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Global Asset Allocation Views
Key findings from the Multi-Asset Solutions Strategy Summit
1Q 2021
AUTHOR IN BRIEF
• The global recovery is set to broaden out with 2021 likely to see growth above trend. Ample slack in the economy suggests inflation will pick up only slowly, so monetary policy is likely to remain supportive throughout the year.
• Nevertheless, the main driver of asset returns likely transitions from liquidity to growth over the course of 2021. This implies potential for short-lived pockets of volatility, but over the year as a whole we anticipate benign market conditions and a continued decline in volatility. John Bilton • We maintain a pro-risk tilt, spread across stocks and credit. We prefer cyclical equities Managing Director and are overweight (OW) U.S. small cap, emerging markets (EM), Europe and Japan, Head of Global Multi-Asset Strategy and neutral on U.S. large cap and UK. In credit, we temper our enthusiasm for U.S. Multi-Asset Solutions corporate credit a little, and diversify credit holdings further with EM debt. • Despite our pro-growth stance, we move duration from underweight (UW) to neutral given ongoing central bank buying. We prefer to play upside risks to inflation via an UW to USD.
EXHIBIT 1: MAS ASSET CLASS VIEWS Asset class Opportunity Set UW N OW Chg Conviction Inflation has displayed little cyclicality in recent economic expansions. Equities Moderate Prices can remain depressed for extended periods of above-trend growth
MAIN Duration ▲ EXHIBIT 2: U.S. CORE CONSUMBER PRICES, Y/Y % ASSET CLASSES Credit Moderate 6% Cash ▼ Moderate U.S. Low 5%
Europe Low UK ▲ 4%
EQUITIES Japan ▲ Low
Emerging markets Moderate 3% U.S. Treasuries
G4 ex-U.S. sovereigns Moderate 2% EMD hard currency ▲ Low EMD local FX ▲ Moderate 1%
FIXED INCOME Corporate inv. grade ▼
PREFERENCE BY ASSET CLASS Corporate high yield Moderate 0% USD Moderate 1 13 25 37 49 61 73 85 97 109 121
EUR Low Number of months since the beginning of economic expansion FX JPY Nov-82 Mar-91 Nov-01 Jun-09 EM FX ▲ Moderate Source: Haver Analytics, J.P. Morgan Asset Management Multi-Asset Solutions; data as of December 2020.
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SUMMARY Our positive outlook on the economy in 2021 calls for a pro-risk tilt in our multi-asset portfolios. As a result we stay overweight A common meme among financial analysts making their year (OW) both equity and credit, with our exposure balanced across ahead forecasts is to project which year in history the upcoming the two asset classes. While we see some path to yields drifting one will most take after. While we can’t say with certainty which higher as growth broadens out, we believe that monetary policy year from the past 2021 will most resemble, we can say with will control the pace at which yields can rise. With 10-year U.S. some conviction that it will be very different from 2020. Treasury yields closing in on 1%, but few signs that central banks True, we’ll start the new year with the same easy monetary policy intend to wind down their quantitative easing any time soon, we that helped us through 2020, and COVID-19 will dictate our social move from underweight to neutral on duration. At the same time, and working interactions for the first quarter or two. But we the risk that inflation expectations pick up implies that real yields approach 2021 with a new cycle broadening out. Fiscal stimulus, along the curve are likely to remain profoundly negative; hence which plugged gaps in 2020, will likely recede as the private we move cash to underweight (UW). sector rebounds. And a global vaccine rollout is already Across the equity complex we take a cyclical tilt, but equally beginning to push coronavirus from a present threat to a historic prefer to remain well diversified. The economic rebound is event. All of these issues have a bearing on asset markets. But global, we believe, and regional leadership is thus more nuanced. for investors the transition from a market fueled largely by In particular we are OW U.S. small cap and emerging market (EM) emergency liquidity and stimulus to one driven increasingly by a equities, which are well exposed to the broadening recovery. We global economic recovery may present the biggest challenge. also have a mild OW to Japanese equities, and to European stocks We will begin 2021 with a renewed conviction that the economic which, though cyclically geared, face some near-term risks from recovery is robust. As the year progresses we expect growth to recent lockdowns and Brexit. We upgrade UK equities from UW to broaden out and “left behind” sectors like travel and leisure to neutral, and are also more neutral on U.S. large cap stocks in our show new signs of life – particularly as vaccine rollouts extend to portfolios given the headwind from elevated valuations. the wider population. Certainly the distortions to the labor In credit we trim U.S. investment grade (IG) to neutral and keep market and to Main Street will take some time to heal, but in our high yield (HY) at OW but with a reduced conviction. Spreads view the extent of permanent scarring is surprisingly contained, across the credit complex tightened sharply in 4Q20, but we still leaving the supply side of the economy mostly intact. believe credit as a whole is well geared to the wider recovery. We The debate around inflation risk also diversify our credit exposure by moving EM debt to OW. In sovereign bonds, we once again prefer U.S. Treasuries to core Nevertheless, we expect monetary policy to remain extremely European bonds. But in general we will be looking to play any accommodative. The Federal Reserve (Fed) will likely prefer a upward repricing of U.S. inflation through a short on the U.S. little more inflation risk to the risk of scuppering the recovery dollar rather than an underweight to duration. through premature withdrawal of policy support. For investors the debate around inflation risk is central both to return Overall our portfolio aligns to expectations of above-trend global expectations and the outlook for market volatility over 2021. growth and easy policy. We acknowledge the risk of rising Market participants who believe that inflation risks are likely to inflation expectations, but believe that should such a repricing elicit a policy reaction are generally more cautious. We see only spur volatility, the Fed would respond swiftly. As the principal limited upside for inflation in the near term, and fully expect the driver of asset returns pivots from policy to growth, we expect Fed to look through it were it to arise. But we also note that cyclical equities to benefit. But with global policy remaining easy, inflation is not well discounted in asset markets. As we turn to bonds may be among the last, rather than the first, of the major our asset allocation views it is a factor we need to consider, if assets to react to the broadening recovery. only at the margin.
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MACRO OVERVIEW the working-age population, more or less even with conditions about three years into the last business cycle expansion. HOW MUCH SLACK? Two calculations of potential GDP tell similar stories: a As a starting point in forming our economic outlook for major moderate amount of slack in the U.S. at end-2020 economies, we considered two big-picture questions that help inform our view of the business cycle and medium-term EXHIBIT 3: U.S. OUTPUT GAP, TWO DEFINITIONS (% OF POTENTIAL GDP) prospects for growth. First, how much slack exists in major 6 economies? Second, what can we say about prospects for 4 inflation in coming quarters? The issues are interconnected. Our 2 baseline view is that the U.S. is currently operating with a 0 moderate amount of spare capacity but that this output gap will -2 likely close by the end of 2021. Other developed market (DM) -4 economies are probably experiencing more slack today and will -6 do so for longer. Even as the economy takes up existing slack, we -8 expect fairly muted inflation to persist throughout next year. -10 The deep recession earlier in 2020 undoubtedly created 2002 2005 2008 2011 2014 2017 2020 Trendline CBO significant slack. After all, GDP in the U.S. – not the hardest hit among major economies – plunged 9.0% year-over-year (y/y) in Source: Haver Analytics, J.P. Morgan Asset Management Multi-Asset Solutions; data and forecasts as of December 2020. 2Q20, and the unemployment rate surged. Since then, though, activity has rebounded sharply. We forecast U.S. GDP will be These metrics do not take into consideration structural factors down just 2.5% y/y by the fourth quarter of this year. By around that might affect the economy’s potential output. For example, September 2021, we expect GDP to climb above the pre-shock the 2008–09 recession appears to have destroyed considerable level while retaining roughly a 2% shortfall compared with the capacity, leading to persistent overestimates of slack in prior trend path. Equally important, those pre-pandemic levels subsequent years. This time around, though, despite the severity likely do not represent the right benchmark for thinking about of the recession, limited scarring seems to have occurred – in spare capacity today: Many economies, including the U.S., were part because the manufacturing sector was less badly hit than likely overheating, operating above potential, at the start of usual. And other indicators of damage, such as commercial 2020. bankruptcies, have been running at low levels. Conversely, a surge in productivity growth, which was indeed reported in the Instead, we estimate the level of potential U.S. GDP in two ways, past two quarters, would significantly boost the economy’s first by adopting the trend growth rate used in our Long-Term capacity. We think most of that jump, though, was a mirage, Capital Market Assumptions and, second, by using the generated by compositional shifts in the economy’s activity (e.g., Congressional Budget Office’s shorter-term econometric the sidelining of restaurants, a low productivity sector). We calculations. These exercises produce similar results, pointing to therefore see merit in considering our calculations as base-case slack that amounts to between 1% and 2% of potential GDP at estimates of slack. year-end 2020 (Exhibit 3), with slightly above-potential GDP by the end of next year. This view of moderate but rapidly shrinking Outside the U.S., the spare capacity picture varies. Most other slack finds an echo in our analysis of the labor market. Here we developed market economies – with Australia as a notable calculate an “employment gap” by combining assessments of a exception – took larger hits in the downturn and have bounced neutral rate of unemployment and the demographically driven back a bit less since. Moreover, the euro area and UK, which have trend in labor market participation. This approach suggests reimposed activity restrictions, appear to be going in reverse for current slack in the labor market equivalent to roughly 2%–3% of now, moving away from their economic potential rather than toward it. Slack thus seems larger there than in the U.S.
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Conversely, China and other North Asian economies have To be sure, surveys of household inflation expectations have experienced more complete recoveries, with industrial edged higher. We attribute that move to earlier increases in production, for example, well above pre-shock levels. These some of the most salient prices in consumers’ minds, such as
economies have likely closed their output gaps and are already staple foods, which we expect to reverse in coming months. As transitioning into more moderate phases of their new we have discussed, slack should also represent a drag, although expansions. one that will fade through the course of 2021. We will monitor the
implications of a weaker dollar for goods prices, although thus CAN INFLATION RETURN? far it has not depreciated enough to exercise a strong influence Our perception of slack informs our outlook for inflation, a topic on overall inflation. Knock-on effects from gas price swings that received considerable attention at our December Strategy should, as usual, prove fairly minimal. Summit. When the economy went into recession earlier this year, All this points to U.S. core inflation running below 2%, in we thought the shock would prove disinflationary, thanks to the annualized sequential terms, throughout next year (although collapse in demand. This would occur despite a contrary base effects will temporarily lift the year-over-year rate above influence from business shutdowns and resulting supply that mark in the second quarter of 2021). A similar message constraints, we believed. Although inflation data have fluctuated emerges from a set of bottom-up, sector-level forecasts (Exhibit in recent months, reflecting reopening effects as well as various 4). That is partly because of the likely stability or deceleration in policy interventions (such as tax cuts and subsidy increases), in the shelter category, by some distance the largest component of general they have borne out that forecast. Our measure of global the U.S. core index. Various measures of rental inflation have core consumer price inflation stood at 1.2% y/y in October, equal been slowing recently, and an unemployment rate above its long- to the prior two months and well below the 1.9% pace observed term average – even if falling fast – typically depresses them at the end of 2019. DM core inflation is running slightly below 1% further. y/y, its weakest since the aftermath of the global financial crisis. Inflation expectations are sluggish at historically low levels In projecting core inflation, we consider various inputs that have proved important over time. Slack is among them, but so are EXHIBIT 4: SURVEY OF PROFESSIONAL FORECASTERS, VARIOUS CONCEPTS inertia and inflation expectations, both of which appear to (%, PER ANNUM) 5 represent powerful medium-term anchors on outcomes. We also assign small roles to currencies and to energy, as a portion of 4 large moves in the oil price can pass through into the prices for other goods and services. This set of influences tracked inflation’s 3 fluctuations fairly closely in the years before the global financial crisis. After the subsequent recession, inflation did not slow as 2 much as this framework would have signaled, but predicted and actual outcomes had reconnected by the tail end of the last 1 expansion. 1991 1995 1999 2003 2007 2011 2015 2019 CPI 1 CPI 5 PCE 5 CPI 10 PCE 10 What do these drivers tell us about U.S. inflation in 2021? Recent Source: Haver Analytics, Bloomberg, J.P. Morgan Asset Management Multi-Asset fluctuations aside, inertia should help keep inflation fairly muted. Solutions; data as of December 2020. Inflation tends to accelerate or decelerate only gradually, and its What could change the picture? We will be monitoring inflation low starting point suggests a limited probability of high inflation expectations closely, especially for signs that the Fed’s new over the next year. Inflation expectations too should serve to average inflation targeting framework is chipping away at that keep a lid on outcomes. In recent years, they appear to have anchor. Perhaps more plausibly, the economy could run through been anchored slightly below the Federal Reserve’s 2% target, its remaining slack more quickly than expected, especially if a and if anything they seem to have shifted down slightly this year.
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persistent household spending boom follows the widespread the output lost in the short run will be recouped in subsequent dissemination of coronavirus vaccines. In recent decades, quarters. The behavior of the “future output expectations” however, inflation’s sensitivity to spare capacity appears to have component of purchasing managers’ indices, which have jumped
diminished significantly – perhaps that is why inflation did not recently across Europe even as the current-activity parts of the react very strongly to the extended weak spell after the previous surveys have fallen, reinforces this view (Exhibit 5). recession. We would expect any noticeable overheating pressures Most economies will likely be back to pre-shock levels of to emerge only during 2022 and beyond. activity by end-2021
For the most part, we see inflation prospects as even more EXHIBIT 5: REAL GDP LEVEL COMPARISONS (%) muted in other DM economies, especially the euro area and 15 Japan. Both are experiencing very low current run rates of 10 inflation, and both have struggled with low inflation expectations. 5 As we’ve noted, the euro area is likely operating with more slack 0 than the U.S., and the same may be true for Japan. Additionally, -5 the euro’s appreciation in recent months looks sufficient to -10 dampen inflation at the margin; the same may be true for the -15 Australian dollar. By contrast, inflation has held up better in the -20 UK and Canada, and neither seems to face too-low expectations, -25 although the UK does have the same spare capacity problem as US EMU JP UK CA CN EM ex-CN 20Q2 v 19Q4 20Q3 v 19Q4 21Q4 v 19Q4 the euro area. Source: Haver Analytics, J.P. Morgan Asset Management Multi-Asset Solutions; MEDIUM-TERM FORECAST DRIVERS data as of December 2020.
Looking beyond near-term risks, we continue to expect the new Support from financial conditions. In part because of highly business-cycle expansion to continue and to deliver above-trend stimulative monetary policy stances, financial conditions have growth, on average, through the end of next year. We forecast moved into very supportive territory, especially in the U.S. Bond solid gains across major economies, albeit with somewhat less yields remain well below pre-shock levels even as equity prices booming conditions in places that have already experienced have reached new highs, while corporate credit spreads have more or less complete recoveries – specifically, China, Korea and narrowed sharply. This situation creates a tailwind for growth Taiwan. that will likely persist through most of next year. Outside the U.S., where financial markets are smaller, conditions have likely eased A more differentiated wobble, without much path- less and represent less of a growth boost. As a substitute, dependence. Our growth forecast has taken on board the recent though, banking sectors appear to be functioning well across DM jump in virus cases across DM economies and the implications of economies, in contrast with the early phase of the last expansion. resulting restrictions and behavior changes, and thus contains In the U.S. and Japan, credit standards may have reached their more of a down-and-up move than previously. Both the euro area tightest level, while remaining modest in the euro area. At the and the UK should see GDP fall in 4Q20, and growth in the U.S. same time, bank credit growth continues in moderately positive and other economies may slow to a crawl around the turn of the territory everywhere. year, leaving 1Q21 GDP up only marginally, with some risk of a contraction. Compared with what was experienced in early 2020, How much of a fiscal policy drag? As emergency measures roll however, we expect weakness in 4Q20 and 1Q21 to be much off, fiscal balances will improve in 2021 for most DM economies. milder, more differentiated across countries and less punishing By traditional metrics, this large-scale improvement in cyclically for industrial sectors. Available survey and mobility data appear adjusted government balances should represent a significant to support these hypotheses. Moreover, given sharply improved drag on growth. In our view, though, considerable uncertainty prospects for vaccination by mid-2021, we suspect that most of surrounds this factor. Although this year’s support measures –
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such as those created by the CARES Act in the U.S. – generally begun to rise. Although industrial production has bounced required legislative approval, they mostly took the form of sharply off its lows, it has trailed demand indicators. As such, automatic stabilizers. That is, they were mainly transfer firms appear to have completed a significant inventory reduction
payments for income support, as distinct from government cycle, and surveys suggest they are now aiming to rebuild stocks. purchases of goods and services or major changes in the tax Beyond the next several months, we will be monitoring global code. As economies have healed, there has been less need for consumption patterns. Will a shift back to spending in services
fiscal support, and indeed its usage has already faded (as significantly crimp goods purchases? If so, recent marginal demonstrated by the plunge in the U.S. unemployment rate, for suppliers of goods – especially North Asian economies – might example). It seems possible, then, that fiscal policy will act as face weaker export demand. more of a neutral force in 2021 – or possibly a positive one if the We project 4.3% quarter-over-quarter, seasonally adjusted European Recovery Fund becomes operational and the U.S. annual rate (q/q, saar) global real GDP growth in the fourth Congress agrees on some form of additional stimulus – than as a quarter of 2020, following the record 39.6% post-pandemic weight on growth prospects. surge in the prior quarter. That forecast incorporates significant Dry powder for consumers. Although household saving rates drops in the euro area and the UK, where confidence and have moved lower in recent months, they have reversed only a mobility have slipped in response to restrictive measures, and a small portion of their earlier, partly restriction-induced spike. The solid 4.0% expansion in the U.S. We expect China, other EM U.S. personal saving rate, for example, stood at 13.6% in October economies and Japan to lead the way this quarter. These 2020, compared with a typical pre-shock level of 7%–8%. We see economies are benefiting from the global industrial cycle and room for further reductions in coming quarters. If the labor earlier improvements in local virus conditions, with Japan and market continues to heal, generating organic income increases, a parts of EM ex-China also experiencing catch-up effects. We solid pace of consumer spending growth can coexist with only a expect a somewhat similar outcome in the first quarter of 2021, partial return to pre-shock saving patterns. Moreover, consumers with U.S. (and Canadian) growth slowing, thanks largely to their have accumulated a stockpile of savings in recent months that own virus wave and shutdowns, and European economies could fuel extremely strong spending once vaccination is bouncing back. widespread. For now, we regard this kind of spending spree as an Assuming at least partial dissemination of vaccines in many upside risk to our forecast rather than a base case. In the past, countries by Q2 next year, we look for temporary reacceleration households have typically not spent their temporary saving in 2Q21 and continued above-trend growth through the surges over the near term but instead allowed them to pass remainder of the year. We estimate that activity in most through into permanent balance sheet improvement. jurisdictions will have returned, or nearly so, to pre-shock levels Additionally, remaining economic weakness centers in services by the end of 2021. China and other EM economies will stand out activities, where rapid consumption is difficult (for example, a on the stronger end of the spectrum (in part because of faster consumer might purchase two pairs of shoes at once but is less trend growth), with the UK toward the weaker end as it deals with likely to take two simultaneous cruises). We do, however, think the Brexit transition on top of the virus. that the state of household finances should support an extended On the price front, as noted earlier, we expect sequential core period of satisfactory growth, with only modest downside risk. inflation to run at fairly low levels, below central bank targets, Room for industry to run. In coming months, we expect global during 2021. Various base effects and other distortions (such as, factories to keep humming. Governments are generally taking for example, the expiration of Germany’s VAT cut in early 2021) care to exclude them from new rounds of activity restrictions, will push around year-over-year figures in coming quarters. We and they look fundamentally well supported. Retail sales are still expect U.S. core inflation to move above 2% y/y in 2Q21, when expanding at a solid pace, although the jump in the goods share the comparison will be with the weakest part of the post-shock of household spending may have run its course. Meanwhile, period. At the end of next year, though, we forecast 1.8% core capex – the other component of global goods demand – has also CPI inflation, with the PCE deflator that the Fed officially targets a
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bit lower. We think other DM core inflation rates, with the What is the prospect for a double dip in U.S. growth over the next possible exception of Canada, will lie below the U.S., with Japan two or three months, and what are our monitoring tools telling us flirting with negative readings and the euro area struggling to about the key risks? We have penciled in a small positive growth
hold above 1%. Headline inflation should follow similar patterns, rate for first-quarter GDP, but that number rests on somewhat albeit with a greater spike around mid-2021, thanks to the upturn shaky ground. For one, state-level data on government in the oil price, which in coming months will likely be far above restrictions show a tightening across a broad array of U.S. states,
2020 levels. and their direct effect thus far has been a mild chilling of 4Q20 GDP growth. Closure levels for schools and workplaces, as well as As we look beyond the next few quarters and consider the rules on public events and gatherings, have turned broadly more business cycle more broadly, we continue to believe that this restrictive, though with two important caveats. First, state-level expansion is unfolding at a far faster pace than its post-2009 restrictions are tightening from levels that in most cases were predecessor. Indeed, we have now moved six of the 10 economic not fully “open” following the first and second waves of the virus, components in our U.S. business cycle scorecard to “mid cycle,” a implying a smaller potential swing compared with the shutdowns progression that took several years after the financial crisis. What in March and April. Second, we note that not all restrictions are a does this tell us about the medium-term outlook? With slack negative for economic activity. Mask wearing, for example, has diminishing, the economy seems unlikely to enjoy strong become mandatory in the vast majority of states and has helped “bounceback” lift indefinitely. Sustaining strong growth will to maintain economic activity in some industries. This more depend on some combination of expansionary private sector nuanced view of virus-related restrictions suggests that the behavior and policy support. Meanwhile, we will be monitoring economy may well keep growing under partial lockdown in the parts of the economy, most notably corporate leverage, for signs coming months, but the risk is that strains on local health care of vulnerabilities that could inhibit the persistence of the systems push local authorities to the edge once again. expansion. With price and wage inflation still firmly in early-cycle territory and likely to remain there, though, we do not think a A double dip is also more likely against the backdrop of labor monetary tightening cycle will threaten the economy for an market performance that is improving at a slower rate. Our extended period to come. overall view of recent labor market flows – incorporating persistently high levels of workers transitioning into SHORT-TERM RISKS TO THE PATH OF GROWTH AND POLICY unemployment, moderating flows of workers back into A year from now, segments of the economy that now lie dormant employment and only a partial recovery in labor force will be reviving as the negative effects of the pandemic fade, and participation – implies a much flatter contour for the the output gap will be somewhere in the vicinity of being closed. unemployment rate than seen since the beginning of the But the months and quarters in the more immediate future could recovery. The associated deceleration in labor income growth in be tumultuous. In the risk scenarios that we outline below, a turn puts much more emphasis on households spending down double dip in U.S. growth – of the sort being experienced right their savings in order to maintain recent buoyant rates of now in the euro area and the UK – is a real possibility in early aggregate consumption growth. The risk in the double-dip risk 2021. It will depend heavily on the depth of the current virus scenario is that the direct effect of government restrictions on shock, as well as the strength of its transmission channels into economic activity is amplified by two factors: a stall in labor force economic activity. This scenario introduces a very important improvements and the precautionary behavior of households temporal aspect to our growth forecast over the coming year. slowing the outflow of accumulated savings into the economy. Our confidence in our medium-term view – which is underscored Finally, our baseline macro scenario assumes that the policy by the very rapid speed of the recovery to date, limited evidence backdrop for growth remains highly favorable. While our of economic scarring, continued ample policy support and the forecasts do not make heroic assumptions about additional fiscal prospect of a vaccine lifting the remaining constraints on activity stimulus spurring growth in 2021, further fillips are quite – implies that a near-term growth wobble is likely to be a possible, and, as mentioned, the extent of the damage that fiscal transient shock, paid back in full as 2021 unfolds.
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drag will exert on GDP over the coming year is subject to debate. uncertainty under a Joe Biden presidency, greater control over In parallel, DM monetary policy will attempt to insulate the the virus, recovery in corporate profitability and solid export economy from downside risks with the combination of asset growth. Finally, we expect China’s export growth to remain
purchases and aggressive forward guidance on policy rates. In robust amid a global economic recovery. the latter half of 2020, a broad swath of central banks adjusted Given our expectation of continued recovery in China, we believe their quantitative easing (QE) programs to provide additional and Beijng’s overall policy stance will turn less accommodative in more sustainable levels of accommodation. But how steadfast 2021. We expect to see a gradual exit from a loose monetary will DM central bank support be in 2021, and what is the risk of policy stance this year as Chinese policymakers focus more on support being withdrawn prematurely? preventing systemic risks in the financial system. Marginal Policymakers face two upcoming forks in the road: the decision monetary policy tightening may come in the form of slower credit to taper QE asset purchases and the decision to normalize policy growth, but we do not expect any hikes in China’s policy rates rates. In the absence of surprisingly strong and persistent next year. Our outlook of mild inflationary pressure for 2021 with inflation outturns, the discussion about when to normalize rates lower food price inflation also reduces the need for the People’s is unlikely to evolve substantially in 2021. Rather, over that time Bank of China (PBoC) to tighten aggressively. frame the Fed’s inflation reaction function and the definition of Fiscal support to the Chinese economy likely moderates in 2021. average inflation targeting will just begin to take shape. The Most of the tax and fee cuts that were introduced this year are taper of asset purchases presents the greater risk of financial set to expire by the end of 2020. We expect China’s official on- conditions inadvertently tightening. Central bankers will likely budget fiscal deficit to drop from 3.6% of GDP in 2020 to 3% in soon establish how the tapering process will unfold. 2021 and also look for a reduction in the issuance of special FOCUS: WHAT’S NEXT FOR CHINA AFTER THE EARLY government bonds. As a result, the official funding support for RECOVERY? infrastructure investment is likely to wane next year. We also expect to see China’s property policies tighten somewhat as the In our view, China’s economic recovery will continue in 2021, with government focuses on reining in developers’ leverage, and this the private sector taking the lead from the public sector in will pose challenges to property investment growth in 2021. spurring growth. Infrastructure investment has been a key driver of China’s growth this year, supported by strong fiscal stimulus. Overall, we see balanced risks to China’s growth outlook. On one In contrast, household consumption has faltered as a result of hand, a faster than expected vaccine rollout will accelerate global three factors: Income growth has weakened, social distancing demand recovery and present an upside risk to China’s export measures have constrained services consumption, and growth. On the other hand, we believe policy overtightening policymakers have focused more on demand stimulus than on represents a key downside risk. China’s economic recovery has so income transfers in response to the COVID-19 shock. far been uneven, with smaller enterprises and the services sector suffering more from the pandemic. In our view, keeping the Looking ahead, we expect private sector consumption and monetary policy stance accommodative will be important over investment to play a more important role in driving China’s the near term to facilitate a smooth transition from public sector- economic growth next year. Loosening of social distancing to private sector-led growth. If financial conditions tighten more measures, likely with the help of a vaccine rollout, should further than expected after the expiration of the debt services normalize services consumption. In addition, household income is moratorium next year, we could see an increased risk of a likely to continue to improve, especially for migrant workers, who widespread credit event. account for a significant share of services sector employment. We also expect consumers to spend some of the precautionary Another risk is escalation of U.S.-China trade tensions, which will savings built up over 2020 as confidence improves. At the same likely weigh on business sentiment and manufacturing time, manufacturing investment growth is likely to rebound investment demand. However, U.S. tariff hikes in 2021 seem further in 2021, helped by a reduction in U.S.-China trade unlikely. The incoming Biden administration will likely prioritize
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its COVID-19 response and domestic policies over the near term. That said, we believe there is more room for cooperation between the two countries on issues related to pandemic control and climate change.
The U.S. economy is advancing rapidly through the early-cycle phase EXHIBIT 6: THE BUSINESS-CYCLE SCORECARD FOR THE U.S.
Early cycle Mid cycle Late cycle Recession Overall economic output Below potential, rising Near potential, rising Above potential, rising Contracting
Consumption Low, lagging income Recovering High, ahead of income Falling
Capital investment Low as % of GDP Rising, moderate as % of GDP High as % of GDP Falling
Residential investment Low as % of GDP Rising, moderate as % of GDP High as % of GDP Contracting
Below central bank target, Price inflation Below CB target, rising Above CB target Falling stable
Wage inflation Low, stable Moderate, rising High Falling
Economic metrics Economic Private credit formation Low, starting to rise Rising in line with output Rising faster than output Falling
Personal savings rate High relative to income Starting to decline Low relative to income Rising vs. income
Unemployment Well above NAIRU Above NAIRU Around or below NAIRU Rising sharply
Consumer confidence Low Moderate Exuberant Falling
EPS revision ratios Downgrade cycle, improving trend Upgrade cycle, improving trend Upgrade cycle, falling trend Downgrade cycle, falling trend
Corporate margins Rising Peaking Declining Low
Credit spreads Wide, contracting Tight, stable Past cyclical trough Wide, unstable
Aggressive issuance Low as share of total Moderate as share of total High as share of total Nonexistent
M&A activity Low Moderate High Nonexistent
Asset market metrics Yield curve Rates low, curve steep Rates rising, curve flattening Rates high, curve flat Rates falling, curve steepening
Volatility Vol high, skew falling Vol low, skew low Vol starting to rise, skew rising Vol high, skew high
Source: J.P. Morgan Asset Management Multi-Asset Solutions; assessments as of December 2020.
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LEVEL ONE ASSET ALLOCATION profoundly negative real rates shows that accommodative monetary policy remains a critical factor. At the end of the third quarter of 2020, global equities were essentially flat on the year, but beneath the surface it was a As optimism grows around a vaccine for COVID-19 and a sustained rebound in global growth, the debate about the 2021 lopsided picture: Only the U.S. posted positive returns at the end of September, and most other regional markets were outlook is shifting to how long we might reasonably expect this underwater. At the time of writing, that picture has changed. accommodation to persist (Exhibit 8), and what side effects it might present. In our view, confidence in the growth outlook for Global equities are now up 12% in 2020, and the profile has become much more balanced. Many regions outside of the U.S. 2021 is now less about the virus-vs.-vaccine debate than about have performed well in the fourth quarter (Exhibit 7) – so much when, and if, the combination of monetary and fiscal stimulus so that for the first time in many quarters, the S&P 500 has stokes inflation, and how central banks might respond. underperformed the European and emerging markets indices. We are closely watching to see whether the combination of Equity market performance in Q4 has been more balanced monetary and fiscal stimulus supports inflation
EXHIBIT 7: MAJOR EQUITY MARKET RETURNS BY QUARTER EXHIBIT 8: CENTRAL BANK BALANCE SHEETS AND FISCAL SPEND, % OF GDP 25,000 120% 30%
100% 20% 20,000
10% 80% 15,000 0% 60% 10,000 -10% 40%
5,000 -20% 20%
-30% 0 0% U.S. Euro Area Japan UK EM ACWI 2005 2007 2009 2011 2013 2015 2017 2019 Q1 Q2 Q3 Q4 (Quarter-to-date) G4 Debt % GDP (RHS) G4 Central Bank Assets, in USD Billions Source: Bloomberg, J.P. Morgan Asset Management Multi-Asset Solutions; data as of December 2020. Source: Bloomberg, Haver Analytics J.P. Morgan Asset Management Multi-Asset Solutions; data as of December 2020. To a casual observer, looking purely at equity returns, 2020 looks like a solid, if unspectacular, year. Global equity returns are only We expect inflation to remain subdued through 2021, and even if 0.23 standard deviations (S.D.) above their average annual return it does start to pick up we believe central banks would prefer to since 1987, and S&P 500 returns are only 0.32 S.D. above their run economies hot than put the nascent recovery at risk. annual average since 1950. By contrast, prevailing bond yields – However, we acknowledge medium-term topside risks to inflation still negative in real terms for around half of the Global and recognize that these are not fully discounted. At some stage, Government Bond Index – clearly bear the imprint of the asset markets will pivot from being driven by financial conditions extraordinary turmoil that was the hallmark of 2020. (liquidity pushing asset prices higher across the board) to being driven more by confidence in growth. When this occurs, some We observed in our last quarterly note that the fourth quarter volatility is to be expected, but provided liquidity support is not was stacked with tail risks in both directions. The performance of abruptly withdrawn we would expect any market disruption to be equity markets in 4Q20, and also that of speculative credit short-lived. Navigating the ebb and flow of inflation expectations (including gains of 5.6% for U.S. high yield and 4.9% for EM hard and likely policy response will be critical in 2021. currency debt), confirm that those risks broadly broke in positive economic terms. Nevertheless, the continued backdrop of
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Our asset allocation preferences reflect our positive stance on Credit has performed particularly well in the fourth quarter. High growth and a view that slack in the economy continues to justify yield has held its gains from the summer, and through November accommodative monetary policy, even as the recovery gathers spreads tightened sharply as risk appetite improved (Exhibit 9).
pace and tail risks moderate. At the same time, the extraordinary From here, there is less capacity for spread tightening in general fiscal support that plugged the gap in private sector activity in so so we look for opportunities to diversify our exposure. While many nations will fade in 2021. However, we expect the broader investors are leaning into IG as a proxy for duration without the
pickup in activity over the next year will mitigate the need for profoundly negative real yield, we see only a limited scope for ongoing government stimulus. Given this backdrop, we favor an further excess return from spread tightening. As a result, we overweight allocation to stocks and credit, a neutral view on downgrade IG credit from OW to neutral. duration and an underweight to cash. Strong risk appetite has supported credit in the fourth quarter Our OW to stocks is broadly spread, with a preference for cyclical EXHIBIT 9: NORMALIZED U.S. IG, HY AND EMD OPTION-ADJUSTED SPREADS regions and small cap equities. But equally, we acknowledge that Z-Score the global nature of the growth rebound in 2021 suggests 6 obvious regional relative value opportunities may be limited and short-lived. Instead, we expect equity markets globally to 5 advance, with their relative performance being a function 4 primarily of their cyclical exposure and overall beta. 3 EM equities and U.S. small cap stocks are the most preferred 2 exposures within our opportunity set, and both express our belief 1 that a period of above-trend global growth lies ahead in 2021. We are also modestly overweight Japanese equities, which are 0 favorably geared to global cyclical sectors, and European -1 equities. The tribulations of Brexit and prevailing virus flare-ups -2 present a headwind for European stocks, giving us low conviction 2000 2002 2004 2007 2009 2011 2013 2015 2017 2020 in our OW stance. But over the course of 2021, we believe the U.S. IG U.S. HY EMD increasing fiscal alignment in the eurozone will spur growth. Source: Bloomberg, J.P. Morgan Asset Management Multi-Asset Solutions; data as We are more neutrally positioned in U.S. large cap equities, of December 2020. where valuation is more extended than in other regions. The picture is brighter in high yield, where there is more room Extensive tech sector exposure delivered a boost this year as new for continued spread compression, even if it realistically must be working patterns helped drive up earnings expectations. But as led by the more speculatively rated segments. We maintain an we move into 2021, the scope for tighter regulation and the OW to HY but with reduced conviction. To be clear, we still beginning of a return to more normal working patterns likely believe credit in general to be attractively geared to growth, but hand the advantage back to other sectors. We are also neutral UK given tighter spreads we look for further diversification. As a stocks but have pared our underweights as the index – 2020’s result, we upgrade both local and hard currency EMD to OW. We weakest major stock market – looks to have fully priced the note the increased duration risk in EMD compared with HY, but implications of Brexit for the UK economy. If, as we expect, we believe that the risk of a sharp bond sell-off damaging EMD pound sterling bears the brunt of further Brexit-related angst, returns is now much reduced. then UK stocks – which disproportionately earn their revenues After riskless yields backed up, we covered our UW to duration. outside of the UK – may receive welcome support for earnings To be clear, this neutral stance on sovereign bonds does not expectations in 2021. suggest we see yields going into reverse and retesting their 2020 lows, but instead acknowledges that central banks are still in an
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ultra-accommodative mode. Moreover, with 10-year U.S. We think that the U.S. dollar is overvalued and that the recent Treasury yields near our 1% target (as flagged in our 4Q20 note), depreciation will persist and our choice to express our economic views through EXHIBIT 10: LONG-TERM USD NOMINAL EFFECTIVE EXCHANGE RATE VALUATIONS overweights to credit and equity, we don’t see a compelling 130 reason to double down with a UW on duration as well. Within the 125 sovereign sphere, we prefer the higher yielding U.S. and 120 Australian markets, and also Italian BTPs, over the negative yielding German Bunds. We do see scope for UK Gilt curves to 115 steepen, but given the multi-layered complexity of Brexit we 110 prefer to play the UK via the currency alone. 105
The outlook for the U.S. dollar is the primary currency call for 100 2021 (as in any year, arguably). Our conviction on further dollar 95 declines persists (Exhibit 10), but we note that after USD declined 90 mainly vs. EUR this year the base of decline is widening out. As a 1997 2000 2003 2006 2009 2011 2014 2017 2020 result, we increase our view on EM FX, as a broad asset class, to United States Nominal Effective Exchange Rate Broad Average OW. Persistent global growth and an easy Fed point to USD Source: Bank of International Settlements, J.P. Morgan Asset Management Multi- weakening in a range of crosses, a feature that also reinforces Asset Solutions; data as of December 2020. broad-based global growth.
Overall, the stance we take is an incremental extension of our bullish view from 4Q20. Some of the tail risks we flagged have passed, and those that remain – trade, climate, etc. – involve new protagonists and new ideas to be discounted. We believe that
2021 will see the economy move through early cycle quickly but at the same time that policymakers will suppress any instinct to withdraw stimulus. As a result, we think liquidity will remain abundant, even as the principal driver of asset returns shifts subtly from financial conditions to broadening growth.
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Our Level One scorecard favors equities and credit
EXHIBIT 11: LEVEL ONE SCORECARD
Considerations Comment Stock Bond Credit Cash
Economic growth Growth is broadening out; we are now in recovery phase and in a new business cycle. + - + 0
Financial conditions Financial conditions remain very easy, vol and spreads have also relaxed substantially + 0 + 0
Monetary policy Developed market central banks are in stimulus mode, with many policy rates hitting their lower bounds + + + - Macro factors Tail risks Vaccine announcements start to mitigate virus risks; inflation concerns now beginning to surface 0 - 0 - Valuation – absolute Global equities now expensive, esp. in the U.S.; real yields rich; less scope for spreads tightening further - - 0 0
Valuation – relative Equity risk premium remains elevated; duration expensive but yield levels capped + 0 + - Fundamentals ERRs turning sharply positive; stimulus balancing growth recovery for bonds; leverage extended in credit + 0 0 0
Equity positioning picking up; bonds more evenly balanced and cash levels falling according to survey data Market factors Positioning - 0 0 - Flows/sentiment Substantial flows into stocks recently, seeing flows into EME and EMD, continued outflows from cash + + + - Overall Score + 0 + - Source: J.P. Morgan Asset Management Multi-Asset Solutions; assessments as of December 2020.
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LEVEL TWO ASSET ALLOCATION banks are also extending asset purchases and providing strong support for global duration through quantitative easing. This At this juncture, we shift our perspective. In the preceding pages, global policy support for duration is a key reason for our duration we examined our Level One asset choices, the basic portfolio upgrade (Exhibit 13). decisions involving broad asset classes (for example, stocks vs. bonds). We now present our Level Two asset decisions. Here we Current Fed QE purchases are shorter in maturity; there is look within asset classes and determine, for example, what type scope for an extension of maturity at some stage of credit (investment grade, high yield or emerging market debt) EXHIBIT 12: WEIGHTED AVERAGE MATURITY OF FED UST PURCHASES appears most attractive. Years 11 RATES 10 We upgrade our view on duration to neutral. U.S. bond yields 9 rose modestly over the last quarter as economic growth data 8 came in better than expected, chances of U.S. fiscal stimulus 7 increased and risk assets delivered very strong performance. In 6 fact, U.S. bonds led global bonds with a modest rise of 20 basis 5 points (bps) since September while yields on 10-year German 4 Bunds fell by 15bps. With yields on 10-year U.S. bonds now close 3 to 1%, the top end of our expected range (as stated in our 2 2003 2006 2008 2010 2013 2015 2018 2020 September note), we are starting to see duration as offering source: Bloomberg, J.P. Morgan Asset Management Multi-Asset Solutions; data as value to multi-asset investors. of December 2020.
If we look at duration in isolation, a modest underweight stance Policymakers have provided unprecedented support can be justified based on valuations. Indeed, our quantitative EXHIBIT 13: MONETARY AND FISCAL POLICY RESPONSES IN GFC VS. 2020 SHOCK models signal a negative view on duration in part for that reason. Change in fiscal deficit vs pre-virus (% GDP) But our qualitative views on central bank bond purchases, as well 16 US Covid as the role of bonds in a multi-asset context, make this view more UK Covid 14 nuanced. Thus, amid higher yields we increasingly view duration JP Covid as a portfolio construction tool for diversification. These different 12 perspectives leave us neutral overall on duration. 10 US GFC UK GFC Euro Covid Why do we expect only a limited rise in bond yields? We point to 8 JP GFC three interconnected reasons. First, monetary policy will keep a 6 lid on the pace at which yields can rise. Second, the inflation 4 Euro GFC outlook will be subdued. And third, global demand for income 2 will remain healthy. 0 As always, a central bank outlook is crucial for any duration call. 3 5 7 9 11 13 15 17
Until recently, the Federal Reserve has struck a very dovish tone Change in Central Bank balance sheet vs pre-virus level (% GDP) by emphasizing the downside risks to growth. This has been Source: Bloomberg, Individual national Treasuries and central banks, J.P. Morgan particularly notable against the background of improving activity Asset Management Multi-Asset Solutions; data as of December 2020. data. Moreover, we expect the Fed to maintain an extremely Inflation will remain subdued over the coming quarters, we accommodative policy stance for an extended period. (Exhibit believe. Fundamentally, recessions generate a disinflationary 12). This will again cap any rise in bond yields. In addition, the impulse, and the COVID-19 crisis is no different. Inflation may be European Central Bank (ECB) and other developed market central
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volatile, but while the global economy is still dealing with excess In terms of stock-bond correlations, we think the negative capacity it is difficult to see an acceleration in inflation over the correlation will remain intact for the coming quarters (Exhibit next few quarters. Moreover, in regions where inflation was 15). In an environment of low inflation, we still see duration
already low pre-virus, such as Europe and Japan, policymakers providing ballast against growth shocks. The effectiveness of that will need to deal with cyclical weakness as well as the structural diversification is lower, though, as we discussed in our forces keeping inflation expectations subdued. September note.
Turning to the global demand for duration, we note that 25% of Stock-bond correlations are likely to remain negative
the global bond market is negative yielding. In this current EXHIBIT 15: ROLLING 6M AND 1Y CORRELATION OF RETURNS BETWEEN STOCKS environment, a 1% yield on the 10-year U.S. Treasury offers AND BONDS value. Further, the hedging cost for holding U.S. duration as a 1.0 foreign investor is less punitive than it has been. Indeed, U.S. 0.8 bonds look attractive to buy on a hedged basis for European and 0.5 Japanese investors (Exhibit 14). 0.3 Foreign investors receive a yield pick by investing in 0.0 Treasuries on a hedged basis -0.3
EXHIBIT 14: 10-YEAR BOND YIELDS FX HEDGED INTO EUR AND JPY (USING 3M -0.5 ROLLING FX HEDGES) -0.8 1.5 -1.0 1 2006 2007 2009 2010 2012 2013 2015 2016 2018 2019 0.5 6-Month 1-Year
0 Source: Bloomberg, J.P. Morgan Asset Management Multi-Asset Solutions; data as -0.5 of December 2020. -1 Bonds do provide protection against specific growth shocks. But -1.5 we would caution that bonds do not hedge all the risks we see on -2 2016 2017 2018 2019 2020 the horizon over the next 12 months. These risks revolve around 10-Year Yield, 3m FX hedged to EUR, % negative growth shocks stemming from the virus. They also U.S. Germany Japan relate to inflation risks that could emerge from stronger fiscal
policy stimulus and bond market volatility risks sparked by an 1.5 unstable recalibration of monetary policy support. Most crucially, 1 the method or instrument to hedge these shocks is different in 0.5 each case, and this makes it more difficult to build ballast in 0 multi-asset portfolios for the coming year. We continue to expect -0.5 government bonds to provide protection against pure growth -1 shocks – as they did in 2020 – but they are an ineffective hedge -1.5 for inflation and volatility. -2 In relative value bond markets, we prefer the higher yielding U.S., 2016 2017 2018 2019 2020 Canadian and Australian markets, and also Italian BTPs, over the 10-Year Yield, 3m FX hedged to JPY, % negative yielding German Bund. Our carry view in Europe U.S. Germany Japan through BTPs remains our highest conviction view, supported by Source: Bloomberg, J.P. Morgan Asset Management Multi-Asset Solutions; data as both monetary and fiscal policy. In fact, the December extension of December 2020. of the ECB’s QE purchase program adds further support to this
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carry position. German bonds remain the least preferred bond since July (Exhibit 16). It remains unclear how the Fed will market, largely due to valuations. However, we are mindful that implement its new average inflation targeting regime, making it the ECB is still easing policy and inflation remains weak in difficult to determine fair value for long-term inflation
Europe. This limits how much Bund yields can rise in this breakevens. For now, we maintain our preference for inflation- environment. linked bonds over nominal bonds but are mindful that valuations have moved up fairly quickly. Australian bonds, which remain in our preferred bucket, have been well supported by the central bank’s recent dovish tilt and 5y5y breakevens in the U.S. have moved above pre-March extension of QE. We acknowledge that Australian bonds are a levels, and are starting to see divergence with EUR higher beta market, and in our economic recovery scenario these EXHIBIT 16: 5-YEAR, 5-YEAR INFLATION SWAP, % bonds could underperform other markets. For now, we prefer the carry within Australian bonds, especially relative to Bunds, but 2.4% 1.9% we are conscious of their sensitivity to growth and rich starting 2.2% 1.6% valuations. 2.0% 1.3% At the margin we prefer Canadian bonds to U.S. Treasuries due to 1.8% 1.1% valuations and the latest actions from the Bank of Canada. Once bond yields do rise (eventually it will happen), we would still 1.6% 0.8% expect them to rise faster in the U.S. than in Canada. Moreover, 1.4% 0.5% as the Canadian economy is exposed to commodity prices, 1.2% 0.3% especially oil, we see relatively more headwinds to growth in Canada than in other regions. 1.0% 0.0% Jan-18 Sep-18 May-19 Jan-20 Sep-20 U.S. Euro (RHS) We continue to be neutral on UK Gilts, buffeted as they are by Brexit headlines. The recent extension of the Bank of England’s Source: Bloomberg, J.P. Morgan Asset Management Multi-Asset Solutions; data as QE program and now increasing discussion of negative rates of December 2020. provide sources of support for Gilts. But uncertainty about the FX outcome of Brexit negotiations and the possibility of a last- The scale of the 2020 contraction sufficiently shocked market minute agreement keeps us neutral for now. We prefer to play sentiment such that FX performance has largely been a beta play. the UK via the currency alone. Reintroduction of virus-related restrictions and second waves of Japanese government bonds are the lowest beta bond market, COVID-19 cases have not altered this environment. due to the Bank of Japan’s yield curve control (YCC) framework. As vaccine development outpaces initial expectations, the global We expect 10-year Japanese government bonds (JGBs) to remain outlook for 2021 grows increasingly constructive. In line with range-bound and within the bands set under YCC. As such, we improving risk sentiment, quarter-to-date performance across maintain a neutral stance. G10 economies has been characterized by broad-based USD In terms of inflation markets, we keep a preference for inflation- weakness (quarter-to-date depreciation of -3.2% in DXY). Within linked bonds over nominals, as we are expecting central banks to the context of this pro-cyclical move, we’ve seen narrow depress real rates. Positive growth is thus likely to be priced into outperformance of individual pairs vs. USD. Relative winners inflation breakevens more easily. What’s more, increased have been largely determined by an overlap of idiosyncratic inflation over the medium term is a key risk, which should be event risk and catch-up performance. Specifically, year-to-date reflected in our relative value framework. We do note that laggards (considering their historical average beta to global risk) inflation breakevens have already risen above pre-March levels such as NOK, NZD and EM FX have recently led our investible and hence have priced in a significant amount of optimism. For opportunity set (Exhibit 17). Respectively, they have enjoyed example, 5y5y TIPS breakevens have risen by 40bps to 12.3%
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some tailwind from oil prices, growth-supportive policy action uncertainty premium built into the currency faded. We expect and reduction of geopolitical tension. political volatility to be a smaller driver of the USD weakness in coming months. Instead, the erosion of U.S. economic Q4 has been marked by broad-based USD weakness. Relative exceptionalism in terms of fiscal policy (due to the likely split winners in this environment have generally lagged YTD Congress and the creation of the EU recovery fund) will be a EXHIBIT 17: COMPARISON OF YTD AND QTD FX PERFORMANCE, % bigger driver for our weaker USD view.
12% We identify one key risk to this outlook. A post-vaccine growth 10% surge could spark a U.S. Treasury-led pickup in bond yields. Fed 8% easing has been proportional to historic growth contraction in 6% 2020, but the recent commitment to average inflation targeting 4% does not completely eliminate the possibility of rate differentials 2% again widening in favor of USD. Through 2021, we think the U.S. 0% yield curve will be especially sensitive to reflationary impulses as -2% markets continually assess the potential for an early policy exit. In sum, over the longer term, global macro conditions, valuations -4% and the need for external financing all suggest USD depreciation. -6% However, near-term price action appears more uncertain as we -8% SEK EUR CHF AUD NZD JPY GBP CAD NOK EM FX transition into a risk environment underpinned by earnings fundamentals rather than just liquidity. As such, both the breadth QTD Performance vs USD YTD Performance vs USD and the magnitude of dollar weakness will likely moderate to Source: Bloomberg, J.P. Morgan Asset Management Multi-Asset Solutions; data as some degree in 2021. of December 2020.
We see the U.S. dollar continuing its drift lower in 2021. Across While it depresses USD, an early-cycle growth environment is the FX outlook, that is our strongest conviction view. A reduced supportive of EM FX, which we move to an overweight. Easy safe haven premium and the erosion of the U.S. real yield financial conditions, continued cheap valuations and positive advantage should allow USD to gradually soften from structurally vaccine developments further increase the likelihood of EM FX rich valuations. Crucially though, we expect the larger move to outperformance as we enter 2021. Across the FX complex, a happen vs EM currencies that have lagged. Biden presidency is also expected to signal reduced geopolitical tensions. In China, substantial bond inflows from foreign In 2020, the reset of the global economic cycle is also resetting investors’ hunt for yield and export sector resilience represent the USD. Generalized USD weakness vs. G10 currencies has come additional cyclical tailwinds. Idiosyncratic sovereign risks often alongside an improvement in global growth. Looking ahead to temper our EM risk appetite, and imbalances generated by the next year, we expect more differentiation in currency COVID-19 will likely emerge as we enter this next phase of markets where the drivers are likely to shift to fundamental greater regional diversification in growth performance. factors such as balance of payments, international flow dynamics Fundamentally driven country-specific risk is most prevalent in and relative output gaps. Our FX framework over the next year Latin America, where performance has already lagged (Exhibit places more emphasis on these structural consideration than on 18), making the region a possible candidate for catch-up plain beta to global risk sentiment. performance. In other words, our newly overweight stance on EM A few factors converged to push the USD weaker in 2020. These FX follows naturally from global growth enthusiasm and USD included concerns about the U.S. fiscal cliff, the Fed’s weakness. At the same time, though, we remain concerned about announcement of average inflation targeting and uncertainty the persistence of negative output gaps and fiscal balance around the U.S. presidential election. Since the elections, the deterioration in the context of limited carry. For this reason, our general risk on environment has pushed the USD weaker as the conviction in our EM FX call is relatively contained.
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EM FX has generally lagged cyclical currencies within G10 through several channels. On the other hand, current disinflation within Europe is likely to increase ECB sensitivity to EUR strength EXHIBIT 18: EQUALLY WEIGHTED EM FX BASKETS (JAN 18 = 100) as a further obstacle to meeting its 2% inflation target. As widely 110 105 expected, a broad set of further monetary easing was announced 100 on December 10. To clarify, bullishness stemming from structural 95 factors, namely the EU’s fiscal fund and strong balance of 90 payment fundamentals has not waned. We continue to be 85 80 constructive on EUR’s outlook. But for a reacceleration of 75 appreciation to historically “expensive” levels, we’d need some 70 brand of European exceptionalism to act as a catalyst. In other 65 60 words, cyclical forces must also act as a tailwind. 55 Cyclical conditions implied by EURUSD’s uptrend far outpace 50 Jan-18 Jul-18 Jan-19 Jul-19 Jan-20 Jul-20 that of relative equity performance
EM Asia vs USD LATAM vs USD EMEA vs USD EURUSD EXHIBIT 19: RELATIVE FX AND EQUITY PERFORMANCE OF EURO AREA VS U.S. 1.25 1.20 Source: Bloomberg, J.P. Morgan Asset Management Multi-Asset Solutions; data as of December 2020. 1.20 1.14
Through 2020 we have emphasized four factors in our analysis of 1.15 1.07 EURUSD - the end of U.S. exceptionalism in both its economic and asset market performance; the elimination of EUR’s real yield 1.10 1.00
disadvantage and the unwinding of carry trades; landmark 1.05 0.93 progress toward joint fiscal issuance through PEPP (pan- European personal pension product); and stable balance of 1.00 0.87 payments fundamentals - as tailwinds generating EUR 0.95 0.80 outperformance. Such a perfect storm of bullish drivers is May Jun Jul Aug Sep Oct Nov Dec unlikely to reemerge, and by extension, momentum in the EUR-USD Eurostoxx 50/S&P 500 (RHS) EURUSD cyclical rebound may fade somewhat in the short-term. Source: Bloomberg, J.P. Morgan Asset Management Multi-Asset Solutions; data as That said, in the context of an increasingly stable macro of December 2020. backdrop, the euro area’s persistent current account surplus, Maintaining our neutral stance on the yen may be somewhat coupled with its long-term investment surpluses, should continue surprising in light of our focus on global growth recovery. Given to buoy its currency. USDJPY’s historical relevance as a risk hedge, one may expect On the topic of EUR-denominated commercial flows, we do constructive risk sentiment to produce a gradual depreciation of recognize the divergence between structural and cyclical the currency similar to that of USD. Swings in investor confidence considerations. This year, European equities have failed to are likely to influence JPY on a trade-weighted basis (as has been outperform despite the context of pro-cyclical risk sentiment, the case in the wake of the U.S. election). Like EURUSD, USDJPY suggesting weaker cyclical conditions than what EUR FX currently enjoys a combination of favorable long-term valuations and implies. Sustained EUR inflows require some degree of European current account surplus. Japan is also one of very few G10 macro outperformance (reminiscent of 2017, as captured by markets with positive real yields. Certainly, 2020 has schooled us Exhibit 19). The ECB also likely poses a cyclical headwind for the in the unreliability of JPY as a risk hedge in the context of public euro. Here, risks are asymmetrically skewed to the downside. In pension funds’ portfolio reallocation outflows. With collapsed this new phase of the global cycle, should long-term European global nominal yields and relatively high Japanese real yields, we inflation expectations see material uplift, EUR would benefit have already seen diminished support to USDJPY from capital
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outflows. This allows for a gradual, structurally driven USDJPY We’re still positive on the prospects for equities over the coming appreciation in the medium term. Yet, at the same time, we do year, but we expect that the going is likely to get tougher from not expect JPY appreciation to outpace more cyclically geared here. The overall equity market picture has not much changed
G10 currencies, thus making a neutral stance appropriate. since our last Summit: We envision a robust earnings rebound as economies reopen over 2021, set against elevated current Even for GBP, the most idiosyncratic of reserve currencies, valuations. The rebound in equities since March of this year was correlation between FX performance and global risk remains entirely valuation led, with rising P/Es accounting for around elevated. That said, specific cyclical developments have 150% of the MSCI World Index’s gains. This is not unusual around influenced price action at the margin. Sterling has cyclical inflection points, when equity prices move in expectation underperformed its historical beta to risk when Brexit of recovering macro fundamentals and earnings. However, equity negotiations are seen to be volatile. The UK has also seen markets now once again find themselves at a typical cyclical particularly severe COVID-19-related contraction and a slow juncture, when actual earnings growth needs to take over as the recovery in economic activity. Structurally, GBP also scores principal driver of returns and thus justify the prior rise in poorly, given its status as a low yielding, current account deficit valuations. currency. More recently, markets have gone through periods of cautious optimism on sterling, assessing the likelihood that a “no Earnings rebound deal” outcome will be avoided. We see little justification to Consensus forecasts continue to see earnings rebound strongly meaningfully price cyclical upside risks for GBP: To get more over the course of the coming year. Analysts project 27% EPS constructive on the currency, we require relative recovery in UK growth for the global MSCI ACWI index, after an expected drop of growth alongside effective vaccine deployment. In the medium 16% in 2020 (Exhibit 20). Unsurprisingly, the regions expected to term, markets will calibrate for the economic reality of a post- deliver the strongest growth in 2021 have by and large seen the Brexit UK, and the determination of fair values should become largest earnings collapse this year. Interestingly, growth less buffeted by news flow. At the same time, external financing expectations for 2021 have begun to fall in a number of markets – need will likely burden sterling, and we lack visibility into whether but for positive reasons. The declines reflect rising expectations there is pent-up demand for GBP-denominated assets. Unlike for 2020 profits, as the incipient recovery is already exceeding USDJPY, where cyclical and structural considerations are analysts’ forecasts. offsetting, our neutral GBP outlook follows from the continued lack of visibility on key risk factors. 2021 earnings growth forecasts: strong, falling in some markets due to positive 2020 surprises EQUITY EXHIBIT 20:REGIONAL CONSENSUS EPS GROWTH FOR 2021 At our last Strategy Summit, in September, global equity markets 50% were in the throes of a largely technically driven correction, 40% which stalled momentum in the broader equity advance over the next two months. Early September seems to have marked the 30% peak of outperformance for the previously all-conquering 20% technology sector (at least, for the time being) while signaling the 10% start of what is now an ongoing regional and style rotation. Like 0% most risk assets, equities got a second wind in early November Mar-19 Jun-19 Sep-19 Dec-19 Mar-20 Jun-20 Sep-20 Dec-20 when positive COVID-19 vaccine news promised an eventual end 2021 EPS Growth, % to the pandemic. The news also helped spur the current rotation ACWI U.S. Large Cap EM toward value as well as cyclical sectors and regions. Overall, Europe UK Japan equity markets have gained around 6% since that early Source: Datastream, J.P. Morgan Asset Management Multi-Asset Solutions; data as of December 2020. September peak, justifying our decision to ride through the short- term volatility.
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In our view, this supportive earnings backdrop is further P/Es are elevated across markets validated by the recent move higher in earnings revision ratios EXHIBIT 22: 12-MONTH TRAILING PE RATIOS (MSCI) (the ratio of analyst 12-month-ahead earnings forecast upgrades 30x to downgrades) across major markets (Exhibit 21). Admittedly, this to a large extent reflects upgrades to 2020 EPS numbers, 25x likely sparked by the second-highest earnings surprise on record in 3Q20, following 2Q20’s all-time record. However, 2021 EPS 20x forecasts are only just beginning to slowly rise. We may well be seeing the reversal of the usual pattern, in which analysts are too 15x slow to adjust their next-year estimates when current-year numbers disappoint. This time around, it looks like analysts have 10x been hesitant to revise higher next-year EPS numbers as this year’s numbers come in better than expected. If so, we may be in 5x the early stages of an earnings upgrade cycle, likely with more 0x upside for 2021 EPS forecasts. 1987 1992 1997 2002 2007 2012 2017
Global earnings revisions are enjoying a second wind DM Ex-U.S. 10-Year Average EXHIBIT 21: 12-MONTH FORWARD ERRs BY REGION U.S. Large Cap 10-Year Average EM 10-Year Average 80% Source: Datastream, MSCI, J.P. Morgan Asset Management Multi-Asset Solutions; 60% data as of December 2020. 40% Indeed, trailing P/E measures such as those in Exhibit 22 are 20% showing signs of peaking across markets despite continued price
0% gains, as trailing delivered earnings are now in the process of bottoming. We read this as a telltale sign of an imminent shift -20% from a valuations-led to an earnings-led market (Exhibit 23). -40% Following the May low in forward earnings, actual delivered -60% (trailing) earnings are now also bottoming -80% EXHIBIT 23: U.S. EPS, 12-MONTH FORWARD VS, 12-MONTH TRAILING -100% 180 2017 2018 2019 2020 170 Net EPS Revisions Ratio, 4-Week Average 160 ACWI U.S. Large Cap EM Europe Japan 150 Source: Datastream, J.P. Morgan Asset Management Multi-Asset Solutions; data 140 as of December 2020. 130 Extended valuations 120 Our equity outlook needs to balance the highly supportive 110 earnings backdrop for next year with a challenging valuation 100 environment. While valuations are most extended in the U.S. Dec-16 Jun-17 Dec-17 Jun-18 Dec-18 Jun-19 Dec-19 Jun-20 equity market, P/E ratios have risen drastically across regions. S&P 12-mth trail EPS (IBES) S&P 12-mth fwd EPS (IBES) Indeed, investors have already priced much of the earnings Source: Datastream, J.P. Morgan Asset Management Multi-Asset Solutions; data recovery ahead (Exhibit 22). as of December 2020.
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Market cycles over time One factor that should help returns over the coming year compared with historical experience is that equity valuations Such a shift would be the normal progression in this unfolding relative to other asset classes still tell a completely different market cycle. Put simply, 2021 is likely to be a year in which rapid story than equity-only metrics such as P/E and P/B ratios. Indeed, earnings gains will be offset by falling P/E ratios. Returns will still when compared with bonds, whose yields remain extremely low be positive, in our view, but less spectacular than they were in by any historical measure, equities look downright cheap. the initial post-recession rebound. Admittedly, our own preferred measure of equity valuations As Exhibit 24 shows, the length of an initial post-bear market relative to bonds, the U.S. equity risk premium over government equity rebound (the latest ended in September, by our admittedly bond yields (Exhibit 25), has been coming down steadily. But it subjective definition) can vary substantially both in size and remains very elevated at 6.7% vs. a long-run average of 4.7% length. Often, it runs out of steam before it regains its pre-bear and a post-global financial crisis average of just over 6%. If low market level (very much unlike the current episode). The average relative valuations continue to attract flows into equities, this length has been around 12 months over the last 50 years or so, may well help P/Es stay somewhat higher than they otherwise which puts the current rebound decidedly toward the shorter end might. Still, some decline in P/Es seems inevitable, especially in of the range but not outside it. Looking at the magnitude of gains the context of the huge earnings surge expected in 2021. tells a similar story. This rebound has been considerably stronger U.S. ERP remains elevated but is falling steadily than the norm, at roughly 63% vs. an average gain of 45% in past cycles, although the gain is not unprecedented. EXHIBIT 25: U.S. EQUITY RISK PREMIUM OVER U.S. 10-YEAR TREASURY
Historical data tell us clearly that gains tend to slow in the year following an initial rebound, on average posting just a 4% rise. We think stocks will do better this time, given the historical average is pulled down by a few negative episodes, and an equity decline next year seems a very unlikely outcome in the context of our macro views. Nevertheless, slowing equity market momentum in 2021 seems very plausible.
Equity market gains should slow in the next phase of this bull market
EXHIBIT 24: COMPARISON OF HISTORICAL EQUITY MARKET POST-BEAR REBOUND PHASES, AND PERFORMANCE THEREAFTER Time from low Gain performance from end of rebound months after x months Market To rebound peak rebound low regain +6 +12 +18 +24 +36 Source: Datastream, J.P. Morgan Asset Management Multi-Asset Solutions; data Oct-74 9.5 n/a 53% n/a 2% 10% 9% 5% 1% as of December 2020. Mar-78 6.3 17.6 23% 22% -7% -2% -5% 11% 8% Aug-82 2.8 2.8 39% 39% 13% 14% 11% 16% 33% In the very near term, we see clear risks to our constructive - Dec-87 22.5 20 58% 49% -5% 5% 8% 14% 16% equity view. First and foremost is the ongoing winter wave of Oct-90 4.2 4.2 26% 26% 6% 12% 14% 21% 28% COVID-19 infections, which is likely to dampen macro momentum Oct-02 20.7 56.5 46% 99% 7% 8% 13% 12% 36% and data over the next few weeks and months. This could upend Mar-09 19.4 49.3 74% 132% 12% 2% 17% 21% 45% today’s bullish equity sentiment and lead to a near-term pullback Mar-20 5.4 4.9 63% 54% in equities. How should we weigh this downside risk against the AVERAGE 12.2 25.1 45% 61% 4% 4% 9% 13% 24% Source: Datastream, J.P. Morgan Asset Management Multi-Asset Solutions; data likely drumbeat of positive news on vaccination progress around as of December 2020. the world? It’s not an easy balance to strike.
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In this context, we also note that equity technicals no longer look Cyclical stocks have continued to appreciate this quarter, as supportive as they have for much of this year. Positioning is no following the end of the global recession and a reduction in longer obviously underweight in a near-term sense, measures of perceived left-tail risks related to the economy. In the global
investor sentiment have swung into bullish territory, and market market index, materials and industrials have been among the breadth metrics are getting quite elevated. Still, the constellation best performers over the past three months, the former driven of these metrics is yet so extreme as to indicate that an imminent by global goods demand and the latter by stimulative industrial
equity correction is unavoidable. Meanwhile, flow metrics remain policy in China. We continue to like cyclical stocks. Breakeven supportive. All in all, we conclude that any near-term equity rates have provided a guide for the cyclical vs. defensive rotation, market weakness driven by worries around the current virus and though the recovery in cyclicals is well advanced, we think wave and/or market technicals should prove temporary. That there is still some runway left (Exhibit 27). would present a buying opportunity, with improving macro and We still like cyclical stocks, emphasizing the continued vaccinations news flow likely to put a floor under sentiment economic expansion and policy support relatively swiftly. EXHIBIT 27: CYCLICALS VS. DEFENSIVES, WITH BREAKEVEN RATES Relative value 120 2.8% At our September Strategy Summit, we considered the 110 implications of narrowing equity market breadth. At that time, we 100 2.3% saw record levels of market cap concentration in the mega cap 90 tech stocks, particularly in the U.S., where it exceeded even the 80 1.8% dot-com bubble. Since then, equity gains have become more 70 broad-based, with 93% of stocks in the S&P 500 now trading 60 1.3% above their 200-day moving average (Exhibit 26). The new 50 market breadth reflects a continued rotation from defensives to 40 0.8% cyclicals and, more recently, from growth to value. 30 20 0.3% Equity market breadth has become less narrow over the 2015 2016 2017 2018 2019 2020
fourth quarter U.S. Cyclicals over Defensives (Morgan Stanley) EXHIBIT 26: EQUITY MARKET BREADTH U.S. 10-Year Breakevens (RHS) 100% Source: Bloomberg, J.P. Morgan Asset Management Multi-Asset Solutions; data as 90% of December 2020. 80% With the cyclicals vs. defensives rotation well underway, market 70% attention not surprisingly focuses on the value vs. growth trade. 60% Here better than expected vaccine trial results have supported 50% the performance of two leading value sectors, energy and 40% financials, making them the best performers since the first 30% vaccine trial announcement, in mid-September. 20% While we think value stocks could perform well in 2021, given 10% their valuation discounts and underperformance over the past 0% year, we have less conviction in the longer sustainability of the 2010 2011 2012 2013 2015 2016 2017 2018 2020 value rotation. This is mainly because we see only limited scope Percent of S&P 500 members above their 200dma, % for higher U.S. Treasury yields and expect cash rates to stay at Source: Bloomberg, J.P. Morgan Asset Management Multi-Asset Solutions; data as current levels for some time (Exhibit 28). A more plausible route of December 2020.
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to a sustainable value vs. growth rotation might emerge from infections was once top of mind for U.S. small cap investors, the weakness on the growth side should large cap tech stocks face a latest vaccine news has allowed U.S. small cap stocks to regulatory push or warrant lower multiples in a period of more outperform. This has occurred despite some near-term weakness abundant earnings growth. in U.S. economic data and without major moves higher in U.S. government bond yields (Exhibit 29). U.S. small caps look to be We think that capped government bond yields limits the ability well supported as the U.S. economy continues to recover in 2021. for value to appreciate against growth U.S. small cap stocks have outperformed strongly, even as 10- EXHIBIT 28: VALUE VS. GROWTH AND YIELDS 3.0 1.0 year Treasury yields have remained contained EXHIBIT 29: U.S. SMALL CAP VS. LARGE CAP AND TREASURY YIELDS 2.5 0.8 2.0% 0.52 2.0 0.7 1.8% 0.51
1.5 0.6 1.6% 0.49
1.0 0.5 1.4% 0.48 1.2% 0.46 0.5 0.4 Jan-19 May-19 Sep-19 Jan-20 May-20 Sep-20 1.0% 0.45
Value over Growth 0.8% 0.43 U.S. 10-Year Yield Value / Growth, U.S. (RHS) 0.6% 0.42 Source: Bloomberg, J.P. Morgan Asset Management Multi-Asset Solutions; data as of December 2020. 0.4% 0.40 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec We grappled with this issue at our September Strategy Summit, when we expressed lower conviction in our long-standing U.S. 10-Year Yield U.S. Small Cap/U.S. Large Cap, RHS overweight to U.S. large cap stocks. And U.S. large caps did Source: Bloomberg, J.P. Morgan Asset Management Multi-Asset Solutions; data as indeed underperform the global average over the past three of December 2020. months. However, the secular supports for the U.S. market make European stocks have significantly underperformed year-to-date. it difficult for us to underweight large caps. The U.S. market has A second wave of COVID-19 infections in Europe, greater than performed well over the last decade, and it is exposed to secular expected, hit the market, especially the many stocks geared to growth winners. That makes it an easy market for investors to the domestic economy. Investors then drove European stocks add to, especially as monetary policy pushes investors out of higher on welcome vaccine news. Digging into countries and bonds and cash and into equities. The U.S. market is structurally sectors, the bank-heavy Spanish index has been a particular more profitable than others, and a split Congress would reduce beneficiary (Exhibit 30). We think there is scope for European the odds of less corporate-friendly tax policy. Should value stocks stocks to recoup some of their 2020 losses. The strength of EUR outperform, it will be difficult for the U.S. to keep pace with other tempers our conviction here, but the policy support, both global markets. But our quant models like the market, and monetary and fiscal, is hard to ignore. Additionally, the risk of a ultimately we are happy to keep U.S. large cap equity as a core euro area breakup, long seen as a key reason not to own position in our portfolios. European stocks, has recently all but vanished. Overall, we remain positive on euro area equities. We continue to like U.S. small caps and are overweight here. Our quant models are quite bullish on the group, as they have been for some time. Whereas the risk of a second wave of coronavirus
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Spain has been a big winner post-vaccine announcement, cyclical market, Japan has been less geared to the recovery while the less domestically-focused German stock market has trade, given its handling of the COVID-19 pandemic and proximity been less responsive to China (Exhibit 31). Still, the market’s exposure to autos and
other global cyclical sectors should be attractive at this point in EXHIBIT 30: EUROPEAN INDEX PERFORMANCE, VS. ACWI Index (Base Period = Jan 2019) the cycle. Longer term, the structural improvement in governance and profitability is a support for Japanese equities. It 105 could support higher valuations, though progress here would 100 likely be gradual. Though our quant model is less positive on the 95 market’s fundamentals, it is quite positive on the market’s technical factors. Weighing all the drivers, we move Japan to an 90 overweight. Looking for cyclical exposure in our equity allocation, 85 we think it likely that Japan’s cyclical characteristics will reassert
80 themselves over our investment horizon.
75 Japanese stocks have not traded in line with U.S. cyclicals vs. defensives recently 70 EXHIBIT 31: CROSS-GEOGRAPHY CORRELATION WITH CYCLICALS VS. DEFENSIVES 65 0.8 Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov
DE FR SP IT 0.6 Relative Index Performance, vs. ACWI, Local (MSCI) 0.4 Source: Bloomberg, J.P. Morgan Asset Management Multi-Asset Solutions; data as of December 2020. 0.2 UK equities have recently outperformed as investor sentiment has warmed up a bit to a market long out of favor. With a heavy 0.0 concentration in financials and energy, the UK has done well in -0.2 the recent value vs. growth rotation. However, the UK continues
to appear near the bottom in our relative ranking. First, our -0.4 quant models dislike the market, giving negative scores for both Hong Australia Emerging Japan U.S. Large Canada UK Europe U.S. Small Kong Markets Cap Cap technicals and fundamentals. Second, the prospect of a Brexit 1-Year Correlation of RV performance with Morgan Stanley Cyclicals vs Defensives (U.S.) deal raises the specter of some strength in GBP, which would be Source: Bloomberg, J.P. Morgan Asset Management Multi-Asset Solutions; data as negative for the bulk of the companies in the index that earn of December 2020. revenue abroad. Third, and perhaps most important, the UK market lacks a compelling secular story: It has very little We have been closely tracking the composition of emerging exposure to any “new economy” sectors and scores poorly from market equity indices this year, noting the underperformance of an environmental perspective. Near term, however, the prospect “old economy” sectors like materials and financials, and the of some further rotation toward value tempers our negative growth in “new economy” sectors such as technology and outlook on the market, and we upgrade the UK to neutral, even communication services. Today, new economy sectors account though we have less conviction in the long-term sustainability of for more than 50% of the capitalization of the MSCI Emerging the value vs. growth rotation. Markets Index (Exhibit 32). This has weakened the market’s negative correlation with the U.S. dollar somewhat, but we would Japanese equities have performed in line with the global average argue that the weaker USD environment is still supportive. We over the past three months. Though traditionally a particularly continue to see emerging market equites as one of our most-
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favored overweights, liking the market’s support from stimulative Exceptional returns in credit have left spreads tight vs. history Chinese policy, exposure to e-commerce and internet names, and EXHIBIT 33: OPTION-ADJUSTED SPREAD: LONG-TERM Z-SCORE the prospect of a catch-up in some of the smaller emerging 3.0 market indices in Latin America. Emerging market stocks also 2.0 have favorable flow dynamics, and our quant models like the asset class as well. 1.0 ‘New economy’ sectors have gained significant market share 0.0 in the emerging markets index this year, especially in consumer discretionary, telecomms and tech -1.0 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec EXHIBIT 32: MSCI EMERGING MARKETS COMPOSITION U.S. Investment Grade OAS Z-Score U.S. High Yield OAS Z-Score
% of MSCI EM Market Capitalization Source: Bloomberg, J.P. Morgan Asset Management Multi-Asset Solutions; data as 70% of December 2020.
60% To be sure, credit’s strong performance has come on the back of improving fundamentals. These include certainty around U.S. 50% elections and positive news on COVID-19 vaccine trials, which 40% herald an eventual end to the pandemic.
30% All risk assets are trading on these improved fundamentals, though, and credit returns are not exceptional. In the U.S., across 20% the quality spectrum, from Bs to CCCs, the degrees of spread 10% compression have been in line with their historical relationship
0% with S&P 500 returns (Exhibit 34) 2000 2003 2006 2009 2011 2014 2017 2020 Unlike equities, though, credit faces a much tougher ceiling on Consumer Discretionary, Telecomms, and Technology valuations. Although our base case sees credit spreads tightening Energy, Materials and Financials modestly further as global economies begin reopening next year, Other the asset class cannot feasibly capture further risk-on upside to the degree that equities might. For equities, repeating Source: Bloomberg, Datastream, HSBC, J.P. Morgan Asset Management Multi- Asset Solutions; data as of December 2020. November’s performance seems unlikely, but for credit doing so seems nigh impossible. Moreover, in the event of significant CREDIT economic deterioration – a low but still higher-than-usual risk We remain broadly overweight credit, albeit with less conviction until vaccines are widely distributed in several months – risk- than at our Strategy Summit in September. Since then, and adjusted credit losses also tend to be more asymmetrically especially since early November, credit has delivered some exposed than equity losses. exceptional returns. Option-adjusted spreads on U.S. high yield, In balanced portfolios, credit typically looks the most attractive for instance, have dropped from well above 5% to well below 4% on a risk-adjusted basis in one of two scenarios: when spreads today – not too far off the tights of the last cycle. That means less are wide or when economic activity is the least volatile, as it scope for price appreciation and greater reliance on carry usually is in mid-cycle. Neither is the case today. Credit still has (Exhibit 33). But carry will be hard to come by. As the current an appeal, especially relative to cash or government bonds, and risk-on period has coincided with only a modest rise in risk-free today is more equally balanced with equities as the way we yields, all-in credit yields have fallen to all-time lows. Simply put, prefer to express our diversified pro-risk stance. valuations now look a lot less compelling.
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Credit returns have been inline with their historical Credit technicals are mixed. But near term, credit may find some relationship with S&P 500 returns support from price momentum and flows, the latter only partly offset by strong issuance. EXHIBIT 34: CREDIT EXCESS RETURNS The worst effects of the coronavirus recession appear to have U.S. IG Monthly Excess Return, % (Spread terms) 8 passed 6 EXHIBIT 35: U.S. CORPORATE DEFAULTS, USD BILLIONS 4 30 2 0 25 -2 20 -4 -6 15 Dec MTD Nov Oct -8 10 -10 -20 -10 0 10 20 5 S&P 500 Monthly Return, % 0 2015 2016 2017 2018 2019 2020 U.S. HY Monthly Excess Return, % (Spread terms) 15 U.S. high yield U.S. leveraged loans 10 Source: J.P. Morgan Securities; data through November 2020, as of December 2020. 5 0 Still, we identify several downside risks beyond the virus. -5 One modest risk: the prospect that the Fed fades support on a -10 strong economic recovery. This year’s outsize equity returns, despite a pandemic and a recession, owe in large part to -15 Dec MTD Nov Oct extraordinary central bank accommodation. Conversely, it seems -20 -20 -10 0 10 20 feasible that, despite improving fundamentals, fading liquidity S&P 500 Monthly Return, % support (or fading expectations of that support) may cause some Source: Bloomberg, J.P. Morgan Asset Management Multi-Asset Solutions; data as credit market indigestion in the first half of next year. Critically, of December 2020. Excess return removes the duration impact of changing risk- though, we expect any such moves would be temporary. And free yields. notwithstanding the recent blunting of its emergency backstop Fundamentals improving, but downside risks remain 13(3) corporate credit facilities, the Fed has established an important precedent of broadly supporting credit markets as a We find credit-specific fundamentals increasingly reassuring. For lender of last resort. If needed, the Fed will return to that role. high yield and leveraged loans, November was the first month in over two years with no actual defaults – further evidence that the Credit pockets of value? worst effects of the coronavirus recession have passed (Exhibit Among U.S. corporate bonds, we still prefer high yield over 35). Should the global economy continue to recover, as we investment grade (and the latter over U.S. Treasuries), since expect, ratings and balance sheet metrics should start to improve valuations on higher quality investment grade, including BBBs, as well. In the nearer term, while U.S. lockdowns may weigh on still look relatively extended. But no quality segment clearly issuers’ earnings, those issuers have largely termed out debt stands out on a risk-adjusted basis. CCCs, which months ago maturities. That makes liquidity risk less of a concern than it was looked more valuable, have since closed the gap and for the last in the spring. And with an end to the pandemic now in sight, two or three months have looked about as attractive as BBs or capital markets should also be more willing to lend.
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Bs. Sectors more affected by COVID-19, such as travel and has recovered more fully, with refinery throughput close to hospitality, are likely to outperform as the economy continues to record levels. But increases elsewhere have been more muted. recover next year. We also see potential for rising stars – in Although the medium-term picture is one of demand recovery, homebuilders, for example, many of which were on an improving over the shorter term oil market participants are focused on the trajectory before the pandemic struck. negative implications of the second wave of lockdowns, especially Compared with the U.S. index, European high yield probably in Europe. As a physical commodity, oil tends to trade off near- presents less risk, despite a relatively lagging economy. That term supply and demand balances. As a result, the market will reflects its higher average quality and a more supportive central struggle in the face of supply-demand mismatches, even if the bank. Indeed, European high yield quality has improved this year medium-term outlook is brighter. Still, oil investors have cheered due to fallen angels, with BBs now making up 70% of the market, the hopeful news on vaccines, pushing the market into compared with 55% in the U.S. And in a comparison of central backwardation (Exhibit 36). banks, while the Fed remains more of a lender of last resort to The market has returned to backwardation, after a long period U.S. corporates, the ECB is actually accelerating its more active of contango. This indicates the continuation of the demand support for credit. However, yields in Europe are appropriately recovery lower; much of the investment grade complex is negative yielding. And since the Fed cut policy rates more dramatically EXHIBIT 36: BRENT OIL CURVE than did the ECB, the cost of hedging euro yields into dollars has $8 Backwardation, implying a supply deficit meant lower all-in yields for European corporate debt compared $6 with the U.S. $4 $2 The outlook for emerging market debt looks comparable to U.S. $0 high yield’s. Fundamentally, emerging markets are likely to be -$2 helped as well if the dollar continues to depreciate, as we expect -$4 it will. In addition, trade tensions, and the consequent economic -$6 uncertainty, may diminish under the new administration. Along -$8 -$10 with slower global growth, risks to emerging markets include a Contango, implying a supply -$12 potential lag in the recovery owing to a relative lag in surplus -$14 vaccinations and, eventually, tightening financial conditions in 2014 2015 2016 2017 2018 2019 2020 developed markets. Brent Backwardation: 1m-6m WTI Backwardation: 1m-6m
COMMODITIES Source: Bloomberg, J.P. Morgan Asset Management Multi-Asset Solutions; data as of December 2020. After several months of range-bound trading, oil prices have recently moved higher, passing $50/bbl, a post-COVID-19 high. Increasingly, market participants focus on oil supply. At the latest The gains reflect positive news on coronavirus vaccines and OPEC+ meeting, member states struck a deal to raise production expectations of only a modest supply increase. From here, oil more moderately than previously planned, committing to prices will likely trade on the depth of the demand weakness over monthly meetings to decide the pace of production hikes. OPEC+ the latest period of lockdowns and the fallout following the most aims to grow production while keeping inventories moving lower, recent OPEC+ meeting. and its members’ coordination suggests only moderate production hikes. In the shale sector, the theme of capital Demand has been the central issue over the past few months. discipline continues to point to a limited supply rebound. The Oil-intensive activity is emerging from a period of severe ramp-up in drilling will largely focus on offsetting production weakness following the coronavirus outbreak. While global oil declines, and capital expenditure budgets are not moving demand is now recovering, it is still down significantly year-over- meaningfully higher. year, and the profile of gains looks uneven. China’s oil demand
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Investors are also weighing possible policy shifts in the upcoming months, and new property developments will be another Biden administration, with or without Democratic control of the important source of demand. Other leading measures, such as Senate. Biden may well use executive orders to introduce truck and excavator data, signal that strong iron ore demand environmental regulations that raise costs for shale producers. should continue. And whatever happens on the federal level, state regulations On the supply side, it is difficult to see negative catalysts. Brazil is continue to move in a more restrictive direction for oil about to enter its wet season, when iron ore supply tends to dip production. due to halts in activity. A large amount of Brazilian iron ore
Of all the reflationary assets, oil is perhaps slowest to recover its supply is still suspended following the Brumadinho disaster, but COVID-19 losses, especially in comparison to breakeven interest most ferrous market forecasters think suspended operations rates and copper. We think that oil prices can continue to move could be up and running again in the second half of next year. higher as economies reopen, the supply response stays muted Supply has also been constrained by a recent decline in and demand in areas such as jet fuel continues to rebuild. Australia’s shipments to China, reflecting maintenance activities.
Renewed strength in the iron ore price – now over $120/mt – All in all, the outlook looks good for the demand and supply sides surprises many commentators. Here China is a critical variable. of the iron ore market. Still, it is difficult to see prices moving Higher iron ore prices reflect rising Chinese steel prices, better significantly higher in light of the commodity’s strong year-to- than expected performance of the Chinese yuan and a strong date performance (and especially with markets trading so far demand environment (Exhibit 37). above the cost curve). As a result, we anticipate more range- bound iron ore prices from here. Renewed strength in steel prices has supported iron ore over recent months Copper is in a significant bull market, with prices from the March
EXHIBIT 37: STEEL PRICES, BY TYPE lows rising sharply from roughly $5,000/mt to over $7,500/mt, a 4400 multi-year high. Not surprisingly, analysts are focused on how much further copper prices can increase. Copper, like iron ore, 4200 has been supported by Chinese demand. Stimulus supporting
4000 infrastructure and property investment has been the key driver of copper demand. As copper is often used at the end of the 3800 construction process, that demand looks set to continue in 2021. Over the medium and long terms, copper will play a role in 3600 China’s increasing urbanization, the rollout of green technologies 3400 and the completion of the country’s transportation infrastructure. In short, demand for copper should be strong over both the near- 3200 and long-term horizons.
3000 With copper supply set for mid-single digit growth in 2020, it Jan-19 May-19 Sep-19 Jan-20 May-20 Sep-20 seems unlikely that a bullish copper price story will be derailed Hot Rolled Steel Sheet, CNY/mt Rebar CNY/mt Billet CNY/mt by a supply response. Copper mines have long lead times, and Source: Bloomberg, J.P. Morgan Asset Management Multi-Asset Solutions; data as of the weakness of today’s supply picture can be ascribed to the December 2020. move lower in copper-related capex following the commodity Chinese demand for iron ore should remain strong over the next price collapse in 2014-2015. As investors are generally very six months, even as Beijing’s fiscal policy likely becomes less overweight copper, positioning presents one potentially negative aggressive in 2021 and demand falls seasonally over winter. catalyst for copper prices. However, our overall outlook Substantial Chinese stimulus has already spurred a range of emphasizes the strength of the fundamental picture, the ongoing projects that will require steel supply for several
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steepening backwardation, very depressed inventory levels and prices that are some way off those seen in 2010 (Exhibit 38).
Copper fundamentals are strong, including inventory data that is very depressed
EXHIBIT 38: GLOBAL COPPER INVENTORIES AND PRICE Stocks, Thousand Tonnes US$/T 1000 11300
900 10300 800
700 9300
600 8300 500 7300 400
300 6300 200 5300 100
0 4300 2010 2011 2013 2014 2016 2017 2019 2020 SHFE Inventories LME Inventories COMEX Inventories LME Copper Price (RHS) Source: Bloomberg, J.P. Morgan Asset Management Multi-Asset Solutions; data as of December 2020.
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PORTFOLIO IMPLICATIONS belief that policymakers will not panic at the first sign of higher inflation risks. But we also note that the lack of return potential Within our multi-asset portfolios, we are positioned with a pro- in the assets most negatively geared to inflation – bonds – is risk tilt to reflect our expectation of above-trend growth in 2021. robbing investors of a portfolio hedge and in turn moderating the Even as the economic recovery broadens out, we expect risk they may be prepared to carry elsewhere. monetary policy to remain highly accommodative. Given this perspective, we see yields only drifting upward rather Over the course of 2021, we expect the drivers of asset returns to than surging. We thus believe that while a short-duration position pivot from liquidity and easy financial conditions toward greater might appear attractive at current levels, the ongoing presence conviction in the trajectory of growth. As this happens, we may of many central banks in the bond market probably caps the see upside risks to inflation begin to be priced. But even then, we upside to yields. Moreover, in the event of disappointment over think policymakers will look through any pickup in inflation to growth, 10-year U.S. Treasury yields near 1% may well offer some ensure that the recovery remains on track. So while we anticipate portfolio protection, since correlations to stocks remain negative a little more volatility as the drivers of returns shift, we don’t (Exhibit 39). Granted, the degree of protection bonds can offer is expect any lasting disruption to the positive trend in many asset probably limited – and bonds are hardly likely to provide the prices. returns in 2021 that they did in 2020. But in a diversified portfolio In constructing an optimized portfolio to capture this view, we context, we think the balance of inflation and growth risks calls are seeking to balance four important factors: the outlook for for a more neutral stance on inflation than the low levels of bond inflation, stock-bond correlation, volatility and the desire for yields might suggest. diversification. While cross-asset volatility remains elevated, stock-bond Inflation was muted over the last cycle – so much so that the Fed correlation has halted its increase and sits in negative in September introduced the concept of average inflation territory targeting to take the place of its old 2% threshold target. Simply EXHIBIT 39: STOCK-BOND CORRELATION AND CROSS-ASSET VOLATILITY put, policymakers will allow inflation to drift some way above their target for a period of time so that, over a reasonable time 30% 20% frame, periods of below-target inflation are offset by periods of 10% above-target inflation. In our view, policymakers are highly 0% unlikely to reverse this recent policy innovation even if inflation -10% begins to pick up in 2021. -20% -30% While the combined deployment of fiscal and monetary stimulus -40% -50% in 2020 may manifest itself in higher inflation risk in the medium -60% term, the forces holding inflation down – technology, -70% globalization, aging of the workforce – have not gone away. Early -80% in a business cycle, there is also ample slack in the economy and 2015 2016 2017 2018 2019 2020 labor force, and as a result we do not expect inflation to be a Cross-Asset Volatility, Realized, 180-Day U.S. Stock-Bond Correlation, Realized, 180-Day concern for policymakers during 2021. Source: Bloomberg, J.P. Morgan Asset Management Multi-Asset Solutions; data as We acknowledge that our constructive stance is based in part on of December 2020. the assumption of a benign policy response to rising inflation. Even allowing for the possibility of some more volatile episodes More bearish analysts tend to flag the risk of sharp policy in 2021 – particularly as the market digests a transition from tightening and/or curve steepening spilling over into stock and financial conditions as the main driver to growth – we expect credit markets, leading to a jump in volatility and a significant de- volatility, on average, to drift downward over 2021. The risking. We disagree with this assessment largely due to our
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dampening effect of easy monetary policy will do part of the – particularly in equity indices – may be dominated by sector and work here, but so too will greater certainty over the economic factor variations. As such, this may be a less favorable outlook as the ravages of the virus fade following vaccination environment for leaning into purely regional relative value programs around the globe. Historically, aggregate volatility positions, and instead it is likely to be preferable to diversify levels tend to fall through the early- and mid-cycle phases of an equity exposures globally. The same applies to credit markets, expansion, rising again only once rate cycles begin to turn. And and given our economic outlook we favor a broadly diversified while the contour of the cycle ahead remains rather murky, we position across and within risk asset markets. As the recovery do think there will be sufficient similarity to prior cycles to expect extends, we do expect to see regional winners and losers emerge volatility to follow its typical path (Exhibit 40). once more, but for the moment we prefer to simply look for a cyclical-over-defensive tilt in stocks and a balanced exposure in The VIX index typically declines for prolonged periods in the credit. early stages of expansions
EXHIBIT 40: VIX PRICE ACTION IN U.S. RECESSIONS SINCE 1990 In sum, our asset allocation is geared to a broadening recovery, while portfolio implementation considerations reflect the nuance Volatility Points of an early-cycle phase and acknowledge the particular policy 70 backdrop that characterizes this expansion. To navigate from day 60 to day, it will be essential to pay particular attention to the potential shift in 2021 from financial conditions to growth as the 50 main driver of asset returns. At the same time, recognizing that 40 volatility is likely – on average – to continue downward may well
30 help avoid the risk of being underexposed to what we believe will be a favorable economic environment in 2021. 20
10
0 1990 1993 1996 1999 2002 2005 2008 2011 2014 2017 2020
Source: Bloomberg, J.P. Morgan Asset Management Multi-Asset Solutions; data as of December 2020.
From a portfolio construction perspective, the outlook for volatility is an important consideration in right-sizing risk levels. In general, an environment of falling volatility can mean that ex post tracking error falls short of ex ante targets – i.e., positions were undersized. Avoiding this pitfall early in the cycle, especially when the outlook remains uncertain and the “muscle memory” of the last crisis is still quite fresh, can be a challenge for investors. However, being aware of the risk of underallocation and seeking additional means of building portfolio robustness – e.g., scenario testing, diversification over a range of assets and factors, FX overlays, etc. – can be helpful in keeping an appropriate gearing to an improving economic outlook.
Among these, diversification remains a critical consideration. In our view, the recovery is global in nature, so regional differences
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Multi-Asset Solutions Key Insights & “Big Ideas” In previous editions of our Global Asset Allocation Views, we included a map and table of key global themes. Those themes helped us discuss the economic and market outlook, and shape the asset allocation that Solutions reflected across portfolios. While some of those themes are still in play, we now choose to share the Key Insights and “Big Ideas” discussed in depth at the Strategy Summit. These reflect the collective core views of the portfolio managers and research teams within Multi-Asset Solutions and are the common perspectives we come back to and regularly retest in all our asset allocation discussions. We use these “Big Ideas” as a way of sense-checking our portfolio tilts and ensuring they are reflected in all of our portfolios. • Rebound accelerates with above-trend growth in 1H21 • Inflation muted, but upside inflation risks rising and underpriced • Fiscal and monetary stimulus persists well into the new cycle • QE is capping yields, but they will rise as growth picks up • The U.S. dollar is entering an extended but gradual downtrend • Credit supported by growth as central bank support is pared back • We look to diversify portfolio risk across equity and credit • Equity earnings improving: prefer cyclicals, U.S. small cap and emerging market equity Active allocation views In normal times, these asset class views apply to a 12- to 18-month horizon; however, given current volatility and uncertainty, they reflect a horizon of several months but are subject to revision as new information becomes available. We will update this tick chart at minimum monthly during this period of volatility. The dots represent our directional view; up/down arrows indicate a positive ( ) or negative ( ) change in view since the last revision. These views should not be construed as a recommended portfolio. This summary of our individual asset class views indicates strength of conviction and relative preferences across a broad-based range of assets but is independent of portfolio construction considerations. Underweight Neutral Overweight Asset class Opportunity set UW N OW Change Conviction Equities Moderate Growth broadening out, earnings set to pick up with base effects supportive in 1H21 MAIN Duration U.S. 10-yr yields around 1% imply more even discounting of growth vs. inflation risks ASSET CLASSES Credit Moderate Scope for spread tightening diminishing, but growth outlook still supportive to credit Cash Moderate Ultra-easy policy and inflation past its lows suggest cash real returns will be poor U.S. Low Strong preference for U.S. small cap supported by quant models and fundamental views Europe Low Cyclically geared market, but near-term Brexit-related disruption a headwind UK 2020’s major underperformer, a messy Brexit may weaken GBP, in turn boosting EPS
EQUITIES Japan Low Sluggish performance in 2020, but gearing to global cyclicals is an attractive feature Emerging markets Moderate Weaker dollar and ample capital supportive, valuations rich, but EPS rebounding U.S. Treasuries At around 1% 10-yr yield, expect international demand to increase, Fed continues to buy G4 ex-U.S. sovereigns Moderate Negative yields in Europe appear vulnerable as growth recovers, even with ECB QE EMD hard currency Low EM economic outlook continues to improve but long duration presents a headwind to returns EMD local FX Moderate Geared to both improving EM economic and FX outlook giving further boost to returns
FIXED INCOME Corporate investment grade Spreads now very tight; a reasonable alternative to duration, but excess return outlook low Corporate high yield Moderate Still some scope for tighter spreads, but increasingly will be led by low rated segments PREFERENCE BY ASSET CLASS ASSET PREFERENCE BY USD Moderate Easy Fed policy and even distribution of global growth suggest further USD downside EUR Low Performed strongly in 2H20 despite easy ECB policy; still meaningfully undervalued JPY BoJ likely to remain broadly accommodative, but little reason to expect unilateral easing CURRENCY EM FX Moderate Broadening global growth and pickup in goods market activity helpful for EM economies Source: J.P. Morgan Asset Management Multi-Asset Solutions; assessments are made using data and information up to December 2020. For illustrative purposes only. Diversification does not guarantee investment returns and does not eliminate the risk of loss. Diversification among investment options and asset classes may help to reduce overall volatility. GLOBAL ASSET ALLOCATION VIEWS
Global Multi-Asset Strategy:
John Bilton Michael Hood Head of Global Multi-Asset Strategy Global Strategist
Multi-Asset Solutions Multi-Asset Solutions
Thushka Maharaj Benjamin Mandel
Global Strategist Global Strategist
Multi-Asset Solutions Multi-Asset Solutions
Michael Albrecht Patrik Schöwitz
Global Strategist Global Strategist
Multi-Asset Solutions Multi-Asset Solutions
Sylvia Sheng Michael Akinyele
Global Strategist Global Strategist
Multi-Asset Solutions Multi-Asset Solutions
Tim Lintern
Global Strategist
Multi-Asset Solutions
33 Multi-Asset Solutions
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