Quarterly Perspectives U.S. 4Q 2018

Transcription

1 Quarterly Perspectives U.S. 4Q 2018 J.P. Morgan Asset Management is pleased to present the latest edition of Quarterly Perspectives. This piece explores key themes from our Guide to the Markets, providing timely economic and investment insight. THIS QUARTER S THEMES U.S. economy and markets: Make hay while the sun shines Fixed income: Flexibility in a rising rate environment U.S. equities: Robust earnings and the late-cycle playbook International equities: A story of sentiment this year STRATEGY TEAM Dr. David P. Kelly, CFA Managing Director Chief Global Strategist David M. Lebovitz Gabriela D. Santos Samantha M. Azzarello Alexander W. Dryden, CFA John C. Manley MARKET INSIGHTS Guide to the Markets U.S. 4Q 2018 As of September 30, 2018 Meera Pandit Jordan K. Jackson Tyler J. Voigt Jennie Li

2 Year-over-year % change FOMC and market expectations for the fed funds rate 7% Federal funds rate FOMC year-end estimates Market expectations on 9/26/18 6% FOMC long-run projection* 5% 4% 3% 2% 1% FOMC September 2018 forecasts Percent run* Change in real GDP, 4Q to 4Q Unemployment rate, 4Q PCE inflation, 4Q to 4Q % 2.38% 3.13% 2.26% 3.38% 3.38% 2.83% 2.85% '99 '01 '03 '05 '07 '09 '11 '13 '15 '17 '19 '21 Long '23 run Source: Bloomberg, FactSet, Federal Reserve, J.P. Morgan Asset Management. Market expectations are the federal funds rates priced into the fed futures market as of the date of the September 2018 FOMC meeting and are through September *Long-run projections are the rates of growth, unemployment and inflation to which a policymaker expects the economy to 7 converge over the next five to six years in absence of further shocks and under appropriate monetary policy. 2 15% 1 Average: 2.7% Real GDP 2Q18 YoY % chg: 2.9% QoQ % chg: 4.2% Expansion average: 2.3% Source: BEA, FactSet, J.P. Morgan Asset Management. Values may not sum to 10 due to rounding. Quarter-over-quarter percent changes are at an annualized rate. Average represents the annualized growth rate for the full period. Expansion average refers to the period starting in the third quarter of Index quarterly operating earnings $44 S&P consensus analyst estimates $41 $38 $35 $32 $29 $26 $23 $20 $17 $14 $11 $8 $5 $2 -$1 Sep. 30, 1981: 15.84% 2Q18 nominal GDP, USD trillions $21 3.9% Housing $ % Investment ex-housing Nominal 10-year Treasury yield 5% Sep. 30, 2018: 3.05% Real 10-year Treasury yield Sep. 30, 2018: 0.86% -5% '58 '63 '68 '73 '78 '83 '88 '93 '98 '03 '08 '13 '18 Source: BLS, FactSet, Federal Reserve, J.P. Morgan Asset Management. Real 10-year Treasury yields are calculated as the daily Treasury yield less year-over-year core CPI inflation for that month except for September 2018, where real yields are calculated by subtracting out August 2018 year-over-year core inflation. 2Q18: $38.65 '02 '05 '08 '11 '14 '17 12% 1 8% 6% 4% 2% $17 $15 $13 $11 $9 $7 $5 $3 $1 -$ % Gov t spending 68. Consumption -2.7% Net exports Quarterly operating earnings per share/sales per share 14% 3.0 Average (1958-YTD 2018) 9/30/2018 Nominal yields 6.05% 3.05% Real yields 2.36% 0.86% Inflation 3.69% 2.19% Year-over-year % change, monthly, USD broad currencies index 4-15% High foreign sales S&P 500 revenues 3 U.S. 56% -1 2 International 44% -5% 1 5% % USD (inv.) -3 2 '04 '05 '06 '07 '08 '09 '10 '11 '12 '13 '14 '15 '16 '17 '92 '94 '96 '98 '00 '02 '04 '06 '08 '10 '12 '14 '16 '18 Source: Compustat, FactSet, Standard & Poor s, J.P. Morgan Asset Management; (Top right) Federal Reserve. EPS levels are based on operating earnings per share. Earnings estimates are Standard & Poor s consensus analyst expectations. Past performance is not indicative of future returns. Currencies in the Trade Weighted U.S. Dollar Broad Currencies Index are: Argentine peso, Australian dollar, Brazil real, British pound, Canadian dollar, Chilean peso, Chinese renminbi, Colombian peso, euro, Honk Kong dollar, Indian rupee, Indonesian rupiah, Israeli new shekel, Japanese yen, Korean won, Malaysia ringgit, Mexican peso, Philippine peso, Russian ruble, Saudi riyal, Singapore dollar, Swedish krona, Swiss franc, New Taiwan dollar, Thai baht, Venezuelan bolivar. High foreign sales is the average of the year-over-year % change in last 12 months sales of the following S&P 500 sectors: information technology, materials, energy, industrials. U.S. dollar has a 9-month lag. Relative fwd. P/E ratio of cyclicals vs. defensives, z-score 25-year annualized return, % 4 14% Cyclicals expensive relative to defensives Total return, USD % EM Current: Cyclicals cheap relative to defensives -2 '99 '01 '03 '05 '07 '09 '11 '13 '15 '17 12% 2% Q18: 11.5% Capital appreciation Dividends % % % Source: FactSet, Standard & Poor s, J.P. Morgan Asset Management. *Cyclical sectors include Consumer Discretionary, Information Technology, Industrials, Financials, Energy and Materials. REITs are excluded from this analysis. It is more appropriate to value a REIT by looking at its price relative to its funds from operations (FFO), an income measure that excludes depreciation. P/E ratios look at price relative to net income, a measure that includes depreciation, making the comparison of valuations across sectors inappropriate. Defensive sectors include Telecommunications, Health Care, Utilities and Consumer Staples. From 9/30/2018 to present Communication Services (previously Telecommunications) is included in the cyclical sectors and removed from the defensive sectors due to changes in the composition of the sector. Sector valuations are equal weighted. 25-yr. annualized return calculated from 9/30/1993-9/30/2018. Past performance is not indicative of future returns. 27.8% 27.8% Europe ex- UK S&P 500 total return index, % ACWI ex- U.S. 24.4% 21.8% 10.6% 1.9% -1.6% Japan U.S. U.S. Japan Europe-ex UK Source: FactSet, MSCI, Standard & Poor s, J.P. Morgan Asset Management. All return values are MSCI Gross Index (official) data, except the U.S., which is the S&P 500. *Multiple expansion is based on the forward P/E ratio and EPS growth outlook is based on NTMA earnings estimates. Chart is for illustrative purposes only. Past performance is not indicative of future results. 23% 2017 EPS, U.S. dollar, next 12 months, Jan = % 2018 YTD Japan Average return before peak Europe 25x 21x 17x 13x 9x 5x Total return Currency effect EPS growth outlook (local) Multiples Dividends 16.9x -2.7% -7.4% ACWI ex- U.S. 15.5x EM 13.5x 13.3x x U.S. DM Europe Japan EM Source: FactSet, MSCI, Standard & Poor s, Thomson Reuters, J.P. Morgan Asset Management. *Valuations refer to NTMA P/E for Europe, U.S., Japan and developed markets and P/B for emerging markets. Valuation and earnings charts use MSCI indices for all regions/countries, except for the U.S., which is the S&P 500. All indices use IBES aggregate earnings estimates, which may differ from earnings estimates used elsewhere in the book. MSCI Europe includes the eurozone as well as countries not in the currency bloc, such as Norway, Sweden, Switzerland and the UK (which collectively make up 46% of the overall index). Past performance is not a reliable indicator of current and future results. U.S. Equity market peak 8% EM Average return after peak 24 months prior 12 months prior 6 months prior 3 months prior 3 months after 6 months after 12 months after 24 months after Source: FactSet, Robert Shiller, Standard & Poor s, J.P. Morgan Asset Management. Chart is based on return data from 11 bear markets since A bear market is defined as a decline of 2 or more in the S&P 500 benchmark. Monthly total return data from 1938 to 1970 is from the S&P Shiller Composite index. From 1970 to present, return data is from Standard & Poor s. -7% -11% Current and 25-year historical valuations* 75x 33x Current 25-year range 29x 25-year average -14% Axis -1% 5.2x 4.8x 4.4x 4.0x 3.6x 3.2x 2.8x 2.4x 2.0x 1.6x 1.2x 0.8x 0.4x 0.0x U.S. economy and markets: Make hay while the sun shines THREE FOLLOWED BY A STRING OF TWOS page 3 LATE-CYCLE RUN-UPS page 4 Economy 19 Real GDP Economic growth and the composition of GDP Investing principles Components of GDP Equity market performance around bear markets Average return leading up to and following equity market peaks The U.S. economy grew at an impressive 4.2% q/q annualized pace in the second quarter. Recent data suggest this momentum will continue through the end of the year. While economic growth continues to look robust, late-cycle signals are becoming more prevalent: a lack of pent-up demand due to low unemployment, rising wages, higher interest rates and firming inflation. There historically has been impressive upside in investing in a latecycle economy. Investors should make hay while the sun shines and maintain some risk exposure, while gradually positioning more defensively as the bull market and economic expansion age. 65 Fixed income: Flexibility in a rising rate environment THE FED WILL CONTINUE TO NORMALIZE MONETARY POLICY page 5 THE LONG BOND BULL MARKET HAS COME TO AN END page 6 Fixed income 31 The Fed and interest rates 6 31 Federal funds rate expectations Fixed income Interest rates and inflation Nominal and real 10-year Treasury yields Long 32 The Federal Reserve (Fed) should continue to tighten monetary policy through Policy normalization will be achieved through two mechanisms: balance sheet reduction and interest rate hikes. Together, these mechanisms make for an unprecedented environment for fixed income investors. As U.S. monetary policy continues to tighten, bond prices should fall further, pushing yields higher, and prolonging a challenging environment for fixed income investing. Moving forward, flexibility in fixed income portfolios is critical to success. 32 U.S. equities: Robust earnings and the late-cycle playbook PROFIT GROWTH REMAINS STRONG, BUT SHOULD SLOW IN 2019 page 7 WILL THERE BE A CHANGING OF THE GUARD IN U.S. EQUITIES? page 8 Equities 7 Corporate profits 7 S&P 500 earnings per share S&P 500 sales and the U.S. dollar Equities Cyclical and defensive sectors Cyclicals vs. defensive valuations* S&P 500 profit margins S&P 500 sector returns: Dividends vs. cap. apprec Strong economic and profit growth on the heels of tax reform have led U.S. equity markets to outperform their international counterparts so far in However, earnings growth in the U.S. should begin to normalize next year. With the macroeconomic background pointing to higher inflation, rising rates and a tailwind to economic growth from fiscal stimulus, we prefer a tilt toward cyclical and value-oriented areas of the U.S. equity market. The current bull market is now the longest in history and much of the easy money has been made. As a result, being selective across sectors and styles will become increasingly important. 12 International equities: A story of sentiment this year WHEN SENTIMENT TAKES OVER page 9 GETTING SENTIMENT UNDER CONTROL page 10 International 42 Global equity markets: Returns 42 Sources of global equity returns* International International equity earnings and valuations Global earnings Global valuations Price-to-earnings 45 Price-to-book After strong returns in 2017 and a solid start to the year, international equities have disappointed investors over the past few months. What exactly has driven the negative international equity returns this year? Breaking down year-to-date returns, we can see that fundamentals have actually been solid. However, negative sentiment has caused multiple contraction and U.S. dollar strength. The good news is that international equity valuations and currencies now largely reflect a lot of the risks that have worried investors this year. Should we see an improvement in these variables, international equities are poised to rebound Q 2018 QUARTERLY PERSPECTIVES

3 1 U.S. economy and markets: Make hay while the sun shines THREE FOLLOWED BY A STRING OF TWOS The U.S. economy grew at a 4.2% q/q annualized pace in the second quarter. Data suggest this momentum will carry through the remainder of the year due to the positive impacts from tax reform. However, fiscal stimulus will begin to fade in 2019 and Given this, we anticipate year-over-year growth to reach 3% in 2018, but moderate to 2% thereafter. While momentum should sustain growth at a healthy pace through the end of the year, investors should not view the second quarter surge as the beginning of a new U.S. growth paradigm or a warning sign that excessive stimulus is overheating the economy. Consumer spending grew 3.9% in the second quarter, thanks both to the stimulative effects of tax reform and the easy comparison relative to a weak first quarter. With most pent-up demand exhausted, however, consumption will not likely continue to contribute meaningfully to growth through the rest of the expansion. The housing sector weakened in the second quarter, as rising home prices and mortgage rates put pressure on potential buyers. As with consumer spending, there seems to be little pent-up demand left for meaningful growth. The U.S. economy grew at an impressive 4.2% q/q annualized pace in the second quarter. Recent data suggest this momentum will continue through the end of the year. While economic growth continues to look robust, late-cycle signals are becoming more prevalent: a lack of pent-up demand due to low unemployment, rising wages, higher interest rates and firming inflation. There historically has been impressive upside in investing in a late-cycle economy. Investors should make hay while the sun shines and maintain some risk exposure, while gradually positioning more defensively as the bull market and economic expansion age. Business fixed investment, particularly in the wake of tax reform, could provide an outsized contribution to growth in the future. With strong corporate profits and a tax code that encourages capital spending, investment should accelerate so long as major sources of uncertainty, like the current trade disputes, are resolved or clarified. Economy Economic growth and the composition of GDP Real GDP Year-over-year % change Average: 2.7% Real GDP 2Q18 YoY % chg: 2.9% QoQ % chg: 4.2% Expansion average: 2.3% Components of GDP 2Q18 nominal GDP, USD trillions $21 $19 $17 $15 $13 $11 $9 $7 $5 $3 $1 -$ % Housing 13.6% Investment ex-housing 17.2% Gov t spending 68. Consumption -2.7% Net exports 19 Growth is still poised to reach 3% in 2018, helped by consumption as signaled by the upwardly revised retail sales data in June and July. The latter part of 2019 into 2020 should see growth ease due to the moderating impact of tax reform and a lack of pent-up demand. As the U.S. expansion continues to age, structural limitations should outweigh the benefits of tax reform. Source: BEA, FactSet, J.P. Morgan Asset Management. Values may not sum to 10 due to rounding. Quarter-over-quarter percent changes are at an annualized rate. Average represents the annualized growth rate for the full period. Expansion average refers to the period starting in the third quarter of Source: Guide to the Markets U.S. 4Q 2018, page 19 QUARTERLY PERSPECTIVES 4Q

4 LATE-CYCLE RUN-UPS While many different events can cause volatility, most often an official bear market has been caused by a recession. In fact, 8 of the last 10 equity bear markets coincided with an economic recession. Therefore, although other triggers are possible, a recession is the most likely cause of a sustained bear market in U.S. stocks. It is extremely difficult to predict when the next recession will occur. And, while the economy is signaling some late-cycle behavior, markets have historically performed well leading up to bear markets. Thus, missing out on late-cycle returns can hurt portfolio returns in the long run. Historically, equity returns leading up to bear markets (defined as declines in the stock market of 2 or greater), show that there has been substantial upside for investors willing to stay invested. In the post-wwii era, there have been 11 bear markets in stocks and, on average, the prior 24-, 12-, 6- and 3-month returns before an equity market peak have been positive and substantial. In the post-wwii era, bear markets, on average, have lasted 19 months. This suggests most of the pain will be felt in the first year and a half. Conversely, bull markets have lasted roughly 60 months on average. This suggests investors are better off getting, and staying, invested rather than trying to time when to get out of the market. INVESTMENT IMPLICATIONS In an aging economic expansion and bull market, investors should maintain flexibility in allocations. Robust earnings growth, low interest rates relative to history and an economy on strong footing all still suggest a modest pro-risk tilt to portfolios makes sense. However, as the expansion continues to age, the Federal Reserve continues to tighten monetary policy and fiscal stimulus begins to fade, the risk of a recession increases in late 2019 and early Given this, at the current juncture investors should make hay while the sun shines and take advantage of a healthy economy and corporate backdrop and benefit from equity market upside Equity market performance around bear markets Average return leading up to and following equity market peaks S&P 500 total return index, % 23% 15% Equity market peak Average return before peak Average return after peak 65 Investors should not miss out on returns leading up to the next bear market. We believe the next recession will not occur for another months, and history suggests there is still upside to equity markets. 1 8% Investing principles % -7% -11% -14% 24 months prior 12 months prior 6 months prior 3 months prior 3 months after 6 months after 12 months after 24 months after Source: FactSet, Robert Shiller, Standard & Poor s, J.P. Morgan Asset Management. Chart is based on return data from 11 bear markets since A bear market is defined as a decline of 2 or more in the S&P 500 benchmark. Monthly total return data from 1938 to 1970 is from the S&P Shiller Composite index. From 1970 to present, return data is from Standard & Poor s. 65 Source: Guide to the Markets U.S. 4Q 2018, page Q 2018 QUARTERLY PERSPECTIVES

5 2 Fixed income: Flexibility in a rising rate environment THE FED WILL CONTINUE TO NORMALIZE MONETARY POLICY Increasing U.S. growth, a tight labor market and firming inflation should allow the Fed to continue to normalize monetary policy. The Fed will normalize policy using two mechanisms: reducing its balance sheet and raising short-term interest rates. Together, these mechanisms make for an unprecedented environment for fixed income investors and should push yields higher across the curve. So long as economic conditions continue to look robust, the Fed should continue to pursue a steady pace of interest rate hikes in the final quarter of 2018, pushing down bond prices and lifting yields. The market has priced in the proposed pace of normalization for this year, but some participants remain skeptical about the future. Therefore, if the Fed does stick to its plan, some investors may be caught off guard. Understanding duration and sector exposure is key to weathering the storm. The Federal Reserve (Fed) should continue to tighten monetary policy through Policy normalization will be achieved through two mechanisms: balance sheet reduction and interest rate hikes. Together, these mechanisms make for an unprecedented environment for fixed income investors. As U.S. monetary policy continues to tighten, bond prices should fall further, pushing yields higher, and prolonging a challenging environment for fixed income investing. Moving forward, flexibility in fixed income portfolios is critical to success. Fixed income Federal funds rate expectations FOMC and market expectations for the fed funds rate 7% 6% 5% 4% 3% 2% 1% The Fed and interest rates 6 Federal funds rate FOMC year-end estimates Market expectations on 9/26/18 FOMC long-run projection* FOMC September 2018 forecasts Percent 2.13% 2.38% Long run* Change in real GDP, 4Q to 4Q Unemployment rate, 4Q PCE inflation, 4Q to 4Q % 3.38% 3.13% 2.26% 2.83% 2.85% The Fed will continue to gradually hike interest rates. Changes in short-term rates will work alongside balance sheet reduction to normalize monetary policy. The combination of Fed actions is unprecedented, and investors should expect some challenges along the way. '99 '01 '03 '05 '07 '09 '11 '13 '15 '17 '19 '21 Long '23 run Source: Bloomberg, FactSet, Federal Reserve, J.P. Morgan Asset Management. Market expectations are the federal funds rates priced into the fed futures market as of the date of the September 2018 FOMC meeting and are through September *Long-run projections are the rates of growth, unemployment and inflation to which a policymaker expects the economy to converge over the next five to six years in absence of further shocks and under appropriate monetary policy. 31 Source: Guide to the Markets U.S. 4Q 2018, page 31 QUARTERLY PERSPECTIVES 4Q

6 THE LONG BOND BULL MARKET HAS COME TO AN END With interest rates trending downward for the better part of 40 years, investors enjoyed an exceptionally long bond bull market. With the Federal Reserve normalizing monetary policy, this bond bull market has ended, and interest rates have risen considerably since the start of the year. The duration of the U.S. bond market is at near-record highs, making monetary policy normalization particularly problematic for fixed income investors. Identifying pockets of opportunity will be more important than ever. After a cooling of both inflation and interest rates since the early 1980s, nominal and real yields have been low for a long time. Yields have backed up meaningfully since the start of the year and, with the post-recession economic expansion looking healthy, should continue to move higher. Ultra-cheap borrowing has pushed duration higher, making investors particularly sensitive to increases in interest rates. As the Fed normalizes monetary policy through 2019, fixed income investors must be careful. INVESTMENT IMPLICATIONS The U.S. economy continues to strengthen and the Federal Reserve is normalizing monetary policy. This has brought an end to a long bull market for fixed income investors, and yields are rising. Fixed income investing will require creativity and flexibility, as investors must navigate the difficult combination of rising interest rates and a low-yield environment. As rates continue to rise, investors must take a flexible approach to duration management. High-quality fixed income still provides critical ballast for a well-diversified portfolio, but investors should look to manage sector exposure. The end of the bond bull market means that an understanding of core fixed income holdings and flexibility in investment approaches will be necessary. Fixed income Nominal and real 10-year Treasury yields 2 15% 1 5% Interest rates and inflation Nominal 10-year Treasury yield Sep. 30, 1981: 15.84% 7 Average (1958-YTD 2018) 9/30/2018 Nominal yields 6.05% 3.05% Real yields 2.36% 0.86% Inflation 3.69% 2.19% 32 Sep. 30, 2018: 3.05% The long bull market in fixed income has ended. Yields will continue to move higher in the U.S. as the Fed raises rates and reduces the size of the balance sheet. Real 10-year Treasury yield Sep. 30, 2018: 0.86% -5% '58 '63 '68 '73 '78 '83 '88 '93 '98 '03 '08 '13 '18 Source: BLS, FactSet, Federal Reserve, J.P. Morgan Asset Management. Real 10-year Treasury yields are calculated as the daily Treasury yield less year-over-year core CPI inflation for that month except for September 2018, where real yields are calculated by subtracting out August 2018 year-over-year core inflation. 32 Source: Guide to the Markets U.S. 4Q 2018, page Q 2018 QUARTERLY PERSPECTIVES

7 3 U.S. equities: Robust earnings and the late-cycle playbook PROFIT GROWTH REMAINS STRONG, BUT SHOULD SLOW IN 2019 S&P 500 operating earnings grew 27% from a year prior in both the first and second quarters of 2018, and it seems reasonable that this pace of earnings growth could be sustained into the end of the year. Consensus estimates are calling for 26.7% year-over-year growth for 2018 as a whole, the fastest pace since We estimate that between 7 to 8 percentage points of this growth have come from tax reform, with the rest coming from strong revenue growth and margin expansion. The second quarter saw profits rise nearly 27% from a year prior, with strong growth in the energy, technology, financials and telecom sectors. Margins also continued to expand, reaching their highest level since Despite a pickup in global equity volatility, strong earnings growth has provided support for U.S. equity markets this year while international markets have struggled. Profit growth should remain solid through the end of 2018 before normalizing in 2019 as the benefits from tax reform begin to fade. Furthermore, margins, and thus earnings, may begin to come under pressure as wages, interest rates and raw material costs all continue to increase. Strong economic and profit growth on the heels of tax reform have led U.S. equity markets to outperform their international counterparts so far in However, earnings growth in the U.S. should begin to normalize next year. With the macroeconomic backdrop pointing to higher inflation, rising rates and a tailwind to economic growth from fiscal stimulus, we prefer a tilt toward cyclical and value-oriented areas of the U.S. equity market. The current bull market is now the longest in history and much of the easy money has been made. As a result, being selective across sectors and styles will become increasingly important. Equities 7 S&P 500 earnings per share Index quarterly operating earnings $44 S&P consensus analyst estimates $41 $38 $35 $32 $29 $26 $23 $20 $17 $14 $11 $8 $5 $2 Corporate profits 2Q18: $ $1 '02 '05 '08 '11 '14 '17 S&P 500 sales and the U.S. dollar 14% 12% 1 8% 6% 4% 2% Year-over-year % change, monthly, USD broad currencies index 4 High foreign sales S&P 500 revenues 3 U.S. 56% 2 International 44% USD (inv.) -3 '04 '05 '06 '07 '08 '09 '10 '11 '12 '13 '14 '15 '16 '17 S&P 500 profit margins Quarterly operating earnings per share/sales per share '92 '94 '96 '98 '00 '02 '04 '06 '08 '10 '12 '14 '16 '18 Source: Compustat, FactSet, Standard & Poor s, J.P. Morgan Asset Management; (Top right) Federal Reserve. EPS levels are based on operating earnings per share. Earnings estimates are Standard & Poor s consensus analyst expectations. Past performance is not indicative of future returns. Currencies in the Trade Weighted U.S. Dollar Broad Currencies Index are: Argentine peso, Australian dollar, Brazil real, British pound, Canadian dollar, Chilean peso, Chinese renminbi, Colombian peso, euro, Honk Kong dollar, Indian rupee, Indonesian rupiah, Israeli new shekel, Japanese yen, Korean won, Malaysia ringgit, Mexican peso, Philippine peso, Russian ruble, Saudi riyal, Singapore dollar, Swedish krona, Swiss franc, New Taiwan dollar, Thai baht, Venezuelan bolivar. High foreign sales is the average of the year-over-year % change in last 12 months sales of the following S&P 500 sectors: information technology, materials, energy, industrials. U.S. dollar has a 9-month lag. 7-15% -1-5% 5% 1 15% 2 2Q18: 11.5% We expect another solid quarter of earnings growth in 3Q18, with gains driven largely by the cyclical sectors. Earnings should begin to normalize in 2019 as the benefits from tax reform fade. In addition to a normalization in earnings, margins may also come under pressure as wages, interest rates and raw material costs continue to increase. Source: Guide to the Markets U.S. 4Q 2018, page 7 QUARTERLY PERSPECTIVES 4Q

8 WILL THERE BE A CHANGING OF THE GUARD IN U.S. EQUITIES? Strong profit and economic growth, coupled with ultra-loose monetary policy, have led cyclicals to outperform defensives and growth to outperform value throughout this expansion. However, as this cycle continues to age, profits and economic growth should begin to slow at a time when global monetary policy is set to tighten. The reversal of these trends could lead to a shift in market leadership. The performance differential between growth and value may begin to close as we enter 2019; the Federal Reserve is continuing to raise rates and reduce its balance sheet, while the European Central Bank is set to end asset purchases at the end of the year and begin normalizing rates in This reduction in liquidity could change market dynamics that have led to the outperformance of growth equities. The boost from tax reform has led to a strong pickup in earnings and economic growth that will likely continue over the next few quarters. This strength should continue to support the cyclical sectors; we prefer a tilt toward the cyclical value sectors that also offer income, such as financials and energy, and would continue to avoid the bond proxies (utilities, consumer staples and real estate). INVESTMENT IMPLICATIONS The current environment leads us to prefer cyclical and value-oriented equities, but we remain selective across sectors within these areas. Late-cycle returns have historically been meaningful for portfolios, but a more balanced total return between income and capital appreciation in equities may be justified. Revisiting U.S. equity positioning and exposures early in 2019 is suggested given the shifting macroeconomic environment. While outright defensive positioning may still be premature in an equity allocation at the current juncture, as profitability and economic growth begin to slow in 2019, it will be an important time to revisit equity exposure and positioning in the context of a broader portfolio. Equities Cyclicals vs. defensive valuations* Relative fwd. P/E ratio of cyclicals vs. defensives, z-score 4 Cyclicals expensive relative to defensives 3 Cyclical and defensive sectors 12 S&P 500 sector returns: Dividends vs. cap. apprec. 25-year annualized return, % 14% Capital appreciation Dividends 12% Defensive sector valuations look attractive when compared to their cyclical peers, but outright defensive positioning is not yet warranted Current: Cyclicals cheap relative to defensives -2 '99 '01 '03 '05 '07 '09 '11 '13 '15 '17 8% 6% 4% 2% Sectors that have a good mix between capital appreciation and income, such as energy, financials and health care, offer a buffer during volatility, while also participating in markets on the upside. 12 Source: FactSet, Standard & Poor s, J.P. Morgan Asset Management. *Cyclical sectors include Consumer Discretionary, Information Technology, Industrials, Financials, Energy and Materials. REITs are excluded from this analysis. It is more appropriate to value a REIT by looking at its price relative to its funds from operations (FFO), an income measure that excludes depreciation. P/E ratios look at price relative to net income, a measure that includes depreciation, making the comparison of valuations across sectors inappropriate. Defensive sectors include Telecommunications, Health Care, Utilities and Consumer Staples. From 9/30/2018 to present Communication Services (previously Telecommunications) is included in the cyclical sectors and removed from the defensive sectors due to changes in the composition of the sector. Sector valuations are equal weighted. 25-yr. annualized return calculated from 9/30/1993-9/30/2018. Past performance is not indicative of future returns. Source: Guide to the Markets U.S. 4Q 2018, page Q 2018 QUARTERLY PERSPECTIVES

9 4 International equities: A story of sentiment this year WHEN SENTIMENT TAKES OVER International equities have been in the headlines over the past few months and not in a favorable light. Investors have been considering a multitude of risk factors this quarter, with sentiment turning decidedly negative. This has been causing multiples to contract around the world and the U.S. dollar to strengthen against the majority of global currencies. Economic data abroad disappointed in the first half of the year, as expectations were quite high, especially for the eurozone and Japan. In addition, China s efforts to tackle its debt problem last year have caused some cooling in growth over the first half of this year. Growing fears of a trade war between the U.S. and its major trading partners have been causing investors to question their outlook for economic and earnings growth. Recent weeks have brought an improvement with regards to Europe and NAFTA, but questions remain with regards to China. The strengthening of the U.S. dollar has caused investors to reconsider the outlook for emerging markets (EM). EM central banks may be forced to raise interest rates in response to falling currencies, dragging economic growth. Turkey and Argentina have been under particular stress, but investors should remember that their large U.S. dollar-denominated debts are exceptions rather than the rule. After strong returns in 2017 and a solid start to the year, international equities have disappointed investors over the past few months. What exactly has driven the negative international equity returns this year? Breaking down year-to-date returns, we can see that fundamentals have actually been solid. However, negative sentiment has caused multiple contraction and U.S. dollar strength. The good news is that international equity valuations and currencies now largely reflect a lot of the risks that have worried investors this year. Should we see an improvement in these variables, international equities are poised to rebound. International Global equity markets: Returns Sources of global equity returns* Total return, USD 37.8% EM 27.8% 27.8% Europe ex- UK ACWI ex- U.S. 24.4% 21.8% 2018 YTD 10.6% 1.9% -1.6% Japan U.S. U.S. Japan Europe-ex UK Source: FactSet, MSCI, Standard & Poor s, J.P. Morgan Asset Management. All return values are MSCI Gross Index (official) data, except the U.S., which is the S&P 500. *Multiple expansion is based on the forward P/E ratio and EPS growth outlook is based on NTMA earnings estimates. Chart is for illustrative purposes only. Past performance is not indicative of future results Total return Currency effect EPS growth outlook (local) Multiples Dividends -2.7% -7.4% ACWI ex- U.S. EM 42 Breaking down global equity returns into its components, we can see that fundamentals have had another solid year, with positive earnings growth outlooks. However, unlike last year, multiple contraction and dollar strength have been driving international returns into negative territory. Sentiment has diverged from fundamentals this year, and this can be attributed to an increase in uncertainty. Source: Guide to the Markets U.S. 4Q 2018, page 42 QUARTERLY PERSPECTIVES 4Q

10 GETTING SENTIMENT UNDER CONTROL While sentiment has turned negative, fundamentals themselves are still strong. Economic data disappointed abroad in the first half of the year, but investors should keep in mind that the global economy is still in much better shape today than in the crisis-filled years of 2011 to Growth has cooled a bit from the hot summer months of In addition, data have begun to improve again in the eurozone, Japan and EM. Earnings growth has also been positive this year, with 16% in EM, 7% in the eurozone and 4% in Japan (in U.S. dollar terms). In comparison to the U.S. corporate tax cut fueled surge in earnings this year, these figures seem muted; however, next year earnings are expected to grow by 1 across the board. Risks to the outlook have increased, but valuations and currencies have declined to reflect this. Positive improvements on economic data, trade tensions and dollar strength would encourage investors to focus back on the positive economic and earnings stories abroad. In fact, we have begun to see some tentative steps in this direction. INVESTMENT IMPLICATIONS This would be the wrong time to abandon international equities, as valuations and currencies already reflect a lot of the risk investors are worried about and fundamentals still look positive. When thinking about what the future might look like, investors should also consider long-term returns. Over the next years, international equities, especially EM, are likely to deliver higher returns than the U.S. In addition, investors should also consider the diversification role of international equities. Global markets moved in unison during the crisis years, but are now increasingly marching to the beat of different drums. International equity earnings and valuations 45 International Global earnings EPS, U.S. dollar, next 12 months, Jan = 100 Japan Europe U.S. EM Global valuations Current and 25-year historical valuations* Price-to-earnings 75x 33x 29x 25x 21x 17x 13x 9x 16.9x Current 25-year range 25-year average 15.5x 13.5x 13.3x Axis 1.6x 5.2x 4.8x 4.4x 4.0x 3.6x 3.2x 2.8x 2.4x 2.0x 1.6x 1.2x 0.8x 0.4x Price-to-book Global earnings already bottomed and have been rising consistently over the past two years. In addition, international valuations are lower than at the beginning of the year, reflecting a lot of the uncertainty. This is a good time for investors to re-evaluate their exposure to international assets keeping in mind their long-term benefits. 5x U.S. DM Europe Japan EM 0.0x 45 Source: FactSet, MSCI, Standard & Poor s, Thomson Reuters, J.P. Morgan Asset Management. *Valuations refer to NTMA P/E for Europe, U.S., Japan and developed markets and P/B for emerging markets. Valuation and earnings charts use MSCI indices for all regions/countries, except for the U.S., which is the S&P 500. All indices use IBES aggregate earnings estimates, which may differ from earnings estimates used elsewhere in the book. MSCI Europe includes the eurozone as well as countries not in the currency bloc, such as Norway, Sweden, Switzerland and the UK (which collectively make up 46% of the overall index). Past performance is not a reliable indicator of current and future results. Source: Guide to the Markets U.S. 4Q 2018, page Q 2018 QUARTERLY PERSPECTIVES

11 GLOBAL MARKET INSIGHTS STRATEGY TEAM Americas Dr. David P. Kelly, CFA Managing Director Chief Global Strategist David Lebovitz Gabriela D. Santos Samantha M. Azzarello Alexander W. Dryden, CFA John C. Manley Meera Pandit Jordan K. Jackson Tyler J. Voigt Jennie Li Europe Karen Ward Managing Director Chief Market Strategist, EMEA London Manuel Arroyo Ozores, CFA Madrid Michael Bell, CFA London Tilmann Galler, CFA Frankfurt Lucia Gutierrez-Mellado Madrid Vincent Juvyns Luxembourg Maria Paola Toschi Milan Nandini L. Ramakrishnan London Jai Malhi London Ambrose Crofton London Asia Tai Hui Managing Director Chief Market Strategist, Asia Hong Kong Kerry Craig, CFA Melbourne Yoshinori Shigemi Tokyo Marcella Chow Hong Kong Ian Hui Hong Kong Agnes Lin Taipei Shogo Maekawa Tokyo Dr. Jasslyn Yeo, CFA Singapore Chaoping Zhu Shanghai Hannah J. Anderson Hong Kong QUARTERLY PERSPECTIVES 4Q

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