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Listen on Google PodcastsEye on the Market Outlook 2024: Pillow Talk
Good morning, everybody. Welcome to the 2024 Eye on the Market Outlook Podcast, which is entitled Pillow Talk. Some of you may remember that Pillow Talk was the name of a movie from the 1950s with Doris Day and Rock Hudson. If you haven't seen it, there was a Rock Hudson documentary that came out last year that's worth seeing.
Anyway, pillow talk here refers to the picture I have, with a bunch of bears falling into some pillows, which is a metaphor for the increasing talk about soft landing from a hard landing and from a bear market to a non-bear market. And a lot of that talk accelerated at the end of the year when the Fed signaled that they would, in fact, be easing monetary policy in 2024, some of which was predicted, but not quite as much as what's predicted right now, after some of those Fed announcements.
So I want to walk you through some of the topics that we covered in the outlook, some of which we'll discuss on the podcast today and some of which we'll discuss on a couple of podcasts being rolled out over the next couple of weeks. So what are the topics? Let's say we cover some really important leading indicators, which I think had a large role to play in the Fed changing its tune, the uninflation monitor that also is tied into the same thing.
We take a look at equity markets in the US and the issue around the mega-cap stocks which continue to dominate markets, an antitrust monitor which we'll discuss in this week's podcast, the latest on Europe and Japan, which are going in opposite directions, at least from the perspective of equity investors, a global fixed-income monitor, some additional comments on US federal debt sustainability, information on the US consumer, a section on China, and then we have a deep dive on weight-loss drugs.
I've been working on this for a little bit. And I thought it was interesting to include it here in the outlook instead of having it on a standalone basis. Maybe we'll issue it on a standalone basis later in the year. And then in honor of Byron Wien, who passed away last year at the age of 90, Byron used to publish a top-10 surprise list every year. In his honor, I'm going to do one this year as well.
So let's get into the details here. The first chart we have in the outlook is by far the messiest chart I have ever created. But it's worth it. I promise, it's worth it because what it shows is the seven post-war recessions that took place and the sequencing of when things hit bottom, whether they were the equity markets or payrolls or housing starts, default rates, the ISM surveys, GDP. And what you can see here is that with the exception of the.dot.com cycle in 2001, equities bottomed way before the worst readings on the other stuff.
So obviously, everybody's recession forecast-- or most recession forecasts for 2024 are going down with the Fed, easing. But even if there is a recession, I think the important point is that equities tend to bottom way before a lot of the other economic and market data that people tend to focus on, which I think is really important to understand as we head into the next year.
Now there are 20-- or at least 22 different leading indicators that we follow on a weekly basis. I just wanted to share two of them that are sending a consistent signal, which is that the coincident indicator, which tells you what's happening right now, looks fine. But the leading indicators look weak. They don't look catastrophically weak. They don't look as weak as they looked in 2020, during COVID.
They don't look as weak as what they did during the 1970s. And they certainly don't look as weak as they did in 2008-2009. But they look like-- they're signaling a run of the mill decline in US economic activity which is consistent with a recession.
And then there's another model that we tend to look at, that looks at a few different variables. And then we extrapolate it out for 18 months. And it does suggest that there will be decline in corporate profits this year. And so both of those models are pointing to modest weakness, maybe a very modest recession. Other leading indicators we look at, particularly some that we like a lot, which is the relationship between manufacturing new orders and inventories, is actually getting better on the margin.
So the big picture here is, it looks like an economic slowdown in the first and second quarter of next year, maybe something like half a percent to 1% growth. I have seen recession forecasts of minus 1%. And I've also seen a bullish GDP forecast for next year of 2%. So the numbers are all over the place. To us, it looks like some modest weakness next year, certainly in the first half of the year, in the neighborhood of a half a percent to 1% GDP growth.
Now the two biggest reasons, I think, why we haven't had a recession yet in spite of a whole lot of Fed tightening is shown in a couple of charts we have in the outlook, one of which looks at corporate interest payments and the other one looks at the corporate-sector financial balance. So normally, two things happen when the Fed raises rates. Number one, it catches the corporate sector off balance.
And the corporate sector typically, heading into a recession, is over spending in terms of cash-flow generation relative to its capital expenditures. And so all of a sudden, Fed tightening knocks the corporate sector for a loop. They have to tighten their belts really tightly. And that contributes to the recession. And on top of that, corporate interest payments go up a lot because of rising interest rates.
Well, this time neither of those two things is happening. This time corporate cash flow is in surplus as the Fed tightened. And for whatever reason, most of which has to do with the Fed-- with most companies having termed out their duration of their debts-- rising interest rates has not yet led to an increase in net interest payments as a percentage of profits. It's remarkable. We have a chart in here that shows just how unique that is.
It could have something to do with the fact that this was-- people had 10 years to, during a period of financial depression, to term out their debt maturities. And so finally they did. Now usually recessions begin around seven quarters after the first Fed hike. And that's where we stand right here, as 2024 begins. And so we don't know for sure that there's not going to be a recession and if there were one, it might not have already happened. It might be happening over the next two, three quarters. But again, right, now I think it's roughly a 50/50 call. And if it does happen, it's a mild one.
What's notable is for all of the consternation about commercial real estate, if you look at that cash flows and NOI and delinquencies, it's really just the regional malls and commercial urban office space that are getting crushed. The delinquency data is actually getting much better for hotels, industrials, multifamily, and even retail once you strip out the regional malls. And so we have a chart in here on that. It is consistent with an economy that has some real isolated weak points, namely regional malls and office, but where the rest of it is doing OK.
And similarly, in households, the scary cycles are when all the delinquency rates go up together. What we have now is a weird one, where subprime auto delinquencies are off-the-charts bad. But subprime auto is about 20% of the overall auto-origination market. So that's not terrible.
And credit card delinquencies are weakening. But prime auto loans and first and second mortgage delinquency rates are very well behaved and as tight as they've been over the last decade. So again, isolated pockets of weakness but nothing really systemic at this point.
Now as tarnished a phrase as "mission accomplished" has been historically in the United States, I think the Fed's mission is mostly accomplished. When we look at different cuts on CPI-- and we show three of them here-- and then we look at falling supply-chain pressures, rising auto inventories, falling used-vehicle prices, declines in very timely measures of residential rent inflation, and also very large amounts of multifamily supply coming online, I think the Fed's justified here in pivoting and thinking about easing rather than tightening.
Similarly, the wage-inflation numbers, those are the things that concern me more. A few months ago, I thought we maybe would be in a situation where consumer prices are falling but wages are really sticky and aren't falling. They've started to roll over-- from high levels, yeah-- but they're starting to roll over.
And then importantly, we're seeing a ton of data, most of which supports the fact that there's weakness in the labor market, declines in temporary help, manufacturing hours, unit labor costs, job-switcher premiums, like how much people get paid when they go from one job to another. Female labor force participation rates are rising. So a bunch of indicators suggest that wage inflation is going to be rolling over as well. So in terms of what the Fed is up to, I think they're justified in thinking about easing.
Now where does that leave the equity markets? The equity markets are-- they're not as expensive as they've been but again, they shouldn't be because now we're in an environment of positive real interest rates again. So those crazy high multiples in 2020 and '21 no longer make any sense at all.
And whether you're looking at the market cap, weighted S&P, or the equal-weighted S&P, the multiples are a little on the high side. To us, 2024 looks like a year with single-digit earnings growth, single-digit returns on the median stock. And if we have to go hunting for sectors, valuations in industrials and energy look interesting. And there's nothing, I think, that's going to stop the mega-cap stocks other than a large shift in antitrust enforcement, which we'll talk about in a minute.
But the bottom line here is that the rally towards the end of the year ended up with the market's pricing in a very soft landing already. So I think there's a lot of soft-landing good outcomes that are already priced into the markets.
All things considered, based on our views on growth, profits, and interest rates, a diversified portfolio with a US, tech, industrial and energy-tilted equities, long-duration municipals and treasuries and high-grade bonds, rather than high-yield, and a decent slug of cash seems to make the most sense heading into 2024.
We spent lots of time looking at the Magnificent Seven. And wish you didn't have to. And but we do. And those are the largest seven companies in the S&P. It reminds me-- when I joined JP Morgan in 1987 and then I worked in emerging markets, the emerging markets, fixed-income markets at the time, were so dominated that basically, Brazil, Mexico, and Argentina was all that really mattered. And all the other countries that they tried to stuff up in the index weren't large enough to affect anyone's portfolio.
We're getting close to that in the S&P 500. We're now at the highest-ever market cap, almost 30%, coming from just the largest seven companies. And if you think about returns last year, the market did great. The market was up 26%. But you had 78% coming from those seven stocks and 15% from the rest.
And then we have a whole bunch of charts in here that look like the one we're showing here, which is these Magnificent Seven stocks generate tons of free cash flow compared to the rest of the market, whose cash-flow generation has basically been flat over the last 18 to 24 months, and rising for the big seven.
So one of the things that we're very attentive to is, are these Magnificent Seven stocks getting too expensive and are going to come back to Earth, like an Icarus moment? If you look at their relative PE versus the market, it looks like they're getting more expensive. But because of the nature of these companies, I think you have to look at them and adjust the relative PE ratio by their relative earnings growth.
And if you do that, they don't look at a line, in which case, the higher valuations is a reflection of much higher earnings growth, both historical and expected. So that's why we spend so much time thinking about antitrust issues, because to me, that's really the one issue that could change the dynamic of profitability that these large companies have been benefiting from over the last decade.
And we have an antitrust monitor in the outlook. If you're not familiar with some of the concepts I'm about to rattle off, you probably should be because of how important they are. So in the antitrust monitor, we get into the issue of traffic-acquisition costs, which are the tens of billions of dollars a year that Google pays to Apple in exchange for having prime placement on those devices of Google search engines and play stores and things like that.
We get into the question of Google Play Store and Google Play billing policies on android phones, which was the topic of some lawsuits recently. Epic Games won a major judicial ruling against Google just this month, in December 2023, that is still reverberating but was quite a shock.
Google was forced to settle with 38 state attorney generals last month as well, where some restrictions are going to be imposed on them regarding their ability to ensure that other phones, android phones, can't come equipped with other app stores and other billing services.
A judge ruled that Apple is, in fact, exercising monopoly power and does, in fact, earn super-competitive commissions, but has some pro-competitive justifications for what it's doing. And there are also lawsuits going on with Meta, Amazon, and T-Mobile from the Department of Justice and the Federal Trade Commission relating to monopolistic behavior and personal social-networking markets, Amazon fulfillment services, anti-discounting tactics, class-action suits. And so it's four pages. It's worth a read, I think, because it does get into the issues that affect the core dominance of these large-cap stocks.
Now on the other hand, let's go to a place where it doesn't have any dominant large-cap technology stocks, which is Europe. I'm on strike in terms of writing a long section on Europe. It under performed the US again in 2023 by around 7%. It is now trading at almost a-- depending on how you measure it-- a 35% or 40% PE discount to the US.
And since 2014, this has been a one-way elevator down. And this has been the mother of all value traps. One day this will end. And one day it will make sense to be long Europe and short the US. After the history of certainly the last decade and the last 25 years or so, I don't think it's a good bet to think that 2024 is going to be that year.
Japan, on the other hand, is enacting all sorts of corporate-governance reforms that do create a better foundation for investing. And we have a table in the Eye on the Market that looks at just the stark difference between equity penetration of households and pensions and payout ratios and companies that trade below book value. You think about this. 4% of the US market cap trades below book value. In Japan, it's 50%.
And so we have this table that looks at some of these statistics. There's a lot of room from very low levels for Japan to enact some corporate-governance policies to try to re-equitize its society. It's aggressively trying to do that. We're seeing more outside directors. We're actually seeing the Tokyo Stock Exchange threaten to delist companies that don't take steps to trade above book value. So Japan had a good year last year.
But this one does seem like it has some legs. We have a section in here called The Low Spark of High-Yield Bonds. If anybody gets the reference, that's a reference to a Traffic song from 1971 with Steve Winwood.
High-yield bond spreads are low, close to the lowest they've been since 2009. We just want to make sure people understand that there are some reasons for that. Interest coverage is still pretty strong. The split between double B's and triple B's is a little better now. Fewer of the borrowers are private equity borrowers that tend to be associated with lower recovery rates in case of default. There's more secured debt. There's very little use of any PIK-bond-- Payment In Kind bonds. So compared to prior cycles, the spreads are a lot lower. But the risks are somewhat lower. So we thought that was worth mentioning.
The big issue here for fixed-income markets is what happens to the 10 year. So obviously we've had a big rally in the 10 year. The simplest way to think about it, our view, is that the 10 year will range from 4% to 5% in 2024. I'd be really surprised, without a deep recession, of a trade much tighter than that. If it does break out of that 4% to 5% range, my sense is that it might trade slightly above 5% because of bond issuance, which has lagged the budget deficit.
And we have a chart in the outlook that shows that the Treasury has fallen behind on issuance. It's at a very high level in terms of the T-bill share of total debt. The Fed's buying less. And the banks are buying less because they're already overloaded with too many underwater treasuries. So all things being equal, some of the financing pressures, I think, might push 10-year treasuries back closer to 5%, at which point, I think they would represent pretty good value.
So to close, I just want to talk about China for a minute. So I have some colleagues who I've worked with for many years that go to our Investment Committee gatherings. And we'll talk about the tremendous opportunity that may be brewing in China. It's been a train wreck of epic proportions for equity investors. And it has been hit with really bad timing. And there's a chart in here that-- I think it makes sense to look at and think about.
Over the last decade or so, as Chinese growth slowed, MSCI made the decision-- because they're the ones that make the decisions about index weights and countries-- they increased the China's weight in the emerging-market index from, let's say, 15% to 40%. So by the beginning of 2021, China represented 40% of the entire emerging-market equity index. So anybody that was anywhere close to index following would have owned tons of Chinese stocks at that point.
And right then, at that 40% index weight, is when China's Progressive Authoritarianism program began. And It started taking pot shots at industry after industry and company after company. And then the US trade war got worse. And over that time, China has under performed world equities by more than 50%. The numbers are just eye-poppingly bad. Since January 2009, US is up over 100%. Europe is up 60%, trailing. China is down 17%. So this is a train wreck.
And now the US Select Committee on Strategic Competition Between the US and China-- they don't pass legislation. But they're laying out a roadmap. The last bastion of partisanship left in the United States Congress are policy policies targeting the Chinese Communist Party. And there's bipartisan agreement for more tariffs, tighter restrictions on Chinese imports, more restrictions on high-tech exports to China, prohibitions of trade with a broader group of Chinese companies.
And then just last week or so, China enacted another policy which drove $0.10 stock down 10% in a day. So this is the ultimate value opportunity. For the last few years, it's been a terrible value trap. And we're monitoring the economic data, which is getting less bad. But at this point, it looks like China would have to do something really unorthodox in order to change sentiment around its economy, international investors, and sentiment about its markets.
Incoming FDI actually went negative last year for the first time in China. So when incoming FDI is negative, that means people are actually selling their investments and taking their money and going home. So I think it's important to monitor anything that gets this cheap.
But I'm not seeing too many catalysts right now. If you had a 5 or 7-year horizon and you believed that China was going to be forced to take steps to reintegrate its markets with the rest of the world, it's worth a look. But the way things stand right now, it's difficult sledding there.
So thanks for listening to this first of three podcasts. Stay tuned. The next one is going to be a deep dive on some research we've been doing around weight-loss drugs, how they work, who pays for them, what are their impact on co morbidities, how durable is the weight loss, and then what are the impacts on consumer behavior and equity markets as a result of higher adoption rates. And so thank you very much for listening. And we will see you next time. Thank you.
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Logo, J.P.Morgan. Text, 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 here in, please contact your J.P. Morgan representative. Investors may get back less than they invest, and past performance is not a reliable indicator of future results. Investment and insurance products: bullet, not a deposit. Bullet, not F.D.I.C. insured. Bullet, not insured by any federal government agency. Bullet, no bank guarantee. Bullet, May lose value.
A new slide has a digital art illustration of brown, grizzly, and polar bears flying through the air and tumbling onto a collection of fluffy white pillows. Text, 2024 Outlook, Pillow Talk. Michael Cembalest, Chairman of Market and Investment Strategy, J.P. Morgan Asset and Wealth Management. January 2024.
JPMorgan Chase Bank N.A. and its affiliates (collectively, quote, "JPMCB", unquote) offer investment products, which may include bank-managed accounts and custody, as part of its trust and fiduciary services. Other investment products and services, such as brokerage and advisory accounts, are offered through J.P. Morgan Securities LLC, quote, JPMS, unquote, a member of FINRA and S.I.P.C.. JPMCB and JPMS are affiliated companies under the common control of JPMorgan Chase & Company, Views expressed herein may differ from other JPMorgan Chase & Company affiliates and employees. This constitutes our judgment based on current market conditions and is subject to change without notice. This has not been prepared with any particular investor in mind, and it may not be suitable for all investors. Investors should speak to their financial representatives before engaging in any investment product or strategy. This material should not be regarded as research or as a J.P. Morgan Research Report. Outlooks and past performance are not reliable indicators of future results. Copyright 2023 JPMorgan Chase & Company, All Rights Reserved. Investment products. Bullet, not F.D.I.C. insured, Bullet, no bank guarantee, Bullet, may lose value. Michael Cembalest speaks in front of a background of shelves filled with ornate ledgers.
(SPEECH)
Good morning, everybody. Welcome to the 2024 Eye on the Market Outlook Podcast, which is entitled Pillow Talk. Some of you may remember that Pillow Talk was the name of a movie from the 1950s with Doris Day and Rock Hudson. If you haven't seen it, there was a Rock Hudson documentary that came out last year that's worth seeing.
Anyway, pillow talk here refers to the picture I have, with a bunch of bears falling into some pillows, which is a metaphor for the increasing talk about soft landing from a hard landing and from a bear market to a non-bear market. And a lot of that talk accelerated at the end of the year when the Fed signaled that they would, in fact, be easing monetary policy in 2024, some of which was predicted, but not quite as much as what's predicted right now, after some of those Fed announcements.
So I want to walk you through some of the topics that we covered in the outlook, some of which we'll discuss on the podcast today and some of which we'll discuss on a couple of podcasts being rolled out over the next couple of weeks.
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The slide transitions to a list of topic bullet points.
(SPEECH)
So what are the topics? Let's say we cover some really important leading indicators, which I think had a large role to play in the Fed changing its tune, the uninflation monitor that also is tied into the same thing.
We take a look at equity markets in the US and the issue around the mega-cap stocks which continue to dominate markets, an antitrust monitor which we'll discuss in this week's podcast, the latest on Europe and Japan, which are going in opposite directions, at least from the perspective of equity investors, a global fixed-income monitor, some additional comments on US federal debt sustainability, information on the US consumer, a section on China, and then we have a deep dive on weight-loss drugs.
I've been working on this for a little bit. And I thought it was interesting to include it here in the outlook instead of having it on a standalone basis. Maybe we'll issue it on a standalone basis later in the year. And then in honor of Byron Wien, who passed away last year at the age of 90, Byron used to publish a top-10 surprise list every year. In his honor, I'm going to do one this year as well.
So let's get into the details here.
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A new slide is titled Equities and Recessions. Text, Equities tend to bottom first during recessions. A chart with an X-axis labelled Months since beginning of recession, ranging from negative 6 to positive 32 months, has timelines for seven different recession events, respectively labelled COVID, GFC, DotCom, 1990's S&L, 1980's double dip, '70s stagflation, and Eisenhower, from top to bottom. To the right of the graph is a legend titled, Symbols, Time of worst reading, with symbols for Equities, I.S.M. survey, GDP, payrolls, S&P earnings, housing starts, High Yield default rates, real estate delinquencies, and end of recession. The symbols are placed in their respective positions to indicate their respective times of worst reading along each of the seven timelines. For all recessions except the DotCom, the red diamonds representing equities are all relatively towards the left compared to most or all of the other indicator symbols. Text, Source, B.E.A., Census, N.A.R., Shiller, Bloomberg, S&P slash Dow Jones, JPMAM, 2023. Past performance is not indicative of future results.
(SPEECH)
The first chart we have in the outlook is by far the messiest chart I have ever created. But it's worth it. I promise, it's worth it because what it shows is the seven post-war recessions that took place and the sequencing of when things hit bottom, whether they were the equity markets or payrolls or housing starts, default rates, the ISM surveys, GDP. And what you can see here is that with the exception of the.dot.com cycle in 2001, equities bottomed way before the worst readings on the other stuff.
So obviously, everybody's recession forecast-- or most recession forecasts for 2024 are going down with the Fed, easing. But even if there is a recession, I think the important point is that equities tend to bottom way before a lot of the other economic and market data that people tend to focus on, which I think is really important to understand as we head into the next year.
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A new slide has a chart titled, Text, Modest weakness, Coincident and leading economic indicators, percent, Year over year. Its x-axis runs from 1970 to 2023 and its y-axis from negative 10% to positive 10%. It features a solid blue line labelled, coincident indicators, left hand side, and a dashed gold line labelled Leading indicators, right hand side. The two lines are well correlated, and the dashed gold line generally makes movements slightly before the blue line. In the most recent years of the graph, however, the leading indicators are declining sharply, towards roughly negative 8 percent Year over year, while the blue line is still hovering at roughly positive 3 percent. Text, Source, Conference Board, J.P.M.A.M., November 2023.
(SPEECH)
Now there are 20-- or at least 22 different leading indicators that we follow on a weekly basis. I just wanted to share two of them that are sending a consistent signal, which is that the coincident indicator, which tells you what's happening right now, looks fine. But the leading indicators look weak. They don't look catastrophically weak. They don't look as weak as they looked in 2020, during COVID.
They don't look as weak as what they did during the 1970s. And they certainly don't look as weak as they did in 2008-2009. But they look like-- they're signaling a run of the mill decline in US economic activity which is consistent with a recession.
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A new slide titled Modest Weakness has a chart titled, Fed funds, effective corporate tax rate, unemployment, productivity growth, right arrow, corporate profits, percent Year on Year. The x-axis ranges from 1998 to 2003 and the chart features a solid blue line labelled Corporate profits model and a dashed gold line labelled Leading Indicator model, 18 month lead. . The two lines are fairly well correlated, and the peaks and troughs of the gold line tend to lead the blue line slightly. To the far right, the gold line is pushing towards negative 15%, while the blue line is dipping slightly below the x-axis. Text, Source, Piper Sandler, Q3 2023.
(SPEECH)
And then there's another model that we tend to look at, that looks at a few different variables. And then we extrapolate it out for 18 months. And it does suggest that there will be decline in corporate profits this year. And so both of those models are pointing to modest weakness, maybe a very modest recession. Other leading indicators we look at, particularly some that we like a lot, which is the relationship between manufacturing new orders and inventories, is actually getting better on the margin.
So the big picture here is, it looks like an economic slowdown in the first and second quarter of next year, maybe something like half a percent to 1% growth. I have seen recession forecasts of minus 1%. And I've also seen a bullish GDP forecast for next year of 2%. So the numbers are all over the place. To us, it looks like some modest weakness next year, certainly in the first half of the year, in the neighborhood of a half a percent to 1% GDP growth.
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A new slide is titled, Why hasn't the increase in Fed policy rates caused a US recession? It has two charts. The one at left is labelled, Corporate net interest costs stable despite rising funds rate. It has an x-axis ranging from 1970 to present and features a solid red line labelled, Corporate net interest payments as a percent of after-tax NIPA profits, with a y-axis ranging from 0 to 120%, as well as a dashed black line labelled, Fed funds rate, with a y-axis ranging from 0 to 20%. Periods of recession are shaded in gray, and the lines appear broadly correlated. At the far right, the dashed black line is spiking from 0% in 2020 towards 6% while the solid red line is continuing to decline from about 35% in 2020 towards about 10%. Text, Source, Bloomberg, JPMAM, Q3 2023.
The chart at right is labelled, US corporate sector financial balance, % of corporate gross value added, 4-quarter average. It has an x-axis ranging from 1960 to present with periods of recession shaded in gray, and features a solid blue line labelled, Gross savings less capital transfers, capital expenditures and foreign profits retained abroad, with a y-axis labelled from negative 6% to positive 4%. Most troughs of the line coincide with the periods of recession and those that do are marked with red arrows. Text, Source, Federal Reserve, B.E.A., JPMAM, Q3 2023.
(SPEECH)
Now the two biggest reasons, I think, why we haven't had a recession yet in spite of a whole lot of Fed tightening is shown in a couple of charts we have in the outlook, one of which looks at corporate interest payments and the other one looks at the corporate-sector financial balance. So normally, two things happen when the Fed raises rates. Number one, it catches the corporate sector off balance.
And the corporate sector typically, heading into a recession, is over spending in terms of cash-flow generation relative to its capital expenditures. And so all of a sudden, Fed tightening knocks the corporate sector for a loop. They have to tighten their belts really tightly. And that contributes to the recession. And on top of that, corporate interest payments go up a lot because of rising interest rates.
Well, this time neither of those two things is happening. This time corporate cash flow is in surplus as the Fed tightened. And for whatever reason, most of which has to do with the Fed-- with most companies having termed out their duration of their debts-- rising interest rates has not yet led to an increase in net interest payments as a percentage of profits. It's remarkable. We have a chart in here that shows just how unique that is.
It could have something to do with the fact that this was-- people had 10 years to, during a period of financial depression, to term out their debt maturities. And so finally they did. Now usually recessions begin around seven quarters after the first Fed hike. And that's where we stand right here, as 2024 begins. And so we don't know for sure that there's not going to be a recession and if there were one, it might not have already happened. It might be happening over the next two, three quarters. But again, right, now I think it's roughly a 50/50 call. And if it does happen, it's a mild one.
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A new slide is titled, Text, CMBS delinquencies remain low for all but regional malls and office. It has a chart labelled, CMBS delinquencies by property type, with an x-axis running from 2001 to present and a y-axis labelled from 0% to 25%. It features seven colored lines, respectively labelled Regional malls, Retail, Hotel, Retail excluding regional malls, Office, Multifamily, and, Industrial. The lines are all declining after a spike around 2020 except for the orange regional malls line, which has returned above 20%, and the blue office line, which is trending upwards beyond 5%. Text, Source, Moody's JPMAM, November 2023.
(SPEECH)
What's notable is for all of the consternation about commercial real estate, if you look at that cash flows and NOI and delinquencies, it's really just the regional malls and commercial urban office space that are getting crushed. The delinquency data is actually getting much better for hotels, industrials, multifamily, and even retail once you strip out the regional malls. And so we have a chart in here on that. It is consistent with an economy that has some real isolated weak points, namely regional malls and office, but where the rest of it is doing OK.
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A new slide titled, Delinquencies rising for subprime auto and credit cards, has a chart titled, US 90+ days loan delinquency transition rates. It has an x-axis ranging from 2004 to 2024 and a y-axis ranging from 0% to 6% and features five colored lines respectively labelled Subprime auto loans, credit cards, auto loans, first mortgage, and second mortgage. At the far right of the chart, only subprime auto loans and credit card delinquencies are still rising significantly, above and approaching 4%, respectively. Text, Source, Experian, S&P Down Jones Indices, JPMAM, July 2023.
(SPEECH)
And similarly, in households, the scary cycles are when all the delinquency rates go up together. What we have now is a weird one, where subprime auto delinquencies are off-the-charts bad. But subprime auto is about 20% of the overall auto-origination market. So that's not terrible.
And credit card delinquencies are weakening. But prime auto loans and first and second mortgage delinquency rates are very well behaved and as tight as they've been over the last decade. So again, isolated pockets of weakness but nothing really systemic at this point.
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A new slide labelled, Inflation Monitor, Mission mostly accomplished, has a chart titled, US consumer price inflation measures, percent, 3 month annualized change. Its x-axis ranges from 1985 to present and its y-axis from 0 to 9%, and it has three tightly correlated lines respectively labelled as Cleveland Fed median CPI, Atlanta Fed sticky CPI, and Cleveland Fed trimmed mean CPI. All three lines spike during Covid but are returning to points closer to their 2020 values.Text, Source, Bloomberg, JPMAM, November 2023. To the right of the chart is text. Bullet, Falling supply chain pressures. Bullet, Rising auto inventories. Bullet, Falling used vehicle values. Bullet, Declines in timely measures of residential rent inflation. Bullet, Residential real estate supply coming online, particularly in multifamily.
(SPEECH)
Now as tarnished a phrase as "mission accomplished" has been historically in the United States, I think the Fed's mission is mostly accomplished. When we look at different cuts on CPI-- and we show three of them here-- and then we look at falling supply-chain pressures, rising auto inventories, falling used-vehicle prices, declines in very timely measures of residential rent inflation, and also very large amounts of multifamily supply coming online, I think the Fed's justified here in pivoting and thinking about easing rather than tightening.
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A new slide labelled Wage inflation has a chart labelled Wage inflation measures, percent, running from 1985 to present with a y-axis labelled from 0% to 8%. It has a blue line labelled Negotiated raises, average year 1 raise in union contracts, a gold line labelled Atlanta Fed Wage Tracker, and a red line labelled Employment Cost Index Year over year wages. The first two indicators have recently peaked or plateaued around 7%, while the third has recently peaked around 5%. Text, Source, BLS, Bloomberg Law, JPMAM, Q3 2023. To the right is text. Bullet, observed declines in, bullet, temporary help, bullet, manufacturing and overtime hours, bullet, unit labor costs, Quote Job switcher versus job stayer unquote, premium, bullet, share of private industries with rising employment, bullet, voluntary quits rate. Bullet, Rising female labor force participation.
(SPEECH)
Similarly, the wage-inflation numbers, those are the things that concern me more. A few months ago, I thought we maybe would be in a situation where consumer prices are falling but wages are really sticky and aren't falling. They've started to roll over-- from high levels, yeah-- but they're starting to roll over.
And then importantly, we're seeing a ton of data, most of which supports the fact that there's weakness in the labor market, declines in temporary help, manufacturing hours, unit labor costs, job-switcher premiums, like how much people get paid when they go from one job to another. Female labor force participation rates are rising. So a bunch of indicators suggest that wage inflation is going to be rolling over as well. So in terms of what the Fed is up to, I think they're justified in thinking about easing.
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A new slide labelled P/E multiples has a chart titled S&P 500 valuations, forward P/E multiple, ranging from 1995 to present and with a y-axis ranging from 12 to 24x. It has a blue line, labelled S&P 500, market-cap weighted which is recently creeping up towards a value of 19x, and a gold line, labelled S&P 500 equal-weighted, which is recently creeping up towards a value of 16x. Text, Source, Factset, JPMAM, December 26, 2023. To the right is text, Bullet, Single digit earnings growth, bullet, single digit returns on the median stock, bullet, compelling valuations in industrials and energy, bullet, continued outperformance of the megacap stocks absent a sharp shift in antitrust enforcement.
(SPEECH)
Now where does that leave the equity markets? The equity markets are-- they're not as expensive as they've been but again, they shouldn't be because now we're in an environment of positive real interest rates again. So those crazy high multiples in 2020 and '21 no longer make any sense at all.
And whether you're looking at the market cap, weighted S&P, or the equal-weighted S&P, the multiples are a little on the high side. To us, 2024 looks like a year with single-digit earnings growth, single-digit returns on the median stock. And if we have to go hunting for sectors, valuations in industrials and energy look interesting. And there's nothing, I think, that's going to stop the mega-cap stocks other than a large shift in antitrust enforcement, which we'll talk about in a minute.
But the bottom line here is that the rally towards the end of the year ended up with the market's pricing in a very soft landing already. So I think there's a lot of soft-landing good outcomes that are already priced into the markets.
All things considered, based on our views on growth, profits, and interest rates, a diversified portfolio with a US, tech, industrial and energy-tilted equities, long-duration municipals and treasuries and high-grade bonds, rather than high-yield, and a decent slug of cash seems to make the most sense heading into 2024.
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A new slide titled The Magnificent Seven has a chart titled, Market cap of largest 7 companies in S&P 500, percent of total index market cap ranges from 1996 to present and has a y-axis labelled from 12% to 30%. Starting around 14% in 1996, it peaks at 22% around 2000 before falling again until 2017, after which it surges up to 28 today. Text, Source, FactSet, JPMAM, December 26, 2023.
(SPEECH)
We spent lots of time looking at the Magnificent Seven. And wish you didn't have to. And but we do. And those are the largest seven companies in the S&P. It reminds me-- when I joined JP Morgan in 1987 and then I worked in emerging markets, the emerging markets, fixed-income markets at the time, were so dominated that basically, Brazil, Mexico, and Argentina was all that really mattered. And all the other countries that they tried to stuff up in the index weren't large enough to affect anyone's portfolio.
We're getting close to that in the S&P 500. We're now at the highest-ever market cap, almost 30%, coming from just the largest seven companies.
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To the right of the chart is text, Bullet, S&P 500 2023 Year-to-date return, 26%. Bullet, Mag 7 2023 Year-to-date return, 78%. S&P 500 ex-Mag 7 Year-to-date return, 15%.
(SPEECH)
And if you think about returns last year, the market did great. The market was up 26%. But you had 78% coming from those seven stocks and 15% from the rest.
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A new slide titled Free Cash Flow Machines has a chart titled, Magnificent 7 growth in free Cash flow versus the rest of S&P 500, Index, 100 equals January 1, 2018, 90-day smoothing. It ranges from 2018 through the present and features a blue line labelled Magnificent 7 and a gold line labelled S&P 500 ex-Mag 7. The blue line peaks around 200 in mid-2022 before shooting up to around 230 at present. The gold line plateaus around 160 in mid-2022 before drifting back down to around 150 at present. Text, source, Bloomberg, JPMAM, December 27, 2023.
(SPEECH)
And then we have a whole bunch of charts in here that look like the one we're showing here, which is these Magnificent Seven stocks generate tons of free cash flow compared to the rest of the market, whose cash-flow generation has basically been flat over the last 18 to 24 months, and rising for the big seven.
(DESCRIPTION)
A new slide title Valuations adjusted for earnings growth has a chart labelled, Valuations of Magnificent 7 versus median S&P 500 stock. It ranges from 2013 to present and has a y-axis labelled from 0.4x to 2.0x. It features a red line labelled Relative P/E and a blue line labelled Relative P/E ratios adjusted for long term earnings growth expectations. The red line begins at 0.8x in 2013 and peaks near 1.9x in 2022 before falling to 1.4x, then finally rebounding to 1.7x today, while the blue line begins at 0.5x in 2013 and peaks around 1.4x in late 2022, before falling back to 0.9x today. Text, Source, GS Global Investment Research, JPMAM, November 2023.
(SPEECH)
So one of the things that we're very attentive to is, are these Magnificent Seven stocks getting too expensive and are going to come back to Earth, like an Icarus moment? If you look at their relative PE versus the market, it looks like they're getting more expensive. But because of the nature of these companies, I think you have to look at them and adjust the relative PE ratio by their relative earnings growth.
And if you do that, they don't look at a line, in which case, the higher valuations is a reflection of much higher earnings growth, both historical and expected. So that's why we spend so much time thinking about antitrust issues, because to me, that's really the one issue that could change the dynamic of profitability that these large companies have been benefiting from over the last decade.
And we have an antitrust monitor in the outlook. If you're not familiar with some of the concepts I'm about to rattle off, you probably should be because of how important they are.
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A new slide is titled, Antitrust Monitor. If you are not familiar with these issues, you should be. It contains 9 bullet points which Michael Cembalest addresses.
(SPEECH)
So in the antitrust monitor, we get into the issue of traffic-acquisition costs, which are the tens of billions of dollars a year that Google pays to Apple in exchange for having prime placement on those devices of Google search engines and play stores and things like that.
We get into the question of Google Play Store and Google Play billing policies on android phones, which was the topic of some lawsuits recently. Epic Games won a major judicial ruling against Google just this month, in December 2023, that is still reverberating but was quite a shock.
Google was forced to settle with 38 state attorney generals last month as well, where some restrictions are going to be imposed on them regarding their ability to ensure that other phones, android phones, can't come equipped with other app stores and other billing services.
A judge ruled that Apple is, in fact, exercising monopoly power and does, in fact, earn super-competitive commissions, but has some pro-competitive justifications for what it's doing.
(DESCRIPTION)
Text, Bullet, Google and Apple, injunctive relief versus damages. Bullet, Meta, personal social networking market, Instagram and WhatsApp. Bullet, Amazon, Prime customers, Amazon fulfillment and anti-discounting tactics. Bullet, T-Mobile, Sprint acquisition and AT&T slash Verizon subscriber class action suit.
(SPEECH)
And there are also lawsuits going on with Meta, Amazon, and T-Mobile from the Department of Justice and the Federal Trade Commission relating to monopolistic behavior and personal social-networking markets, Amazon fulfillment services, anti-discounting tactics, class-action suits. And so it's four pages. It's worth a read, I think, because it does get into the issues that affect the core dominance of these large-cap stocks.
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A new slide titled Europe has a chart labelled, Europe P/E discount versus US. Relative P/E discount based on forward earnings. It ranges from 2006 to present and has a y-axis labelled from 0% to negative 40%. It features a gold line labelled Bloomberg and a blue line labelled Datastream, which are tightly correlated. Both begin in the 10% to 15% range in 2006 before dropping to the 25% to 30% range circa 2009. They then rebound towards the 2006 figures around 2015 before continuously declining to the negative 35% to 40% range now. Text, Source, Bloomberg, Datastream, JPMAM, December 1, 2023.
(SPEECH)
Now on the other hand, let's go to a place where it doesn't have any dominant large-cap technology stocks, which is Europe. I'm on strike in terms of writing a long section on Europe. It under performed the US again in 2023 by around 7%. It is now trading at almost a-- depending on how you measure it-- a 35% or 40% PE discount to the US.
And since 2014, this has been a one-way elevator down. And this has been the mother of all value traps. One day this will end. And one day it will make sense to be long Europe and short the US. After the history of certainly the last decade and the last 25 years or so, I don't think it's a good bet to think that 2024 is going to be that year.
(DESCRIPTION)
A new slide is titled, Japanese corporate governance reforms create a better foundation for investing. It has a table titled, Room for Japan to, quote, equitize, unquote. The table has two columns comparing the U.S. and Japan on 7 criteria, including 10-year dividend payout ratio, 70% versus 30%, cash % of market capitalization, 7% versus 21%, share of companies trading below book value, 4% versus 50%, corporate buybacks as % of market capitalization, 2.0% to 3.5% versus 0.7% to 1.4%, Household equity allocation 40% versus 11%, pension equity allocation 40% versus 25%, and household cash allocation 15% versus 55%. Text, Source, Bridgewater, JPMAM, December 2023.
(SPEECH)
Japan, on the other hand, is enacting all sorts of corporate-governance reforms that do create a better foundation for investing. And we have a table in the Eye on the Market that looks at just the stark difference between equity penetration of households and pensions and payout ratios and companies that trade below book value. You think about this. 4% of the US market cap trades below book value. In Japan, it's 50%.
And so we have this table that looks at some of these statistics. There's a lot of room from very low levels for Japan to enact some corporate-governance policies to try to re-equitize its society. It's aggressively trying to do that. We're seeing more outside directors. We're actually seeing the Tokyo Stock Exchange threaten to delist companies that don't take steps to trade above book value. So Japan had a good year last year.
But this one does seem like it has some legs.
(DESCRIPTION)
A new slide is titled The low spark of high yield bonds. At left is a chart labelled, US high yield bond spreads, JPDFHTI index spread versus U.S.T., basis points. It ranges from 1995 to present and has a y-axis labelled from 200 to 1400. The line begins around 400 in 1995 before spiking above 1000 in the early 2000s, exceeding 1400 during the Great Financial Crisis, then proceeds through a series of further peaks and troughs to finish below 400 at present.
(SPEECH)
We have a section in here called The Low Spark of High-Yield Bonds. If anybody gets the reference, that's a reference to a Traffic song from 1971 with Steve Winwood.
(DESCRIPTION)
To the right is, text, Compared to prior cycles, bullet, stronger interest coverage, better double B slash triple C mix, bullet, lower share of private equity borrowers that are associated with lower recovery rates, bullet, higher share of secured debt, bullet, less use of payment-in-kind bonds. High yield energy spreads are roughly the same as the broad High Yield market but reflect a more profitable universe whose weakest links have mostly defaulted already. The double B slash triple C energy mix is now 63% slash 5%.
(SPEECH)
High-yield bond spreads are low, close to the lowest they've been since 2009. We just want to make sure people understand that there are some reasons for that. Interest coverage is still pretty strong. The split between double B's and triple B's is a little better now. Fewer of the borrowers are private equity borrowers that tend to be associated with lower recovery rates in case of default. There's more secured debt. There's very little use of any PIK-bond-- Payment In Kind bonds. So compared to prior cycles, the spreads are a lot lower. But the risks are somewhat lower. So we thought that was worth mentioning.
(DESCRIPTION)
A new slide is titled, Treasury bond issuance, demand and the 10-year Treasury. It has four charts. The top left is labelled, Bond issuance versus budget deficit, percent of GDP. It ranges from 2005 to present and has a y-axis labelled from 0% to 20%. It features a red line labelled budget deficit and a blue line labelled net bond issuance. These lines are tightly coupled and spike during the Great Financial Crisis, then more sharply again during COVID. They remain tightly coupled until late 2022, when the budget deficit begins to increase to the 6 to 8% range while the net bond issuance crashes to the 0 to 2% range. Text, Source, US Treasury, JPMAM, November 2023.
The top right chart is labelled, US T-Bill share of US debt, percent. It ranges from 1995 to 2023 and has a y-axis labelled from 5% to 30%. It begins near 25%, spikes to 35% during the Great Financial Crisis, then, declines to 10% in 2016 before spiking again to 25% during Covid, falling to 15% in 2022, and recovering past 20% today. Text, Source, US Treasury, JPMAM, November 2023. The lower right chart is labeled, Bank purchases of treasuries, percent of GDP. It ranges from 1970 to 2025 and has a y-axis labelled from negative 2% to positive 5%. It shows several large spikes, but none beyond 3% until it spikes beyond 4% during COVID. It then declines to a trough of negative 1% in 2022 to 2023. Text, Source, Federal Reserve, JPMAM, Q3 2023.
Finally, the bottom left chart is labelled Federal reserve Balance Sheet, percent of GDP. It ranges from 1991 to today and has a y-axis labelled from 0% to 40%. It hovers around 5% until the Great Financial Crisis, then spikes as high as 25% in 2023 and ultimately beyond 35% during COVID before declining below 30% today. Text, Source, Bloomberg, JPMAM, November 2023.
(SPEECH)
The big issue here for fixed-income markets is what happens to the 10 year. So obviously we've had a big rally in the 10 year. The simplest way to think about it, our view, is that the 10 year will range from 4% to 5% in 2024. I'd be really surprised, without a deep recession, of a trade much tighter than that. If it does break out of that 4% to 5% range, my sense is that it might trade slightly above 5% because of bond issuance, which has lagged the budget deficit.
And we have a chart in the outlook that shows that the Treasury has fallen behind on issuance. It's at a very high level in terms of the T-bill share of total debt. The Fed's buying less. And the banks are buying less because they're already overloaded with too many underwater treasuries. So all things being equal, some of the financing pressures, I think, might push 10-year treasuries back closer to 5%, at which point, I think they would represent pretty good value.
(DESCRIPTION)
A new slide is titled China, Really bad timing. It features a chart labelled, China's index weight, performance and Policy changes. It ranges from 2005 to present and features a blue line labelled, Rolling 3 Year performance of China versus World equities, left hand side, with y-axis labelled from negative 100% to positive 350%, and a brown line labelled, China weight in MSCI EM, right hand side, with y-axis labelled from 0% to 45%. A dashed vertical line at 2021 is labelled, Xi's progressive authoritarianism begins. The blue ling begins around 50% in 2005 before spiking to 300% around 2008, then declining towards a minimum of negative 50% around 2015 before recovering slightly above 0% in the late 2010s. It then heads firmly negative to below negative 50% after 2021. The brown line begins at roughly negative 2% in 2005 and rises steadily to peak above 40% around 2020 before declining sharply to just above 30% today. Text, Source, Bloomberg, JPMAM, December 22, 2023.
(SPEECH)
So to close, I just want to talk about China for a minute. So I have some colleagues who I've worked with for many years that go to our Investment Committee gatherings. And we'll talk about the tremendous opportunity that may be brewing in China. It's been a train wreck of epic proportions for equity investors. And it has been hit with really bad timing. And there's a chart in here that-- I think it makes sense to look at and think about.
Over the last decade or so, as Chinese growth slowed, MSCI made the decision-- because they're the ones that make the decisions about index weights and countries-- they increased the China's weight in the emerging-market index from, let's say, 15% to 40%. So by the beginning of 2021, China represented 40% of the entire emerging-market equity index. So anybody that was anywhere close to index following would have owned tons of Chinese stocks at that point.
And right then, at that 40% index weight, is when China's Progressive Authoritarianism program began. And It started taking pot shots at industry after industry and company after company. And then the US trade war got worse. And over that time, China has under performed world equities by more than 50%. The numbers are just eye-poppingly bad. Since January 2009, US is up over 100%. Europe is up 60%, trailing. China is down 17%. So this is a train wreck.
And now the US Select Committee on Strategic Competition Between the US and China-- they don't pass legislation. But they're laying out a roadmap. The last bastion of partisanship left in the United States Congress are policy policies targeting the Chinese Communist Party. And there's bipartisan agreement for more tariffs, tighter restrictions on Chinese imports, more restrictions on high-tech exports to China, prohibitions of trade with a broader group of Chinese companies.
(DESCRIPTION)
Text, Equity returns since January 2019, U.S. 107%, Europe 58%, China negative 17%.
(SPEECH)
And then just last week or so, China enacted another policy which drove $0.10 stock down 10% in a day. So this is the ultimate value opportunity. For the last few years, it's been a terrible value trap. And we're monitoring the economic data, which is getting less bad. But at this point, it looks like China would have to do something really unorthodox in order to change sentiment around its economy, international investors, and sentiment about its markets.
Incoming FDI actually went negative last year for the first time in China. So when incoming FDI is negative, that means people are actually selling their investments and taking their money and going home. So I think it's important to monitor anything that gets this cheap.
But I'm not seeing too many catalysts right now. If you had a 5 or 7-year horizon and you believed that China was going to be forced to take steps to reintegrate its markets with the rest of the world, it's worth a look. But the way things stand right now, it's difficult sledding there.
(DESCRIPTION)
Text, A new slide is titled, Stay tuned for additional podcasts on weight loss drugs and my top ten surprises for 2024. It features a 3D cartoon image of a rotund light-colored character in a black bowtie and tophat sitting at a honky tonk piano with a band in the background.
(SPEECH)
So thanks for listening to this first of three podcasts. Stay tuned. The next one is going to be a deep dive on some research we've been doing around weight-loss drugs, how they work, who pays for them, what are their impact on co morbidities, how durable is the weight loss, and then what are the impacts on consumer behavior and equity markets as a result of higher adoption rates. And so thank you very much for listening. And we will see you next time. Thank you.
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Logo, J.P.Morgan.
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