JPMorgan Sees Market Overcoming Stock Rout, But Beware Trade War

Despite a

harrowing week
for U.S. stocks, market conditions are looking favorable heading into the second quarter, according to JPMorgan Chase & Co.

Conditions for stability will probably come together in the second quarter, and asset allocations should remain oriented toward growth, JPMorgan strategists led by John Normand wrote in a note Friday after the S&P 500 closed down 6 percent for the week. They also suggested, however, that a potential trade war is a threat to economic growth.

“Two of four conditions for market stability have been met (tamer inflation, not-so-hawkish Federal Reserve), and the two others could align in the second quarter (stable activity data, de-escalation of trade conflict),” the strategists wrote.

Their recommended asset allocation includes being overweight equities versus bonds; long financials, industrials and oil; and selectively long on emerging markets.

While there’s now a risk premium for worse growth through bad policies, the strategists said that U.S. sanctions this year “equate to less than 0.5 percent of U.S. gross domestic product,” and China’s retaliation this week has been “disproportionately mild.”

‘Catch-All Theme’

So far, 2018’s huge dispersion in asset-lass returns defies any “catch-all theme,” they wrote, though “the cleaner link between macro trends and markets may explain why only bond managers seem to have generated much alpha this year.”

JPMorgan sees potential for “idiosyncratic” catalysts in the coming quarter.

Positive:

  • U.S. equities: first-quarter earnings season, where earnings growth of at least 15 percent year-over-year is seen
  • European equities: possible further earnings surprises relative to the U.S.
  • U.S. Credit: issuance should decline if the usual seasonal pattern repeats

Negative:

  • Widening London interbank offered rate-overnight index swap spreads
  • Geopolitics, which is unlikely to fade as U.S. foreign-policy focus pivots toward Iran

The strategists said the Libor-OIS spread has been the greatest source of client inquiry over the past two weeks, though they haven’t highlighted it because the move seemed temporary given the Treasury’s issuance strategy.

“We suspect spreads will need to stabilize or narrow before investors feel comfortable enough with funding rates to add risky market exposure,” they said.

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Soaring U.S. Libor Trickles Into Funding Markets Worldwide

As for the focus on Iran, “at least the U.S. cannot directly threaten oil supplies by embargoing a country it doesn’t trade with,” JPMorgan said. Enlisting Europe to tighten sanctions could put a risk premium into oil prices, a danger for a global economy where retail-sales growth has been mediocre.

“We stay hedged against this risk through longs in Brent and in oil currencies” such as the Russian ruble and Norwegian krone, the strategists said.

‘Cautious Stance’

In equities, the strategists see concerns over inflation, bond yields and central banks as overdone, and see equities falling further only if bond yields also go down. The growth backdrop should be the primary focus — and a recent deterioration in macro indicators is unlikely to build on itself, while bonds are looking overbought.

The JPMorgan strategists want “to be buying the dip,” while maintaining a somewhat more cautious stance on emerging markets, commodities, tech and cyclicals.

In terms of credit, while they haven’t revised their year-end 2018 spread targets, the strategists suggest they might not make the same forecasts today.

“It feels like we have transitioned into a higher-volatility environment earlier than expected,” they wrote, requiring “some sort of spread reset.”

In currencies, U.S. trade policy is among the factors to watch, they said, but “basic directions of our foreign-exchange forecasts are little changed from the beginning of the year.”

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