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MR. MICHAEL CEMBALEST:  Good afternoon.  This is the “Eye on the Market” for April 8th, 2019.  And if you are listening you are about to hear some Fed Zeppelin because that's the title of today's note.  We were optimistic that we'd have a rebound this year in the U.S. and emerging markets, and we wrote about that in December, you know, the morning after Christmas and in The Outlook but markets have moved well above even what we thought we would see.  U.S. equity valuations are now back above median and the recovery after the bear market we had in December is now tied for the fastest recovery after a bear market in the post-war era.  So why did this all happen at a time when global growth is slowing and there is a black hole in European manufacturing and things like that?

 

Well it has a lot to do with the Fed.  So the Fed has pivoted from a stance where they were going to be tightening this year to one where they will no longer be shrinking their balance sheet, no more rate hikes, and the benefits are pronounced for risk-taking for the U.S. and also from many markets, and for a lot of credit markets globally.  China is also the big driver of the rally.  We've got the increased probability of a trade deal as well as a lot of Chinese fiscal stimulus, which is pushing up some of the leading indicators.  But the real story and why we're talking about Fed Zeppelin is the, the fuel, the explosive fuel for this recovery that we've had this year is the Fed, which our investment bank was initially thinking we'd see maybe four hikes this year and I've never seen anything like this in my 31 years, in over the span of two months our investment bank went from projecting four hikes to none based on this pivot that the Fed has done.  

 

Now they made a big mistake the Fed did, in 1966 when they switched to tightening… from tightening to easing after an equity markets sell off and they were ignoring some of the inflationary pressures at the time.  But what we get into this week is a lot has changed regarding the pass-through from falling unemployment to rising wages and prices so the Fed's making a big gamble that the Phillips curve is dead.  We have modest confidence that they're right, but if they, if they turn out to get this wrong, we could have a pretty sharp correction.  So we walk through in this week eye on the market some of the indicators to keep track of to get a sense for whether or not the Fed is making a mistake. As for the slow down in global growth in earnings that we're seeing, this looks like definitely a soft patch of economic activity centered in Europe, but rather than a sign… a temporary one, but rather than as a sign that the global cycle is now coming to a more abrupt end. 

 

And so on the second page of this week's Note you can see the extraordinary statistics behind this bounce in the market.  We've recovered almost 80% of the sell-off within 2 months. That's only happened once before back in 1982.  Aside from that, usually 2 months in we've only recovered anywhere from 10 to 30% of the sell-off, and now we're at 80.  Valuations for equities in the U.S. and Europe are back in the 70 to 80% range in terms of percentiles versus history, and again all of this is happening at a time when global GDP profits, manufacturing, U.S. capital spending surveys, and all this stuff is rolling over so the Fed's making a big gamble here that falling unemployment is not going to translate into rising wage inflation.  China is the other big piece of this as I mentioned.  We have some charts in here on fiscal stimulus and the rebound in some of the manufacturing and service sector data.  There is another chart that we had in here.  

 

We've always felt that that was going to be a deal between the U.S. and China and one of the charts we have shows the linkages between the U.S. and China are much deeper linkages then potential adversaries or actual adversaries of the past.  And I know that a lot of people read this new book called Thucydides is Trap and I don't even know if I'm pronouncing it right, but it is a book from Graham Allison at Harvard that refers to the inevitability of conflict between the U.S. and China, based on historical parallels.  I'll say this, when you look back historically, and we have a chart in here that shows the numbers, you won't find prior adversaries whether they were actual or potential that held massive amounts of each other's government debt in their central banks that had the level of bilateral foreign direct investment that we see going on between the U.S. and China and that have the annual trade flows.  So we've always felt that there was a lot of economic incentives that were more suggestive that there would be a deal rather than a worst-case trade war along the lines of what the Peterson Institute and other and other firms and other think tanks were examining.  And just, I do want to say this about if there is some kind of deal I can already hear in my head, the media sniping and complaints about that the U.S. deal with China maybe entails more purchases of U.S. goods and some modest opening of Chinese markets but doesn't accomplish enough on IP and joint venture requirements and Chinese subsidies and discriminatory regulatory practices.  It looks like the deal that's on the table is a modest one.

 

But any Chinese concessions at all would be a lot more than the Bush and Obama administrations accomplished after China joined the World Trade Organization in 2001.  So I think in the realm of the possible, this administration may have gotten more accomplished then than its two prior ones and as Europe is finding right now, they're considering tougher regulations on Chinese foreign direct investment and how to deal with Chinese overcapacity and force tech transfers and things like that.  It's not a simple thing to do.

 

When I mentioned that the Fed's gamble is that the Phillips curve remains broken for those of you familiar with the Phillips curve measures the relationship between changes in unemployment and its impact on wages and prices.  And so one of the other things we take a look at this week is what's happened to the Phillips curve and why from 1980, let's say to 2000 that it behave the way it normally did where unemployment falls and eventually wages and prices go up and over the last decade or two all of a sudden that relationship is broken.  We take a close look at how behavior of companies to absorb cost changes through margins rather than prices, globalization, which makes U.S. prices more sensitive to global conditions and domestic ones, impact of on online retailing, impact of falling labor bargaining power.  All of these things have contributed to this collapse and so while it is kind of remarkable, we're now at I don't know, a 50 year low in the unemployment rate and yet the employment cost index is only going up, but let's say 2 and a half to 3 percent and productivity is rising a little bit.  So the real unit labor costs are rising even more slowly.  Core PCE inflation is pretty relaxed.  Most inflation expectation numbers are pretty stable, so it looks like the Fed despite an incredibly tight job market is in a safe zone right now with respect to this approach to no longer tightening and some people think maybe easing now.  If it turns out they're wrong and they make a mistake the way they did a 1966, they'll be quite a large correction from that and then to finish the thoughts for the week.  How else might this Fed Zeppelin explode?

 

Well the risks over the long run from leaving relate to low forever is really destructive for large institutional investors who buy a lot of fixed income that don't benefit from lower deposit rates, and those are of course pension funds and insurance companies.  And as you know from our arc and the covenants work on municipals, there is a handful of states that really look irredeemably insolvent when you think about them on a long-term perspective.  So that's a brief description of what we've got going on this week and look forward to talk to you soon. 

 

ANNOUNCER:  Michael Cembalest, “Eye on the Market” offers a unique perspective on the economy, current events, markets and investment portfolios and is a production of J.P. Morgan Asset and Wealth Management.  Michael Cembalest is the chairman of market and investment strategy for J.P. Morgan Asset Management and is one of our most renowned and provocative speakers.  For more information, please subscribe to the “Eye on the Market” by contacting your J.P. Morgan representative.  If you'd like to hear more, please explore episodes on iTunes or on our website.  This podcast is intended for informational purposes only and is a communication on behalf of J.P. Morgan Institutional Investments, Incorporated.  Views may not be suitable for all investors and are not intended as personal investment advice or as a solicitation or recommendation.  Outlooks and past performance or never guarantees of future results.  This is not investment research.  Please read other important information which can be found at www.jpmorgan.com/disclaimer-eotm

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We were optimistic about a 2019 rebound in the US and in Emerging Markets, as described in our Dec/Jan Eye on the Market notes. But markets have now moved even higher than I expected: US equity valuations are well above median again despite consensus US EPS growth of just 3% for 2019. The recovery from the December 2018 equity bear market is now the fastest in the post-war era. The fuel for the rally: the US Fed, whose newfound patience means no more balance sheet reduction, and no more rate hikes. The benefits are global, particularly for Emerging Markets. In this Eye on the Market, we look at the essential high-stakes gamble the Fed is making: that the linkage between unemployment and inflation remains broken. Other topics include China, which is the other driver of the rally due to increased probability of a trade deal (whose likelihood we felt was high given deep bilateral US-China economic linkages compared to prior historical adversaries), and plenty of Chinese stimulus.

Download the PDF to read the full piece.

This two-line chart compares the recovery of the S&P 500 following the 2018/2019 bear market to the median S&P post-bear market recoveries for previous 11 periods. We can see that 70 days out from the market bottom, the median market recovery is about 30% of market loss but in 2018/2019 the S&P had recovered approximately 90% of its value in that time.