuts. Even though rates have been on the rise for several years, now a more dovish Fed could bring rates even lower from here. Therefore, in this rate environment and at this stage in the economic cycle, flexibility in fixed income investing will become increasingly important.

Interest rates and inflation

S&P 500 valuation measures

8. U.S. equity valuations are near long-term averages

Market volatility in the fourth quarter of 2018 brought equity valuations closer to their long-run averages; however, equity markets have moved higher this year and have achieved new market highs. Although valuations do not appear to be overextended, they are not cheap either. Although the market may have room to run, it is important for investors not to be positioned too aggressively, as many uncertainties, such as the Fed’s next move, trade and growth, remain, and may cause volatility ahead.

9. International stocks offer long-term opportunities

For most of the last three decades, both U.S. and international markets moved sideways. However, come 2011, U.S. markets took off while international markets remained stuck. In 2017, international markets started to outperform, they saw a reversal in 2018, leaving many to wonder if international strength was short-lived. However, international equities remain attractive over the long run thanks to strong economic growth and likely a downward trajectory for the U.S. dollar. Moreover, valuation measures suggest that international stocks are cheap relative to both the U.S. and their long term histories.

U.S. and international equities at inflection points

Asset class returns

10. Broad diversification and careful portfolio management are required in late cycle

Despite slowing economic growth ahead, equity markets and the economy still have room to run. However, an older expansion and bull market call for a more disciplined approach, with smaller over-weights and under-weights relative to a normal portfolio. It will be even more important for investors to maintain well-diversified portfolios and be willing to make adjustments as late-cycle risks gradually rise.