Investment Strategy

What assets should investors consider trimming in the year ahead?

While we have a positive outlook on 2022, investors may want to revisit exposure to these three areas.

Our Top Market Takeaways for December 20, 2021.

Markets in a minute

Powell keeps his options open. Last weekthe Federal Reserve officially made its pivot from maximum support for the economy to increased flexibility to fight inflation. There are three takeaways that illustrate this move:

  1. The Fed is expecting higher inflation and lower unemployment. Powell emphasized that the labor market was making rapid progress toward full employment, and the statement suggested the Fed has fulfilled its inflation target (to say the least).
  2. It is accelerating the pace of tapering. Now, the Fed will be out of the bond buying business by its March meeting. It doesn’t want to raise interest rates while also buying securities, so this is an important step that opens the door to rate hikes as soon as March.
  3. It is forecasting more rate hikes, and sooner. The “dot plot,” which shows where Fed officials believe policy rates will be, now suggests three 25 basis points (bps) hikes in 2022 and three more in 2023. As shown in the chart below, this is more or less what the market expects for next year, while they are less convinced that tightening will continue late into 2023.
This chart shows the Fed funds rate from 2016 to the end of September 2021, then the projected market expectations to 2025 from January 1, 2021 relative to today, as well as median FOMC member dots. It began at 0.375% in 2016, then jumped again to 0.625% in early 2017, maintaining that for three months when it jumped to 0.875% in late April 2017. In late May 2017, it jumped to 1.125%. In the end of 2017, it jumped to 1.375%. It then hiked to 1.625% by the end of April 2018. In the end of October 2018, it hiked again to 2.125%. Finally, it jumped to an all-time peak during this time period to 2.375% by the end of 2018. From there, it began its descent. The Fed funds rate fell to 1.625% by the end of October 2019. It maintained that level until the end of February 2020 when it fell back down to 0.125% by the end of April 2020. It maintained that rate until recent. The median FOMC member dot is placed at this point, followed by one at 0.86% in December 2022 and 1.625% in December 2023. Market expectations follow a similar trend, reaching 0.83% in February 2022 and 1.27% in November 2023.

All things considered, markets took the news in stride. Broad equity markets are down a little bit after some ups and downs. The digital economy and speculative names are taking the news hardest, while more cyclically sensitive stocks (think banks and energy) are doing well. Bond yields have drifted lower. This suggests that the Fed had done a decent job prepping investors for what was coming (e.g., Powell’s congressional testimony a few weeks ago).

We still believe there is a chance the Fed turns out to be more patient than markets expect and, importantly, that the economy can handle higher short-term interest rates before the economy starts to slow down materially. This means that generally we expect rate hikes will come a little bit later than the market expects, and that the rate hiking cycle will be more sustained than the market expects. This argues for marginally higher interest rates.

A lot of investors will focus on when the Fed will start hiking rates. We don’t think the start of a rate hiking cycle is the time to worry. The Fed will raise rates because the labor market is strong and price pressures are building. Said differently, the economy will be healthy. To us, the real time to worry is when the Fed stops raising rates because it starts to see that the markets and economy can’t handle the rate hikes. We don’t think this will happen for quite some time.        

Three things to trim or avoid

Our view for the next year has three defining characteristics: strong nominal growth, elevated but slowing inflation, and higher interest rates as policymakers start to remove accommodative policy. We have spent most of our outlook focusing on how investors should position for that environment (favor stocks over bonds, focus on quality, rely on hybrids and private investments for yield, and use dynamic active management to help protect against potential equity volatility).

What we haven’t talked about as much is what we think investors should trim (or avoid) as we head into the year ahead.

In today’s note, we focus on three things that fit this bill: unprofitable equities, investment grade and upper-tier high yield bonds, and gold.

[1] Unprofitable, high-valuation equities. Investing in companies that don’t turn a profit but have a clear long-term growth story can be very lucrative. In 2013, mega caps such as Amazon, Facebook (Meta), Tesla and Salesforce all struggled to turn a profit. Now they are some of the largest companies in the world.

Throughout the pandemic era, investors flocked toward companies that looked like they had the same potential. They placed a premium on long-term secular growth stories to avoid dealing with the near-term uncertainties driven by the ever-changing virus landscape.

Further, the historically supportive stance of global central banks (especially relative to the underlying strength of the economy) forced inflation-adjusted interest rates to historically low levels. Given that cash today is paying less than nothing after adjusting for inflation, cash flows that could happen far in the future have become ever more valuable.

The result is that unprofitable, high-valuation companies outperformed the broader index by almost 300% from April 2020 through February 2021.

Now the air is coming out of the bubble. Unprofitable tech companies are almost 40% below their highs, while the broader stock market is still hovering near all-time highs.

This chart shows the price index (February 2020 = 100) of non-profitable technology and the S&P 500 from January 2020 to mid-December 2021. In early 2020, non-profitable tech began at 93, rising to 106 by the end of February, and falling to a series low of 69 in mid-March. It rose steadily from here to a series high of 354 in mid-February 2021. At this point, it fell to 220 in mid-May 2021, rallied to 289 at the end of June 2021, before dipping again to 242 in mid-August 2021. It rose and fell to a similar level before rising again to 293 by mid-November 2021. As of late, the non-profitable technology index fell to 221 by mid-December 2021. Meanwhile, the S&P 500 started at 110 in early January 2020. It remained level until the end of February 2020 at 113, when it dipped to a series low of 76 by the end of March 2020. It rose steadily, at a much shallower pace relative to non-profitable technology over about a year and a half. As of recently, the S&P 500 Index landed at 157 in mid-December 2021.

We think performance between unprofitable companies and the broad market will continue to converge. We expect strong economic growth next year. When growth isn’t scarce, the premium demanded by investors for growth stories could fall. Further, less accommodative policy from the Fed should put upward pressure on real interest rates, which could further pressure valuations. For now, we think investors are better served to focus on quality (earnings consistency, return on equity, balance sheet strength, etc.).

To be clear, we are still very excited about innovation in areas such as digital transformation, healthcare and sustainability over the medium term; we just aren’t willing to pay any price for it today. That is why we are relying on the active managers on our platform to sort through the noise and identify long-term beneficiaries of secular trends.

[2] Investment grade and upper-tier high yield bonds. The time to buy investment grade and upper-tier high yield bonds tactically is when the difference between their yields and the yield of Treasury bonds (which is theoretically risk-free) is wide. In March 2020, this was the case. The risk of default due to widespread lockdowns and lack of support from policymakers was real, and reflected in wide spreads. We know the story since.

Policy stimulus and healthcare advancements led to a rapid recovery from the initial shock of lockdowns, and now there is very little risk embedded in upper-tier high yield spreads.

This chart shows the spread to worst of the constituents of the J.P. Morgan Domestic High Yield BB Index from January 2019 to mid-December 2021. At the start, the spread marked 385.4bps, falling to 240.5 bps by mid-April 2019. It ebbed and flowed from here, remaining rangebound between 344.4 bps and 264 bps, until landing at a series low of 229.4 in mid-January 2020. It skyrocketed from here to 868.9 bps by the end of March 2020. It fell at this point to 501 bps by mid-April 2020, 374.8 bps by early September 2020, and 273.1 bps by mid-February 2021. At this point, the slope shallowed significantly, reaching 253.6 in early July 2021 and 248.4 in early November 2021. It felt a slight rally before falling again to land at 278.5 by December 13, 2021. Additionally, the table within the chart shows the starting spread and total return on a quarterly basis. As of March 31, 2020, the starting spread was 658 and the total return was 23.8%. As of June 30, 2020, the starting spread was 499 and the total return was 13.5%. As of September 30, 2020, the starting spread was 422 and the total return was 8.9%. Finally, as of December 31, 2020, the starting spread was 300 and the total return was 3.5%.

For investors, this also means there is relatively little benefit to holding on to a large overweight to upper-tier high yield. The fundamentals for the asset class actually look pretty good. We don’t expect corporate defaults to rise dramatically next year, corporate balance sheets look strong, and earnings and cash flows should be healthy. But the returns for upper-tier high yield bonds are uninspiring, and we think you can do better in other parts of fixed income. We even feel better about issues with lower credit ratings. Relative spreads are about in line with historical average, but we think they can tighten further, given the growth outlook.

Opportunities exist in private credit strategies for those seeking income (in exchange for lack of liquidity), and in dynamic active management in both fixed income and across asset classes for those seeking a similar risk and return profile.

[3] Gold. Investors typically buy gold when they need a safe haven, and especially when they need a safe haven when inflation is high. Unfortunately for gold holders, in 2021 gold did not hedge against inflation at all. Despite some of the highest inflation readings in decades globally, gold has lost over 7% of its value.

In 2022, we expect more of the same for gold. For one, we expect inflation to decelerate, which will likely mean that investors will become incrementally less focused on inflation protection.

Second, we expect the Fed to begin the process of tightening policy from very accommodative levels. This means that inflation-adjusted interest rates are likely to rise. When inflation-adjusted interest rates rise, gold tends to fall because it makes more sense to buy Treasury bonds as a safe haven (because they give you some cash flows) rather than gold (which does not give you any cash flows—it just sits in a vault somewhere).

Finally, as short-term interest rates rise in the United States, foreign capital will likely flow in, which will support the dollar. This also tends to be a headwind for gold because foreign purchasing power is eroded (because gold is denominated in U.S. dollars). 

This chart shows the U.S. 5-year real Treasury yield, inverted, and gold price in USD/oz from 2009 to December 2021. In 2009, 5-year yield began at 1.97%, falling steadily to -0.47% by early November 2010, and -1.62% by early October 2012. Meanwhile, gold started at $934.7, rising to $1,875.3 in early April 2011. At this point, it began to fall to $1,200.7 in late February 2013 and $1,015.1 in late September 2015. For the 5-year, it began its ascent at the end of 2012, reaching 0.14% in early September 2013 and 0.50% in late December 2014. By September 2015, it landed at 0.3%. At this point, gold began to climb, reaching $1,345.2 in late June 2016, remaining rangebound until late June 2018 at $1,174.2, when it began to climb again. Meanwhile, the 5-year kept climbing to a relative high of 1.2% by late December 2018. At this point, the yield kept falling as gold rose. The 5-year hit -0.6% in early March 2020, spiked to 0.6% by mid-March before falling again to -1.4% by September 2020 and -1.5% by mid-December 2020. Meanwhile, gold rose to $2,035.6 by the end of July 2020, dipped to $1,685.2 by mid-March 2021, and as of recently, landed at $1,775.3 by mid-December 2021.

If you are looking for an inflation hedge, we think you are better off in equities or real assets such as real estate or infrastructure.

We have a constructive view of the global economy and risk assets next year, but we still think it can add value to portfolios to trim some exposure to the areas listed above. For more on our outlook, please get in touch with your J.P. Morgan advisor.

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All market and economic data as of December 2021  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.

Investments in commodities may have greater volatility than investments in traditional securities, particularly if the instruments involve leverage. The value of commodity-linked derivative instruments may be affected by changes in overall market movements, commodity index volatility, changes in interest rates, or factors affecting a particular industry or commodity, such as drought, floods, weather, livestock disease, embargoes, tariffs and international economic, political and regulatory developments. Use of leveraged commodity-linked derivatives creates an opportunity for increased return but, at the same time, creates the possibility for greater loss.

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JPMorgan Chase Bank, N.A. and its affiliates (collectively "JPMCB") 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 ("JPMS"), a member of FINRA and SIPC. Annuities are made available through Chase Insurance Agency, Inc. (CIA), a licensed insurance agency, doing business as Chase Insurance Agency Services, Inc. in Florida. JPMCB, JPMS and CIA are affiliated companies under the common control of JPMorgan Chase & Co. Products not available in all states. Please read the Legal Disclaimer in conjunction with these pages.

INVESTMENT AND INSURANCE PRODUCTS ARE: • NOT FDIC INSURED • NOT INSURED BY ANY FEDERAL GOVERNMENT AGENCY • NOT A DEPOSIT OR OTHER OBLIGATION OF, OR GUARANTEED BY, JPMORGAN CHASE BANK, N.A. OR ANY OF ITS AFFILIATES • SUBJECT TO INVESTMENT RISKS, INCLUDING POSSIBLE LOSS OF THE PRINCIPAL AMOUNT INVESTED

Equal Housing Lender Icon Bank deposit products, such as checking, savings and bank lending and related services are offered by JPMorgan Chase Bank, N.A. Member FDIC. Not a commitment to lend. All extensions of credit are subject to credit approval.