JP Morgan Investment Outlook: A Difficult Place to Start – Investing in 2018 and Beyond

JP Morgan Asset Management: The Investment Outlook for 2018

A difficult starting point

  • Entering 2018, most American investors should feel richly rewarded by a long economic expansion and extended bull market in equities and bonds
  • However, looking forward, they should also recognize that this is not a great starting point and that the very length and strength of the bull markets to this point will limit returns going forward
  • US economic expansion has provided just 2.2% growth per year since its inception in 2009; it appeared to pick up its pace in the middle of 2017 as falling unemployment boosted both consumer and business confidence
  • Above-trend pace of growth will continue into the first half of 2018 as lower income tax withholding and corporate tax cuts promote increased consumer and investment spending
  • Either way, economic growth will likely slow down to a 2% or slower pace later in 2018 and beyond (reason for this can be found in the jobs market)
  • US unemployment rate has fallen from a peak of 10% in October 2009 to 4.1% today; however, this decline in the unemployment rate has been accelerated by very slow 0.5% annual growth in the labor force
    • This largely reflects a wave of workers retiring, a trend that started in earnest in 2012 as the first baby boomers turned 65
  • An “Indian summer” of economic growth in 2017 and early 2018 may well push the unemployment rate down to 3.5% by late 2018
    • However, it is unlikely to go much lower than that given the everyday friction and churning that occurs in the job market
    • Barring a surge in immigration, US economy will have to get by with roughly 0.5% annual employment growth per year
    • Lack of investment spending in recent years has meant that output per worker has grown by just 0.9% per year over the past decade
  • Barring major structural change, US will not be able to sustain growth above 2% in the years ahead; however, we believe that a slower expansion with slightly higher inflation could be sustained for a few years to come, making this the longest expansion in US history
  • Earnings should look strong in the first half of 2018 but then earnings could come under pressure from low top-line revenue growth and the higher interest rates and wage costs that could accompany an economy operating at the peak of its capacity
  • One of the great puzzles of the economic expansion throughout the developed world has been the low level of consumer inflation
  • In a highly competitive global economy, both wages and consumer prices have not responded to continuous infusions of central bank liquidity
  • We believe that excess liquidity could continue to push a wide range of asset prices higher, boosting consumer wealth but also raising the specter of asset bubbles
  • Europe has seen solid improvement over the past year, despite tensions from Brexit and in Catalonia and, with 8.9% unemployment, clearly still has plenty of capacity for above-trend growth
  • Japan has also had a good year and a lower yen could help maintain economic momentum even though inflation is slow to respond to very low unemployment
  • China will emphasize the quality of growth rather than its pace in the years ahead but there seems little reason to fear an abrupt slowdown
  • Other emerging markets should continue to improve following the commodity slump of 2015/2016, with a reform agenda in many countries holding out hope for more stable growth going forward
  • For the Fed, economy of 2018 should provide ample justification for further tightening; very low unemployment, slowly rising inflation, faster-rising asset prices, a weaker dollar, strong overseas growth and domestic fiscal stimulus all suggest that monetary policy remains too loose
  • Presuming Jerome Powell is confirmed as Fed chair, he may be more likely to follow the balance of opinion on the FOMC with regard to tightening, a consensus that may be more hawkish than in 2017, given a turnover in personnel in the Fed

Fixed Income: preparing for monetary policy normalization

  • A faster-moving economy is no doubt a good thing for investors’ portfolios, helping to boost earnings, lift sentiment and move risk assets higher
  • However, faster economic growth also presents a challenge to global central bankers and fixed income investors
  • With central banks hiking interest rates, reducing asset purchase programs and shrinking balance sheets, there will be some negative withdrawal effects around the world over the next 12 months, particularly in fixed income markets
  • Central bankers are not going to make financial markets go “cold turkey” by withdrawing monetary policy stimulus all at once; assuming inflation remains relatively subdued, it is likely to be a long and gradual journey back toward a more normal approach to monetary policy
  • Beyond interest rate hikes, asset purchase programs by ECB and Bank of Japan are also set to slow in 2018
  • As the rest of the world begins to normalize policy in 2018, the Fed will already be well along its way, having been the first mover in both interest rate hikes and balance sheet reduction
  • As monetary policy is normalized around the developed world, bond prices should fall and yields should move gradually higher
  • US investors should expect a little less from their core fixed income holdings. Investors should look to clip the coupon and brace for some small negative movements in bond prices
  • With the global economic backdrop looking robust, areas such as emerging market debt look particularly attractive, while in the US sectors with atypical responses to rising interest rates, like high yield and emerging market debt, could play a part in helping to lift returns

US Equities: Back to School

  • In 2017, economic growth surprised to the upside. Will this better-than-expected growth continue? Will a corporate tax cut get passed? What are the market implications of a shift in both monetary and fiscal policy? How far can rates rise before they begin to weigh on equity market performance?
  • Equity market performance in the coming year should hinge on 3 variables: earnings, inflation, and interest rates
  • Even a moderate pace of underlying growth, coupled with a slight acceleration in the pace of inflation, could lead to stronger-than-expected revenue growth and potentially offset any downward pressure on margins stemming from a rise in wages
  • While there is room for inflation to accelerate before it comes in conflict with the Fed’s 2% target, any meaningful acceleration in inflation could lead market-based expectations of interest rates to re-price, potentially undermining the low interest rate and low volatility environment that has underpinned the melt-up in multiples seen over the past year
  • At what level will rising rates begin to weigh on equity markets? Historically, the 10-year US Treasury yield has been able to rise to a level of 5% before interest rates and equity markets become negatively correlated
  • If rates are rising for all the right reasons – namely better economic growth, more normal monetary policy or healthier rates of inflation – equities should continue to move higher
  • If rates begin rising for the wrong reasons – the economy is overheating, the Fed is trying to cool things off or inflation is getting a bit too hot – equities, and equity multiples, will likely begin to come under pressure
  • Economies outside the US are far earlier in their respective business cycles and still experiencing double-digit profit growth

International Equities in 2018: Still Climbing

  • After 4 years of underperformance relative to US equities, it makes sense that some investors are scared to board the flight again
  • However, after over a year of strong, synchronized global economic and earnings growth, investors should recognize that the scariest part of the flight is behind us
  • 96% of major economies have a PMI figure above 50, indicating acceleration; this created a virtuous cycle of consumption, earnings growth and investment around the world; we expect this momentum to continue in 2018, which, combined with still low levels of inflation in the developed world and a gradual normalization of monetary policy from major central banks, is a positive backdrop for international equities to continue outperforming those in the US in the year ahead
  • While US companies have been reporting record-high earnings since 2011, emerging market earnings would have to grow by 10% to reach their previous peak, and Eurozone earnings would have to grow by 59% to reach theirs
  • We expect USD to continue acting as a tailwind to international returns for US investors; believe we are still at the beginning stages of a long move down for the dollar, as a result of better global growth, narrowing interest rate differentials, more stable commodity prices and a persistent US current account deficit

Conclusion: Focus on time-tested principles

  • Cash has and will continue to be a poor long-term investment. Even with rates continuing to normalize in 2018, interest rates and therefore the return on cash will not increase enough to make the overall cash return attractive
    • When we factor in inflation, we continue to get a negative real return on cash as has been the case in every year since 2009
    • There are enormous amounts of cash sitting on the sidelines, almost $110,000 on a per household basis – well above total home mortgage debt
  • Diversification: being diversified has been key for investors, and that will continue to be the case in 2018. Over the last 15 years, a hypothetical diversified portfolio had an average annual return of almost 7%, with a volatility of 11% – an attractive risk/return profile
    • Will be especially important in fixed income, where a rising rate environment will mean that navigating the asset class in an active way will be essential
    • Being diversified and increasingly selective in equities will also be crucial. With returns in the longer term being limited by our starting point in 2018, choosing sectors, factors and regions will be critical for higher returns
  • Compounding: the only way to have the power of compounding on your side is to be invested. Combination of opportunities in the market and the math that compounding starts working immediately provide persuasive reasons as to why investors should not wait for a correction to invest
  • Last principle concerns volatility and the value of knowing that volatility is normal. Government policy, Fed action and events abroad all have the ability to spook the market in different ways. Investors should not let volatility derail their asset allocation or time invested in the market

Image Source: Barclays, Bloomberg, FactSet, MSCI, NAREIT, Russell, S&P, JPM Asset Management