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Our Thinking

Brick By Brick

Andrew Goldberg, Global Head of Client Investment Strategy, J.P. Morgan Private Bank

Anthony Chan, PhD, Chief Economist for Chase

Billy Huzar, Vice President Client Investment Strategy, J.P. Morgan Private Bank

Revisiting the “wall of worry”

 

Let’s go back to the beginning of summer. At the time, we wrote an article, The Wall of Worry, covering the three “bricks” that are forming a “wall of worry” for U.S. markets:

 

1. U.S. – China trade tensions

2. Rising interest rates

3. Fears over an aging cycle

 

Back then, we concluded that these issues, though worth monitoring, wouldn’t derail global growth or our belief in continuing to overweight stocks versus bonds. Within stocks, we emphasized the importance of including non-U.S. markets in a diversified portfolio, given positive growth dynamics abroad.

 

As we now enter autumn, the same three bricks are still the main components of the wall of worry. However, our assessment of them has evolved with the changing landscape, especially as trade tensions have escalated materially. While we still think stocks look more attractive than bonds, and global diversification remains important, we believe that U.S. stocks stand to outperform international stocks over the next year.

 

A Second Look at the Three Bricks
 

“We expect the U.S. to continue to outperform through 2018, particularly given forecasts for roughly 24% earnings growth this year.”

1.
U.S. – China trade tensions

What once seemed like a trade “skirmish” has now developed into a more serious dispute. Flash back to May, when only a little more than $100 billion worth of imports was threatened with tariffs. Today, it’s more than $800 billion.1 We believe the Trump administration has been emboldened by the market’s response to their tactics thus far. The president’s approval ratings have moved higher as economic growth and corporate profits remain well above trend.2 We see it as a distinct possibility that the administration keeps the pressure on China and others right up to the midterm elections.

 

While we’re still a long way from a full-blown “trade war,” stock markets have already started to react to the possibility that continued escalation could hinder global trade. The S&P 500 has been remarkably resilient, rising about 9% since the beginning of May, but MSCI indices for Europe, Japan and Asia Ex-Japan are down 2%, 4% and 7%, respectively. We expect the U.S. to continue to outperform through 2018, particularly given forecasts for roughly 24% earnings growth this year.3 An earlier-than-expected resolution to the trade dispute could spur a relief rally, but that is not our most likely scenario.

“We think it could be as long as a year before short-term interest rates exceed long-term rates, and stocks don’t typically peak until well after that happens.”

2.
Rising interest rates

The lack of clarity around the trade situation stands in stark contrast to the transparency from the Federal Reserve. The Fed appears set to hike interest rates two more times this year and three or four times in 2019. The reasons are clear: Inflation is rising toward their 2% target.4 The unemployment rate is holding steady at around 4%5. And financial conditions remain pretty easy, meaning rising asset prices continue to make it relatively easy for households and businesses to borrow and invest.

 

Despite more Fed hikes on the horizon, we don’t expect longer-term interest rates to rise much from here. As short-term rates rise faster than long-term rates, the yield curve should continue to flatten. But that doesn’t mean the end is near for stocks. Importantly, we think it could be as long as a year before short-term rates exceed long-term rates (“inverted yield curve”)—and stocks don’t typically peak until well after that happens (see chart). While a flattening yield curve is often seen as a sign of an impending downturn, we think it’s still too early to worry about the end of the cycle.

S&P 500 returns, from yield curve inversion to market peak

In the last five instances, U.S. stocks gained an average of 18% after the yield curve inverted - and that hasn't happened yet in the current cycle. 

yield-curve-inversion

Source: NBER, FRED, Standard & Poor’s, FactSet. Data is as of August 22, 2018. Yield curve is measured as the difference between the U.S. 10-year Treasury yield and U.S. 2-year Treasury yield.

“Although we may be in the later stages of the cycle, we aren’t at the end.”

3.
Fears over an aging cycle

It’s no secret that the U.S. economic expansion has entered its later innings. At 112 months and counting, it’s already the second-longest expansion in U.S. history! But we think it still has room to run.

 

Although we may be in the later stages of the cycle, we aren’t at the end. Even with Fed rate hikes, the cost of capital remains well below expected rates of return. Consumer and corporate confidence is high, and leading indicators of economic activity seem healthy. However, as you might expect from a later-stage economic cycle, we’re seeing some signs of fatigue. Credit growth has slowed recently, the yield curve continues to flatten, and the Fed seems set to raise the cost of capital gradually over the next 18 months.

 

What does it all mean for you?

 

There’s no denying that these bricks continue to contribute to a wall of worry for investors. Yet stock markets seem to be identifying the risks and reacting accordingly—in other words, they’re slowly climbing the wall. Across nearly all geographies, stock valuations have declined since May, signaling that the markets share our same worries (see chart). Just as importantly, like a car that has slowed from 60 to 40 mph, those cheaper stock prices help reduce downside risk should things go wrong.


Current stock market valuations

Price to earnings ratios
Across the world, stock valuations have declined from market peaks and now look more attractive.

current-valuations

Source: FactSet, as of 8/20/18.

With the Fed continuing its hiking cycle and short-term rates rising faster than long-term rates, we favor an active approach to fixed income investing. We’re still overweight stocks, especially in the U.S., as economic fundamentals and corporate profits suggest a healthy environment for returns.

“Stock returns can be strong in the final phases, and bond yields become more compelling as interest rates rise.”

Ongoing and escalating trade tensions remain the biggest risk to our view, as a descent into a full-blown trade war would be a negative for stocks worldwide. However, we believe all parties will ultimately recognize the dangers to the global economy and reach some sort of agreement.

 

In the end, diversification remains critical at the later stages of the cycle. Stock returns can be strong in the final phases, and bond yields become more compelling as interest rates rise.

The views and opinions expressed in this material are those of the featured J.P. Morgan Chase & Co. (“J.P. Morgan”) employee and do not necessarily reflect the policies or positions of JPMorgan Chase & Co. The material is provided for informational purposes only and is designed to provide general market commentary. It does not constitute J.P. Morgan research nor should it be considered a recommendation of a particular investment strategy or an o er or solicitation for the purchase or sale of any financial instrument. Opinions and estimates offered constitute the featured J.P. Morgan employee’s judgment as of the date of this material and are subject to change without notice as are statements of financial market trends, which are based on current market conditions. J.P. Morgan believes the information provided here is reliable, but do not warrant its accuracy or completeness. References to future returns are not promises or even estimates of actual returns a client portfolio may achieve. Any forecasts contained herein are for illustrative purposes only and are not to be relied upon as advice or interpreted as a recommendation for any particular action.


Investing involves market risk, including the possible loss of principal. Investments in international or emerging markets can be more volatile and involve a greater degree of risk. Not all investments or strategies are suitable for all investors and there is no guarantee that a particular
investment objective will be achieved. Past performance is not a guarantee of future results. You should speak to your financial advisor before making any investment decisions. J.P. Morgan and its affiliates do not provide legal, tax or account advice so you should seek professional guidance if you have questions.


Diversification does not ensure a profit or protect against a loss.


© 2018 JPMorgan Chase & Co.

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