Our latest thoughts on inflation, elections, all-time highs, and more.
Authored by: Madison Faller and Matthew Landon
Last week was a tale of two halves.
The start of the week was dominated by Tuesday’s hotter-than-expected U.S. CPI print that sent both stocks and bonds reeling. But after some softer data that quelled those worries, the S&P 500 made a new high and closed out the week not too far from where it started it.
Since releasing our Outlook 2024, our strategists have hit the road across the globe to bring our views to investors. Today, we share the top questions we’re hearing – and our answers:
- How can you be so sure the inflation problem is over? The U.S. economy seems pretty strong.
- What do geopolitical tensions in the Middle East mean for inflation?
- Stocks have already rallied a lot. Should I just wait to invest?
- If [insert Trump or Biden here] wins the U.S. election, what does this mean for markets?
- The U.S. debt situation is worrying. Is this a problem, and what's the potential impact?
- Why bother with active management? It doesn’t feel worth the cost.
1) How can you be so sure the inflation problem is over? The U.S. economy seems pretty strong.
Last week’s U.S. CPI print reminded investors that the path back to 2% inflation probably isn’t a straight line. The reality check may have been needed: heading into the year, markets had been betting on an arguably overexuberant path for rate cuts (at one point calling for ~170 basis points (bps) worth of Federal Reserve cuts in 2024).
Expectations seem more reasonable today, and looking at the bigger picture, inflation is still trending in the right direction. That is good news, given that Fed Chair Powell was clear that we just need to see a continuation rather than an improvement of current inflation trends to get comfortable with rate cuts this year. Each of the three key drivers of inflation – the labor market, shelter and supply chains – are still showing promising signs. Last week’s data showed us that this is broadly consistent with the trend here in Europe and the UK too.
But why would the Fed cut rates at all if the economy is so strong? At today’s levels, policy rates are restrictive. Consider that the real policy rate has actually risen as inflation has decelerated, even though the Fed has stopped hiking. This means that as inflation continues to move lower, central banks need to cut just in order to maintain the same level of restrictiveness. Policymakers are thus tasked with balancing the risks of inflation reaccelerating against the risks of overtightening. We think 125bps worth of rate cuts this year seems reasonable.
This line chart shows the real Federal funds rate, defined as the Federal funds rate minus U.S. headline CPI inflation from 1972 to 2024.
The line starts at 0% in 1972 and increases to almost 5% over the next two years before falling sharply to -5.2% by early 1975. From there, the rate increases over the next several years to a series peak of 10% by 1981 and then declines over the next decade back towards 0% by 1993. There is than a jump back up towards 4% in the late 1990s before falling to -2% in 2004, moving back up to 4% over the next two years, and then collapsing back to -4% during the global financial crisis in 2008. From there, the real rate then fluctuates between 0% and -2% over the next decade. In late 2020, a sharp decline begins from 0% to the series low of -8% by March 2022. Since then, the real rate has rebounded to today’s level at 2.4%.
The chart also contains a marker at 3.5%, which denotes the real rate that we would see if inflation returned to 2% and the Fed didn’t cut.
2) What do geopolitical tensions in the Middle East mean for inflation?
We’ve already seen shipping costs spike, and some companies have been citing supply chain worries in their earnings calls.
However, context is important. Disruptions in the Red Sea are just making trade more difficult, with container ships circumnavigating around Africa rather than through the Suez Canal – far from a complete stop as we saw during the pandemic. This has meant that while shipping costs have spiked, they remain more than 60% below their 2020 highs.
The pressure we are feeling also may abate soon. Consider what we heard last week from shipping giant Maersk, often viewed as a barometer for global trade. While it acknowledged the uncertainty around the situation, it also noted that more new vessels are on their way to market than needed to send ships around Africa instead, cushioning the impact of higher expected journey times and higher freight rates.
Finally, we anticipate little feed through into inflation as it is. Goods account for just about one-third of U.S. PCE (the Fed’s preferred gauge of inflation) – and only about one-third of that can also be traced to imports. Moreover, only 4% of the cargo through the Suez Canal is traveling to America. For Europe, the impact could be slightly more meaningful, as goods account for more than half of the inflation basket and ~40% of the Suez Canal cargo ends up in the region. We don’t think that this will alter the path of central banks for now, but it is a tail risk that warrants monitoring.
3) Stocks have already rallied a lot. Should I just wait to invest?
U.S. stocks have rallied over 20% in just a matter of months. Questions abound over whether sitting on the sidelines means you’ve “missed it”.
History tells us that investing when the market is at an all-time high often spells for solid future returns. Over the last 50-odd years (going back to 1970), if you invested in the S&P 500 at an all-time high, your investment would have been higher a year later 70% of the time, with an average return of 9.4%—versus the 9.0% on average when investing at any time.
We also think today’s backdrop could be a good one for stocks. Some inflation (i.e., headline CPI within a 2-3% range) tends to be good for corporate earnings. Indeed, this Q4 earnings season stands to mark a second straight quarter of growth after almost a year of contraction. Stellar results from big tech have shown those companies as worthy of their rallies. Chipmaker Nvidia overtook both Alphabet and Amazon last week to become the third-largest company in the world. Meanwhile, other sectors are also joining in. Since late October, the equally weighted S&P 500 has kept pace with the market cap-weighted index, and U.S. small caps have actually outperformed.
This bar chart shows the year-over-year earnings per share growth for the S&P 500 from Q1 2017 to Q3 2023, with consensus expectations shown for Q4 2023 to Q4 2025.
The historical data shows the following EPS growth rates by quarter:
Q1 ’17: 14.8%
Q2 ’17: 10.4%
Q3 ’17: 7.0%
Q4 ’17: 21.4%
Q1 ’18: 24.4%
Q2 ’18: 25.6%
Q3 ’18: 26.9%
Q4 ’18: 14.7%
Q1 ’19: 0.8%
Q2 ’19: 0.5%
Q3 ’19: -1.2%
Q4 ’19: 1.5%
Q1 ’20: -14.2%
Q2 ’20: -33.6%
Q3 ’20: -8.2%
Q4 ’20: 0.8%
Q1 ’21: 47.1%
Q2 ’21: 89.0%
Q3 ’21: 38.6%
Q4 ’21: 27.7%
Q1 ’22: 12.7%
Q2 ’22: 9.1%
Q3 ’22: 3.0%
Q4 ’22: -2.8%
Q1 ’23: -3.6%
Q2 ’23: -3.4%
Q3 ’23: 6.1%
The consensus expectations show the following EPS growth rates:
Q4 ’24: 8.4%
Q1 ’25: 3.8%
Q2 ’25: 8.8%
Q3 ’25: 8.0%
Q4 ’25: 14.4%
Q1 ’26: 15.1%
Q2 ’26: 14.3%
Q3 ’26: 12.8%
Q4 ’26: 12.7%
4) If [insert Trump or Biden here] wins the U.S. election, what does this mean for markets?
The U.S. election came up in virtually every event. To start, it’s worth remembering that returns in election years and non-election years haven’t been all that different, with both producing solid returns.
The chart shows the S&P 500 average annual price returns from 1926-2023 in election years versus non-election years.
In an election year the average return is 7.5% while the non-election year average is 8.0%.
As we get closer to November, we’re starting to piece together what potential Trump and Biden policy proposals might mean for our outlook. Trump has already proposed a new round of tariffs on imports from foreign countries, an extension of the 2017 Tax Cuts and Jobs Act (TCJA), more defense spending and deregulation. On net, our initial sense is that such a scenario could lift bond yields, support small- and mid-cap stocks, and push the dollar higher. On the other hand, Biden may keep some parts of the TCJA but make shifts toward Democrats’ preferences, signal tighter regulation (we’ve already seen a rise in big tech antirust cases), protect and build on the Affordable Care Act, and focus on multilateralism and the energy transition.
In the end, long-term investors have a good track record when it comes to dealing with elections. After all, they happen every four years. Historically, macro factors tend to matter most for broad markets, with policy shifts most impactful at the industry and asset class level. Based on the economic backdrop we see today, we think either candidate’s potential administrations will have solid earnings momentum on their side to support markets.
5) The U.S. debt situation is worrying. Is this a problem, and what's the potential impact?
Alongside election chatter, we also heard lingering concerns over mounting U.S. debt. While this might lead to some tough battles ahead over taxes and government spending, we don’t foresee a U.S. fiscal crisis.
Currency markets have historically shouldered most of the burden of a sovereign fiscal crisis. We don’t think the dollar looks at risk of losing its reserve status anytime soon, especially given its dominant position within global trade and other transactions, but it might be prudent to diversify exposure across other global currencies. Real assets can play an important role as a potential portfolio diversifier and income source to hedge against the long-term risk. Finally, for those that are U.S. taxpayers and looking to manage the risks, tax-efficient investing in the next decade should be a priority.
6) Why bother with active management? It doesn’t feel worth the cost.
The concentration of last year’s rally in big tech created a challenging backdrop for active managers. And while we still think those names will keep pushing higher this year, our constructive view on equities is also predicated on more sectors joining in. However, not all sectors are created equal and experiencing solid profit growth. Dispersion is wide.
This table categorizes the 11 S&P 500 sectors by their expected earning per share growth rate in Q4 2023.
There are four sectors that are expected to deliver an EPS contraction of -15% or less: Energy, Financials, Health care, Materials.
There are four sectors that are expected to deliver flat to positive EPS growth: Consumer Staples, Industrials, Real estate.
There are four sectors that are expected to deliver EPS growth of more than +20%: Communication services, Consumer Discretionary, Information Technology, Utilities.
This creates an environment in which alpha is the driver of returns rather than beta. With that in mind, we believe it’s not a matter of finding the right time for active management. Rather, the key is where to consider using it in your portfolio. We think segments of the market with high return dispersion, low index concentration and relatively low levels of analyst coverage tend to offer some of the best potential opportunities to generate excess returns.
We are here to help you make informed investment decisions that keep you on track to achieve your goals. Whether it’s reviewing your existing investment portfolio or seeking new investment opportunities, we can help you decide if an active or passive strategy is right for you. Contact your J.P. Morgan team to learn more.
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