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J.P. Morgan strategist David Kelly.

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These Investments Could Help Clients Rest Easier: J.P. Morgan Strategists

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What You Need to Know

  • The Fed's latest rate hike raises the recession risk, J.P. Morgan's David Kelly said.
  • High-quality fixed income or a covered call strategy could help calm fears of further market drops.
  • The firm is shifting to a more defensive posture but says stock valuations are attractive.

J.P. Morgan investment strategists see a greater recession risk given the Federal Reserve’s latest rate hike. They acknowledged that client emotions may be running high and suggested some investments that could ease fears of further market drops.

David Kelly, chief global strategist at J.P. Morgan Asset Management, said Wednesday he expects U.S. economic growth to slow this year and considers it a “jump ball” as to whether the economy will slip into a recession later this year.

Speaking to financial advisors shortly after the Fed’s move that day to raise its benchmark interest rate by 75 basis points — the biggest hike since 1994 — Kelly suggested that the central bank should be more patient in addressing high inflation.

“What the Fed’s own forecasts say is that growth will slow down, inflation will come down, and they’re raising rates very aggressively to try and combat that, but I think a little bit too aggressively. And so I think their actions today do raise the risk of a recession starting this year or early next year,” Kelly said.

The Fed also has raised the risk “that they’re not going to be able to keep at raising interest rates that long,” he added. “I wouldn’t be surprised if within a year we’re actually having a meeting where the Federal Reserve is considering cutting interest rates.” 

If there is a recession, it’s likely to be mild and short, Kelly said.  “Your client’s investment horizon is far longer than one business cycle.”

The firm has moved from an overweight to neutral stance toward U.S. equities but also noted this week that lower valuations have created a more attractive entry point for investors. The strategy team also is bullish on government bonds and believes investment-grade credit could slightly outperform U.S. stocks if the economy avoids recession.

Jordan Jackson, global market strategist at the firm, explained J.P. Morgan’s views on asset allocation and acknowledged that financial advisors’ conversations with clients may be centering on emotions more than market moves now that stocks have entered a bear market.

Investing Strategies to Ease Client Worries

Jackson offered approaches for dealing with investor concerns.

For a client who is particularly concerned about a recession, he suggested overweighting high-quality, core fixed income assets, and noted a broad Treasury index can return north of 3%. He also said an ultra-short bond ladder strategy from a cash position makes sense, given the Fed’s aggressive rate hikes.

Longer-dated municipal debt can play defense in a recession environment, and for clients who need more equities but are concerned about stocks sliding another leg lower, a covered call strategy can generate income while limiting downside participation, Jackson said.

For long-term investors, it’s important to remember that at some point, equity markets will reach and exceed their previous peak. If it takes three years to get to the Jan. 3 S&P 500 peak 4,797, that would be a cumulative total 27% return, or an annualized 8% to 8.5% return, from Wednesday’s close.

Taking inflation into account, that would translate into a positive real annualized return of about 5%, Jackson said, encouraging investors not to get too hung up on current market volatility.

More Attractive U.S. Stock Valuations

Given the higher recession risk, the firm is neutral toward U.S. equities but not underweight, Jackson said, noting that U.S. stock valuations had fallen by about 28% year to date as of Tuesday’s market close.

That translates into a forward price-to-earnings ratio of 15.6 for the next 12 months, which is 7.5% lower than the 25-year average of 16.9 times price to forward-year earnings, he said. (Stocks tumbled further Thursday as central banks in Europe also raised interest rates.)

“You’re seeing a much more attractive entry point from a valuations perspective by investing today,” Jackson said, noting that this year’s decline in valuations has occurred against a backdrop of improving earnings estimates. 

There needs to be more of a recalibration in the earnings outlook, especially for 2023, based on factors such as higher input costs and wages that threaten corporate profit margins, but that’s being offset by a “very attractive valuation argument,” Jackson said.

Even with the elevated uncertainty in the financial markets, valuations should be structurally higher today than they were 20 years ago, according to Jackson, who explained that the technology sector’s representation in the S&P 500 has doubled to about 30% in that time.

Also, he said, companies are flush with much more cash than historically and may start to put it to work in share buybacks, which is another support. 

In addition, real interest rates are meaningfully lower than two decades ago, “all of which support potentially higher valuations than where we’re at today,” Jackson explained.

Shifting to Defensive Mode

“From an allocation standpoint, we still think that an investor should have broad-based market exposure, but being generally selective,” he added. Given the rise in the recession risk, the firm is shifting gears toward a more defensive positioning, choosing “defensive sectors which we believe are best placed to navigate the twin challenges of higher inflation and slowing economic momentum,” Jackson said.

That translates into a focus on reasonably priced tech stocks; health care companies, which have seen earnings resilience; and utilities, he said.

Despite challenges abroad, “valuations continue to look very, very attractive by investing internationally versus here in the U.S.,” Jackson added. “International stocks now trade at a 25% discount relative to the U.S. and are also providing roughly a 2% more in dividend income relative to U.S. stocks.” 

Longer term, the dollar is very overvalued and may remain elevated given the hawkish Fed, Jackson said. In the next five to seven years, the dollar likely will fall and depreciate, and “that acts as a nice little cherry on top as a U.S. investor investing in international stocks.”

Bullish on Government Bonds

High yields make government bonds particularly attractive now, according to Jackson.

“Where we are kind of pounding the table and overweight are government bonds,” he said, adding that yields have probably peaked amid the Fed’s “peak hawkishness” and may start to move lower.

Inflation likely will come down in the second half, although maybe not as quickly as policymakers like, sparking downward pressure on bond yields, he predicted. Owning a U.S. Treasury bond with a 3.4% yield makes sense, especially given the higher recession risk, he said.

(Yields fell Thursday, the day after the Fed’s rate hike, with 10-year Treasurys slipping to 3.307% from an 11-year high 3.498% reached Tuesday, Reuters reported.)

Municipal bond yields also look “incredibly, incredibly, attractive,” Jackson said. “Their balance sheets and fundamentals are in really, really good shape and that’s where we’ll start to be putting some money to work.”

Given increased recession risks, J.P. Morgan has a bias toward overweight in investment-grade credit relative to high yield, with a more than 5% investment-grade yield the highest since 2010, Jackson said. High-yield fundamentals have been hanging in there, though, and default rates are only modestly higher, he added, noting that the firm has increased its default rate forecasts.

Even high quality investment-grade bonds will come under pressure in a recession, but if the economy narrowly avoids recession and the Fed achieves a “softish landing,” J.P. Morgan thinks investment-grade credit will marginally outperform U.S. equities, especially on a risk-adjusted basis, Jackson said.

Alternatives? Know the Goal

Investing in alternatives requires an outcome-oriented approach, so it’s important to know whether the investor seeks income or diversification, according to Jackson. Private assets like real estate, infrastructure and timber “all have pretty much zero correlation to both stocks and bonds and are providing a healthy degree of income,” he said.

In an elevated-volatility environment, covered call strategies can allow investors to monetize that volatility and limit downside, he said. 


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