Interview with JP Morgan Asset Management’s Chief Global Strategist.
What is your stock market outlook for the second half? It’s been a particularly difficult year, but I’m reasonably optimistic. The main concerns this year have been inflation, the Federal Reserve raising rates very rapidly and the possibility of a recession. We don’t know the geopolitical events, whether in Ukraine or in other situations that will erupt. But I think economic growth can moderate without going into recession, I think inflation can moderate, and I think the Federal Reserve will tone down. That should make for a reasonably positive second half for US equities.
What are your forecasts for the economy and inflation? By the fourth quarter, I expect economic growth, adjusted for inflation, to be below 2.5% year-over-year; by the fourth quarter of next year, less than 2.0%. So I think the economy will grow, but at a much slower pace. Regarding inflation, we expect the consumer price index to come back to 4.3% by the end of this year, to 3.5% by the end of the next year. Why do I think inflation will go down? Because there really is a transitory inflation. It was caused by the pandemic and the political response. The pandemic is fading and supply chains will improve. Much of the money poured into the economy in terms of fiscal stimulus over the past two years is drying up. This money has increased the demand for many goods. With less demand, inflation will naturally subside.
Why are you convinced that we will circumvent a recession? Despite the two extraordinary recessions we have experienced since the turn of the century—the pandemic recession and the great financial crisis—I think GDP volatility has declined. It is quite difficult to start a normal recession. There is a huge excess demand for labor, and this momentum will keep the economy from going into recession. The unemployment rate will fall to 3.3% by the fourth quarter of this year, which will be the lowest in 70 years, and to around 3.1% by the fourth quarter of next year.
Are US corporate earnings in good shape? It is more difficult for companies in general. It looks like operating profit will be up about 7-8% in the first quarter compared to the same period last year. This is representative of what we will see this year. We saw huge revenue gains last year. The profits are extremely high, but it is very difficult to grow them from here. And businesses are under pressure. A rising dollar hurts the value of offshore earnings. Also, you have rising payroll costs, rising interest costs. Thus, the overall profits will increase more slowly. But within the market, there are stocks that are cheap relative to earnings and others that are expensive. Valuation scrutiny will be much more important in the second half of this year and beyond. Investors will be a bit more parsimonious about what they buy. But within the market, there are a lot of opportunities.
How should investors position their portfolios? The first thing investors should do is look in the mirror. We have made tremendous gains over the past three years. If you haven’t rebalanced, the good news is that you have a lot more money. The bad news is that you are heavily overweight large cap growth stocks. Is this where you want to be? People need to look at how the environment has changed and ensure their portfolios are appropriately aligned in terms of risk and expected return. What risk do you want to take?
When it comes to opportunities, valuations give you the answer. Value-priced stocks typically sell at a steep discount to growth-oriented stocks. Over the past 25 years, the price-to-earnings ratio of value stocks has averaged 72% of that of growth stocks. Now it’s an average of 60%. People piled into mega-cap growth stocks. But the more restrained world of 2022 and possibly 2023 will cause those valuation gaps to narrow. Likewise, international equities in general have rarely looked as cheap as they do today relative to US equities. Many people are very underweight in international equities – now is a good time to stock up. You can get double the dividend yield you can get in the US, and you’re buying at much better valuations.
When you say international investment, where do you mean? Europe and China. Europe is cheap. It is threatened by what is happening in Ukraine and by high energy prices which will slow down the European economy. But a silver lining of Ukraine’s very dark cloud is that it brought Europe together. The pandemic has also helped bring Europe together. We are seeing more common fiscal policies. In the end, Europe will overcome its energy problems and return to moderate growth. European stocks are so cheap that there is a big opportunity here. The global value play is European stocks. China is a different situation. China has taken a huge hit. It will be a bumpy year as China overcomes its vulnerability to COVID. But financial assets are long term and China has great potential for growth. Chinese stocks look very cheap compared to the rest of the world.
What other pockets of opportunity do you see? Small cap stocks could do well. They tend to do well when the economy is coming out of recession and do poorly when threatened by recession, but I think we can avoid a recession here. Again, small cap value looks cheap relative to small cap growth.
What about inflation hedges, always a good strategy? The inflationary threat may be receding a bit, but some exposure to commodities and parts of the real estate market is acceptable. And stocks as a whole are an inflation hedge against fixed income or cash. Many people are tempted to buy inflation-protected Treasury securities. But the yield on 10-year TIPS is negative in inflation-adjusted terms. Basically, you’re giving the government money for 10 years, and at the end of the day it’ll give you less purchasing power—not much.
What future for bond investors? People may feel more comfortable investing in fixed income securities than they might at the start of the year. Then we had a 10-year Treasury yield of 1.5%; now we are closer to 3%. This gives you a better stream of income. And the Federal Reserve will become less hawkish over the next few months, reducing the risk of a bond sell-off. I would still be underweight fixed income relative to equities, but would only be a slight underweight rather than a significant underweight, which I would have been at the start of 2022.
Something to add ? I would urge investors to think carefully about the true value of the business or assets you are buying. We’ve had years where meme stocks have done well, cryptocurrencies have done well. There is a lot of excitement in these spaces. But in the end, there is a lot of smoke and mirrors in the crypto space. To be honest, I think that’s mostly nonsense. It’s important that people invest in businesses that generate a real product, a real good, a real service, a real cash flow. This is how you build a portfolio for the long term. The last few years have been fashionable. I don’t think the next few years will be.