Research Recap | Mid-Year Outlook 2023

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HOST: Welcome to Research Recap’s Mid-Year Outlook, on JP Morgan’s “Making Sense”. Today, we’re joined by a few of our colleagues from J.P. Morgan Research, who will be taking stock of what has happened so far in 2023 and exploring what’s ahead for markets in the second half of the year. First up, let’s take a look at the global economic outlook with our Chief Global Economist Bruce Kasman. 

BRUCE KASMAN: Thanks for having me, glad to be here.

HOST: Bruce, there’s been a lot of discussion this year around the possibility of recession, and when and if inflation will cool. What’s your take? 

BRUCE KASMAN: So, our outlook for 2023 has really been based on three principles. The first one is that neither the US nor the global economy is fragile or likely to fall into recession any time, at least through the third quarter of the year. That view is based on the idea that while respecting the tightening in monetary policy, there are other supports that are quite powerful that are providing a significant offset, including the fading of last year's negative shocks, the resiliency of a very healthy private sector, and including central banks that we think are tightening, but still want to preserve expansions. The second point is that we do not think inflation is going to come back to central bank comfort zones by themselves. Yes, there's a decline going on. But no, we do not think you're going to get inflation back below 3% in the US or the euro area this year in an environment in which supply has been damaged in a more lasting way and inflation psychology has shifted. The final point is that in a world in which you do not have sustainably lower inflation and you have resiliency, there is a tension here. And how that plays out and what it means for the life of the expansion is somewhat difficult to forecast. We certainly think the expansion is likely to end early, both in the US and globally. But we don't feel particularly confident in forecasting the specific timing. We have a baseline forecast for the US of recession ending at the end of this year. But I would emphasize the broad window that that's possible in terms of what that timing is. And our bias continues to be on recessions later, on rate paths for central banks higher, and ultimately more synchronized recession dynamics, and therefore, deeper in terms of the ultimate outcome once the expansion comes to an end. 

HOST: Very interesting. Has anything changed in your view since the first half of the year?

BRUCE KASMAN: So, our outlook for 2023 has really been based on three principles. The first one is that neither the US nor the global economy is fragile or likely to fall into recession any time, at least through the third quarter of the year. That view is based on the idea that while respecting the tightening in monetary policy, there are other supports that are quite powerful that are providing a significant offset, including the fading of last year's negative shocks, the resiliency of a very healthy private sector, and including central banks that we think are tightening, but still want to preserve expansions. The second point is that we do not think inflation is going to come back to central bank comfort zones by themselves. Yes, there's a decline going on. But no, we do not think you're going to get inflation back below 3% in the US or the euro area this year in an environment in which supply has been damaged in a more lasting way and inflation psychology has shifted. The final point is that in a world in which you do not have sustainably lower inflation and you have resiliency, there is a tension here. And how that plays out and what it means for the life of the expansion is somewhat difficult to forecast. We certainly think the expansion is likely to end early, both in the US and globally. But we don't feel particularly confident in forecasting the specific timing. We have a baseline forecast for the US of recession ending at the end of this year. But I would emphasize the broad window that that's possible in terms of what that timing is. And our bias continues to be on recessions later, on rate paths for central banks higher, and ultimately more synchronized recession dynamics, and therefore, deeper in terms of the ultimate outcome once the expansion comes to an end. 
HOST: Very interesting. Has anything changed in your view since the first half of the year?

BRUCE KASMAN: So, one of the odd parts of this year is that basically, our key outlook themes have actually held up. So, we really haven't changed our views in any meaningful way. If anything, growth and inflation, which we thought would be resilient at both surprise to the upside, central banks which we had thought would start to downshift and possibly pause do look like they're validating that. I think we're at an interesting juncture because we see different sectoral and regional performance than we had hoped for. The manufacturing sector, which we had hoped would be in recovery phase by the middle of the year still looks weak. Services which we had expected strength, but had been looking for it to somewhat fade by this point, has not. So while overall performance has been somewhat stronger than we expected, the sectoral imbalance between services and manufacturing has been sustained. That raises some interesting tensions, as does the regional story, where we had expected the US to underperform in a significant way. But we've had US surprises to the upside more recently at the same time that China and Western Europe have been more disappointing. So this creates a wider range of uncertainty. But it hasn't really shaken our core views about growth resilience, about inflation persistence, and about broadly divergences in performance, even if those divergences haven't quite played out to our expectations. 

HOST: What risks are on your radar going into the 2nd half of the year?

BRUCE KASMAN: So I think there's a couple of risks here. The first risk is that we're just wrong fundamentally, and that there is far more downside pressure on activity right now. I think if that were the case, it would be coming from the fact that the weakness I just mentioned in the manufacturing sector reflects a degree of business caution that is going to spread out to the broader US and global economy. And we would slide into recession earlier. The second major risk is that we're right, and that inflation turns out to be more elevated than we expect. It turns out to be more broad based in that problem across the world. And we have a more synchronized recession with more restrictive and earlier tightenings on the part of central banks that we expect. And then I think the final risk here is the idea that we are not building in a financial market event in terms of a shock and an environment in which central banks have moved quite aggressively, and where there is these substantial pressure points that are coming from high inflation and credit tightening. We could be missing something there that could turn out to be quite powerful and not within the contours of the business cycle dynamics that I've explained up till now. 

HOST: Thanks, Bruce, for that global snapshot. Next, we’re joined by Jay Barry, our Co-Head of U.S. Rates Strategy. Jay – can you walk us through your expectations for U.S. Rates and the fixed income markets.

JAY BARRY: Sure. So, as we enter the second half, we think that we're very close to the end of the most aggressive Fed tightening cycle that we've seen over the last 40 years. So, as you heard from our colleagues in economics, we look for the Fed to raise rates one more time in July, but then go on hold and likely stay on hold until the middle of next year. As the economy does slow, but inflation remains still above the Fed's target. If we look at historical dynamics, once the Fed goes on hold, that's typically supportive of rates declining somewhat. But on average, because the Fed has usually been lowering rates within 7 to 8 months of the last hike, we think that this descent is going to be a bit more gradual than it's been in the past. So, we see scope for yields to decline over the second half of the year, but when compared to other post-Fed tightening regimes, we think this is going to be much more limited in scope, in large part due to those inflation dynamics, but also due to the global policy backdrop. The Fed will be continuing to draw down the size of its balance sheet, and other global developed market central banks are doing the same. And while this is a passive sort-of story, we do find that there's a stock value here, that the Fed's share of the treasury market, as a decline, should on margin steepen out the yield curve. 

HOST: So monetary policy is at the top of your mind as we move into the second half?

JAY BARRY: It's absolutely starting with the Fed will be the most important one. Their latest projections indicated that there's room to hike twice more, and again, we think that there's only scope for one more hike. So, we'll see how the market is pricing the Fed over the balance of the year. We're also really interested to see how the market digests treasury supply. We believe that the Treasury Department will begin raising its auction sizes in this summer and continue on through the beginning of next year. And that matters to us, because we think we've been transitioning from an environment in which the treasury market has been largely supported by price-insensitive demand, in the form of the Fed, commercial banks, and foreign official investors. But each of those and their sources of demand have been waning, over the course of the past year. So, as we shift towards more price-sensitive demand, will this have an impact on yield levels, and how will that impact the term structure of US interest rates? 

Host: Fantastic, thanks very much Jay. Turning to rates and fixed income around the globe, we’re joined by Fabio Bassi, our Head of International Rates Strategy. 

FABIO BASSI: Hi, it's a pleasure to be here. 

HOST: Fabio, are we seeing similar trends for international rates and fixed income markets? 

FABIO BASSI: I mean, looking at the big picture, our thoughts here is that in an environment where central banks are going to be closer to the end of the tightening cycle, you definitely go into an environment that becomes more positive for bonds as an asset class. Clearly need to be extremely tactical in that dynamic because banks are not done yet, and rates may still be moved higher relative to current level. In Europe, we believe that the ECB is going to deliver two additional 25-basis-point hike, taking the terminal rate at 4%. And in that scenario, we would like to treat duration with a bullish bias in the intermediate sector of the curve. We have a strong bias for a steepening of the curve between the 5 and the long end. And we also believe that in an environment where the central bank is approaching the end of the tightening cycle, it's an environment that is going to be quite supportive for spread product and intra-EMU spread. That is the reason why we believe we are positive on intra-EMU spread, and we like long in a intra-EU country, like Spain and France, cross-market versus Germany. In UK, I think that the dynamic is a bit more challenging. The BOE is facing a lot of issue in terms of constraint on persistent inflation and the dynamic of the labor market. That means that on the strategy side, you need to be more cautious. Nevertheless, we are forecasting lower yield between now and the end of the year. And we have a bias to basically start overweighting duration in yield at cross-market versus treasury. 

HOST: Has anything changed since the 1st half of the year? 

FABIO BASSI: We came from a long period, between 12 and 18 months, in which DM central bank ex Fed have been hiking quite aggressively. And I believe that that dynamic will continue in the second half of 2023, although some differentiation will start to emerge between different central banks. In terms of the challenges that central banks are going to be facing, I think that the dynamic of the labor market and wages is going to be critical in determining what is the residual journey that the central banks have to complete. The ECB made it clear that for the time being, they don't see a wage-price spiral. But nevertheless, this is something that needs to be monitored to basically assess what is going to happen over the medium term in terms of the tightening cycle. And the other big theme that we need to keep an eye on in terms of international rate is the exit strategy from the BOJ. Inflation is definitely above their target, but the BOJ has a lot of concern about the medium-term sustainability of that dynamic. And they have been reluctant in removing the control. We believe that that eventually is going to take place in the upcoming meetings. And that is basically going to be another big factor that should be a driver for international rates.

HOST: That’s great. Thanks, Fabio. Now, we’re headed for the credit markets. Stephen Dulake, our Global Head of Credit, Securitized Products and Public Finance Research, joins us. Steve, what’s your outlook for these assets as we move into the 2nd half?

STEPHEN DULAKE: Some of the takeaways for our second half year outlook are a little bit like our first half outlook, which means that some of the things we were expecting haven't quite happened. I think probably the standout there is decompression between high grade and high yield, which we thought would be a big feature of developed credit markets in both North America and Europe. But courtesy of a lot more economic resilience than we were forecasting at the turn of the year, that hasn't proven to be the case. So being a quote, unquote, "decompressionista," as we would say, has been a very difficult place to be. We've actually seen compression rather than decompression. Nonetheless, we do think that decompression is something  that will emerge through the second half of the year. I think given the resilience today, it's likely to be quite back-ended in the second half of the year. But we think it's a case of decompression deferred rather than delayed or postponed altogether. So that's probably one of the bigger takeaways from our outlook. I think the other one is that, again, courtesy of some of the underperformance of the securitized product space in the first half of the year, we think there's a little bit of a value opportunity between securitized products and unsecured corporates. Mortgages in particular, look a little bit cheap. I think some of the concerns in the mortgage space are resolutely technical. Fundamentals actually have improved. In particular, I'd highlight the fact that home prices are no longer falling. We've actually unveiled a full-year forecast where we expect home prices in the US to be unchanged. Also, people aren't selling their homes. They're hanging onto their homes given that most households are on a much lower rate mortgage than you can achieve today. So why sell a home and put yourself into a higher rate mortgage going forward? I think that's been a positive through the first half of the year. What hasn't been a positive has been the potential for FDIC sales. And I think some ongoing concern that you could have some re-emergence of stress within the regional bank sector and some associated selling. So, from us, decompression deferred and securitized products looking cheap versus unsecured corporates will be our two main takeaways. 

HOST: Has the overall sentiment changed from the beginning of the year?

STEPHEN DULAKE: In terms of changes, first half of '21 versus first half of '22 I think in order to think about some of those differences you have to think about where we were wrong in the first half of the year. So, I think we've seen generally a lot more economic resilience. We've faded a recession narrative twice now in the past six months. That was a narrative that was really focused on Europe going into the winter as a result of high gas and energy prices. And the weather and government measures I think offset that. Today, it's really about the resilience of things like the US consumer, which you can see across a multitude of different dimensions here. But I think what it means for creditors is that we haven't seen some of the-- having a much firmer economic baseline has supported corporate cash flows. It's meant that balance sheets are entering the second year in pretty decent shape. As much as we do think we will see some deterioration as growth slows a bit, the entry point is pretty strong. So again, coming back to what we've mentioned previously, it's one of the reasons why the decompression that we thought we might see in the first half of the year is something that we're rolling forward to the second half of the year. 

HOST: Finally, what are some major themes or factors that you’re watching? 

STEPHEN DULAKE: I think keeping an eye on the financial sector is probably a good thing through the second half of the year. And I would highlight two things. Firstly, in terms of the resolution of what's been happening to the regional banks in the US, I think that the workout will be somewhat attritional just as it was with the European banks or European banking sector way back when. Things that could change that and cause some stress would be if we do see large deposit outflows as a result of the Treasury aggressively selling bills and looking to replenish its general account very quickly. I think that's something to keep an eye on. And in the spirit of everybody having been focused or very concerned about the potential for a lack of credit availability as a result of regional bank stress and regional banks pulling back and becoming more defensive. I think it will be interesting to keep an eye on the non-bank financial sector and in particular, some of the large direct lenders, private credit providers, and the extent to which they step into the breach and offset any potential decline in credit. So one negative, one positive. Both related to the regional banking sector. Those would be the two things we're focused on in the second half of the year. 

HOST: That was great. Thanks, Steve. Next, we’re joined by Meera Chandan, our Co-Head of Global FX Strategy. Meera, how do you think the major currencies will perform in the second half of the year? Are there any themes you’re keeping an eye on?

MEERA CHANDAN: So, the top two themes in FX that I'm focused on are the following. First, we have been recommending, for the last few weeks, a long position in the dollar. The reason for that has been because growth momentum outside the US has slowed considerably. And we like being long dollar versus the most vulnerable part of the FX universe, which is the lower-yielding, growth-sensitive currencies. Whether that's currencies like Scandis, or New Zealand, or sterling, for example, which have some stagflation concerns, that's the kind of recommendations that we are emphasizing going into the second half. The second theme is around carry. We think the overall backdrop for carry, given overall yield levels, is still quite attractive. But as we're getting to the later and later stages of the cycle, clearly, the underpinnings of this theme is getting more and more fragile. So, I still like selective exposure to carry, particularly in the LATAM currencies, which our EM strategist’s favor. But we recommend using your dollar longs that I mentioned earlier as a part hedge to that. So those two combinations are the main themes that we focused on for FX. In terms of major targets, euro-dollar, look-- we've been of the view that the range is 1.05 to 1.10 for the year, for euro-dollar, so nothing to write home about. The first half, we expected the upper end of that range to be tested. It was 110. Now we're looking for that lower end to be tested, 1.05 for second half. For dollar-CNY, we're at the 725 going into year end. So overall, expecting modest weakness from these currencies versus the dollar. But the big moves, I think, the larger moves can actually come from the growth-sensitive currencies that are lower yielding, which is why that's our preference from a trade recommendation standpoint.

HOST: How is the backdrop for currencies different now than the start of the year?

MEERA CHANDAN: I think the macro backdrop is markedly different in the second half of this year on two main dimensions. The first dimension is something that's very well-known and well flagged, which is growth, where we've actually seen the growth momentum in China and in Europe running out of steam. And I think that's very much in contrast to the first half, where we saw really outstanding and above trend growth and upside risks to growth in the region. So that I think is a big part that informs our bullish dollar view now. We consider the sort of regime shift. This change in growth is a regime shift, should allow the dollar to strengthen more in the second half. So, it does change the background dynamics a bit.And then the second thing that I would say is really on inflation. First half, everybody was quite excited and very happy to see that inflation metrics were coming down across countries. And we're still seeing that with headline inflation. But what we're finding now is that core inflation is going to be quite sticky in some countries. And that's going to become a problem for the currencies in those countries. And I would point to for example, Sterling or Sweden, from that point of view. So, this inflation differentiation is going to be an important dynamic going into the second half of the year.

HOST: Thanks for those insights, Meera. 

MEERA CHANDAN: Thanks for having me. 

HOST: Moving from currencies to commodities, let’s turn to Natasha Kaneva, our Head of Global Commodities Strategy. Natasha, can you tell us, in a nutshell, what’s the outlook for commodities markets?

NATASHA KANEVA: Well, thank you for your question. So, the long-feared recession is coming. But the magnitude and the timing is uncertain. So, the baseline from our economists remains that it will be coming later this year. But the bias is for significantly later, and significantly higher terminal rate. Overall, these imminent recession fears have materialized. And it's very visible in the positioning of the investor. So, you know, those skittish investors have taken cover. And if you look at the numbers, the net positioning and the investors across all commodities markets, it's at the lowest since the start of 2019. And just for scale, to put this into perspective, positioning, investor positioning across energy, grains, metals, is at the lowest, or even below the levels where it was at the peak of COVID. So that's very telling. The way we view the market over the next six months is that recession is imminent. But we don't know when it's coming. In the interim, the supply-demand fundamentals in every single market could play a very significant role. And because of that, those idiosyncrasies across the markets, assuming recession is absent, can result in about 8% to 10% return for the Bloomberg Commodities Index. So that's definitely something to keep in mind. By commodity, in energy, we see 11% return, a gain, of that-- absent of recession, in the case of oil markets, the inventories started drawing, that should become more visible towards the second half of the year. We do believe $10 higher oil is not only possible, it's probable. In the case of natural gas markets, the production is declining. We believe by July it will become visible across the markets. In metals, we're receiving the news that China might consider stimulating, or will be stimulating. So that's a significant boost. If indeed the fears around demand are lifted, the inventories are very low. The market will start paying attention to that. And that can result in another 11% return towards the end of the year. And we're bullish across every agriculture commodity on developing El Nino. 

HOST: And How’s our outlook changed since last year?

NATASHA KANEVA: Yes. So in November of last year, when we put our outlook for this year, our number-one call was to be bullish on gold. We are maintaining on this position. So, this is a long-term structural call on precious metals. The biggest uptick for that particular market is we need the fed to start cutting rates. But regardless where we are today, we're range bound. But we still see an upside. So, if we look at the previous three fed cycles during the fed on pause, gold returns about 4%. And when the fed starts cutting, that’s another 11% return from that perspective for the next six months. So, it's very, I would say, obvious upside for the prices of gold from today towards the end of the year. We see about 4% return because the call from our economists is that the fed will hike one more time in July, 25 basis points, and will begin cutting only into the second quarter of next year. So that was number-one call. We were bullish in November, we had a view that the US natural gas prices would decline 40%. That was an excellent call. That materialized. So at this point, we are neutral to start-- to slightly optimistic. 

HOST: And if you had to pick one major theme you’re keeping an eye on for the remainder of 2023, what would it be? 

NATASHA KANEVA: For very cyclical asset class, like commodities, China is definitely the biggest driving factor. 55% of metals demand comes from that country. It's about 13% in energy demand as well. So, the difference between China stimulating and not stimulating, it's another 5% to 10% return. 

HOST: Thanks very much, Natasha. Sticking with that international focus, let’s take a closer look at what’s going on in emerging markets. Jonny Goulden, our Head of EM Local Markets and Sovereign Debt Strategy, joins us. Johnny, how are things looking?

JONNY GOULDEN: So, we're thinking in emerging market fixed income of a late cycle growth and inflation slowdown, and possibly leading into a US recession as we get towards the end of the year. I think for the different parts of emerging markets, we think about that quite differently in terms of its implications. So, starting first with local currency. Generally, we prefer local currency bonds in emerging markets to sovereign credit, or what we call hard currency. If we think of the drivers for local currency bonds, we have seen a large inflation cycle across the world and in emerging markets over the last 18 months or so. That has led emerging market central banks to want to hike rates quite dramatically. We are now seeing inflation coming down. The forecast from our economists that it’s going to continue and be more pronounced in the second half of the year. And that should start to lead to emerging market central banks actually cutting interest rates. And this should support EM local bonds, even after the initial rally that we have seen in the beginning of this year. We came into this year bullish on EM local bonds, and that is something that we are taking with us into the second half of the year. For currencies, it's a bit more of a mixed picture. We are neutral in emerging market currencies. We have some currencies, certainly, which have high-carry and high-real carry. Those occurrences like Brazil, Mexico. And we think those currencies are positioned to continue doing well as we go into the second half of the year. But we also have a range of currencies. If you take out just a handful of high-carry currencies, which actually don't give you much carry against the dollar at the moment, they have not really done anything so far this year in terms of a trend. And those are currencies that we prefer to be underweight. They're typically in Asia and in EMEA EM time zone. So that gives us regionally in FX quite a split. Sovereign credit is the last. And, as I said, we prefer to be in local rather than hard currency or sovereign credit. And that means we're underweight in sovereign credit as we go into the second half of the year. This is an asset class where, aside from a handful of quite widespread countries which look like they have interesting opportunities, the bulk of the asset class is actually trading at spreads around 40 basis points tight to their long-term average. And for us, given where we think we are in this cycle, we think that looks too tight. So, we think it makes sense to want to be underweight there, expecting wider spreads as we get through this late cycle and towards the real end of the cycle. 

HOST: Interesting. What’s changed since the beginning of the year?

JONNY GOULDEN: Some of the factors feel quite similar to the first half of the year. Maybe the one thing which does feel a bit different is the way the market is thinking about China at the moment and the impact that's having on markets. Coming into the year, China's rebound and opening up after COVID was seen as very much a bullish driver of markets. As we're standing right now, the data is looking a lot softer in China after a very strong Q1, and our economists have been revising downgrowth in China. And so that's really gone from something which has been a tailwind to something, as we're looking forward, is becoming much more of a headwind in terms of our own asset class. 

HOST: Finally, what are some major themes or factors that you’re watching?

JONNY GOULDEN: The first two themes are probably quite common to many markets. We are following the growth cycle, really trying to understand exactly where we are, particularly in the US growth cycle. But also, I've mentioned within emerging markets as well, we've had a lot of policy tightening. Naturally with a lag, we would expect to see an impact on growth. We've yet to fully see that. The first quarter of the year was quite strong in emerging markets, and that's something we're going to be monitoring through the data. I think the employment data in particular is something which has yet to really show the significant shift that we would expect after that. And that's something which we think we're going to be looking at. And with that second is something, again, most markets are looking at, which is what central banks are doing. We all take our lead from the Fed in emerging markets. The Fed's reaction function to data is going to be particularly important for EM currencies as well. And, also, the ability of EM central banks really to start easing their own monetary policy, which they would like to do if the Fed is not going to be hiking a lot more. They may struggle to do so if we're seeing renewed pressure on the Fed to go more. And I think the last factor is something which is much more about emerging markets themselves. There is a lot of idiosyncratic situations going on in emerging markets, countries with a lot of significant developments. And we'll be watching to see how those developments come through. So, Turkey is a major emerging market country which has just had an important election. I think we are all waiting to see what is the new policy going to be after that. On the other end of the spectrum, we have quite a few small emerging market countries who are going through debt restructurings. And we're going to be seeing how that is going and how those restructuring processes get through in the second half of the year. 

HOST: Fantastic! Thanks very much, Johnny. There are plenty of common themes emerging this year in our mid-year outlooks. Let’s turn now to Tom Salopek, our head of Global Asset Strategy. Tom, do you see similar themes surfacing across asset classes? What’s expected to outperform or underperform?

TOM SALOPEK: So, we're talking about cross-asset strategy here, specifically this is something a bit different from the other segments, which are looking to the end of the year. In this case, we're talking about the three to five year expected returns for a number of asset classes at the midyear point. So, I think one of the key things to highlight has been the contradiction between the near-term environment and the longer-term view. This is one of the purposes of this exercise, which is to build a bridge between the short-term house view, or targets which go a year out, and a more medium-term perspective. And generally, what we're seeing in the market is a contradiction, in the sense that recession probabilities for a lot of things are flashing red, whether it's yield curve steepness, housing starts and permits, SLOOS lending standards-- a lot of those things are flashing a recession sign. But at the same time, we've faced relatively mild market conditions with rising stocks and low volatilities. And that's left a lot of investors nervous at this point. When we think about the rally we've seen this year, it's been a rally for the most part, that was driven off very thin participation. Recently, after a jobs number, that participation jumped up, and market breadth improved. We think that reflects short covering. For that to improve on a longer-term basis, we would need to see more fundamental improvement. We don't think we've seen that necessarily, in the sense that claims numbers came in worse. And at the same time, the Fed on pause with looking to possibly hike further later into the year means that we are facing a restrictive environment, which should be difficult for stock. In addition, I'd highlight the fact that vol markets look artificially low to us, with the preponderance of 0 data expiry option sellers. So basically, what it amounts to is that from the medium-term perspective, recession is likely still in the picture on the three to five year basis, which will be a drag on their expected returns for risk assets. 

HOST: Has anything changed heading into the second half?

TOM SALOPEK: So in terms of the changes, we've seen in the first half of the year, of course, stocks have rallied tremendously off of the enthusiasm for generative AI. On the other hand, bond yields have risen in the past quarter, although they failed to reach the highs of last year. And what we've seen there is a repricing, as investors now see less easing going forward. Vol also has the potential to go higher, even as it's fallen dramatically in the first half of the year. In the first half of the year, we saw the continuation of this rally, which started in the fall of last year. Vol fell from the 20s to where it is now, fairly low levels. On the one hand, it's a reflection that a fair number of problems were moving in the direction of resolution, namely inflation continuing to fall, European natural gas prices falling, China reopening. But at the same time, the thing that has brought vol down, we would question whether it can continue to go much further. And we would also be a bit concerned about the possibility of volatility going a lot higher as the job market starts to erode, and excess cash cushions starts to disappear. 

HOST: And looking ahead – what themes are you keeping in mind in your 3-to-5-year horizon?

TOM SALOPEK: the big one for us is really the end of the hiking cycle, the end of the QE era, the end of 0 interest rate policy, and really, what that's done to the relative mix of expected returns across the asset classes. So, focusing things on the three-to-five-year horizon, stock returns are well below long term averages. Meanwhile, credit returns on a three-to-five-year basis are generally above long-term averages. For high grade, we would expect that the expected returns are in the vicinity of the starting yield. Whereas in high yield, expected returns will be worse than the starting yield, reflecting an uptick in default risk. In terms of government bonds, the expected returns on a three-to-five-year basis should be better than stocks, but worse than credit. They will be worse than long term averages, but improved due to the hiking cycle, due their improved level. At the same time, we should also get a return on the three-to-five-year basis, which is better than the starting yield, reflecting rate cuts that we would expect in 2024. Finally, putting this all together in terms of a portfolio, if we take these expected returns on a three-to-five-year basis-- we'll focus on the three year example. If we compare it to a 60/40 benchmark, running a Black-Litterman optimization using these inputs would suggest 12% underweight in equities, in particular in underweight to US stocks, 1% overweight to government bonds, favoring UK gilts, and finally, a 17% overweight in credit, favoring US high grade.

HOST: Thanks for joining us, Tom.

TOM SALOPEK: Thank you so much for having me.

HOST: And rounding out our mid-year outlook episode, let’s turn to the equity markets, Mislav Matejka, our head of Global Equity Strategy joins us. Mislav, what can we expect to see as we head into the 2nd half. 

MISLAV MATEJKA: The first and the key one is the potential change in the growth policy trade for the balance of the year. Because if you consider first half, it was pretty much a Goldilocks set up for the investors and for the equity market. On one hand, you had inflation, which was just steadily moving down. But on the other hand, you had a pickup in the growth momentum helped by the China reopening, helped by the easing in the energy crisis in Europe. Labor market stayed very strong. And that allowed the equity markets to perform well. And we are now at a point where S&P 500 is close to 20 times forward earnings with a record low volatility. So, the question is, is there complacency building here? We think what happens in the second half is peaking in the profit margins. Some cracks in the labor market starting to show. But at the same time, central banks will keep with their hawkish stance and potentially hike further. So that trade off just doesn't look that good anymore for the second half. And in terms of the styles within the equity market positioning, we started this year with long growth, short value style, which is exactly opposite to the investment strategy that we had through last year and in 2021, where we were long value, long financials, long commodities, and short tech at the time. So, we changed that with this year. We think growth should be outperforming value. And the key call here is that this recent rotation in the market in June that we had the broadening is not sustainable in our view. Growth has done well so far this year. And we think in the second half of the year, that is going to remain the winning strategy. 

HOST: Has anything shifted since in the beginning of the year? Are there new areas of focus or themes emerging?  

MISLAV MATEJKA: In terms of the key change to our positioning, I would highlight the regional calls, where we had over the last year a very strong view that Eurozone is going to perform actually well. And despite the war and despite a lot of problems that markets have been going through the last year, our view was that a euro area should be an overweight, especially versus the US. And we had a 30% plus move in dollar terms. And that's why we think that that trade should be changing. We have last month cut Eurozone all the way to underweight. We think the best of the positive drivers is now behind us. And the growth policy tradeoff for Eurozone is turning around to more difficult ones. So that's what we changed regionally. After favoring Eurozone, we have moved to underweight. And I would just highlight that what we didn't change, what we think should have legs is Japan. We started the year long Japan from a global asset allocation perspective. And we still think in the second half of the year, the positives for Japan will be prevailing.  

HOST: Thanks, Mislav. 

MISLAV MATEJKA: Thanks for having me.

HOST: That wraps up our mid-year outlook episode here on Research Recap. We hope you’ve found the insights from our analysts helpful, and thank you so much for tuning in. For more market insights, visit jpmorgan.com/research. 

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