Our Thinking

Navigating a Maturing Cycle

Andrew Goldberg, Global Head of Market Strategy & Advice, J.P. Morgan Private Bank
Jacob Manoukian, Global Market Strategist, J.P. Morgan Private Bank
A compass on a boat

When we were preparing our investment outlook for 2019 in the fall of last year, Fed Chairman Jerome Powell said that interest rates were “a long way from neutral.” This implied that the Fed had a long way to go in its rate-hiking cycle, and that seemed like a risk to markets and the economy. Sectors that are sensitive to interest rates (like housing) were already suffering, and the rest of the world failed to take the baton from the United States as an engine of growth. It seemed like the conditions we thought necessary for recession (restrictive interest rates, slowing global growth and the imbalance of an indebted corporate sector) would all be in place by the first half of 2020.

The stock market recognized the risks we had identified much earlier than we expected, and declined by 20% from September to Christmas Eve. After the sell-off, the Fed changed its tune. Instead of saying rates were “a long way from neutral,” Chairman Powell said he was “listening sensitively to markets.” Investors took this to mean that the rate-hiking cycle would pause, and risk assets (like stocks and high yield bonds) rallied in relief. Their hunch was correct: Last fall, the median FOMC member expected the Fed to raise rates twice in 2019 and again in 2020. Now, the median FOMC member doesn’t foresee any moves in 2019 and a rate cut in 2020. This changes things.

Threat of overtightening seems off the table

Fed funds rate, %

graph showing the threat of overtightening seems off the table

Source: Bloomberg, June 2019.

There is still a chance that the Fed may have already tightened monetary policy to a level that could cause a recession, but we think it is more likely that rates are low enough to accommodate further growth. Valuations across asset classes are now close to or above long-term averages, which seems appropriate for the current environment, but we don't think the coast is clear. Despite the Fed’s pause, the U.S. economy is still late in the cycle, and growth looks set to slow. Last year, the U.S. economy was being driven by three engines: business investment, fiscal spending and the consumer. The first two supports are now fading. While the consumer should be able to keep the economy growing, it won’t be enough to match the pace of the recent past.

Globally, the manufacturing sector is still working its way through a rough patch, and trade is weak amid tariff tensions between the United States and its trading partners. However, modest stimulus from Chinese policymakers and relatively healthy domestic conditions should act as a ballast against these headwinds. In short, our base case calls for growth rates to continue to slow, but not to recessionary levels that would cause the Fed to cut rates significantly. However, a downside surprise seems more likely than one to the upside at this point.

To be clear, our view of “no recession” in the near term is not sufficient for us to take outsized risk in portfolios. So what are investors to do? We are focused on three key themes.

  1. Participation with protection

    After 10 years of strong returns, we believe it is time to add more protection to portfolios—and there is a range of ways to do so. We think a focus on quality, both in stocks and bonds, is prudent. Higher-quality securities tend to outperform lower-quality ones in times of market stress. We also suggest adding duration in fixed income. This can support portfolios should markets take a turn for the worse. Other non-correlated asset classes could further cushion portfolios from equity losses. Finally, begin to rotate from stocks to bonds. It is too early to do this in a wholesale fashion, but we believe it is time to gradually change the composition of multi-asset portfolios.

  2. Harvesting yield

    We are sharpening our focus on generating returns from yield rather than from capital appreciation. There are multiple yield-harvesting tools to use across asset classes. Diversifying fixed income remains a core strategy, especially in a world of low default rates. Municipal bonds may make sense, particularly for investors in high-tax states. Further, structured products may provide the opportunity to exchange upside participation for protection and coupon payments.

  3. Finding growth in a low-growth world

    We believe the global economy will continue to slow. With growth scarce, sectors that are demonstrating the ability to grow should demand a premium. Technology and Healthcare are benefiting from secular trends (not dependent on seasonality or economic trends), and there are also several specific industries and themes that could provide above-market growth, such as cloud computing and software, 5G, data privacy and gene therapy.

graph showing what has changed from the second half of 2018 to the first half of 2019

Source: J.P. Morgan, Bloomberg, “Then” data as of second half of 2018. “Now” data as of first half of 2019.

RISKS TO OUR VIEW

No outlook is without its risks. We are watching the following areas:

 

  • Trade war: If tariffs remain in place on Chinese imports, it could reduce consumption, hamper business confidence and spending, and hurt asset valuations. Further escalation (through mechanisms like export controls, boycotts, cyber attacks, etc.) would also hurt confidence.
  • Global manufacturing slowdown: Even without the trade war, manufacturing is still slowing worldwide. If growth slides further than we expect, it could lead to job cuts in the United States.
  • Corporate sector debt levels: While corporate debt levels are high, corporate debt service metrics still look healthy, but those can change if growth slows materially.
  • Market structure and liquidity: The equity market selloffs at the beginning and end of 2018 showed the risks of modern market structure. Liquidity in fixed income markets is also more limited than it has been in the past.
  • Election 2020: Whether we like it or not, the next election cycle will kick off soon. Popular talking points among candidates, including “Medicaid for All” and the breakup of “Big Tech,” have already made an impact on markets. Uncertainty around the outcome and headlines around specific policies could result in volatility for the next year and a half.

 

Conclusion

The Fed’s decision to pause breathed new life into markets and likely extended the cycle. But the cycle has not been reset, so investors should take a prudent approach to risk. While we see the potential for more upside, the risks are greater. Adding protection and focusing on yield are important, while the timeless strategy of diversification is all the more critical.

None of this caution precludes us from finding growth trends of the future. Technology and Healthcare are two key areas where we see substantial growth potential that is not currently factored into markets.

Finally, by shifting portfolios toward quality, liquidity, yield and secular growth, we can be prepared for greater uncertainty ahead. In portfolios that we manage, we have been making changes like this to ensure that we can be more comfortable staying invested and helping clients move toward achieving their goals.

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 offer 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. You should speak to your financial advisor before making any investment decisions.

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