Economic Take Podcast Transcripts

Greetings! I’m Jim Glassman, Head Economist for JPMorgan Chase Commercial Banking.

The market has tumbled 20%, bringing the value of the stock market down to about 1½ times the size of the economy from double the size of the economy at the start of the year.

If you’re not familiar with how financial markets work, you might be tempted to think that the stock market is just one big casino based on wishful thinking and imagination. Well, it is based on imagination, and that’s the beauty of financial markets.

No one knows the future, of course, but market participants have a pretty good idea that there will be a future. If we weren’t willing to count on that—if we insisted on waiting until the future were now and obvious—we’d miss out on a lot of opportunity.

The way investors try to figure out what a company’s shares are worth is to make an educated guess about how those earnings will perform. By calculating the present value of those earnings, they come up with a useful way to value a company based on its current earnings. That’s what determines the price-earnings multiples of a company. That same logic applies to the broad stock market.

The problem is that the standard way of valuing the stock market—looking at price-earnings multiples—is all about the rearview mirror, about the past and the present and not the future. So, when the stock market drops 20%, as it has this year, you’ll hear people dragging out their history books to tell you where the value of the stock market should be based on historical norms for price-earnings multiples and based on historical norms for earnings.

Even the Federal Reserve’s analysts get caught up in this thought process in their quarterly Financial Stability Report. They’ve been saying that the stock market valuations have been high by historic norms, and they’re right.

Comparing the market’s P/E with historic norms is certainly a logical idea and a good start. But historic norms have become kind of irrelevant, owing to fundamental changes in the economy that have been creeping up on us for at least 25 years. These fundamental changes are more visible from a macro perspective than a micro perspective.

I’m referring to two important changes that are key to what guides stock market trends.

Take the price-earnings multiples that investors use to value business operations. Investors’ price-earnings multiples are based on the discount rates they use to value the earnings they expect a company to produce. They calculate the present value of what they think the future stream of earnings will look like based on an appropriate discount rate.

For example, if they value future earnings at a discount rate of 6%, they’ll tend to conclude that the present value of the market today should be about 16.6 times the current level of earnings. Now if their discount rate declines, say from 6% to 4%, the price-earnings multiple they use should rise, say from 16.6 times earnings to 25 times earnings.

You would guess that the discount rate that investors use to value earnings streams should be lower today—their P/E multiples higher—for fundamental reasons. We learn in our economic classes that the natural level of interest rates is highly correlated with the potential real growth of an economy. The slower an economy grows over long stretches of time, the lower the natural level of interest rates. 

Well guess what’s been going on for a decade? The economy’s potential growth rate has been slowing. Japan knows all about this story. So do many European countries. Our natural growth rate has been slowing because our population and its working age population is slowing.

This is a fundamental assumption that has underpinned the Congressional Budget Office’s prediction of a growing fiscal imbalance. It has been assuming for a long time that the U.S. economy will grow at half the 3½% annual pace of the last century. The Fed has plenty of research, as well, confirming that the natural level of interest rates has declined.

Now if the equilibrium level of real interest rates has declined from the past, why would historical norms for asset valuation be relevant? Well, they wouldn’t be. Specifically, if P/E multiples have increased from 16 to 25 times earnings, for example, the value of the stock market would be expected to rise to, say, 1½ times GDP—not parity, as in the past, if nothing has changed on the earnings front, that is, if after tax profits reverted to their historical norm of 6% of gross domestic income.

But that leads to the second fundamental reason why historic norms have become obsolete.

For the longest time, until about 25 years ago, after-tax profit margins tended to oscillate back and forth over the business cycle, eventually reverting to about 6% of GDP. If you apply a P/E multiple of 16.6 times the historical average of earnings, you could see why the stock market might over time match the size of the U.S. economy—16.6 P/E times 0.06 earnings, 0.06 as a percent of GDI, that equals 1.0 times GDI.

But in this millennium, after-tax profit margins have not looked anything like what we once knew. They have climbed to basically double the level of the past century. Economists think this is all about innovation, a more competitive economy and globalization.

If the evolution of profits over the past quarter century were a hint of the new normal, you could see why the value of the U.S. stock market could climb to more like 2½ times the size of the economy—that is 25 multiple times 0.12 percent of gross domestic income equals 2½ times GDI.

What’s the point of all this?

If you thought the stock market’s high valuation at the start of the year was a sign that the U.S. stock market was a bubble, because its valuation was well above historic norms, then you’d view the 20% correction this year as merely bringing valuations back to earth.

But if you think that something important has changed on the interest rate and earnings fronts, then you might conclude that this year’s drop is more about sentiment, which can be fickle, and not about fundamentals and valuation.

I think there are many reasons to believe that the economy is undergoing a fundamental change and that this is what the stock market has been all about. And there’s little reason to think that the worries of the day will jeopardize that.

Look for more find more economic analysis on our Internet site, jpmorgan.com/cb.

Hey there! I’m Jim Glassman, Head Economist for JPMorgan Chase Commercial Banking.

The worry that plagues the financial markets this year reflects two ideas.

One is that, like what happened in the 1970s when the Fed was forced to shut down the economy in order to get a grip on inflation, today’s inflation pressures will prove to be more deeply rooted and not transitory.

The other idea is that the Fed will have no options but to do what Paul Volcker had to do back in the 1970s and accept a recession.

Neither of these ideas make any sense to me.

On the character of today’s inflation story, you often hear people say that what we’re dealing with bears a lot of similarities to what happened in the 1970s. There’s nothing similar between today’s inflation and the 1970s.

Just as the economic shock caused by the pandemic was like no other in history, with the economy back on its feet within two years, so too will be the inflation dynamic.

The inflation problems in the 1970s didn’t spring up out of the blue like today’s price pressures. They were brewing for two decades, going back to how the government financed the Vietnam War. At the same time, it was well known that the Clean Air Act of 1970 was an issue. The Act did a lot of good for the environment, but added to price pressures because business leaders, unions and workers failed to scale back expectations when productivity growth fell as a result.

The Clean Air Act slowed output and labor productivity growth only because we don’t include things like the quality of the air in our output measures.

Then, OPEC’s oil embargoes created havoc because the U.S. economy was using five times as much petroleum as we use today to produce a dollar of GDP. That’s because we had gotten used to cheap oil for decades. Those supply shocks were permanent shifts, not temporary dislocations like today’s.

To make matters worse—and what really distinguishes the economy of the 1970s from ours today—regulations from the Great Depression Era created many obstacles to competition. And domestic businesses were very shielded from international competition.

This all started to change around the mid-1970s, when we began to deregulate airlines, trucking, railroads, petroleum, natural gas and, in the early 1980s, the banking system. But it was all too late to defuse the inflation problems that forced the Fed under Paul Volcker to take action.

It should be pretty obvious that there’s nothing about the economy’s structure in the 1970s that looks anything like today’s economy, and that’s an important consideration.

The reason to compare these two inflation moments—today versus the 1970s—is to uncover how different the supply shocks we’re dealing with are from those that caused the problems in the 1970s. Today’s are the result of temporary imbalances. Those (oil price jumps and environmental regulations) were the result of permanent shifts. One-time jumps in supply shocks linger longer than temporary supply dislocations.

Last week, we got a little taste of what may be coming in the months ahead, with the headline inflation readings easing but core inflation readings staying a little elevated.

That’s because high energy costs creep into everything, including the items that are in the core (excluding food and energy). We’ll get a break from the pressures in the motor vehicle sector if the industry is able to boost production and prices of new and used cars begin to normalize, as they seemed to even in the April CPI.

There’s a good chance that, by the time the Fed reaches a neutral interest rate setting later this year, we’ll be seeing many more signs of inflation relief.

The most important difference, though, between today and the 1970s challenges the other worry you hear in the market, the idea that the Fed will have no choice, maybe later this year, but to slam on the brakes after it gets its interest rate target back to a neutral level.

When Paul Volcker took the reins at the Fed in 1979, the inflationary psychology was basically out of control. The Fed had few options. Like now, the Fed pledged allegiance to the dual mandate of maximum employment and price stability, but the “price stability” idea sounded more like a lofty idea with no practical meaning.

Today’s situation is fundamentally different, and that is the key. For the past decade, the Fed has officially affirmed its commitment to targeting 2% inflation over the longer run. The inflation mandate now has a practical meaning for bond markets, and that’s very visible today.

Bond investors’ views of inflation have held pretty steady near 2% amid the considerable debate about inflation this year. Implied market-based inflation expectations in the near term have risen a little since 2020, but expectations of inflation a few years out remain near 2%.

This same idea is reflected in the views of professional forecasters. Last week, the Federal Reserve Bank of Philadelphia published its quarterly survey of professional forecasters. And it indicated that while folks see some upside inflation pressure for the next year, looking ahead five years from now, they see inflation remaining near 2%.

Forecasters have stuck with this view for the decade since the Fed officially committed to the 2% inflation target.

This is a very different psychology than what Paul Volcker faced, and it gives the Fed a lot more flexibility.

Bottom line: When the Fed gets its federal funds rate target to a neutral zone, say 2-3%, I think it will proceed much more carefully. There’s no need—will be no need—to take action that raises the risk of a recession if market participants see no long-term inflation problem.

The main reason to compare the psychology of inflation now versus back then in the 1970s, is that it underscores the flexibility a central bank has gained as a result of the credibility its long-run game plan has earned.

In this case, the Fed has the ability to be more patient than the Paul Volcker Fed did.

People love to debate about whether we’ll have a hard landing or a soft landing. For me, this is not something the Fed can manage. The economy can take care of itself—if the Fed is patient. 

The Fed’s policies don’t guide every twist and turn the economy makes. The economy will only struggle if the Fed deliberately attempts to slow it down.

You’ll find more economic analysis on our internet site, jpmorgan.com/cb.

Greetings! I am Jim Glassman, Head Economist for JPMorgan Chase Commercial Banking.

Thoughts on three topics: What do bond investors think about inflation into the beyond? Two, how have this spring’s dramatic events changed the economic outlook?  And three, is it over for globalization?

First topic, inflation expectations.

You don’t hear about this much, maybe because it doesn’t harmonize with the inflation conversation, but the economists at the Fed do some pretty careful work trying to disentangle bond investor views about inflation from securities prices.

Last week, they just published updates of implied market-based inflation expectations as of April 29. This is not as straightforward as you’d think.

Most people just look at the difference between nominal Treasury yields and Treasury Inflation Protected yields, TIPS. That differential, what we refer to as the break-even spread, has widened and implies that investor inflation expectations for the next decade have increased from 2% to 3% annually.

But that differential isn’t just about inflation expectations. To know what investors really think, you also have to take account of the things like the liquidity of TIPS, the premium for the possibility that inflation differs from what investors expect, and the difference between the CPI and PCE inflation. TIPS are all about the CPI, and the PCE measure has been running 38 basis points annually below the CPI on average for some time.

This is what the Fed economists do well. Last week’s updates from the Fed showed that bond investors continue to expect CPI inflation to average about 2.25% over the next decade. That’s not much different from what they have been thinking in the last two years. If you translate that opinion into the PCE measure, investors could be telling you they think PCE inflation will average just under 2% for the next decade.

Their views about this have been pretty consistent over the past two years despite all the inflation issues that dominate the conversation.

Isn’t this interesting? Because it sounds like, despite all that is going on today, bond investors agree with the Fed’s initial instinct that many of the current price pressures will prove to be transitory.

You can understand why they might think so, because most the inflation readings have “pandemic” written all over them when you look closely at the data.

Second topic, recent market events and the economic outlook.

First and perhaps most important, the Federal Reserve has communicated that it will move more quickly to withdraw its stimulative monetary policies in response to elevated inflation readings in the early months of this year.

At the March policy meeting, the Fed had bumped up its median forecast of the appropriate federal funds rate by the end of 2022 and 2023 by a full percentage point from what it said late last year. The Fed now seems to want to move even faster, at least for the next several months.

The market has responded and anticipates that the Fed might get the funds rate to a neutral 2-3% ZIP code by the end of this year. The Fed’s game plan has been transmitted through the various financial channels like bond yields, currency values and the stock market. So how might this change the economic picture?

Mortgage rates have completely retraced what happened in the pandemic. 30-year rates have climbed from 3% to over 5%. A 2-percentage-point rise in mortgage rates reduces the size of a mortgage loan that a typical buyer can qualify for by about 22%.

We’re going to feel this impact in coming months. Residential activity should be fine but house prices won’t be repeating last year’s 20% appreciation and may actually give back some of that.

The Federal Reserve’s pivot is a striking contrast to the postures of the Bank of Japan, which remains committed to capping its 10-year interest rate; the People’s Bank of China, which has to deal with COVID-19 lockdown issues; and the European Central Bank, which has to manage the dislocations caused by the Ukraine crisis.

This is why the trade-weighted value of the U.S. dollar has increased in recent months by about 10%. That could trim this year’s U.S. inflation readings by a full percentage point or more. Imports comprise about 16% of U.S. demand.

The Federal Reserve’s pivot probably is weighing on the equity market, which has retreated about 14%, although the war in Ukraine may be as much a factor as the Federal Reserve’s shift.

A second factor reshaping the near-term economic outlook is that China’s aggressive effort to control its latest virus outbreak is slowing that economy. Real GDP in China now is forecast to expand 5.2% over the four quarters of 2022, down from the 6% area that we forecast a couple months ago.

Third, Russia’s invasion of Ukraine is creating dislocations in energy and agricultural markets. It’s reshaping the outlook for the European region. Real GDP of the euro area now is forecast to grow 2.2% over the four quarters of 2022, half as fast as the growth forecasts at the beginning of this year.

Fourth, this year’s surge in energy prices may prove to be temporary. For a while, however, energy is remaining pricey as countries work to diversify their energy sources.

The economy may not grow as quickly this year as we thought only a few months ago, but inflation pressures may ease faster than people think, with bottlenecks starting to ease and the dollar helping to shift some of the inflation from the U.S., which doesn’t need it, to others who could absorb it. That would allow the Fed to be more patient once it gets its rate up into the 2-3% range without having to be more aggressive. Makes me more optimistic about the medium-term outlook.

Third topic: Prospects for globalization.

The supply chain bottlenecks and tragedy that Ukraine has to deal with is making people wonder if it’s over for globalization that has done so much to reduce global poverty, particularly for medium-income countries. GDP per capita has increased by 50% just in this millennium.

I don’t think so, because globalization frankly is not our call. It’s the call of developing economies. True, for a while businesses in the developed economies were the big drivers as they outsourced operations. But that never would have happened if developing economies didn’t allow it.

The drive to find low-cost regions might have been the story of the past couple decades. But the ambitions of developing economies are now in the driver’s seat. It’s the developing economies that are hungry for more that will be driving globalization. If emerging economies continue to open up, most businesses in the developed economies will be hungry to participate in the new consumer markets.

This week, the April CPI. Forecasters see the possibility of a more moderate reading. That would be a relief.

Take a look at our iInternet site, jpmorgan.com/cb, has more insights from our teams.