What people are missing when it comes to trade, stocks, and the market's favourite recession signal, according to a JPMorgan chief strategist

  • David Kelly, Chief Global Strategist of JPMorgan Asset Management, explains why the US trade deficit with China doesn’t matter. Kelly explains that he runs a trade deficit with Costco and many other retailers. What does matter is whether you run a trade deficit overall.
  • He says the cause for the US trade deficit is the country’s budget deficit.
  • Kelly expects US stocks to continue higher this year barring an even worse trade conflict.
  • Kelly expects the yield curve to be almost completely flat a year from now and he says not to worry if it ends up inverted. He calls the inverted yield curve a broken barometer that can no longer be trusted.

Following is a transcript of the video.

Sara Silverstein: So everybody’s talking about trade wars and trade deficits. What do people get wrong about trade deficits?

David Kelly:I wrote a piece actually, on my LinkedIn blog a few weeks ago called “My Trade Deficit with Costco” and I think it’s a good way of looking at this. I run a trade deficit with Costco. I buy a lot of their stuff, they don’t seem to want to buy what I have to sell, which is basically investment insight, but I run a trade deficit with almost everybody. I run a trade deficit with Whole Foods. I run a trade deficit with CVS. The only people that I run a trade surplus with are JPMorgan Chase, my employer, but that’s actually ok because overall, I run a trade surplus, and I don’t really care who I run the trade deficit with. So I think that’s the first thing.

We focus on, “We’ve got a real problem with China,” or “We’ve got a problem with Germany.” It doesn’t matter, so long as, overall, we run a trade surplus, we wouldn’t have a problem. But of course, we don’t. But then that gets to the second point. Why do I run a trade deficit with Costco? Or why do people get into problems in which they’re buying a lot of things from one group and not selling them? It’s because I overspent. And as a nation, we overspend.

The reason we have a trade deficit is actually because we have a budget deficit. If you think about it this way, you’ve got the private sector, you’ve got the public sector, you got trade. If the private sector more or less pays its way, if we fund our investment through our savings, but if the government runs a big budget deficit, if it spends a whole pile more than it’s taking in taxes, then we, as a nation, will live beyond our means. I think this is so important. It’s not a matter of tariffs, it’s not a matter of the dollar. If we run a big budget deficit, if we continue to buy morestuff -the government does and it takes it intaxes -we will run a trade deficit. So if wewant tofix our trade problem, we got to start by fixing the budget deficit.

Silverstein:And totake your analogy further, when is it ok to run a budget deficit or a trade deficit as an individual, or a nation?

Kelly:It’s actually a very good point, because now, I suppose, I do overall run a trade surplus, and that’s good. But 20 or 30 years ago when I was a younger man I actually ran a trade deficit. I was borrowing money every year just to fund my expeditions to Costco, because I wasn’t getting paid enough. But that’s ok, because I knew that over time, I’d get paid more. And that’s actually truefor – forexample, emerging market economies. It’s ok for them to borrow a whole pile of money to grow their economies because they’re young, they have got plenty of room to grow. We are an old, mature economy. Our economic growth isgoing tobe about 2% in the long run. In this kind of economy, and with so many people retiring, we actually should be running a budget surplus and a trade surplus. We should be storing up money to pay for our retirement, and of course, we’re doing exactly the opposite.

Silverstein:And what’s your outlook for the markets? Do you think that the US stock market is expensive right now?

Kelly:No, I think the US market is ok. I mean, it’s had asort ofrocky kind of year, and I think the reason for that is people have a hard time appreciating just the earnings we’re receiving right now. The problem is, I think stock market investing is kind of a monotheistic religion; there’s only one god, and that is future earnings growth. And the thing is, you cannot see much future earnings growth from here. Next year it’s going to be tougher than this year. But look how good it’s this year. I mean, this year we think we’re going to do about 26% year-over-year growth in operating earnings per share for the S&P 500. That’s extraordinary in the tenth year of a bull market in equities. And it’s like you’re getting five years’ of earnings growth packed into this year. So I think we should appreciate, and I think investors eventually will appreciate, just how good these earnings are right now, the ability of companies to earn this cash, to distribute this cash, that should push the market up. And I think the market, barring some worse trade conflict, I think the market will probably move up between now and the end of the year.

Silverstein:And that’s my next question. What would it take for the market to dive? Is trade the biggest –

Kelly:I think there is a risk there, if we keep on doubling down on a trade conflict. Remember, people like Xi Jinping, they’re notgoing tocapitulate here, because they are politicians, in a broader sense, in China. They cannot be seen to lose face over this. And they think that – you know, there’s no midterm elections in China. And because of that, they’re notgoing togive in easy, and so the danger is, the trade war gets prolonged.

Now, honestly, I think we may see sort of a trade war ceasefire before the midterm elections, because I think the pushback on Washington about this trade war is getting bigger and bigger and bigger, and eventually I think that’sgoing tohave an impact on the administration. But there is a risk.

One of the biggest risks facing this economy is that we keep on pushing up tariffs, because tariffs are such a bad idea. It is an idea twice-cursed. It curses the person inflicting the tariffs and it curses the one upon whom the tariffs are inflicted. It’s just going to slow down global growth. It slows down economic growth in the United States, so it is a big risk, but hopefully it’s one that we sort of back away from before the end of the year.

Silverstein:And where else are you seeing opportunities for investors?

Kelly:Well, I think there’s a lot of opportunities in equities overall, particularly outside the United States. And remember, we’re going to slow down eventually to about 2% growth. We don’t have the population growth, we don’t have the workforce growth, honestly, to do more than that. But if you look overseas, Europe’s still got a lot of unemployment, that unemployment rate’s coming down, they can grow faster. Emerging markets, there’s always something going wrong in emerging markets, but overall they have got much better long-term growth prospects. And then if you look at valuations, the US is fairly valued, but Europe is cheaper than average, and emerging markets are cheaper than average. So I honestly think that if the US can give you about 5% total return per year over the next five years, I think Europe and emerging markets can give you about 10%. I think that’s where the opportunity is.

Silverstein:Great, and what’s your outlook for the Fed?

Kelly:I think the Fed will keep on tightening. I mean, the economy’s doing very well. We’ve met all their targets in terms of growth, in terms of unemployment, in terms of inflation. I think they are worried, frankly, about all this fiscal stimulus. We’re at full employment. You don’t normally put this much stimulus into an economy at full employment. It’s kind of like bringing an extra keg to a frat party at 2 a.m. It’s going to make the party louder but it will make the hangover worse. So they have got to counteract this fiscal stimulus. I think that’s what they’re going to do. So I think another four rate hikes in September, December, March, and June, that will bring us up to two and three-quarters to 3% on the federal funds rate. I think and I hope they will stop there, because you’re talking about risks. The other risk to the economy is the Fed overtightens the rate. Just as the economy slows down in the second half of next year- and we think it will – ifthey raise rates too much at that point, that could cause problems.

Silverstein:And what will the yield curve look like a year from now after they raise rates?

Kelly:If they stop at four, I think it will be almost exactly flat. In other words, I think the yield on a two-year treasury note will be the same as the yield on a 10-year bond. If they go more than four rate hikes, I think it might get inverted, but- peopleworry too much about an inverted yield curve. It is a broken barometer. It used to be the yield curve was a very good predictor of what the economy was going to do, because why would you buy a long-term bond with a lower yield than a short-term bond? It’s because you think the Fed’s going to cut rates. Why’s the Fedgoing tocut rates? Because the economy’s in trouble. But you can’t trust the long end any more.


Kelly:Well, because central banks have been buying long-term bonds like never before, and they’re basically sitting at the long end of the yield curve, and that’s distorting it. It’s kind of like, I don’t believe in torture, because torture is immoral, but also, a tortured prisoner is going to lie to you. The yield curve is being tortured by central banks, and is going to tell us lies. Now, it doesn’t mean there couldn’t be problems in the future, but we’re going to need a better measure of what’s going on than the yield curve.

Silverstein:And how does an inverted yield curve affect consumers or borrowers?

Kelly:That’s a funny thing. It is a symptom without being a disease. Because, as I said, an inverted yield curve has usually been a problem, or has suggested a problem is coming, because it means the Fed’s worried about something. But if you think about it, American households have got about three dollars in financial, interest-bearing assets for every one dollar they have in debt. And most of those interest-bearing assets are short-term, things like CDs, and most of that data are long-term, things like mortgages, so if you got an inverted yield curve if short rates go up more than long rates, guess what, you’re giving more income to consumers, and you’re not pushing up their expenses. It actually stimulates the economy. And that’s one of the funny things, people worry about it, but it’s harmless as of itself, and if it doesn’t work as a barometer of where the economy is going, there are lots of things to worry about, think about. I wouldn’t worry too much about the yield curve.

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