Fed Should Announce Taper Plans Soon: J.P. Morgan's Kelly

The U.S. economy likely recovered all the strength it lost during the coronavirus pandemic by the end of the second quarter, which presages more gains for the rest of this year and into 2022, says David Kelly, chief global strategist at J.P. Morgan Asset Management.

"It does appear that we are getting past the worst of the pandemic and will be able to get back to normal by the fall in human and economic activity," Kelly said in a recent midyear outlook webinar.

He cited increasing Transportation Security Administration traffic data along with rising credit card activity, mortgage applications and dining out. Although about 9 million workers remain unemployed, there are an equal number of job openings, according to the JOLTS (Job Openings and Labor Turnover Survey), Kelly said.

Rising Inflation

But along with the good news are signs of rising inflation due to rising wages and rising prices, pushing inflation well above the Federal Reserve's 2% target, Kelly said.

Core personal consumption expenditures (PCE), the Fed's favorite inflation gauge — which excludes food and energy — rose 3.4% between April and May, while the consumer price index in May gained 5% over the past 12 months.

"I'm not looking for explosive inflation, but the latest data suggest the increase may be a little more than transitory … because wage growth has picked up and inflation expectations," Kelly said. "Our basic bet is that we have moved to something of a new paradigm."

The Fed's official position has been that the price increases are transitory.

Due to rising inflation and rising asset prices, the Fed should not try to target the 3.5% unemployment rate set in September 2019 — a 50-year low — in its quest for full employment, but instead begin soon to prepare for tapering its bond purchases, Kelly said.

He expects the Fed officials will announce their taper intentions at the annual Jackson Hole, Wyoming, conference in late August or in September and begin tapering in December, with a final unwind 12 months later. Rate increases could then follow in December, followed by further hikes every three months thereafter if the economy stays healthy.

The Fed currently buys $80 billion worth of Treasurys and $40 billion worth of mortgage-backed securities each month as it continues its monetary stimulus to boost the economy, but the mortgage purchases in particular make little sense as home prices surge, Kelly said. "The facts are changing, and the Fed should change their policy in reaction."

Outlook for Stocks

The growing strength of the U.S. economy bodes well for corporate earnings and equity prices, said David Lebovitz, a global market strategist at J.P. Morgan Asset Management who also took part in the webinar.

He's forecasting $190 earnings per share (EPS) for 2021, which represents 36% growth year-over-year and further gains to around $210 EPS in 2022.

"Earnings will continue to rise, but multiples can decline as price gains moderate.

"The elephant in the room is what happens to margins, which are now around 13%," Lebovitz said, referring to profit margins for the S&P 500. "That's unsustainable given the dynamics, especially on the wage front."

He said the stock market has "come very, very fast, and the most important thing now is to hit singles and doubles" using a diversified approach for "a more comfortable ride."

In the meantime, the stock market, which has had an uninterrupted rally since November 2020, when news broke about an impending coronavirus vaccine, is due for a "run-of-the-mill correction."