J.P. Morgan Asset Management‘s Multi-Asset Solutions (MAS) team allocates capital across global markets against a wide range of client benchmarks and investment objectives. Here, the MAS team shares insights into the macroeconomic trends, market opportunities and key risks that inform our portfolio construction process. This quarter has a particular focus on the path of real rates, U.S. small caps and real estate and concludes with a summary of portfolio positioning themes.
Why lean into risk when real rates are restrictive?
High real interest rates tend to constrain economic growth and are generally negative for risk assets. As 2024 gets underway, declining inflation and restrictive Federal Reserve (Fed) policy are raising real rates, and some investors see a risk to the market’s soft-landing expectations. We take a different view. Our constructive stance on risk assets builds on our base case outlook: While we are not making any heroic assumptions about the path of monetary policy, there is potential for more rate cuts than the markets have priced in because inflation may continue to fall faster than expectations. We believe this is supportive for risk assets.
Central to our thesis is the Phillips curve, which describes the relationship between employment and inflation. In a traditional Phillips curve relationship, bringing inflation back to target requires a material rise in unemployment. The relationship broadly holds, in our view, but we are skeptical that the “last mile” of inflation will deliver more economic pain than the trip from 9.1% to 3.4% inflation, a scenario that would be reflected in what is known as a “kinked” Phillips curve (chart below).1
As a Federal Reserve paper concluded in January 2024, a kinked Phillips curve “does not receive compelling support.” This suggests that inflation can continue to fall without sparking a severe economic downturn, and that the Fed will adjust to this reality by adjusting rates lower. Shortages in labor supply are putting a cap on the unemployment rate, giving the Fed more scope to ease monetary policy.
Examining the internal components of price changes provides further support for the likelihood of a decline in inflation. While goods prices have normalized, core services have not, with shelter accounting for nearly 75% of the excess contribution to inflation. As shelter impacts overall inflation with a lagged effect, recent declines in shelter inflation could yet translate into consumer price data. In addition, an increased pace of new construction could help bring shelter prices down.
Of course, we acknowledge the risk of inflation accelerating. To name one, tensions in the Middle East – including attacks on ships in the Red Sea – could lead to an oil price shock and distorted transportation prices, pushing inflation higher.
But absent geopolitical shocks, we believe the current level of inflation and high real rates will give the Fed ample room to cut rates in 2024.
What are the catalysts for U.S. small caps?
With many markets trading at elevated valuations, where can investors find opportunities to benefit from a stronger growth story and inflation falling faster than expectations? While we are not there yet, one attractive option is: U.S. small caps, which are sensitive to economic conditions and currently trade at slightly cheaper valuations.
Starting price/book valuations and GDP growth rates have explained two-thirds of Russell 2000 1-year returns since 1995. And the relative performance of small cap over large cap is greatest when growth is above trend and valuations are cheap. In a stronger growth environment, historical data suggest that small cap returns may outpace large cap returns by over 3.5%, while in a more negative economic scenario the underperformance would be relatively muted.
Can above-trend growth and cooling inflation co-exist? It happened in the mid-1990s, when the U.S. economy grew above potential, fueled in part by improving productivity, and inflation fell.
Our base case for the U.S. economy in 2024 is a soft landing with slightly below-trend growth (comfortably avoiding recession), but growth could well surprise to the upside. In fact, fourth quarter U.S. real GDP came in much stronger than expected at 3.3% quarter over quarter (q/q) seasonally adjusted annual rate (saar) vs. a consensus estimate of 2% q/q saar. Additionally, with inflation cooling in a healthy labor market, real wages are increasing – providing support for consumer demand.
A mixed outlook for public and private real estate markets
Liquidity is scarce within the real estate market as equity and debt pricing are not yet attracting new investment. Further declines in prices or interest rates will be needed, we think, for transaction activity to increase. Meanwhile, core real estate, as proxied by the ODCE index, continues to decline, down 6.5% in Q4 2023 .
Still, an increase in transaction volumes may not lead directly to an immediate rebound in prices. That’s because a substantial cohort of existing investors is looking to redeem capital from the sector: On average, for 16 funds within ODCE, the redemption queue stands at 17.1% of net asset value (NAV) as of September 30, 2023.
For investors looking to allocate capital opportunistically, public REITs are trading at a material discount to private assets. On one hand, this supports the idea that private markets may need to move another notch lower for properties to clear. However, it also suggests that REIT valuations are more attractive than private real estate. A recent “take-private” transaction for a public REIT confirmed that view.
On the debt side, capital markets are opening for quality borrowers, and REITs took advantage of lower interest rates by issuing record debt in the first half of January. The new debt is expected to create price discovery and thus help boost transaction volumes.
Even with the modest decline in rates recently, market participants worry about the wall of commercial mortgage-backed securities (CMBS) maturities and borrowers’ ability to refinance. The debt maturing in 2024 will most likely be refinanced at higher rates and this will impact debt service costs. As one data point, REITs have about 10% of their outstanding debt maturing in 2024, which has an average ~4% coupon. Refinancing this debt at current rates would decrease the funds coming from operation by 200 bps.
What is the outlook for debt defaults? Investor concerns may prove to be somewhat overstated. Of the nearly $190 billion maturing in 2024, only $70 billion is maturing without extension options, and that debt could still be modified by the servicer.
In short, public real estate is trading cheap relative to private real estate. Stronger REITs are issuing debt and preparing to make opportunistic acquisitions. Financing costs have come down, which helps, but private valuations may need another markdown to be priced attractively relative to public markets.
Summary of portfolio positioning themes
Here we present an asset allocation snapshot— sectors and asset classes where we see potential for upside growth, areas where we are cautiously stepping back, and areas where are waiting for more information.