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Investing

Investors have embraced the optimism

The world is healing—quickly—and we’ve updated our outlook for 2021.


 

Markets have been moving quickly to reflect the coming end of the pandemic and robust economic growth. Since we published our Outlook at the beginning of December, global equities have hit all-time highs, and high yield credit spreads (which reflect the risk of default) are near post–Global Financial Crisis lows. Most importantly, sovereign bond yields around the world have moved sharply higher.

The direction of the market moves doesn’t surprise us. Still, the rapid pace has introduced some volatility. Investors are rightfully asking questions about where the economy and markets stand—and what they should do about it.

We believe that, since last spring, markets have been driven by hope. Now, they’re transitioning into a more familiar, less dramatic phase in which the interplay of economic activity, inflation, interest rates and corporate earnings growth will drive equity markets to new highs.

Embracing the optimism was the right call. Now it is time to harness growth.

 

Markets moved quickly

Why did markets move so dramatically? The answer lies in what’s happened to the five big forces we identified in our December Outlook: 

  1. The virus and vaccines—We weren’t optimistic enough back in December. An end to the pandemic finally came into sight. The five Western vaccines have been proving extremely powerful at preventing severe disease, hospitalization and death. It now seems reasonable to expect that most adults in the United States and the United Kingdom who want to be vaccinated will be by the summer.
  2. Policy support—The United States’ latest legislation, the American Rescue Plan Act, will bring total U.S. fiscal support to combat the COVID-19 crisis to around 25% of GDP. (Post–financial crisis fiscal support was around 5% of GDP.) Central banks around the world also remain accommodative. We think the Federal Reserve’s first rate hike won’t come until the end of 2023.
  3. Inflation—Markets have priced in a full recovery in U.S. inflation. We might see some inflation in 2021, as pent-up demand is unleashed on the service sector and supply shortages take a toll. But we don’t expect consumer prices to be a sustained pressure until the labor market fully heals.
  4. Equity valuations—Though interest rates have moved higher, equity market valuations are still attractive relative to bonds. However, we expect earnings growth of 15%–30% across regions to power markets higher from here.
  5. The U.S. dollar—The broad dollar decline has stalled (largely because the United States is outstimulating and outvaccinating most other countries). However, we do expect the U.S. dollar to weaken against the currencies that are most sensitive to economic growth, such as the Australian and Canadian dollars, and those in select emerging markets.

 

10-year Treasury bonds are moving in tandem with vaccinations

A new phase sparks new concerns

The rapid move across markets has some investors rightfully asking such important questions as:

  • Where are we in the economic cycle?
  • Are equity markets moving too far, too fast?
  • Are rising interest rates a threat to the rally or the economic recovery?

Our answers are: We believe the U.S. economy is in transition from early to mid-cycle. The rally was justified, and earnings growth will drive equity markets still higher. We are not concerned now about rates or inflation rising.

Here’s our reasoning: 

The economy is transitioning from an early to a mid-cycle environment.

Consumption is recovering and supported by incomes. The household savings rate is very high and declining. Consumer confidence is improving.

Meanwhile, the labor market has suffered severe damage. Ten million fewer Americans have jobs compared to pre-pandemic levels. In fact, the ratio of prime age employment to population is now about the same level as in the depths of the financial crisis.

 

The labor market is still depressed

Indeed, the U.S. economy is recovering, but there is still a long way to go until it’s at full health.

Meanwhile, around the world, there is still a great divergence across regions:

  • China is furthest along in the recovery process; its policymakers are slowly removing policy support and focusing on organic growth and innovation.
  • The rest of Asia has been buoyed by strong export demand.
  • Eurozone labor markets are still deeply depressed, and vaccination programs are lagging the United States and the United Kingdom.
  • Latin America broadly may get a lifeline from higher commodity prices, but domestic political issues pose challenges.

Not only was the rally justified, but earnings growth can be expected to drive equity markets higher.

We believe markets have been surging because they were pricing in the higher probability of a better future, not because investors are irrationally exuberant. They have been in a “hope” phase. These tend to happen after crises and recessions when valuations expand before earnings actually improve.

Now we’re transitioning into a “growth” phase, in which earnings growth will drive equity market returns.

Some investors may be confusing this hope with euphoria (i.e., when markets also rise because of higher and higher valuations). However, euphoria phases often come after a period of growth when enthusiasm in equity markets sets a bar that is too high for actual earnings results to clear.

Pockets of froth and exuberance (such as SPACs and solar energy) have been correcting recently. Meanwhile, the market as a whole has been insulated by strong performance from economically sensitive sectors, such as financials, energy, industrials and materials.

 

Where we are in the market cycle

Interest rates are rising, but are unlikely to end this cycle anytime soon.

Rising rates have coincided with the end of most every market and economic cycle since the 1980s. However, we think there is a long way to go before interest rates threaten equity markets or the economy. Here are three reasons why:

  1. The Fed has stated that two things need to happen before it will raise policy rates: Actual inflation needs to average 2% over the cycle. The labor market needs to show maximum employment. It will take years to reach both of those conditions.
  2. The housing market could withstand higher rates. Currently, outstanding mortgage rates are about 100 basis points lower than the average outstanding mortgage rate (estimated using the trailing five-year average mortgage rate). This fact suggests most homeowners would lower their financing costs if they took out a new mortgage today.
  3. Stocks do not look stretched relative to bonds. Ten-year Treasury yields are at parity with the S&P 500’s dividend yield (Treasury yields are generally higher). Meanwhile, the earnings and cash flow yields of the equity market relative to bond yields are merely at average levels.

 

The mortgage market is still supported by low rates

Quick and volatile moves higher in bond yields could cause quick and volatile moves lower in equity prices. But if rates keep grinding higher, it would be entirely consistent with falling unemployment, more labor force participation, better earnings and higher equity markets. Doesn’t sound bad, right?

We are not concerned about inflation now.

We don’t expect sustained upward pressure on consumer price inflation until the labor market heals substantially and rents start to rise again. The earliest we expect core inflation to hit 2% on a sustained basis is the second half of 2023. For a deeper dive into our take on every angle of the inflation debate, see Worried about inflation? We’re not

 

Find your investing opportunities

How should investors put our updated outlook into practice? On a tactical level, we prefer to focus on playing offense rather than defense:

  • In bonds—We favor extended credit over core fixed income. Within core fixed income, we think it’s wise to avoid interest rate risk by keeping duration shorter.
  • In equities—We want to focus on areas that have both exposure to cyclical acceleration and a tailwind from secular megatrends. Our favorite way to express this view is through innovative companies. Financial technology looks set to gain influence. Next generation vehicles will drive growth. Chinese policymakers are prioritizing innovation. Some other examples include physical and digital infrastructure; increased mobility and transportation; digital entertainment and de-carbonization.
  • In commodities—We prefer industrial metals such as copper over precious metals such as gold.

On a strategic level, we think investors’ goals and priorities should drive portfolio allocation decisions. So if you are looking:

  • To find yield, consider relying on extended credit, real estate and infrastructure.
  • To harness megatrends that could drive capital appreciation, consider companies that drive innovation in technology, healthcare and sustainability.
  • To navigate volatility, speak with your J.P. Morgan team about whether your traditional bond allocations still provide the protection you expect or need to meet your goals. If they do not, consider alternatives and active management to dampen volatility.

 

The future is closer than you think.

Soon markets will be driven increasingly by traditional (read: boring) factors—such as earnings growth, corporate margins, labor force participation rates, inflation and economic growth—rather than the more novel, such as trillion dollar fiscal support packages, epidemiological models and vaccine efficacy rates.

Of course, the rapid price gains that accompanied the latest hope phase may moderate, but this new, albeit less dramatic, growth phase isn’t one to miss. We expect the strongest economic growth in the United States in more than 35 years.

Markets may already have moved substantially, but the global healing process is just getting started. 

 

It’s been a while since we’ve seen a boom

Speak with your J.P. Morgan team to explore what opportunities might support your long-term goals.

 

 

 

 

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