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Strategy for a Second Gear Economy

April 22nd, 2013

by David Kelly

of J.P. Morgan Funds

American investors could be forgiven for feeling just a little confused. One week after the stock market posted its strongest first-quarter gains since 1998, the Bureau of Labor Statistics announced the weakest monthly job growth in nine months. Real GDP growth was just 0.4% in the fourth quarter but appears to have been much stronger in the first. So is the economy getting stronger or weaker, how is the Federal Reserve likely to react to it and what, if anything, should investors do about it?

On the negative side, the March jobs report was genuinely weak - 88,000 non-farm payroll jobs added when consensus was expecting over 190,000. The unemployment rate fell, but only because half a million people left the labor force, pushing the participation rate down to its lowest level since 1979. Other labor market indicators were more mixed with upward revisions to payrolls for prior months and a gain in the employment component of the ISM manufacturing index being offset by recently rising unemployment claims and layoff announcements. Overall, job creation remains far short of what the economy needs.

However, jobs are only one aspect of the economic picture. On the output side, vehicle sales and housing starts both appear to have hit post-recession highs in the first quarter. Moreover, slightly faster-rising inventories and improved trade, combined with a solid 3%+ gain in real consumer spending, could boost first quarter real GDP growth to above 3%. So which economy is this?

The truth is that the U.S. economy is stuck in second gear. It is being supported by pent-up demand for houses, consumer goods and investment equipment following a deep recession and four years of half-hearted recovery. It is also being helped by a rebound in wealth, with higher stock prices and home prices adding roughly $3 trillion to household net worth in the first quarter alone.

On the flip side, the economy is contending with a sharp fiscal drag. According to the CBO, the federal budget deficit for the first three months of 2013 was roughly $307 billion, down $150 billion from the same three months a year earlier. Indeed, on current trends, due to the combined effects of some economic growth, sharp tax hikes and some spending cuts, the deficit this fiscal year could be as low as 4.9% of GDP compared to 7.0% of GDP in fiscal 2012 (which ended on Sept. 30th 2012).

In addition, the Federal Reserve’s extremely aggressive monetary policy may well be doing the economy more harm than good as very low long-term interest rates discourage lenders from lending, while low short-term rates suppress consumer interest income more than interest expense. Finally, overseas economies are a mixed bag with some strength in emerging markets but dismal recession in Europe.

Given that the Federal Reserve was already employing an aggressively dovish monetary policy before the employment report, weaker job numbers will, if anything, make them even more reluctant to hint at when they might ease up on the easing. However, if we are right in doubting the positive effects of this monetary stimulus, further quantitative easing will do little to quicken growth. Although the economy appears to be in little danger of renewed recession, Washington and the world will have to get friendlier if America is to grow faster.

While a warm-up in either fiscal conditions or the global economy seems unlikely in the short-run, today’s U.S.

economy probably still justifies an overweight position towards equities. With both short-term and long-term interest rates at treacherously low levels, and earnings still likely on a slow growth path, there should be a steady tide of money moving out of fixed income into asset classes, most notably stocks, that have a better promise of long-term gains.

The bottom line is that, given current relative valuations, an overweight to stocks starting from an appropriately balanced portfolio remains justified not by the strength of the expansion but merely by its existence.

Contact JPMorgan Distribution Services, Inc. at 1-800-480-4111 for a fund prospectus. You can also visit us at www.jpmorganfunds.com. Investors should carefully consider the investment objectives and risks as well as charges and expenses of the mutual fund before investing. The prospectus contains this and other information about the mutual fund. Read the prospectus carefully before investing.

Any performance quoted is past performance and is not a guarantee of future results.

Diversification does not guarantee investment returns and does not eliminate risk of loss.

Opinions and estimates offered constitute our judgment and are subject to change without notice, as are statements of financial market trends, which are

based on current market conditions. We believe the information provided here is reliable, but do not warrant its accuracy or completeness. This material is not

intended as an offer or solicitation for the purchase or sale of any financial instrument. The views and strategies described may not be suitable for all investors. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, accounting, legal or tax advice. References to future returns are not promises or even estimates of actual returns a client portfolio may achieve. Any forecasts contained herein are for illustrative purposes only and are not to be relied upon as advice or interpreted as a recommendation.

J.P. Morgan Asset Management is the marketing name for the asset management businesses of JPMorgan Chase & Co. Those businesses include, but are not limited to, J.P. Morgan Investment Management Inc., Security Capital Research & Management Incorporated and J.P. Morgan Alternative Asset Management, Inc.

J.P. Morgan Funds are distributed by JPMorgan Distribution Services, Inc., which is an affiliate of JPMorgan Chase & Co. Affiliates of JPMorgan Chase & Co.

receive fees for providing various services to the funds. JPMorgan Distribution Services, Inc. is a member of FINRA/SIPC.

© JPMorgan Chase & Co., April 2013

NOT FDIC INSURED | NO BANK GUARANTEE | MAY LOSE VALUE

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