Summary, Commentary and Highlights of JP Morgan's Pillow Talk: Markets 2024 outlook by Michael Cembalest (Chairman of Market and Investment Strategy for J.P. Morgan Asset & Wealth Management)
Compiled By Chinedu Okoye for Zero Analytics
Introductory notes and Commentary:
Cooling inflation and prospects of a Federal Reserve rate cut has increased the chances of a soft landing, but leading indicators point to lower growth.
Investors challenges going into 2024 identified were; the damage to public sector finance from large deficits, the priced in soft landing in the markets, and the concentrated contribution of Mega cap stocks.
All things considered the author predicts; slower GDP growth, single digit corporate earnings growth, and single digit returns on the median S&P 500 stock.
He then recommended a portfolio diversification of; cash, long duration government bonds, high quality corporates, and equities. On the equities component the author favored Industrials and Energy.
Zero Analytics adds one more component to the mix; Commodities, seen as industrials and energy sectors are expected to rally, the expectations spill over into relevant commodities (i.e., Industrial Metals, Crude Oil, and Natural Gas).
1. Leading Indicators point to a weaker US growth:
ISM improved in the last month, however other indicators such as US bank lending standards, capital expenditure, and small business expectations for sales and profits all slumped.
Monetary tightening hasn’t caused a recession because real rates are still below levels preceding past recessions. Cashflow is stable, corporates and households already termed out their maturities prior to rate hikes by at least 76%. This partially insulates them from rate hikes.
Supply chain pressures have eased, auto inventories are up as used vehicle prices drop as well. This is indicative of a breathing room for the Fed.
Easing Supply Chain Pressures:
Vehicle Inventories up, used vehicle prices down:
Rent is down:
2. US equity markets and domination of the Mega caps:
Yields on equities, high grade bonds, treasury bills, and REITs have all converged, an occurrence it was stated that hasn’t happened in 20 years, hence the mention cash earlier, as “it seems like good value on a risk-adjusted basis”.
Higher margins and free cashflow of the magnificent 7 companies in the S&P 500 outweigh the rest of the market as the charts below would also illustrate that the modest S&P 500 ex. Mag 7 gains in 2023. This highlights the concentration risks in US equities.
Market Cap of largest 7 % of total S&P 500 index market cap:
Big 7 leads S&P returns:
To put this into perspective, the chart shows the heart to date returns of the Magnificent 7, year to date returns in the S&p index with and without the big 7.
3. European and Japan Equities:
European Equities underperformed the US by 7% in 2023 even though they trade close to a record low PE.
Europe trades at a discount to the US:
In Japan, the exit from deflation has made cash less attractive relative to equities. As at December 2023, Japanese companies had more cash as a percentage of market cap, with half of these companies trading below book value and less corporate buy-backs as a percentage of market capitalization. More households in Japan held cash as well.
This creates "room to equitize" as households equity allocation is only 11% as opposed to 40% in the US. Consequently, households cash allocations stand at 55%, 40 percentage points higher than US household at 15%.
Japan Exits deflation:
Core CPI in Japan is up, marking an exit from the deflation. Japan’s low price-to-book companies are expected to take steps to increase shareholder value. Global stocks underweight are modest and the Yen weakness maybe a tailwind for investors.
Some risk factors in Japan where identified;
a) 2023 growth in Japan was dominated by exports rather than domestic exports
b) Industrial production is not different in Japan from Europe,
c) BOJ projection of the country's potential growth rate is still modest.
The outlook for Japan is based on a onetime exit from deflation and additional boosts from corporate governance and investment incentives. "These rationales cannot endure for years."
4. Fixed Income: the low spark of high yield:
US Mega caps are minimally insulated from rising interest rates as S&P fixed debt is 76% compared with below 50% in 2007. This is the main reason why interest rate coverage ratio still looked good despite high levels of debt to free cash flow and debt to equity figures.
Yield Convergence:
US treasuries are expected to fluctuate between 4% - 5%, but JP Morgan sees long term value at 4.5%. hence the long duration government bonds suggestion above for a diversified portfolio going into 2024.
5. US Debt Sustainability: The Boiling frog
The US budget deficit has been detoriating steadily since 2018, not in itself a unique feature in comparison to other developed countries, but unique in it's starting point. By 2030, all US government revenues would be consumed by entitlement spending and interest payments in existing debt as projected by CBO.
Treasuries are still a buy as the US Dollar hasn’t experienced any material change in it’s status as worlds reserve currency. The market is accustomed to detoriating government finances with little consequence for investors but that may change hence the boiling frog analogy.
Before the above takes place though, a combination of market pressure and ratings downgrades will force the government to adopt policies that woyld reduce government spending and increase government revenue. The policies suggested are outlined below:
Policies to Raise Revenue:
Various policies can be implemented to increase revenue, such as eliminating or raising the cap on income for Social Security contributions, imposing a lifetime/means-tested cap on 401k contributions, and introducing federal taxes on municipal bonds for AGI over $250k. Additionally, measures like unifying capital gains and income tax rates at a higher level for AGI over $250k, implementing value-added taxes, and carbon taxes can contribute to revenue generation.
Policies to reduce Government Expenditure:
On the other hand, policies aimed at reducing entitlement spending involve government price-setting on drugs and treatments within Medicare/Medicaid, higher Medicare co-pays and deductibles for all, means-testing Medicare outlays based on lifetime income, caps on Medicaid spending, raising the Medicare eligibility age and/or Social Security retirement age, and adopting the Chained CPI for Social Security benefits.
( Source: CBO, JPMAM, 2023. AGI = Adjusted Gross Income.)
Debt Held by the public in the US is at its highest ever.
Net interest Expense shot up post COVID:
Budget Deficit as a share of GDP also went up exponentially on emergency support measures needed to shore up the economy during the pandemic:
Unemployment rate is at its lowest at times of higher deficits as well from the chart below never has unemployment rate been lower than budget deficit in the US:
China holdings of US Dollar assets, despite the recent offloading last year of billions in US Treasuries, has been fairly stable since 2015
US Consumer Spending:
Consumer Spending in the US surprised to the upside in 2023, a reflection of tight labor markets, wealth effect from rising equity and home prices, and excess savings which are being tapped out.
Real Consumer Spending: For the US consumer spending after adjusting for Inflation is higher than developed country peers.
Real Savings Rate: Consequently reals savings rate is also below its peers:
US household Savings Exhaustion:
Credit Delinquency Rates Up:
Zero Analytics Take on US Economy:
The US Consumer seems exhausted and if that be the case, aggregate demand is expected to slow, according to Analyst at Zero Analytics. That could spill over into the labor market as businesses try to cut costs in a high interest rate and real wage environment.
This could lead to more credit delinquencies and reduce bank willingness to lend. The overall effect would be a lower aggregate demand and a negative effect on output (GDP) growth. How negative is yet to be determined.
China:
From the paper, China is seen as the ultimate value trap which could come to an end soon. "China’s massive 40% savings rates represent potential ammunition for an equity market rebound, but there’s no catalyst yet."
Subpar performance for investors in China equities relative to peers
Since Jan 1, 2019 till date; US large cap equities +107%, Europe equities + 58%, and China equities -17%.
Zero Analytics Positioning:
The report by Michael Cembaleste advises a diversified portfolio: cash, long-term government bonds, high-quality corporate bonds, and Industrials/Energy stocks. Cash is recommended due to converging rates, offering flexibility for fixed-income opportunities.
The US Dollar remains strong in global transactions, cautioning against dollar shorts. With potential labor market challenges, we are bearish on equities (except Industrials/Energy).
We favor government bonds for developed countries, high-quality corporate bonds, and select equities. Asia's value in Japan and China, but watch corporate governance.
With the Yuan and Yen down against the Dollar, presenting opportunities. Bearish on European stocks, prefer Euro-area sovereign bonds.
Overall, value in Cash, Sovereigns, high-quality corporate bonds, and select Asian equities. Emerging Markets require caution, suitable for high-risk tolerance institutional investors. Commodities offer opportunities especially in industrial metals, Gold, Crude Oil and Natural Gas.
DISCLAIMER:
THE ABOVE IS A REVIEW OF THE WORK BY JP MORGAN'S MICHEAL CEMBALESTE AND NOT THE WORK OF ZERO EQUILIBRIUM. ADDITIONAL COMMENTARY AND TAKES BY ZERO ANALYTICS DOES NOT CONSTITUTE INVESTMENT ADVICE. WE ARE LONG TREASURIES, COMMODITIES AND USD.
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