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

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.”


Economic & Market Update: Using the Guide to the Markets to explain the investment environment

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 the first half of 2018 on the back of fiscal stimulus; however, it then decelerated in the third and fourth quarter. Moving forward, growth should resume its expansion average pace of roughly 2%. 

RIGHT: Consumption is the foundation of GDP

Consumption comprises 70% GDP, but in the fourth quarter GDP growth benefited from a notable pick-up in business fixed investment, and the change in inventories remained elevated. Housing and net exports continued to be weaker components of GDP in terms of growth and overall contribution.

Economic growth and the composition of GDP

Unemployment and wages

2. Unemployment continues to fall and wage growth has accelerated

While the economy pace of growth slows, 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, although at a slower pace than we have experienced so far in this expansion. Finally, we have also seen a 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 slowed

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. While there is some noise in the fourth quarter numbers due to accounting irregularities affecting only a small number of companies, the trend of single-digit profit growth is likely to remain throughout 2019. This is due to the fading effects of the tax cuts, but also slightly higher interest costs, higher input costs of materials and higher wages.

However, the combination of healthy profits and a correction in stock prices late last year have brought equity valuations near their long-term averages.

Sources of earnings per share growth


4. Inflation has drifted down

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 even though oil has had a healthy rebound since last year’s lows, inflation has still remained subdued. 

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, not stalled

Amid global trade tensions that remain unresolved, political turmoil in places like Italy, France, and the U.K., 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. On the other hand, services PMI have held up reasonably strong, indicating some strength in the domestic economies. Still, headwinds remain for the global economy which will slow but not stall in 2019.

Manufacturing momentum

The Fed and interest rates

6. The Fed appears to have paused

Although interest rates are still historically low, it appears the Federal Reserve is on pause in its rate hiking cycle. The labor market continues to tighten, yet there is no sign of inflation and financial conditions have moderated. The Fed has vowed to be patient and data-dependent, monitoring the conditions of the economy and financial markets. It has the challenging task of not stymieing more tepid economic growth with a rate hike, but also not allowing asset bubbles to form in the absence of a hike. Still, we anticipate no further rate hikes in 2019 unless conditions change substantially.

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 not, a pause by the Federal Reserve could mean the rates linger at these levels a little longer. 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, quelling fears that the equity market is overvalued. This was not only due to market corrections, but also to healthy profits, which are unfortunately set to slow and have experienced some deceleration already. Despite a pick-up in the equity market in early 2019, valuations still remain at reasonable levels.

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 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.