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Download attachment-1 Global Equity Strategy and Quantitative Research US Portfolio Strategy: Equities Sell Off, But Deep Correction Is Unlikely   The S&P 500 reached its all-time high on May 21 and since then has corrected by roughly 10%. While this drawdown has shaken up investor sentiment significantly, it should not necessarily come as a complete surprise given the unprecedented period of market calm that we’ve had. In fact, this has been the third longest period in almost 90 years that US equities have gone without a 10% or greater correction. In our July US Portfolio Strategy report (Further Downside, But a Deep Correction Unlikely) we highlighted that a total correction of roughly 10% was reasonable to expect. Our JPM Composite Macro Indicator (CMI) remains in deceleration phase of the business cycle since this January, but above levels that signal outright recession. Further, our market Momentum Diffusion Indicator (MDI) fell into negative territory at the end of June for the first time since 3Q 2011, when S&P 500 corrected by more than 10%. We remain cautious in the short term given outstanding global risks and higher degree of technical market deterioration, but view a deep correction as unlikely. While it is hard to pinpoint the exact bottom of the current sell-off, we view this as an opportunity to start buying the dips. Technicals are significantly oversold. S&P 500 has now closed at 1893, which is 4.96 standard deviations below its 50 DMA. A negative move of this magnitude has only been seen on two prior occasions since 1900—on Oct. 19th, 1987 (Black Monday) and on May 13th-14th, 1940 when Germany invaded France (WWII). However, market rebound will likely be a slow grind higher. Globally, “animal spirits” will probably stay subdued as rate of return and productivity growth remains unexciting. After years of QE, central banks’ ability to provide fresh stimulus is more likely limited. Sep. and Oct. are seasonally weaker months and volatility should remain elevated. Nov. and Dec. months are seasonally stronger, with “window dressing” effects often times a catalyst for momentum trades into year-end. Our year-end S&P 500 EPS and price targets remain positive, but due to continued US Dollar strength we revise down our EPS target from $123 to $120 (vs. consensus of $119). Our lower EPS target coupled with multiple de-rating driven by technical market deterioration leads us to also revise down our year-end price target for S&P 500 to 2150 from 2250. Why is US recession unlikely? Domestic growth is moderate and should remain on a sustainable path, with housing and consumption cycles not exhausted. Our Economists are calling for 2% and 2.5% US GDP growth in Q3 and Q4, respectively. While the current correction and China slowdown will likely have some negative feedback into US real activity, the effect should remain limited. Exports to China account for only ~1% of US GDP. Moreover, S&P 500 has limited revenue exposure to China (2-3%) and EM (6-7%). Further, previous market peaks were characterized by several conditions that we do not see present today, where (1) Fed Funds rate is not high or rising and is likely to remain low for longer with the Fed Futures curve implying 24% probability of a Sep. hike and 47% by year-end, (2) 10Yr bond yield remains low (2.0%) and expensive versus equities with S&P 500 Fwd EY at 6.3% and Total Yield (Dividends + Buybacks) at 4.1%, (3) extreme inflation (high or low) is not currently present, (4) oil prices falling should be a net-net positive for US, (5) profit margins are high and moving sideways but lower commodity and borrowing costs are likely to continue providing a cushion, (6) ISM manufacturing (52.7) and non-manufacturing (60.3) indices remain above 50 implying continued positive growth, (7) yield curve has flattened but is not close to inversion territory. Risks to watch—Investor sentiment will likely remain fluid and market volatility elevated; prolonged equity market weakness can erode consumer confidence, dent consumer spending and stall housing recovery; China growth continues to disappoint, causing tightening of global financial conditions and creating a negative feedback loop for economic growth; FED monetary normalization deviating from street expectations, can induce further appreciation of US Dollar and weigh in on US earnings. Sector Positioning—We favor Consumer Discretionary, Healthcare and Technology, while underweighting Utilities, Telecom, and Industrials. Healthcare ex-Biotech (OW) and Technology (OW) should benefit from their stronger revenue growth profile in an anemic global growth environment. Also we expect positive earnings surprises as companies in these sectors prove capable of holding margins even in a strong dollar environment. We upgrade Consumer Discretionary (from N to OW) as the sector should benefit from the lower oil price and given expectations of rising wage growth with the unemployment rate reaching NAIRU. The sector should benefit from improving labor market trends, high consumer sentiment, and lower gas prices. Also, the strong dollar is beneficial for companies that import from abroad and sell in the US (Multi-line and Specialty Retail). Downgrade Financials (from OW to N) as Fed hike expectations get pushed back (Fed Futures curve is implying 24% probability of a Sep. hike and 47% by year-end) and the yield curve flattens; we wait for a better re-entry point. Downgrade Industrials from (N to UW), which is a sector that is an early cycle play with higher US dollar sensitivity, lower pricing power and lower margins. Upgrade Staples (from UW to N); a combination of lower bond yields (rotation into bond proxies) and lower oil prices warrant an upgrade to this sector. Composite Macro Indicator—The Composite Macro Indicator (CMI) leads the turning points in the Coincident Economic Indicator and continues to suggest that the Business Cycle is in a “deceleration” (or “contractionary”) state and that macro activity will be slower in the coming period. Of the various factors used in constructing CMI, many growth-related as well as sentiment-related indicators contributed to the fall. At the same time, liquidity and inflation-related indicators showed improvement. In all 43% of indicators are signaling “deceleration” while 29% of the indicators are signaling “recovery”. The early signs of CMI turning up in May proved to be a false dawn as the indicator fell back in June and July—we are watching cautiously for broader signs of recovery. While we expect economic activity to be slow in the coming period, this does not necessarily translate to an economic recession but rather signals a significant weakening of macroeconomic conditions. Indeed, we have seen similar episodes in 2011, 1998, 1986 when the economy experienced a significant deceleration without tipping into recession. We expect growth in the US to rebound over the coming quarters, as dollar and oil-related headwinds largely pass through. The broader business cycle that started in ’09 should remain mostly intact with room to expand further, albeit likely limited. Style Positioning—Given the relationship between style rotation and the business cycle, our analysis would typically suggest that in a deceleration phase investors should favor high Quality as well as low Volatility, increasingly move in favor of Value over Growth and reduce their exposure to Momentum (Figure 27). However, in the late part of slowdown and early phase of contraction, being overweight Value is fraught with risk. As a result, like last month, we are recommending Neutral stance on Value versus Growth and also to stay Neutral Momentum. One, Value factors work best after market dislocation, usually in late deceleration or early recovery phase of the cycle. While the US seems to be in an intra-cycle scare, global uncertainties suggest it may be prudent to wait before going fully overweight Value. When risk aversion is rising, Value may struggle. Perhaps the best sign that investors are ready to embrace the risky part of the equity spectrum is when bond yields rise. Furthermore, though dispersion in stock valuations is picking up, it remains close to its historical low suggesting limited Value opportunities. Similarly, Momentum is likely to reverse only in the late part of deceleration/contraction and early recovery. Two, though CMI continues to suggest deceleration, a closer look at the indicators suggests that we remain on the cusp between deceleration and recovery. This leads us to be Neutral on Momentum rather than Underweight. In sum, this month we are recommending a continuation from last month—continue to favor high Quality and low Volatility and a Neutral stance on Value, Growth and Momentum. Size Positioning—Small-Cap Risk/Reward Remains Unattractive even after the Recent Underperformance. Russell 2000 has seen its relative outperformance YTD of +4.4% (as of June 25th) decline to only +0.3%, which we believe is likely to erode further for the following reasons: (1) rising rate environment is associated with higher market volatility; (2) in this environment growth capital becomes scarcer with declining issuance activity; (3) small-caps have a higher reliance on shorter duration debt; and (4) widening corporate HY spreads and an expected pickup in default rate from 1.5% in 2015 to 3.0% in 2016. Recommended investment themes (see pg. 25) ·         Housing Recovery Trade (JPAMHOUS)—Housing market fundamentals remain constructive with a pick-up in demand, tightening supply, high affordability, low household leverage, and easing credit standards. Taken together, we believe these are likely to be drivers of an outperformance of equities levered to the housing recovery. The J.P. Morgan US Housing Basket is composed of a diversified portfolio of companies that have direct or indirect exposure to the US housing market and should benefit from the continued pick-up in residential investment—both direct beneficiaries of housing (e.g., Homebuilders, Building Products) as well as derivative industry plays (e.g., Durables, Retail, Financials). ·         Contrarian Energy Picks (JPAMENRG)—In a lower-for-longer oil price scenario, we think this is an opportune time for investors to get back into the J.P. Morgan US Energy Basket, which provides exposure to higher-quality/lower-breakeven Energy companies that J.P. Morgan fundamental equity analysts suggest are best positioned to outperform in a depressed oil environment. ·         Airlines (JPAMAIRL)—Out of favor by investors just a few weeks ago, the Airlines sector has been the beneficiary of the sympathy trade as oil prices continue to weaken. The J.P. Morgan US Airlines Basket is up +9% in 3Q, outperforming the S&P 500 by ~1300bps and the benchmark XAL Index by ~1600bps. Although there is near-term risk to the sector if oil moves higher or if investors continue to question management commitment to capacity discipline, we agree with our Airlines analyst and think long-term investors should stick with this sector as it continues to be attractively valued (2016E P/E only 9.7x vs. Transports 12.7x, Industrials 16.0x, SPX 16.9x).

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