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Investors

Market Thoughts: Positioning portfolios for stronger growth and inflation

We’re moving into a phase where expectations meet reality. As we continue reopening across the global economy, higher frequency macroeconomic data is going to remain choppy. So are markets.


Is the inflation pressure temporary or secular?

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Why we are overweight on Europe

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Let’s talk about taxes

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The potential for returns looking ahead

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KEY TAKEAWAYS

  • Investors have moved from concern that the Fed will tighten too quickly, to alarm the Fed may react too late. That keeps the spotlight on U.S. interest rates and inflation.
  • Corporate earnings have been extraordinarily strong. Equity markets ran hard ahead of those earnings. Markets are letting earnings do the heavy lifting of growing into valuation levels. It’s a ‘Goldilocks’ moment.
  • We’re focused on how pricing pressure is coming through in earnings. That includes supply chain disruptions. With input costs increasing, we are trying to gauge any lasting impact on operating leverage.
  • I want to ensure we have ample liquidity in portfolios to quickly deploy capital, as we’ve done repeatedly over the past year. Markets don’t only move in straight lines.

As we continue the transition to reopening across the global economy, higher frequency macroeconomic data is going to remain choppy. So are markets. We’re moving into a phase where expectations meet reality.

Economic data is signaling ‘liftoff’ as higher frequency data improves. We see that happening both in U.S. and European data. Labor markets are strengthening, as is consumption. I’m keeping a close eye on jobs data, confidence indicators and inflation expectations. Normalization will come in fits and starts.

I expect the nascent shift we’ve begun to observe in spending from goods to services can quickly ramp up. Consumers have the willingness. Thanks to fiscal stimulus, particularly in the U.S., they also have the ability to spend. That should make for a potent cocktail of economic and earnings growth.

From recovery to expansion. Inflation has been a bogeyman to investors over the past few months. It’s easy to have a view about inflation. It’s funny how extreme positions can make for excited headlines and markets. We’re either never climbing out of a disinflationary spiral or inflation is about to go parabolic. The truth lies somewhere in between.

Investors have moved from concern the Fed will tighten too quickly, to alarm that the Fed may react too late. The U.S. economy is leading the recovery across developed markets (Figure 1). That will keep the spotlight on U.S. interest rates and inflation. To play off a well-worn song lyric: where they lead, markets will follow.

Recovery from global pandemic shutdown

Source: National Statistics Agencies, Haver Analytics. Data as of Q1 2021.

The Fed is already talking about the need to taper bond purchases. My sense is that a more structured discussion will be heard at Chair Powell’s semi-annual testimony to Congress in July, or in August at the Kansas City Fed’s Jackson Hole economic symposium. The economy and markets are ready to see the Fed begin to pull back on loose monetary policy.

The Fed anticipates a faster pace of reopening and is patient about current policy and inflation. I continue to take them at their word. That said, my sense is Jay Powell will have to remain vocal about the inflationary outlook. The proof statement around the durability of higher inflation will be in the data. That will take time to play out.

Europe is moving through a stage of ‘peak pessimism’ but green shoots are present. Europe is a few months behind the U.S. in terms of its pace of recovery. Tactically, I see European equity markets continuing to play catch-up to the U.S. With a few notable exceptions, emerging markets have been particularly hard hit by the virus. It’s going to take longer for many of those economies to recover. That said, I believe the final leg of the global recovery will be played out across emerging equity markets. It’s why we continue to hold onto those investment positions.

Bond and equity markets remain relatively well behaved in the face of growing inflation expectations. Our base case is that longer-dated bond yields will press higher as the global economy rebounds. With rising growth and inflation comes higher interest rates as we move from recovery to expansion.

Extraordinary earnings. Corporate earnings have been extraordinarily strong. Equity markets ran hard ahead of those earnings. For anyone wondering why we haven’t seen markets move even higher, investors are digesting expensive multiples. Markets are letting earnings do the heavy lifting of growing into valuation levels. It’s a ‘Goldilocks’ moment. That moment allows markets to consolidate and should help keep investors focused on fundamentals.

We expect earnings will continue to beat to the upside across global markets. Analysts have revised both 2021 and 2022 earnings higher. Positive revisions are apparent across major regions. We believe there is a bit more upside ahead.

As we move from recovery to expansion, I believe stocks could outperform bonds with greater volatility. For now, equity markets can continue to grow into multiples as revenues and earnings press higher. That can create an environment where equity markets move higher and forward multiples pull back, as earnings grow faster than price.

I’m particularly focused on how rising pricing pressure is coming through in earnings. With input costs increasing, we are trying to gauge any lasting impact on operating leverage and margins (Figure 2). That is particularly the case as pipeline pressure in producer price measures remain strong across business surveys globally.

Profit margins may be a risk going forward

Source: MSCI, FactSet. Data as of Q1 2021. Past performance is not a guarantee of future results. It is not possible to invest directly in an index.

Supply chain disruption has been a keen focus for us, as have input costs in general. While we are seeing pockets of the market face rising price pressures, in majority it’s been covered by greater than expected top line revenue growth. That’s good news for a few more quarters.

The supply chain question is broader than constrained supplies. Embedded in it is a geopolitical question as developed economies debate how to reframe trade relationships. That includes where and how we source things now recognized as more strategic than previously thought – medicine, medical supplies, rare earth metals, 5G infrastructure and semiconductors, to name a few.

I believe ‘just in time’ inventory dependence is going to go through a radical rethink by major corporations and countries. That’s likely to mean a pass through in higher costs as companies either hold more inventory and/or suppliers demand a higher price for ‘first in queue’ delivery. Also, costs may rise as companies look to repatriate strategic manufacturing home.

We’re likely to see increasing pressure ahead on margins. Today, margins are strong. The question will quickly become: do companies feel confident they can continue to pass higher input costs on to consumers? The answer may come right about the time the Fed begins to determine if the transitory rise we’re seeing in inflation is something more durable.

The impact of higher corporate U.S. taxes hasn’t fully been factored in by the market. Investors have experienced a ‘shot across the bow’ as Washington debates raising taxes. Higher expected earnings in 2022 is good news. Revising those higher earnings lower because of tax increases ahead has yet to be priced in.

With markets having run fast and hard the first-half of this year, we’re due for a healthy phase of consolidation and digestion. That’s likely to be accompanied by broader market swings. If market turbulence turns into something worse, we’re ready to take advantage of the right opportunities.

A little trickier from here. I continue to view the macro outlook constructively. Thanks to record monetary and fiscal stimulus, we’ve bounced back stronger and faster than I think anyone could have imagined, certainly me. Whiplash has taken on a whole new meaning as it relates to the current pace of recovery. If there was ever an ‘easy’ part to the past year, it’s behind us. The road gets a little trickier from here.

We are overweight stocks versus bonds. We are also underweight duration. While we continue to hold a modest overweight in high yield, we’ve reduced this positioning by two-thirds in multi-asset portfolios. Default risk in high yield is being pushed out as companies continue to refinance at low rates and extend debt maturities. Also, the high yield index has benefited from positive ratings actions. What’s capped is the upside, which we believe is limited to carry.

We are overweight U.S., emerging and European equity markets, funded from fixed income. We remain positioned with a pro-cyclical bias. In the U.S., we have been pulling back overweight positions to big tech since last year. We have shifted that exposure into both industrials and financials. We continue to like those sectors.

We see upside for cyclicals more broadly, including Europe and emerging markets (EM). Having lagged, we see them as beneficiaries of the global reopening. EM looks particularly inexpensive to developed markets. Earnings across emerging economies have upside, but caution prevails. That is especially the case as it relates to China tightening regulation around Chinese big tech. We are keeping a close eye on how the regulatory environment unfolds.

China is also focused on deleveraging their economy after last year’s wave of stimulus (Figure 3). I expect that may keep emerging equity markets range bound a while longer. Having watched what leverage brought to developed markets in the 2007-2009 financial crisis, China has no intent of going down a similar path. Investors need to better appreciate that I say that as a positive.

China's private leverage is elevated vs. other economies

Source: Bank of International Settlements, Haver Analytics. Data as of Q3 2020.

I will leave aside my observations about what a degrading relationship between the U.S. and China might mean. This isn’t simply about trade. Cybersecurity, tech development, innovation and geopolitical détente each play a role. So might an escalating show of force in the South China Sea.

The big risk to markets – outside of a left-tail geopolitical event or variant virus surge – relates to inflation. For the right reasons, markets aren’t pricing in the risk of fast-rising durable inflation. I’m making that point because if consensus is wrong about inflation and it becomes a bigger issue for policy makers, markets won’t like it.

Investors aren’t completely disregarding the fact that higher corporate taxes are coming. I think they’re waiting to see where we land. It’s easier to be patient when you expect stronger earnings growth revisions to continue. Once those positive revisions peak, investors may become a bit more concerned.

Throw into the mix the fact that the U.S. and Europe are attempting to more tightly regulate big tech, and that the Group of 7 (G-7) nations have endorsed the implementation of a global minimum corporate tax rate. Each creates a backdrop for a series of risks that can provoke market air pockets.

I‘m focused on making sure we’ve well diversified risk positioning across portfolios. How we are tactically allocating within each asset class is as important as our over- and underweights to an asset class. I want to ensure portfolios are not overreaching for risk.

I also want to ensure we have ample liquidity to quickly deploy capital, as we’ve done repeatedly over the past year. Markets don’t only move in straight lines. That said, given the amount of cash that remains sidelined, there is a pool of investor capital eager to buy the dips.

Red light, green light. When the Madigan twins were young, they loved playing the game red light, green light. As we roamed around our Manhattan neighborhood, they would wait for my wife (or me) to shout a color. Red meant stop, green meant go. We threw in the occasional yellow, blue or rainbow to see how creative they could be. They were always very creative.

It's astonishing to recognize how slow and fast the world around us has moved over the past year. Red light. Green light. Everything we do to more fully engage in living is going to feel a little different. I intend to relish each and every moment. We’re only here once…

INDEX DEFINITIONS

MSCI USA Index: The MSCI USA Index is designed to measure the performance of the large and mid cap segments of the US market. With 620 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in the US.

MSCI Europe Index: The MSCI Europe Index captures large and mid cap representation across 15 Developed Markets (DM) countries in Europe. With 434 constituents, the index covers approximately 85% of the free float-adjusted market capitalization across the European Developed Markets equity universe.

MSCI Japan Index: The MSCI Japan Index is designed to measure the performance of the large and mid cap segments of the Japanese market. With 301 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in Japan.

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