2018 investment outlook: Mid-year update - J.P. …...2018 investment outlook: Mid-year update Pro-risk tilt remains, but becoming more balanced June 2018 IN BRIEF • Our investment

MARKET INSIGHTS

2018 investment outlook: Mid-year update Pro-risk tilt remains, but becoming more balanced June 2018

I N B R I E F• Our investment outlook for 2018 was titled, “It

ain’t over till the central banks sing”. We argued that although the cycle was relatively old, there were still not convincing signs that the global economy was at full capacity. Until inflation reared its ugly head, the central banks were likely to keep global monetary conditions loose, which would continue to support risk assets.

• With unemployment now sub-4% in the US, the Federal Reserve (Fed) has started humming. But the European Central Bank (ECB) and Bank of Japan (BoJ) are yet to break out a tune. Such loose monetary policy outside of the US continues to weigh on global monetary conditions and the US 10-year government bond yield has not managed to sustain a break much above 3%.

• What we perhaps hadn’t bargained for was an increasing amount of background noise from governments—the US administration in

particular. The threat of a global “trade war” is dampening corporate spirits in the major export hubs of Europe and Asia.

• There are no such signs of weakness in the US and growth and interest rate differentials have contributed to a sizeable upward squeeze on the dollar which in turn has created challenges for some emerging market (EM) economies.

• Over the second half of the year we expect some reacceleration in growth outside of the US as the underlying drivers of the synchronised recovery–employment growth and increased availability of cheap credit–reassert themselves.

• The combination of robust earnings and subdued prices leaves equity valuations less stretched than they appeared earlier in the year. We expect modest gains in equity prices by year end as government bond prices drift lower.

AUTHOR

Karen WardManaging Director,Chief Market Strategist for EMEA

2 PRO-RISK TILT REMAINS, BUT BECOMING MORE BALANCED

2018 INVESTMENT OUTLOOK: MID-YEAR UPDATE

SYNCHRONISED RECOVERY STILL IN PLACE

The synchronised recovery, which proved so fertile for assets markets last year, is still ongoing, with growth in the major economies—the US, the eurozone, Japan and China—still above trend.

This is translating into robust corporate earnings. First-quarter earnings beat expectations across the board. US bourses were the star performer as the sizeable tax cut helped earnings per share jump 25% in the first quarter. But earnings were also comfortably above expectations in Europe and Japan. European companies reported earnings growth of 10% and the TOPIX 11%.

In Q1, earnings beat expectations in all major markets

EXHIBIT 1: EARNINGS PER SHARE GROWTH FOR Q1

% change year on year

0

5

10

15

20

25

30

Europe Japan US

Expectations Delivered

Source: J.P. Morgan Securities Research, J.P. Morgan Asset Management. Q1 Earnings per share growth for European companies, TOPIX companies and S&P 500 companies. Data as of 12 June 2018.

Growth has been broadening from consumer spending to corporate investment. The memories of the great recession took a long time to fade, and for many years corporates lacked the confidence to expand business investment. Although this has been a long recovery it has been a very shallow one, largely due to this hesitancy among corporates to invest.

Labour shortages suggest firms will need to raise productivity

EXHIBIT 2: PRODUCTIVITY GROWTH AND QUALITY OF LABOUR

% of firms (LHS); 3-year % change, annualised (RHS)

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

0

5

10

15

20

25

30

'86 '90 '94 '98 '02 '06 '10 '14 '18

NFIB single most important problem:Quality of labour

Productivity growth(lagged 3 years)

Source: Bloomberg, BLS, NFIB (National Federation of Independent Business), Thomson Reuters Datastream, J.P. Morgan Asset Management. Data as of 12 June 2018.

Firms are being forced to spend more on capital as labour is becoming increasingly scarce–particularly in the US. Going forward, firms will have to squeeze more out of their existing employees—in other words, they will need to raise productivity. Evidence of rising productivity would be a very positive development for markets because it has the potential to extend the cycle, keep inflation low (by reducing unit labour costs), support corporate profitability and limit the need for much higher interest rates.

“TRADE WARS” ARE A KEY RISK BUT UNLIKELY TO ESCALATE FURTHER

Left alone, there is potential for this virtuous cycle of growing confidence, growing investment and growing productivity to flourish. But policy coming out of Washington is creating risks around the benign outlook.

The prospect of a global trade war is the most concerning. The US administration believes the large current account deficit in non-energy goods is a reflection of lopsided trade deals. So far, the only concrete action has been the introduction of tariffs on steel and aluminium entering the US. These alone will have very little impact on either US or global activity. But the risk is these relatively minor actions escalate in a “tit-for-tat” manner to other products.

J .P. MORGAN ASSET MANAGEMENT 3


Our central expectation is that these skirmishes do not escalate into a full trade war. Although “cheap” imports challenge some sectors and workers in the US, the vast majority of US households benefit from these lower prices. Much does depend on how these policies are received domestically as the midterm elections approach. It is unclear at this stage whether the US administration has a political incentive to dial it up or dial it down before voters go to the ballot box. This uncertainty alone argues for a more cautious approach to risk.

TRADE CONCERNS AND HIGHER OIL PRICES WEIGHING ON EUROPE TEMPORARILY

The US administration has also pulled out of the Iran nuclear deal, which has helped push oil prices towards USD 80/barrel. The combination of trade concerns and higher oil prices is weighing on European sentiment. The composite purchasing managers’ index—the main survey of business sentiment—now suggests the eurozone is growing at around 2%, rather than a level closer to 3% at the end of last year. We have seen a similar downturn in the sentiment of Japanese companies, which are similarly trade and oil sensitive.

We expect global trade concerns to recede and the underlying drivers of the European recovery to reassert themselves through the second half of the year. European banks are now on a much firmer footing and competition is seeing interest rates fall and lending standards loosen. The labour market is also healing. Employment is growing as fast in Europe as in the US, which is helping push consumer confidence towards record highs.

Falling unemployment is supporting consumer confidence and spending

EXHIBIT 4: EUROPE CONSUMER CONFIDENCE AND MSCI EUROPE

Index level

-40

-35

-30

-25

-20

-15

-10

-5

0

5

0

200

400

600

800

1,000

1,200

1,400

1,600

1,800

'99 '01 '03 '05 '07 '09 '11 '13 '15 '17

MSCI Europe

European consumer confidence

Recession

Source: European Commission, MSCI, Thomson Reuters Datastream, J.P. Morgan Asset Management. Light grey columns indicate recession. Data as of 12 June 2018.

EUROPEAN POLITICS BACK IN THE SPOTLIGHT—CONCERNING BUT NOT A SYSTEMIC RISK

The Italian election created considerable volatility over the course of May as the market digested the implications of a government led by the two main populist parties (Five Star Movement and Northern League).1 We still have a lot to learn about the new Italian coalition’s economic and political priorities. However, many of the more extreme policies that each party included in early manifestos—such as a referendum on the euro—have been abandoned.

Trade concerns are a near-term drag on eurozone activity

EXHIBIT 3: CONTRIBUTION TO EUROZONE REAL GDP GROWTH AND COMPOSITE PMI

% change year on year (LHS); index level (RHS)

30

35

40

45

50

55

60

65

-8

-6

-4

-2

0

2

4

6

'00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12 '13 '14 '15 '16 '17 '18

Change in inventories

Net exports Investment

Consumption

Government

Composite PMI (RHS)

Source: Eurostat, Markit, Thomson Reuters Datastream, J.P. Morgan Asset Management. PMI is Purchasing Managers’ Index where a score of 50 indicates that economic activity is neither expanding nor contracting, above 50 indicates expansion. PMI data is shown with quarterly frequency. Data as of 12 June 2018.

1 A populist shift in Italy but not a systemic risk, Maria Paola Toschi, J.P. Morgan Asset Management, 24 May 2018.



The main features of the programme at this stage are tax cuts and a universal income for Italy’s poorest households. This could serve to boost Italian activity in the near term, but such fiscal largesse may also trouble the European Commission given that Italy’s government debt to GDP already stands at 130%.

After an alleged corruption scandal, Spain’s prime minister was also forced to leave office. We don’t believe either of these political developments will destabilise the region politically or economically in the short term. However, it will likely make Germany more reluctant to engage in the risk-sharing that is required for further integration. Progress on the banking union is looking less likely, which does increase the vulnerabilities of the region in the next downturn. This has served to weigh on the prospects for European equity benchmarks, given their high weighting to financials.

BREXIT DEAL LIKELY BY END-YEAR

By the 18-19 October summit, we expect a Brexit deal to be agreed—one that preserves trade in both goods and services.2 Such a positive outcome may not seem obvious in the coming weeks, given the concessions that will need to be accepted by certain factions of the UK Conservative Party. The headlines will likely get worse before they get better.

If our expectations are proved to be correct, there could be considerable implications for UK markets. We would expect to see a broad-based increase in sterling, which would in turn lower UK inflation at a time when real wages are rising. The

outlook for the UK consumer could improve significantly into next year. Given that unemployment stands at a multi-decade low, it is likely to be increasingly clear that the economy does not need such accommodative monetary policy. We expect the Bank of England to raise the base rate of interest by 25 basis points (bps) in November and to hike twice more next year.

US POWERING AHEAD HAS PUT UPWARD PRESSURE ON THE DOLLAR

While cracks have appeared in growth in Europe and Japan, the US is powering ahead full steam as the stimulus from the Tax and Jobs Act and additional government spending slowly filters through the economy. Given that the income tax effects are likely to be most keenly felt in the first half of 2019, the fiscal stimulus has the potential to extend the US cycle for another year, despite its rather advanced age. The recent increase in the oil price should also serve as a major stimulus to the sizeable US shale sector, at least partially offsetting the drag on consumer spending.

The risk remains that this additional boost to growth—when unemployment is already low—shows up more in inflation than it does in growth. Despite US unemployment pushing below 4%, wage growth is still moderate. The forces of globalisation, and workers’ fear of automation, are likely to mean wage growth stays relatively subdued. After all, unemployment in Japan has been below 4% for much of the past few decades and wage growth has failed to accelerate. But perhaps the most

Fiscal spending is likely to extend the cycle, but does carry inflation risks

EXHIBIT 5: US FISCAL BALANCE AND UNEMPLOYMENT

% (LHS); % of nominal GDP (RHS)

-10

-8

-6

-4

-2

0

2

41

2

3

4

5

6

7

8

9

10

11

'61 '65 '69 '73 '77 '81 '85 '89 '93 '97 '01 '05 '09 '13 '17 '21

Unemploymentrate

Fiscal balance(inverted)

ForecastRecession

Source: BEA, J.P. Morgan, Thomson Reuters Datastream, J.P. Morgan Asset Management. Unemployment rate is a yearly average. Fiscal balance and unemployment for 2018 and 2019 are using J.P. Morgan Securities Research forecasts. Light grey columns indicate recessions determined by NBER. Data as of 12 June 2018.

2 How will the Brexit negotiations affect European markets?, J.P. Morgan Asset Management, 4 April 2018.



fundamental question for investors—of which no-one truly has the answer—is whether inflation is dead or merely sleeping? As a result, investors will remain very sensitive to indicators of inflation, which is likely to lead to bouts of market volatility, as we have already seen this year.

Outside the US, core inflation is still too low

EXHIBIT 6: CORE INFLATION % change year on year

-2

-1

0

1

2

3

4

'00 '02 '04 '06 '08 '10 '12 '14 '16 '18

USEurozoneJapan

Headline inflation target

Source: Bank of Japan, BLS, Eurostat, Thomson Reuters Datastream, J.P. Morgan Asset Management. CPI is the Consumer Price Index. Core inflation for the US and Japan is defined as CPI excluding food and energy. Core inflation the eurozone is defined as CPI less energy, food, alcohol and tobacco. Japan core CPI has been adjusted down by 2% from April 2014 to March 2015 to remove the estimated impact of the consumption tax hike over this period. Data as of 12 June 2018.

Even without a significant pickup in underlying inflation, the Fed is likely to continue normalising policy gradually—at a pace of around 25 bps per quarter. But with core inflation remaining stubbornly low elsewhere in the developed world, it seems highly unlikely that we will see either the BoJ or ECB follow with higher interest rates any time soon.

This leaves US yields increasingly attractive relative to those offered by other developed world government bonds. Coupled with rising geopolitical noise, which is tempering enthusiasm for risk, May saw a significant squeeze higher in the value of the dollar.

We don’t expect this strength to last. We believe growth in other major economies, including Europe and Japan, remains solid, which will start to tempt capital back to these markets at some point over the coming year. And, longer term, we believe the combination of a large US trade deficit and seemingly ever-rising government debt will weigh on the dollar.

A STRONGER DOLLAR IS CHALLENGING FOR SOME EMERGING ECONOMIES, BUT NOT ALL

Near-term however, higher US interest rates and a stronger dollar are challenging some emerging economies. The most vulnerable countries are those with large external debts (most commonly oil importers) and relatively limited currency reserves. These countries—most notably Argentina and Turkey—have been forced to raise interest rates to defend their currencies, which will likely precipitate a domestic slowdown.

But there are other countries that have reduced their external leverage significantly following the experience of the “taper tantrum” in 2013 and built up domestic reserves. And the market is showing some ability to differentiate. While the Argentine peso and Turkish lira are both down more than 15% year to date, the Malaysian ringgit and Thai baht are both up on the year, and many other Asian currencies are broadly stable.

The market is distinguishing between strong and weak in emerging markets

EXHIBIT 7: EMERGING MARKETS CURRENCIES PERFORMANCE % change vs US dollar year to date

Argentine peso

Turkish lira

Brazilian real

Russian ruble

South African rand

Indian rupee

Philippine peso

Mexican peso

Indonesian rupiah

Taiwanese dollar

Singapore dollar

Malaysian ringgit

Chinese renminbi

Thai baht

Colombian peso

-30 -25 -20 -15 -10 -5 0 5 10

Source: Bloomberg, J.P. Morgan Asset Management. Data as of 12 June 2018.

While we always have to cope with higher volatility when investing in emerging economies, in our view China provides a solid bedrock for selective EM investment. The China 2025 initiative is likely to see China continue to evolve towards a more sophisticated economy with higher personal incomes. Initiatives such as One Belt, One Road are likely to see some of this expansion filter into surrounding economies as trade and investment partnerships flourish. Over the longer term, we still believe emerging markets—and emerging Asia, in particular—provide the greatest opportunities.



CONCLUSION

Despite the tailwinds of strong growth and loose global monetary conditions, geopolitical turbulence will make for a less pleasant journey than we experienced in 2017. This argues for a slightly more cautious approach to risk. At some point, higher wage costs and interest rates will begin to erode corporate profitability in the US. And bonds will play an increasing role in portfolios as yields rise and the need for protection against an economic downturn increases. But these are conversations to be had more seriously next year. For the remainder of this year, we still expect equities to offer modest positive returns and bond prices to grind slightly lower.

Strong corporate earnings may lift equities more than credit, given valuations

EXHIBIT 8A: GLOBAL EQUITY VALUATIONS

x multiple, forward price to earnings ratio

EXHIBIT 8B: FIXED INCOME DEBT YIELDS

% yield

0x

5x

10x

15x

20x

25x

30x

35x

75x

US Europe ex-UK UK Japan EM

Range since 1990Average since 1990

CurrentOne year ago

0.82.7

1.0

3.9 3.7

6.6 6.5 7.3

0

5

10

15

20

25

Euro Gov. US Treasury Euro IG US IG Euro HY US HY EMsovereign

(USD)

EM local

10-year range10-year average

Current

Source: IBES, MSCI, Standard & Poor’s, Thomson Reuters Datastream, J.P. Morgan Asset Management. Valuations refer to 12-month forward price-to-earnings ratios for Europe ex-UK, US, Japan, UK and emerging markets. Valuation and earnings charts use MSCI indices for all regions/countries, except for the US, which is the S&P 500. Data as of 12 June 2018.

Source: Barclays, BofA/Merrill Lynch, FactSet, J.P. Morgan Economic Research, J.P. Morgan Asset Management. Yields are yield to maturity. Euro Gov.: Bloomberg Barclays Euro Agg. Government; US Treasury: Bloomberg Barclays US Agg. Gov. – Treasury; Euro IG: Bloomberg Barclays Euro Agg. – Credit – Corporate; US IG: Bloomberg Barclays US Agg. Corporate – Investment Grade; Euro HY: BofA/Merrill Lynch Euro Non-Financial; US HY: BofA/Merrill Lynch US High Yield Constrained; EM sovereign (USD): J.P. Morgan EMBIG index; EM local: J.P. Morgan GBI-EM index. Data as of 12 June 2018.



MARKET INSIGHTS

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2018 investment outlook: Mid-year update - J.P. …...2018 investment outlook: Mid-year update Pro-risk tilt remains, but becoming more balanced June 2018 IN BRIEF • Our investment