Investment Strategy

Are you prepared for the maturing economic cycle?

Apr 15, 2022

Here are three considerations to "spring clean" your portfolio today.

Elyse Ausenbaugh, Global Investment Strategist

Olivia Schwern, Global Investment Strategist

 

Our Top Market Takeaways for April 15, 2022.

Market update

Inflation nation

Setting the backdrop for this week’s market price action was yet another multi-decade-high inflation print in the United States, but at least it surprised to the downside. Through Thursday’s close (U.S. markets were closed Friday due to the weekend holidays), both the NASDAQ 100 (-2.3%) and S&P 500 (-2.1%) posted losses on the week.

What did we see in the details of the March Consumer Price Index report? Core prices (which exclude food and energy) only increased 0.3% month-over-month, which was the slowest pace since last September. The aggregate measure including food and energy saw a much more significant 1.2% jump as the world continued to digest the implications of cut-off Russian commodity supply.

This chart shows the U.S. March Core and Headline CPI month-on-month change from January 2019 to March 2022. Core CPI had consistent month-on-month changes less than 0.25% until January 2020, when it popped to 0.3%. It then fell to -0.4% in April 2020 before rallying up to 0.6% in July 2020. It moderated, then jumped again to 0.9% in April 2021. It fell before rallying again to 0.6% in October 2021, held that pace for a few months until March 2022, when it posted a moderated 0.3%. Meanwhile, headline rose to 0.4% in April 2019 and fell to 0% in June 2019. It rose again to 0.3% in October 2019 before falling to -0.8% in April 2020. It rallied to 0.5% in July 2020, moderated from here, then rose again to 0.9% in June 2021. It dipped, then rose again to a striking 1.2% month-on-month change in March 2022.

To be sure, some other categories beyond food and energy ran hot, particularly those highly exposed to economic reopening and higher oil prices. Take airfares, up 10.7% month-over-month, as an example. On the flipside, many durable goods categories that drove broad price increases in 2021 showed signs of cooling (such as used cars, which actually saw prices fall 3.8%).

Regardless if you focus on which components are cooling versus heating up, the reality remains that the year-on-year pace for both core and headline inflation is untenable from both a political and Federal Reserve policy perspective. That said, the bond market reacted in a way that suggests inflation could be peaking here. Expectations for the year-end fed funds rate fell slightly 2.54% to 2.48%. Short-end Treasury yields are mostly down versus a week ago, with the two-year yield having dropped around 6 basis points (bps). Meanwhile, longer-dated yields rose: The 10-year yield moved up 12 bps.

We still expect the Fed to hike interest rates aggressively in the months ahead in order to slow down inflation and economic activity. It’s worth starting to think through steps to prepare your portfolio for the evolving investment environment.  

Spotlight

Spring cleaning: Portfolio edition

Like the seasons, investment backdrops change. Sometimes it just happens more quickly than you expect. In fact, over the past two years, our composite tracker of the U.S. economic lifecycle has shown the fastest move from recession to the middle stages of an expansion since 1975. At this rate, investors might find themselves navigating “late” cycle by year-end.

History suggests that looks like:

  • A slowdown in economic activity. The broad economy continues to grow, but at a rate more in line with the average. In 2021, we saw the U.S. economy expand by nearly 6%. We’re expecting something more like 3.1% this year, and below 2% next year.
  • Mounting headwinds to corporate profitability. Following the period of global lockdowns in 2020, companies saw some of their strongest quarters of earnings growth in history. Today, price pressures plus a slowdown in demand growth are conspiring to challenge broad market earnings growth, urging more selectivity from investors.
  • Increasingly restrictive monetary policy. The Fed and other central banks have been loud and clear: In order to get inflation under control, policy rates need to move higher to cool things off.  

There are still gains to be reaped in the later stages of the cycle, and staying invested has historically served people well. But making tweaks to portfolio exposures can help optimize the tradeoffs we make between risk and return for the changing environment—think of it as some “spring cleaning.” Here are three high-level considerations for investment positioning.

1. Be mindful of where you park your cash. You’ve heard the saying, “work smarter, not harder,” right? Apply that to how you think about your cash holdings. Given the torrid rise in interest rates year-to-date, stepping out of cash into even modestly longer-dated Treasuries can offer a solid pickup in yield. Today, a one-month Treasury yields around 0.2%, while a three-month Treasury trades about 0.5% higher. A year ago, you got about the same measly 0.02% yield from both.

Why such a drastic difference today versus last year? The market knows that the Fed plans to hike overnight interest rates by somewhere between 50 and 100 bps between now and the end of June. Given the current persistence of inflation, there are very few scenarios in which those plans would change. Investors no longer need to consider big tradeoffs to get more from their reserves and excess cash holdings—they just need to be smart about where they park them. 

This chart shows the U.S. Treasury yield of the 1M, 3M, 6M, 1Y and 2Y: 0.2%, 0.8%, 1.2%, 1.7% and 2.3%, respectively. The 1M Treasury is used as a cash proxy.

2. Sell high yield fixed income and move into core bonds. Generally speaking, there are two reasons why an investor might choose high yield credits over higher-quality core bonds. One is that the investor believes the economic environment is strong enough to keep defaults at bay and the yield spread versus Treasury bonds tight. The other is that yields overall are so low that the investor is willing to accept additional risk for the sake of generating a respectable return.

Last April, both were true, and many investors were willing to make the tradeoffs for a ~4% yield from U.S. high yield bonds. But now that rates have risen so meaningfully, investment-grade corporate and high-quality municipal bonds are back on the menu.

U.S. Aggregate bond yields have more than doubled over the past year (currently around 3.9%), and aggregate muni bond tax-equivalent yields are close to 4.9%. We are leaning into the renewed benefits of defensiveness and income generation that can now be found in core bonds.

This chart shows a comparison of the the yield to worst of U.S. Aggregate Bonds (IG, represented by the Bloomberg U.S. Aggregate Bond Index), U.S. Municipal Bonds (Tax Equivalent Yield assuming a 40.8% tax rate, represented by the Bloomberg Municipal Bond Index), and U.S. High Yield Bonds (represented by the S&P U.S. High Yield Bond Index) as of April 13, 2021, and on April 13, 2022. As of one year ago, U.S. Aggregate Bonds’ yield to worst was 2.2%, U.S. Municipal Bonds’ tax-equivalent yield to worst was 1.8%, and U.S. High Yield Bonds’ yield to worst was 4.0%. U.S. Aggregate Bonds’ yield to worst is 3.9%, U.S. Municipal Bonds’ tax-equivalent yield to worst is 4.9%, and U.S. High Yield Bonds’ yield to worst is 6.4%.

3. Swap highly cyclical stocks for more defensive ones. Upgrading the quality of assets held in portfolios isn’t just a fixed income conversation, it’s the overarching theme of how we’re thinking about all portfolio positions. Your equity allocation is no exception.

The early stages of an economic cycle tend to act as a rising tide that lifts all boats. Companies that display high degrees of cyclicality—meaning that their revenues and profits ebb and flow with the tides of the broader economic backdrop—tend to fare best in that environment. Now that the backdrop is slowing, we would prefer to take gains on early-cycle winners to fund an increase in exposure to higher-quality market segments.

We’re keen on identifying companies with:

  • Strong competitive advantages and profit margins, so that they can pass on higher expenses to end-customers.
  • Defensive revenue streams that tend to stay steady or grow modestly even as broad spending starts to decelerate.
  • Secular growth drivers linked to long-term trends that gain more momentum over time.

To us, that puts sectors such as healthcare, utilities and segments of tech at the top of our list. We also think larger companies, which tend to be more established and sturdy, could fare better than their smaller-cap counterparts. At a more nuanced level, we think entry points in ever-important secular themes such as cybersecurity look compelling here as well.

The bottom line

A maturing economic cycle calls for a portfolio tune-up, but not an overhaul. More volatility should be expected in the future, and the shifts discussed above may help smooth out the ride for investors. There are other considerations as the backdrop continues to evolve (e.g., using that volatility to add some downside protection while maintaining market exposure), and we’re here to guide you through them. Your J.P. Morgan team can help. 

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All market and economic data as of April 2022 and sourced from Bloomberg and FactSet unless otherwise stated.

We believe the information contained in this material to be reliable but do not warrant its accuracy or completeness. Opinions, estimates, and investment strategies and views expressed in this document constitute our judgment based on current market conditions and are subject to change without notice.

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