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Hello, this is David Kelly.
I'm Chief Strategist here at JPMorgan Funds,
and I head the team that produces
the Guide to the Markets.
Welcome to the Economic and Market Update
for the First Quarter of 2022.
At the start of a new year, the economy and financial markets
are still being impacted by COVID-19.
However, two years into the pandemic, these impacts
are slowly beginning to fade.
In part, this is because almost all Americans now
have some immunity to the virus, either through inoculation
or infection.
However, it's also because the American economy has now
adapted to the pandemic, with many people simply resuming
their normal activities, and others adjusting
their lifestyles to provide themselves
with greater protection from infection,
while still fully participating in the economy.
This has allowed the US economy to fully recover
from the pandemic recession.
And, following a weak third quarter,
economic growth is accelerating over the winter.
This acceleration has prompted a sharp fall in the unemployment
rate and has contributed to strong growth
in corporate profits.
However, it's also been accompanied
by some of the strongest inflation seen in the past 40
years.
Both the economic improvement and higher inflation
has prompted the Federal Reserve to accelerate
the pace at which it's tapering its bond purchases
and project multiple increases in short-term interest rates
into 2022.
Fiscal policy will also be much less supportive
in the year ahead.
Despite a less friendly Washington,
US stocks saw a third consecutive year
of very strong gains in 2021, while long-term interest rates
only rose modestly.
However, as interest rates rise further,
and pandemic uncertainty falls in the year ahead,
high valuations appear likely to limit long-term returns
from both US equities and traditional fixed income,
increasing the need for a more diversified approach.
We believe any investment strategy
should start with a broad assessment
of these fundamental issues, which has, of course, always
been the goal of the Guide to the Markets.
However, it's important to do this concisely.
There are over 60 pages in the Guide.
But that's far too many for any conversation
with an investor about markets.
So what we do here is boil it down to just 12 slides.
In particular, we start with an update
on the course of the pandemic and fiscal policy.
We then look at the pace of recovery,
considering trends in economic growth, jobs, profits,
and inflation.
This is followed by comments on monetary policy.
Finally, we consider the implications
of all of this for those investing in US fixed income
and equities, as well as international equities,
and highlight the importance of investing
in a diversified way in an evolving economic environment.
Any assessment of the economic and market environment
has to start with the pandemic.
The left-hand side chart on slide 19
shows the seven-day moving average of new confirmed cases
and fatalities.
After a decline last summer, cases and fatalities
surged in the fall due to the Delta variant
and could surge again over the winter due to the emergence
of the Omicron variant.
However, barring the emergence of some further dominant
variant, both series should peak in the weeks ahead,
reflecting more widespread immunity from vaccinations
and prior infections.
The right-hand chart of this slide
provides some color on this.
Coupling vaccinations with the total number of individuals
who have already had the virus, we estimate that over 90%
of the US population has at least some immunity
to COVID-19.
This should allow cases, and particularly fatalities,
to fall in the months ahead.
In addition, while the pandemic isn't over yet,
many parts of the economy have adapted
to operate in a pandemic environment.
We all hope that the pandemic itself
will fade as we move into 2022.
But whether it does or not, it should
have much less of an impact on the economy
than it has had over the past two years.
Apart from vaccinations, unprecedented fiscal stimulus
from both the previous and current administrations
has proven to be a powerful accelerant
for the economic recovery.
Indeed, legislation passed in the last two fiscal years
has added $5.3 trillion to the economy.
However, this stimulus is likely to drop sharply
in the current fiscal year.
Page 22 shows the impact of the recession
and fiscal stimulus on the federal budget,
according to the Congressional Budget Office,
before accounting for the impact of the infrastructure bill.
These forecasts also assume the individual tax cuts contained
in the 2017 Tax Act expire on schedule
in the middle of this decade.
In addition, as we show in the table to the left,
the CBO is assuming a continuation
of very low long-term interest rates,
even in the midst of economic recovery and huge deficit
spending.
However, even if we include an extension of the tax cuts
and new benefits passed under the current administration
and the last one, the deficit is likely to fall dramatically
in the years ahead.
In 2022, the economy should be much
healthier than over the past two years,
but it will also receive much less government support.
The initial shock of the pandemic
and the subsequent fiscal aid set off
a wave pattern in economic output
that has now lasted almost two years.
Economic output fell in the first quarter of 2020
and then plunged in the second quarter,
with a peak-to-trough recession that was
the deepest since World War II.
However, output rebounded sharply after that,
and the economy grew very strongly
into the summer of 2021.
Economic growth slowed again at that point,
largely due to acute supply chain issues and the impact
of the Delta variant.
However, growth reaccelerated at the end of 2021
and should continue to be very strong into early 2022,
as reopening resumes and companies
try to rebuild inventories.
However, as we move further into the new year,
real output looks likely to exceed the path estimated
from its long-term pre-pandemic trend,
indicating a full recovery.
At that point, with a shortage of workers
and much less fiscal and monetary stimulus,
we expect economic growth to slow towards a long-term trend
of roughly 2% annualized.
In short, economic growth in 2022 should come in like a lion
and go out like a lamb.
The surge in GDP has been mirrored
by a rebound in the labor market as the economy reopens.
After shedding an astonishing 22.4 million jobs
between February and April of 2020,
the economy has now recovered 18.4 million jobs, or 83%
of the total pandemic loss.
That being said, the job market recovery is not quite complete,
with the unemployment rate at 4.2%,
compared to 3.5% before the pandemic.
While this might suggest that a small amount of labor slack
remains, wages tell a different story.
The blue line shows the annualized growth
in average hourly earnings.
Wage growth has been rising and is
at annualized rates not seen since the 1980s.
Putting this together with surging labor demand,
this suggests the employment shortfall is primarily
an issue of labor supply.
Labor supply has been slower to recover as the economy reopens,
and this has likely been constrained
by enhanced unemployment benefits, lower immigration,
higher costs for child care, and lingering pandemic fears.
This is an important issue for the Federal Reserve,
as higher wages should lead to higher inflation,
implying that the economy could reach maximum employment sooner
than in past economic cycles.
Overall, while the labor shortage
is likely to persist for some time,
we expect some of these pandemic effects to recede.
And this should allow unemployment
to fall below 4% in the first half of 2022.
The deep economic recession was mirrored
in big declines in S&P 500 operating earnings
in early 2020.
However, as shown on page 8 of the Guide,
earnings have now recovered spectacularly
and hit a new all-time high in 2021.
This partly reflects the reality that some
of the most important sectors of the US equity market,
including technology, communication services, health
care, and consumer staples, saw few negative impacts
from the pandemic and, in many cases, saw stronger revenues.
More generally, earnings have been
bolstered by powerful consumer demand and higher productivity,
as businesses have been able to reduce costs
in a more virtual environment.
However, entering 2022 and beyond, things will get harder.
We're headed toward slower economic growth, higher wages,
higher interest rates, and potentially higher
corporate taxes.
Consequently, investors should consider valuations
very carefully, as the potential for further earnings growth
looks much more modest.
Inflation has heated up significantly
over the past year as surging consumer demand has
collided with supply shortages across major sectors
of the economy.
CPI inflation has been accelerating
since the start of the summer, with the latest
year-over-year gain in CPI at 6.8% overall and 4.9%,
excluding food and energy.
These year-over-year gains in inflation
have been amplified by weak increases in prices a year ago.
But supply chain issues have been a problem.
In particular, the global semiconductor shortage
has increased prices of a wide range
of goods throughout the economy, and most notably autos.
These higher input costs have sent inflation higher,
and this has been amplified by a general recovery in prices
of airfares, restaurants, and rents from their pandemic lows.
Fiscal support for lower- and middle-income households
has also bolstered the demand for food,
leading to higher food prices, while a spike in oil
prices to over $80 a barrel in October
boosted the volatile energy components of CPI.
Importantly, the PC deflator, which
is the Fed's preferred measure of inflation,
is up by more than 5% year over year, well
above the Fed's long-term target of 2%.
We believe that much of the current inflation surge
will prove transitory, including the energy and supply chain
issues.
However, the impacts of higher wage growth, rising rents,
and generally higher inflation expectations should linger.
And this should imply inflation that
is well above 2% for the remainder
of this economic expansion.
Since the start of the pandemic, the Federal Reserve
has provided significant monetary stimulus
by cutting the federal funds rate to near-zero levels
and adding substantially to its balance sheet,
with $120 billion of bond purchases at a maximum
each month.
At the November meeting, they'd cut purchases to $105 billion
monthly in recognition of the progress the economy had made
towards their goals of maximum employment and inflation
running a little bit above 2%.
At its December meeting, the FOMC
delivered a significantly more hawkish message,
recognizing that the Delta variant had slowed
economic progress, but also that the labor market recovery has
been robust, and inflation may well
be stickier than they had previously assumed.
This is reflected in the Fed's updated summary
of economic projections, which show
upward revisions to its inflation estimates
and a reduction in the estimated unemployment rate.
Consequently, the Fed accelerated the pace
of tapering, now proposing to reduce bond purchases by $30
billion per month, with an eye to completing
the process by March.
This should clear the way for increase
in the federal funds rate potentially
starting as early as June.
And the median dot plot of FOMC participants
now suggests the potential for three rate hikes
by the end of 2022 and three further rate hikes in 2023.
So what does all this mean for investors?
For fixed-income investors, the challenge
is that the combination of very easy monetary policy
and a recession has left 10-year Treasury
yields at very low levels, as is shown on page 33.
Despite consistent upside surprises
on measures of wages, home prices, and consumer prices,
long-term rates have held steady at around 1.5%,
after backing up to 1.7% earlier last year.
The liquidity facilities established by the Fed
to protect other parts of the bond market
have tended to compress credit spreads,
while low foreign yields, portfolio rebalancing
into long-term bonds, and a temporary lull
in the supply of Treasuries have all suppressed
long-term interest rates.
However, policy support for the Treasury market
is now fading, and a new, higher debt ceiling
has been approved by Congress, allowing for an increased
supply of Treasuries.
Given this and an economic backdrop
of strong economic growth and high inflation,
we expect long-term interest rates to rise in the year
ahead.
Of course, there continues to be a place in portfolios for fixed
income to provide diversification and protection
in the case of an equity market or economic relapse.
However, given an unfavorable fundamental backdrop
for fixed income generally and tight spreads in credit
markets, investors may want to keep durations relatively short
and limit their exposure to credit risks
within the bond market.
Half the story in any investment analysis is valuations.
And valuations are very high.
On slide 5 of the Guide, we show the PE ratio
over the last 25 years.
The S&P 500 is currently selling at over 21
times forward earnings, which is more
than one standard deviation above its long-term average.
Earnings likely continue to grow in the fourth quarter 2021,
and extrapolating these higher earnings into 2022
could lead to a further compression in these ratios.
Relatively low interest rates likely justify
some elevation of valuation measures
above their historical averages.
However, these interest rates are
likely to rise somewhat in the year ahead,
and slowing economic growth, higher corporate taxes,
and stronger wage pressures could all
impede earnings growth.
Consequently, investors may want to take a sober look
at valuations and recognize the limited potential for gains
in broad US equity indices in the years ahead.
After multiple years of strong outperformance
of growth stocks, most notably during the pandemic in 2020,
value stocks began to recover earlier last year.
However, a combination of declining interest rates,
fears about the Delta variant, and disappointing economic data
relative to expectations led growth
to outperform in the second half of the year.
Does value still have room to run?
Page 10 of the Guide provides some insight into this debate.
The left-hand side shows that value stocks
remain at historically cheap levels
relative to growth stocks compared to long-term averages
and carry substantially higher dividends.
Additionally, value generally tends to outperform growth
during periods of above-trend economic activity and rising
interest rates, such as we project
over the next few months.
This reflects the fact that earnings
of value-oriented sectors tend to be
more sensitive to the pace of economic growth,
as shown on the right-hand side of the chart.
However, investors would be wise not to abandon growth stocks
altogether, as the economy is likely to slow down
to a much slower pace of economic growth later in 2022
and in 2023, and growth stocks have traditionally
outperformed value stocks in a slow economic growth
environment.
Investors may also want to increase their holdings
of international equities.
While the expected synchronized global recovery
has been delayed, it has not been derailed.
And vaccination programs overseas
have made significant progress, with many countries now
outpacing the United States.
In addition, valuations remain attractive,
with both emerging-market and developed-country stocks
outside the United States selling
at some of their cheapest levels relative to their US
counterparts in the last 20 years.
International equities also offer greater sensitivity
to the powerful post-pandemic economic rebound,
particularly Europe and Japan, where cyclical sectors comprise
over half of the respective equity markets.
This, along with structural growth opportunities
and the prospect of lower dollar in the long run,
all argue for greater allocation to international equities,
with a particular focus on Europe and East Asia.
Finally, slide 12 shows the valuation dispersion
of stocks within the S&P 500 over the last 25 years,
illustrating a widening valuation
gap between the most- and least-favorite stocks
in the market.
This current S&P 500 valuation spread
is markedly higher than 25-year average.
This wide dispersion of valuations
points to an opportunity for active management.
The US economy has had a bumpy recovery,
with higher than expected inflation,
but is still on a strong footing as we enter 2022,
and further progress on the pandemic at home and abroad
will continue to be a tailwind for the global economic
recovery.
Given the substantial gains markets
have seen thus far in the economic cycle,
investors would be wise to focus on fundamentals
and maintain a well-diversified stance
as we move forward into a hopefully happier
and much healthier 2022.
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