The first time JPMorgan warned of market downside was in early March when the bank's US equity strategist Dubravko Lakos-Bujas wrote that while the fundamental backdrop remains supporting, the "short-term downside risk" in the S&P is increasing. Less than two months later, JPM presented six "red flags" why it is starting to sell stocks. Then, just a few weeks later, JPM turned on the flashing red light again in late May, when the bank "sounded the alarm on the size of US debt, and warned of a financial crisis" while in the interim, JPM's quant Marko Kolanovic on several occasions warned that stocks are poised for a sharp drop due to purely technical and systemic factors. Of course, throughout this period stocks only kept going higher, closing at all time highs last Friday.
So has JPM thrown in the towel on being tactically bearish for months, and re-embraced the "Icarus" meltup in the same way that BofA' Michael Harnett (who realizes a crash is coming but not before the market's last hurrah all the way to 2,550-2,600) has? Nope.
In a note released overnight, JPM's equity strategist Mislav Matejka writes that "we were very constructive on beta until early May, when we advised to cut portfolio risk" and "wquities performed strongly." However, with "key positive catalysts moved behind us, and some red flags started to appear."
Here are the "red flags" that JPMorgan sees as of today:
1) Soft patch in global activity ahead? US growth momentum has turned mixed, with a rollover in manufacturing indicators, credit, housing and car sales. US CESI is in negative territory, which was typically associated with more defensive market leadership. CESI has a good correlation with the S&P500 and points to 10%+ downside for stocks.
China new project starts have turned negative for the first time since summer ’15. On that occasion, a phase of significant de-risking followed. In addition, it was a big stimulus package which stabilised the activity then, but this time around, a new support programme might not be forthcoming. The impact of the Chinese stimulus is fading. This is seen in the sharp decline in new project starts and car sales, among others
Eurozone has been very strong so far, but even that region could see some softness ahead. Eurozone M1, an important lead indicator, points to lower Eurozone PMIs from here.
2) Renewed weakness in pricing coming. Commodity prices are weaker ytd, Brent at -13% and Iron ore at -29%, inflation forwards are down, and yield curves are flattening again. Headline inflation prints could roll over meaningfully, as could Chinese PPI, which has implications for Chinese corporate profitability. All of these are the problems for the credibility of the reflation trade.
3) Earnings outlook to deteriorate, post strong Q1. We were very bullish regarding the upturn in earnings, but the hurdle rate is much steeper now, with elevated consensus expectations and the base effects turning less positive. The potentially weaker activity and pricing prints from here could be the headwinds.
4) Bond yields are struggling to break out of their ytd range, which is an increasing problem for market breadth, health and leadership. The decoupling between internals and the market levels has typicallytended not to last for too long. Bond yields remain strongly positively correlated to the Value/Growth preference and to the Cyclicals vs Defensives performance. Yields need to move higher for the risk-on trade to resume.
5) Summer seasonals are negative and Vix is still in a complacent territory. Equities have posted below-average / negative returns on most occasions during the May-Sept period. On the flipside, Jan-Apr and Oct-Dec have produced strong gains, on average. Vix is currently at 10, near the historical lows. As good as it gets?
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Still, despite the above, JPM is not turning "structually bearish" yet. Here's why JPM believes that any upcoming dips, even 10% ones, are to be bought:
Is the potential increase in volatility during the upcoming summer something that might become more sinister than just the typical profit-taking given poorer seasonals and a likely soft patch in global activity momentum? We don’t think so.
Our medium-term fundamental view remains that equities are in an upcycle and that the potential weakness over the summer should be used as another good entry point. We see the following key medium-term supports:
- Earnings base remains depressed in EM and in Eurozone. There is significant upside potential from here in both regions.
- Credit conditions remain supportive and HY spreads are well behaved.
- Equities are still underowned, where the only buyers over the past 10 years have been the corporates, through buybacks. There are some signs that this is starting to change.
- Even though in absolute terms equities appear pricey, relative value proposition between equities and fixed income still holds.
- USD behaviour might not add to the risk-off concerns. Typically, as one enters a de-risking phase, USD has tended to rally. This, in turn, becomes a problem for EM, as the EM central banks need to hike interest rates in order to protect their currencies, which ultimately hurts EM growth. Also, rallying USD is a headwind for commodity prices. We do not see USD strengthening this time around.
Confused about JPM's ambivalence? Don't worry, so is JPM, which is why the bank leaves it off with the following rhetorical question: "What would make us turn risk-on again?" The answer:
If during the summer, ECB starts to point more forcefully towards tapering, we think that would be taken positively by the market and it might overshadow the potential consolidation phase that we envisage. This is because the ECB’s taper would likely result in two clear positive signals: 1. Bund yields breaking out of their current range; and 2. USD comprehensively rolling over.
Unless, of course, for a market habituated hundreds of billions in central bank liquidity every mont, it is precisely the ECB taper that is the far bigger risk off signal. We should get further insight on this potential risk factor on Thursday when the ECB is widely expected to provide its first substantial tightening hint.