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Dec 04
Making Sense of Uncertainty

​Thursday, November 9, 2017

Speaker: David Lebovitz, Global Market Strategist, J.P. Morgan

1.    Global Growth Outlook.

  • Global economic growth continues to look solid - the global Purchasing Managers' Index (PMI) for manufacturing suggests a "synchronized global economic expansion" starting fall of 2016. We observed the acceleration of growth across the developed markets and stabilization of growth in the emerging markets.
  • The reflation is in the process of running its course and has not yet come to an end. We see a slight acceleration in global economic growth in 2018.
  • The key takeaway – the ongoing trend suggests it continues to make sense to lean into risky assets, to maintain exposure to various parts of the global credit markets as well as to equities.
  • US Market:
    • The average annual US real GDP growth over the past 50 years was 2.8%. Since June 2009 the real economy growth has averaged to 2.2% annually.
    • The potential economic growth is a variable of growth in the labor force and growth in productivity. In the current economic environment both these variables are under pressure which led to a lower estimate of potential economic growth – the growth around 2% is now considered sustainable.
    • Given that currently the economy is growing in line with its growth potential, we believe that this could be one of the longest economic expansion on record.
    • The recession is unlikely in 2018-19 – key growth drivers (e.g. consumption, government spending, and investments) are in relatively good shape.
    • There is an upside risk to our base case scenario of 2% economic growth, but we think that levels of growth higher than estimated potential are not sustainable in the current economy and periods with 2.5%-3% economic growth will be followed with cooler economy afterwards.
  • European Market growth drivers:
    • European economy has been growing robustly at around 2% over the past few quarters (vs. estimated potential of 1.0-1.5%).
    • What drives the growth? Is strong EUR is a risk? What is going to keep this expansion growing?
    • Strong EUR is not a risk (or not quite yet) to the ongoing growth – strong domestic demand (rather than exports) suggests that this is an internally generated recovery.
    • The employment rate in Europe is still below its full employment level (current unemployment rate of 8.9% is above the threshold of 7.0-7.5% consistent with the full employment level) implying there is still a room for economic growth. In contrast, the US economy is currently running at its full employment levels (with unemployment rate of 4.3%).
    • Demand for credit is healthy and we see a continuation of credit growth across the Europe.
    • Given all the above, we are optimistic about potential returns from the European stocks in the next 12-18 months.
  • Emerging Markets (EM):
    • There is a statistically significant relationship between the growth in EM growth premium (the difference between the consensus GDP growth between developed and emerging markets) and the outperformance of the emerging markets equities relative to their developed market counterparts.
    • In the past 12 months we have been seeing a growth in the EM growth premium. Moreover, better economic growth has passed through into better economic profits thereby providing a fundamental support for the equity performance that we are seeing across the EM.

2.    Federal Reserve and Monetary Policy.

  • Both Fed and market are expecting the third and final (for this year) increase in federal rate in the upcoming December.
  • However, there is a gap in expectations between Fed and market looking forward into 2018-19. Similar dynamic was in 2015 and 2016 and led to uncertain and vulnerable market environment.
  • Newly appointed Fed Chairman Jerome Powell is a "market friendly outcome". We do not expect change in Fed rates trajectory.
  • Beginning of October the Federal Reserve has started a balance sheet reduction program which allows a $10bn/month run-off of government securities ($6bn of Treasuries and $4bn of mortgages) from its $4.5 trillion portfolio. The program presumes a terminal run-off rate of $50bn/month or $600bn/year of maturing assets which is nearly in line with the federal budget deficit.
  • As a result, the source of price insensitive demand, e.g. the Fed, which has been present in fixed-income markets for the past decade, is finally beginning to step back. Therefore, we expect the interest rates to grow, estimating a 10Y Treasury yield at around 2.50-2.75% by the end of 2017, and expecting it to reach 3% by the end of 2018.

3.    Investment Opportunities.

  • Fixed income.
    • Rising rates => fixed income is going to be more challenging than it has been in the past 35 years.
    • Rethink allocation – embrace opportunities both domestically (core exposure) and abroad (developed markets AND emerging fixed income markets).
  • Equities.
    • In contrast to fixed income market, rising rates should not be challenging for equities – historically, when yields are below 5%, rising rates have been associated with rising stock prices.
    • The 5% (historical) threshold could be biased upside, the "magic number" is around 3.5%-4% threshold.
    • Given the current 10Y Treasury yield, we believe there is a plenty of room for the interest rates to rise before they begin to negatively impact the performance of equities.
    • Within equities, there are favorable opportunities outside of the US with EM equities returns looking the most attractive going forward.
    • In our long term forecast, we expect some steady depreciation of $ going forward.
    • Data from the past 35 years suggests: volatility is normal, volatility should be expected, but the equity market is resilient.
    • We believe that the right investment plan remains the one with diversification. Historical data suggests that over the past 15 years the return on Balanced/Asset Allocation portfolio has over performed the return on S&P500 portfolio and it has done so with about 2/3 of underlined volatility.


​​​​1.  Why is there a difference between the US and European full employment rates?
  • Europe has structurally higher unemployment rate due to set of rules and social regulations in place – it is far harder to hire and fire people in Europe than in the US.
  • The silver lining is that there is still a room for employment growth in Europe which should help it to continue expanding above its potential over the coming course.  

​​2.  You started with the premise that the housing is the largest source of equity for households, and some could argue that the Fed has spent most of its QE1, QE2, and QE3 trying to shore up the housing market after the last recession. However, it seems as though the current administration, at least the House, is crafting fairly punitive measure for homeowners (in terms of taxation), at the same time the Fed may likely do things that increase the interest rates on the long end thereby raising the question of housing affordability. Is the future of housing one of the factors that can lead to slowdown in the economy?
  • We can see people picking up on housing because there has finally been a softness in the housing market over the course of this year.
  • In terms of housing affordability – the Fed raising interest rates on the short end will not necessarily do all that much to the long end of the curve. The rates will need to move a couple of hundreds basis points higher in order to see the affordability deteriorating.
  • In terms of new tax plan and its impact on housing market – the Senate version differs considerably from the House's initial proposal and most probably anything we end up with on the tax reform is going to be far different than what the House initially proposed. ​

​​3.  Does JP Morgan have a view if we would see corporate tax release passed before the end of the year or sometime in 2018?
  • The consensus view is that we will see some tax cuts at the beginning of next year which will likely be applied retroactively if it happens sometime in the first quarter of 2018.

​​4. Is there a way to get ahead of an asset bubble/assess a probability of seeing an irrational reaction? What about equity roll off in the next year and few months?
  • Better 5 and 10-year numbers could lead a retail investor, which tends to be a big swing factor when it comes to asset bubbles, to participate in the way that has not been the case up until this point.
  • Sentiment, enthusiasm, and exuberance are very hard to quantify. Therefore, JP Morgan is particularly focused on earnings and fundamentals as drivers of our investment views.
  • We prefer to employ some caution and be positively surprised: e.g. our forecast for US equities estimates 7% earnings growth, and that does not take into account any change in taxes, if we get a tax cut that bumps the earnings growth up to 11-12%. ​


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