Quarterly Perspectives UK Q2 2017

Transcription

1 Quarterly Perspectives UK Q2 217 J.P. Morgan Asset Management is pleased to present the latest edition of Quarterly Perspectives. This piece explores key themes from our Guide to the Markets, providing timely economic and investment insights. THIS QUARTER S THEMES 1 US equities: keeping a lid on expectations 2 Fixed income: investing in a rising rate realm 3 European equities: be greedy when others are fearful 4 Correlations up, dispersion down: what are market internals telling us? STRATEGISTS Stephanie Flanders Managing Director Chief Market Strategist for the UK & Europe Tilmann Galler Executive Director Global Market Strategist Vincent Juvyns Executive Director Global Market Strategist Dr. David Stubbs Executive Director Global Market Strategist Maria Paola Toschi Executive Director Global Market Strategist Michael Bell, CFA Vice President Global Market Strategist MARKET INSIGHTS Guide to the Markets UK Q2 217 As of 31 March 217 Alex Dryden, CFA Associate Market Analyst Nandini Ramakrishnan Associate Market Analyst

2 1 US equities: keeping a lid on expectations Plenty of opportunity to improve the business environment There are numerous ways that the new US administration could potentially improve the environment for American businesses. As the right-hand chart of page 3 shows, the headline tax rate in America has not changed in the last decade, while many other developed market economies have cut their headline rates. Lowering the corporation tax would deliver an earnings boost to US corporates of all sizes. As the top left-hand chart shows, the US ranks 51st in the world when it comes to the ease of setting up a business. This puts the US behind many other developed market peers, discouraging entrepreneurs and damaging growth prospects. One of the most discussed taxation changes so far this year has been the implementation of a border adjustment tax effectively a tax on imports into the US. The bottom left-hand chart highlights which sectors would be most adversely affected by the potential change in tax policy. OVERVIEW US equities have rallied by more than 1% since the US Presidential election on the prospect of additional fiscal stimulus, tax cuts and deregulation, as well as an improvement in the broader economic environment. There is scope for deregulation and lower business taxes under the Trump administration to improve the business climate, supporting US earnings and economic growth. However, implementing major tax cuts is easier said than done and any fiscal expansion is likely to come at the cost of higher borrowing and government debt. Global economy 3 US business environment Difficulty of setting up a business Country rank, higher score indicates more difficult Foreign content of domestic sales % New Zealand Canada Australia UK Russia France US Italy Spain National tax rate on corporate income %, including local government taxes GTM UK Clothing Tech Autos Energy Staples US Japan Italy Germany Canada UK Source: (Top left) World Bank, J.P. Morgan Asset Management. Economies are ranked on their ease of doing business by aggregating scores across 1 equally weighted topics. The US scores highly in two categories (getting credit and resolving insolvency); however, it scores poorly on other measures such as difficultly of starting a business. (Bottom left) US Department of Commerce, J.P. Morgan Asset Management. (Right) Deutsche Bundesbank, OECD, J.P. Morgan Asset Management. Guide to the Markets - UK. Data as of 31 March % 4% 41% 33% 37% 31% 39% 3% 36% 27% Headline rate 3% 2% The long-term growth outlook also looks challenging. The labour market has tightened, leaving further growth dependent on rising output per head, or productivity. This could constrain equity market returns relative to earlier stages of the cycle and to other markets. However, a bear market looks unlikely in the short term, given the relatively low risk of a recession. Valuations are above their long-run average but are not at worryingly high levels. According to the World Bank, it is easier to start a business in UK, Russia and France than it is in the US. Source: Guide to the Markets UK, page 3 2 QUARTERLY PERSPECTIVES Q2 217

3 Fiscal stimulus is difficult and the long-term growth picture looks challenging There has been plenty of talk of fiscal policy stimulus in Washington, but the US has a federal budget deficit of 3.2% of GDP and many in President Trump s own party are not in favour of increasing it substantially, given the relatively high level of US debt. A more important question at this stage of the cycle is how fast can the economy grow without triggering inflation? This will depend crucially on the supply side of the economy particularly labour force growth and the growth of productivity (or output per head). The right-hand chart of page 28 of the Guide to the Markets shows that both of these drivers could be constrained going forward. The top left panel shows that growth in the US working age population is likely to be far lower in the coming decade than it was in the past. The bottom left panel shows that investment an important driver of productivity growth has been subdued but has picked up slightly in recent quarters. A pick up in productivity growth due to higher investment and rising animal spirits is quite possible and would allow the US to grow faster than it might have done otherwise. But there is little scope for any administration to raise the potential growth rate dramatically in the space of a year or two. This suggests that investors should have only modest expectations for US equity market returns going forward. Long-term drivers of US economic growth GTM UK 28 Global economy Growth in US working age population % increase in civilian non-institutional population ages % % 1.5% 1.% 1.3%.7% '55-'64 '65-'74 '75-'84 '85-94 '95-'4 '5-'14 '15-'24 Growth in investment in structures and equipment Non-residential fixed assets, year on year % change Forecast*.4% 216: 1.6% '55 '6 '65 '7 '75 '8 '85 '9 '95 ' '5 '1 '15 Drivers of US GDP growth Average year on year % change % 1.4% 3.% 2.% 3.3% 2.1% Growth in workers + Growth in real output per worker Growth in real GDP 3.1% 1.5% 3.2% 1.3% 1.3%.4% 2.8% 1.1% 1.2% 1.6% 1.9%.9% '57-'66 '67-'76 '77-'86 '87-'96 '97-'6 '7-'16 Average US economic growth over the last decade is less than half of what it has been over the previous 5 years. Source: (Top left) Census Bureau, DOD, DOJ, J.P. Morgan Asset Management. *Forecast by J.P. Morgan Asset Management. (Bottom left) BEA, BLS, J.P. Morgan Asset Management. (Right) BEA, BLS, J.P. Morgan Asset Management. GDP drivers are calculated as the average annualised growth between Q4 of the first and last year. Future working age population is calculated as the total estimated number of Americans from the Census Bureau, controlled for military enrollment, growth in institutionalised population and demographic trends. Guide to the Markets - UK. Data as of 31 March Source: Guide to the Markets UK, page 28 J.P. MORGAN ASSET MANAGEMENT 3

4 Recent economic data suggests a bear market is unlikely Despite the fact that returns may be constrained going forward, the chances of a bear market remain low. The left-hand chart of page 49 shows a composite of several leading economic indicators vs. the S&P 5. Typically, a composite of leading economic indicators will decline ahead of a bear market. However, as the leading economic indicator index continues to trend upward, it is likely that there is still underlying support for the equity market going forward. Recently, investors have also expressed concern about US equity valuations. At 17.7x forward earnings, the S&P 5 is 13% above its long-run average. While no longer as inexpensive as it has been, valuations for the S&P 5 remain well below the levels they reached during the dotcom bubble in Equities 49 US S&P 5 equity indicators Leading economic indicator vs. S&P 5 performance Index level 13 2, Leading economic indicator S&P 5 '98 ' '2 '4 '6 '8 '1 '12 '14 '16 GTM UK 49 Forward P/E ratio x, multiple Jul 1999: x Mar 217: x Average: x 1 '9 '92 '94 '96 '98 ' '2 '4 '6 '8 '1 '12 '14 '16 S&P 5 Shiller cyclically adjusted P/E x, adjusted using trailing 1-year average inflation-adjusted earnings 5 31 Mar 217: 29.x 4 ' '1 '2 '3 '4 '5 '6 '7 '8 '9 ' '1 Source: (Left) Conference Board, FactSet, Standard & Poor s, J.P. Morgan Asset Management. (Top right) Standard & Poor s, Thomson Reuters Datastream, J.P. Morgan Asset Management. Forward P/E ratio is a bottom-up calculation based on the most recent price data divided by consensus estimates for earnings in the next 12 months and is provided by FactSet Market Aggregates. (Bottom right) FactSet, Robert Shiller, J.P. Morgan Asset Management. Guide to the Markets - UK. Data as of 31 March ,4 2,2 2, 1,8 1,6 1,4 1,2 1, Average: 16.7x INVESTMENT IMPLICATIONS The US equity market rally seen since the presidential election has been partly driven by global hopes of reflation, but expectations for deregulation and business tax cuts have also played a role. This seems reasonable, but investors should probably keep a lid on their expectations for large-scale US fiscal stimulus. Economic growth at this later stage of the economic cycle will be constrained by the tightness of the labour market and dependent on growth in productivity. This, in turn, is likely to lead to lower returns for US equities than we have seen over the last few years. In the short term, a bear market remains unlikely in an economy that does not look in immediate risk of entering a recession. Investors must be aware that valuations are not as attractive as they used to be, but US equities do not look dramatically overvalued relative to past periods. At the height of the dotcom bubble, average forward P/E ratios reached 24.5 x forward earnings. The S&P 5 is still well off from the valuations at those exceedingly high levels. Source: Guide to the Markets UK, page 49 4 QUARTERLY PERSPECTIVES Q2 217

5 2 Fixed income: investing in a rising rate realm Government bonds are not the haven they once were Fixed income yields have been falling for the past few decades and despite the recent uptick since summer 216 are currently at the lower end of their historical range. It is not just government bonds that are low, but much of the fixed income universe, including global investment grade, high-yield bonds, emerging markets (EM) debt and other fixed income assets. Given the view that the US Federal Reserve will continue raising interest rates and bond prices in the market will echo those rises, the 3 year-plus downtrend in yields looks to be going into reverse, albeit slowly and with some resistance. This paradigm shift means that investors should pay close attention to the fixed income holdings in their portfolios. Capital returns in the fixed income market may be significantly impacted by rising rates. The bottom chart on page 62 from the Guide to the Markets shows the hypothetical impact of a 1% rise in local interest rates on selected fixed income sub asset classes. Government bonds would likely be impacted the most, while the juicier coupon payments of high yield, EM debt and convertible bonds would offer a buffer to those losses, even making the return effects positive in some scenarios. OVERVIEW In July 216, nearly 4% of global government bonds were trading at a yield of below zero. Now, only 23% have a negative yield and yields are expected to rise further as global growth, inflation and interest rates pick up. This potential reversal, after decades of falling yields, raises challenges for fixed income investors and long-duration sovereign bonds, in particular. However, not every bond market has responded the same way. The yield on a 1-year US Treasury has risen.9% since the summer of 216, while equivalent yields have risen.5% in Germany,.3% in the UK and.3% in the Japan. At this pivotal time for fixed income markets, investors need to consider not just duration risk, but also the great variety of fixed income assets, some of which could actually benefit from rising rates. Fixed income interest rate risk GTM UK 62 Current and historical yields for selected indices % yield, fluctuations over the last 1 years* How to interpret this chart Max Source: (Both charts) Barclays, Bloomberg, FactSet, J.P. Morgan Asset Management. *Historical yield range is based on the last 1 years of data, with the exception of local currency emerging markets debt, which is based on eight years, due to data availability. Fixed income 1 5 UK Gilts 1-3 years 5-7 years 1+ years Floating Investmentgrade rate credit High yield EMD USD EMD USD EMD LC Convertibles sovereign corporate sovereign Illustration of the impact a 1% rise in local interest rates may have on selected indices % change, assumes a parallel shift in the yield curve and spreads are maintained Average Current Min Price return Total return Fixed income sectors shown are provided by Barclays and are represented by: Treasury UK: Barclays Sterling Aggregate Gilts; Floating rate: Barclays US Floating Rate Notes (BBB); IG credit: Barclays Global Aggregate Corporates; High yield: Barclays Global High Yield; Convertibles: Bloomberg Barclays Credit/Rate Sensitive; EMD sovereign USD: Barclays Emerging Markets Sovereigns; EMD corporate ($): Barclays Emerging Markets Corporates; EMD sovereign (LC): Barclays Emerging Market Local Currency Government. For illustrative purposes only. Change in bond price is calculated using both duration and convexity, with the exception of Convertibles, which is historical change. Guide to the Markets - UK. Data as of 31 March 217. A 1% rise in local interest rates could wipe away 18% of long-dated gilt price returns. UK Gilts 1-3 years 5-7 years 1+ years Floating rate Investmentgrade credit High yield Convertibles EMD USD sovereign EMD USD corporate EMD LC sovereign 62 Source: Guide to the Markets UK, page 62 J.P. MORGAN ASSET MANAGEMENT 5

6 Avoid putting all your fixed income eggs in one basket Within fixed income, there is a wide array of options, each with its own risk-and-return profile. As shown on page 61 of the Guide, no single sub asset class has outperformed the others consistently over the past few years. A diversified approach, and one that focuses more on higher-yielding securities not just government bonds could provide robust returns. Although fundamental measures of investment-grade bonds, such as leverage and interest rate coverage, are not at some of their best levels, robust demand from institutional investors has lifted the prices over the past six years. (Shown on page 66 of the Guide to the Markets). Alternatively, for emerging market debt, since many EM currencies have already weakened significantly against the US dollar, the upside for asset prices in these currencies and countries may higher than before, and the risks somewhat diminished. In the high-yield space, leverage measures are reassuring for both US and European high-yield. We show this on page 68 and 69 of the Guide to the Markets. The energy sector within the US high-yield universe for example, no longer has the burden of a low oil price. Alternatively, in Europe, the high-quality nature of the market gives investors a different risk-and-return profile compared to the US high-yield market. INVESTMENT IMPLICATIONS Investors should expect rising yields in core bond markets. This could have negative effects on capital return in portfolios. But this doesn t mean all fixed income should be avoided; in fact, some fixed income assets will benefit from a rise in yields. Look for returns in areas of the market that will be supported by specific factors. An active approach to choosing global investment grade, high yield, convertibles and EM debt are worth considering at a time when the interest rate tides are turning. Global fixed income: Yields and returns GTM UK 61 Fixed income US HY EM Debt Euro HY US Corporate IG Portfolio UK IG US Treasury YTM (%) Characteristics Size Duration (GBP bns) (years) Correlation to: 1-year Gilt 1-year UST 6.2 1, , , Fixed income sector returns Q117 : 11.6% 18.9% 7.7% 4.1% 2.5% Euro HY Infl Linked EM Debt US HY EM Debt Lcl: 8.8% 18.9% 1.8% 17.5% 3.8% 5.4% 14.1% 6.7% 3.8% 1.9% US HY US IG US Treas. EM Debt UK IG 7.4% 7.5%.8% 9.6% 1.9% 1.6% 14.1% 5.1% 27.5% 1.8% UK IG UK Gilts US IG Euro HY Infl Linked 1.6% 14.1% -.7% 1.1% 1.8% -.1% 12.8% 3.% 26.6% 1.8% Infl Linked EM Debt Portfolio US IG Euro HY -.1% 6.2%.1% 6.1% 1.6% -2.2% 12.5% 1.2% 24.2% 1.6% Portfolio Portfolio UK Gilts Infl Linked UK Gilts -1.4% 9.3% 1.2% 24.2% 1.6% -3.4% 12.5%.9% 22.9% 1.5% US IG UK IG US HY Portfolio US HY -1.5% 12.5% -4.6% 1.6% 2.7% -4.2% 11.6%.7% 2.5% 1.2% UK Gilts US Treas. UK IG US Treas. Portfolio -4.2% 5.1%.7% 1.% 1.9% 1-yr ann. 12.5% US HY 7.5% 11.6% EM Debt 6.6% 1.4% US IG 5.5% 9.4% Euro HY 6.9% 9.2% Portfolio 6.6% 8.9% US Treas. 4.% 8.8% Infl Linked 8.8% Government bonds have already suffered negative returns. But the returns from corporate credit have been far higher. UK Gilts 1.4 1, % US Treas. -2.7% 8.9% US HY 2.5% -.9% Infl Linked -.9% 12.3% UK IG 12.3%.% US IG 1.2% 6.4% UK Gilts 6.4% Infl Linked % EM Debt -8.3% -1.6% Euro HY 5.5% -4.6% Euro HY.5% 1.7% UK Gilts 1.7% -.5% US Treas..7% 6.% UK IG 6.% 61 Source: Barclays, BofA/Merrill Lynch, FactSet, FTSE, J.P. Morgan Economic Research, J.P. Morgan Asset Management. YTM = Yield to maturity. Annualised return covers period 27 to 216. US HY: BofA/Merrill Lynch US High Yield Constrained; EM Debt: J.P. Morgan EMBI+; Euro HY: BofA/Merrill Lynch Euro Non-Financial High Yield Constrained; US IG: Barclays US Agg. Corporate Investment Grade; UK IG: Barclays Sterling Agg. Non-Gilts Corporate; UK Gilts: J.P. Morgan UK Global Bond; US Treasuries: Barclays US Agg. Gov. Treasury; Infl Linked: BofA Merrill Lynch UK Gilt Inflation-Linked Government. Hypothetical portfolio (for illustrative purposes only and should not be taken as a recommendation): 2% UK Gilts; 15% US Treasuries; 1% Linkers; 15% US IG; 1% UK IG; 1% US HY; 5% Euro HY; 15% EM Debt. Returns are unhedged in sterling and local currencies. 1 years worth of weekly data is used to calculate the correlation to UST and Gilts. Guide to the Markets - UK. Data as of 31 March 217. Source: Guide to the Markets UK, page 61 6 QUARTERLY PERSPECTIVES Q2 217

7 3 European equities: be greedy when others are fearful Europe s economy looks healthier than in many years, despite political risks The European economy is continuing to improve, with unemployment falling rapidly. This should continue to be supportive for consumer confidence and overall demand. Trends in retail sales and industrial production are also positive, as consumption and industrial output continue to recover. This is unsurprising, given both are recovering from a low base as the economy has endured two recessions in the last decade, leaving plenty of pent-up demand and spare capacity. Business survey data is the strongest it has been in six years, and is at levels that have historically been consistent with real GDP growth of more than 2%. With inflation also rising, nominal growth and hence company sales are likely to be the strongest in many years. OVERVIEW The European recovery looks healthier than in many years, but political risks have kept investors on the sidelines in advance of key elections. However, the polls suggest that French political risk may be overstated. This could provide an attractive potential buying opportunity for European equities as political downside risks subside. Key to stronger European performance will be faster growth in earnings, which has disappointed for many years. Earnings expectations are now being revised up and companies are starting to deliver the growth required to drive returns higher. Eurozone growth monitor GTM UK 18 Global economy Change in unemployment and unemployment rate Thousands of people per three months (LHS); % rate (RHS) 2, 1,5 1, Change in unemployment Recession Unemployment rate Retail sales and industrial production Index level 12 Industrial production (LHS) 115 Retail sales (RHS) ' '2 '4 '6 '8 '1 '12 '14 ' ' '2 '4 '6 '8 '1 '12 '14 ' Composite PMI and GDP Index level (LHS); % change year on year (RHS) 65 PMI GDP 35 ' '2 '4 '6 '8 '1 '12 '14 ' The European composite purchasing managers index is a leading indicator of GDP and suggests growth be poised to accelerate further. Source: (Left and top right) Eurostat, Thomson Reuters Datastream, J.P. Morgan Asset Management. (Bottom right) Eurostat, Markit, Bloomberg, J.P. Morgan Asset Management. Light grey columns in all charts indicate recession. Guide to the Markets - UK. Data as of 31 March Source: Guide to the Markets UK, page 18 J.P. MORGAN ASSET MANAGEMENT 7

8 European companies are finally starting to deliver on earnings growth For European equities to really start to perform, companies will need to deliver on earnings growth. The good news is that after five years of earnings expectations being consistently revised downwards, downgrades have finally stopped this year and expectations are even being revised slightly higher. Not only are earnings expectations rising, but actual delivered earnings have also started to grow, with growth spreading across most sectors. Energy remains a drag, but if oil prices remain at current levels or higher, year-on-year earnings will soon turn positive for the energy sector as well. Within European equities, we expect the cheaper parts of the market to outperform. When investors are concerned about global growth prospects and worried about deflation, growth stocks, which can grow their earnings irrespective of the strength of the economy, are favoured. Hence the recent underperformance of value stocks, as bond yields fell along with growth and inflation expectations. However, when global growth and inflation are picking up and bond yields are rising, investors tend to rotate out of overvalued growth stocks and into undervalued value stocks. MSCI Europe ex-uk performance and drivers GTM UK 41 MSCI Europe ex-uk earnings and performance Index level, next 12 months earnings estimates (LHS); index level (RHS) MSCI Europe ex-uk EPS MSCI Europe ex-uk index level 1,4 1,3 Europe yearly earnings trend EPS, rebased to 1 in January Equities ,2 1,1 1, Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Europe earnings by sector EPS, % change year on year Expectations for European earnings growth are no longer being downgraded '8 '9 '1 '11 '12 '13 '14 '15 '16 '17 Source: (Left) MSCI, Thomson Reuters Datastream, J.P. Morgan Asset Management. (Bottom right) FactSet, MSCI, J.P. Morgan Asset Management. EPS is earnings per share. (Top right) Goldman Sachs, J.P. Morgan Asset Management. Yearly earnings trend is Stoxx 6. Guide to the Markets - UK. Data as of 31 March Source: Guide to the Markets UK, page 41 8 QUARTERLY PERSPECTIVES Q2 217

9 The end of European equity underperformance? The underperformance of European equities since the financial crisis can be almost entirely explained by the underperformance of European earnings. Comparing the sector composition of the main European equity index to the S&P 5 goes a long way to explaining this relative shortfall in earnings. The European equity market has lower exposure to expensive growth stocks such as some tech companies, and higher exposure to financials and commodities, both of which have struggled in recent years. Financial sector companies find it particularly difficult to grow earnings in an environment of extremely low interest rates and flatter yield curves, which reduce the gap between the rate charged to consumers and businesses and the underlying borrowing rate for banks. With these key headwinds now receding, forecasts for European earnings are looking up, and so is the probability that European equities might finally outperform. Relative performance of European equities Europe vs. US: Relative performance and earnings Europe vs. US sector breakdown Rebased to 1 in December 22 % of index 3 MSCI Europe ex-uk Europe index and earnings 25 outperforming US 2 S&P 5 15 MSCI Europe ex-uk/s&p 5 1 earnings 5 GTM UK 4 INVESTMENT IMPLICATIONS For investors who can stomach the political risk, now could be a good time to take advantage of the caution of others, which has prevented many from buying into the improving European economic fundamentals. European equities should be helped by a fall in political risk, if Marine Le Pen loses the French election, and by an improvement in earnings growth, which is finally starting to come through after many years of disappointment. Europe s long-term challenges remain. But an improvement in the earnings outlook would take away the main handicap that has held back European equities relative to the US since 21. So investors could be rewarded for broadening out their equity exposure to include more European equities. Equities MSCI Europe ex-uk banks relative performance vs. German 1-year yields Rebased to 1 in 29 (LHS); % (RHS) MSCI Europe ex-uk/s&p 5 performance US index and earnings outperforming Europe MSCI Europe ex-uk banks relative to index Source: (Left) FactSet, MSCI, Standard & Poor s, J.P. Morgan Asset Management. (Top right) MSCI, Standard & Poor s, Thomson Reuters Datastream, J.P. Morgan Asset Management. Commodities is materials and energy combined. Consumer is consumer staples and consumer discretionary combined. (Bottom right) FactSet, MSCI, J.P. Morgan Asset Management. Guide to the Markets - UK. Data as of 31 March 217. German 1-yr yields Rising yields should be positive for the performance of financials, which are a large part of the European index. 4 Source: Guide to the Markets UK, page 4 J.P. MORGAN ASSET MANAGEMENT 9

10 4 Correlations up, dispersion down: what are market internals telling us? A new regime? Investors have enjoyed significant returns from the equity markets since the end of the Global Financial Crisis. The post-crisis period has also been marked by elevated levels of correlation within equities, with the stocks of different companies bouncing around together. At the same time, investors were swinging between hope that the recovery was progressing well and fear that a relapse was around the corner. This risk-on, risk off behaviour has characterised the investing landscape for so long that one could be forgiven for assuming it had become a permanent feature until a few months ago. Throughout the second half of last year, stocks started to move more independently of one another, and the dispersion of sector returns (how differently each sector was performing relative to the others) has also risen. This phenomenon has primarily been driven by certain sectors surging higher: financials (as interest rates rose and hopes of deregulation in the US grew) and energy and materials stocks (as commodity prices continued their recovery). These sector movements have also helped explain the outperformance of value vs. growth in the second half of 216. OVERVIEW Equity markets have been relatively stable so far in 217, but under the surface, significant shifts are occurring. Sector movements are playing an important role. Energy and materials stocks have rallied as commodity prices have risen. Financial stocks have surged on the back of reflation and policy hopes. Together these have driven significant dispersion in sector returns in most equity regions. Correlations between stocks are also dropping, although this could end once sector movements settle. These movements could indicate that investors are returning to stock-level differentiation as the macroeconomic worries of the postcrisis period fade. Correlation and dispersion GTM UK 6 US equity sector dispersion Percentile, inter-sector dispersion per quarter 12-month moving average Equities 6 '1 '3 '5 '7 '9 '11 '13 '15 '17 Number of days where the S&P 5 has moved +/- 1% Average global stock-to-stock correlation 16 %, rolling six-month average pairwise correlations YTD: 1 Average: 2 days days '95 '97 '99 '1 '3 '5 '7 '9 '11 '13 '15 '17 ' '2 '4 '6 '8 '1 '12 '14 '16 Source: (Top) MSCI, Thomson Reuters Datastream, J.P. Morgan Asset Management. Dispersion is a measure of relative returns of each equity sector in the index, weighted by the size of each sector. The greater the dispersion, the more difference there is between the performance of significant parts of the index. (Bottom left) Standard and Poor s, FactSet, J.P. Morgan Asset Management. (Bottom right) MSCI, Bernstein Research, J.P. Morgan Asset Management. Correlation is a measure of how similar the price changes of each stock are relative to the other stocks in the index. The lower the correlation, the less similarity between the movements of stocks. Guide to the Markets - UK. Data as of 31 March 217. Recent quiet in equity markets has been masking big moves under the surface. Source: Guide to the Markets UK, page 6 1 QUARTERLY PERSPECTIVES Q2 217

11 Calm on the surface but with movement underneath Somewhat counter-intuitively, all this movement within stock markets has actually led to a period of notable calm at the index level. On average, the first quarter sees 18 days in which the S&P 5 has moved up or down by more than 1%, the same period this year saw only 2 days where such movements occurred. It is not clear at this point whether this pattern will persist in coming quarters. The big sector movements have been crucial in the correlation breakdown we have witnessed and, as the surge in those sectors abates, correlations may rise again. If correlations remain low, we may have entered a new investing regime where investors are less concerned about macroeconomic instability and more interested in company-specific factors when making an investment. In this case, active managers could have a greater opportunity set than before, and value investing may well be more rewarded than in the recent past. As markets have already delivered impressive returns to investors this cycle, the coming years may well be more about generating alpha within stock indices, rather than riding the market as a whole higher. Equity markets and reflation S&P 5 average P/E ratio in various inflation environments US bond yield vs. value/growth performance* Relative index level (LHS); % (RHS) GTM UK 5 US 1-year yield INVESTMENT IMPLICATIONS The jury is still out on whether correlations between stocks have truly transitioned from their elevated post-crisis levels. If current conditions persist, the opportunity set for active stock selection would appear to be richer than in recent years, potentially boosting the probability of outperformance by skilled managers. Value stocks and cyclical sectors would likely outperform in that scenario. If the willingness to differentiate between stocks reflects a greater confidence over the resilience of the global economic cycle, then more flows may soon follow, injecting further dynamism into the equity market rally. If things play out that way, then growth stocks, which investors tend to buy when growth is scarce, would likely underperform Equities S&P 5 trailing P/E Value/growth US bond yield vs. banks/staples performance** Relative index level (LHS); % (RHS) Banks/staples US 1-year yield As stocks have entered an inflation sweet spot, value and cyclicals have started to outperform. 8-1 to to 1 1 to 3 3 to 5 5 to 7 7 to 1 1 to 15 >15 US inflation ranges (% CPI y/y) Source: (Left) Robert Shiller, J.P. Morgan Asset Management. (Top right) FactSet, Russell, Tullett Prebon, J.P. Morgan Asset Management. (Bottom right) FactSet, MSCI, Tullett Prebon, J.P. Morgan Asset Management. *Value index is the Russell 1 value index. The growth index is the Russell 1 growth index. **MSCI USA index used for both banks and consumer staples indices. Guide to the Markets - UK. Data as of 31 March Source: Guide to the Markets UK, page 5 J.P. MORGAN ASSET MANAGEMENT 11

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