David Kelly Weighs in on Today’s Investment Climate

David Kelly

J.P. Morgan Asset Management’s chief global strategist David Kelly has just shared his thoughts on a number of issues of concern to investors, and he covers a lot of ground.

While most investors approach investing in a completely passive way, and don’t really have a plan to react to circumstances and outlooks as they develop over time, many do maintain an interest of some sort and want to keep abreast of things. J.P. Morgan strategist David Kelly has just shared many of his thoughts on the issues of the day, covering a lot of ground and addressing several key things of interest to a lot of investors and is certainly worth us spending a little time having a look at.

Kelly takes us away from conventional thinking enough to make things interesting at least, and although it’s never hard to find flaws, there is often some real insights that can be gained as well, starting with his treatment of the risk of a recession that a lot of people are worried about currently. We can also learn from whatever flaws are present and there is perhaps no better way to learn the right path than looking at paths that aren’t so right to see where they go off course and allow us to correct ours.

Kelly starts by pointing out that the current risk of a recession at this point is low due to there not being either of what he feels are the two key drivers of recessions, which are overly tight monetary policy and a boom that is at risk of busting.

In respect to the monetary policy issue, we know that expansionary policy promotes growth and contractionary policy reduces it, so if we’re worried about the economy contracting, the first thing we need to look at is how much pressure the Fed is putting on it to contract. We have quite the opposite now, and it’s not just that this is helping, but perhaps more importantly, they aren’t hurting.

This is a lot bigger deal than we usually think, and all we have to do is look back upon troubled times in the past to see how overtightening can bring on economic decline. We had the mini-bear market from last year to show this pretty well, where the Fed stepped a little past the line with their tightening and we saw both the economy and especially the stock market take a tumble.

This has since been corrected and we’re back on the right path now. Leading up to the housing bubble bursting in 2007-08, we also had the Fed overtighten at a time where things were particularly fragile, and while defaults were the proximate cause of this crisis, overtightening significantly contributed to this.

We also don’t see a big runup that we see prior to collapse, with growth running too hot, and the best way to think of this is when we overextend ourselves too much, this leads to our needing to cool things down, and the higher things spike, the bigger the spike the other way. Kelly points out that we have nothing of the sort going on now and the current growth we have is delightfully slow and steady. That’s the ideal kind.

The best way to grasp all this is to understand how the rate of change affects risk, where the more upward the rate of change is, the greater the risk of reversal is. Boom and bust economic cycles are the classic example, and when the amount of boom we have is as muted as it is now, the risk of a bust is muted correspondingly.

Retirees Will Need to Change Up Their Game Plan

He then addresses something that we can clearly benefit from thinking about more, which is how we deal with the strategy of spending down our principal in retirement. Kelly rightly feels that people have become too stubborn about this, often out of fear, and could benefit from taking a step back and realizing that we saved up money to use, and part of using it is actually spending it when warranted.

We do want our money to last, but we can’t always live off returns, especially if we’re getting levels of returns that are too modest. The first place we want to look in order to address this is seeing how we might increase our returns, but we also do not want to forget that we may be able to also put together a sustainable plan to draw down our savings over time and rely substantially on this in addition to whatever returns we can manage, out of necessity perhaps more than ever.

Kelly advises the yield hunters that they aren’t going to be too happy in the coming years, not that they should ever be. The key to high yields is high inflation, and inflation is very low now. In spite of bonds rising to a clearly overbought position, which we’re coming down from now, and is expected to continue for a while, the equilibrium that we will reach will have us far away from the yields many investors crave, because there just isn’t anything to drive them up further.

We also need to point out that when both inflation and yields rise, this is actually a bad thing for bondholders, as the only yield that matters is the one net of inflation. Such an environment also puts down the value of bonds and is undesirable on all counts, so people wishing for such a thing need to better appreciate what it is that they actually are wishing for, which turns out to be clearly undesirable.

Kelly believes that growth in equities will be quite limited in the coming years due to his believing that we are coming up against the wall of the perception of appropriate valuations. Earnings just aren’t growing that fast these days and if that serves as too much of a limiting factor, where we may not want to go too far past current valuations, this will slow things down quite a bit.

While there isn’t anything intrinsic at work here and investors could drive up price to earnings ratio to any amount in theory, people do get nervous about these things at certain levels. This ends up being more of a cultural thing than anything where we may get comfortable with higher ratios over time as our culture adapts, but there is always a threshold here and the current one may indeed cap things quite a bit and serve as a ceiling to keep us in line with the more modest GDP growth of today.

Kelly feels that this is a time where we should be looking to get off of the beaten path with some of our money at least, and he suggests we look at things like international equities, private equity investing, and real estate. This could end up being a good idea depending on how things materialize, but we never want to jump the gun here and resist the temptation to be too much of a pioneer, who are the ones most prone to getting scalped. There may be a time for everything but we often have to wait for it and impatience in investing gets punished more often than not.

The Work of the Fed is Very Important, Rain or Shine

Kelly’s views on central banks are perhaps the most interesting, and this is also where he goes off the rails at least somewhat. He believes that expansionary monetary policy is most effective when responding to a crisis, which may be true, but this does not in any way imply we should forebear in more normal situations as he suggests, where such policies may still help.

There’s much less to do these days than there was responding to the blowing up of credit markets that we saw a decade ago, but this does not mean that important work isn’t being done by these policies. Kelly believes that the Fed should refrain from stimulating the money supply in the manner that they are currently doing, and feels that doing nothing right now would be best.

He tells us that he doesn’t believe this works during good times, but it is clear that it does, and this flies in the face of overwhelming evidence in fact. This insight is clearly off the mark, although we can rest easy in the fact that the Fed isn’t swayed by such things and do not wish to see growth slide from minimally acceptable to unacceptable. If we wish a recession, while too much tightening is the quickest path there, not enough loosening can take us there as well in time if we are negligent in this duty.

The reason is that this is all on a continuum, and even though rates are low they still may be too tight for conditions. If this is left inadequately addressed, this relative tightness will have its say, and we don’t want this to speak too loudly.

In a boom cycle, the damage doesn’t occur from the boom itself but by way of how this puts up inflation, where we end up raising rates to control this. Higher rates lead to higher default rates, which in itself shrinks the money supply as well as causing businesses to go under, shrinking employment numbers and further shrinking the money supply and contracting the economy.

Kelly doesn’t mention this specifically but some others are concerned about pushing too hard with interest rate cuts can set things up for a fall later as inflation picks up and rates get raised. This is why the Fed worries about inflation so much but it’s well under control and nothing of the sort of thing that should really worry us is on the horizon. We have a lot of debt out there but not an amount that should really concern us, but if rates need to be raised too much this could produce some real problems, but that’s not on the table right now and Kelly agrees that this isn’t a real issue.

He also points out that the trade war hasn’t had that big of an effect but it would have if not for all the stimulus that we have in place right now. He tells us that we have Trump’s tax stimulus package he put in place in 2017 to thank for this and wonders how much worse the effects of these tariffs would be if not for this. We can also add the expansionary monetary policy of the Fed which will also help cushion the blow.

This does bring us to his suggesting that we should not worry so much about which party is in power in Washington, but while this is normally true, the end of Trump’s stimulus and going in the other direction with fiscal policy makes this situation stand out. Just repealing these corporate tax cuts will have a significant impact upon the economy and therefore political parties do matter this time and matter quite a bit.

We’ve cried wolf before in prior elections, and the wolves have been kept at bay reasonably well in the past, but this one, if given the chance, wants to attack the economy with a ferocity that we may not have seen since the days of FDR. While FDR is seen by most as a hero of the Depression era, we got out of this mess not because of his efforts but in spite of them. It seemed reasonable enough to tax people a lot more but this took a fragile economy and delivered a knockout punch that kept us down on the ground squirming for considerably longer.

We’re risking the same situation again, only this time they are breaking out bigger sticks to bash the economy with, and we ignore the danger here at our peril. This is not to say that things will be anywhere near as bad this time, and the Fed allowing all those bank failures is what started this collapse back then, but our economy is in no shape for the clubbing that is planned and there will be much blood on the ice if they get their way.

Kelly has some interesting ideas as far as how we might expand fiscal stimulus by providing people subsidies for things like buying a house or car, but we need to ask where this money is to come from and there just isn’t a good way to pay for this, just like there isn’t for Medicare for All, College for All, or any other pie in the sky suggestions out there from the Democrats.

We already spend like there is no tomorrow, and while it is reasonable to do so to keep the ship afloat and avoid economic depression, we also need to be careful to not do more than this lest we increase the rate at which our ultimate demise is being accelerated. The U.S. government is doomed to collapse along with every other government in the world, when our debt becomes so large that we can no longer keep up, and while this is years away, we want to try to limit the rate of acceleration toward financial doomsday.

One of his more insightful remarks is the one about how we need to work harder to expand our labor market, and if we do not, this will continue to limit growth. This is not a problem at all unless we go beyond full employment, but we have now, and as he points out, we could grow faster if we had more people that we could hire. We have a labor shortage right now in a lot of sectors as well as overall, and he points out that we need to account for this within our immigration policies.

This is not without its problems though and it’s actually pretty unusual to go beyond full employment, and it’s not that we can revoke their green cards once the labor market cools off. The best way to solve this is to use temporary visas more, which will allow us to benefit now and not commit to be overly burdened in the aftermath, tailoring the solution to the need.

Overall, Kelly’s remarks are well above average and he demonstrates a considerably better than average understanding of the issues than you normally see with market strategists or with anyone for that matter. We may need to take his advice on things like getting off the normal U.S. investment highway and venturing off into the woods with many grains of salt, and his view of the effectiveness of the Fed in good times runs counter to the evidence, but there are some good insights contained in his remarks and this is one of the better interviews that you will see out there on these important topics.

Monica

Editor, MarketReview.com

Monica uses a balanced approach to investment analysis, ensuring that we looking at the right things and not confined to a single and limiting theory which can lead us astray.

Contact Monica: [email protected]

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