What to do as rates continue to move higher?

Authors: Global Investment Strategy Group

*Our Global Investment Strategy View integrates the knowledge and analysis of our economists, investment strategists and asset class strategists. The View takes shape at a monthly Forum where the team debates and hones its views and outlooks. We will aim to publish this updated global view in the first Asia Strategy Weekly of every month.

Key takeaways

• Buy the S&P 500 dip. J.P. Morgan Private Bank clients have been persistent net sellers of equities since March. We continue to think the S&P 500 could reach new highs by mid-2024.
• The Fed is expecting the real Fed funds rate to exceed real GDP in 2024. This has happened five times since 1980; in all but one instance, growth slowed as a result. We continue to expect a growth slowdown, not a recession.
• Rates keep moving higher. Keep buying bonds to lock in yields. We have been early to add duration. However, higher rates make bonds an even more powerful tool for investors to reach their goals with less risk. Consider pairing short duration strategies (for yield) with longer-dated core bonds (for protection), or laddering portfolios to get to your strategic duration target.
• Cell phone usage in most major U.S. cities is structurally lower post-COVID. The decline is yet another indicator that downtown office building occupancy and valuations are impaired. Turn commercial real estate stress into opportunity.
• Our high-conviction investment ideas include: fixed income, equal weighted S&P 500 and mid-cap equities, plus private credit.

Buy the S&P 500 dip. At J.P. Morgan Private Bank clients have been net sellers of equities every week since the banking crisis in March 2023.

Why it matters: Persistent net selling suggests our JPM community does not believe the 12% year-to-date (YTD) rally in equities can extend. We disagree and continue to think the S&P 500 could make new highs by mid-2024. Here’s why:

1. Despite economic doom and gloom, CFOs are optimistic about their own business prospects. While CFOs are generally more optimistic about their own businesses than they are the economy, the current spread is especially wide. We continue to expect 2024 S&P 500 earnings of $240, which is slightly below consensus of $248.
2. The post-COVID rolling earnings recession is moving to the rear-view. On a year-over-year basis, Q2 was the low point for earnings growth; driven by tech and healthcare, which account for ~50% of S&P 500 market cap. We expect YoY earnings growth rates to inflect higher this quarter.
3. Attractive valuations. Excluding the magnificent 7 – S&P 500 equity valuations are below their 10-year median price-to-earnings ratio.

Bottom line: We continue to expect new highs in the S&P 500 by mid-year 2024. By sector, we continue to favor industrials given the policy initiatives and see upside for consumer discretionary. By capitalization, we currently like the S&P 400 (mid-caps) and equal-weighted S&P 500 on relative valuation and quality metrics.

The Fed is expecting the real Fed funds rate to exceed real GDP in 2024 (2.5% vs. 1.5%). This has happened five times since 1980, and in all but one instance growth slowed within three quarters.

Why it matters: The U.S. economy has proven to be resilient this year in the face of a historic Fed tightening cycle. However, we are rotating into a phase where growth could slow. If you think of the U.S. economy as one big business:

1. Earnings deteriorate if expense growth (interest rates) is above revenue growth (GDP).
2. Capital expenditures could slow. Why would I invest my money in my business to earn a rate of return (GDP) lower than what I could get risk-free (interest rates)?

What’s unique about this growth slowdown episode is that underlying inflation, proxied by core services ex shelter, is already back near 2.5% annualized over the last three months. Historically, when inflation is below 4%, developed market central banks have caused shallower recessions than when inflation is above 4%.

Bottom line: Macro uncertainty remains high, but we continue to think the last Fed rate hike is behind us. We expect a growth slowdown in the quarters ahead and that’s likely the confirming indicator that the Fed needs to ensure that inflation won’t just pick back up again. Our base case of a softish landing is predicated on the Fed cutting rates relatively quickly when that growth slowdown shows. With low conviction, we expect the first Fed rate cut around mid-year 2024 (vs. March prior).

Rates keep moving higher. Keep buying bonds to lock in yields. If 2023 ended on September 30th, it would have been the first time the U.S. Aggregate Index experienced three consecutive calendar years of negative total returns. Our indicator suggests that roughly half the move higher in rates this quarter is from “risk premium”, and the other half is from fundamentals (growth and monetary policy).

Why it matters: Risk premium is the additional compensation for holding longer duration bonds compared to rolling cash. We attribute the rising risk premium to increasing Treasury supply and broader worries about the fiscal trajectory in America. Rising risk premium is a double-edge sword for investors. On the one hand, higher rates for non-economic reasons suggest growth could slow faster than previously expected – a case for buying longer-dated bonds. On the other hand, risk premium is difficult to model – making it hard to time and size longer-dated bond purchases.

We revise our expected mid-2024 10-year Treasury outlook to 3.8% (from 3.25% prior) to reflect slightly higher growth in 2024 and higher risk premium.

Bottom line: We have been early to add duration. However, clients are under-allocated to fixed income and higher rates make bonds a more powerful tool for investors to reach their goals with less risk – so now is not the time to back off. We continue to favor rotating cash to bonds, as we think rates are high enough to slow growth and inflation (reinvestment risk > duration risk). Given the rising risk premium, consider pairing short duration strategies (for yield) with longer-dated core bonds (for protection) or laddering portfolios to get to your strategic duration target.

Cell phone usage in most major U.S. cities is structurally lower post-COVID. In San Francisco, cell tower traffic is just 32% of what it was in 2019. Even thriving cities in Texas, where many Americans migrated post-COVID, are experiencing cell phone usage around 65% of where it was.

Why it matters: The decline in major city cell phone usage is yet another indicator that downtown office building occupancy and valuations are impaired. Between 2023-2025, there is ~$1.5tr of commercial real estate (CRE) loans coming due for refinancing, and regional banks that hold these loans likely need to start selling loans now. Here’s why:

1. Regional banks have more CRE loans than equity. Those loans aren’t all bad debts, but rather indicative of how scarce equity is.
2. When loans go bad, banks need more equity. For the most part financial markets aren’t open for regional banks to issue more equity, so selling loans is the next best option.
3. Business preparedness. Banks need liquidity to ensure they can meet the needs of their clients in the future.

Go deeper on opportunities in stressed CRE here.

Bottom line: The structural shift towards work from home and higher interest rates are pressuring banks to sell assets as they search for liquidity/equity. Turn commercial real estate stress into opportunity.

U.S. exceptionalism. The broad dollar index has appreciated by 6.5% since mid-July. The USD has appreciated in ten of the past eleven weeks, a streak last seen in 2014 and only a handful of times over the past 25 years.

Why it matters: At the start of 2023, it was widely anticipated that the U.S. would lead the global economic growth slowdown. However, economic data has come in stronger than expected in the U.S., at the same time data has continued to disappoint elsewhere.

1. In Europe, growth has slowed precipitously as European Central Bank (ECB) rate hikes drag down spending and investment. Based solely on recent growth revisions between the U.S. and Europe, we estimate fair value for the EURUSD at around €1.03 (€1.02-1.04) vs. €1.06 currently. The last time our indicators put fair value so low was Q4 2022, when fears of an energy shortage in Europe were acute. This month we revise slightly down our near-term growth expectations for Europe.
2. In China, the property sector woes continue. In July and August, housing sales were down ~30% on a year-over-year basis. At the same time, over 50bn square meters of residential floor space is under construction and likely unsold. At the current demand rate, clearing inventory could take three to four years. Stimulus measures do seem to be stabilizing the economy, but risks remain. We continue to expect sub-trend Chinese growth in 2023 and 2024.

Go deeper on China’s property downturn and the implications here.

Bottom line: Tactically we continue to prefer the U.S. over the rest of the world. We removed our preference for European equities at the beginning of August, and since then the market is down 6%. That said, strategically the JPM community is still underweight ex-U.S. exposure. For those looking for global diversification, consider national champions in Europe, where we expect earnings resiliency amid the slowdown.

All market and economic data as of October 05, 2023 and sourced from Bloomberg Finance L.P. and FactSet unless otherwise stated.

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Index Definitions

Standard and Poor’s 500 Index is a capitalization-weighted index of 500 stocks. The index is designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries. The index was developed with a base level of 10 for the 1941–43 base period.

Standard and Poor’s Midcap 400 Index is a capitalization-weighted index which measures the performance of the mid-range sector of the U.S. stock market. The index was developed with a base level of 100 as of December 31, 1990.