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Dr. Kelly's Commentary: A 3% Year

Dr. Kelly's Monthly Commentary for November 2013

DOCUMENT | NOV 12, 2013

Dr. David Kelly, CFA
Managing Director
Chief Global Strategist
J.P. Morgan Funds
From 1960 to 2005, real GDP, the inflation-adjusted output of goods and services in the United States, grew at an average rate of 3.4% per year. However, since 2005, annual growth has never even reached 3.0%, as the economy fell into a deep recession and crawled only slowly out of it. That being said, over the course of 2014, there is a good chance that the economy will grow by more than 3.0% for the first time in the last nine years. While there are plenty of potential obstacles to even this modest achievement, growth at this pace should, to some extent, validate much of the stock market advance seen in recent years and set the stage for a further rise in interest rates.

The foundation for stronger growth lies in stronger consumer fundamentals. The last few years have seen a very significant rebuilding of consumer finances, with households now devoting less than 10% of their disposable income to servicing debt for the first time in at least 34 years. Simultaneously, rising home and stock prices have pushed household wealth to record highs. A combination of modest wage increases, job gains and low inflation should boost real disposable income in 2014 which, unlike in 2013, should not be offset by higher payroll and income taxes. In addition, subdued spending has allowed pent-up demand for durable goods to rise in recent years - for example, according to automotive research firm R.L. Polk, the average age of registered light vehicles in the United States was 11.4 years at the start of 2013 compared to 11.2 years at the start of 2012 and 10.1 years at the start of 2008. Consumer confidence, dinged recently by the government shutdown, should bounce back on the strength of lower unemployment, higher home and stock prices and lower gasoline prices. Barring some shock, consumers should be able to lead the economy to stronger growth in 2014.

However, consumers will not have to do all the heavy lifting alone. Business investment spending should increase in line with rising confidence, still low interest rates, cash-rich balance sheets and healthy profits. Home-building should continue to recover as the inventory of homes on the market or in foreclosure continues to fall and banks become a little easier on lending standards. Federal government spending should remain subdued, but state and local spending could rise as revenues continue to improve with a stronger economy. In addition, U.S. exports should post decent gains on a somewhat stronger global economy. In October, the JPMorgan Global Manufacturing & Services PMI hit its highest level in almost three years, as all major regions of the global economy are now experiencing moderate growth.

Added up, all of this suggests that 3% real GDP growth is possible in 2014. With still relatively low productivity growth, this should imply the addition of more than 2 million new payroll jobs, and with very low growth in the labor force, this may be sufficient to cut the unemployment rate to 6.5% by the end of the year. This will likely be coupled with some pick up in wage growth, but general inflation should be held in check by subdued global energy prices.

All of this has important implications for investors.

First, a 3% economy should put pressure on the Federal Reserve to phase out bond purchases over the course of 2014, and the removal of $1 trillion in annual bond purchases should boost interest rates further. This suggests that relative to their normal strategic allocation, investors may want to be a little underweight fixed income and keep the duration of their bond holdings relatively short.

Second, a 3% economy is one that should allow earnings to continue to grow, providing further support for the stock market. However, it needs to be recognized that, after a 160% gain in the S&P500 from its low in March of 2009, U.S. stocks no longer look cheap in absolute terms, but still look attractive relative to an environment of low inflation and low interest rates. Although this does not tell us anything about when a market correction might occur, it does suggest investors may want to consider increasing their exposure to overseas equity markets to take advantage of more attractive valuations abroad.

Third, a 3% economy is built on the assumption of no major shocks. However, the last 15 years in the global economy and financial markets is littered with shocks, and a number of risks still remain. Among the known risks are the potential for bubbles in the Chinese economy, the danger of political discord or relapse in Europe, the risk of a new Middle-East crisis or geopolitical event, or some domestic political event in a still very divided Washington D.C. Because of these potential risks and others that are harder to forecast, it will still make sense in 2014, as it has for many years, for investors to maintain very broadly diversified and well balanced portfolios.

Any performance quoted is past performance and is not a guarantee of future results.

Diversification does not guarantee investment returns and does not eliminate risk of loss.

International investing involves a greater degree of risk and increased volatility. Changes in currency exchange rates and differences in accounting and taxation policies outside the U.S. can raise or lower returns. Also, some overseas markets may not be as politically and economically stable as the United States and other nations.

Opinions and estimates offered constitute our judgment and are subject to change without notice, as are statements of financial market trends, which are based on current market conditions. We believe the information provided here is reliable, but do not warrant its accuracy or completeness. This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The views and strategies described may not be suitable for all investors. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, accounting, legal or tax advice. References to future returns are not promises or even estimates of actual returns a client portfolio may achieve. Any forecasts contained herein are for illustrative purposes only and are not to be relied upon as advice or interpreted as a recommendation.

J.P. Morgan Asset Management is the marketing name for the asset management businesses of JPMorgan Chase & Co. Those businesses include, but are not limited to, J.P. Morgan Investment Management Inc., Security Capital Research & Management Incorporated and J.P. Morgan Alternative Asset Management, Inc.

J.P. Morgan Funds are distributed by JPMorgan Distribution Services, Inc., which is an affiliate of JPMorgan Chase & Co. Affiliates of JPMorgan Chase & Co. receive fees for providing various services to the funds. JPMorgan Distribution Services, Inc. is a member of FINRA/SIPC.

©  JPMorgan Chase & Co., November 2013

Topics: U.S. Recovery