Markets: ‘We came a little fast and furious out of the gate this year,’ strategist says

J.P. Morgan Asset Management Global Market Strategist Gabriela Santos joins Yahoo Finance Live to share her thoughts on the markets' performance year to date.

Video Transcript

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JARED BLIKRE: And now we want to bring in Gabriela Santos, JP Morgan Asset Management Global Market Strategist. As I promised you before the show, no questions on balloons. But I do have to ask you about the US stock market. And just to kind of set things up, Wednesday last week, we had this big Fed meeting. We saw stocks rocket to multi-month highs here. People are excited, new highs the next day.

Then we get that payrolls report, a little bit heavier, a little bit hotter than expected in terms of the number, down for that day in the S&P 500. And now people are saying maybe that was an interim top. Does a Fed know what it's doing? What's the outlook here?

GABRIELA SANTOS: I think the trick is, we came a little fast and furious out of the gate this year in terms of equities, in terms of bonds and credit. And there has been progress, right? We are seeing disinflation. We are close to the last rate hike. We have priced in some better soggy growth into earnings expectations. They're down 7 percentage points since May. So investors are reducing underweights and getting a little bit more involved in adding risks, especially on the equity side.

With that said, it is not surprising that there is some consolidation here and perhaps even a period of some further downside in risk and in the bond market because fundamentally, we still have unanswered questions. Where does inflation settle? Are there going to be rate cuts? And can the economy and earnings get through this period without a period of contraction?

So we don't want to go to the other extreme and go overweight equities quite yet. We think a small-- very small underweight makes sense. We don't want to be chasing everything here so far so soon.

DAVE BRIGGS: Yeah, given the earnings that we've seen thus far, it is surprising. The NASDAQ's been up all five weeks this year and the S&P four out of five weeks this year. Can that type of momentum continue?

GABRIELA SANTOS: So it does seem to us that we are perhaps starting or perhaps soon will start a period of some consolidation and even a selloff in the equity market again, going back to that earnings question. Now, we have made some progress. Back in May, we were expecting 9.7 percentage of earnings growth for this year. We're now expecting consensus 2 and 1/2.

So there's been progress, but that is still too high for a soggy economy with wages rising, higher interest rates, and higher corporate taxes. So we just think, given that scenario, which is still kind of a soft landing scenario, earnings need to price in a small contraction of minus 5%. And then if you start pricing in the risk of a mild recession in the second half of the year, then you're talking about an earnings contraction of minus 10%, minus 15%. So it goes back to that earnings question, the margin pressure, the decline in demand, and the need to still price that into the equity market and the credit market.

JARED BLIKRE: Yes, and we haven't seen the credit market fallout. I've seen spreads pretty tight recently. So let me ask you if I'm getting this right. You're not expecting the bottom to fall out. We have-- we're probably going to have a negative quarter of earnings growth in the S&P 500 this quarter. Maybe we get one next quarter. So we get that earnings recession. But how deep are we talking about here? And what's the potential headwind? What's the-- where are we wrong?

GABRIELA SANTOS: Exactly. We don't imagine the bottom to fall out, quote, unquote, or an earnings contraction like you've had in the previous two recessions, which then is minus 20%, minus 40%. We're not talking about that kind of scenario. And we've also adjusted expectations over the past few months, a little bit lower, which is good.

With that said, we're still to be seen a period where we need to better price in that contraction I mentioned of minus 5% for just a soggy economy or minus 10% to 15% for a mild recession. So we're not quite there yet. So where we shake out is we're past the period of being very underweight equities versus bonds, but we're not quite at the other extreme of being overweighted. We want to be close to that neutral with a very small underweight.

And especially when it comes to credit, we want to still be leaning into investment-grade over high-yield because spreads are extremely tight in high-yield, 400 basis points. And we think there would be a better entry point later in the year when they get above 700 bips.

DAVE BRIGGS: Many a guest sat in that seat and killed the 60/40 portfolio time and time and time again. You say it's back why?

GABRIELA SANTOS: We do absolutely say it's back because this is the year where we're talking about disinflation not inflation. And inflation what-- was what was so damaging to both sides of that 60 and the 40 last year. And now we're really talking about a period of bringing inflation back down to Earth so bonds can react as a diversifier. They're reacting much more to recession fears.

So you've got that diversification benefit. And for both sides, you now have a better entry point in terms of valuation for the long run. So we're the most optimistic, not short term, but long run returns that we've been since 2010.

And it's not just in the US. It's also in international. We would take that other side of the China discussion. China, emerging markets, and Europe is where we would already be overweight on the equity side versus the US.

DAVE BRIGGS: We'll take optimism in whatever form it comes. Gabriella, nice to see you. Thanks so much. Appreciate that.