JP Morgan 3Q18 Guide to the Markets

  1. The economic expansion is continuing at a slow but steady pace
    1. As of December, the expansion is in its ninth year, making it the third longest expansion since 1900
    2. Growth should accelerate and stabilize through the end of 2018, reflecting a pick-up in exports, inventories, government spending and fiscal stimulus through tax reform
    3. Stronger investment spending and an improving global economy should also be tailwinds, with some give-back from a weaker-than-expected first quarter likely
    4. Regardless, weak productivity and labor force dynamics should prevent sustained growth at 3%, with growth likely slowing to 2% or less in 2019 and beyond
  2. Unemployment continues to fall, which should drive up wages
    1. Solid GDP growth should cut the unemployment further, perhaps to 3.5% by end of 2018
    2. While wages have been slow to react to a tight labor market so far, extra pressure to find workers spurred by tax cuts could finally boost wage growth by end of year
  3. Earnings headwinds should be behind us, but future growth may be muted
    1. Earnings growth could be more muted in 2019, though a positive impact from tax reform should provide a boost for the rest of this year, so long as the stronger growth offsets higher wages and interest rates on corporate income
    2. With over 40% of S&P 500 revenues coming from abroad, a weaker dollar will boost foreign sales, particularly in 2018
    3. Corporate margins are at near record-highs, meaning companies are more efficient than they’ve been in some time. As wage pressures start to build and interest rates rise, corporate margins may start to slip, eroding profit growth slightly in 2019 and beyond
  4. Inflation should rise gradually
    1. Inflation looks set to continue to edge up through the end of 2018, helped by a weaker dollar, higher oil prices and tightening labor and housing markets
    2. The use of IT around the world has empowered buyers of goods and services, a powerful structural force that has put downward pressure on inflation globally in recent history
  5. The global economy is growing everywhere but booming nowhere
    1. So far in 2018, though some countries have reported slowdowns, it does not appear that the broader global growth story will end any time soon
    2. Eurozone is growing particularly fast, thanks to a still undervalued currency, rising confidence and considerable pent-up demand, while other developed markets like Japan, Canada, and the US continues to accelerate
    3. Rebound in demand for commodities continues to be a general positive for Latin America, Canada, and Australia, while Chinese contribution has ebbed slightly as authorities try to restrain financial speculation
  6. The Fed should feel comfortable about raising interest rates
    1. The global economy is generating fewer worries than in recent years and the US is approaching or at many long-term targets, like unemployment and inflation, making it clear that interest rates are still too low
    2. Barring any significant negative shocks or fiscal stimulus, we anticipate the Fed to further raise by 0.25% two more times in 2018
  7. Rising rates will make fixed income investing more difficult
    1. In 2018, some forces like further hikes in the federal funds rate; stronger economic growth and lessening accommodation by other central banks should push yields higher
    2. This back-up in rates should result in weak total returns on Treasuries and some high-quality corporate bonds, suggesting that investors may want to consider investing in other fixed income sectors, like high yield debt or emerging markets, or shifting their portfolio allocation to underweight bonds relative to other asset classes
  8. US stocks are slightly expensive relative to history, but not relative to bonds
    1. Many valuation measures show the US equity market to be slightly expensive relative to history, with both forward P/E and Shiller P/E ratios trending higher than long-term averages
    2. The most important ratio is the comparison between the earnings yield on stocks and yield on BAA bonds – this is, in essence, an adjusted risk-free rate, incorporating credit risk. Looking at this metric, it would still appear that owning the equity of a company is a better investment than owning the debt
    3. Bonds, like stocks, look expensive, and rising interest and wage costs may put pressure on margins, underscoring the importance of diversification outside of the most traditional asset classes
  9. International stocks may offer better opportunities
    1. Thanks to lower than average valuations, higher dividend yields than US stocks and a falling USD, which should amplify returns on international investments, it appears that there are still opportunities available for overseas exposure
  10. Higher valuations and uncertainty underscore the need for broad diversification and careful portfolio management
    1. Cash is still paying close to nothing and global economic momentum and reasonable global stock valuations suggest that this is still a time to be overweight risk assets
    2. Because of higher valuations and potential dangers from policy mistakes or geopolitical risks, it will be even more important for investors to maintain well-diversified portfolios and be willing to make adjustments in response to changing valuations or the investment environment

JP Morgan Economic & Market Update

Image Source: Factset, Robert Shiller, S&P, Thompson Reuters, JP Morgan