Month/Quarter end rebalance could push the market up 7% this week? H2 outlook via J.P. Morgan

This week is the end of the month, quarter and first half of the year. It is a time when most fixed-weight portfolios rebalance their asset exposure.

This week rebalance is important since equity markets were down significantly over the past month, quarter and six-month time periods (hence the various rebalance frequencies reinforce each other), and it is happening in a period of low liquidity. On top of that, the market is in an oversold condition, cash balances are at record levels, and recent market shorting activity reached levels not seen since 2008.

This year the impact of rebalances has been significant due to large market moves and low liquidity. For instance, near the end of the first quarter, the market was down ­10% and experienced a significant 7% rally in the last week going into quarter-end. On the most recent monthly rebalance, near the end of May, the market was down 10% and experienced a significant rally of 7% going into month-end.

Let's look at the current rebalance setup. Broad equities are down 17.93% for the year, 13.66% for the quarter, and 5.33% for the month. Rebalances across all three lookback windows would reinforce and, based on historical regression, would imply a 7% move up in equities this week according to $JPMorgan (JPM.US)$ . This is considering the current market liquidity, as measured by futures market depth, which is five times lower than the historical average. Of course, rebalances are not the only drivers and the estimated move is assuming 'all else equal.' At the same time, bonds would feel moderate downward pressure from rebalances and the increase of yields could further result in rotation towards cyclical equities (and away from defensives).

2. What are the views for the second half of the year of J.P. Morgan's research?

The economics department of J.P. Morgan does not see a recession materializing this year. While the probability of recession increased meaningfully, J.P. Morgan does not see it as a base case over the next 12 months. In fact, it sees global growth accelerating from 1.3% in the first half of this year to 3.1% in the second half. It sees inflation declining from a 9.4% annualized rate in the first half to 4.2% in the second half, which would allow central banks to pivot and avoid producing an economic downturn.

J.P. Morgan also views China's growth will significantly accelerate to 7.5% in the second half. This will provide tremendous support not just to EM Asia assets such as China equities but also for the global cycle. Analysts of JPM believe that in the second half of the year, the realization of economic constraints and realpolitik will lead to progress towards a solution or at least a lasting ceasefire in Europe. The analysts continue to believe in the commodity supercycle and view commodities and commodity-related assets (sectors, countries, etc.) as both a valuable source of returns and a hedge against inflation and geopolitics.

According to J.P. Morgan, risky asset classes could recover most of their losses from the first half if there is no recession. Risky asset prices are too cheap now. For instance, small-cap stocks in the US currently trade near the lowest valuations ever. Many equity market segments are down 60-80%. Positioning and sentiment of investors are at multi-decade lows.