The Week Ahead by JPMorgan Funds

Taking Down the Spinnaker

Successful investing requires both courage and brains, but in different quantities at different times. In a deep economic and market slump, courage is the key, since it is a no-brainer that both the economy and markets will eventually recover. However, once both markets and the economy have fully recovered, it’s brains that count, since investors need to find strong returns in markets which generally promise only mediocre ones. This is particularly relevant in the week ahead, as the current bull market celebrates its eighth birthday on Thursday.

Eight years ago, on March 9th, 2009, the S&P500 closed at 677, down 57% from where it had been just 18 months earlier.  10-year Treasury yields had fallen from 3.6% to 2.9% over the previous year and, given a core inflation rate of 1.8% year-over-year, real yields were well below their long-term average. Investors were depressed and scared.  However, good long-term returns from stocks were almost inevitable at that point because economic and market fundamentals were at unsustainably low levels.

–Payroll jobs had fallen by over 650,000 in February and the unemployment rate had risen by 0.5% in just one month.

–Housing Starts had slumped to just 466,000 in January, less than a third of their long-term average, and,–Light-vehicle sales had fallen to just 9 million units, more than 40% below their long-term average.

Meantime, the Federal Reserve had slashed short-term interest rates to near zero and the Federal Government was set to unleash a significant stimulus package. Most importantly, the lessons of Lehman Brothers had not been forgotten and the government was determined not to let any of 30 named major financial institutions go bankrupt. Once this was clear, it was also obvious that the economy would begin to heal and would foster a recovery in corporate earnings.  Unemployment does not rise for ever and the huge pent-up demand implied by dismal vehicle sales and housing starts meant the economy was setting itself up for a bounce-back.

In nautical terms, it was time to hoist the spinnaker and take advantage of a strong cyclical tailwind propelling a stock rebound.
Eight years later, the financial landscape has changed completely.

–Vehicle sales, at 17.5 million units in February are back above their long-term average.

–Housing starts at 1.25 million units in January are closing in on what will likely be a lower post-financial-crisis trend.

–The unemployment rate is 4.8% and, in this Friday’s jobs report, could well fall to 4.7%.  Meanwhile, initial unemployment claims last week fell to 223,000 – their lowest level in almost 44 years.

On Friday, Janet Yellen made it clear that, barring a significant negative surprise in the next few days, the Fed will raise interest rates for the third time in this expansion when the FOMC meets on March 15th. Most importantly for investors, both stocks and bonds are now significantly more expensive than eight years ago.

On the equity side, the S&P 500 closed at 2,383 on Friday, boosting the forward P/E ratio to 17.8 times, about 12% above its 25-year average.  Remarkably, however, Treasury bonds are also more expensive than they were eight years ago with a 10-year yield of 2.5% despite a pickup in core inflation to 2.3% year over year. While confidence is far higher than eight years ago, returns for both large-cap U.S. stocks and high-quality bonds now face a significant valuation headwind. With earnings growing more slowly, dividend yields and bond coupons low, and the potential for P/E ratios and real yields to mean revert, a traditional 60/40 U.S. stock/bond portfolio could well generate returns over the next five years that are less than half the roughly 8% annualized gain that such a portfolio provided over the past 25 years. In nautical terms it is time to take down the spinnaker and tack to find a better wind.

So where is there still opportunity?

One place to look is in U.S. equity sector selection.  While stocks are now generally more expensive than average, in a rising rate environment, cyclical sectors, such as financials and technology should be able to outpace more defensive sectors such as consumer staples, utilities and REITs.

A second opportunity lies in European stocks, which appear significantly undervalued relative to U.S. stocks, with lower P/E ratios (even relative to their own historical averages), higher dividend yields and likely stronger earnings prospects, given Europe’s earlier stage in the business cycle.  Moreover, an unhedged position in Euro Zone stocks should, in the long run, be able to take advantage of a rebound in an undervalued Euro.

A third area for potentially better returns is EM stocks, which, despite a good start to the year, remain well below long-term average price-to-book ratios.  The commodity slump that has haunted EM equities appears to have come to an end and EM economies should be able to resume their normal sizable growth advantage over developed countries in the years ahead.

Eight years ago, investors were very skittish and too ready to sell at the slightest rumor of “another shoe dropping”.

Today, there is the complacency of confusion, as investors wait and wonder about how the Trump agenda might impact the investment environment.  There is, indeed, a great deal of uncertainty about this.  However, any reasonable reading suggests that the market has priced in a close-to-best-case scenario for both bonds and stocks.

This is not to predict an imminent market correction or to recommend that investors hide in cash.  Given low cash yields, it still makes sense to be in long-term investments including both domestic stocks and bonds.  However, it is time to adopt a more diversified and thoughtful approach that recognizes the importance of valuations and relies less on that most naïve of all assumptions – the prospect of wisdom from Washington.

David Kelly
Chief Global Strategist
JPMorgan Funds

The Week Ahead by JPMorgan Funds

Unwrapping the Present

A wrapped present is always an object of optimistic speculation. When I was very young, in the days leading up to Christmas, I would shake the presents under the tree, making some very unreasonable assumptions about both the affections and the finances of my various uncles and aunts.  I always smiled when I tore the presents open – even then I knew it was impolite to do otherwise.  However, as I got older, my expectations became more reasonable and my disappointments less severe.

Since the election, U.S. investors have, at times, manifested an almost childlike faith in what the unopened box of policy change might mean for the stock market.  In the week ahead, some of the wrapping paper will be torn off, potentially setting the stage for disappointment.

More specifically, the next week should provide us with some insight on the three key issues shaping the U.S. investment environment: monetary policy, fiscal policy and the economy to which these policies are being applied.

On the third issue, data due out this week should be revealing.

Fourth-quarter GDP is likely to be revised up, reflecting more strength in retail sales and inventories than was initially reported.  Numbers on real activity for the first quarter should also look a bit more positive, with potentially strong gains in January Durable Goods orders and Pending Home Sales on Monday, and equally impressive strength in Manufacturing PMI data, due out on Wednesday.  However, readings on the consumer may be less upbeat, with a slight retrenchment in Consumer Confidence on Tuesday as well just moderate January Consumer Spending numbers and February Light-Vehicle Sales on Wednesday.  Unemployment Claims should follow their recently extremely low path, confirming that the labor market is essentially at full employment.

Perhaps most significantly, the Personal Consumption Deflator could hit 1.9% or 2.0% year-over-year for January, achieving the Fed’s long-elusive target of 2% inflation.  On Wednesday, the current economic expansion will enter its 93rd month, making it the third longest expansion since the civil war.  While this is a very positive milestone, it remains a stubbornly slow expansion and shows no sign of near-term acceleration.

Various Federal Reserve communications this week, including the Beige Book and speeches by Chair Yellen and Vice Chair Fischer, could note recently stronger readings on inflation.  These communications will likely sound somewhat hawkish, if only to foster expectations that the Fed could well hike rates on March 15th and thus allow the Fed to do so, if it wishes, without shocking the market.

Most important for the market, however, will be the President’s address to Congress on Tuesday night.  The speech itself is unlikely to be detailed in terms of policy proposals.  However, it will be important to see how optimistic the Administration is about the economic outlook and how willing it is to boost the deficit in an attempt to fulfill the President’s campaign promises.

The new Treasury Secretary has argued that changes in tax policies and regulation could boost real growth to a sustained pace of 3%.  The problem with this is that the economy is essentially at full employment.  Boosting demand in the economy, without increasing the economy’s potential to provide more goods and services, would primarily lead to higher inflation and interest rates.

Lower corporate taxes and less regulation could help boost potential GDP growth some.  However, it is crucial to recognize the extent of the challenge. Over the past decade the economy has achieved just 1.3% real GDP growth, reflecting weakness in both labor-force and productivity growth.  Unless the former can be boosted through higher immigration or the latter can be increased through much higher capital spending, maintaining growth at 2% would be an achievement and sustaining growth at anything close to 3% seems highly unlikely.  Moreover, policies that had the effect of curtailing either trade or legal immigration would almost certainly make the problem worse.

The budget situation is also very difficult.  According to CBO forecasts, under current law, the federal debt will rise to almost 89% of GDP by 2027 from 77% of GDP today.  These forecasts are based relatively optimistic assumptions of 2% real growth, unemployment that never exceeds 5% and 10-year Treasury yields that never exceed 4%.

Tax cuts and spending increases would clearly worsen these numbers.  Moreover, if the Congress adopts significant fiscal stimulus to try to boost demand in the economy, the result would likely be a hotter economy, inducing the Federal Reserve to raise interest rates faster, increasing the cost of servicing the national debt and thus worsening the fiscal problem.

The President’s words will be important – equally, important, however, will be the response of House and Senate Republicans.

A congressional adoption of both economic optimism and very expansionary fiscal policy could have negative implications for the bond market.  If, conversely, congressional Republicans take a more conservative stance in opposing both optimistic economic assumptions and unfunded tax cuts and spending increases, the stock market may have to abandon its hope of dramatic stock-friendly policy change, threatening the post-election rally.

Even without a policy boost, the stock market still has the potential to move higher.  However, investors would be wise to temper their hopes for a surge in U.S. stock prices and recognize that strong gains from here will require both broader global diversification and a more parsimonious approach to security, sector and asset-class selection.

David Kelly
Chief Global Strategist
JPMorgan Funds

Questionnaire Issued For 2017 Insurance Investment Outsourcing Report

Insurance asset managers have been sent the questionnaire for the fourth edition of the Insurance Investment Outsourcing Report (IIOR) that will profile their performances and contribute to an industry-wide picture of this multi-trillion dollar sector entering 2017. Publication is scheduled for May 1.

The IIOR is a joint publication of the Insurance Asset Outsourcing Exchange, Insurance AUM, and InsurerAM News.

As in previous editions, IIOR 2017 will focus on outsourced General Account assets, both affiliated and non-affiliated. Coverage will be global: North America, UK/Europe, APAC and offshore centers such as Bermuda, Cayman Islands and the Isle of Man.

Participants in last year’s IIOR numbered 43 and reported a collective total of $1.68 trillion in non-affiliated general account assets. The top ten managers, in order, were BlackRock, Deutsche Asset Management, Goldman Sachs Asset Management, Amundi, Wellington, Guggenheim, PIMCO, J.P. Morgan, Delaware and Conning.

The principal contact for new IIOR asset manager applicants is David Holmes of the Insurance Asset Outsourcing Exchange: (502) 657-6478 or

The Week Ahead by JPMorgan Funds

Finding a Better Opportunity in Europe

One simple approach to investing is to ask three questions.

(1)   Where are valuations?
(2)   Where are fundamentals?
(3)   What is it that is keeping (1) and (2) in different places?

With the S&P500 now up 5% year-to-date and 22% year-over-year, these are important questions for American investors to consider.

From a valuation perspective, the U.S. stock market is looking more expensive.  On Friday, the S&P500 closed at 2,351, or 17.7 times operating earnings expected by analysts over the next year.  This is 11% above its 25-year average. Moreover, the forward earnings estimate upon which this is based is a lofty 24% higher than the actual operating EPS achieved by S&P500 companies last year.

Overall, U.S. fundamentals do still look promising.  Economic growth is solid, profits are rising, interest rates remain low and there is the prospect of help from the federal government both in terms of less regulation and tax cuts.  Numbers due out this week should generally support this bullish case with positive readings on Manufacturing PMI on Tuesday, Existing and New Home Sales on Wednesday and Friday respectively and Unemployment Claims on Thursday.

However, the U.S. is now in the eighth year of an economic expansion and diminished slack in the economy should drag on earnings growth going forward.  Annual real GDP growth over the next five years is unlikely to average more than 2.0% and nominal GDP growth is unlikely to exceed 5%.  With interest costs and wage pressures rising, earnings per share are also unlikely to grow more than 5% per year from 2018 on, giving a price appreciation of 5% per year if P/E’s were flat.  However it is more reasonable to assume that P/E ratios will revert to their mean and, if this were to happen over the next five years, it would subtract 2% per year from price appreciation.  Adding on a dividend yield of 2%, could boost total returns to 5%.

A reduction in corporate taxes would, of course, add something to this.  However, a recession, which more than likely will occur within this time span, would have the opposite effect.

All told, because of more expensive valuations, returns of 5% per year now seem like a relatively optimistic forecast for U.S. large cap stocks over the next five years.

European stocks, by contrast, look more attractive.  The current forward P/E at 15.0 times, is just 3% above its 25-year average, and analysts in Europe, while probably still a little too optimistic in forecasting an 11% 2017 earnings jump, may end up being more accurate than their U.S. counterparts.  In addition, the average dividend yield on the MSCI-Europe index is 3.6% compared to 2.0% on the S&P500.

Moreover, the Eurozone is still earlier in its economic expansion than the U.S. which is essentially at full employment.  The U.S. unemployment rate has fallen to 4.8% in January of this year from an October 2009 peak of 10.0%.  In the Eurozone, by contrast, the unemployment peak didn’t occur until June of 2013 at 12.1% and, while it has now fallen back to 9.6%, further declines in unemployment could fuel above-trend economic growth for many years year to come.

Another key factor is that the Euro appears to be too low against the U.S. dollar.  In 2016 the U.S. ran a current account deficit of roughly $500 billion, or 2.7% of GDP while the Euro Zone ran a surplus of €200 billion, or 2% of GDP.  Since the Euro was launched in 1999, it has traded at an average exchange rate of $1.21.  All of this suggests that the Euro, at $1.06, is significantly undervalued.  For unhedged U.S. investors, a rebounding Euro over the next few years should add a currency kicker to better local currency returns.

A little back of the envelope math can summarize the case for an overweight to European equities.  If we assume:

–Both European and U.S. earnings per share rise by 5% per year from 2018 on,
–Both the S&P500 and the MSCI-Europe revert to their 25-year average P/E over the next 5 years,
–The Euro returns to its 18-year average exchange rate of $1.21 against the dollar over the next five years, and,
–Both European and U.S. stocks maintain their current dividend yields, thenEuropean stocks could return 5.9% more per year than U.S. stocks, composed of a 1.6% advantage due to a smaller decline in P/Es, a 1.6% advantage because of higher dividend yields and a 2.7% gain due to Euro appreciation.

This brings us to the third question.  If fundamentals and valuations suggest European equities are undervalued relative to their U.S. counterparts, then what is it that is keeping them that way and will this go away?

One answer may simply be that investors are too optimistic about what political change could mean for U.S. equities and too gloomy about political change in Europe.

In the U.S., while Americans are very divided politically, the stock market appears to be taking an optimistic view about what the new administration could mean for stocks.  However, this optimism could be a little overdone.  In reality, barring a surge in immigration, there simply aren’t enough workers to allow the economy grow much faster.

The stock market would benefit from policies to reduce corporate taxes and regulation if that is where it stopped.  However, it is more likely that the President and Congress will either severely limit corporate tax cuts and other stimulus in order to maintain fiscal discipline, or else, throw caution to the wind and over-stimulate a full employment economy, leading to higher inflation and interest rates.  In addition, there is some risk of policies could restrict trade and legal immigration, which could counter the positive effects of less regulation and lower corporate taxes.  In short, as the political fog clears, the Washington landscape may not seem quite as market friendly as is being imagined by U.S. investors today.

Conversely, global investors seem to be hyper-aware of the political threats posed by populist parties throughout Europe, particularly with elections in France, the Netherlands, Germany and possible Italy this year.  However, in each case, the populists still look unlikely to win a governing position.  If this continues, then European election results this year could actually reduce uncertainty and boost both the Euro and stock prices.

In summary, while U.S. equities still look cheaper than Treasuries and cash, they are not as attractive as they once were.  Investors looking for stronger long-term returns may find a better opportunity in Europe.

David Kelly
Chief Global Strategist
JPMorgan Funds

The Week Ahead by JPMorgan Funds

Three Questions for the Chair

The most important event this week will be Janet Yellen’s semi-annual testimony to Congress.  A key issue will be how she responds to three questions on fiscal stimulus, namely: can we afford it, do we need it, and how will the Fed respond to it?

Before she is interrogated on these matters, however, she will warm up the crowd by expounding on the current state of the economy.  Very likely she will express some satisfaction at the cumulative progress made in the almost eight years of the current economic expansion.  And data due out this week should support her perspective.

Initial Jobless Claims, on Thursday, should continue to hover near 43-year lows. Retail Sales on Wednesday, should log solid gains, and, while real consumer spending looks to be tracking below 2% growth for the first quarter, the economy overall appears to be achieving  year-over-year growth of between 2.0% and 2.5%, right in line with its expansion average.  Inflation indicators should also be to the Fed’s liking, with CPI in January potentially up by 2.5% year-over-year, in its strongest read in almost five years.

Chair Yellen may well linger in her prepared remarks because, for someone who would like to avoid politics, the questions from then on will likely become awkward.

First, she may well be asked whether the Federal Government can afford more fiscal stimulus.  (The most pointed questions may reference “tax cuts for the rich”, but exactly the same question could be asked about increased spending on defense, veterans’ affairs or infrastructure.)

I’ve always hated the question “can we afford?” because it’s so ambiguous.  In years gone by, when my wife has asked me, “can we afford to remodel the kitchen?” the answer is (a) yes – if you mean “could we”, since the bank would lend us the money and (b) no – if you mean “should we” because prudently, given the uncertainty of life and our need to save for retirement and our kids’ college costs, it would likely leave us in bad shape in the long run.

By criteria (a) the Federal Government can easily finance further fiscal stimulus.  However, by criteria (b), further fiscal stimulus seems reckless.  The federal budget deficit for the last fiscal year was $587 billion, or 3.2% of GDP. According to a recent report by the Congressional Budget Office, under current law, that deficit would swell to $1.4 trillion by 2027, pushing the national debt in the hands of the public to almost $25 trillion or nearly 89% of GDP from its current 77%.  Moreover, even these projections rely on  optimistic assumptions that real GDP will climb by close to 2.0% annually over the next decade (compared to 1.3% over the past 10 years), that unemployment will hover at 5% or below and that the yield on 10-year government bonds will stay below 4%.

In short, under current law and a relatively rosy scenario, the federal budget will gradually spiral out of control.  It would be reckless to take steps to worsen this trajectory, unless it was to meet some dire national security or economic need.

The proponents of fiscal stimulus may argue either that they will pay for tax cuts with offsetting spending cuts or that, because of “dynamic effects”, the actual budget hit from stimulus would be much less than suggested by static analysis.

On the first issue, there would be little meaningful stimulus if government spending is cut by as much as taxes.  Government spending, even if wasteful, counts as aggregate demand just as much as consumer spending does and it is even likely that some tax cuts, such as eliminating the estate tax, would result in a net negative impact on aggregate demand, if coupled with spending cuts to fund it.

On the second issue, it is true that a tax cut that led to a surge in economic activity could fund some of its own expense.  This is why many who have advocated tax cuts have insisted on “dynamic scoring” by the CBO and Joint Committee on Taxation in assessing their true cost.

However, these dynamic effects would be greatest in an economy that is far from full employment, since tax cuts could allow the economy to absorb slack more quickly.  If today’s economy is actually at full employment, these dynamic effects will be very weak.

So is there any significant slack left in the labor market?  While both the Fed Chair and the President have argued that there is, (although to wildly differing extents), the evidence doesn’t really support that perspective.  Consider that:

–The unemployment rate, at 4.8%, is lower than it has been 81% of the time over the past 50 years.

–The four-week moving average of initial claims for unemployment benefits is at its lowest level in over 43 years, and,

–Despite the best technology in history to help workers connect with jobs, there are a near-record high 5.5 million unfilled job openings in the U.S. economy.

There is still a slightly elevated number of people who are working part-time for economic reasons and wage growth remains slow.  However, the first of these problems likely reflects the evolving structure of part-time employment in the low-end services sector, while the second may reflect a simple misperception, by both workers and employers, about how much slack there is in the labor market.  If you are told the job market is horrible, you may not want to ask for a raise.

To be fair, in recent comments, even Chair Yellen seems to be coming round to the idea that the labor market is nearly out of slack.  Consequently, while the Fed might well cheer supply-side measures to increase productivity (such as tax and regulatory reform), or boost the labor force, (perhaps through more legal immigration), it is unlikely to endorse broad fiscal stimulus at this time.

Finally, and most importantly for investors, how is the Fed likely to respond to fiscal stimulus if it occurs?  Despite the very dovish tendencies of the current Federal Open Market Committee, it will likely “lean against” any fiscal expansion.  Consequently, if the Administration does announce a big tax cut proposal in the next few weeks, as the President indicated on Thursday, the odds will rise on a Fed rate hike on March 15th.

This is not necessarily bad news for the equity market.  In the past, the stock market has tolerated rate increases from low levels very well and equity investors have much more at stake in the corporate tax debate than in slight modulations in the pace of Fed tightening.  However, for the bond market, it is important.  Today’s very low interest rates depend on maintaining the very soft landing that the economic expansion has achieved so far.  We are simply too far down the runway to start revving the engines now.

David Kelly
Chief Global Strategist
JPMorgan Funds

World Economy Strengthens Despite Uncertainty Hitting New Highs: Schroders QuickView

By Keith Wade, chief economist and strategist

“Despite the increase in economic uncertainty, the world economy is strengthening with business surveys signaling an acceleration in growth. Concerns about Brexit and President Trump’s populist policies have been swept aside, prompting talk of a crisis in economic forecasting.

The dismal science seems to be living up to its name with economists out of step with the surge in business confidence. Growth forecasts are likely to be upgraded, but we still have doubts about the sustainability of the upswing now that oil prices and inflation are rising again. President Trump’s rapid shift toward protectionism only threatens to exacerbate inflationary pressure whilst halting the nascent recovery in global trade.”

Wade continued: “There can be no doubt that policy uncertainty is high with the global Economic Policy Uncertainty index (EPU) currently running at elevated levels, around 2.5 times higher than the average since 1997. This measure is based on search results for newspaper articles discussing policy-related economic uncertainty, the dispersion of forecasters’ expectations for key macro measures, and additionally for the US, the number of temporary tax measures set to expire in the coming years. The global index uses data for 17 countries that account for two-thirds of global GDP.”

The Week Ahead by JPMorgan Funds

Trade Policy Chess

The week ahead should feature solid January Job gains, confirmation of a strong earnings season, very healthy global PMI indices and a Federal Reserve firmly teeing up the market for a March rate hike.  However, the attention of investors will likely still be focused on Washington.

It is perhaps an understatement to note that President Trump’s first days in office have been busy on many fronts.  However, for investors, his statements on trade policy may the most consequential.  So what actions are being discussed, what is likely to be enacted, and what does all of this mean for the economy and investing?

To understand why trade policy is such a hot issue, just note that last year the U.S. ran a current account trade deficit of roughly $500 billion or 2.7% of our GDP.  This was a key issue in the Presidential election as it was alleged by both the left and the right that this trade deficit was just a manifestation of “unfair” trade deals, such as NAFTA, which have allegedly decimated U.S. manufacturing.  As an example of this argument, in the first presidential debate, when discussing NAFTA, Mr. Trump said:  “When we sell into Mexico, there’s a tax…..- an automatic 16% approximately – when they sell to us, there’s no tax.  It’s a defective agreement”.   The 16% he mentioned was presumably, Mexico’s 16% value-added tax or VAT – a subject to which we will return.

In prescribing policy remedies for our trade deficit, the President has argued in favor of tariffs on China in retaliation for alleged currency manipulation.  In addition, the new Administration has speculated on whether a tariff on Mexico could “pay” for a wall on the U.S. border with Mexico.  The President has separately proposed leaving the current corporate tax structure in place but dramatically cutting the tax rate and allowing for an even lower rate on repatriated foreign profits.

As an alternative, House Speaker Paul Ryan has proposed achieving the goals of both tariffs and corporate tax reform by replacing the current corporate tax system with a tax on corporate cash-flow with border adjustments which, for simplicity, we can call a Border Adjustment Tax or BAT.

In order to consider which policy might be adopted and what it might mean for investors, it is crucial to understand the difference between a tariff, a VAT and a BAT.

So let’s start with a tariff.

A tariff is simply a tax on imports which could raise substantial revenue for the government.  Indeed, the President’s press secretary has suggested that a 20% tariff on Mexican goods and services would be one way to force Mexico to “pay” for the cost of building the wall.  It should be noted that, in 2015, the U.S. imported $316 billion in goods and services from Mexico and exported $267 billion to Mexico, thus running a trade deficit with Mexico of $49 billion.  A 20% tariff on goods and services imported from Mexico would, in theory, raise roughly $62 billion, far more than the total cost of the wall, assuming that the volume of U.S. imports from Mexico was roughly unchanged.  Even if the volume of imports from Mexico fell, the revenue raised would be substantial.

However, economists generally regard tariffs as a terrible idea.  The first result of such a policy is that U.S. consumers would have to pay more for Mexican imports, making them worse off.  They would presumably also buy fewer of these imports, leading to layoffs among Mexican workers.  The second result of such a policy is that Mexico would very likely retaliate with tariffs of its own, hurting Mexican consumers and U.S. workers.  The volume of trade would be lower, consumers and workers would be worse off on both sides of the border and Mexican and U.S. government revenue would be higher.  In short, a tariff for a tariff makes the whole world poor.

But what about the President’s charge that current U.S.-Mexico trade relations are grossly unfair because Mexico taxes our exports at the border and we don’t tax theirs?

To adjudicate this, it’s crucial to understand that this isn’t a Mexican tariff on U.S. goods and services.  There have been virtually no Mexican tariffs on imports from the U.S. or vice-versa since 1994 when NAFTA was implemented.  Rather this is the impact of Mexico’s VAT.

Most global consumers are very familiar with value-added taxes since roughly 160 countries have them, although the U.S. does not.  Essentially, it’s like a national sales tax with one key difference.  In the U.S., sales tax is only charged once, when the consumer buys it from the retailer.  With a VAT, every importer, manufacturer, wholesaler and retailer has to charge VAT on the value they added to the process.


It’s worth going through an example to see how this works.

Suppose I buy a mop at the store and there is a 10% sales tax on mops.  The manufacturer makes the mop in the U.S. using $20 worth of imported components, sells it to a distributor for $30, who sells it on to a retailer for $40, who sells it to me for $66, including $6 in sales tax.

Now suppose the government imposes a 10% value-added tax, or VAT, instead.

The importer pays the government 10% VAT on his $20 of imported components (i.e. $2) which he adds to the price he charges the manufacturer. The manufacturer pays the government 10% VAT on his $10 of value added (i.e. $1) and adds this to the price he charges the distributor.  The distributor pays the government 10% VAT on his $10 of value added (i.e. $1) and adds this to the price he charges the retailer.  Finally the retailer pays the government 10% VAT on his $20 of value added (i.e. $2) and adds this to the price he charges me.  I still end up paying $66 and the government still gets $6 – it’s just that they get four different checks along the way.

Alternatively, suppose the government tries to get its $6 with a cash-flow border-adjustment tax or BAT.  If we assume in our example that U.S. manufacturers, distributors and retailers spend half their total value added on wages and interest which they can deduct from the tax calculation, then a BAT rate of 15% will do the job.  The importer pays 15% on $20, or $3.00, while the manufacturer, distributor and retailer pay 15% tax on half their value added, amounting to $0.75, $0.75 and $1.50 respectively.  The government still gets $6 in tax and I still pay $66 for the mop.

But notice one important difference.  Under a VAT, both domestic content and imported content face the same tax – 10%.  Under the BAT, because domestic producers are able to deduct half their value added, the effective tax rate on imported content is 15% and the effective tax rate on domestic content is 7.5%.


OK, back to the real world.

Mexico does charge a 16% VAT and that is imposed on imports from the U.S. and everywhere else for that matter.  However, this does not put U.S. goods and services at any disadvantage relative to Mexican goods and services because they also incur 16% VAT.  Because of this, the Mexican VAT is not judged to be a trade barrier by the World Trade Organization (WTO).  Mexico is not discriminating against imports.

However, a BAT would discriminate against imports and so would likely eventually be ruled as being in violation of WTO rules.  In the meantime, our trading partners could reasonably decide that a tariff by any other name stinks as sour and impose retaliatory tariffs on us.

There is actually, a solid argument for eliminating our corporate income tax altogether and replacing it with a VAT.  The U.S. has relatively high income taxes (including the corporate income tax) and relatively low consumption taxes.  Compared to almost all of our trading partners, our tax system favors consumption over production.  One natural result of this is that, as a nation, we tend to overconsume and underproduce, resulting in a trade deficit.  However, it hardly seems reasonable to demand that the rest of the world adopt our system or face tariffs.  It seems more sensible to just change ours.

So what’s likely to happen?  The politics are tangled to say the least.  However, the President would likely have a harder time getting Congress to approve of broad tariffs than a more opaque corporate tax reform that achieves the same result.  For his part, the House Speaker will want to achieve a victory on his pet project.  Congress will run into opposition from retailers, oil refiners and other industries that will argue that this amounts to a major tax increase on them which they will have to pass on to consumers.  Nor are they likely to be assuaged by the very dubious claim that the dollar will immediately appreciate enough in response to such a tax as to negate its effects on import prices.

However, the way out of this dilemma for both the Congress and the President is simply to abandon all pretense of revenue neutrality and cut the rate to a low enough level as to make the pain reasonable, particularly in return for an abolition of the corporate income tax.

In summary, while the political chess match will be complicated, a replacement of the corporate income tax with a low-rate cash-flow tax with border adjustments seems the most likely outcome.  If this occurs, it could boost after-tax operating earnings and the budget deficit.  However, it would also add to inflation, potentially increasing interest rates.  It would finally, likely increase the value of the dollar.  In combination, these changes would favor U.S. stocks over bonds and U.S. stocks over international and particularly EM stocks.

Something to consider at the start of just the second full week of the Trump Presidency.

David Kelly
Chief Global Strategist
JPMorgan Funds

The Week Ahead by JPMorgan Funds

Which Republicans?

It’s beginning to look like there will be no quiet weeks in the Trump Presidency.  However, laying out the details of his agenda will be complicated, requiring work by his various cabinet secretaries and their staffs and agreement with congressional Republicans.  Consequently, in many areas, it will take weeks, if not months, for new policies to fully take shape.

Nevertheless, it is quite possible that actions and statements by the new President could move markets in the week ahead.  A reiteration of promises to roll back regulations, cut taxes, and increase infrastructure and defense spending would likely be stock-market friendly and bond-market negative.  However, tough talk on tariffs and tightening visa programs would be less so, particularly if it triggered an aggressive response from our neighbors and trading partners.

During the election campaign, it was often noted that the Republican Party was split between a populist wing that favored a crackdown on illegal immigration and a tougher stance on trade and more traditional Republicans focused on lower taxes, less regulation and more defense spending.  In the end, these two wings mostly came together to elect Donald Trump.  The net effect of the policies of either wing, at this stage, would probably represent bad news for the bond market, either because they might tend to restrict labor supply and increase inflation directly or because they could provide significant fiscal stimulus.

However, the traditional Republican agenda seems far more equity friendly.  Consequently, the fortunes of the U.S. stock market in the months ahead may depend to a large extent on which side of the Republican Party ultimately wins these policy debates.

When investors aren’t watching Washington this week there should still be plenty to move markets.  On the economic front, data on New and Existing Home Sales and Home Prices should paint a generally positive picture.  The four-week moving average for Unemployment Claims hit a 43-year low last week and a continuation of this trend would provide further confirmation that the economy is essentially at full employment.

Numbers on International Trade, Inventories and Durable Goods for December should tee up Friday’s GDP report.  We are expecting real GDP growth of 1.9%, as a solid gain in real consumer spending is offset by weakness in government purchases and stronger inventory growth is negated by a worsening trade deficit.  Investors will also be watching inflation data within this report.  We expect the GDP deflator to rise by 1.9% annualized in the fourth quarter and the personal consumption deflator to increase by 2.2%.  Overall, a GDP report that would certainly justify a higher level of interest rates but not one that is likely to trigger action from the Fed when the FOMC meets next week.

Investors will also be looking at January flash PMI data from Europe and Japan that shouldn’t show much deceleration from strong December readings.

Finally, we are in the thick of the earnings season, with 70 S&P 500 companies set to report in the week ahead.  As of last Thursday, with 15% of market cap reporting, earnings appear to have fully recovered from their dollar/oil slump of 2015 and overall operating earnings per share will likely end up between $28 and $30 for the quarter, coming close to the all-time high of $29.60 achieved in the fourth quarter of 2014.  However, in a slow-growing economy with rising wage pressures, earnings gains from this point on will be harder to achieve, without Washington tax relief.

Still, having said this, the general flow of news should be more supportive of equities than bonds, even as policy uncertainty persists.

David Kelly
Chief Global Strategist
JPMorgan Funds

The Week Ahead by JPMorgan Funds

Some years ago, I found myself wandering the halls of a high school in Ohio, waiting to make a speech to investors in the auditorium.  Earlier in the day, I’d heard about a nearby plant that had closed down a few months earlier.  I was a little early for the speech and so, as I pottered around, I looked at the photos of recent graduating classes and realized, sadly, how few of those young faces would ever return to live in that town.

Plant shutdowns, of course, aren’t a new story.  U.S. manufacturing employment collapsed in the 2000s, falling from 17.3 million jobs at the start of the decade, to less than 11.5 million by its end.  Since then, it has recovered slightly, to almost 12.3 million jobs today.  However, the pain of the shutdowns lingers and that pain clearly contributed to the election of the new President.  It is also fueling calls for tariffs on imported goods to protect U.S. jobs.

However, as someone born in Ireland, a country well used to economic devastation, I know this is the wrong answer.

In 1841, before the Great Famine, 6.5 million people lived in what is now the Republic of Ireland.  However, by the time Ireland achieved its independence in 1921, the population was barely 3 million, with most of the decline being due to emigration.

From the 1930s to the 1960s, Irish governments sought to fix this through tariffs on almost everything imported from shoe-laces to bicycle reflectors.  The idea was to protect a wide variety of local industries from foreign competition.  However, the result was a disaster.  Domestic industries could neither thrive nor become more competitive without foreign markets and domestic consumers, impoverished in part by high import taxes, could not provide the demand to help them grow.  As a result, two more generations of Irish children emigrated and the population, in a land of large families, was no higher in 1966 than in 1926.

It was only in the 1960s, that Ireland recognized that tariffs weren’t the answer.  The key to Irish growth was not importing less but exporting more and this could only be achieved through free trade and making Ireland as attractive a location for business as was possible.  This is the policy that Ireland has pursued ever since and one which has, in my lifetime, transformed it from the poorest country in Western Europe to one of the richest.

In the next few months, the new U.S. Administration will also have to decide whether it wants to be pro-growth or pro-protection.  It can’t be both.

A pro-growth policy would start with the kind of corporate tax cut the President elect included in his economic plan:  A big cut in the federal corporate tax rate to 15% or 20%, with a lower rate for money repatriated in the short run, would boost both the stock market and investment spending.

However, an alternative tax plan, espoused by some in the House of Representatives, would replace the current corporate tax system with a modified value-added tax or VAT, where corporations could deduct exports but not imports in determining their tax liability.  They would also be able to deduct domestic labor costs in calculating their liability.   Because of this provision, the U.S. would be at a trade advantage to other countries that use a VAT and so the enactment of such a tax scheme would be seen as being effectively a tariff, in violation of World Trade Organization rules.  As such it would invite other countries to impose tariffs on U.S. exports.

While corporate tax reform is badly needed, this particular type would be a spectacularly bad idea for the American economy for many reasons:

–First, tariffs, even if hidden in the corporate tax code, are a tax on American consumers.  They would also boost inflation in a way that could trigger further Fed tightening.

–Second, tariffs invite retaliation.  Foreign countries would respond to U.S. tariffs with tariffs of their own, hurting U.S. exports.

–Third, unlike Ireland, the U.S. is an enormous player in the global economy.  U.S. tariffs, by slowing global trade, could weaken the global economy in a way that further depresses U.S. exports.

–Finally, a cut in the corporate tax rate that turned out to be revenue neutral could do nothing to boost earnings per share.  Given the market rally since the election, a policy that undercut economic growth while doing nothing to reduce the average burden of corporate taxes would be a negative for the U.S. stock market.

But if tariffs aren’t the answer, can anything be done about our $500 billion current account trade deficit?

The answer is yes.  The U.S. dollar is too high and it has been too high for a long time, making our exports too expensive and our imports too cheap.  For decades, the U.S. government has been the only pacifist in a global currency war, with the Federal Reserve deferring to the Treasury on the issue of the exchange rate and successive Treasury Secretaries espousing a belief in “market” forces and the virtue of a “strong dollar”.

But the truth is the “market” in question is mainly driven by currency investors rather than export and import fundamentals.  This being the case, it makes sense for the Federal Reserve and Federal Government to switch to a more deliberate attempt to bring the dollar down to more trade-neutral ranges.   Simply announcing such a policy change might do the trick.  If not, any suggestion by the Fed that it would replace some U.S. Treasuries on its massive balance sheet with foreign sovereign debt, could lay the groundwork for a cheaper dollar.

This should, over time achieve greater trade balance for  the United States but do so in a way that allows exports, imports and corporate profits to grow.

In the week ahead, how the new President intends to address this and many other issues will be the main focus of investors.

He has promised a large number of executive actions on his first day in office.  In addition, he has made very explicit promises regarding his first 100 days, including working with Congress to introduce legislation on personal tax reform, corporate tax reform, health care reform, child and eldercare assistance, defense spending, VA spending, immigration and tariffs.  All of this should shape the U.S. investment environment for 2017 and beyond.

Investors this week will also be absorbing some economic numbers.  The December Industrial Production report as well as January numbers from the New York and Philadelphia Federal Reserve banks should paint a relatively bright picture of manufacturing momentum.  Meanwhile, Housing Starts should have rebounded in December from a temporary falloff in November.  Of most relevance to investors, however, will be the December CPI report, which should show headline CPI moving above 2% year-over-year for the first time in two and a half years.

Investors will also be paying attention to the earnings season.  Last week’s strong numbers from the financial sector looked solid and this week’s broader set of reports should be reassuring.  Overall, it appears the profits will continue to recover as we enter 2017.  However, the strength and sustainability of this improvement depends, to a remarkable extent, on the actions of the new Administration and new Congress and their dedication to pro-growth policies.

David Kelly
Chief Global Strategist
JPMorgan Funds

The Week Ahead by JPMorgan Funds

Coaxing an Old Expansion into Stronger Growth

In the week ahead, as has been the case in every week since the election, investor attention will be divided between assessing current market fundamentals and speculating on how policies from the incoming administration could change them.

On the first issue, last week’s jobs report was generally positive.  Payroll gains were a healthy 156,000 and, although the overall unemployment rate edged up to 4.7%, following a sharp decline in the prior month, the U-6 unemployment rate fell to its lowest level since April of 2008.  With wage growth picking up, the economy is essentially at full employment.

Numbers due out this week should generally confirm this picture.  Tuesday’s Job Openings and Labor Turnover report should still more than 5,000,000 job openings while Unemployment Claims should continue to run under 300,000 per week.  In addition, the Retail Sales report for December should show that consumers spent heavily last month, although gains for autos, gas stations and on line, look a lot stronger than chain-store activity.  These numbers should also help narrow estimates of fourth-quarter GDP.

It should, however, be noted that these estimates should still only show real GDP growth of between 1.5% and 2.0%, payback for a 3.5% surge in the prior quarter.  While the U.S. economy remains healthy, it has shown no meaningful acceleration in recent months.

In addition, even though the economy is at full employment, its journey here has been deeply disappointing.  Over the past decade the economy has eked out just 1.3% annual real GDP growth, only half a percent more than annualized population growth over the same period and far short of a pace that would provide any meaningful increase in living standards to the average American.

In many ways, of course, it is this slow growth that fueled the success of populist movements in 2016 and the election of the new President.  But can the new administration’s policies improve this?

The answer to this is a qualified yes.  The qualification is, that in order to achieve stronger growth, the government will have to pursue policies that both boost the number of people employed and the growth in labor productivity, and avoid policies that would impede either.

On the first issue, encouraging workers to retire later and rehabilitating those with addiction issues or felony convictions could boost the labor force.  However, it would also seem sensible to increase the number of legal immigrants or work visas also since the retirement of the baby boom is leaving the U.S. with a virtually stagnant working age population.  It must be admitted that there have been no signals of steps in this direction from the incoming administration.  However, American business is well represented in the new government and could well nudge Washington policy in this direction.

The new administration is likely to push for policies that could strengthen labor productivity.  Indeed, stronger productivity growth could be fostered just by boosting investment spending, which could, in turn, be triggered by reducing regulations and implementing a corporate tax cut, particularly one which encouraged the immediate repatriation of corporate cash held overseas.

However, it will be important for Washington to avoid steps that could undermine a pro-growth agenda.

–First, any trade war would likely reduce capital spending as companies won’t want to invest more in the U.S. if they are not sure about their access to foreign markets. In addition, higher tariffs would boost U.S. inflation, potentially triggering a more hawkish stance by the Federal Reserve.

–Second, any reduction in legal immigration could cause a problem as the United States is already chronically short of qualified workers.

–Third, any big surge in government spending on defense or public infrastructure or any big reduction in personal taxes could overheat the economy and prompt the Fed to adopt a more aggressive stance, boosting interest rates and potentially choking off stronger investment spending.

–Finally, prolonged uncertainty about changes to policies could sabotage any attempt to implement a pro-growth agenda as businesses might hold off making any decisions until they have a clearer idea of government policies.

In short, this is an old expansion that still has the potential for stronger growth.  However, it will need to be coaxed into better performance in a moderate and disciplined way.  This discipline includes near-term clarity on a Washington agenda focused on policies that genuinely boost investment rather than restricting trade or legal immigration.

As of today, markets appear to be assuming that Washington will mostly make these choices, with the dollar and stock prices rising since Election Day.  However, we will likely have to wait for at least a few weeks into the new Administration to see if this assumption was correct.  In the meantime, long-term investors should note that the rest of the global economy also appears to be doing better right now, with international equity markets generally sporting more attractive valuations than the U.S.  This being the case, despite enthusiasm about new policies from the U.S. government, global diversification seems more important than ever.

David Kelly
Chief Global Strategist
JPMorgan Funds