Can the immaculate disinflation continue?

*Our Global Investment Strategy View integrates the knowledge and analysis of our economists, investment strategists and asset class strategists. The View takes shape at a monthly Forum where the team debates and hones its views and outlooks. We will aim to publish this updated global view in the first Asia Strategy Weekly of every month.

Key takeaways

• Our high-conviction investment ideas include long-duration fixed income, equal weighted S&P 500 and mid-cap equities, plus private credit.
• An immaculate U.S. labor market loosening continues. Despite strong payroll growth and an unemployment rate that’s bouncing around near 50-year lows. The rate of workers quitting their job is at a three year low suggesting employee power is waning and wages can slow further.
• The recession obsession fades, and CEOs are increasingly optimistic. Only 11% of S&P 500 companies cited an economic slowdown in their quarterly earnings calls, down from 35% a year ago. Earnings estimates are bottoming.
• China is slowing, but the impact on global markets is smaller than commonly assumed. Despite being the world’s second largest economy, only 1.5% of U.S. corporate income is from sales in China.
• If you hold too much cash, add duration. 27% of all investable assets in JPM Global Wealth Management are held in cash and fixed income with a maturity of less than one year, up from 20% in 2022. The Fed is most likely done with its hiking cycle, thereby raising the reinvestment risk.
• Where have all the multi-asset investors gone? Year-to-date, JPM Global Wealth Management multi-asset investment flows have been non-existent on a net basis, compared to a trailing 3-year average of 36% of all flows directed to multi-asset. The case for multi-asset investing is growing.

An immaculate U.S. labor market loosening continues. Despite strong payroll growth and an unemployment rate that is bouncing around near 50-year lows, workers are saying “I quit” to their bosses at the slowest rate in almost three years. Less confidence to quit your job suggests employee power is waning; and wages are likely to slow further.

Why it matters: Economics 101 tells us that supply and demand imbalances drive inflation. The post-COVID inflation surge was initially driven by supply chain issues that have since evaporated. Earlier this year we feared a tight labor market would keep demand high and inflation above the Fed’s 2% goal – a fear that is so far unfounded. We credit the immaculate U.S. labor market loosening to:

1. Work from home luring workers back to the workforce. Prime age labor force participation is above pre-COVID levels, particularly for women.
2. An acceleration in immigration. The share of foreign-born workers in the U.S. is rising rapidly.

Core services ex-shelter inflation, the one of the best proxies for demand-led inflation, has fallen from >4% last quarter to ~2.5%.  Historically, when inflation is above 4%, developed market central banks have caused deeper recessions than when inflation is below 4%.

Bottom line: We continue to expect a soft(ish) landing in the U.S. economy, where first half 2024 growth declines slightly and the unemployment rate rises to just 4.25% next year. Still, macro scenarios are highly uncertain, and a period of sub-trend growth is likely necessary to ensure inflation doesn’t bounce back up.

The recession obsession fades, and CEOs are increasingly optimistic. Only 11% of S&P 500 companies cited an economic slowdown in their quarterly earnings calls, down from 35% a year ago.

Why it matters: Investors consistently cite the expensive valuations of the S&P 500, which trades at a next 12-month price to earnings (NTM P/E) of ~19x, as a reason not to get invested. We disagree:

1. The rich valuations are concentrated in the biggest names in the index. Excluding the biggest stocks in the index, NTM P/Es are in line with historical averages. While we expect the market-cap weighted S&P 500 to advance by high-single digits by mid-’24, we see better upside in the equal-weighted index where a soft-landing is not priced into valuations nor the earnings estimates (particularly cyclical components).
2. Wall Street analysts are underappreciating the fundamentals, and earnings are bottoming. The average S&P 500 earnings surprise for Q2 2023 was 7%, the highest beat spread since Q3 2021. We expect the majority of S&P 500 sectors to turn profitable in Q3 2023.
3. 12-month forward EPS revisions have been positive over the last month, and most acutely in Consumer Discretionary, where 88% of companies beat estimates. We are upgrading our view of the Consumer Discretionary sector, as we expect earnings to bottom with a normalization in inventory levels, and valuations are reasonable.

Bottom line: We continue to expect new all-time highs in the S&P 500 by mid-year 2024. We anticipate mid-cap tech will likely take the short-term baton of leadership. By sector, we continue to favor Industrials given the current policy initiatives and see upside for Consumer Discretionary. By capitalization, we currently like the S&P 400 (mid-caps) and equal-weighted S&P 500 on relative valuation and quality metrics.

China is slowing, but the impact on global markets is smaller than commonly assumed. Chinese housing activity is collapsing; home sales fell by 23% year-on-year in July and continued to weaken further in August. The property sector represents approximately one third of China’s GDP, so broad economic pain is expected. Some property developers are on the edge of default as they struggle to complete projects and meet debt obligations. Policymakers are responding with efforts to stem the downturn (policy rate cuts and a loosening of housing policies), but it is too soon to know whether they will be enough.

Why it matters: Despite being the world’s second largest economy, China’s slowdown will likely have only a small impact on developed world investments:

1. Only 1.5% of U.S. corporate income is from sales in China.
2. 10% of European corporate income is from sales in China. China exposure is one of the reasons why we have below consensus European earnings expectations for 2023 and 2024, and why we no longer recommend broad exposure to the UK.
3. Chinese defaults are rising, but less than 4% of outstanding Chinese bonds are held abroad.

Bottom line: We continue to expect below trend GDP growth and muted inflation in China as the economy transitions away from property-led growth. We have lowered our mid-2024 MSCI China Index outlook to 66-68 (from 78-82) prior. The China slowdown is not a reason to be bearish on developed market investments.

If you hold too much cash, add duration. 27% of all investable assets in JPM Global Wealth Management are held in cash and fixed income with a maturity of less than one year, up from 20% in 2022.

Why it matters: The Fed is most likely done with its hiking cycle, which raises reinvestment risk. Economic indicators are increasingly pointing towards a Fed pause. In August, the U.S. economy added a healthy 187 thousand jobs. However, the pace of payroll gains has stepped down significantly. The 3-month moving average of monthly payroll gains (to smooth volatility) is currently at 150 thousand jobs, down from 288 thousand jobs in June 2023¹. The continued slowdown in the quit rate suggests wages could keep cooling.

The simple pillars of adding duration still apply:

1. If you like cash rates today, consider locking in those yields for a longer time horizon.
2. Historically, duration tends to outperform cash after the last Fed rate hike.

Macro heavyweights Larry Summers and Bill Dudley recently suggested the equilibrium 10-year Treasury rate – the rate where the U.S. economy is growing at potential and inflation is stable – is between 4.5% and 4.8%. These equilibrium rates are a bit higher than the current 10-year Treasury yield (4.2%). Our 2023 Long Term Capital Market Assumptions (LTCMAs) estimate the equilibrium 10-year Treasury yield at 3.2%, the same level we expect the 10-year Treasury to yield at mid-2024.

Bottom line: The Fed hiking cycle is most likely over. We continue to expect lower cash rates and lower Treasury yields at mid-2024. Reinvestment risk is real, so add duration.

Where have all the multi-asset investors gone? Year-to-date, JPM Global Wealth Management multi-asset investment flows have been non-existent on a net basis, compared to a trailing 3-year average of 36% of all flows directed to multi-asset. Over a recent short window, investment flows have broadened.

Beyond fading recession risk, the case for multi-asset investing is growing.

1. Our 2023 LTCMAs suggest investors can expect 7.2% total returns in a USD 60/40 portfolio over the next 10-15 years. Over the next year, we are more optimistic than consensus on both stock and bond total returns.
2. The diversification benefits of bonds are back. Over the last 25 years, hiking cycles have caused the inverse correlation between stocks and bonds to temporarily turn positive (stocks and bonds losing value at the same time). Historically, the inverse correlation between stocks and bonds has reasserted itself at the end of the hiking cycle.

Bottom line: Multi-asset investing can once again be the bedrock of portfolios.

All market and economic data as of September 07, 2023 and sourced from Bloomberg Finance L.P. and FactSet unless otherwise stated.

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