Four economic factors influencing markets today

I’m Staci West and today I’ve been joined by Hugh Gimber, Global Market Strategist at JPMorgan to give us an update on markets today. So, Hugh, thanks for joining us.

[00:11] Thanks for having me.

So, there’s probably too much to cover for one short little video, so perhaps let’s just start with the UK inflation and interest rates: UK inflation is falling, but core inflation is going up. So, is this normal and where do you see inflation going from here?

[00:32] Yeah, I think you’re right to start with inflation because it’s clearly the biggest driver of markets at the moment. When inflation feels like it’s going away, markets get a lot more positive and vice versa. And, in the UK, I think we do face a particularly sticky problem. As you say, headline inflation now is starting to improve, but core inflation is still picking up and it’s really down to what you are putting in both of those different baskets.

So, it’s really energy base effects, which are helping to bring headline inflation down. And what I mean by base effects is that when you compare energy prices today to where energy prices stood a year ago, that year-over-year comparison is now starting to help headline inflation move lower. So, we expect as the year goes on, that you’ll continue to see that improvement because, remember, it was really in the spring of last year that energy prices were surging higher as a result of Russia’s invasion of Ukraine. So, we do expect that headline inflation number to continue to moderate over the next six to 12 months.

Core inflation is more sticky, and that’s really being driven by what we see in the domestic UK economy. So, when you think about what’s going into core inflation, it’s services activity, it’s some goods activity and it’s really the tightness of the labour market – and wage growth, in particular – that we think is fueling core inflation today. Because when jobs are plentiful, when businesses are having to pay up to get their hands on the workers that they need, you tend to find that that then leads to people earning a bit more, they go out and spend a little bit more, and you get left with this very sticky core inflation.

So, at the moment the Bank of England I think is looking at the inflation picture and saying, well, we are happy that the headline numbers are coming down, but actually we probably have a bit more work to do until we get more confident that that core number and that domestically-generated number, is also turning lower.

And obviously this is causing interest rates to rise. And you have a great slide on the impact of rates on UK mortgage holders. So, maybe tell us when will the impact really hit home here?

[02:44] Of course. So, the key point that we are making on this slide is really twofold. The first thing to highlight is that the mortgage market today is a lot less sensitive than it was going back six, seven years ago. So, we’ve seen UK households shifting away from floating rate mortgages and moving onto fixed rate mortgages so, the interest rate increases that we saw in 2022 were only biting for a small part of the population that were sat on floating rate mortgages. There’s going to be a lagged effect of tightening. And what we mean by that is that it’s only really over time, as fixed rate mortgages, either two year or five year mortgages, start to expire and households have to reset onto higher interest rates, that the bite from that policy tightening is really going to start. So, to put some numbers around that, we were looking at the breakdown of UK mortgages as of the end of last year and by our numbers there were only about 12% or so of mortgage holders that were already on floating rate ie. they were already feeling the hit from higher interest rates coming through.

But if you roll forward to the end of this year, when we factor in all of those previously fixed rate mortgages, which will then be resetting onto higher rates, you get to around about 40% of all mortgage holders in the UK then being affected. Roll forward to the end of 2024 and you get to about 60% of mortgage holders. So, the bottom line is that the feed through from higher interest rates is a gradual one, but it’s going to build over time, and I think that’s maybe why the Bank of England so far has been a little bit hesitant in not wanting to raise rates too hard or too quickly because they know that they have to wait to see the full impact of that rate tightening feeding through as people shift away from previous fixed rate mortgages at much lower rates, onto the more painful higher rates that we see in mortgage markets today.

And then shifting slightly to the US. The US market is in a bull market, so what’s going on over there? But then also maybe if you could just touch on another slide that you have, which is about the US consumers excess savings?

[04:59] Of course. So, I think the two are quite clearly linked in that the US economy is showing some pretty healthy resilience over the first six months of this year. We came into 2023 with many economists forecasting a recession. And actually lots of the data that we’ve had so far has been surprising to the upside, it’s been more positive than many would’ve expected. And it’s been a consumer-driven rebound that’s really been clear in the underlying data; the services parts of the economy, think hospitality, leisure, all of that spending that people are still catching up on after a couple of years of the pandemic, are some of the stronger parts of the economy today. But what that slide on the US consumer also shows is that those excess savings are now starting to be run down quite quickly and therefore that sort of pent-up demand boom is starting to tail off, which is one of the reasons that we do still expect a US economy which is going to continue slowing, and unfortunately recession does remain the base case over the next 12 months.

When it comes to the stock market, partly it’s been that better economic data, but then also you’ve had a very, very concentrated stock market in that the top 10 names in the US stock market have given you pretty much all of your year-to-date returns. And so, some of that’s linked to the data, but I also think this new theme around artificial intelligence and what that might mean for some of the technology players in the US has really caught markets’ optimism and enthusiasm and we’ve seen valuations pushing quite substantially higher.

When I tie those two together, it leaves us slightly uncomfortable frankly because you have an economic view where we still see the US economy slowing, we still think recession is more likely than not over the next 12 months. But then you look at valuations in the US equity market and you start to think, well, hang on a minute, to what extent now are the US stocks appropriately pricing the slow down ahead? So, I’d say as a team, we’ve certainly become a little bit more cautious over the past few months, primarily because it’s just increasingly hard to argue that the US equity market in aggregate is appropriately priced for the slowdown that we see to come.

And then I just want to finish on another slide that shows predictions for asset return expectations over the next 10 and 15 years. And on this slide you have China top, followed by Europe and Japan. So maybe if you could just explain the thinking behind this, why these areas?

[07:32] Sure. So, this is our ’10 to 15 year ahead capital market assumptions’. So, this is a firm wide exercise, it happens once a year. We pull together lots of the best thinkers from a huge number of different teams across JPMorgan to try and provide our assumptions for how we see different markets faring, as I say, on that 10-to-15 year time horizon. And so, when you do that type of exercise, you then break down the stock market and you say what are your key drivers of return? So, you’ve got earnings as one, you’ve got valuations moving as two, and then you’ve got dividends as three, as your kind of fairly simple building blocks. Of course, you can get more granular within each of those, but those are the three key pillars.

So, when I look at our emerging markets capital market assumption, as you say, top of the pile [is] China in particular, right up there at the moment, and that’s due to a combination of stronger earnings growth, which is closely linked to the stronger economic growth that we’d expect to see from China and EM across that 10-to-15-year time horizon. But then also generally a more favourable starting point on valuations compared to something like the US market, which as I say is looking quite fully priced, quite expensive today.

So, over time you sort of build this together and think, right, well if my valuation today is lower than I’d expect it to be over the medium term, then that’s going to be a positive contributor to your capital market assumption over the next decade. And so the cheaper you are today, the more room you have for valuations to increase. So, in EM it’s a case of a mix of slightly stronger earnings growth and then also a better starting point on valuations.

Then when we move to Europe and Japan, the similar is really true, although I’d say that valuations in particular are the standout here. So, relative to other parts of the world, if your starting point is cheaper, you’re going to fare better when we pull together this kind of work.

I just flagged one other page in the guide, which I think is really important on this topic, where we look at how important your starting valuation on equity markets is for your long-term returns. And what we do here is we say, if you know in advance, you know, looking back over time, take the starting valuation and then see how that impacted your market returns over the next one year. Very little relationship there. It’s basically a kind of random scatter blot on the page because effectively, you know, cheap markets can stay cheap for a while and very expensive markets can get even more expensive in the short run. But over the long-term, that relationship is much tighter, that valuations really matter for long-term investors and that’s why those regions that you highlight tend to fare better

Thank you very much for walking us through various different points of what’s going on today.

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