The Week Ahead By JPMorgan Funds


In three weeks, I’m going to try to run the New York marathon.  I’m pretty nervous about this – it is my first, and undoubtedly last, marathon, and it would have been easier if I had attempted it 20 years ago.  Still it has been fun training for a goal and I’ve learned a lot about the science and psychology of long-distance running over the past few months.

One thing I’ve realized is that a marathon runner, in the later stages of the race, has a shortened horizon.  It is easier, on aching legs, to think only of the distance to the next bend in the road, the next mile marker, or the next water stop. It is very hard to plan past the finish line.

The American people have now suffered through their own marathon…a thoroughly dispiriting election campaign, dominated by insults and scandal rather than any serious discussion of the issues that are supposed to divide Republicans and Democrats.  From an investment perspective, it has been a perpetual distraction and the three weeks left in the campaign feel a bit like the last three miles of a marathon.  However, for investors, it is important to think past the finish line and consider the investment environment after the election.

One aspect of this will likely be a decline in uncertainty and relief that it is over.  This, on its own, could be a positive for economic and market sentiment.  However, fiscal policy under a new administration could also add to demand in the economy.

This view is not based on a careful analysis of the policy positions of either candidate.  Even if we assume that both candidates are firmly committed to those policies, it needs to be recognized that, barring a political earthquake, the House of Representatives will remain in Republican control, with Paul Ryan as Speaker of the House.

Consequently, the most important post-election reality is that either Hillary Clinton or Donald Trump will have to negotiate with Mr. Ryan, and, given his comments on both candidates, it is highly unlikely that he, or Congress in general, would rubber-stamp the policy agenda of either potential president.  It is possible that the outcome of the election could give new impetus to immigration reform or corporate tax reform.  However, on other issues, much less change is likely to be delivered than is being promised.

Having said this, one likely outcome, under either potential president, is fiscal expansion. Last week, the Treasury department announced a federal deficit for fiscal 2016 (which ended on September 30th) of $537 billion or roughly 3.2% of GDP, up from $439 billion or 2.5% of GDP a year earlier.  This fiscal year, even with no policy changes, the deficit would likely climb higher.  However, with a strong populist tide in both political parties, there will be significant pressure to increase infrastructure spending, cut taxes on middle-class Americans and to further relax the “sequester” cuts, boosting the deficit.

All of this could add to aggregate demand in an economy which is already showing signs of healthy growth and some inflation pressure.  Data due out this week should confirm this.  Reports on Industrial Production for September and the Philadelphia and New York Fed Manufacturing Surveys for October should show improvement while Housing Starts and Existing Home Sales should both show robust gains.  More significantly for markets, CPI Inflation data, due out on Tuesday, should show solid increases, with headline inflation of 0.3% for September and 1.5% over the past year and inflation outside of food and energy maintaining a 2.3% year-over-year pace.  If oil prices hold steady over the next few months then headline CPI should reach 2% year-over-year by December and the headline personal consumption deflator should surpass the 2% year-over-year threshold by February of next year.

All of this adds to the significance of Fed Chair Janet Yellen’s speech last Friday.  In it, she suggested that “….temporarily running a “high-pressure economy”, with robust aggregate demand and a tight labor market…” might boost both labor supply and productivity.

While this may be so, it also carries with it a risk.  The Fed has saturated the economy with liquidity for years and both households and corporations are holding vast cash balances.  If a “high-pressure economy” became a higher inflation economy, many might feel the need to convert these cash balances into goods or services or assets, thereby further stoking inflation.  For many the years, the Federal Reserve has recognized that its actions only impact the economy with a lag and thus its policy needs to be preemptive.  However, over the past decade, the Fed has slid from being preemptive to being data-dependent, to being reactive and now, based on Chair Yellen’s words to perhaps not being that reactive to signs of rising inflation.

An experienced marathon runner has a plan for the 27th mile.  What are they going to drink and eat after the race?  Where will they meet friends and family? How will they get some rest?  In the same way, investors today need to have a plan for after the election. With both the Federal Government and the Federal Reserve looking to further stimulate an already full-employment economy, adding to growth but also adding to inflation, that plan should probably tilt towards equities relative to fixed income or cash.

David Kelly
Chief Global Strategist
JPMorgan Funds

No BoJ Rate Cut, But New Policies Designed To Boost Inflation

“The Bank of Japan (BoJ) did not cut rates but did introduce two new policy measures at today’s meeting. The first is “QQE (quantitative and qualitative easing) with yield curve control” which essentially means directing asset purchases so as to keep 10-year government bond yields close to zero. When combined with changes in the policy rate at the short end this should enable the BoJ to control the yield curve.

The second is an “inflation overshooting commitment” which means keeping monetary policy loose until inflation exceeds 2% and stays above target.

Some Relief for Banks

The first measure aims to mitigate the adverse effects of negative interest rates on the financial sector, a policy which squeezes bank margins. By targeting a zero 10-year JGB (Japanese government bond) yield, the BoJ can at least ensure that the curve is positively sloped with a negative policy rate, thus helping the banks (which essentially borrow short and lend long). The financial sector led a strong rally in the equity market in response.

Raising Inflation Expectations is Key

The second measure is an acknowledgement by the BoJ that they have failed to hit their 2% inflation target. Increasing the target to one of “overshooting” may seem perverse, but the aim is to raise inflation expectations in the economy. Increasing the commitment to higher prices is a bold attempt to break the deflationary mind-set which holds back wage rises and thus reinforces low inflation.

Further Action Likely to be Needed

Today’s moves have been well received by the markets: alongside the rally in the equity market, government bond yields have risen slightly and despite an increase in volatility the yen has been stable. There was a risk that by not cutting rates the market would have seen today’s action as hawkish, thus sparking a strong rally in the yen and a tightening of financial conditions. However, in terms of economic impact we are sceptical as to whether today’s moves will make much difference. The overshooting commitment is welcome, but for it to succeed the public must believe that the BoJ can credibly raise inflation, something it has failed to do so far.

That does not mean it will fail, only that more action will be needed and we would look for a rate cut at the next BoJ meeting on 1 November.”

Schroders QuickView by Keith Wade, Chief Economist

The Week Ahead By JPMorgan Funds

Late Innings Baseball

Managing the late innings of a baseball game is tricky. On a good day, your starting pitcher gets you to the sixth or seventh inning. However, once you go to the bullpen, it gets more difficult, as you rotate through multiple pitchers on your way to a closer. Sometimes you put a pitcher in just to get one batter out and
then replace them.

Similarly, asset allocation in the late innings of an economic expansion is more complicated. The early years are simple enough. If stocks are cheap and the expansion looks healthy, you stick with a stock overweight. However, as the expansion ages you have to consider how it could end. An economy that overheats
before it slumps suggests an overweight to stocks and commodities over bonds and cash, at least initially. An economy that gradually slides into recession suggests an overweight to fixed income. And overlaid on top of this are valuations. How cheap or expensive are various assets as you head into the late innings?

Good financial advice is always important – but it is particularly important in the late innings of an economic expansion.

Having said this, the good news is that the current expansion, already in its eighth year, looks like it is headed to extra innings. Over the past year, economic growth has decelerated while labor force growth has quickened, resulting in a much slower reduction in labor market slack than in the early years of the expansion.

Last Friday’s August employment report provided the clearest evidence of this. The report was straight down the middle – a 151,000 gain in payrolls but with only a moderate 0.2% rise in the average hourly earnings of production workers. Moreover, the most important aspect of the report was the unemployment rate, which didn’t fall but rather stayed at 4.9%, unchanged from July and, actually, unchanged from January.

Part of the reason for this is a slowdown in the pace of real GDP growth, which amounted to just 1.2% in the year ended in the second quarter, compared to a 2.1% expansion average. This has somewhat constrained the growth in labor demand.

A second reason has been a revival in labor supply. Over the past year, while the population aged 16 to 64 grew by just 0.6%, the labor force grew by 1.5%.

This may be partly due to a decline in the number of people claiming disability benefits, which fell by 70,000 in the year ended in July instead of rising by 100,000 which would have kept pace with the growth in the over 16 population. The last two years have seen a crackdown on people claiming disability without good cause, after explosive growth in the prior decade, and this may have pushed many adults back into the labor market.

In addition, according to the Conference Board, perceptions about the job market have improved over the past year and real wages have increased – both factors that may have boosted labor supply. Whatever the reason, the net result is that the unemployment rate fell by just 0.2% over the past year.

In the first six years of this expansion, economic growth averaged 2.2%, household employment grew by 1.0% per year and the labor force grew by just 0.3% per year. If these trends had continued, the unemployment rate would have been 4.7% in the second quarter of this year, 4.1% in the second quarter of next year and 3.7% by the fourth quarter of next year.

Over the past 40 years, the low water mark for the unemployment rate was 3.8%, a level briefly touched in the early months of 2000. A year ago, it seemed probable that we would hit this mark by the end of next year and that we would, by now, be experiencing an acceleration in wage inflation. Now it seems we have a little more time. However, the question still is: where do we go from here?

On economic growth, a reacceleration appears likely. Consumer spending appears to be growing at a 3%+ pace in the third quarter and recent data on investment spending looks more hopeful. Importantly, the major drags of the last year, falling investment spending on energy infrastructure and a slowdown in inventory growth, now appear to be behind us. Barring a shock, the economy could easily grow by between 2% and 3% over the next year.

On labor force, while a crackdown on dubious disability benefits and more optimistic perceptions of the labor market have helped over the past year, these should be temporary effects while the chronic slowdown in the growth of the 16-64 age cohort is a long-term one. The most likely path is one where the unemployment rate resumes its steady decline with consequent inflationary pressures reasserting themselves.

This is one reason why the Federal Reserve would be well advised to restart its interest-rate normalization path when it meets in two weeks. It is also a reason investors should continue to prepare for the potential for higher growth, higher inflation, higher interest rates, and, eventually, the next U.S. recession.

In other words, just because we look headed for extra innings doesn’t mean investors should relax. Almost 50% of baseball games that reach the 10th inning end in the 10th inning. Most are over by the end of the 11th. Extended expansions, like free baseball, are a gift that should not be taken for granted.

David Kelly
Chief Global Strategist
JPMorgan Funds

The Week Ahead By JPMorgan Funds

Taking Advantage of Good Weather

School starts this week in Acton, Massachusetts, and on Wednesday, nervous but fashionable students will once again line up at the end of our driveway, waiting for the school bus. This is the real end of summer for many, when the thrumming of diesel buses drowns out the lazier chirping of the crickets. However, those of us
who are less tied to the rhythms of the school year will continue to sit outside in the sun, taking advantage of the good weather while it lasts. Last fall was beautiful – perhaps this one will be also.

Investors should also take advantage of good weather while it lasts and the months ahead look promising. In particular, the U.S. appears set for stronger economic growth and a bounce in corporate profits, with only a slow rise in inflation and an even milder increase in interest rates likely to restrain gains in risk assets.

On growth, while last week saw a reduction in estimated second quarter GDP growth from +1.2% annualized to an even more anemic +1.1%, a downward revision to inventory growth within these numbers was important. Real inventories, which had been growing by $94 billion annualized a year ago, shrank by $12 billion annualized in the second quarter. Over the next year, inventory growth should return to a more normal $30 billion annualized pace and, by doing so, should add to real GDP growth. This week’s data on Personal Income and Spending on Monday, Construction Spending and Vehicle Sales on Thursday and International Trade in Goods and Services on Friday, while not booming, should reinforce a rebound theme, with real GDP growth tracking between 2.5% and 3.0% for the second half of the year.

Profits should also look healthier in the second half of 2016. In the first half of year, the dollar was up 2% year over year and WTI crude oil prices were down 26%. If both the dollar and crude oil prices simply stay flat at last Friday’s level, then in the second half of the year they will be down 3% and up 5% respectively. The dollar/oil headwinds will have turned into tailwinds. This, combined with stronger real GDP growth, should allow S&P500 operating EPS growth to turn positive in the third quarter and log double-digit year-over-year gains in the fourth quarter and in 2017.

Inflation should see a milder bounce with core inflation edging up slowly and overall inflation beginning to rise above it on a year-over-year basis, as energy prices begin to exceed their year-ago levels. Even measured by the rather conservative yardstick of the personal consumption deflator, overall inflation should reach 2% year-over-year in the first quarter of next year.

The smallest bounce will likely come from interest rates. In her speech on Friday, at the Jackson Hole Monetary Policy Conference, Chair Yellen allowed that “…the case for an increase in the federal funds rate has strengthened in recent months”. She and her colleagues will be watching Friday’s Employment Report and a payroll gain of 150,000+, combined with solid wage gains and a fall in the unemployment rate would increase the odds of a September rate hike.

However, the overall tone of Chair Yellen’s speech and the other contributions to the conference suggested no appetite for aggressive tightening. Indeed the overriding theme seemed to be the invention of new ways to squeeze even lower interest rates out of financial markets rather than any reflection either on the counterproductive impacts of abnormally low rates on demand or on the long-term damage caused by fixing the most important price in the global economy at an artificial level.

With such a central bank mindset, any improvement in growth and profits is unlikely to impose a proportionate penalty on financial markets in the form of higher interest rates. This cannot last forever. However, for now, this a season of opportunity for equities and one which long-term investors should take advantage of.

David Kelly
Chief Global Strategist
JPMorgan Funds

The Week Ahead By JPMorgan Funds

 A Deceptive Calm

On the surface, the week ahead looks downright boring, with only Janet Yellen’s
speech on Friday having the potential to move markets, and, even that, only if she
departs from her characteristic caution. New and Existing Home Sales may dip from
their expansion highs set in June. Conversely, Durable Goods Orders are likely to
rebound following some very ugly June readings. Flash August Markit PMI data for
the U.S., Japan and the Eurozone may see a slight dip from July, but should still
show global manufacturing to be recovering. Meanwhile, small downward revisions to
second quarter GDP should be offset by a nice quarter-to-quarter increase in the
government’s estimate of Adjusted After-Tax Corporate Profits.

However, beneath the surface, some key aspects of the economy and financial markets
are far from balance and each week sees a continued building of pressures that
should ultimately push the economy and markets back towards balance, perhaps with
some violence. For example, (and noting that these are rough estimates, ignoring

–In the week ahead, the U.S. population will grow by 47,000 people and we
estimate that 21,000 houses will be started, for a population-growth-to-house ratio
of 2.2. In the 50 years prior to the financial crisis, one new house was started
for every 1.8 people added to the population. While this is only one of many ways
to look at the housing market, like most of the others, it suggests still growing
pent-up demand for housing.

–In the week ahead, the federal government will continue to run a budget
deficit, adding roughly $10 billion to the federal debt. The deficit-to-GDP ratio
is now on an upward trend.

–In the week ahead, we estimate the U.S. economy could produce more than
40,000 net new jobs. However, the population aged 18 to 64 should rise by only
15,000. Due to the retirement of the baby boom, the number of jobs continues to
rise faster than the number of potential workers, whittling away at the unemployment

–In the week ahead, according to the Department of Energy, the world should
consume roughly 672 million barrels of oil, up 1.1% from a year ago. It should, at
the same time, produce roughly 676 million barrels of oil, up just 0.1% from a year
ago. While inventories remain bloated, global excess supply is diminishing, setting
the stage for price increases, particularly in 2017.

–In the week ahead, (extrapolating from the first half of the year),
America could export $42 billion in goods and services and import $51 billion,
adding $9 billion to our foreign obligations and highlighting the economic reality
that the U.S. dollar remains too high and should eventually fall.

–In the week ahead, if the commercial banking system sustains its
year-to-date pace, the M2 Money supply will rise by $19 billion, boosting the stock
of money by 7.3% from a year ago, compared to a less-than-3% year-over-year rise in
nominal GDP. In economic history, when money supply growth has outpaced nominal
output growth, as it has now done for six years, the eventual result has almost
always been higher inflation.

This may seem like a random collection of statistics. However, they all point in
the same direction and highlight the same general imbalance. The economy has latent
excess demand for goods and services and workers. So far, this has not resulted in
inflation, partly because of a strong dollar and weak oil prices. However, these
trends may now be turning and if real growth stays on track and inflation
expectations rise, the huge growth in the money supply in recent years may act as an

This is not a warning of imminent danger. Slow-growing economies overseas and a
lack of inflation psychology here at home should delay any rise in inflation.
However, while on the surface, this should be a quiet week for markets, at a more
fundamental level it will be yet another week where too little supply will meet too
much demand and too much money will add to long-term pressures for higher inflation
and interest rates.

For investors, this is a reason, even in a quiet week, to make sure they have enough
exposure to foreign equities, real assets and less interest-sensitive U.S. assets
and are less exposed to very low yielding and long-duration assets in a U.S.
financial environment of deceptive calm.

David Kelly
Chief Global Strategist
JPMorgan Funds

Could Negative Interest Rates Lead To The End Of Cash?

By Julian Wellesley, Global Equity Opportunities Analyst, Loomis, Sayles & Company, L.P.

Wellesley’s blog, posted today, notes that “some believe physical cash might one day be abolished altogether. This isn’t as fanciful as it sounds. Bank of England chief economist Andy Haldane has discussed abolishing physical cash and shifting to an electronic wallet as a way to stop people from hoarding cash if interest rates go well below zero. In the near term, it is more likely that central banks will follow the lead of Europe and the UK and shift away from printing the highest denomination bank notes.”




The Week Ahead By JPMorgan Funds

The Case for September

This week should be relatively quiet, with major economic releases for the month and
the earnings season largely behind us. The next potentially market-moving event,
Janet Yellen’s speech at the Kansas City Fed’s annual conference in Jackson Hole,
Wyoming, will not occur until the end of next week.

In the meantime, market participants will look forward to that speech, and the FOMC
Minutes due out this Wednesday, for hints on whether the Fed might, in fact,
announce its first rate hike of the year when it meets in mid-September.

Markets are betting heavily against this with the fed funds futures market only
pricing in a 9% probability of a rate hike as of last Friday. However, both as a
way to understand the current economy and a guide to where interest rates might go
in the future, it is worth reviewing the case for a September rate hike.

First, the Fed has stated repeatedly that the path of the federal funds rate is data
dependent, and specifically depends on signs of strengthening economic activity, a
tightening labor market and confidence that inflation is heading back to its goal of

On these issues, numbers due out this week should be reassuring. The July read on
Industrial Production and August numbers on manufacturing activity from the Philly
Fed and Empire State indices should all show improvement. Meanwhile, although
Housing Starts may fall from a weather-inflated June reading, the more important
Building Permits series may still have registered a gain in July. Real GDP growth
for the second quarter was a disappointing 1.2% annualized and may be revised lower.
However, trends in consumer spending, housing and manufacturing activity look
positive in the middle of the third quarter and with inventory growth potentially
rebounding from a negative second quarter read, third-quarter GDP real growth
continues to track between 2% and 3% annualized.

On employment, last week’s reports on job openings and unemployment claims both
suggest continued labor market tightening. The last year has seen a welcome,
albeit likely temporary, increase in labor force participation, which has slowed the
decline in the unemployment rate. Even so, however, at 4.9% the unemployment rate
is lower than it has been 79% of the time over the past 50 years. Other measures of
labor market health such as the number of discouraged workers, the number of
long-term unemployed, the number working part-time who would like to work full time
and wage growth have all shown steady improvement and are all at healthy levels. In
short, the labor market cannot really be used as an excuse for not tightening at
this stage.

On inflation, this week will see the release of Consumer Prices for July. Lower
energy prices may keep the overall index at flat for the month and up a tame 0.9%
year-over-year. However, the core CPI, which excludes food and energy, could rise
by 0.2%, climbing to 2.3% year-over-year. The core is what is really important here
since, barring some shock, energy prices should switch from being down 10%
year-over-year in July to being up 10% year-over-year by the first quarter of next
year. This should push the Fed’s preferred inflation measure, the headline
consumption deflator, above 2% year-over-year by the first quarter.

In short, there is no case for further delay based on growth, jobs or inflation.

However, particularly over the last year, the Fed has expressed more general
concerns about overseas economies and unsettled markets. There will, of course,
never be a point of complete tranquility for the global economy and markets.
However, the latest data from China suggest near-term stability, global PMI data
show that Brexit effects appear to be limited to the United Kingdom and global
equity markets have been enjoying a nice rally in recent weeks.

Another concern for the Fed is that, if they do raise interest rates, this might
boost an already too-high dollar. This is a risk. However, the relationship
between short-term interest rates and the exchange rate is highly volatile, so it is
by no means certain that a September rate hike would actually boost the dollar.
Moreover, if this is the excuse that the Fed falls back on for not tightening, it
could preclude tightening for the next decade. After all, a too high dollar is, to
some extent, revealed by a current account trade deficit and no credible U.S.
economic forecast has the U.S. achieving a trade surplus for years to come.

The Fed’s final excuse for not tightening earlier this year, which might again be
invoked in September, is perhaps the least logical. In Janet Yellen’s press
conference after the June FOMC meeting she stated:

“….Caution is all the more appropriate given that short-term interest rates
are still near zero, which means that monetary policy can more effectively
respond to surprisingly strong inflation pressures in the future than to a
weakening labor market and falling inflation”

Translated this is almost an admission that in this long-economic expansion, now in
its eighth year, the Fed has missed the opportunity to get monetary policy back to a
normal stance and so would not be in a position to fight a recession if it were to
occur. Therefore they need to be extra careful not to precipitate one.

This is, in fact, the very worst excuse for inaction, for two reasons. First, there
will be a recession at some stage in the future anyway and the Fed will want to be
in a position to fight it. If we are lucky, it could be a few years away, which may
still give the Fed time to get rates back to normal first. Their delay to this
point is no excuse for further procrastination.

However, even more frustrating is that the Fed apparently doesn’t recognize that the
first few rate hikes are much more likely to reduce recession risks than increase
them. The first few rate hikes would boost consumer interest income more than
interest expense, give home-buyers an incentive to borrow ahead of higher rates,
steepen the yield curve and thus increase the incentive for banks to lend, reduce
the need for companies and municipalities to funnel money into actuarially
underfunded pension plans, and likely increase consumer confidence as the Fed would
be seen as less scared to raise rates. The first few rate hikes would not price
anyone out of buying a home since, in today’s market, high credit scores and high
down payments are the real barriers to home-ownership.

Finally, by moving away from a near-zero percent policy, the Fed could begin to
mitigate some of the unwelcome long-term effects of artificially-low interest rates
including the misallocation of resources within the economy, the discrimination in
favor of borrowers over savers and the potential for asset bubbles which, as we have
learnt many times in the past, are a potent source of economic disruption.

The title of the Fed’s Wyoming retreat is “Designing Resilient Monetary Policy
Frameworks for the Future”. The topic could hardly be more appropriate because the
need for reflection on these issues has never been more urgent.

David Kelly
Chief Global Strategist
JPMorgan Funds

The Week Ahead By JPMorgan Funds

Pressure on the Profit Slice

The economy is neither as weak as portrayed in the GDP report of two weeks ago, nor as strong as suggested by last Friday’s jobs numbers.  However, for investors, neither GDP nor jobs are that important.  What does matter are the direction of interest rates and the growth in profits.  Data due out this week should help clarify these trends.

On interest rates, both Import Prices and Producer Prices should paint a picture of relatively tame inflation in July.  However, analysts should pay close attention to Productivity numbers and particularly Unit Labor Costs, due out on Tuesday.  Recent data on employment costs and average hourly earnings clearly show an uptick in the growth in hourly compensation.  Unfortunately, this is occurring at a time of diminished productivity growth, with output per hour likely to show a year-over-year decline.  This combination can both reduce profit growth and boost inflation.

In addition, numbers on Unemployment Claims on Thursday and Retail Sales on Friday should reassure investors that both the labor market and the consumer sector are healthy.  This reassurance, combined with a less dovish stance recently emanating from the Bank of Japan and the Bank of England, should be enough to keep a rate hike on the table for the next FOMC meeting on September 20th and 21st.  In addition, prospects of both somewhat stronger inflation and a slightly less dovish Fed could raise long-term interest rates from what are still extraordinarily low levels.

On profits, the second-quarter earnings season is winding down, with 23 S&P500 companies reporting their numbers this week.  Through last Thursday, with 87% of S&P500 market cap reporting, 69% of firms had beaten analyst estimates on earnings and 42% had beaten estimates on revenues, making it a very normal earnings season in terms of surprises.

However, yet again, write-downs of energy assets hurt earnings numbers with the energy sector, which used to account for roughly 12% of S&P500 earnings, posting a loss for the sixth consecutive quarter.  Overall, S&P500 operating EPS is tracking $26.02 for the quarter, down 0.4% year-over-year, although still a substantial improvement from the first quarter.

But where do we go from here?  A small drift down in the dollar and a small drift up in oil prices could boost profits in the year ahead.  With half the year now done, we believe S&P500 operating EPS could reach $103.50 for 2016 and $117.50 for 2017, gains of 3.0% and 13.5% respectively.  Note that, while these numbers are well below the sum of consensus analyst estimates, in recent years those estimates have consistently been proven to be too optimistic a few quarters in advance.

It should be also noted that even our milder double-digit expected gain for 2017 is a little misleading, mostly reflecting a reversal of the dollar and oil drags rather than sustainably easier business conditions.  In fact, just as the issues that have restrained earnings over the past two years fade, rising costs may pose a more general threat to profitability.

One approach to forecasting profits is to think of them being the last slice of a big GDP pizza.  Apart from profits, there are slices for labor compensation, rent, interest, depreciation, and corporate taxes.  Once everyone else has had their slice, the profit slice is what is left.

In a recession, the pizza itself gets smaller, with profits suffering the most as the other slices are less flexible.  In the early years of an expansion, the pizza expands, with profits benefitting the most.  However, as the expansion ages, the pressure on the profit slice rises again.  Years of investment spending leads to more depreciation.  Tight labor markets push up wage costs while rising inflation boosts interest costs and rental costs.  So far in this expansion, most of these costs have been held at bay, partly because of gloom in the labor market, which has held wages in check, a lack of business confidence curtailing investment spending and thus depreciation, and a very dovish attitude among central banks, holding interest costs in check.

However, as labor markets continue to tighten, these costs could rise more quickly, chomping into profits, particularly in 2018 and beyond.  While 2017 should see a bounce in profitability, profit growth thereafter should be slow.  All of this should give investors appropriate pause for thought, particularly as the S&P500 closed at a record high of 2,183 on Friday.

This does not suggest that the U.S. equity market is in any imminent danger.  As has been consistently the case throughout this long expansion, neither cash nor the bond market look attractive from valuation perspective, and this should continue, at least for a while, to funnel money towards the stock market.

However, as stocks move higher, particularly if inflation and long-term interest rates also rise, it will be important for investors to maintain a balanced approach to investing.  In practical terms, this means looking at cheaper equity markets and younger expansions overseas along with alternative investments, while curbing their enthusiasm for U.S. equities as the long-term pressure on earnings mounts.

David Kelly
Chief Global Strategist
JPMorgan Funds

The Week Ahead By JPMorgan Funds

The Tortoise Ambles Forward

The first order of business for investors this week will be deciphering the government’s latest report on GDP.  The headline numbers were ugly, with real GDP rising just 1.2% annualized in the second quarter, well below consensus forecasts. Moreover, downward revisions to recent quarters left real GDP growth at an anemic 1.2% year-over-year and just 2.1% since the start of the expansion.

However, it is important to recognize some key truths about this expansion with regard to its durability, the reasons for the slowdown over the past year, and prospects for growth going forward.  On balance, the numbers portray the same, now familiar U.S. economy – a healthy tortoise moving steadily forward but at afrustratingly slow pace.

On durability, it is worth noting that we are now in the eighth year of this expansion making it the 4th longest of the 23 expansions since 1900.  It has been very slow – its 2.1% pace since inception was unchanged by GDP revisions (which showed stronger growth in 2013 and 2015, before a weaker gain so far this year). However, it has been a persistent expansion and its continuation has allowed unemployment to fall below 5%, home and stock prices to set new records, and real disposable income per head to rise by 8.2% over seven years.   If the expansion continues for a few more years, its cumulative impact on living standards could be quite significant.

On the last year, it is important to understand how inventories and energy sector investment spending impacted GDP growth.

In the second quarter of last year, inventories were growing at an annualized pace of $94 billion.  By the second quarter of this year, that pace had fallen to -$8 billion.  This change alone reduced real GDP growth by over 0.6% over the past year. In addition, investment spending on energy infrastructure fell from $96 billion annualized in the second quarter of 2015 to $48 billion in the second quarter of this year, subtracting a further 0.3% from year-over-year real GDP growth.

Of course, both the slump in inventory growth and energy investment spending are real.  However, their impact, uncompensated for by stronger growth elsewhere in the government accounts, has resulted in GDP growth for the past year that looks suspiciously weak.  In particular, it implies a 0.4% year-over-year decline in output per worker.  While productivity growth is undeniably weak, it is hard to imagine why it would be negative on a year-over-year basis and future revisions may show a somewhat stronger last year for U.S. economic output.

As for the economy’s prospects, growth should be stronger in the second half of 2016 than in the first half.  Consider that:

–Over the past 10 years, real inventories have grown at an average pace of $26 billion.  Just getting back to this number, over say four quarters, would add $34 billion or 0.2% to real GDP.

–Real investment spending on energy structures is now down 64% from its peak.  With oil prices more stable and rig counts now rising, further energy investment spending cuts should not be a significant drag on GDP over the next few quarters.

–Both government spending and home-building fell in the first quarter, according to the advance GDP report.  These are likely to rise in the quarters ahead.

–Finally, Commerce department numbers on corporate profits confirmed that they were undercounting earnings in recent years as we had long believed.  Higher levels of profits, combined with what appears to be the start of a bounce-back in earnings for the second quarter, suggest that corporations may increase recently anemic capital spending.

On balance, the tortoise is still ambling forward and should achieve relatively steady real GDP growth of roughly 2% for the rest of this year and in 2017. Data out this week should support this forecast.  The ISM Manufacturing PMI, while potentially down from a strong June, should remain well above 50, while the MarkitManufacturing Index will presumably stay close to its strong “flash” reading of 52.9.  Industry reports suggest that July saw a strong bounce-back in Light-Vehicle Sales following a dip in June, while both Personal Consumption and Personal Income appear to have had good momentum at the end of the second quarter.

Finally, on the economic front, Friday’s Employment Report should be solid, based on low unemployment claims and positive readings on consumer perceptions of the job market.  We are looking for job gains of between 150,000-200,000 with a solid 0.3% rise in average hourly earnings and a dip in the unemployment rate to 4.8%.

The week ahead will also be an important one for corporate earnings with 123 companies, representing 16.2% of the S&P500, set to release their numbers.  Through last Thursday, 295 companies (or 68% of market cap) had reported, with a healthy 71% beating expectations on earnings and 47% beating on revenues.  Importantly, S&P500 operating EPS is currently tracking a 3.8% year-over-year increase, which would be the first year-over-year gain in seven quarters, as the headwinds of a strong dollar and cheap oil fade.  The biggest risk to this forecast would be further write downs in the energy sector – the reports of 15 energy-sector S&P500 companies this week should shed some light on this.

Finally, global PMI data should be relatively positive this week, following some solid reports on unemployment from both Japan and Europe last week.  So far, it appears that the global economy may also be poised to grow faster in the second half of 2016 than in the first.

The Bank of England will likely cut interest rates this week and perhaps engage in further QE programs, in response to Brexit.  But this is a special case.  More general central bank behavior in the summer of 2016 suggests that we may be very close to the end of ever-easier money.

The reasons are varied from worries about the impact of NIRP on the banking system, to an expectation that monetary stimulus will be replaced by fiscal stimulus, to a growing sense that economies can no longer benefit from monetary easing from very low rates.  Whatever the reason, the possibility of less dovish central banks while both growth and earnings seem set to rebound still seems like an environment in which to overweight global stocks over fixed income or cash relative to a normal portfolio.

David Kelly
Chief Global Strategist
JPMorgan Funds

The Week Ahead By JPMorgan Funds

Seven-Point Reality Checkup

Perceptions of the American economy today remain gloomy, simultaneously depressing long-term interest rates, sustaining record holdings in cash accounts and discouraging a very timid Federal Reserve from moving away from extreme liquidity policies.

However, while markets swing with perceptions, they trend with reality.  For this reason, it is worth doing a quick “reality checkup” on the investment environment. The week ahead is a particularly good time for such a checkup as it will be full of significant numbers.

Growth:  Friday’s GDP release should show roughly 2.5% real growth for the 2nd quarter, with 4%+ gains in real consumer spending being offset by weakness in inventory building and energy investment spending.  Importantly, however, consumer strength should be sustained in the months ahead due to gains in employment, wages, wealth and credit availability.  By contrast, the investment spending drag should fade, since inventory growth should have fallen to a normal pace in the second quarter and investment spending on energy structures should already be down nearly 75% from its peak.  Led by consumption and with some support from housing and government spending, real GDP should grow at a 2-2.5% pace for the rest of 2016 and 2017.

Jobs: Investors will have to wait until next week for the July jobs report. However, unemployment claims have been running a little lower over the past four weeks than in the lead-up to the June jobs report and the Markit flash manufacturing index showed a nice improvement in its employment component.  This week’s reading on employment conditions in Tuesday’s Consumer Confidence report should further help tighten estimates. Overall, the economy still seems on track to produce 150,000-200,000 net new jobs per month, which should allow the unemployment rate to resume its downward trend and wage growth to rise.

Profits: The week ahead will be extremely busy on the earnings front with 192 companies, representing almost 40% of S&P500 market cap, set to release their 2nd quarter numbers.  So far, the earnings season has been pretty typical, with two-thirds of companies beating expectations on earnings and half beating on revenues.  Importantly, however, these expectations assumed a year-over-year earnings rebound, reflecting a slightly weaker dollar and stronger oil prices.  This week’s numbers should validate that expectation.  In addition, revisions to the government’s numbers on corporate profits over the past three years could show some improvement and add clarity to a series that has been muddled by retroactive changes in tax laws in recent years.

Inflation: Investors this week will keep an eye on both the GDP Deflator and the consumption deflator.  Both should look benign for the second quarter.  However, with wage pressures gradually rising, (as should be seen in Thursday’s Employment Cost Index report) and rental markets tightening, (as will likely be seen in Thursday’s Rental Vacancy and Homeownership Report), core inflation is likely to move slowly higher in the months ahead and be outpaced by headline inflation, on a year-over-year basis, as energy prices trend higher.

Wealth:  Household wealth is also at a record high.  Last week’s record close on the S&P500 leaves it up 6.4% year-to-date.  However, equally important is that, last week, average home prices for June were reported up 4.2% year-over-year at their highest level ever.

Interest Rates: Of course, recent gains in both stock prices and home prices have been fostered by very low interest rates.  This week, the Fed will meet to discuss monetary policy.  At their June meeting, they decided not to raise rates in response to a weak jobs report and uncertainty about the potential impacts of the then upcoming Brexit vote.  Since then, while job numbers have been reassuring and financial markets have clearly weathered the Brexit decision, few observers expect a very dovish Fed to tighten this week.  This will leave interest rates at levels that are supportive of asset prices, if not really helping real economic growth. Meanwhile, global interest rates could be further restrained this week by a widely-expected decision by the Bank of Japan to delve further into the netherworld of negative interest rates.

Valuations: Finally, there is the question of valuations.  Often, when the stock market hits an all-time record high it is very expensive.  This is, however, not the case right now, with forward P/E ratios at about 17.5 times, only modestly above their 25-year average of 15.9 times.  Moreover, in an environment where long-term bond yields are extremely low around the world and cash is paying a negative real return, stocks still look cheap in relative terms.

Overall, for an expansion entering its 8th year, it has a remarkably clean bill of health.  While always disappointing in its pace, this tortoise-like expansion is generating steady growth, low unemployment and record levels of wealth.  Profits are now on an upswing and, as yet, both inflation and interest rates are low.  Angry politicians on both extremes will say the country is headed in the wrong direction and they are aided, as always, by a drama-obsessed news media.  Those in the center hardly dare to challenge the negative consensus for fear of being labeled “out-of-touch”.

But the numbers don’t lie.  The reality is that investment environment is healthy today and much better than it has been over most recent decades.  For long-term investors, logic has always proven to be a better friend than emotion and logic still suggests this is still a good time to be invested in risk assets.

David Kelly
Chief Global Strategist
JPMorgan Funds