12 Insights on Inflation, Recession and Where to Invest Now: JPMorgan

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12 Insights on Inflation, Recession and Where to Invest Now: JPMorgan

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Portfolio > Economy & Markets

12 Insights on Inflation, Recession and Where to Invest Now: JPMorgan

By Dinah Wisenberg Brin

Slideshow July 07, 2022 at 02:09 PM Share & Print

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Strategists at J.P. Morgan Asset Management see a good chance that the U.S. economy will tip into recession but expect the downturn to be brief and mild if it does. They also note signs that high inflation is starting to turn.

Chief global strategist David Kelly and global market strategist David Lebovitz discussed their outlook Tuesday as the firm released its third-quarter Guide to the Markets. In the gallery above is a look at their insights.

Dinah Wisenberg Brin

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12 Insights on Inflation, Recession and Where to Invest Now: JPMorgan

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1. Inflation Really Is Transitory
David Kelly, J.P. Morgan Asset Management chief global strategist, noted that long-term market returns are strongly positive despite being “pretty ugly across the board” so far this year. What happened was simple: inflation remained hotter than the Federal Reserve and markets expected and the Fed decided to tighten aggressively, he said.

Inflation may be turning in the right direction, though.

“This is not your grandfather's inflation, this is not a 1970s inflation again,” Kelly said. “It really is actually transitory,” he added, citing factors including pandemic-related supply chain shortages, China’s zero-COVID policy, Russia’s Ukraine invasion and western sanctions against Russia.

“That has prolonged the inflation rate, but I think it’s important to recognize that it’s not going to last forever, we’re already seeing some signs of inflation turning,” Kelly said, adding that the market may not see it in forthcoming June Consumer Price Index data.

As of Tuesday afternoon, the Bloomberg Commodity Index was down 18% from its June 9 peak, he noted. “We’re seeing prices for commodities fall. I think airfares (have) already topped out. So I do think inflation's beginning to roll over.”

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2. 'Good Chance' for Mild, Brief Recession
Fed actions this year have “really increased the risk for recession,” Kelly said.

In December, Fed officials expected inflation to ease, for vaccines to contain the COVID pandemic and for supply chain issues to resolve. “When that did not materialize, that is when they lost their nerve,” Kelly said. “Honestly I think they should have kept their cool,” because these were temporary factors, he added.

Now the central bank has raised interest rates much more than they anticipated six months ago.

“Will we end up in recession? I think there’s a good chance we will,” Kelly said, quickly adding that it’s likely to be mild if it happens.

The ratio of job openings to job seekers is likely to come down “but it still is so high by historical standards that there will probably be an excess amount of labor all the way to the end of this year. And if that’s the case, that should keep the unemployment rate low, it should keep payroll job growth positive, and it’s hard to say you’ve got a recession if you’ve got a low, flat unemployment rate and payroll jobs growth,” Kelly said.

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3. No 'Boom to Bust' Excesses in Key Sectors
Conditions don’t appear to be in place for a traditional recession, according to Kelly. Generally, he said, at least one of four factors — light vehicle sales, the inventory-to-sales ratio, residential investment as a percentage of GDP and business investment as a percentage of GDP — must go from boom to bust.

“But none of these sectors today is overbuilt. There’s no excess. We don’t have excessive numbers of houses or cars, we don’t have excessive business investments, we don't have excessive inventories — quite the reverse — and it’s very hard to injure yourself if you fall out a basement window,” he said.

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4. Plenty of Pent-Up Demand in Economy
Other signs also point to any U.S. recession being brief and modest, Kelly said.

“Banks are well-capitalized. There’s plenty of pent-up demand in the economy, there’s pent-up demand for workers. If we have a recession it should be mild, it should be short-lived, and in fact that is actually what a modern recession is,” he said.

Historically, expansions are much longer than recessions, he said, explaining that in the last 100 years the average expansion lasted 47 months while recessions lasted 14 months. And in the post-World War II period, expansions have averaged five years and recessions less than one. “That’s really much more typical,” Kelly said.

If the economy does enter a recession, it should fix some problems the country faced in early 2022, such as a massive federal budget deficit relative to GDP, the excess of jobs relative to workers and financial market imbalances, Kelly said.

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5. Stocks, Bonds Likely to Resume Their Negative Correlation
Global market strategist David Lebovitz noted that average investors faced the troubling specter this year of watching their stocks and bonds sell off together as correlations between these asset classes turned positive — i.e. they moved in the same direction — a development not seen since the 1990s. J.P. Morgan Asset Management expects stocks and bonds to re-establish their negative correlation.

“The Fed was spooked by inflation” so they tightened monetary policy, and since stock and bond markets dislike tightening, “everything sold off effectively in lockstep,” Lebovitz noted.

“We think about the road ahead, we do believe that this negative correlation between stocks and bonds will reassert itself, particularly as investors begin to focus more on a potential downturn in growth as opposed to the issue of inflation,” he said.

“But the reality here is that the distribution of outcomes has risen, uncertainty is elevated, and it’s times like these when focusing on the fundamentals and, more importantly, focusing on valuations, is the best investment approach to take.”

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6. Valuations Attractive Across Fixed Income
Valuations across fixed income are looking more attractive than they have in quite some time, according to Lebovitz. He suggested it may make sense for investors to take on “a bit more duration” given the yield pickup and as a hedge against potential recession in the next 12 to 18 months.

“There’s a very good chance that we’ve seen peak yields for the current cycle, particularly in the 10-year to 30, and so if you’ve been short-duration up until this point, maybe moving back to more of an intermediate posture makes sense as we think about the remainder of this year and the beginning of next year,” Lebovitz said.

“We frankly think that the higher-rated parts of high yield are looking interesting. Corporate fundamentals are solid. Revenue and earnings growth is still positive, coverage ratios look good and the bottom line is that these companies have a ton of cash which we think could limit any rise in defaults if the economy were to roll over,” he said.

“And so while we’re being somewhat selective when it comes to the credit markets broadly; we are willing to take on that risk within the context of a diversified fixed-income portfolio,” Lebovitz explained.

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7. Alternative Investments Becoming Essential
Alternative investments have become an important part of portfolios, according to Lebovitz, who noted yields remain low from a historical view and that another inflation scare could mean stocks and bonds move together again.

“We think that alternatives have continued their transition from optional to essential,” he said. Yield is available across the alternative investment universe, including transportation, private credit, infrastructure and real estate. “Not only can alternatives be a source of income, they can also be an additional source of diversification,” Lebovitz said.

Hedge funds, he added, can “provide diversification without taking on additional interest rate sensitivity.”

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8. Consensus Earnings Views May Be High but No Call for Pessimism
U.S. stocks are inexpensive now relative to fixed-income securities and their own historical performance, with the S&P 500’s forward-looking price-to-earnings ratio down 27% year-to-date at the end of the second quarter, Lebovitz noted. Many investors want to know if earnings are “the next shoe to drop,” he said.

Looking at more than 100 years of data, however, the firm found that “it is very rare for both earnings and multiples to detract from returns in the same calendar year,” he said.

Consensus earnings estimates are probably too high for this year and definitely for 2023, but “we’re not as pessimistic as some,” Lebovitz said, adding that earnings will likely be flat next year, with some downside risk for that forecast. The firm is not in the camp that thinks there needs to be a big earnings rerating in the next 12 to 18 months, he added.

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. International Stocks Present Opportunity
The global economy isn’t as strong as J.P. Morgan Asset Management’s team would like to see it, but that situation could turn around. And it may present investment opportunities. “There is a lack of momentum outside the United States for now, but again, this should be temporary,” Kelly said. If a ceasefire happens in Ukraine, “I think you could see a turn up in international fortune,” he added.

“There are plenty of opportunities overseas,” Kelly said. International investments offer an opportunity to take advantage of relatively cheap valuations and the possibility of the dollar eventually coming down, he said. The strong dollar is hurting U.S. corporate profits and exports and is among the factors slowing the economy, Kelly said. When the Fed turns less hawkish and cuts interest rates, it’s likely to do so more aggressively and dramatically than other central banks, which would probably push down the dollar, he added.

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10. Three Value Sectors Could Benefit Most in Slower Growth Environment
J.P. Morgan Asset Management sees opportunities in both growth and value stocks, and takes a "GARP" approach, or growth at a reasonable price, strategy, according to Lebovitz.

Three value sectors — energy, financial and materials — appear best poised to benefit in a nominal growth environment, although growth sectors including technology and health should see advantages too, according to the firm.

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11. A Focus on U.S., Emerging Market Stocks
The firm likes the idea of barbelling U.S. and emerging market stocks, which are the most attractive now, Lebovitz said. “We wouldn’t completely run away from developed markets,” he said, noting that Europe’s outlook could improve with certain developments, such as the Ukraine war settling sooner than expected or Europe figuring out its energy issue.

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12. Outlook Becoming 'More Constructive'
The team isn’t calling a bottom on the market and isn’t completely sold that it has run its course, but at some point, it will turn around, Lebovitz said.

Even if it took the S&P 500 five years to get back to its peak, he said, it would generate average annualized returns of nearly 7%.

The firm thinks the economy has seen peak inflation and that yields will decline, he said. “It does feel like the outlook is becoming more constructive.”

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