After the Rate Reset: Investing Reconfigured
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Inflation will likely settle. You should still hedge against it.
The cash conundrum: the benefits and risks of holding too much
That’s not a big surprise—holding more cash than you usually do when rates are high and other markets are volatile can work well. But today’s high yields might not last as long as you’re expecting, and cash in the coming cycle will have its own subtle risks.
Bonds are more competitive with stocks—adjust the mix according to your ambitions
With AI momentum, equities seem to be on the march to new highs
Pockets of credit stress loom, but they will likely be limited
Our Global Perspective
Indian equity is one of the few emerging markets where stock investors have been rewarded for underlying economic growth.
Europe’s luxury goods sector delivers global brands with enduring pricing power, renewed by digital innovation.
Nearshoring creates new openings for Latin American markets, especially in Mexico.
Our Global Investment Strategy View integrates the knowledge and analysis of our economists, investment strategists and asset class strategists. This month’s focus: Investment implications of the rate reset.
Conclusion: Investing reconfigured
Welcome to the JP Morgan webcast. This is intended for informational purposes only. Opinions expressed herein are those of the speakers and may differ from those of other JP Morgan employees and affiliates. Historical information and outlooks are not guarantees of future results. Any views and strategies described may not be appropriate for all participants and should not be intended as personal investment, financial, or other advice. As a reminder, investment products are not FDIC-insured, do not have bank guarantee, and they may lose value. The webcast may now begin.
Hello. My name is Grace Peters, and I'm delighted to welcome you today to dig into the findings of our 2024 outlook titled After the Rate Reset: Investing Reconfigured. I'd like to start by introducing my colleagues Tom Kennedy, our chief investment strategist, and Abby Yoder, a senior equity strategist.
Now any outlook must start with reflection. Looking back to where we were this time last year when we issued our expectations for 2023. And the mood could not have been more different than it is today. A year ago, the world was worried about entrenched inflation, a global recession energy, crisis in Europe. And US equities were down 20%, and it was easy to be bearish.
Yet we at JP Morgan delivered a constructive outlook entitled See the Potential, advocating for stronger markets despite an expectation of weaker growth. Now that was predicated on the notion that peak growth and peak inflation fears were already discounted by the market in October, 2022. This was a contrarian view at the time, but seeing the potential did turn out to be the right call.
So far this year, the S&P is up around 20%, and a 60/40 portfolio of stocks and bonds has delivered a 13% return. As we now look to the year ahead, we believe the most important dynamic for investors to consider is the rate reset. We've seen a substantial rise in global bond yields that started after the pandemic but really gathered pace in the last few months.
The US Treasury curve stands close to 5% across the curve, and this theme is global, with half of the developed world's sovereign bonds trading with a yield higher than 4%. Critically, we think the rise in interest rates has run its course. The rate reset is over because inflation and growth will continue to fall next year, and central banks will start cutting rates.
History shows us that after the rate reset, bonds and stocks can do well. Investors have good options to deploy new money. And indeed, today's starting point of higher rates gives multiple choices to investors in crafting their financial plans. The key points of our outlook are inflation will likely settle. We see a landing zone in the 2% to 2.5% range. The cash conundrum, we think this is as good as it gets for cash. And we think that the opportunity cost of not being invested has started.
Bonds, it's time to lock in yields for today's high yields may not last for long. And on stocks, expect equities to keep climbing in 2024, making new highs driven by an earnings recovery that lies ahead. Finally, in credit, the real economy is still adapting to higher rates and lower credit availability. So pockets of credit stress loom, and defaults will likely rise. But overall, we believe stress will be limited.
Tom, let's start with you and dig into inflation. So we see inflation coming down. Talk about what you're seeing in the most recent data and how you think that plays out over the course of 2024.
Great, Grace. Thank you so much. 2023, looking backwards, has been the year of the immaculate disinflation. That word is so powerful because it breaks the trend of history, and we've seen inflation come down without a meaningful increase in the unemployment rate. And intuitively, that's the balancing act central banks are trying to navigate always.
Think about the Fed as an example. They have a maximum employment mandate and a stable prices mandate. Historically, these are at odds. And the higher inflation has been historically the more you'd have to push the unemployment rate up to normalize and rebalance the economy.
2023, immaculate. You did not see a meaningful increase in unemployment. Yet core inflation, as we were sitting here this time last year, was at 5.5% on a year over year basis. Here today, 3.5%. So this environment of expecting an economy and markets to perform well is actually conducive with a Fed balancing act that is more in check.
So so far, so good. 5.5% down to 3.5%. But some would argue that the last mile is the toughest bit, and we are still some way from mandate. So what's it going to take to get us down to that 2% to 2.5% range that I mentioned?
I think it's important to go deeper than a year over year 3.5% inflation number. Over the last six months, core inflation in America is running at about 2.5%. That disinflationary process is largely the goods sector. And last five months, Grace, we've seen goods-based inflation, deflationary, prices going down. So that process is I think what we would call the easy part. Next becomes the labor market and wages.
Wages have decelerated in America as well but not quite back to the rate we would think consistent with 2% inflation. So I do think you're going to need an economic slowdown. You will need to see the unemployment rate come up a little bit, but not very much given that the trade off between inflation and the labor market has become more in balance so far.
So does that mean that the central banks will be able to pivot away from the inflation part of their mandate and focus more on the growth side, and what does that mean when we start to think about cuts in 2024, which is something that obviously the markets got very excited about really in the last few months?
Yeah. This negotiation and tradeoff is adapting very quickly, where central banks seem to be very focused on fighting inflation, but now they can pivot in 2024, we think, to support growth. We're expecting rate cuts next year in the second half of the year. And that could become in a methodical fashion-- maybe think, Grace, one interest rate cut per quarter or per meeting if growth only slows a little bit.
But let's not forget that central banks have raised rates a lot. In the event growth slows very quickly, they can cut rates very quickly as well. And that should support an economy and prevent a deep recession. In a growth sense, we're expecting a slowdown in the first half of the year where growth in America is below trend. We're expecting the same in Europe as well, to be fair, but that the cuts can support the growth outlook in the back half of the year.
Very good. So we've got inflation coming down to that 2% to 2.5% level growth, below trend, a methodical cut from the Fed starting mid-year. Broadening out around the world, who's going to blink first? When we think about the Fed, the ECB, the Bank of England, how are you appraising those relative situations?
Historically, you would see the Fed cut before the ECB and before the Bank of England. We actually think it's going to be different this time. The rate hiking cycles globally have been very sharp, very aggressive. And economies in Europe are more interest rate sensitive. And we are actually seeing the growth slowdown happen faster in Europe than we are in the United States. So we're expecting the ECB to go first. And again, another thesis of how this time is quite different, even though those are famous last words. If we're putting down on our view, that's what we think is going to be first. The ECB and Europe will blink first.
OK. Very good. So I think that articulates the rate reset and the reason why we think that that pivot comes now. Which leads us on to the cash conundrum. And what we observe across our client portfolios is a lot of clients over the last couple of years have kept higher cash allocations, whether that be in cash itself, in short term treasuries, or money market funds. And we know that this is also mirrored across the market when we look at flows into these products as well.
So in my mind, that means there's a lot of cash to be deployed. And so when we think about movements, as we've seen in November, more and more clients are asking, have I missed out on the move because they can be quite sharp when you have this money in motion? So let's think about after the rate reset, ideas for our clients to deploy cash.
And Abby, I'd like to start with you on the equity side because I think when we think about what feels intuitive? So we have inflation coming back towards target. We have growth slowing. Either not going negative but still being below trend. And therefore, I think it makes sense to move out of cash. Clients can probably digest that yields available on cash or indeed fixed income, as we'll come onto, might not be available for as long as they hope. But help us piece together the equity piece of that. How do we think about rising equities, new highs in the S&P, despite an economic slowdown?
Yeah. I do think that is the biggest question right now. It's like how do you buy an asset that's typically very highly correlated to GDP growth when we're saying that growth is decelerating? And I think the important thing is, first of all, that we are expecting new highs for the equity market by the end of the year next year.
And it's important to keep in context what has happened over the past two years with equity markets. It's been completely disconnected from GDP growth, right? Last year in 2022, we were having nominal GDP growth well in excess of potential. And same with this year. And you've seen earnings growth actually flat over those two years for the equity market. So we've had two years of below trend earnings growth for the S&P 500, and a lot of that has been because we've been going through what we've been calling a rolling earnings recession.
So break that down for us. What does that mean, a rolling earnings recession?
And it's very important to break it down. So thinking about, OK, what happened over 2020 and 2021? We had all of these supply chain disruptions. We had a shift from consumers consuming goods to consuming services. So all of these different changes in consumption patterns, supply chains that resulted in different earnings recessions for different sectors.
So think industrials or consumers happening at different times. So at a headline level, the market never really saw that peak to trough drawdown in earnings of 10% to 15% that it typically does, but we did have nine of the 11 sectors already go through three consecutive negative quarters of earnings growth. And this quarter, 3Q 2023, was actually the first quarter that we've seen positive earnings growth since 3Q of 2022.
So that's very noteworthy. What you've described is because of the rolling earnings recession, we haven't seen a sharp drawdown at a headline level in S&P earnings. But playing that out into the recovery, we may not therefore see a V-shaped recovery from the S&P. So talk about the earnings profile perhaps as this rolling earnings recession turns into a rolling earnings recovery.
Right. And that is true. And I would also keep in mind, we have to think about market cap, right? So tech in particular was going through a negative earnings recession for the past couple of quarters and is starting to inflect higher. And not only are they inflecting higher because they're seeing their margin profile improve because they cut costs so much. Think about all the layoffs that were in the news this time last year for tech companies.
But they've also had this cyclical rebound in companies starting to spend more on CapEx, but then we have AI kicker, right? So you've got not only these more cyclical aspects that are helping the tech sector, but you've got the structural growth drivers in AI that is also propelling it. And remember, that's 23% of S&P 500 earnings. So that's a huge component of it. And so basically, we're expecting earnings to continue to accelerate in 4Q and in 2024, where we really start to see, in conjunction with that pickup in GDP growth, even stronger growth in the second half of 2024.
So we think that this is something that investors are going to be able to see starting now really in the quarterly earnings season on an improving trajectory as we go through the first half of the year, which I think if that plays out, will be pretty compelling when it comes to equity investing.
But we can't talk about equities obviously without valuations. And a natural thing to think about I guess is that as we reach peak rates, bond yields fall, that that could be helpful for equity valuations. How are you thinking about valuations in the context of the overall price target for the S&P?
Well, it's interesting. Even though we do have yields coming down in our outlook from where they are today, we actually within our price target maintain valuations where they are today. We're not making any grandiose assumptions about valuation expansion. Typically what you see is valuations expand where we are today in the cycle, right? Where there's max uncertainty, where earnings have seemed to have troughed, that's when you typically tend to see multiples at their highest. And so again, we're not calling for any type of multiple expansion going into the year. We're actually calling for multiples to remain where they are today.
OK. So we've got a price target on the S&P of $4,850. That's despite obviously a 20% rally that we've seen so far. But we feel that we're being pretty conservative when we think about what's driving that between the multiple, not significantly expanding, but really being carried by corporate earnings that's something quite visible that we'll be able to see as that plays out through the course of the year.
OK. I also just want to draw out that in the outlook, we dig into some global perspectives as well. And I hope that you find that interesting but when we think through high conviction, non-US ideas, we highlight India as one of the emerging markets where you really get that correlation between GDP growth and shareholder returns when you think about the earnings component of that.
Europe, luxury goods spending is a pocket of the market that we think will have very resilient pricing power. And also within LATAM where we're seeing real evidence of nearshoring being a real reality at the moment. So we hope that that's of interest to clients as well.
OK. Let's move on from the equity component and go back to fixed income, which we said before perhaps is the more intuitive part of the outlook. Take us through from here sort of parts of the fixed income market that we think are most attractive for investors next year.
Yeah. I think the most attractive places are going to be core fixed income allocations. Think investment grade bonds, and for taxpayers in America, municipal bonds. To find value in this, you can just look to history and keep it simple and say, after the last Fed rate hike in previous cycles, interest rates tend to decline 10-year Treasury rates, as an example. But I think the more compelling conversation is a recognition that interest rates are restrictive today.
And intuitively, it's quite odd, Grace, to see interest rates above the GDP rate in America. It doesn't happen very often. And again, intuitively, I think it's why would a business owner borrow at a rate that's higher than what their expected return on investment is? And I'm using GDP as a proxy for that. Quite odd, right?
Rather, what would a business owner do there? They would not borrow money and rather save. And the evidence is there. Over the last three months, annualized bank lending growth is almost zero. And you mentioned it up front. The dash to cash, the dash to money fund assets, this cycle has seen the fastest increase in money fund assets ever. So you're getting the evidence that rates are restrictive. And if that's true, by definition, they should come down in the future. So how can I get access to that? I can think about an investment grade or a municipal bond as a way to lock in those yields.
So we think it's worth stepping out of government bonds. You get a yield pickup there and investment grade credit being a good example of that. How do you think about the shape of the curve, and which part, what duration specifically, is appealing given the overall context of the outlook that we see?
I think the ideal sweet spot for an investor is somewhere in the five to seven-year maturity. I think it's going to give you the compelling yield and lock-in yields but not take excessive risk in locking in a bond yield for 30 years. Remember the investment grade market and the municipal bond market, you're getting a yield conversation with very little default risk. And I'm relying on history for that. Historical default rates in munis and investment grade bonds is quite low.
But I like the tradeoff in the five to seven-year point yields. I can lock in compelling yield, call it mid-single digits. But if our rate outlook is right and rates decline, your total return will be something higher than that. Call it higher single digits. And then what if we're wrong? What if rates back up again, another year of higher rates? For an investment grade bond index, it would take about a one percentage point increase in yields to just get a zero total return. I really like that asymmetric return profile.
And help us talk through the bond math because I think this can be actually-- whilst it is a little bit technical, it actually really articulates the power of owning duration maybe using the investment grade, the seven-year example that you mentioned.
Yeah. The investment grade bond index has a duration, which is how long until I get my principal back to me as an investor? And the more interest rate duration you take, the more sensitive you are to changes in interest rates. So in our outlook, we're expecting interest rates, 10-year interest rates, five-year interest rates to come down about 25 basis points. And that supports your total return. It increases it above your yield. Now the reverse is true too if rates back up, it will decrease your total return. But again, almost 100 basis points or one percentage point increase in yields, and you only see a total return of about zero over a year's time.
So when we think about the outlook for fixed income after what has obviously been a very tricky couple of years for fixed income holders, then this new rate regime really does present an opportunity to lock in yields. Yes, the front end feels perhaps a little bit more intuitive, but actually extending duration is really where you get not only the yield benefit but that protection. Should we get a downside growth shock? Whilst the environment feels quite buoyant at the moment, it's often obviously good to have that in the portfolio as well.
And I think that starts to bring us on therefore to alternate scenarios. So let's think about-- Tom, and I'll come back to you to carry on with the cycle around where we are in the credit cycle. But in the introduction, we spoke to the fact that whilst markets have adjusted very quickly, we can talk about how the new rate regime has seen this huge rise in bond yields that we think is now over. But I think the real economy has not yet adjusted to this new world of slightly higher inflation and rates over the long term. How are you thinking about other parts of the market and the opportunity set on a go forward basis?
Monetary policy famously works with long and variable lags. You just described them. It happens via credit markets. Interest rates we think are quite restrictive. And now the world has to adapt to that. Simple analogy. Imagine you're a small business, and you were borrowing money to invest in your business at near zero rates just two years ago. Well, now you walk into one of our amazing businesses throughout the world, one of our amazing branches, and you're going to see interest rates between 5% and 10% at least. There's consequence to that.
So the credit cycle, to your point, is a way to see those lags operate through the economy, and they're here. I think the perspective is when I look at the media, is it's just office. But we are seeing the credit cycle broaden out beyond there. You can look at the loan market where, again, mostly floating rate debt, so they're experiencing higher interest rates very quickly. And defaults there have picked up from near zero to about 3%. Nothing to worry about but trending higher.
And then you can look to the consumer as well. The consumer is in good shape, but we are seeing them change their behavior. They were using excess savings to keep their consumption high, and now they're turning to their credit card. And credit card, newly delinquent credit card rates are inflecting higher at quite a rapid clip.
So there are consequences. And ultimately, we don't think it will broaden out much beyond the commercial real estate sector but because the Fed will be able to cut rates. In the event we're wrong, and the Fed doesn't cut rates in 2024, I do think this credit cycle will be more extensive and deeper than what we have priced right now.
I'd like to come back to you in a bit, Abby, actually on the consumer. I think that's a really good point. I'd love to hear what the companies are saying about the consumer. But just carrying on a little bit with this notion of the credit cycle that perhaps still lays out before us. As investors, what's the advice around how we can avoid the worst, any potholes that may come out in the quarters and years ahead, but also capitalize on what will undoubtedly be some opportunities?
Yeah. I think the way to avoid this being a central part of your portfolio is to try to get that safe protection back. It draws back to the bond core bond conversation. So then with that portfolio protection, we can get opportunistic and find good ideas. I think the central place where we'll see this distress show up is going to be in the loan market. And office is the epicenter. It's where the credit cycle is happening right now.
Most of those loans are owned by regional banks, and it's most likely those banks will end up having to sell assets to shore up their balance sheets. So I think that's a place to get opportunistic. Where can we be buyers of those loans? And they may not necessarily be distressed loans. They could be perfectly healthy loans.
And then there's even more aggressive, which is you can go to the equity cohort of these distressed ideas and be a provider of capital in that market as well. I think you have to make sure your portfolio has the right protective characteristics before you get to that opportunistic idea. But in the event of what if the downturn is deeper than we think, this is the place I think to action that idea or that thought.
Abby, consumer. You and the team go through hundreds of transcripts. You listen to all the calls. What are companies saying and their forward-looking guidance about the state of the consumer?
Well, so I think what's so interesting about the consumer, it makes up such a big part of GDP, right? 70% of GDP. It's very important. And it is kind of the linchpin of the argument between the bears and the bulls, I would say. And that's not to say that we expect the consumer to stay at the level that it is right now, spending in terms of the consumer. We do expect that to decelerate along with GDP growth.
And I think it's very easy to pick one data point as a bear and say like look at that excess savings coming down, and there's no room for the consumer to really spend any more. But when you take the consumer at a whole, right? You think about their income statement. You think about their balance sheet. You think about the way that they've had all of this cash inflow over the past couple of years, they've actually been very prudent. They have been paying down their debt over the past couple of years. Yes, you're seeing delinquency rates come up, but that's coming off very, very low levels.
And then also in tandem with that, you think about their assets, their financial assets. Their homes. They've all appreciated 30% to 40% over the past couple of years. So it's not just about the savings rate or one tiny data point. It's about thinking about the consumer as a whole. And I would say the companies that we've been hearing from would agree, right? There's a little bit of a slowdown that they're expecting. But overall, particularly when we're thinking about banks and credit cards, they're very much positive on the consumer going into 2024.
And I think what you've hit on there is really the very notion of the resilience that we've seen play out in 2023 because of that overall net household position being strong despite obviously excess savings coming down. Abby, when it comes to the equity market and some of those alternate scenarios, help us think through what maybe a less rosy picture would be, but also what a more blue sky could be if we think a degree of this resilience continues through 2024?
Yeah. So I think the biggest downside scenario, obviously we're very optimistic in terms of our outlook, I think that would be GDP growth slowing in excess of what we were expecting, and inflation being higher than we expected, and being entrenched, right? Because a big part of the story is actually that we're seeing margins stabilize and expand for the S&P 500. If inflation were to stay higher, particularly on the wage front, I think that's where you could see margins probably compress for large companies in particular.
And then on the other side of that, I mean, I think we do have a very optimistic scenario going into the year. It's really about the Fed being able to land this plane, right? This is about a soft landing coming to fruition. And I think there is definitely scope for that. As Tom talked about, immaculate disinflation, this really is coming to bear, and the labor market continues to remain strong. So I think our view really does embed that optimism. The upside would be if we see earnings come in better than expected. And that's really driven by a revenue acceleration and then again margins expanding more to the upside than what we have penciled in, which is around 25 basis points.
Good. Now still a question. I know that in the outlook, we've got inflation coming down. It is settling higher though, isn't it? 2% to 2.5%. So significantly higher, and as mentioned before, perhaps with more inflation volatility. So still a question that we get from clients a lot, which I think is very valid, is what if inflation continues to surprise to the upside? Should I have portfolio hedges, and what should they be? So maybe Tom, do you want to take us through some of the benefits of real assets in the portfolio?
Yeah. I think when you look back through history, real assets like core real estate as an idea has, for the most part, outpaced inflation over time. And it suggests pricing power, and it also is in line with the notion of we're making a lot more people. We're not making a lot more land. This inflation protection, well, in our baseline scenario, may not be especially necessary. Volatility this cycle is the name of the game. So this is a place where you can I think get compelling yield, opportunity for price appreciation in excess of inflation, and it could be somewhat uncorrelated in your portfolio. So I think the merits of it, even if not essential scenario, to give you the portfolio characteristics that we're looking for, it's all there.
Very good. OK. The time has come to end our conversation. I thank Abby and Tom for sharing their insights today and express my gratitude to you, our audience, for joining us. Let me wrap up with the five points I hope you will draw from today's webinar. Firstly, inflation is coming in to land, we think, in the 2% to 2.5% range, and you should still have some inflation hedges in the portfolio.
Secondly, the cash conundrum, we think this is as good as it gets for cash. Bonds, lock-in yields, they may not last as long as you're expecting. But meanwhile, stocks could keep climbing in 2024, making new highs as the rally broadens. Finally, credit, where we think pockets of credit stress still loom, but that you can be opportunistic as distressed opportunities emerge within real estate and private credit sectors.
We hope that you've enjoyed JP Morgan's 2024 outlook and that we've conveyed our belief that markets offer a promising and diverse opportunity set. Please do reach out to your JP Morgan advisor to discuss portfolio actions you could take in today's new interest rate regime.
Whatever markets have in store in 2024, we rely on each other, and we highly value the relationships we forged over time with you. We're honored to stand by your side as your financial partner, and we thank you for your continued trust and confidence in JP Morgan.
Thank you for joining us. Prior to making financial or investment decisions, you should speak with a qualified professional in your JP Morgan team. This concludes today's webcast. You may now disconnect.
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Text, Outlook 2024. Investing Reconfigured. After the Rate Reset: Five considerations for the year ahead. JP Morgan Private Bank.
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(SPEECH)
Welcome to the JP Morgan webcast. This is intended for informational purposes only. Opinions expressed herein are those of the speakers and may differ from those of other JP Morgan employees and affiliates. Historical information and outlooks are not guarantees of future results. Any views and strategies described may not be appropriate for all participants and should not be intended as personal investment, financial, or other advice. As a reminder, investment products are not FDIC-insured, do not have bank guarantee, and they may lose value. The webcast may now begin.
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Text, JP Morgan. A woman appears sitting in a chair with another man and woman sitting to her right. Grace Peters, Global Head of Investment Strategy.
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Hello. My name is Grace Peters, and I'm delighted to welcome you today to dig into the findings of our 2024 outlook titled After the Rate Reset: Investing Reconfigured. I'd like to start by introducing my colleagues Tom Kennedy, our chief investment strategist, and Abby Yoder, a senior equity strategist.
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Text, 2024 Outlook. After the Rate Reset: Investing Reconfigured.
(SPEECH)
Now any outlook must start with reflection. Looking back to where we were this time last year when we issued our expectations for 2023. And the mood could not have been more different than it is today. A year ago, the world was worried about entrenched inflation, a global recession energy, crisis in Europe. And US equities were down 20%, and it was easy to be bearish.
Yet we at JP Morgan delivered a constructive outlook entitled See the Potential, advocating for stronger markets despite an expectation of weaker growth. Now that was predicated on the notion that peak growth and peak inflation fears were already discounted by the market in October, 2022. This was a contrarian view at the time, but seeing the potential did turn out to be the right call.
So far this year, the S&P is up around 20%, and a 60/40 portfolio of stocks and bonds has delivered a 13% return. As we now look to the year ahead, we believe the most important dynamic for investors to consider is the rate reset. We've seen a substantial rise in global bond yields that started after the pandemic but really gathered pace in the last few months.
The US Treasury curve stands close to 5% across the curve, and this theme is global, with half of the developed world's sovereign bonds trading with a yield higher than 4%. Critically, we think the rise in interest rates has run its course. The rate reset is over because inflation and growth will continue to fall next year, and central banks will start cutting rates.
History shows us that after the rate reset, bonds and stocks can do well. Investors have good options to deploy new money. And indeed, today's starting point of higher rates gives multiple choices to investors in crafting their financial plans.
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Text, 2024 Outlook - Inflation, cash, bonds, stocks, and credit stress.
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The key points of our outlook are inflation will likely settle. We see a landing zone in the 2% to 2.5% range. The cash conundrum, we think this is as good as it gets for cash. And we think that the opportunity cost of not being invested has started.
Bonds, it's time to lock in yields for today's high yields may not last for long. And on stocks, expect equities to keep climbing in 2024, making new highs driven by an earnings recovery that lies ahead. Finally, in credit, the real economy is still adapting to higher rates and lower credit availability. So pockets of credit stress loom, and defaults will likely rise. But overall, we believe stress will be limited.
Tom, let's start with you and dig into inflation. So we see inflation coming down. Talk about what you're seeing in the most recent data and how you think that plays out over the course of 2024.
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Tom Kennedy, Chief Investment Strategist.
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Great, Grace. Thank you so much. 2023, looking backwards, has been the year of the immaculate disinflation.
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Text, Inflation to likely settle, You should still hedge against it.
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That word is so powerful because it breaks the trend of history, and we've seen inflation come down without a meaningful increase in the unemployment rate. And intuitively, that's the balancing act central banks are trying to navigate always.
Think about the Fed as an example. They have a maximum employment mandate and a stable prices mandate. Historically, these are at odds. And the higher inflation has been historically the more you'd have to push the unemployment rate up to normalize and rebalance the economy.
2023, immaculate. You did not see a meaningful increase in unemployment. Yet core inflation, as we were sitting here this time last year, was at 5.5% on a year over year basis. Here today, 3.5%. So this environment of expecting an economy and markets to perform well is actually conducive with a Fed balancing act that is more in check.
So so far, so good. 5.5% down to 3.5%. But some would argue that the last mile is the toughest bit, and we are still some way from mandate. So what's it going to take to get us down to that 2% to 2.5% range that I mentioned?
I think it's important to go deeper than a year over year 3.5% inflation number. Over the last six months, core inflation in America is running at about 2.5%. That disinflationary process is largely the goods sector. And last five months, Grace, we've seen goods-based inflation, deflationary, prices going down. So that process is I think what we would call the easy part. Next becomes the labor market and wages.
Wages have decelerated in America as well but not quite back to the rate we would think consistent with 2% inflation. So I do think you're going to need an economic slowdown. You will need to see the unemployment rate come up a little bit, but not very much given that the trade off between inflation and the labor market has become more in balance so far.
So does that mean that the central banks will be able to pivot away from the inflation part of their mandate and focus more on the growth side, and what does that mean when we start to think about cuts in 2024, which is something that obviously the markets got very excited about really in the last few months?
Yeah. This negotiation and tradeoff is adapting very quickly, where central banks seem to be very focused on fighting inflation, but now they can pivot in 2024, we think, to support growth. We're expecting rate cuts next year in the second half of the year. And that could become in a methodical fashion-- maybe think, Grace, one interest rate cut per quarter or per meeting if growth only slows a little bit.
But let's not forget that central banks have raised rates a lot. In the event growth slows very quickly, they can cut rates very quickly as well. And that should support an economy and prevent a deep recession. In a growth sense, we're expecting a slowdown in the first half of the year where growth in America is below trend. We're expecting the same in Europe as well, to be fair, but that the cuts can support the growth outlook in the back half of the year.
Very good. So we've got inflation coming down to that 2% to 2.5% level growth, below trend, a methodical cut from the Fed starting mid-year. Broadening out around the world, who's going to blink first? When we think about the Fed, the ECB, the Bank of England, how are you appraising those relative situations?
Historically, you would see the Fed cut before the ECB and before the Bank of England. We actually think it's going to be different this time. The rate hiking cycles globally have been very sharp, very aggressive. And economies in Europe are more interest rate sensitive. And we are actually seeing the growth slowdown happen faster in Europe than we are in the United States. So we're expecting the ECB to go first. And again, another thesis of how this time is quite different, even though those are famous last words. If we're putting down on our view, that's what we think is going to be first. The ECB and Europe will blink first.
OK. Very good. So I think that articulates the rate reset and the reason why we think that that pivot comes now. Which leads us on to the cash conundrum.
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Text, The cash conundrum. The benefits and risks of holding too much.
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And what we observe across our client portfolios is a lot of clients over the last couple of years have kept higher cash allocations, whether that be in cash itself, in short term treasuries, or money market funds. And we know that this is also mirrored across the market when we look at flows into these products as well.
So in my mind, that means there's a lot of cash to be deployed. And so when we think about movements, as we've seen in November, more and more clients are asking, have I missed out on the move because they can be quite sharp when you have this money in motion? So let's think about after the rate reset, ideas for our clients to deploy cash.
And Abby, I'd like to start with you on the equity side because I think when we think about what feels intuitive? So we have inflation coming back towards target. We have growth slowing. Either not going negative but still being below trend. And therefore, I think it makes sense to move out of cash. Clients can probably digest that yields available on cash or indeed fixed income, as we'll come onto, might not be available for as long as they hope. But help us piece together the equity piece of that. How do we think about rising equities, new highs in the S&P, despite an economic slowdown?
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Abby Yoder, U.S. Equity Strategist.
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Yeah. I do think that is the biggest question right now. It's like how do you buy an asset that's typically very highly correlated to GDP growth when we're saying that growth is decelerating? And I think the important thing is, first of all, that we are expecting new highs for the equity market by the end of the year next year.
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Text, Stocks on the march. With AI momentum, equities may see new highs.
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And it's important to keep in context what has happened over the past two years with equity markets. It's been completely disconnected from GDP growth, right? Last year in 2022, we were having nominal GDP growth well in excess of potential. And same with this year. And you've seen earnings growth actually flat over those two years for the equity market. So we've had two years of below trend earnings growth for the S&P 500, and a lot of that has been because we've been going through what we've been calling a rolling earnings recession.
So break that down for us. What does that mean, a rolling earnings recession?
And it's very important to break it down. So thinking about, OK, what happened over 2020 and 2021? We had all of these supply chain disruptions. We had a shift from consumers consuming goods to consuming services. So all of these different changes in consumption patterns, supply chains that resulted in different earnings recessions for different sectors.
So think industrials or consumers happening at different times. So at a headline level, the market never really saw that peak to trough drawdown in earnings of 10% to 15% that it typically does, but we did have nine of the 11 sectors already go through three consecutive negative quarters of earnings growth. And this quarter, 3Q 2023, was actually the first quarter that we've seen positive earnings growth since 3Q of 2022.
So that's very noteworthy. What you've described is because of the rolling earnings recession, we haven't seen a sharp drawdown at a headline level in S&P earnings. But playing that out into the recovery, we may not therefore see a V-shaped recovery from the S&P. So talk about the earnings profile perhaps as this rolling earnings recession turns into a rolling earnings recovery.
Right. And that is true. And I would also keep in mind, we have to think about market cap, right? So tech in particular was going through a negative earnings recession for the past couple of quarters and is starting to inflect higher. And not only are they inflecting higher because they're seeing their margin profile improve because they cut costs so much. Think about all the layoffs that were in the news this time last year for tech companies.
But they've also had this cyclical rebound in companies starting to spend more on CapEx, but then we have AI kicker, right? So you've got not only these more cyclical aspects that are helping the tech sector, but you've got the structural growth drivers in AI that is also propelling it. And remember, that's 23% of S&P 500 earnings. So that's a huge component of it. And so basically, we're expecting earnings to continue to accelerate in 4Q and in 2024, where we really start to see, in conjunction with that pickup in GDP growth, even stronger growth in the second half of 2024.
So we think that this is something that investors are going to be able to see starting now really in the quarterly earnings season on an improving trajectory as we go through the first half of the year, which I think if that plays out, will be pretty compelling when it comes to equity investing.
But we can't talk about equities obviously without valuations. And a natural thing to think about I guess is that as we reach peak rates, bond yields fall, that that could be helpful for equity valuations. How are you thinking about valuations in the context of the overall price target for the S&P?
Well, it's interesting. Even though we do have yields coming down in our outlook from where they are today, we actually within our price target maintain valuations where they are today. We're not making any grandiose assumptions about valuation expansion. Typically what you see is valuations expand where we are today in the cycle, right? Where there's max uncertainty, where earnings have seemed to have troughed, that's when you typically tend to see multiples at their highest. And so again, we're not calling for any type of multiple expansion going into the year. We're actually calling for multiples to remain where they are today.
OK. So we've got a price target on the S&P of $4,850. That's despite obviously a 20% rally that we've seen so far. But we feel that we're being pretty conservative when we think about what's driving that between the multiple, not significantly expanding, but really being carried by corporate earnings that's something quite visible that we'll be able to see as that plays out through the course of the year.
OK. I also just want to draw out that in the outlook, we dig into some global perspectives as well. And I hope that you find that interesting but when we think through high conviction, non-US ideas, we highlight India as one of the emerging markets where you really get that correlation between GDP growth and shareholder returns when you think about the earnings component of that.
Europe, luxury goods spending is a pocket of the market that we think will have very resilient pricing power. And also within LATAM where we're seeing real evidence of nearshoring being a real reality at the moment. So we hope that that's of interest to clients as well.
OK. Let's move on from the equity component and go back to fixed income, which we said before perhaps is the more intuitive part of the outlook. Take us through from here sort of parts of the fixed income market that we think are most attractive for investors next year.
Yeah.
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Bonds more competitive with stocks. Adjust the mix according to your ambitions.
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I think the most attractive places are going to be core fixed income allocations. Think investment grade bonds, and for taxpayers in America, municipal bonds. To find value in this, you can just look to history and keep it simple and say, after the last Fed rate hike in previous cycles, interest rates tend to decline 10-year Treasury rates, as an example. But I think the more compelling conversation is a recognition that interest rates are restrictive today.
And intuitively, it's quite odd, Grace, to see interest rates above the GDP rate in America. It doesn't happen very often. And again, intuitively, I think it's why would a business owner borrow at a rate that's higher than what their expected return on investment is? And I'm using GDP as a proxy for that. Quite odd, right?
Rather, what would a business owner do there? They would not borrow money and rather save. And the evidence is there. Over the last three months, annualized bank lending growth is almost zero. And you mentioned it up front. The dash to cash, the dash to money fund assets, this cycle has seen the fastest increase in money fund assets ever. So you're getting the evidence that rates are restrictive. And if that's true, by definition, they should come down in the future. So how can I get access to that? I can think about an investment grade or a municipal bond as a way to lock in those yields.
So we think it's worth stepping out of government bonds. You get a yield pickup there and investment grade credit being a good example of that. How do you think about the shape of the curve, and which part, what duration specifically, is appealing given the overall context of the outlook that we see?
I think the ideal sweet spot for an investor is somewhere in the five to seven-year maturity. I think it's going to give you the compelling yield and lock-in yields but not take excessive risk in locking in a bond yield for 30 years. Remember the investment grade market and the municipal bond market, you're getting a yield conversation with very little default risk. And I'm relying on history for that. Historical default rates in munis and investment grade bonds is quite low.
But I like the tradeoff in the five to seven-year point yields. I can lock in compelling yield, call it mid-single digits. But if our rate outlook is right and rates decline, your total return will be something higher than that. Call it higher single digits. And then what if we're wrong? What if rates back up again, another year of higher rates? For an investment grade bond index, it would take about a one percentage point increase in yields to just get a zero total return. I really like that asymmetric return profile.
And help us talk through the bond math because I think this can be actually-- whilst it is a little bit technical, it actually really articulates the power of owning duration maybe using the investment grade, the seven-year example that you mentioned.
Yeah. The investment grade bond index has a duration, which is how long until I get my principal back to me as an investor? And the more interest rate duration you take, the more sensitive you are to changes in interest rates. So in our outlook, we're expecting interest rates, 10-year interest rates, five-year interest rates to come down about 25 basis points. And that supports your total return. It increases it above your yield. Now the reverse is true too if rates back up, it will decrease your total return. But again, almost 100 basis points or one percentage point increase in yields, and you only see a total return of about zero over a year's time.
So when we think about the outlook for fixed income after what has obviously been a very tricky couple of years for fixed income holders, then this new rate regime really does present an opportunity to lock in yields. Yes, the front end feels perhaps a little bit more intuitive, but actually extending duration is really where you get not only the yield benefit but that protection. Should we get a downside growth shock? Whilst the environment feels quite buoyant at the moment, it's often obviously good to have that in the portfolio as well.
And I think that starts to bring us on therefore to alternate scenarios. So let's think about-- Tom, and I'll come back to you to carry on with the cycle around where we are in the credit cycle. But in the introduction, we spoke to the fact that whilst markets have adjusted very quickly, we can talk about how the new rate regime has seen this huge rise in bond yields that we think is now over. But I think the real economy has not yet adjusted to this new world of slightly higher inflation and rates over the long term. How are you thinking about other parts of the market and the opportunity set on a go forward basis?
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Text, Credit stress. Pockets of credit stress loom, but they will likely be limited.
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Monetary policy famously works with long and variable lags. You just described them. It happens via credit markets. Interest rates we think are quite restrictive. And now the world has to adapt to that. Simple analogy. Imagine you're a small business, and you were borrowing money to invest in your business at near zero rates just two years ago. Well, now you walk into one of our amazing businesses throughout the world, one of our amazing branches, and you're going to see interest rates between 5% and 10% at least. There's consequence to that.
So the credit cycle, to your point, is a way to see those lags operate through the economy, and they're here. I think the perspective is when I look at the media, is it's just office. But we are seeing the credit cycle broaden out beyond there. You can look at the loan market where, again, mostly floating rate debt, so they're experiencing higher interest rates very quickly. And defaults there have picked up from near zero to about 3%. Nothing to worry about but trending higher.
And then you can look to the consumer as well. The consumer is in good shape, but we are seeing them change their behavior. They were using excess savings to keep their consumption high, and now they're turning to their credit card. And credit card, newly delinquent credit card rates are inflecting higher at quite a rapid clip.
So there are consequences. And ultimately, we don't think it will broaden out much beyond the commercial real estate sector but because the Fed will be able to cut rates. In the event we're wrong, and the Fed doesn't cut rates in 2024, I do think this credit cycle will be more extensive and deeper than what we have priced right now.
I'd like to come back to you in a bit, Abby, actually on the consumer. I think that's a really good point. I'd love to hear what the companies are saying about the consumer. But just carrying on a little bit with this notion of the credit cycle that perhaps still lays out before us. As investors, what's the advice around how we can avoid the worst, any potholes that may come out in the quarters and years ahead, but also capitalize on what will undoubtedly be some opportunities?
Yeah. I think the way to avoid this being a central part of your portfolio is to try to get that safe protection back. It draws back to the bond core bond conversation. So then with that portfolio protection, we can get opportunistic and find good ideas. I think the central place where we'll see this distress show up is going to be in the loan market. And office is the epicenter. It's where the credit cycle is happening right now.
Most of those loans are owned by regional banks, and it's most likely those banks will end up having to sell assets to shore up their balance sheets. So I think that's a place to get opportunistic. Where can we be buyers of those loans? And they may not necessarily be distressed loans. They could be perfectly healthy loans.
And then there's even more aggressive, which is you can go to the equity cohort of these distressed ideas and be a provider of capital in that market as well. I think you have to make sure your portfolio has the right protective characteristics before you get to that opportunistic idea. But in the event of what if the downturn is deeper than we think, this is the place I think to action that idea or that thought.
Abby, consumer. You and the team go through hundreds of transcripts. You listen to all the calls. What are companies saying and their forward-looking guidance about the state of the consumer?
Well, so I think what's so interesting about the consumer, it makes up such a big part of GDP, right? 70% of GDP. It's very important. And it is kind of the linchpin of the argument between the bears and the bulls, I would say. And that's not to say that we expect the consumer to stay at the level that it is right now, spending in terms of the consumer. We do expect that to decelerate along with GDP growth.
And I think it's very easy to pick one data point as a bear and say like look at that excess savings coming down, and there's no room for the consumer to really spend any more. But when you take the consumer at a whole, right? You think about their income statement. You think about their balance sheet. You think about the way that they've had all of this cash inflow over the past couple of years, they've actually been very prudent. They have been paying down their debt over the past couple of years. Yes, you're seeing delinquency rates come up, but that's coming off very, very low levels.
And then also in tandem with that, you think about their assets, their financial assets. Their homes. They've all appreciated 30% to 40% over the past couple of years. So it's not just about the savings rate or one tiny data point. It's about thinking about the consumer as a whole. And I would say the companies that we've been hearing from would agree, right? There's a little bit of a slowdown that they're expecting. But overall, particularly when we're thinking about banks and credit cards, they're very much positive on the consumer going into 2024.
And I think what you've hit on there is really the very notion of the resilience that we've seen play out in 2023 because of that overall net household position being strong despite obviously excess savings coming down. Abby, when it comes to the equity market and some of those alternate scenarios, help us think through what maybe a less rosy picture would be, but also what a more blue sky could be if we think a degree of this resilience continues through 2024?
Yeah. So I think the biggest downside scenario, obviously we're very optimistic in terms of our outlook, I think that would be GDP growth slowing in excess of what we were expecting, and inflation being higher than we expected, and being entrenched, right? Because a big part of the story is actually that we're seeing margins stabilize and expand for the S&P 500. If inflation were to stay higher, particularly on the wage front, I think that's where you could see margins probably compress for large companies in particular.
And then on the other side of that, I mean, I think we do have a very optimistic scenario going into the year. It's really about the Fed being able to land this plane, right? This is about a soft landing coming to fruition. And I think there is definitely scope for that. As Tom talked about, immaculate disinflation, this really is coming to bear, and the labor market continues to remain strong. So I think our view really does embed that optimism. The upside would be if we see earnings come in better than expected. And that's really driven by a revenue acceleration and then again margins expanding more to the upside than what we have penciled in, which is around 25 basis points.
Good. Now still a question. I know that in the outlook, we've got inflation coming down. It is settling higher though, isn't it? 2% to 2.5%. So significantly higher, and as mentioned before, perhaps with more inflation volatility. So still a question that we get from clients a lot, which I think is very valid, is what if inflation continues to surprise to the upside? Should I have portfolio hedges, and what should they be? So maybe Tom, do you want to take us through some of the benefits of real assets in the portfolio?
Yeah. I think when you look back through history, real assets like core real estate as an idea has, for the most part, outpaced inflation over time. And it suggests pricing power, and it also is in line with the notion of we're making a lot more people. We're not making a lot more land. This inflation protection, well, in our baseline scenario, may not be especially necessary. Volatility this cycle is the name of the game. So this is a place where you can I think get compelling yield, opportunity for price appreciation in excess of inflation, and it could be somewhat uncorrelated in your portfolio. So I think the merits of it, even if not essential scenario, to give you the portfolio characteristics that we're looking for, it's all there.
Very good. OK. The time has come to end our conversation. I thank Abby and Tom for sharing their insights today and express my gratitude to you, our audience, for joining us. Let me wrap up with the five points I hope you will draw from today's webinar. Firstly, inflation is coming in to land, we think, in the 2% to 2.5% range, and you should still have some inflation hedges in the portfolio.
Secondly, the cash conundrum, we think this is as good as it gets for cash. Bonds, lock-in yields, they may not last as long as you're expecting. But meanwhile, stocks could keep climbing in 2024, making new highs as the rally broadens. Finally, credit, where we think pockets of credit stress still loom, but that you can be opportunistic as distressed opportunities emerge within real estate and private credit sectors.
We hope that you've enjoyed JP Morgan's 2024 outlook and that we've conveyed our belief that markets offer a promising and diverse opportunity set. Please do reach out to your JP Morgan advisor to discuss portfolio actions you could take in today's new interest rate regime.
Whatever markets have in store in 2024, we rely on each other, and we highly value the relationships we forged over time with you. We're honored to stand by your side as your financial partner, and we thank you for your continued trust and confidence in JP Morgan.
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