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 U.S. economy heated up in 2018, but should resume a slow and steady pace in 2019

LEFT: This has been a slow but resilient expansion

This economic expansion has been like a healthy tortoise – slow but steady. In fact, at 10 years old, this is the second longest expansion since 1900. Growth accelerated meaningfully in 2018 on the back of fiscal stimulus and an improving trade deficit. Moving forward, however, growth should slow as trade numbers worsen, the effects of fiscal stimulus fade, and structural limitations become a drag.

RIGHT: The economy has grew faster in 2018

Growth accelerated in 2018, with real GDP growth reaching 3.0% year-over-year by the third quarter, reflecting a pick-up in inventories, government spending and fiscal stimulus through tax reform. However, in 2019 growth is likely to slow without any new tax cuts or stimulus, reverting to the roughly 2% pace that it averaged between 2010 and 2016.

Economic growth and the composition of GDP

Unemployment and wages

2. Unemployment continues to fall and wage growth has moved modestly

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.

Unemployment has reached a multi-decade low, and factors that limit labor force growth, such as retiring baby boomers and tighter immigration, should continue to push the unemployment rate down. Finally, we have also seen a modest response from wages, however many companies continue to resist raising wages. Still, difficulty finding qualified workers many force companies to make some concessions, causing wage growth to edge up but not surge in 2019.

3. Corporate profits have been strong, but will slow

Profit growth was extremely strong in 2018, with the operating earnings per share of S&P 500 companies rising by over 30% year-over-year in the third quarter. Revenues have been boosted by a surge in oil prices and above-trend GDP growth. Margins have also risen thanks to corporate tax cuts and persistently low inflation and interest rates. Share buybacks, a product of excess cash, have also modestly boosted earnings per share.

In 2019 and beyond, however, many of these factors will fade. As a result, earnings growth should return to a mid-single-digit pace. However, the combination of healthy profits and a correction in stock prices have brought equity valuations down to near their long-term averages.

Sources of earnings per share growth

Inflation

4. Inflation should remain stable

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. Although oil surged and then retreated in 2018, it should stabilize in 2019, sustaining steady inflation.

Information technology continues to make consumer markets more competitive and this, along with only modest wage growth, suggests that CPI inflation will hover at just over 2% year-over-year over the next 12 months, with inflation as measured by the personal consumption deflator, staying very close to the Federal Reserve’s 2% target.

5. The global economy has slowed down

After experiencing synchronous global growth coming into 2018, many developed countries lost some momentum, and emerging markets faced headwinds from a strong U.S. dollar and tightening U.S. monetary policy. Concerns over trade fed fears of slowing global growth. Nonetheless, PMI data show that most global economies are still in expansion mode, with a few notable exceptions such as Italy, Taiwan and Korea.

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. Moreover, inappropriately expansionary fiscal policy and the desire for future flexibility of monetary policy in the event of a recession has made the need to normalize policy more immediate. Barring any significant negative shocks, we anticipate the Fed to further raise rates by 0.25% twice in the first half of 2019.

7. Careful fixed income positioning is necessary in a rising rate environment

Long-term interest rates remain very low, especially compared to historical averages. As the Fed continues to raise interest rates in a low-inflation environment, there is the possibility of a yield curve inversion. While this has historically been a reliable signal of an impending recession, recent unprecedented central bank policy may mean that the yield curve has been distorted. As a result, a yield curve inversion may not mean what it used to.

As rates rise, and the economy continues to grow, credit risk, rather than duration risk, is more appropriate in fixed income investing. That said, as interest rates continue to rise and bonds approach normal valuations, flexibility 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, quelling fears that the equity market is overvalued. This was not only due to market corrections, but also to very healthy profits. The earnings yield on stocks is still higher than the yield on BAA corporate bonds, making stocks cheap relative to bonds.

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, but 2018 was a year of U.S. outperformance, 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 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 volatile markets

Despite market volatility at the end of the year and 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.