What Lies Beneath: An Updated Outlook on the Economy and Investing

[Music] Hello and welcome to Notes on the Week ahead, a JP Morgan asset management podcast that provides insights on the markets and the economy to help you stay informed in the week ahead. [Music] Hello, this is David Kelly. I'm Chief Strategist here at JP Morgan asset management. Today's August 10th, 2026. The summer of 2026 has been dominated by the AI boom. Some fear that AI is advancing too fast for thoughtful regulation. Others worry that end user revenues will lag too far behind massive capital spending and fast growing debt. From an economic perspective however, AI is pure momentum, generating huge profit gains, adding to investment spending, boosting upper income consumer spending via a wealth effect, and coinciding with very strong gains in productivity. That being said, beneath the AI economy, there's plenty of weakness as was confirmed in last Friday's employment report. Job growth of the past year is barely positive according to the payroll survey and negative according to the household survey. A collapse in net migration has contributed to a significant decline in the labor force, but even with this, a year-over-year wage growth continues to slide, falling below CPI inflation we estimate for a fourth consecutive month in July. Whom building is stagnant, also victim to weak demographic demand and a shortage of construction workers. Employment at both the federal and the local levels is down year-over-year, while exports outside of tech remain relatively soft. An updated view on the US economy requires an assessment of both of these broad trends and begs the central question of whether the AI boom can lift the rest of the economy, or whether the economic expansion and booming stock market could be dragged down by what lies beneath. To address this we review the headwinds and tailwinds impact in the US economy, construct a baseline forecast of key economic variables, and wrap up with some thoughts on Fed policy, the dollar, and what all of this means for investors. So starting with the force is shaping the forecast. The end-game in the Iran War seems clear enough. The US can change the Iranian regime and can't make the straight-of-form moves safer commercial traffic without Iran's cooperation. Consequently, a deal will be brokered by which Iran has some control of the strait and the ability to produce and export its own oil in return for facilitating safe passage to the strait for everyone else and a promise not to develop neutral weapons. A fractured leadership in Iran and vaccination in the US's radio position may delay such an agreement for some weeks more, and this will continue to whittle away global oil inventories. However, the prospect of the deal could allow for relatively stable oil prices for the rest of the year. In 2027, a potential democratic takeover of the House of Representatives and increased economic hardship in Iran may push the parties towards a more durable piece, allowing oil prices to slowly shift down. The administration has announced new tariffs to replace the temporary tariffs imposed following the Supreme Court's ruling of the AEPA tariffs. However, we estimate that these tariffs like the temporary levies would be less onerous than the AEPA tariffs, with tariffs as a percent of imports running at about 7.5% in the fourth quarter of 2026. Compared to 11.5% in the fourth quarter of 2025, we assume the tariff rates stay relatively steady over the course of 2027, as Congress exerts more control over trade policy. The administration's hardlining immigration continues with a notable increase in deportations ordered by U.S. courts, a continued very low level of southern border crossings, and the termination of temporary protected status for Haitians and Syrians. Recent data on legal immigration are unavailable. However, continuing to clients in foreign tourism and foreign student enrollment suggests that net immigration has fallen to very low levels, contributing to a steady decline in the working age population. We assume this continues throughout 2027. The federal deficit for the current fiscal year, which ends in less than two months, will be close to $2 trillion. This, combined with the lack of consistent tariff revenue and other distractions in Washington, suggests that there will be no further stimulus enacted in the current Congress. Moreover, if Democrats win control of the House of Representatives in November, they are unlikely to support further fiscal stimulus. Unless it is financed by higher taxes, an upper income Americans or corporations, something the administration would likely veto. Consumer spending will continue to be supported by the very strong stock market recent years, however, with very slow job growth and population growth, meager wage gains, weak sentiment and no further fiscal stimulus, it is likely that consumer spending growth will downshift in the fourth quarter of 2026 and beyond. The capital spending boom set in train by the race to develop artificial intelligence should be more enduring. The last year saw a 6.7% increase in business fixed investment with very strong gains in equipment and intellectual property being partly offset by continued weakness in commercial construction. In the year ahead, we expect a slight moderation in the growth of equipment and R&D spending being offset by better gains in commercial construction as booming strength in the building of data centers and supporting infrastructure offsets sluggestness elsewhere. While the stock market performance of companies at different points in the AI supply chain could vary widely, it looks like the broad project still has plenty of capital or can raise plenty of capital to support the AI expansion effort. Given all of this, a base case economic forecast remains one of moderate growth, tight labor markets and slowly easing inflation. In particular, economic growth in the second quarter was suppressed by a $34 billion slide in inventory accumulation and a $73 billion widening of the trade deficit. Inventory should form more slowly in the third quarter, actually adding economic growth while trade should only worsen to a small extent. These twin effects should help real GDP growth rise to 2.8% in the third quarter compared to 1.5% in the second. Strong federal defense spending could sustain above 20 economic growth in the fourth quarter. Thereafter however, we expect growth to decelerate to a roughly 2% pace in 2027. A strong investment spending on the AI build-at is offset by weak growth in consumer spending, home building, and the government sector. The July employment reporter, Eurene forced the idea of a labor market that is tight but not strong. Despite steady economic growth, a lack of available workers should hold payroll employment growth to a range of 50,000 to 100,000 per month. Even this endemic pace of job creation should put downward pressure on the unemployment rate, which we expect to fall to 4.0% by the fourth quarter of 2026 and 3.8% by the fourth quarter of 2027. Finally, it should be noted that even with July's unemployment rate of 4.1%, the lowest in 18 months, average hourly earnings rose just a 3.2% euro-year, the weakest gain in over 5 years, underscoring a lack of bargaining power among American workers. We expect this to persist in the months ahead, with the euro-year wage growth falling to 3.0% at the fourth quarter of 2026 and staying relative to be flat thereafter reaching 3.1% in the fourth quarter of 2027. Underlying inflation should fall in the months ahead, even if the pace of decline is frustratingly slow for policymakers and consumers. We expect this Wednesday's July CPI report to show 3.4% year-over-year gain in headline consumer prices down from 3.5% in June. Forces of roading and inflation include rising rental vacancy rates that are restraining rent growth, a less onerous tariff regime than a year ago and moderating wage gains. However, the pace of the wage inflation declines depends on how long it takes to return to normal traffic through the strain of formals. As discussed earlier, we do think this will occur in 2026, and thus allow euro-year CPI inflation to fall to 3.2% by December 2026, dip below 2% euro-year in May, which is the anniversary of this year's inflation spike, and then settle into a range of 2 to 2.5% for the balance of 2027. This should roughly correspond to reaching the Fed's 2% target for the year-over-year increase in the consumption to measure by the spring of 2027. With over 80% of S&P 500 market cap having now reported, the second quarter earnings season has seen spectacular gains. It should be emphasized that the 50% euro-year gain in pro-former EPS reported by FACSET is grossly exaggerated by over $150 billion in unrealized capital gains by two huge tech companies. Without this, the euro-year EPS gain would have been closer to 20%. However, even a 20% gain is remarkable for a slow-growing late-cycle economy. We're over the fact that a well above normal 85% of firms' beat-second quarter earnings expectations speaks to a remarkably positive earnings environment. As companies take advantage of steady economic growth, strong productivity gains, corporate tax breaks from the OBBA, and very tame wage demands for workers. Much of this could continue in the immediate future, with technology companies benefiting from a capital spending boom and energy companies taking advantage of higher oil prices, as the result of the Iran war. While S&P 500 operating EPS will fall back as one time equity gains drop out of the numbers, the broader government measure of adjusted after-tax profits could rise at a high single-digit pace in 2027, following a double-digit gain in 2026. Markets remain deeply divided on whether the Fed will raise the federal funds rate at the mid-September FOMC meeting. At this point, we believe the Fed will stay unhooked. While Chairman Worsh has expressed his impatience concerning inflation exceeding the Fed's 2% target, the committee should see enough evidence that inflation is on a downward path to leave rates unchanged. This may be more dovish than the actions of the European Central Bank, Bank of England, and the Bank of Japan. who are all expected to raise rates before the end of the year. If this turns out to be true, the gap between US interest rates and those of other developed countries should narrow, allowing for resumption of the dollar decline. For investors, this may all appear to be a very benign forecast. However, it's important to put it in the context evaluations. After three blockbuster years of gains, the S&P 5.0 is now up a further 13.3% year to date. Remarkably, given surge in corporate earnings, this still leaves the four PE rates of the index at 20.2 times, elevated, but down significantly from its 2025 peak. However, this is very misleading. Analyst expectations for earnings have been bolstered by its spectacular recent results and forecast a very strong capital spending by major tech firms in the year as a head. At some stage, at least some of these tech firms will disappoint and perhaps cut capital spending as well as write off some of the value of past investments. The acceleration depreciation for tax purposes that was part of the OBBBA helps earnings in the short run but is a drag on earnings longer term. Moreover, it is still by no means clear that these companies will be able to maintain their huge margins, given competitive pressures and rising input costs. Elsewhere, despite very strong gains in 2025 and so far in 2026, international stocks look much cheaper than their US counterparts and can be used with active management to diversify away from a concentrated US AI bet. US fixed income also is fairly priced, particularly if we are correct in our view of inflation and the Fed. Finally, alternative investments, particularly in areas such as infrastructure and real estate can provide further diversification. And this diversification is important in an economy that is as unbalanced as the American economy of 2026. With the latest stock market surge, we estimate that the market value of all US corporate equity is now over 400% of GDP. This compares to 244% just before the pandemic, 204% at the peak of the Dalcom bubble and 74% for the 1987 stock market crash. In the end, the value of American corporations depends to a large extent on the work and spending of the American people. While productivity gains could lift all boats, stock prices are unlikely to continue to soar unless the fortunes of American consumers and American workers see broader improvement. (soft music) Well, that's it for this week. Please tune in again next week. And if you have any questions in the meantime, please reach out to JP Morgan Rep. 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