The Rasputin Effect: Explaining global economic and equity market resilience in the face of the fastest central bank hiking cycle on record; China reopening flops due to housing overhang
Legend has it that Rasputin was poisoned, shot twice, beaten and then drowned before finally succumbing to Russian nobles trying to end his sway over the Czar. I’m reminded of this (probably false) account when looking at global resilience. Despite 400-500 basis points of rapid policy tightening in the US and Europe (since 2021 ~95% of the world’s central banks have raised rates, even more than during the 1970’s inflation shock), and despite a very tepid Chinese recovery, global Q3 GDP growth is still projected to be ~2% and the MSCI World Equity Index is up 18% this year.
How can we explain this? The obvious place to start: the decline in inflation surprises and in related measures (core, trimmed, sticky and median measures of consumer price inflation; NY Fed underlying inflation gauge; “truflation”; the Global Supply Chain Pressure Index, the jobs-workers gap, etc). But there are 6 other factors worth reviewing as well, which is the subject of this month’s note.
Line chart compares the percent change in forecasted global GDP for Q1 through Q3 2023. The line chart shows that GDP for each quarter is projected above 1%, with Q3 still projected to be ~2%.
Line chart shows the inflation surprise index for the US and World since 2018. The line chart illustrates that the decline in inflation has been much lower than expected, with accompanying measures falling rapidly.
[1] The “inverted yield curve -> recession” argument is premature. Yes, inverted yield curves tend to precede recessions as shown on the left. But why was it such a consistent signal? Before prior recessions (other than COVID), yield curve inversion reflected policy rates that were restrictive in real terms (i.e., relative to inflation). This time, policy tightening in the US is barely restrictive at all, as shown on the right. And while a simple read of the yield curve points to recession, the health of the US corporate sector does not: the corporate sector financial balance is still in surplus, a condition which has never preceded a recession (see chart below).
Line chart shows the spread between the 10-year and 3-month yield since 1967. The line chart shows that an inverted yield curve tends to precede recessions.
Line chart shows the difference between the Fed Funds rate and Core CPI since 1957. The line chart shows that the difference, or “real interest rates”, is around 0%. This means that policy rates are barely restrictive.
[2] Central banks have only removed around one third of the $11 trillion in global liquidity they created in 2020/2021. In other words when considering points #1 and #2, there’s still plenty of liquidity in the system and the cost of money is not prohibitive.
Line chart shows the total assets of various countries since 2007. The line chart shows that ~$11 trillion of global liquidity was created in 2020 and 2021. However, only about one-third of that liquidity has been removed.
Line chart shows the financial balance of the US non-financial corporate sector since 1960. The line chart shows that prior/during most recessions, the financial balance of the corporate sector has been negative. Currently, however, the corporate sector is still in a surplus.
[3] Biden’s industrial and fiscal policies offset part of the drag from higher policy rates. The charts below show the construction bounce in the manufacturing sector, and the direct government spending and tax incentives associated with semiconductor, infrastructure and energy bills. And don’t look now, but US fiscal policy has become very loose again: the latest fiscal deficit is not far off the peak deficit during the financial crisis of 2009. A recent note from our economist colleagues goes into the details1.
Line chart shows the total amount of spending on manufacturing construction since 2005. The line chart shows a large increase in spending at the exact time the CHIPS Act and IRA were signed in 2022.
Bar chart shows the total amount of direct government spending and tax expenditures for the CHIPS Act, IRA, and Infrastructure Bill. The bar chart shows the US government is set to spend ~$800 billion on industrial policy, and an additional ~$500 billion in tax expenditures.
Bar chart shows the direct and indirect subsidies for semidconductors and batteries from 2023 to 2031. The bar chart shows that the investment and credits are ~$500 billion.
Line chart shows the US and Eurozone surplus / deficit as a percent of GDP since 1969. The line chart shows the latest fiscal deficit is nearing the peak deficit level during the financial crisis in 2009.
Bidenomics, opioids and the Third Man. I’ve got questions on the long-term inflationary impact of Bidenomics. Two examples: the ultimate cost of US semiconductor production compared to Taiwan, and the cost of energy systems with large amounts of renewable power that also require substantial backup thermal power and/or energy storage. Also, the notion that hiring IRS agents will raise enough money to finance the energy bill and reduce the deficit is to me totally implausible. But there’s one thing to be optimistic about: the potential for industrial policy to partially revitalize US manufacturing communities that were left in the dust by China’s entry into the World Trade Organization. I’ve written before on the connection between post-WTO Chinese FX intervention, US manufacturing job losses and US opioid addiction rates (see Eye on the Market 7/13/2021). The “battery belt” that will stretch from Michigan to Georgia through Ohio, Kentucky and Tennessee will be welcome news in many communities.
I never do media appearances but I did accept an invitation in July to speak on a video podcast called The Compound which is moderated by money manager Josh Brown. The reason I accepted: it’s a long form 90-minute show that allows for in-depth discussion and debate that does not occur in any other media I’ve seen. Anyway, they end the show by asking for a book and movie recommendation. I mentioned “Empire of Pain” by Patrick Keefe on the family behind the opioid crisis, and the 1949 film The Third Man. The connection: the ferris wheel scene in which Orson Welles describes to Joseph Cotton how he rationalizes his tainted penicillin scheme.
[4] Rising interest rates will take time to flow through to profit margins and household balance sheets. In contrast to some US banks that made extremely poor decisions to extend asset duration at the lows in rates2, many US and European companies extended liability duration and enjoy the lowest levels of interest expense to cash flow in decades. As shown below, for the first time on record, corporate interest expense is falling as the Fed is hiking rates. US household debt service costs are also low. One reason: the average coupon on outstanding residential mortgages is ~3.5%, immunizing many homeowners from the spike in mortgage rates to ~7%. Credit card and auto delinquencies are rising, but from low levels and are now back at 2010-2020 averages.
Line chart compares the Fed Funds rate and corporate net interest payments as a percent of after-tax profits since 1970. The line chart shows that for the first time on record, corporate interest expense is declining as the Fed hikes rates.
Line chart shows both the household debt service to disposable income and average rate on outstanding mortgages since 1980. The line chart shows that debt service costs are incredibly low, one reason being the average coupon on outstanding residential mortgages is ~3.5%.
While higher interest rates hit US housing pretty hard, the lowest housing inventory in decades3 offsets what might have been an even sharper decline in home prices, permits and starts. Also: tight US labor markets have sustained personal income and spending. While goods spending is weakening, services spending and auto spending are holding up. Note how the timing and magnitude of the expected consumer slowdown has changed since January. Tech layoffs have declined by 50%-75% from peak levels according to Challenger data; the AI frenzy came just in time for some.
Line chart shows the months supply of existing single family homes since 1982. The line chart illustrates the lowest level of housing inventory in decades, which offset what might have been a sharper decline in prices, permits, and starts.
Line chart compares the PCE forecasts of sell-side economists from January 2023 to January 2025. The report shows that economists project sustained personal income and spending, with the Q/Q percent change at ~2% in 2025.
Note that the US government is not nearly as immune from rising interest rates as households or companies. Net interest payments to GDP have already risen from a post-war low of 1.2% in 2015 to 1.9%, and are heading to 3.2% by 2029 which would match the post-1960 high last seen in 1991. See our American Gothic piece from January for more on the long-term unsustainability of US Federal debt, entitlement spending and interest.
[5] Just wait, economic weakness is coming later this year or in early 2024. Monetary policy tightening works with a lag and is occurring after a period of unprecedented stimulus. Excess US household savings are projected to run out sometime in 2024, and while current economic indicators are robust, there’s weakness in Conference Board leading indicators.
Line chart compares the estimates of US household excess savings by JP Morgan’s Economics Team, Private Bank, and Investment Bank since 2020. The chart shows that excess US household savings are projected to run out sometime in 2024.
Line chart compares the Conference Board coincident and leading economic indicators index since 1970. The line chart shows that coincident economic indicators are robust, but there is weakness in the leading economic indicators.
We also monitor the longer-dated indicators shown in the table. The overall pulse does not point to a significant contraction, just to modestly weaker US conditions in 6-9 months. Furthermore, new orders less inventories (#5) has improved three months in a row. We watch this metric closely given its leading signal on the PMI index, a useful predictor of economic growth and stock market returns over the long run.
Table of monitored leading indicators.
[6] YTD US equity returns have been substantially boosted by rising valuations of a few mega-cap stocks, most of which have not seen their earnings projections grow at all this year. We covered this issue in June, and J.P. Morgan’s Global Markets Strategy team wrote on the topic as well4.
- While NVDA and META earnings projections are rising for 2023 and 2024, they are flat for MSFT, GOOGL, AMZN and AAPL. Even so, the latter 4 stocks are up 40%-60% this year. TSLA, whose earnings are projected to decline by ~30% from 2022, has risen by over 100% this year
- Market cap concentration in a handful of stocks is at its highest level since the early 1970’s, even narrower leadership than during the 2000 TMT Bubble. Also: the increase in market cap concentration just reached its highest level in 60 years
- Six mega-cap stocks (MSFT, GOOGL, AMZN, META, NVDA, CRM) explain 51% of S&P 500 performance and 54% of the Nasdaq 100
- Crowding in growth factor investing has reached the 97th percentile, eclipsed only in early 2000
- A steep rise in concentration and narrow market leadership has historically reversed with the S&P 500 equal-weighted index outperforming the market-cap weighted index
Line chart shows the market cap of the largest 7 companies as a percentage of total large-cap market capitalization from 1990 to the present. The largest 7 companies increased their share of market cap significantly since 2020 and now account for almost 25% of total large-cap market cap (up from ~15% in 2019).
Scatter chart plots historic MSCI World equity return through July of each year on the y-axis against the trailing 12 month change in Fed Funds rate on the x-axis. 2023 is in the upper right quadrant, exhibiting strong equity returns against increases in rates.
Line graph shows the evolution of 2023 earnings expectations for 7 stocks (NVIDIA, Meta, Google, Microsoft, Apple, Amazon, and Tesla). These are indexed to their December 2022 levels. The earnings expectations for NVIDIA and Meta have increased dramatically since then. The earnings expectations for Tesla have fallen. The earnings expectations for the other stocks are relatively close to their December 2022 levels
The bottom line: risk appetite is back, courtesy of immaculate disinflation and plenty of liquidity
The equity rally can be justified on the grounds that the Fed’s “immaculate disinflation” was not expected by many investors, some of whom added risk this year after conservative positioning in 2022. But: rising valuations account for 90%+ of the gain in the S&P 500 this year, with earnings growth accounting for the rest. Multiple expansion has occurred despite the lack of a rebound in long term earnings growth expectations. As shown on the left, this is unusual. In other words, there’s a lot of good news priced in at current levels and little room for any negative developments in the Russia-Ukraine war and global energy/food prices next winter.
More signs of investor optimism:
- market sentiment is in the 95th percentile of bullishness
- the cost of a one-year 95 strike put on the S&P 500 is in the 85th percentile of cheapness since 20085
- the Dow Jones Index rallied for 13 consecutive days through July 26, the longest streak since 1987
- don’t look now, but the YUCs (young unprofitable companies) are rising again. The rally in electric aviation company JOBY is a prime example…see our energy paper on the dubious prospects for electrified aviation
The equity rally is also taking place when fixed income is competitive with equities from a yield perspective for the first time since 2002, as shown on the right. For risk-averse investors, some fixed income opportunities offer compelling risk-reward compared to equity counterparts6.
Line chart displays S&P 500 Price / 12m forward earnings and S&P 500 earnings forecasts from 1985 to the present. P/E ratios have risen this year while long-term earnings forecasts have dropped; rising valuations account for most of the gain in the S&P 500.
Line chart shows the convergence of yields across three assets from 2000 through the present: S&P 500 12m forward earnings yield, US corporate investment grade bonds, and the US three-month treasury rate. All three assets have converged for the first time since 2002.
Line graph shows the young unprofitable companies as a % of equity market capitalization from 1990 through current date. The % of total market cap is beginning to increase again, following a decline in 2021-2022.
After the Flop, waiting for the Turn: China’s reopening fizzles due to real estate overhang
After Strange World, Lightyear, Amsterdam and Babylon flopped in 2022, China’s grand reopening did the same in 2023. The latest problem with China’s economy stems more from misallocated investment in residential real estate than from excess industrial capacity. China’s home ownership rate is ~90% (a figure unheard of in the US even during the most feverish attempts by the FHFA to unsustainably inflate it), and 20% of Chinese households own more than one home. Vacant properties amount to 2+ years of sales, and consumer confidence remains low despite low mortgage rates designed to boost leverage and homebuying.
As discussed in our April piece on the dollar as the world’s reserve currency, China relies on large amounts of trapped domestic savings to finance itself. Rather than a balance of payments or banking crisis, the housing situation in China has resulted in a period of slower growth and an equity market that trades at 10-12x earnings, a steep discount to the developed world. The Chinese Politburo appears to have announced intentions to provide more stimulus, but the timing and amounts are unclear.
Line chart shows the weighted average of 10 monthly indicators to track the strength of economic activity in China from 2015 to current. There was a drop in activity at the beginning of 2020, followed by a very large spike in 2021. Since the spike in 2021, the index has declined to below historical trend.
Line chart shows the y/y growth of China’s residential floor space of newly started houses. It also shows the y/y growth of China state-owned land use right transfer revenue. Both have declined notably to negative 20-30%.
Line chart shows the China consumer confidence index since 1996. The index was at very high levels from 2018-2021. More recently, the index has seen a drastic drop-off.
Table shows the housing comparison of China and the US. It compares the value of housing stock relative to personal consumption, real estate activities as a share of GDP, home price to income ratios, and home ownership rate. China is much higher than the US in all of these metrics.
1“The Curious Case of the 2023 Fiscal Expansion”, JP Morgan North America Economic Research, M. Feroli, July 26 2023
2What happened to the US banking crisis? The perception of a blanket FDIC guarantee of uninsured deposits after SIVB and new Fed borrowing facilities has led to a sharp slowdown in bank deposit outflows, despite the ongoing gap between money market rates at ~5.0%, 1-year CDs at 1.8%-2.6% and deposit rates at ~0.5%.
3New homes are selling at roughly the same price as existing homes for the first time since the late 1960’s. Most likely reason: very low levels of existing supply.
4“Steepest Rise in Concentration, Narrowest Leadership, ML Application of Crowding to Predict Market Returns”, J.P. Morgan Global Market Strategy, July 21, 2023, Dubravko Lakos-Bujas and Marko Kolanovic
5Some press reports cite put options as being cheaper than at any time since 2008, but this is a little misleading. Option premiums incorporate short term interest rates and as rates rise, premiums get cheaper. When analyzing put option premiums struck based on S&P 500 forward prices (which effectively incorporates rate changes), they’re still cheap but not quite as much as when looking at premiums based on S&P 500 spot prices.
6Another example: the yield on investment grade REIT debt is roughly the same as REIT cap rates (5.8%)
Good afternoon, and welcome to the August Eye on the Market audio/video podcast. I'm not really in San Francisco. That's just a Zoom background.
But I have this fancy new microphone because some of you have commented that the audio from my iPhone headphones is terrible. So I now have a professional Edward R. Murrow-style microphone. And you'll be able to see this on video if you're accessing it through our website rather than the Spotify or Apple podcast portal.
Anyway, welcome to the August Eye on the Market audio-visual extravaganza. So like everybody else, I'm somewhat surprised that, despite 400 to 500 basis points of tightening in the US and Europe and a very weak Chinese recovery, the equity markets are up globally about 18% this year. And Q3 GDP looks like it's globally going to hang in and still poised for around 2%.
So the reason I'm calling this the Rasputin recovery is, if you remember the legend around Rasputin, which is almost certainly false, but he was, I think, beaten, poisoned, shot twice, and then finally drowned before he dies. And it's a proxy for how I see the global economy right now. No matter what the central banks are throwing at it, it continues to exhibit some resilience, and the same goes for the equity markets as well.
How can we explain this? Well, the obvious catalyst is the decline in inflation surprises. So we've got a chart in here that shows for the US and globally what those inflation surprises looked like just in the beginning of this year, and they have collapsed.
And whether you're looking at core inflation, trimmed inflation, sticky price inflation, median inflation, and then a bunch of other measures related to supply chains and the jobs-workers gap, the inflation outlook has cooled more or less the way the Fed thought it should. It just took them another year or so before it started to happen. And that's the obvious big catalyst. But I wanted to walk through six other important catalysts so that everybody understands where we are, why the markets are doing this well, and where we go from here.
I think the biggest surprise to some people has been a chart that we have showing that on seven prior occasions, every time the yield curve inverted, you had a recession. And it was almost automatic, and there were very few, if any, false signals where you had an inverted yield curve and you didn't get a recession. So we have a chart in here with these little red arrows showing that if you look at the yield curve inversion from three months to 10 years, it was a really consistent signal. And as you can see, the yield curve is mega inverted right now.
But I don't think this is such a great signal this time around. And I've been explaining to clients this year when I've been meeting them that the reason why that inverted yield curve was such a successful signal, if you look back, was that the yield curve was inverted, but that's because the short end of the curve was really high relative to inflation. And if you look at a chart on the real cost of money associated with those yield curve inversions, you saw real cost of money 2%, 4%, 8%, maybe even 10%.
This time around, the real cost of money is still barely positive. So I think it's premature to even look at this recession indicator inversion thing because the real cost of money this time around is barely positive at all. And it's a sign of just how far behind the Fed got relative to inflation.
The other thing, too, is if you're really into that kind of yield curve inversion always predicts a recession stuff, then you've got to look at the corporate sector financial balance, which is a kind of broad measure of the profitability of the entire corporate sector, not just public companies, net of capital spending and other kinds of transfers.
And in the past, you got a recession because that corporate sector financial balance went negative. This time around, it's still substantially positive. So if you're into recession indicator tracking, the corporate sector financial balance would offset the yield curve inversion signal, even if you believed it, which I don't.
The second thing is, yes, the central banks are starting to take back some of the stimulus. But if you look broadly across the Fed and Europe and Japan and the Swiss National Bank, Canada, Bank of England, and then the relevant comparable entity within China, only around 35% of the emergency stimulus, from a monetary perspective, has been withdrawn. So there's still a lot of money sloshing around, and the real cost of money is not prohibitively high. Those are the first two takeaways in terms of why things are doing so well despite 5% higher Fed funds rates than we started the year with.
The third factor is fiscal stimulus. And we have a chart here showing the spike-- a really big spike-- in construction spending not related to commercial real estate but related to manufacturing. And that started to happen shortly after the semiconductor bill and the energy bill and the infrastructure bills were passed.
There's a lot of money getting spent here, and more broadly-- this is the amazing part-- the fiscal deficit in the United States is almost as large as it was at its peak level in 2009 when you had the global recession. So, yeah, there's a lot of monetary tightening taking place, but there's a lot of fiscal easing offsetting that.
Our partners in the investment bank, they have a great economics team. And Mike Feroli and his team wrote a piece on analyzing what's driving the US deficit. And it's a lot of little bits and pieces, but lower income and payroll tax receipts, drop in remittances from the Federal Reserve to the Treasury, more cost of living adjustments, higher Medicaid and Medicare outlays, higher interest on the federal debt. And then, of course, don't forget about the last one, which is increased FDIC payments to depositors after the bank failures that occurred earlier this year. But the bottom line is there's a lot of fiscal stimulus taking place.
The fourth factor that has helped contribute to this Rasputin market and Rasputin economy is it's going to take a while for higher interest rates to feed into the corporate sector and the household sector. And so there's a chart in here. And I'll be honest with you, I can't tell you exactly why this is happening because it's remarkable.
But we have a chart that shows that every time since the early '70s, when the Fed funds rate went up-- in other words, when policy rates went up-- corporate interest payments, as a percentage of their profits, went up, too. This time, not only is that net interest payment ratio not rising. It's still falling. And, now, there's a number of things that could be contributing to this, notably companies that have a lot of short-term excess cash or reinvesting and earning higher rates.
And those same companies, one can infer, extended duration massively at the lows [? in ?] rates. How ironic is it that the corporate sector understood the assignment when rates were-- when 10 year rates were 1 and 1/2. The corporate sector extended duration, whereas some of the banks, who you would assume were experts in asset liability management-- some of the banks, as you now know, extended their asset duration at the lows [? in ?] rates while the corporate sector got it right and extended their liability duration. I think it's kind of ironic.
But you can see in this chart that the corporate sector is not really getting hit right now from higher interest rates. Most certainly, that has something to do with their having extended duration when rates were much lower. And same for the household sector-- look at the rate on outstanding mortgages. That rate has come down steadily and is now around, let's say, 3 and 1/2%.
So in contrast to Europe, most homeowners in the United States have long duration, fixed-rate mortgages. And while mortgages look prohibitively expensive for new home buyers, existing home owners have locked in really low rates, which is one of the reasons why the debt service to income ratio of the US household sector has gone up a little bit with higher rates but is still close to the lowest levels that it's been at since 1980. So not just the corporate sector has been resilient to higher rates but also households.
And housing's gotten hit pretty hard in terms of starts and permits and mortgage applications and the normal stuff that you'd look at. But housing would have looked much worse if not for the fact that we have very tight inventory levels in terms of single-family homes. We have a chart in here showing that we're still close to the levels of the last 40 years or so in terms of the supply of existing single-family homes. So that tight supply-- now, there's all sorts of problems related to that in terms of productivity and employment and labor mobility. But this time around, it's made the housing markets more resilient than it might have been to rising interest rates.
So if we step back and look at the US consumer, in January of this year, the consensus forecasts were a consumer-led recession by the summer. All of the factors I've just walked through have helped prevent that from happening so far. And now, when you look at those same forecasts, the decline's pushed out a little bit, but notably doesn't go negative on any kind of year-on-year or quarter-on-quarter basis. So the forecast of the consumer slowdown has changed in terms of both timing and magnitude.
And the other thing-- and this gets discussed a lot, and I think it should-- households are still burning off massive amounts of excess savings that they got during COVID via both fiscal stimulus means and monetary stimulus means. And here are three different forecasts from three different parts of JPMorgan we have in this chart. And they're all pointing to the same thing, which is, sometime in 2024, that runs out. But that still gives you at least a few months of cushion where households will have the ability to spend in excess of their earned income.
Now, even with all of that, just wait. The leading indicators are still projecting weakness this fall, Q4, Q1. We have a chart in here showing you can split leading indicators into coincident indicators, meaning the stuff that's happening now, and leading indicators, which is the stuff that's expected to happen in a few months. And the coincident indicators all look fine, whereas the leading indicators still look pretty weak.
And so we take a closer look than just at these aggregate baskets, and we track 20 or so long-dated leading indicators that give us a sense for what might be happening anywhere from three months to six months, nine months, 12 months. They don't look terrible. We have a color-coded table in the Eye on the Market that shows roughly what we're expecting based on each one.
And there's a modest slowdown expected later this year, or early first quarter, that I would put at something like 1% growth rather than recession. But that does have implications for how large an equity market drawdown you might expect, even if there is one. And a lot of these signals look a lot less malevolent than they did a few months ago.
Now, of course, the last and the sixth factor is what's been driving the market this year is the return of risk appetite in a big way. So just be aware of that. This is not an earnings-led recovery. First of all, the market cap of the largest seven companies is at its highest level since the 1970s. It's even narrower market leadership than during the TMT bubble during 2000. And you've all read about this. We've written about it before. The crowding and growth factor investing has reached the 97th percentile, eclipsed only in the year 2000.
There was a very good piece that the Investment Bank, JPMorgan's Investment Bank, put out last week by the Us Equity Strategy team that gets into detail on this. I cited in the Eye on the Market the name of that piece in case you want to look at it.
And for those of you that are fans of the Eye on the Market, just be aware the YUCs are back. So we track the percentage of overall market cap made up of the YUCs, which are the young unprofitable companies. One of the signals that I wrote about a lot that I was very worried about where markets were valued in 2021 and early 2022 is how high this was. It corrected in 2022 in the fall but now is going up again. And so just be aware, rising YUC shares of the overall market is-- there's a reason we call it YUC. I'd rather not be seeing this in terms of how stable this rally is.
And then I think the most important chart in some ways in the piece we have is one that looks at the rise in the valuation multiple on the PE ratio for the S&P compared to long-term earnings growth forecasts. Now, sometimes long-term earnings growth forecasts take a while to change. Corporate guidance and the analyst community have to kind of get on board and reflect what they're seeing.
But undoubtedly, the chart we've got here shows the valuation multiple has gone up almost 4 points, maybe 3 and 1/2 points, without any movement higher in long-term earnings growth forecasts. That's unusual. That doesn't happen a lot. And there's no escaping the fact that there's a lot of good news priced into the markets right now and not a lot of room for negative developments, should they come from Russia-Ukraine war, global energy and food prices, or anything else.
So I think there's a reasonable foundation for the rally that's taking place this year because inflation has outperformed almost everybody's forecasts in terms of how quickly it would fall. Wage inflation is declining a little bit more slowly. And a lot of people were underinvested at the end of 2022. They added risk. I get it. But I think it's important to understand exactly where we are at this point in a kind of earningless appreciation cycle that's taking place in a handful of stocks.
So just a couple more things. First, I think this is the best time for risk-averse investors in 20 years. So why do I say that? We have a chart at the end of the piece that looks at the earnings yield on the S&P, which is basically earnings divided by price, and we compare that to the to the short-term returns on corporate bonds and treasuries. And they've all converged to somewhere around 5% to 5 and 1/2%.
The last time you earned more money on treasuries than you did on equities was in early 2000s. So it's been over 20 years since a risk-averse investor could look at the fixed income markets and consider them roughly comparable in earnable yield terms compared to equities, and that's where we are right now.
So one last thing I wanted to mention-- and I hope I'm not running out of time. But I don't do any press. I don't have a lot of time for that, and our compliance people generally get very nervous when I'm put in front of press people, which I can understand. But I agreed to do this video podcast of a money manager called Josh Brown. And he does an in-depth 90-minute video podcast a couple times a month, and I joined over the summer.
And the reason I'm mentioning it is, at the end of the podcast, he asks the people that joined for that session to name a book and a movie that they liked. And I started thinking about Bidenomics, which is essentially the United States having an industrial policy for the first time really in 50, 60 years. And there's a lot of money that's going to be spent in terms of direct government spending or tax expenditures on infrastructure, energy, semiconductors.
I have questions about the long-term inflationary consequences here. How much will it eventually cost to produce semiconductors in Arizona versus Taiwan? What's going to be the cost of energy once you have both the cost of storage and backup thermal power added on to the cost of a high renewable system-- things we explore in the energy paper? So I've got some questions about the inflationary consequences of this.
But one thing I am optimistic on is the ability for Bidenomics to reverse some of the damage that was done to manufacturing communities in the United States after China joined the World Trade Organization. I showed some research a couple of years ago that, after China joined the WTO and then started engaging in currency intervention, US manufacturing employment and wages plummeted, and opioid use started rising specifically in the counties that had the most intense competitive economic pressures with China.
And so I'm hopeful that the battery belt that will stretch from Georgia up to Michigan and some of the other monies that get spent here alleviate some of the pain and suffering in those communities. And on the podcast, I mentioned the book Empire of Pain about the history of the opioid crisis and the family behind it. And I mentioned the movie The Third Man with Orson Welles because there's a scene where he's explaining his justification for his tainted penicillin scheme, and I thought that that was a nice way to wrap the whole message up together.
Anyway, thank you for listening slash watching. I hope this all worked, and we'll see you sometime in September. Thank you.
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Text, JPMorgan. The views and strategies described herein may not be suitable for all clients and are subject to investment risks. Certain opinions, estimates, investment strategies and views expressed in this document constitute our judgment based on current market conditions and are subject to change without notice. This material should not be regarded as research or as a J.P. Morgan research report. The information contained herein should not be relied upon in isolation for the purpose of making an investment decision. More complete information is available, including product profiles, which discuss risks, benefits, liquidity and other matters of interest. For more information on any of the investment ideas and products illustrated herein, please contact your J.P. Morgan representative. Investors may get back less than they invested, and past performance is not a reliable indicator of future results. Investments and insurance products: Not a deposit, not F.D.I.C. insured by any federal government agency, no bank guarantee, may lose value.
The Rasputin Effect: Global Economic and Equity Market Resilience. August 2023. Michael Cembalest, Chairman of Market and Investment Strategy.
(SPEECH)
Good afternoon, and welcome to the August Eye on the Market audio/video podcast. I'm not really in San Francisco. That's just a Zoom background.
But I have this fancy new microphone because some of you have commented that the audio from my iPhone headphones is terrible. So I now have a professional Edward R. Murrow-style microphone. And you'll be able to see this on video if you're accessing it through our website rather than the Spotify or Apple podcast portal.
Anyway, welcome to the August Eye on the Market audio-visual extravaganza. So like everybody else, I'm somewhat surprised that, despite 400 to 500 basis points of tightening in the US and Europe and a very weak Chinese recovery, the equity markets are up globally about 18% this year.
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A line graph titled Growth contains a blue line representing quarter 1, a yellow line representing quarter 2, and a red line representing quarter 3. The x-axis shows the dates January 2022, April 2022, July 2022, October 2022, January 2023, April 2023, and July 2023. The y-axis contains 1.0% to 4.5% in 0.5% increments. Source: JP Morgan Economics, July 28, 2023.
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And Q3 GDP looks like it's globally going to hang in and still poised for around 2%.
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Text, Despite 400 to 500 b.p.s. of tightening in U.S. and E.U. and weak Chinese economy.
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So the reason I'm calling this the Rasputin recovery is, if you remember the legend around Rasputin, which is almost certainly false, but he was, I think, beaten, poisoned, shot twice, and then finally drowned before he dies. And it's a proxy for how I see the global economy right now. No matter what the central banks are throwing at it, it continues to exhibit some resilience, and the same goes for the equity markets as well.
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A line graph titled Inflation surprise index shows a blue line representing the U.S. and a yellow line representing global. The x-axis contains the years 2018 through 2023, and the y-axis contains negative 40 to 100 in 20 unit increments. Both line begins to rise in 2021, peak around 80 in 2022, and fall fast in 2023. Source, Bloomberg, JPMAM, June 2023.
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How can we explain this? Well, the obvious catalyst is the decline in inflation surprises. So we've got a chart in here that shows for the US and globally what those inflation surprises looked like just in the beginning of this year, and they have collapsed.
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Text, core, trimmed, sticky and median measures of consumer price inflation, NY Fed underlying inflation gauge, truflation. Global Supply Chain Pressure Index, and jobs-workers gap.
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And whether you're looking at core inflation, trimmed inflation, sticky price inflation, median inflation, and then a bunch of other measures related to supply chains and the jobs-workers gap, the inflation outlook has cooled more or less the way the Fed thought it should. It just took them another year or so before it started to happen. And that's the obvious big catalyst. But I wanted to walk through six other important catalysts so that everybody understands where we are, why the markets are doing this well, and where we go from here.
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Text, Recession indicators. Yield curve inversion preceded all recessions. Basis points 10Y through 3M yield spread, 30 day smoothing. A line graph contains the years 1967, 1972, 1977, 1982, 1987,1992, 1997, 2002, 2007, 2012, 2017, and 2022. The y-axis contains the numbers negative 200 to 400 in 100 unit increments. A red arrow points to the dip in each curve for each year. Source, Bloomberg, JPMAM, June 2023.Bloomberg, JPMAM, June 2023.
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I think the biggest surprise to some people has been a chart that we have showing that on seven prior occasions, every time the yield curve inverted, you had a recession. And it was almost automatic, and there were very few, if any, false signals where you had an inverted yield curve and you didn't get a recession. So we have a chart in here with these little red arrows showing that if you look at the yield curve inversion from three months to 10 years, it was a really consistent signal. And as you can see, the yield curve is mega inverted right now.
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Title, Real interest rates (FED Funds - Core CPI), 21day smoothing. A line graph displays the years 1957, 1962, 1967, 1972, 1977, 1982, 1987, 1992, 1997, 2002, 2007, 2012, 2017, and 2022 on the x-axis and negative 6% to 10% on the y-axis. Red arrows point to the peaks in each of the curves. Bloomberg, JPMAM, June 2023.
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But I don't think this is such a great signal this time around. And I've been explaining to clients this year when I've been meeting them that the reason why that inverted yield curve was such a successful signal, if you look back, was that the yield curve was inverted, but that's because the short end of the curve was really high relative to inflation. And if you look at a chart on the real cost of money associated with those yield curve inversions, you saw real cost of money 2%, 4%, 8%, maybe even 10%.
This time around, the real cost of money is still barely positive. So I think it's premature to even look at this recession indicator inversion thing because the real cost of money this time around is barely positive at all. And it's a sign of just how far behind the Fed got relative to inflation.
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Text, U.S. corporate sector financial balance. Percent of corporate gross value added, 4-quarter average. A line graph features the years 1960, 1970, 1980, 1990, 2000, 2010, and 2020 on the x-axis and negative 6% to 4% on the y-axis. Source. Federal Reserve, B.E.A., JPNAN, Q2 2023.
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The other thing, too, is if you're really into that kind of yield curve inversion always predicts a recession stuff, then you've got to look at the corporate sector financial balance, which is a kind of broad measure of the profitability of the entire corporate sector, not just public companies, net of capital spending and other kinds of transfers.
And in the past, you got a recession because that corporate sector financial balance went negative. This time around, it's still substantially positive. So if you're into recession indicator tracking, the corporate sector financial balance would offset the yield curve inversion signal, even if you believed it, which I don't.
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Title, Monetary stimulus. Central banks have reversed approximately 35% of emergency stimulus. Total assets. U.S. dollars in trillion. A line graph features the years 2007 to 2023 on the x-axis and $0 to $32 trillion on the y-axis. The line steadily climbs year after year until 2022 when it sharply rises. It begins to fall in 2023. Text, Stock includes Fed, ECB, BoJ, SNB, BoC, and FX reserves of PBoC. Bloomberg, JPMAM, June 2023.
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The second thing is, yes, the central banks are starting to take back some of the stimulus. But if you look broadly across the Fed and Europe and Japan and the Swiss National Bank, Canada, Bank of England, and then the relevant comparable entity within China, only around 35% of the emergency stimulus, from a monetary perspective, has been withdrawn. So there's still a lot of money sloshing around, and the real cost of money is not prohibitively high. Those are the first two takeaways in terms of why things are doing so well despite 5% higher Fed funds rates than we started the year with.
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Title, Fiscal stimulus. Real total manufacturing construction spending. 2022 U.S. dollars in billions. A line graph contains the years 2005 to 2023 on the x-axis and $50 billion to $200 billion on the y-axis. A dashed line directly in front of 2023 represents the CHIPS Act, I.R.A. signed. The line sharply increases when it reaches this dashed line. Bloomberg, JPMAM, June 2023.
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The third factor is fiscal stimulus. And we have a chart here showing the spike-- a really big spike-- in construction spending not related to commercial real estate but related to manufacturing. And that started to happen shortly after the semiconductor bill and the energy bill and the infrastructure bills were passed.
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Text, U.S. and Eurozone budget balance. Surplus (deficit) percent of GDP. A line graph features two lines, a blue line representing the U.S. and a yellow line representing the Eurozone. The x-axis shows the years 1969, 1979, 1989, 1999, 2009, and 2019, and the y-axis shows negative 20% to 5%. The blue line dips to almost negative 20% after 2019. Bloomberg, JPMAM, June 2023.
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There's a lot of money getting spent here, and more broadly-- this is the amazing part-- the fiscal deficit in the United States is almost as large as it was at its peak level in 2009 when you had the global recession. So, yeah, there's a lot of monetary tightening taking place, but there's a lot of fiscal easing offsetting that.
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Text, Primary factors driving the 2023 deficit: lower income and payroll tax receipts, drop in remittance from the Fed to Treasury, more COLA spending, higher Medicaid and Medicare outlays, higher interest on Federal debt, and increased payments to depositors.
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Our partners in the investment bank, they have a great economics team. And Mike Feroli and his team wrote a piece on analyzing what's driving the US deficit. And it's a lot of little bits and pieces, but lower income and payroll tax receipts, drop in remittances from the Federal Reserve to the Treasury, more cost of living adjustments, higher Medicaid and Medicare outlays, higher interest on the federal debt. And then, of course, don't forget about the last one, which is increased FDIC payments to depositors after the bank failures that occurred earlier this year. But the bottom line is there's a lot of fiscal stimulus taking place.
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Title, 4, Resilience to higher rates. U.S. nonfin corporate net interest costs at 60 year low. A line graph features a red line that represents corporate net interest payments as a percent of after-tax NIPA profits and a dashed black line that represents Fed fund rate. The x-axis contains the years 1970 to 2020 in 10 year increments. The left side of the graph contains 0% to 120% and the right side contains 0% to 20%. Bloomberg, JPMAM, Q1 2023.
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The fourth factor that has helped contribute to this Rasputin market and Rasputin economy is it's going to take a while for higher interest rates to feed into the corporate sector and the household sector. And so there's a chart in here. And I'll be honest with you, I can't tell you exactly why this is happening because it's remarkable.
But we have a chart that shows that every time since the early '70s, when the Fed funds rate went up-- in other words, when policy rates went up-- corporate interest payments, as a percentage of their profits, went up, too. This time, not only is that net interest payment ratio not rising. It's still falling. And, now, there's a number of things that could be contributing to this, notably companies that have a lot of short-term excess cash or reinvesting and earning higher rates.
And those same companies, one can infer, extended duration massively at the lows [? in ?] rates. How ironic is it that the corporate sector understood the assignment when rates were-- when 10 year rates were 1 and 1/2. The corporate sector extended duration, whereas some of the banks, who you would assume were experts in asset liability management-- some of the banks, as you now know, extended their asset duration at the lows [? in ?] rates while the corporate sector got it right and extended their liability duration. I think it's kind of ironic.
But you can see in this chart that the corporate sector is not really getting hit right now from higher interest rates. Most certainly, that has something to do with their having extended duration when rates were much lower.
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Text, Resilience to higher rates. U.S. household debt. A line graph features a blue line representing debt service to disposable income and a yellow line representing average rate on outstanding mortgages. The x-axis shows the years 1980 to 2020. The lefts side of the graph contains the ratio of 8 times to 14 times. The right side of the graph shows the percent from 3% to 12%. Bloomberg, B.E.A., JPMAM, June 2023.
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And same for the household sector-- look at the rate on outstanding mortgages. That rate has come down steadily and is now around, let's say, 3 and 1/2%.
So in contrast to Europe, most homeowners in the United States have long duration, fixed-rate mortgages. And while mortgages look prohibitively expensive for new home buyers, existing home owners have locked in really low rates, which is one of the reasons why the debt service to income ratio of the US household sector has gone up a little bit with higher rates but is still close to the lowest levels that it's been at since 1980. So not just the corporate sector has been resilient to higher rates but also households.
And
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Title, Months supply of existing single family homes. A line graph features the years 1982 to 2022 on the x-axis and months 0 to 14 on the y-axis. Source, National Association of Realtors, JPMAM, June 2023.
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housing's gotten hit pretty hard in terms of starts and permits and mortgage applications and the normal stuff that you'd look at. But housing would have looked much worse if not for the fact that we have very tight inventory levels in terms of single-family homes. We have a chart in here showing that we're still close to the levels of the last 40 years or so in terms of the supply of existing single-family homes. So that tight supply-- now, there's all sorts of problems related to that in terms of productivity and employment and labor mobility. But this time around, it's made the housing markets more resilient than it might have been to rising interest rates.
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Title, Consumer. Timing and magnitude of expected consumer slowdown changed since January, Real personal consumption expenditures, Q/Q annual percent change. A line graph features a red dashed line that represents the January 2023 and a blue dashed line that represents the July 2023 Report. The dotted line equals Blue Chip Financial forecasts. The x-axis contains January - 23, July - 23, January - 24, July - 24, and January - 25. The y-axis contains negative 1% to 5%. Source: Haver Analytics, JPMAM, Q2 2023.
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So if we step back and look at the US consumer, in January of this year, the consensus forecasts were a consumer-led recession by the summer. All of the factors I've just walked through have helped prevent that from happening so far. And now, when you look at those same forecasts, the decline's pushed out a little bit, but notably doesn't go negative on any kind of year-on-year or quarter-on-quarter basis. So the forecast of the consumer slowdown has changed in terms of both timing and magnitude.
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Text, Estimates of U.S. household excess savings. U.S. dollars in billion. A line graph contains three lines - a yellow line representing JPM Economics, a blue line representing JPM Private Bank, and a red line representing Investment Bank. The x-axis displays the years 2020 to 2025, and the y-axis displays negative $500 billion to $2,500 billion. All three lines peak between 2021 and 2022 and then steadily begin to fall. Source, JP Morgan, April 2023.
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And the other thing-- and this gets discussed a lot, and I think it should-- households are still burning off massive amounts of excess savings that they got during COVID via both fiscal stimulus means and monetary stimulus means. And here are three different forecasts from three different parts of JPMorgan we have in this chart. And they're all pointing to the same thing, which is, sometime in 2024, that runs out. But that still gives you at least a few months of cushion where households will have the ability to spend in excess of their earned income.
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Title, 5, Leading indicators. Leading Economic Index points to Coincident Economic Index. A line graph features a solid blue line that represents Conference Board Coincident Economic Index and a yellow dash line that represents Conference Board Leading Economic Index. The x-axis shows the dates 1970 through 2020. The right side of the graph contains negative 10% to 10%. The right side contains negative 20% to 20%. Source, Conference Board, JPMAM, June 2023.
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Now, even with all of that, just wait. The leading indicators are still projecting weakness this fall, Q4, Q1. We have a chart in here showing you can split leading indicators into coincident indicators, meaning the stuff that's happening now, and leading indicators, which is the stuff that's expected to happen in a few months. And the coincident indicators all look fine, whereas the leading indicators still look pretty weak.
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Title, Leading Indicators. A table contains a column for number, category, leading indicator, advanced by, predicts a deterioration in, and pulse. Source, Bloomberg, Morgan Stanley, Piper Sandler, Steno Research, JPMAM, July 2023. Weakness projection colors: red equals substantial, orange equals modest, and yellow equals slight.
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And so we take a closer look than just at these aggregate baskets, and we track 20 or so long-dated leading indicators that give us a sense for what might be happening anywhere from three months to six months, nine months, 12 months. They don't look terrible. We have a color-coded table in the Eye on the Market that shows roughly what we're expecting based on each one.
And there's a modest slowdown expected later this year, or early first quarter, that I would put at something like 1% growth rather than recession. But that does have implications for how large an equity market drawdown you might expect, even if there is one. And a lot of these signals look a lot less malevolent than they did a few months ago.
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Title, 6, Market concentrations, risk appetite and valuations. Market cap of largest 7 companies. A line graph contains the dates 1990 through 2020 on the x-axis, and the percent of total large cap market cap from 10.0% to 25.0% on the y-axis. Source, Factset, JPMAM, Q2 2023.
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Now, of course, the last and the sixth factor is what's been driving the market this year is the return of risk appetite in a big way. So just be aware of that. This is not an earnings-led recovery. First of all, the market cap of the largest seven companies is at its highest level since the 1970s. It's even narrower market leadership than during the TMT bubble during 2000. And you've all read about this. We've written about it before.
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Text, Six mega-cap stocks (MSFT, GOOGL, AMZN, META, NVDA, CRM) explain 51% of S&P 500 performance and 54% of the Nasdaq 100. Crowding in growth factor investing reached the 97th percentile, eclipsed only in 2000
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The crowding and growth factor investing has reached the 97th percentile, eclipsed only in the year 2000.
There was a very good piece that the Investment Bank, JPMorgan's Investment Bank, put out last week by the Us Equity Strategy team that gets into detail on this. I cited in the Eye on the Market the name of that piece in case you want to look at it.
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Title, Valuations. The Y.U.C.s: Young Unprofitable Companies. A line graph contains a blue line that starts out as a dashed line and turns solid around the year 2000. The years 1990 through 2020 run along the x-axis. And the percent of equity market capitalization from 0% to 5% runs along the y-axis. Young unprofitable company: Negative net income in two of the last three years, less than 5 years since IPO, and annual revenues growing greater than 15%. Source, Factset, JPMAM, July 25, 2023.
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And for those of you that are fans of the Eye on the Market, just be aware the YUCs are back. So we track the percentage of overall market cap made up of the YUCs, which are the young unprofitable companies. One of the signals that I wrote about a lot that I was very worried about where markets were valued in 2021 and early 2022 is how high this was. It corrected in 2022 in the fall but now is going up again. And so just be aware, rising YUC shares of the overall market is-- there's a reason we call it YUC. I'd rather not be seeing this in terms of how stable this rally is.
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Text, S and P P/E versus long-term earnings growth forecasts. This line graph features a blue line representing S and P 500 P/E and a yellow line representing S and P 500 earnings forecasts. The years 1995 to 2020 run along the x-axis. The price per 12m forward earnings from 6 to 26 run along the left side of the graph. The percent per annual increase in earnings from 8% to 24% runs along the right hand side. Source, Datastream, JPMAM, June 2023.
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And then I think the most important chart in some ways in the piece we have is one that looks at the rise in the valuation multiple on the PE ratio for the S&P compared to long-term earnings growth forecasts. Now, sometimes long-term earnings growth forecasts take a while to change. Corporate guidance and the analyst community have to kind of get on board and reflect what they're seeing.
But undoubtedly, the chart we've got here shows the valuation multiple has gone up almost 4 points, maybe 3 and 1/2 points, without any movement higher in long-term earnings growth forecasts. That's unusual. That doesn't happen a lot. And there's no escaping the fact that there's a lot of good news priced into the markets right now and not a lot of room for negative developments, should they come from Russia-Ukraine war, global energy and food prices, or anything else.
So I think there's a reasonable foundation for the rally that's taking place this year because inflation has outperformed almost everybody's forecasts in terms of how quickly it would fall. Wage inflation is declining a little bit more slowly. And a lot of people were underinvested at the end of 2022. They added risk. I get it. But I think it's important to understand exactly where we are at this point in a kind of earningless appreciation cycle that's taking place in a handful of stocks.
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Text, Best time for risk-adverse investors in 20 years. Convergence of yields across assets. A line graph features a blue line representing S and P 500 12M forward earnings yield, a dashed yellow line representing U.S. corporate investment grade bonds, and a solid yellow line representing U.S. three-month treasury rate. The x-axis contains the years from 2000 to 2022, and the y axis contains 0% to 12%/ Source, Bloomberg, JPMAM, July 21, 2023.
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So just a couple more things. First, I think this is the best time for risk-averse investors in 20 years. So why do I say that? We have a chart at the end of the piece that looks at the earnings yield on the S&P, which is basically earnings divided by price, and we compare that to the to the short-term returns on corporate bonds and treasuries. And they've all converged to somewhere around 5% to 5 and 1/2%.
The last time you earned more money on treasuries than you did on equities was in early 2000s. So it's been over 20 years since a risk-averse investor could look at the fixed income markets and consider them roughly comparable in earnable yield terms compared to equities, and that's where we are right now.
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Text, Bidenomics, inflation, opioids, and the Third Man. Industrial policy. A bar graph shows government spending in one bar, which encompasses the infrastructure bill, Inflation Reduction Act, CHIPS Act authorized and appropriated, and CHIPS Act authorized only. The second bar on the x-axis features tax expenditures and includes the Inflation Reduction Act. The y-axis shows $0 to $800 in U.S. billion.
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So one last thing I wanted to mention-- and I hope I'm not running out of time. But I don't do any press. I don't have a lot of time for that, and our compliance people generally get very nervous when I'm put in front of press people, which I can understand. But I agreed to do this video podcast of a money manager called Josh Brown. And he does an in-depth 90-minute video podcast a couple times a month, and I joined over the summer.
And the reason I'm mentioning it is, at the end of the podcast, he asks the people that joined for that session to name a book and a movie that they liked. And I started thinking about Bidenomics, which is essentially the United States having an industrial policy for the first time really in 50, 60 years. And there's a lot of money that's going to be spent in terms of direct government spending or tax expenditures on infrastructure, energy, semiconductors.
I have questions about the long-term inflationary consequences here. How much will it eventually cost to produce semiconductors in Arizona versus Taiwan? What's going to be the cost of energy once you have both the cost of storage and backup thermal power added on to the cost of a high renewable system-- things we explore in the energy paper? So I've got some questions about the inflationary consequences of this.
But one thing I am optimistic on is the ability for Bidenomics to reverse some of the damage that was done to manufacturing communities in the United States after China joined the World Trade Organization. I showed some research a couple of years ago that, after China joined the WTO and then started engaging in currency intervention, US manufacturing employment and wages plummeted, and opioid use started rising specifically in the counties that had the most intense competitive economic pressures with China.
And so I'm hopeful that the battery belt that will stretch from Georgia up to Michigan and some of the other monies that get spent here alleviate some of the pain and suffering in those communities. And on the podcast, I mentioned the book Empire of Pain about the history of the opioid crisis and the family behind it. And I mentioned the movie The Third Man with Orson Welles because there's a scene where he's explaining his justification for his tainted penicillin scheme, and I thought that that was a nice way to wrap the whole message up together.
Anyway, thank you for listening slash watching. I hope this all worked, and we'll see you sometime in September. Thank you.
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Text, JP Morgan.
