Voiceover: Welcome to Market Matters, our markets podcast on Making Sense, the hub for J.P. Morgan corporate and investment bank podcasts. In each episode of Market Matters, we discuss the latest news and trends shaping markets today.

Eloise: Hi, I'm Eloise Goulder, head of the Data Assets and Alpha Group here at J.P. Morgan. And today I'm really excited to be joined by my colleagues Andrew Tyler and John Schlegel to talk about U.S. equities following a bit of weakness over the last few weeks. As a reminder, for those of you who don't know, Drew is head of our U.S. market intelligence team and John is head of our global positioning intelligence team.

As always, I'm looking forward to hearing their perspectives on markets from here. So, Drew, John, thank you so much for being here today.

Drew: Thanks for having us. It's great to be here.

John: Yes, great to be with you both.

Eloise: And you're at the start of your week-long London trip. So how are things going so far?

Drew: So far so good. It's always nice to be across.

John: Things are well so far. It's a busy week, but we're looking forward to it.

Eloise: Brilliant. So, Drew, can we start with you?

U.S. equities have obviously been very strong on a six -month view. The S &P 500 is up 24 % from late October lows. But U.S. markets have been weak in recent weeks, losing almost 6 % peak to trough in the first three weeks of April, albeit rebounding a little bit last week. So Drew, can you start by discussing why you think we've seen this bout of equity weakness through April?

Drew: Certainly. So the S&P made all-time highs on March 28th at a little over 5,200.

So that was the day before the Good Friday market holiday. So the next three weeks saw that S&P sell-off that you just referenced, and that also kind of happened as the 10-year yield surged a bit more than 40 basis points. So NASDAQ 100, as well as the Russell 2000, underperformed the S&P by 121 basis points and 287 basis points respectively. So what triggered the sell-off?

So it appears to be a combination of hotter than expected inflation data, which triggered a reprice of the yield curve alongside valuation fears, stress positioning, and general rebalancing of portfolios. So returning to that point on inflation, what we saw was bond markets rapidly reassessing Powell's dovish pivot from December of last year. So the first quarter of 2024, what we saw was an increase in inflation that made investors nervous. And that was illustrated by the bond market going from pricing multiple rate cuts this year, to now being about a coin flip if we even see one rate cut.

So that said, the inflation trend appears to have been a spike in January and then a disinflationary trend throughout the quarter. And this is all based upon the data we saw from the PCE that was released last week, which is the Fed's preferred measure of inflation, not CPI. So another thing to kind of flag is that the Fed has a meeting this week and the market is preparing for a more hawkish tone. And so to kind of sum this up, while the bar to cut rates is very high, the bar to hike is even farther away.

Eloise: Thanks, Drew, that makes sense. So when we think about the equities path from here, what are your views? I mean, you've been bullish equities for over a year now, as you've articulated many times on this podcast series, but the S&P 500 has gained 24 % since last October. And as you say, there are now renewed inflation and hawkish Fed type risks. So when you put it all together, where do you see markets going from here?

Drew: Yeah, that's a great question. So I would say that I remain tactfully bullish. And so the hypothesis can be summarized as this. If you have at or above trend GDP growth, combine that with positive earnings growth and a paused Fed, and that's a bull market for stocks. And that's really what we've seen play out over the last year and a half. So while we have seen a volatile month in April as bond yields surge with the 10-year yield increasing again more than 40 some odd points month to date, none of this has changed the hypothesis materially.

So while Q1 GDP of this year, so 2024 Q1 GDP, did disappoint, this disappointment was mainly due to a surge in imports. And again, that's the consumer spending, albeit on non-US goods. And so what we have seen recently is the U.S. chief economist, Mike Feroli, he did increase his 2024 Q2 estimates for GDP from 1.5 % to 2.5%. And this is being driven by the strength of the U.S. consumer.

And as a reminder, consumption is more than two thirds of the U.S. economy. That consumer strength is what underlies my bullish hypothesis dating back to January of 2023. I think the U.S. consumer will continue to surprise to the upside, pushing equities higher, irrespective of the path of bond yields. That said, the pace at which bond yields move can be a headwind to equities, as evidenced by April's price moves.

Eloise: Thanks, Drew. That's all really helpful. And what a huge upgrade to Q2 2024 GDP forecast from our US chief economist from 1 .5 % to 2 .5%. So, Drew, under this bullish scenario that you hold, which sectors do you think will lead? I mean, over the last six months, tech and consumer discretionary have led. Do you think that continues or do you expect a broadening of the rally?

Drew: So I do think that tech- and AI-related plays will continue to lead the market.

But I do expect that rally to broaden, especially as bond yields stabilize and the market narrative, which had been one of Goldilocks, then shifted towards stagflation, now returning to soft landing. So it's important to note that the rally since late October has actually been fairly broad. So the S&P returned 24%, as you mentioned, but it's also important to note that the Russell 2000 returned more than 22%.

And so if the rally had been a bit more narrow, then you would have seen the divergence between the S&P and the Russell 2000 even larger than that 2% move. And yet another way to consider breadth would be the percentage of S&P 500 members trading above their 200 day moving average, with higher levels meaning more broadness. The average this year has been 75% of those members trading above their 200-day moving average. And this compares to a five -year average of 62%. And since the October lows, that number has averaged 70%.

So I guess another way of saying this is like since that October lows, we've actually seen a very broad based rally. Now it hasn't all been consistent across the last six months, but that's basically what we've seen.

Eloise: Yes, I think that's a brilliant point and it's often underestimated or understated, I'd argue, that the rally over the last six months has been pretty broad.

So on that theme, which sectors in addition to tech- and AI-related plays do you really expect to outperform from here?

Drew: Yeah, so the two-eyed highlight would be financials and industrials and also to kind of within that AI theme, which is going to be very, very powerful, I think, for the rest of this year and potentially throughout 2025. I think people are really going to look for the second and third order plays and not just the handful of names that people recognize.

Eloise: Yeah, makes sense. So you're clearly relying on continued robust U.S. economic growth, plus, as you say, some stability in bond yields to support your bullish equity view

In this context, what are the key catalysts you'll be watching to confirm or potentially to refute this view?

Drew: No, absolutely. So from a macro perspective, I would say that you want to see the ISM prints remain in expansion territory, aka above 50. And then you really need to see CPI stabilize with a preference for a disinflationary trend to resume. So, shifting gears and thinking about this from a micro perspective, it's really the earnings from mega-cap tech and AI-related themes that are most important to markets. But more generally, you want to see earnings growth remain positive. So far, through this earnings season with about half of the S&P companies reporting, that's what we're seeing.

Shifting gears and thinking about the risks, I would highlight macro data that points to a recession, such as non-farm payrolls approaching zero or perhaps even going negative, a spike to unemployment rate, significant declines to consumption, a negative earnings season on either a quarter over a quarter or year over year basis or just in general a spike to inflation.

Eloise: Thank you, Drew. John, over to you. So first of all, with the S&P 500 down about 3% now post the peaks in late March, how much selling have you seen amid this and from who?

John: So that's a great question. I think, you know, given the sell off, it's not surprising that we've seen a number of investor types selling. And I would argue actually it's been very broad. So the types of investors that we see kind of negative flows in cover, you know, the asset managers, the CTAs, hedge funds, even retail sentiment getting a bit more bearish.

So across the board, it seems like it's taking a more negative tone. And if we look at our tactical positioning monitor, the four week change has reached a negative two standard deviation level as of late last week. So, overall, that would suggest it's been a pretty negative skew in the positioning changes, but really coming from a broad base of investors.

Eloise: That's really interesting. Thank you. So where does that leave positioning today?

John: So positioning, to just back up a little bit, had been elevated for a long period of time. It's one of the things that we've kind of noted in the past. We saw a huge increase in positioning in late last year and got to about the 90th percentile by mid to late December and it stayed elevated throughout the next call it three and a half four months and so coming off of those levels that were around the 90th percentile, which is where we arguably were about a month ago, we're down to basically neutral. So our overall aggregate positioning score is 0.1 standard variations now, so basically at average and it's really come from, once again, if I look at the underlying components, we have hedge funds who have taken down their net leverage a bit for the long short funds down to about the 70th percentile, they were as high as the 85th percentile a few weeks ago. If I look at CTAs, they were running around the 90th percentile versus data over the past 20 plus years and that's down to about the 40th percentile. So, you know, across the board and I could go through other stats, but in general, the story is one of going from elevated level positioning as the markets continue to rally throughout Q1 to a very neutral level as of late April.

Eloise: Thank you. Well, in a way, I think it's quite surprising that positioning levels have dropped so significantly back to neutral levels versus history, in spite of the fact that U.S. markets, the S&P 500 is still up a full 24%, as we've said, over the last six months. And on the face of it, given the bullish fundamental backdrop that Drew just articulated, that could be quite an attractive setup for equities. I mean, is that your base case from here, John?

John: So at this stage, it is our base case. Part of this is because when we look at the negative four -week changes in our tactical positioning monitor, it did trigger what we consider an attractive setup for US equities as of early last week. And so typically, the one to four-week increases are better following those scenarios than they are on average. And even it extends on a three-month period. So arguably, that negative impulse does suggest a better and cleaner setup for equities going forward.

If I think about like how much positioning came off, given the rally and that we're still up so much, as you mentioned earlier, I think part of what this reflects is that the rally wasn't simply a positioning move. And a lot of this came from the combination of strong macro data, strong earnings and things that Drew has articulated multiple times in the past. And so you don't necessarily need positioning to keep going up or it can be high and the markets can still work if the underlying data is strong.

And so, in terms of what this could mean in terms of the drop in positioning and where we are today, there's some amount of this that looks very similar to the fall of last year, where in August, you had a similar level of market decline, similar level of positioning decline, things stabilized for a few weeks and actually rebounded a bit, and then they sold off further.

And the main catalyst for that was concerns about a recession as well as rates going higher. And so I think some of those risks are still there, but at the moment, as long as rates stay contained and the growth narrative holds up, I think this positioning being neutral could be supportive for equities in the near term. And then the one other scenario that we're thinking about, which once again points to a bit more positivity in the near term, but more mixed outlook in the medium term, is the late 2010 to early 2011 period.

So the way the markets performed into that period, the way positioning was and how elevated it was for a long period of time, it looks very similar across none of these metrics. And if we think about what happened there, after you got the pullback, which was about 6 .5%, I think, in March of 2011, you saw markets actually rally a little over 8%, but stay kind of range-bound over the next, call it three to four months. And so, there's some of that that does seem appropriate as sort of an analogue to what we're seeing today and where we could see things go.

Eloise: Thank you, John. And just going back to this neutral aggregate positioning level that you see in US markets, I mean, that's what you see at the index level. Presumably, there's a lot of bifurcation under the surface.

Which sectors do you see as particularly stretched and which sectors do you see with lighter positioning at this stage?

John: So I think it's probably no surprise that one of the most well-owned sectors remains tech in the U.S. I think it's not necessarily all coming from funds chasing the performance. It depends on which investor type we're talking about. But overall, I would argue tech across investor types is still one of the most well-owned.

And so, you know, it needs the earnings to be there, I would argue, to keep things going. On the flip side, you know, with more bearish positioning, we see at least from hedge funds is actually in some of the consumer related plays. So there's been a bit of bearishness that's crept into some of the retail stocks, which arguably had performed very well prior to this month. Also, some of the home builders have seen some selling. And I would argue generally some of the consumer plays is where we see that more of that negativity. And one of the areas that we still see a bit of reticence to really buy into what's been a decent rally, at least earlier this year, is banks. I know that's one Drew mentioned. It's one that still seems very interesting to me, because even in the large cap banks, which have done better than some of the regional banks, we don't see funds willing to really buy into that in a meaningful way in the US. And so I think there's still arguably a decent amount of positioning upside, both from the hedge fund and ETF perspective.

Eloise: So banks seems to be the sector that Drew believes in fundamentally and John, you're highlighting that positioning is particularly light there. So certainly one to watch. Thank you. So final question for you, John, from your perspective, are there any other catalysts or risk factors that you would be watching?

John: Yeah. So I think the one that's come up the most throughout the last few months is risk to a momentum unwind which generally means the stocks that had been winning for a long time start to underperform, the stocks that have been lagging starting to outperform.

We've seen momentum in the U.S. as a factor be pretty choppy despite the market sell off. And I think, you know, the key risk, in my opinion, is rates going down because of better inflation data that gets some of the laggards, small caps or riskier stocks to see a decent cover bid on the short side. And I mention this because when we look at the sensitivity of hedge fund positioning and performance to momentum as a factor, a lot of it, or the majority of it, really comes from the short side.

So if you get that impulse of rates down for the right reasons, and you get new life breathes into some of those companies that have been pressured by the higher rate environment, I think that's the catalyst where you could see a bit more of this rotation, arguably in probably a rallying market of the laggers once again, sort of coming back to the fore and outperforming.

Eloise: Thank you. So between the two of you, you've really identified two quite distinct risks there. Drew, on the one hand, identifying the hawkish narrative, higher inflation, Fed not cutting perhaps this year in the way that we had expected. And that could, in the extreme, be negative for markets. But on the other hand, John, you highlighting that actually if bond deals come down from here and macro data remains strong and it's positive for equities as a whole, that could be negative for momentum because of course the short leg could disproportionately rally and that could hurt hedge fund returns.

John: That's correct. Yep.

Eloise: Great. Well, thank you both, Drew and John, for articulating such clear views once again. Lots to watch from here. Really appreciate you coming in and taking the time to record this with me.

Drew: Well, thanks for hosting us. It's been a pleasure.

John: Yeah, it's been great.

Eloise: Thank you also to our listeners for tuning into this bi-weekly podcast series from our group. If you have feedback or if you'd like to get in touch, then please do go to our website at jpmorgan.com/market-data-intelligence, where you can send us a message via the contact us form. And with that we'll close. Thank you.

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