The Recession Obsession

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Text, Tom Kennedy, Chief Investment Strategist.

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Hello, and welcome to our mid-year 2023 outlook, titled "The Recession Obsession." My name is Tom Kennedy, and I'm the Chief Investment Strategist for JP Morgan Wealth Management. Thank you so much for spending the time with us today.

The title of our outlook is, really, a recognition that it's hard to miss the threats to the global economy. In America, the Fed is nearly done with the most aggressive hiking cycle we have seen in over 40 years. Over the last six months, we've seen banks fail in America, a very rare rare occurrence. And, abroad, you're seeing similar risks, like the war in Ukraine that continues to press on, and in Asia, geopolitical risk continue to percolate.

What's so interesting is that markets really haven't cared so much about it so far. Year to date, a 60-40 balanced portfolio of stocks and bonds is up over 7%. A really key message is, markets and the economy are not necessarily the same thing.

In our mid-year outlook, we did something novel for us, and we're really excited to share it with you. We drew on anonymized wealth management client data to draw out investment insights and to try to give some really credible advice about the path forward. Today, I'm joined by two of my fantastic colleagues, Elyse Ausenbaugh and Stephanie Roth, and they're going to help me draw out the big takeaways from this outlook.

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The three presenters sit behind a desk with a J. P. Morgan signature logo on the wall behind them.

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And there are five of them. I'd like to run through them quickly, and then we'll go do them one by one. First, you may hold too much cash and not enough bonds. Two, rebuild your equity portfolios for the next bull market. Three, you probably stay too close to home with your investments. Four, manage your concentrated positions. And, five, there are risks out there, things like real estate and bank failures in the regional banking sector. Know these risks, but make them opportunities.

All right, shall we do it? Let's get into them, take them one by one? Great. All right, the first one is about cash, and potentially having too much of it. I'd like to read the stat, and then, Steph, I want to get your reaction.

Our clients' allocations to cash in investment accounts, certificates of deposit, and short-term fixed income-- think fixed income less than one year to maturity-- have risen by over $150 billion over the last 12 months. This means our clients will need to reinvest over $500 billion, or about 25% of investible assets, in the next 12 months. When you heard that, and we uncovered that piece of intelligence, what did you think? Were you surprised?

Well, it's a really big number, but it's just a reminder of how big a footprint that we have here.

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Text, Stephanie Roth, Senior Markets Economist.

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Now, the Fed is trying to encourage people to hold cash, so that part's not that surprising. The idea of raising interest rates to make cash more attractive is exactly what our clients are doing. That's exactly what they should be doing in this environment. Cash rates have come up pretty significantly.

Now, that means that they're less likely to invest in their businesses, less likely to invest in financial assets. So it's a headwind for the economy, which is what the Fed is trying to do. They're trying to slow down the world and bring inflation down with it.

So, if the Fed's goal is to slow the world down, number one, are you seeing evidence of that? How do they know when rates are high enough to get those desired outcomes, slower growth and, ultimately, slower inflation?

There's three big ways that rates are restrictive today. First is housing. That's the most interest rate-sensitive sector of the economy. That slowed down dramatically last year. It's now sitting around recessionary levels. The second would be capital spending in this economy. It slowed down to just 1% in the first quarter. That's really, really weak growth.

And then the third and most resilient sector of the economy would be the consumer, but we're just starting to see some cracks. You've seen consumer leverage pick up a little bit in the first quarter. That tells you that people are trying to finance their current spending, and they're having to do that with a little bit of leverage, which is a headwind looking forward. That's not sustainable, especially with rates having backed up the way they have.

The economist community, I think if you surveyed, and you polled an average economist-- none of them are average-- but the median economist says that we will see a recession in the next 12 months. When you look at the Fed's expectations for the economy, I would say they're expecting a recession as well. How do you feel about that? Do you think we get a recession, and if so, how deep, how protracted is it likely to be?

It's more likely than not that we get a recessionist economy. If you look at history as a guide, any time you've seen rates back up like this, and the Fed tightening this kind of way, you're likely to get a big slowdown in the economy. So, yeah, more likely than not, you get a recession. Is it possible we get a soft landing, where the economy just slows down, and inflation comes down with it? Of course. It's just not in the history's guide, so we would just say it's more likely that you do get a big slowdown.

As for how protracted, I think about it in terms of the unemployment rate. That's the most tangible way to think about it. Our best guess is the unemployment rate continues to rise, rise to about five 4.5% at the end of this year, and 5.25% at the beginning of next year.

In a historical context,

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Tom gestures in a circle with his hands.

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is that a deep recession? Is that average? What is that? Give me some context to understand how bad that might be.

I would call that an average recession, a run-of-the-mill recession. A lot of people are focusing on this word "mild," but that's not really tangible. What does that mean? So, when you think about the unemployment rate and the rise that we're expected, that's the average rise in the unemployment rate in historical recessions.

Very good. Now, let's circle back to the cash. For folks that have been moving their money into cash, to your point, it makes sense. That's what the Fed is encouraging you to do, with a seemingly very attractive 5% risk-free rate. But we're near a catalyst for a change in the way that, cash, we should be perceiving it.

It's most likely the Fed is near the end of its hiking cycle, right? If restraints are restrictive, why would they keep hiking to make the recession, if it should come, worse than it needs to be? So, historically, history as a guide, when the Fed ends its hiking cycle, in the two years after that, longer-duration bonds, with a longer maturity, tend to outperform.

To add precision to that, the Barclays Aggregate Index has outperformed cash, the two years after the end of the rate hiking cycle, by about 14%, meaningful outperformance. So, from an advice perspective, consider taking some of that cash and buying longer-duration bonds. Anything else either of you would want to add on this topic?

Yeah, the one thing that we didn't hit on is the correlation between stocks and bonds. In 2022, it was the worst in market environment for a multi-asset investor, or an investor that has both stocks and bonds. You lost in both, which is actually typical for Fed hiking cycles, but, generally speaking, after the Fed stops hiking interest rates, you get that negative correlation reasserting itself, meaning that bonds tend to protect your portfolio.

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Text, Too much cash, not enough bonds? Bonds can do well when the Fed pauses.

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So, now is a great time to deploy that cash, because you know that your bonds will very likely protect you in the coming years.

All right, let's move to takeaway number two. Let's talk about equities. Here's the stat, Elyse.

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Text, Rebuilding your equity portfolio. What do you want it to look like in the next bull market?

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Our clients were net sellers of stocks in 2022, a pretty good trade, considering equities were down about 20%. But while stocks have rallied since last October, our clients have been net buyers of equities only seven of the 30 weeks since that market bottom, and around half of our clients now have lower allocation to equities than they did a year ago. Reflections? What do you think?

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Text, Elyse Ausenbaugh, Global Investment Strategist.

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When I think about the conversations we've been having with our clients over the past year, we've placed a lot of emphasis on finding ways to keep folks on track towards their financial goals, while derisking their portfolios or putting money to work in a less risky way.

So, reflecting on the experience we've had, making that decision to actively buy stocks, when risk-free yields are climbing, climbing, climbing towards 5%, that's very different than doing the same decision making process when cash yields are close to zero, like they were in the post-financial era.

So, what we have to think through today now is, OK, we're sitting here at this stage in the cycle, we think that those risk-free yields are probably at or near the peak of this cycle, so where do we go from here, and how do we build that portfolio that we want to carry, not just as the recession comes to fruition, but also once the cycle resets?

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Elyse gestures in a circle with her hands.

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You mentioned there, those long-term capital market assumptions, foundational to what we do. What are expected returns from a multi-asset or equity portfolio there?

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Text, Rebuilding Your Equity Portfolio. What do you want it to look like in the next bull market?

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Yeah, so, I'm glad you brought them up, because that's really where we have to start, right? Remember that the entire point of owning equities in your portfolio is for them to serve as that engine of capital appreciation over time. Our long-term capital market assumptions are calling for equities to annualize returns somewhere in the neighborhood of 7.5% and to 10%, depending on which segment of the market that we're looking for, over the course of the next 10 to 15 years.

So, what that means is that we think that stocks will continue to be the efficacious builders of wealth that they historically have been, and not just make your money so that it's treading water with inflation, but so that it's actually growing in real terms.

Agreed. The long-term horizon, though, feels really far away in a world this volatile. How can we feel good about allocating to equities, even amid this recession obsession? We feel really confident in this view, but let's articulate it in a way that is recognizing that these are long-term portfolios, but we've gotta do something in the meantime.

Right, why now?

Yeah.

For this one, the short answer is that we think you should be adding to equities now because we think the worst of this bear market is probably behind us.

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Text, Rebuilding Your Equity Portfolio. The Bear Market is Likely Over.

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We think that the lows were put in back in October, when we had that peak-to-trough drawdown of 27%.

Now, a lot of that drawdown was sentiment-driven, but when you zoom out and look at different parts of the market, you find that there are segments who have already gone through those recessionary-type catharses that are necessary in order for us to get to the other side.

Talk about-- Give us one. You can't get there without talking about megacap tech--

Of course.

--which is, for the sake of this conversation, your six biggest stocks in America. Talk about this process of catharsis, as you meant. Like, double click on that. Tell us what you mean by that.

Sure. So, in thinking about the tech complex, in 2022, it led on the way down. That sector has already seen four consecutive quarters of earnings contraction. And, so, what that's forced a lot of these companies to do is go ahead and rationalize their business, do things to protect their margins, like pursue layoffs in order to cut costs.

And so I think, heading into 2023, investors have been willing to reward those efforts to shore up those margins, and also gotten excited about emerging trends like artificial intelligence, and how quickly that's starting to roll out. And so you've seen that segment of the market start to lead the way.

We do think that investors can continue to hold that position in technology, but we also want to acknowledge that it's not exactly a value play for new money right now. So, when we look at the overall opportunity set, we want to be really mindful of what's in the price.

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Text, Rebuilding Your Equity Portfolio. Profit Growth Could Be Bigger than Expected.

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The good news is that, if you do strip out those six biggest names in the index, you actually find that the rest of the 494 companies in the S&P 500 are trading at a valuation that's below average. Other areas, you can look, maybe mid-cap equities, right? The index as a whole is trading at a discount, relative to its history. International markets, which I know is an area that we're going to touch on here in just a moment, or you can think about certain styles that allow you to build more defensive exposure that could be resilient, as the recession comes to fruition.

What you describe via the tech sector is how that sector of the economy has really gone through something that looks like a recession already, and there may be a macro recession ahead, but they have taken measures, like cutting costs, maybe even doing some layoffs, to help insulate their business, should that happen, and you may see that rolling through the economy at different phases, maybe one of the very unique phases of this business cycle.

But to the point, earnings are an important aspect, but valuations as well. Tech sector valuations are quite full, a respect for the artificial intelligence, transformational properties on the economy, maybe. But there are other places where you're getting valuation support, and I love that you highlighted some of those.

I think, for some out there, they're going to say, I'm a little bit more worried than you guys are, and, really, there are hedged ideas that you can get access to this market as well, hedged equity vehicles which will give you an opportunity to participate, but with some downside protection.

The equity market conversation, I think, can be really challenging, amid this recession obsession. Why would I really engage in that market, if I think a recession is coming? But you outlined some really important points. Earnings estimates are going to diverge across markets. Markets are going through some of this recessionary pain at different times. Great.

Valuations are quite different. Your megacap stocks, biggest in America, are trading, quote, unquote, "above their historical averages," but the rest of the market is really below, so, getting compensation for some of this downside risk to earnings.

The places that you can engage now, you outlined some of them. US mid-cap stocks, where valuation support and maybe some earnings resiliency is there, focused on dividend growers, things that are safe, or safer, and can give you some expected returns and growth. And then hedged equity vehicles.

Definitely.

Some people just will say, you know what, I hear you, but I'm a little more worried than you guys are. Well, we can find areas where you can get earnings exposure and get some mitigated downside risk, via these hedge products. Point three, can we move on?

Sure.

Very good.

All right, here's the stat.

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Text, Don't Stay Too Close to Home. China Valuations are Reasonable.

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Over 2/3 of us clients have no exposure to China at all, and around half of our US clients are materially underweight Europe relative to developed equity benchmarks. Steph, when we uncovered this one, what did you think? What was your reaction? Surprised? Not surprised?

Not super surprised, I think, for two reasons. There are two biases inherent there, a recency bias and a home bias. So, from a recency bias perspective, the US has outperformed in the past two cycles, and from a numbers perspective, it outperformed Europe by about 100% and China by 175%.

So, it's natural for US investors to feel a little bit more comfortable for those two reasons. And when you even look abroad, you see that home bias is visible in Europe clients, as well as in Asia. But that doesn't mean that that's what makes sense going forward.

And if you look throughout history, in the past seven cycles, international equities have actually outperformed for three of them.

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Text, Don't Stay Too Close to Home. Avoid "Home Bias" in Your Portfolio.

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So, just because it outperformed the past two cycles, doesn't mean that's going to be the case going forward. So we would very much suggest that clients start to dip their toes into some of the international equity space.

So, you made an important distinction between recency bias and home bias, attacking an equity allocation for all investors. I think, sometimes, we think about, in the US perspective, we have a home bias, because maybe it's just technology, and a technology bias, but you're also noting that, in Europe, there's a home bias there as well. Really important, and, of course, underneath everything we do is diversification benefits, and really nice. But let's focus.

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Tom points forward with one finger.

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US investors, where should they be diversifying the status about China and Europe? Which one do you start with?

I'd start with Europe. It's a little bit more of the defensive options, and there are a lot of tailwinds there. So, Europe is generally a little bit cheaper to the US, but it's even more cheap than normal. So you have a particular valuation support. On top of that, Europe is exiting it's negative interest rate backdrop. That's important for the banks, which has been a really big headwind for the past cycle.

And by the way, technology is a bigger share of the US market. That outperformed last cycle, but we don't think that's necessarily going to be the case next cycle. It might be more about the real economy, which has a bigger weight in the European market.

You said Europe ahead of China. Does that mean we think China has an opportunity to outperform the US over the next 12 months, as an example as well?

Definitely, an opportunity. It's a bit more of a higher-risk, higher-reward place to be. The potential for double-digit earnings, or mid-single digit earnings growth there, so that's important. There's not an inflation problem. Big diversification benefits there. But there's always the geopolitical headwind, so we would just think it's a little bit more prudent to emphasize Europe over China today.

I think a lot of pushback we'll get is, how can you reasonably believe Europe would stay out of a recession if the US goes into a recession? And I think we have to agree that is rather rare. There have been divergences in the economies in the past, most recently in the '90s, and that was monetary policy-led discrepancies between those economies, and it's very similar to what we're expecting this go round. So, it is possible.

I want to put an exclamation point on something you said, though. From a valuation perspective, Europe is trading about 30% cheap to the US, and that is very cheap relative to historical averages.

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Text, Don't Stay Too Close to Home. Europe Defying Expectations.

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So, valuation support there. Valuations may be compensating you for some of that risk. So, from a diversification benefit, consider Europe, and I love the case there

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Elyse smiles broadly.

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OK, let's move to takeaway number four, concentrated positions. And for this one, we did something a little bit different. We're layering on market data, rather than client data. So, the Russell 3,000, which is the 3,000 largest companies in America, may be trading, on average, only 15% below their 2021 high, but one out of every five stocks in the index has fallen more than 75% since their 2021 peaks. So, concentrated positions, what was your reaction, Elyse, when you heard this stat?

Look, a 75% peak-to-trough drawdown, that's really jarring. And I think, when you combine it with the bank failures that were making headlines back in the spring, it should be a wake up call for people who hold a concentrated position.

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Text, Manage your Concentrated Positions. Volatility can be Devastating When Holding One Stock or Security.

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A lot of the investors that we work with have generated their wealth via a concentrated position, whether that arose from the sale of a successful business or, you know, a home-run stock pick that's seen its value appreciate over the years.

Regardless, the reasons why we want to think through diversifying that concentrated position are really because, you know, the perils of not diversifying it can be rather significant, and you don't need a devastating 75% peak-to-trough drawdown in order for it to really change the calculus of a financial plan.

We went through this case study in our mid-year outlook, where we said, OK, you've got a family, 50% of their wealth is in a diversified portfolio, the other 50% is in a concentrated position. If that position draws down just 30%, what kind of tradeoffs is it going to force in terms of that financial plan? And it meant maybe having to retire at 67, instead of 62, all the while cutting back on your spending. Or maybe it meant retiring on time, but forgoing gifts to future generations or philanthropies that you really care about.

At the end of the day, this isn't about severing the heartstrings, or trying to rip away the pride that you have associated with how you built that concentrated position in the first place. It's really about us helping you diversify your portfolio, so that it has a higher probability of success in keeping you on track towards those things you really want to accomplish with your money.

Very elegant way to marry investment advice meets wealth advice, as well too. These can be very challenging conversations. These are businesses, maybe, someone may have built, or, to your point, everyone loves to pick a winner, and it's very hard to get rid of those, sometimes.

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Text, Manage your Concentrated Positions. Many Strategies Can Help You Manage Your Positions.

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But there are some really easy strategies that are as simple as just agreeing on what a sell price might be on this idea, using options to hedge the position, or more complex things, like exchange funds. So there's lots of options. Your points are really important, though. This is where behaviors meet investment decisions. Those two things can be hard to coexist. Awesome. Any last points I missed on there that you wanted to add on ways to implement?

No, just that the specific option that's going to be best-suited for you, that's something your JPMorgan team can help you figure out.

Perfect. All right, onto takeaway number five. This one is about risks and opportunities in the regional banks space and real estate, commercial real estate. So, here's a stat. Steph, I want you to react to this one. Seven billion of client capital in our JPMorgan community has been allocated to real assets and private credit over the last 12 months.

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Tom begins to count on his fingers.

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That's the largest capital allocated to those two sectors over a 12-month horizon ever in this community.

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He gestures outwards across his chest.

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What do you think? What was your takeaway when we uncovered this one?

This one wasn't surprising to me.

OK.

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Elyse and Tom smile broadly.

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So, the investment in real assets, that makes perfect sense. There were a lot of concerns around inflation, and that's a great inflation protection. As for the private credit, it makes perfect sense, provide capital where capital is scarce. Given all of the tightening in liquidity and credit, it makes perfect sense that clients would take opportunities there.

Yeah, these are two sectors that are really part of the obsession recession, right?

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Text, Real Estate and Regional Banks, Bank Lending Could be Harder to Come By.

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Banks failing is not a normal phenomenon. There's been lots of conversations about why they failed, were are they unique? Really, in our investment committee, we focus on, what does it mean for the economy, and it should mean a slower economy in the future.

Banks just learned that deposits could leave their banks very quickly, and they'll have to pay more to keep those deposits there.

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Tom gestures downward with his palm, then clenches his fist.

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That should shrink profitability, which, in turn, means they can't give as many loans, and that's the piece that really will transmit through the economy.

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He points to Stephanie.

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Steph, you've done some good work about lending growth, and what it means for the. Economy share what you think these bank failures might mean for the lending channel in America.

So, we're not seeing a big liquidity crunch, but what's important is banks are going to pull back on their ability and willingness to spend, to make loans.

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Stephanie makes two fists and gathers them back towards her.

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So, if you think about the headwind to GDP, if you slow down the pace of lending growth this year, it could be about a two percentage point headwind on GDP. That's really important, and kind of the specifics in terms of how we get to the recession that we had been anticipating.

So, the bank channel, this slowdown in lending, will most likely be felt by regional banks, which are the biggest lenders to commercial real estate and to small businesses, so, places in the economy where we're going to be looking for seeing transmission effects.

But the commercial real estate environment, particularly office, has another headwind. It's work-from-home activity.

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Text, Real Estate and Regional Banks, Work From Home and Higher Rates Hurt Office Buildings.

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30% of all hours worked, by credible surveys, are telling you 30% are being done from home. Very different. So, densely populated urban office space, regions are going to feel some of this pain.

Circling back to the private credit, though, it's a really great opportunity to make this recession obsession be on the offense for our client portfolios. Private credit is stepping in, lending into these spaces, what we're deeming to be credible returns, and compensation for the risk.

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Tom counts on his fingers.

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Really, a great opportunity to try to get offensive again, even having this recession obsession.

Thank you both for being here today. Very insightful, and, as a team here, we could not do it without you. Thank you so much.

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Text, 2023 Mid-Year Outlook, The 'Recession Obsession" Can be Navigated.

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The recession obsession is real, but, importantly, today, we tried to disaggregate the economy from financial markets. We drew on anonymized JP Morgan Wealth Management data to try to give you insights into what's happening in this community here.

We're trying to work through this recession obsession, and help you reach your financial goals despite a potential recession ahead of us. We had five big takeaways. First one, reinvestment risk is real if we hit a recession, so consider extending duration to lock in higher interest rates.

Point number two, consider building your equity portfolio for the next bull market. It may feel counterintuitive to do that ahead of a recession, but, Elyse, you outlined, our long-term capital market assumption is calling for 7% to 10% equity returns over the next 10 years, and we can find markets that are already pricing some level of recession risk. So, great points that you were making their.

Point three, face your home bias. Steph, I love how you made that a recency bias and a home bias, and it's not just us folks that are doing that. So, for our US investors, consider adding European equities.

Point number four, manage your concentrated positions. Elyse, you really brought that home with that example, and concentrated positions can be a blessing and a curse to try to work through. That's behavioral economics meeting investing.

And, lastly, know the risks. A part of this recession obsession is the worry about regional banks and commercial real estate. We can find ways to take those worries and turn them into offense amid this recession obsession.

So, thank you all for your time today. And just as importantly, thank you so much for your trust and confidence you put in JPMorgan.