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Prepare for a Recession but Stick With Stocks: JPMorgan's Kelly

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What will the U.S. economy look like a year from now, and how should investors prepare in the meantime?

According to David Kelly, chief global strategist at JPMorgan Asset Management, the federal deficit will have climbed to close to 5%, up from just under 4% this year; the 30-year fixed mortgage rate will have reached 5% — it’s currently around 4.5% — and the U.S. economy will be slipping into a recession or nearing one, in 2020.

“Be prepared” for a recession in 2019 or 2020, said Kelly who recently held a webinar on his third quarter outlook.

Despite this prediction, Kelly adamantly advises against timing portfolios based on expectations for when the next recession will occur.  “It’s hard to balance when riding a bicycle slowly,” said Kelly, likening riding a slow-moving bike to investing in a slowing economy verging on recession.

(Related: Don’t Expect Active Funds to Outperform in a Bear Market)

Moreover, Kelly is not anticipating a big bear market when the economy does finally retreat into negative territory for several reasons:

  • Current stock market valuations are not excessive, with the 12-month forward P/E for the S&P 500 near 16x. The average forward P/E has been 50% higher since 2000, so the market is less vulnerable now.
  • The average correction in nine of 11 recessions post-World War II has been 25%, which is nothing to scoff at but it’s half the decline of the last two bear markets.
  • The last two recessions, in 2000-2001 and 2007-2009, and the bear markets that followed involved a financial crisis, which is less likely for the next one. Why? The economy is more stable and banks are in much better shape. Unemployment, for example, is more likely to rise to near 7% rather than 10%, as in the last recession.

Before the next U.S. recession occurs, Kelly expects the gap between short-term and long-term bond yields  — currently 28 basis points between the two-year and 10-year compared to 132 basis points a year ago — will continue to narrow as the Federal Reserve raises short-term rates and long-term rates rise half as much.

The yield curve will possibly invert, historically a telltale signal of an impending recession, but the inversion, said Kelly, is merely “a symptom, not a disease” and it has some benefits. When long rates fall, it’s easier for consumers to buy a home, and when short-term rate rise, they collect more interest on savings accounts, according to Kelly.

The yield curve is “something to watch but “but long term it doesn’t necessarily predict doom,” said Kelly. “Watch all financial values.”

He favors value stocks over growth because value is cheaper, in line or slightly below the 20-year P/E average, while growth stocks are at or above the 20-year P/E averages — across small-cap, mid-cap and large-cap stocks.

“Valuations matter in the long run,” said Kelly.

(Related: Emerging Markets: More Downside to Come)

That’s one reason Kelly and JPMorgan Global Market Strategist Gabriela Santos also like international stocks. They have been underperforming U.S. stocks this year, reversing last year’s trend. The MSCI All Country World Index (ACWI)  minus the U.S. was down 3.4% through June 30 versus the S&P 500, which was up 2.6%. Through the first week of July that spread has widened with the S&P 500 up over 3% and the ACWI index minus the U.S. down more than 5%.

Other reasons to continue to hold international stocks now, according to Kelly and Santos:

  • They account for about 45% of the world’s stock market (U.S. stocks are only 54%)
  • The current correlation between U.S. and international stocks has declined to about 50%, from 76% in September 2009
  • Foreign economies, including those in emerging markets, have greater potential for growth while the surge in U.S. economic growth is not sustainable (The current economic slowdown in overseas economies is a just a “temporary disappointment” not a crisis, said Santos.)
  • International stock markets, including emerging markets, are trading below average 25-year valuations; U.S. stocks are trading above their 25-year average valuation.
  • The middle class will continue to grow in emerging market economies for decades to come, boosting economic growth. For example, China’s middle class, now about 30% of its  population, is expected to surge to 70% by 2030, said Santos.

Santos is not too worried about the growing trade conflict between the U.S. and other countries as countries retaliate against higher U.S. tariffs. “The global economy can  weather the trade storm so there is no need to rethink international investing.”

(Related: Metal Markets Prepare for New World Disorder)


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