Expectations of ‘Goldilocks’ conditions for US markets too good to be true, says JP Morgan

JP Morgan Asset Management says a better-than-expected year for the US economy should also lead to expectations of an extended period of higher interest rates.

Markets expect the return of so-called “Goldilocks conditions” in the US, but JP Morgan doesn’t agree.

Investors betting on a return to “Goldilocks” US economic conditions will look for another month of resilient jobs growth and cooling average hourly earnings in Friday’s non-farm payrolls data.

Thoughts on the Fed’s ability to return inflation to its target without a recession will also be shaped by initial jobless claims and services sector PMI data this week. A downward surprise in US CPI data next Wednesday could lower expectations of further Fed tightening, fuelling share market gains.

But in their mid-year investment outlook for 2023, JP Morgan Asset Management strategists argue that a better-than-expected year for the economy should also lead to expectations of an extended period of higher interest rates, which isn’t currently embedded into sharemarket pricing.

“It seems markets are increasingly hopeful that Goldilocks is back; that the economy can avoid recession with inflation falling back to target,” JP Morgan Asset Management chief market strategist of EMEA Karen Ward said.

Inflation is “priced to fade quickly”, allowing central banks to shift their focus to supporting growth. Instead of driving a recession, investors assume their priority — as it has been for three decades — is to prevent one, which would be “music to both stock and bond investors’ ears.”

“To us, however, this feels a little too good to be true,” Ms Ward said.

“There are a number of questions that are still outstanding and will need to be answered.”

Running through these issues, she concludes that its more likely that interest rates won’t be slashed pre-emptively and therefore a recession is “still more likely than not”.

If rates are cut, her base case is that it will probably be because a recession has “occurred” which “could trouble risk assets” like shares and commodities.

In their mid-year outlook, JPMAM strategists focus on the need for client portfolios to be well diversified against both recession and inflation risk by allocating to stocks in a relatively defensive fashion, while gaining exposure to secular themes like deglobalisation and decarbonisation that “seem increasingly dominant as we shift from a world of abundance to scarcity.”

To be sure, inflation has come down a long way in the past year.

Disinflation without a recession has historically driven strong returns in the US share market.

But the fact is, core inflation remains well above target in Western economies.

Minutes from the FOMC’s June board meeting this week repeated that officials saw the risks around their baseline inflation forecast as “tilted to the upside”.

Economic scenarios with higher inflation “appeared more likely than a downside scenario with lower inflation”, and “inflation could continue to be more persistent than expected and inflation expectations could become unanchored after a long period of elevated inflation”, Fed minutes said.

Ms Ward said central banks still faced a “difficult balancing act” in which they need to see labour markets weaken enough to put core inflation on a fast enough path back to target levels.

Headline inflation is expected to keep retreating in the coming months.

Europe is set to benefit from favourable base effects as the large gains in energy and food prices seen this time last year start to drop out of the annual calculation.

But JPMAM is “less convinced that core inflation is on a speedy path back to 2 per cent.”

Demand for services remains buoyant with households still seemingly intent on making up for lost experiences in Covid times, and the tightness of the labour market and ongoing pressure on wages will also keep upward pressure on cost and prices until a recession hits, according to Ms Ward.

Stepping back from the short-term drivers, her main concern is that she struggles to see a world in which goods price inflation will be as low and stable as it has been in the past.

US consumers paid the same for the basket of goods that they bought in 2020 as they did 20 years earlier. For the UK consumer it was the same 30 years earlier.

“With the combination of higher input costs as we transition from fossil fuels and less of a disinflationary drag from globalisation, we struggle to see such a feat being repeated,” Ms Ward said.

If goods price inflation ends up being higher on average then central banks would have to drive services inflation lower if they are serious about meeting their 2 per cent targets sustainably.

The last time US service sector inflation dipped below 1 per cent was amid a very deep recession.

The caveat is that the economic cost of could make it a “politically unrealistic outcome”.

“For governments, a little unanticipated inflation also appears an easier way out of a debt problem, having already exhausted the option of austerity,” Ms Ward said.

The latest surveys of inflation expectations suggest JPMAM isn’t alone in its suspicions that higher medium-term inflation is on the cards.

If central banks do end up cutting rates later this year prior to the onset of a recession, it would only strengthen JPMAM’s conviction that investors should prepare their portfolios for both higher inflation on average over the medium term and more frequent bouts of inflation volatility.