Investors and the Federal Reserve are in the difficult position of a photographer trying to take a picture of a kindergarten class, David Kelly, chief global strategist for JPMorgan Funds, said on a call Wednesday. “They all look adorable, but the problem is you’ll never get them to smile at the same time.”
The Fed is “waiting until they’ve got some kind of global nirvana,” with good growth, inflation rising to 2% and a strengthening labor market, Kelly said. “Waiting for perfection over the last few years has left them sadly behind the curve and actually inflicting a lot of damage to the economy in the long run.”
Investors aren’t doing much better, he said, leaving more than $12 trillion parked in short-term accounts in the U.S., “earning essentially nothing while long-term assets continue to provide positive returns in the first half of this year.”
He pointed out that when interest rates, confidence, earnings and growth all “look good, […] that is the definition of a market top.”
Instead, investors should “take advantage of the single biggest anomaly out there”: low global short-term interest rates.
Consumer spending is driving economic growth and was 69% of GDP in the first quarter, Kelly said. He expects consumer spending growth in the second quarter will be 4.3%, as an increase in jobs and wages, low gasoline prices, and rebounds in home prices and consumer confidence drive spending.
“The funny thing is that when you ask people about the direction of the country, they think it’s going in a terrible direction. If you ask them about their own finances, they’re actually feeling a little bit more optimistic,” Kelly said.
Consumers are also holding more assets than debt, he said, and most of that debt is mortgages. With low interest rates, they’re able to pay if off, too; Kelly said total consumer credit (including credit cards and personal loans) delinquency rates are below 2% for “only the second time since 1987.”
“That’s why we feel strongly that unless some big shock hits the economy, this economy is not on the verge of any recession. It’s just going to keep ambling along,” Kelly said.
On the other hand, energy investment is down about 75% from its peak, he said. “To be honest, it can’t fall much further, but that has been a big drag and will continue to show up in second-quarter GDP.”
3 Problems With the Fed Forecast
In its June forecast, the Fed predicted real GDP growth of 2% for 2016 and 1.9% over the long run. Kelly believes 2016 growth will be closer to 1.7%. Economic growth over the long term will likely only be around 1.5%, rather than the 1.9% predicted by the Fed, he said.
Over the last 50 years, the economy has grown by an average 3.3% per year, Kelly said, most of which came in an increase in the number of workers. However, the last decade has seen only 1.4% growth, which Kelly expects will continue.
“I think a very reasonable outlook for the long run is half a percent growth in the number of workers, 1% growth in productivity, [which] gives you 1.5% growth, not 1.9%.”
The Fed forecast unemployment of 4.7% in 2016, falling to 4.6% in 2017 and 2018. However, Kelly said, unemployment already reached 4.7% in May, falling from 10% in October 2009. He estimates that unemployment will reach 4.5% by the fourth quarter of this year, and 3.9% by the end of 2017.
Kelly cautioned that unemployment numbers have a lot of variability, but he expects that the jobs report that will come out on Friday will show the labor market is strengthening.
Inflation will also not likely follow the Fed’s prediction of 1.5% for 2016, Kelly said. Big declines in food and energy pushed the headline personal consumption expenditures (PCE) below the core PCE price index, which excludes food and energy prices, in May.
“By the fourth quarter of this year, if we simply maintain the May level of food prices, oil prices, gasoline prices and natural gas prices, if we just stay at those levels, we will see big year-over-year increases in all of those numbers,” Kelly said, which would drive the headline PCE up by about 0.3%. “That would take you to about a 1.9% inflation rate if core doesn’t move higher.”
The Fed predicted inflation wouldn’t reach 2% until the end of 2018, but Kelly said, “I think they’re going to hit it by the end of this year.”
It’s possible that the Fed will still do two rate hikes this year, but Kelly is doubtful. He expects it “will use Brexit as an excuse not to raise rates at the end of July,” and he “doesn’t think there’s a chance” the Fed will raise rates at the October meeting, days before the election. If the U.S. economy isn’t impacted by Brexit (and Kelly doesn’t think it will be), the Fed may feel some pressure to raise rates in September, and possibly again in December.
Eurozone growth was at 2.2% in the first quarter of 2016, and Kelly believes that level will continue. Unemployment fell by about 0.7% per year since 2013, dropping from just over 12% in June of that year to 10.1% in May, he said. “If you feel like you’ve heard that before, you have, because that’s exactly what the U.S. was doing starting in 2009,” he said.
Kelly believes unemployment will continue to fall and that “Europe will benefit from this austerity.”
China is a lingering risk, Kelly said. Debt in the country is increasing, and although he believes in the short run the country will maintain growth, the debt ratio could be a bigger problem in the long run.
Equity, Bond Markets
At the end of the second quarter, 74% of developed-market government bonds were paying less than 1%, Kelly said, and 36% had negative yields. Global central banks are trying to “limbo down” to the Fed’s rates, he said, and are more likely to be impacted by Brexit.
The Bank of England will be more accommodative, he said, and the European Central Bank may be inclined to do the same. The Bank of Japan would probably do the same, “if they could, but they’re pretty much at the limit of what they can do in reducing rates.”
The 10-year German bund nominal yield is -0.18%, and in Japan, the 10-year JGB yield is -0.28%. “You pay 18 basis points per year just for the privilege of lending your money to the German government with no return whatsoever,” he said.
All the money that would go to those bonds is being pushed toward the U.S., which is holding rates down, he said. “That’s frankly why we think it’s going to take some time for this really extraordinary bond market to right itself.”
“This has been a very nice year for fixed income” in the U.S., he said, “but if ever there was a case of past performance are not indicative of future returns” this is it. He panned Treasury inflation-protected securities and Treasuries, although spreads on corporate and high-yield bonds are at least average or better.
The stock market “hasn’t gone anywhere for two years,” according to Kelly, due to a higher dollar and falling oil prices. “When oil stops falling and the dollar stops rising,” he said, “what has been headwinds should turn into tailwinds.”
— Read U.S. Economy SLUGish; Brexit Shock Lingers: Schwab’s Sonders on ThinkAdvisor.