Hello, and welcome to Notes on the Week Ahead, a J.P. Morgan Asset Management podcast that provides insights on the markets and the economy to help you stay informed in the week ahead. Hello, this is David Kelly. I'm Chief Strategist here at J.P. Morgan Asset Management. Today is June 17th, 2024. As a young lad growing up in South Dublin, I received certain geography lessons, and where I could, or could not, safely roam. In particular, I was warned not to stray north of O'Connell Street.
I remember debating my mother on this issue, once when I wanted to go to a movie at a theatre near Parnell Square. I can't remember exactly what I said, but I probably claimed that bad things didn't happen on the north side quite as frequently as south side mothers thought they did. But my mother held her ground on this occasion. Someone might or might not get beaten up in Parnell Square that afternoon, but if her son wasn't there, it wouldn't be him.
After almost every speech, someone asked me about risks, what keeps me up at night. And today, with a soft-landing economy and the stock market near record highs, it does seem like a good time to review risks. But it's important to recognize the most obvious point about market risk. The risk to you as an investor isn't simply the danger of some negative event, it is the product of the probability of that event and your exposure to it.
How you are positioned, this has a great deal about how worried you should be about any risk. One of the lessons of the 21st century so far. Is the biggest risk to markets and the economy are events that we truly couldn't predict, like 9-11, the pandemic, and Lehman Brothers taking down the entire global financial system? However, surveying potential risks in 2024 suggests that they could fall into one of five broad buckets.
Economic trends, policy mistakes, geopolitical tensions, natural disasters, and overvaluation. On economic trends, our base case is that the soft landing continues, at least into 2025. However, there is a risk that the expansion peters out before then. Consumer spending appears to be softening, with real non-durable goods spending lower in April than in December. Sentiments still very low. and credit card and auto loan delinquency rates rising.
Tuesday's retail sales report will provide some fresh evidence on this issue. Business investment spending outside of intellectual property also seems relatively sluggish. It could also be that higher for longer interest rates will gradually lead to increased defaults in parts of commercial real estate and bankruptcies for some highly levered companies in the private equity space. It should be emphasised that there are also forces operating in the opposite
direction. year-over-year wage growth has outpaced inflation for over a year. The economy has produced more than 2.7 million new jobs over the past year, and we estimate that household net worth has grown by $7 trillion so far this year, after advancing by $11 trillion or 8% last year. Still, weakening trends in consumer spending on the basics, combined with business cutbacks, could result in slower growth going forward, particularly if they are amplified by some further shock.
Moreover, if the economy were to weaken enough for the Federal Reserve to cut interest rates aggressively, history suggests that their actions would do more to undermine confidence than promote borrowing and could thus actually trigger the recession they were trying to forestall. A path to resurgent inflation is a little hard to see. However, it could happen if growth were to accelerate or some shock caused a spike in energy prices.
Overall, while our base case is for continued expansion, there is some risk of a near-term recession and a smaller risk of rising inflation. With divided government, it is unlikely that we'll see any major policy moves before the November elections. It's also unlikely that we'll see any government shutdown. And regardless who wins in November, the debt ceiling will in all probability be raised or suspended before the concurrent suspension ends on January 1st of next year.
However, beyond this, there are risks of policy mistakes. A single-party government that resulted in big tax cuts or increases in spending could overheat the economy and worsen an already very troubling fiscal situation. A renewed tariff war could harm both the global economy and the U.S. economy.
Moreover, while the current immigration situation is chaotic, to say the least, a sudden sharp reduction in both legal and illegal immigration could have serious consequences in a country that is seeing a steady decline in the native-born, working-age population. Finally, there are serious, though hard to quantify, risks associated with the age and character of the two candidates running for president.
Those wishing to assess these risks will have an opportunity to do so in the presidential debate scheduled for Thursday of next week. On geopolitical tensions, the ongoing wars in Ukraine and Gaza are clearly destabilizing. In addition, there is an obvious risk to energy supplies from tensions between the United States and Iran, and some threat to the supply of semiconductors from tensions between China and Taiwan.
Needless to say, the economic consequences of a serious escalation in either case would be overshadowed by even greater dangers. The same could be said of tensions between the United States and Russia, and the United States and North Korea. Terrorism, whether associated with these tensions or not, also poses a risk. However, in all cases, no matter how horrible the human toll, the impact on financial markets from geopolitical shocks depends on their impact on economic activity.
If, in the aftermath of an event, the economy continued to function normally while rebuilding or adjusting to a new reality, then financial market losses shouldn't be permanent. Natural disasters are, of course, the most difficult to predict. However, as shown by the impact of Hurricane Katrina on oil prices, the Tohoku earthquake and tsunami on global supply chains, and most notably the shutdowns caused by COVID-19, natural disasters can have a significant impact on economic activity.
Looking forward, some of these risks seem low and stable, such as threats posed by earthquakes, volcanoes, and solar flares. In some cases, the risks may be slowly rising, Increased international travel raises the danger of pandemics, while an acceleration in global warming may increase the risk of hurricanes.
However, as with geopolitical events, the key question for investors is whether, in the aftermath of the event, economic activity is impaired, or whether rebuilding activity actually provides a boost to economic activity. And finally, there's the issue of valuations. On the fixed income side, valuations look reasonable. In the 50 years before the financial crisis, 10-year treasury yields averaged 2.7% above core CPI inflation.
Even if the core CPI inflation rate were to fall to 2% from its current 3.4%, as we expect it to do over the next two years, the current 10-year treasury yield of 4.22% seems low, albeit only to a moderate extent. Credit spreads are narrow. However, that may make sense in an extended soft landing with low defaults. U.S. equity valuations are high for mega-cap stocks, with the top 10 stocks sporting a forward P.E. ratio of 30 times forward earnings, almost 50% above their average since 1996.
However, the other stocks in the index are selling at an average forward P.E. Of just 17.5 times, only 12% higher than their average over the same period. A similar observation could be made within the style boxes overall, with large-cap looking expensive relative to small-cap and growth-looking expensive relative to value. Also, international equities continue to look very cheap relative to U.S.
Stocks, with the Acqui XUS selling at a forward PE ratio of 13.5 times compared to 21 times for the S&P 500. Since the start of 2023, the S&P 500 has provided a cumulative total return of 44.9%, while the Bloomberg Aggregate Bond Index has returned just 5.5%. Moreover, the stock market gains have been extraordinarily concentrated.
Today, the top 10 stocks in the S&P 500 account for an astonishing 37% of overall market cap, while U.S. stocks account for an equally improbable 64% of global stock market capitalization. There may not be that much risk to financial markets overall in any of this. A general rotation within the U.S. stock market or between U.S.
Stocks and international stocks, or even from equities to fixed income, would create winners as well as losers, and should not necessarily impede the ability of business in general to finance its operations. However, it does have implications for many individual investors. Those who passively invest in the S&P 500 have the same heightened exposure to mega-cap tech heck, as the index itself, and more if they have also explicitly bought growth stocks and shunned value stocks.
Those who have more than 64% of their equity exposure allocated to U.S. Equities, which is the vast majority of U.S. investors, are even more unbalanced in their exposure than global indices. And those who are aiming for a 60-40 allocation between U.S. Equities and bonds, but who will last rebalance at the start of 2023, would now have a 67-33 allocation. Moreover, all of this applies to investors who are at least attempting to achieve a balanced portfolio.
Many investors on top of this have added positions in meme stocks or cryptocurrencies, assets that are only kept aloft by the hot air of hype and confusion. However, many investors, of course, realize that their portfolios are out of balance, but are loathe to write a check to Uncle Sam for realized capital gains. This does highlight the value of tax-smart investing.
Others say, as I remember many saying back in the late 1990s, that they'll have plenty of time to reallocate if an over-concentrated market finally moves in the direction of balance. I'm always nervous about such statements. There are far too many cases of people who knew they could reallocate, but never moved fast enough to actually achieve it. It reminds me of one final argument I put to my mother many years ago.
If there was any trouble, ensure I have a good pair of running shoes and I can get out of there quickly. She didn't buy it. Lots could go wrong with my escape plan. And the truth is sometimes there just isn't a right time to be in the wrong place. The same is true for investors. Well, that's it for this week. Please tune in again next week. And if you have any questions in the meantime, please reach out to your J.P. Morgan representative.
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