Equities update at mid-year: What drove the recent rally and what’s next?

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Edwina Lowe: Hi, and welcome to J.P. Morgan's Making Sense. I'm Edwina Lowe from our Data Assets and Alpha Group, and today I'm delighted to be sitting down with Eloise Goulder for this two-part episode discussing initially the long-term strength that we've seen in markets of late. We'll then hand over to John Schlegel and Drew Tyler to discuss nearer-term dynamics and implications from here.

So Eloise, we've seen a particularly strong run in markets over the last three years or so, with the S&P delivering over 20% in both 2023 and again in 2024, and over 15% last year in 2025, and we've had a particularly strong start to the first five months or so of this year. Could you give a bit of context to what we've seen and what you consider the key drivers to have been behind this outperformance?

Eloise Goulder: Yes, absolutely, Edwina, and as you say, it has been a very unusually and consistently positive period for global equities and U.S. equities in particular. So in terms of your questions on the drivers well, I would summarize it as the macro, the micro, and then just the sheer strength of the tech and the AI industry.

So on the macro front, despite an aggressive rate hiking cycle through 2022 and 2023, and that was really to tackle inflation post the Russia-Ukraine conflict, and also in spite of the Liberation Day tariffs that we saw start last year, real GDP growth in the U.S. has just continued to be very resilient. We've seen over 2% real GDP growth in each year since 2023. So that has been providing core support on the macro front. If we then turn to the micro front, the micro economy, the bottom-up earnings for US corporates has also been incredibly strong. We actually see earnings for the S&P 500 having roughly doubled since 2019. So a large chunk of equity market gains have been driven by real underlying earnings growth. Now where have those earnings come from? For a long period of time, they were predominantly coming from tech and the Mag 7. In 2024, about half of earnings growth was delivered from the Mag 7, but it was only really in the last year or so that we've seen the rest of the S&P 500 begin to catch up with strong earnings growth as well.

And that takes me to my third point another very significant driver of equity market strength in recent years, and that's been AI and AI CapEx. Now if we look at what the Mag 7 have reported at Q1 earnings, they are expecting to spend about $700-billion on CapEx this year. The majority of that CapEx being spent on AI related infrastructure. At $700-billion, that represents more than 2% of U.S. GDP, and that is not a static 2%. That 2% has been created over the last few years. That comparable AI CapEx spend number was only around $100 billion back in 2021. So AI CapEx is absolutely contributing towards meaningful GDP growth. We're now at the stage where you can't have a view on the macro economy without having a view on the micro economy because these handful of names are making up a large chunk of both growth at the GDP level, but also earnings growth. Of course, there is a question as to how sustainable this trend is, nearly 100% of operating cash flow from the Mag7 goes on this CapEx. What are the returns on this investment? These are key questions, but indeed they do help explain the strength in the stock market.

Edwina Lowe: So if I was to summarize the key drivers of what's been behind this particularly strong equity growth that we've seen in recent years, it would be firstly, the macro resilience, secondly, the micro earnings growth, and then thirdly, the significance of AI CapEx.

Eloise Goulder: Yes and I guess the final point is that we have also seen some multiple expansion. I mentioned that earnings have roughly doubled from 2019 to today, but stock markets have obviously more than doubled. And so that remainder of that has been multiple expansion. The trailing price earnings for the S&P 500 is now running at well above historical averages. And this does really reflect the hope or the expectations of supernormal future earnings growth, presumably catalyzed by AI and the strength of the tech cycle right now. And this goes into one of the key risks, the circularity of the strength in markets at this stage. Like all cycles, many aspects of this are interrelated.

There's the GDP growth, as I mentioned, a large chunk of U.S. GDP growth at this stage is coming from AI CapEx. There's earnings growth where some of the earnings growth reported from the Mag 7, for example, are coming via private investment markups, a very function of the fact that private investments have gone up in value. There's circularity in AI cash flows in one company's spending, a Mag 7, being another company's earnings growth, AI capex beneficiaries, semis companies. There are multiple elements of circularity in this, which are a positive reinforcing cyclical factor right now, but we do need to be aware that they could reverse at some stage in the future. But bottom line is there's been macro, micro and AI support for this stock market rally, plus some multiple expansion reflecting further hope of growth.

Edwina Lowe: So amidst this strong market growth that we've seen over recent years, we've seen a significant and sustained pickup in volumes. Why is that?

Eloise Goulder: Yeah, we've seen this massive rise in equity volumes. As you say, U.S. equity volumes are up two and a half times. So they've more than doubled since the pre-COVID 2019 levels. In terms of the drivers, I'd argue there's a few. It's a function of the significant rise of the retail investor. It's a function of the rise in options use and options availability and the creation of shorter dated options, including zero day to expiry options. It's a function of this enormous growth in off exchange and dark pools, a trend away from lit markets.  And it's also a function of other investor types growing on the scene. So quant hedge funds is one significant group which has been growing in share of volumes. And finally, in terms of investor types, we've seen this rise in the thematic investor, both from an institutional perspective in that we've seen a rise in thematic investing mandates, but also from a retail perspective in that the retail investor very frequently discusses themes that span multiple sectors on social media. And I think this is natural in a period where you're going through immense structural change with tech and AI right now, whether this is akin to the dotcom revolution of 25 to 30 years ago, or whether this is more akin to, say, the railroad revolution or even the industrial revolution of 200 plus years ago.

We've also seen a rise in passive investors, generally over the last 10-20 years. And of course, the rise of thematics is giving rise to thematic ETFs around many of these themes. So all of these significant changes in market structure, and it's really changed the nature of our roles, hasn't it Edwina, in terms of what we need to be providing to our investing clients?

Edwina Lowe: Absolutely, yes. If I was to pick up on firstly, the retail investor, we make available our social media data set precisely for that reason, so that people can stay aware of what the retail investor is talking about online, and therefore likely to act upon in terms of their investing decisions. And it's worth highlighting that we did a dedicated podcast discussing the retail investor a couple of months ago. And then secondly, your point about the disproportionate growth that we've seen in the quant hedge fund investor base, I would say that what we see there is this strong appetite for data, and that data can come in different guises.

We've talked about these strong drivers that have contributed to this significant outperformance in equity markets over recent years, but it would be remiss of me not to ask you about the risks, particularly Eloise, because I'm aware that your own view is more nuanced.

Eloise Goulder: Yes, well, circularity keeps coming up, doesn't it? And to some extent, it's natural in any cycle. One positive feeds on another positive and vice versa. But of course, there are warning signs. These warning signs don't mean we're at the top, we're at the peak. But it does mean that it's critical to be on top of what they are.

A related risk is around concentration, that 10 stocks in the S&P 500 now make up about 40% of the index. So to the extent that that handful of stocks become vulnerable, this could bring the index down with it. There are also crowding risks, as we've discussed on this podcast series before.

Outside of these markets related risks, I would say from a more macroeconomic perspective, the three key risks to watch are one, inflation. We've obviously had another geopolitical conflict this year in Iran, and inflation is ticking up as a result. And we haven't yet seen the full pass through from that, but it remains a significant risk and bond deals have been widening as a result. Unemployment is another risk. The unemployment rate has been rising in recent years. And as we all know, with AI cost savings, there is a knock on vulnerability for unemployment.

And finally, I'd mention indebtedness of the government sector. It's quite staggering the extent to which governments have raised debt over the last five, 10 years. We're now at the stage where global government debt represents about 95% of global GDP. The question is whether AI induced productivity gains will allow us to grow out of this indebtedness.

Edwina Lowe: And it's worth pointing out that as a team, we have our own positioning and sentiment indicators that we use all the time to monitor these things.

Eloise Goulder: Absolutely. Tracking, positioning and sentiment is key to understanding the relative risk reward playing out in the market at a given point in time. If positioning is extreme, very high versus history, then of course, the bar for positive surprises is that much higher and the risk reward is less favorable. The good news right now is that positioning is not looking too extreme. Our tactical positioning monitor, which John will talk to shortly, is only just above the historical average levels at this stage. And that gives me a lot more comfort around the bullish view. But yes, going back to our toolkits, we have our tactical positioning monitor from our positioning intelligence team and we have our tactical sentiment monitor from our data intelligence team. And tracking those two is proving to be incredibly powerful in both directions.

Of course, right now, we're tracking to see if they get too elevated over the short term or the longer term. But back in late March, for example, we were tracking them on the other side. They both got pretty depressed. And it was really that last week of March where both fell significantly on a one month view that gave us confidence to call for a tactical upswing in markets.

Edwina Lowe: Well, I think this is a natural point to wrap up our conversation, Eloise, and to hand over to John and Drew from our wider team to talk more tactical and near-term market dynamics. So thank you very much, Eloise, for joining me today.

Eloise Goulder: Thank you so much.

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John Schlegel: Thanks, Eloise and Edwina for all your thoughts. Hi, my name is John Schlegel, and I head up our Positioning Intelligence team at J.P. Morgan. And I'm here with Drew Tyler, who heads up our Global Market Intelligence team.

Drew Tyler: Thanks for having me, John. Good to see you.

John Schlegel: Great to be back with you, Drew. So we are going to talk a little bit about the more tactical view on markets from both what's going on in the broader macro economy as well as the positioning angle. I just want to note that we're recording this on Tuesday, June 9th, and there's a number of key catalysts coming up in the near term that could change the outlook quite a bit. So I just want our listeners to be aware of that.

So maybe first, starting on the rally that we've seen and the macro resilience that's been present throughout that. We've had really good earnings. There's been strong AI CapEx numbers. If you have to translate this into a tactical view for the next few months, where do you land?

Drew Tyler: Yeah, so the first thing I would start with is just kind of the underlying macro fundamentals, right? And so where we're seeing right now is a U.S. economy that I would characterize as good and getting better, right? And so some of the things that we'll look at to judge that are the health of the labor market. So what is the consumer doing? How much money do they have? How much are they willing to spend? The answer to that with both, it's a lot. But then from there, when we map this to earnings, which is the other key driver of U.S. equities, what we saw was a very exceptional kind of Q1, right? We're about 10% top line revenue growth. Then we saw about 27% kind of earnings growth with broadening margins. And I think that that translates to a very healthy outlook from here. But that said is as we're kind of sat here with a number of near term catalysts, I do kind of worry, right? Is inflation going to be something that we need to consider once again? And as we kind of have seen in the past, when you increase bond volatility, you tend to kind of see stocks decline.

John Schlegel: Well, that's great. I mean, I think the backdrop of the earnings being so strong this past quarter does set things up pretty well. But tying into that bond market risk a little bit, do you have a base case that yields will trend higher because of inflation? How does the situation geopolitically play into that? Does it swing you much more tactically cautious or just modestly more in the buy the dip camp?

Drew Tyler: So our chief economist, Mike Ferroli, has a forecast of 2.5% GDP growth for the second quarter. Now I think when we look at the second half, there are upside risks that are there from an impulse from growth, right?

So the growth trajectory should, in theory, bring bond yields a little bit higher from here. Now the risk factor is what we're seeing from Strait of Hormuz and the energy-related inflation. And really the question from here is, does that energy shock then broaden out to other inflation categories, what we refer to as core inflation? And is that quote unquote sticky, meaning it takes a little bit longer than we would expect for it to get back to a 2% level. That's really the key risk.

John Schlegel: Got it, so bond yields higher for the right reasons, because growth is so strong, not necessarily going to be anything detrimental. Maybe change the makeup of what works and what doesn't. But really if the inflation risk comes through more strongly, then we could see a bit of a soft patch.

Drew Tyler: Absolutely.

John Schlegel: Going back to the AI CapEx, you know Eloise highlighted the scale of this. What's the bullish case in their term versus what do you think could break it?

Drew Tyler: And that's kind of the multi-trillion dollar question, right, as measured by market cap globally. So I think on the positive side is, we see that AI, it works, right? There's not any ambiguity around that. And so right now it still is a question of, how quickly do we build the infrastructure? And there's headlines today that even China's about to spend 295 billion U.S. dollars building out additional AI facilities within China. So I think right now the natural trajectory is going to be for that entire theme to continue to appreciate higher. Now what we have seen in terms of behavior are clients moving from some of the more obvious plays, that being the hyperscalers, the quote-unquote Mag seven, to who are the other beneficiaries. And we've seen that this year very clearly within semiconductors. And so is that Korea being up almost 100% year over year, or is it more along the lines of like, we want to find other kind of plays inside of like, whether that's Europe or LATAM or in the U.S.? And so I think that behavior's going to continue. Where's the best value? And so I think like that trend continues to go higher.

Now in terms of what could break it, that's the toughest question out there. So I think on one hand, we always talk about valuation getting too high. Historically, valuation has never broken a bull market, but it is something that can trigger rotation out of the U.S. So I think that's the behavior we saw towards the end of last year. Now in terms of other things that might make people nervous is the cost of tokenization. And so for those listeners that are not aware, every time you do something on AI, it costs a level of tokens, and agentic AI is even more expensive. And there have been some headline risks around companies telling their employees to curtail some of their usage due to the token spend relative to the return on investment.

So it becomes an AI return on investment argument, maybe that rears its head again. Now aside from that, I guess you could think about what are the bottlenecks to AI? Well on the construction side, you have everything from labor force, then you also have electricity, and that's become a political issue in the United States, but a little less so outside of the U.S. To sum it up, I would say adoption rate and how do you power it are probably the two biggest risks that could create a near-term headwind to the AI trade.

John Schlegel: Yeah, so some things to be mindful of, but it sounds overall quite positive. Maybe one of the things that comes up in terms of broader risks out there is AI-induced unemployment. What's your take on this?

Drew Tyler: Yeah, so I think right now it's probably a little bit overblown. I think what we have seen is there are examples of large tech companies who have spent so much on their tech build that they're now losing money. That's very different than we can replace you with a technology, and I don't think that we're there yet.

Now could we get there in the next year or two? Absolutely, and I think that's one of the reasons why you see so many people looking at physical AI. Because we've already seen industrial robots and warehouses for some of the Mag7 companies. We're starting to see this in terms of farmland, right? So whether this is planting new seeds, milking cows, whatever it might be. In general, I would sum it up as I think that AI is going to be a productivity boost, specifically in white-collar jobs. Now, for anything that appears to be repetitive, we will replace that with automation, fine, but I also think that this looks a lot like what we saw in the late 90s and into the early 2000s, a productivity boost that's going to end up being a boon to GDP, a boon to earnings, and a boon to the global economy.

With that in mind, maybe you could walk us through kind of a little bit more generally what you think about positioning, what you're seeing kind of aggregate across the U.S., across the globe, and maybe touch on one or two key themes that really stand out.

John Schlegel: So I think what's interesting about this whole AI theme is how global it is. So what's interesting, if you were to look at the pecking order of where clients we think are most long versus less long, it really starts at the long end of the spectrum in Asia. So areas like Korea, Taiwan, parts of tech in Japan are very long and honestly, the highest we've ever measured. If you look beyond Asia, the U.S., there are certainly pockets where people are very crowded in, and I would say it's generally the AI, semis, tech hardware trade, but less so outside of that complex. And so the overall position in the U.S. we think is a little bit above average, but not extremely so.

And then if you look further afield to Europe, which doesn't have that many AI-native companies, positioning we think is still pretty light. Call it the 30th, 40th percentile, a little below average, not extremely bearish, but definitely lighter than we see elsewhere. And I would say Hong Kong is the other region, if you will, where positioning has been somewhat light.

Drew Tyler: So another topic that comes up a lot is the concept of seasonality. And we've heard the old adage of sell in May and go away. But in your experience, can you walk us through some of the things that you've seen from seasonality in the mosaic of flows as well as factor exposure?

John Schlegel: Yeah. So I think what's interesting about what you mentioned in seasonality is we don't really see the flows turning bearish from a directional standpoint in May or even June. They, in fact, turn a bit more positive in June. But the driver of that tends to be a shift towards continued funds adding to the long side of the book but starting to lighten up on short. So it actually is this bullish impulse from a net directional perspective into early July, and then it starts to come off a little bit. I think what's a bit more topical for some of our more hedge fund clients is that their leverage levels currently are very high. And the impulse to continue to increase that typically continues into the middle part of June. There are a number of large index rebalances that are taking place right now that also catalyzes some of this. But that starts to flip in late June to July.

So what we're a bit wary of is given how crowded positioning is on the long side and things related to AI, and then on the short side and things that are being hurt by AI or concerns around the consumer, there could be a bit of a reshuffle if you were to see this typical pattern of some deleveraging to occur in late June into July, which also has historically tended to coincide with a bit of momentum weakness. Not necessarily a big drawdown, but we've seen some weakness over the last few weeks, and that could continue to be a bit choppy over the next month. So those are the types of things that we're a bit mindful of.

Drew Tyler: Thank you for that. Where would you see any potential key risks or key opportunities?

John Schlegel: Yeah, so I think on the key risks, the obvious ones are if something more fundamental were to change in terms of the trajectory for AI and the spending around it, that could cause a much bigger reshuffle. But generally speaking, in themes that are very secular, it usually isn't just elevated positioning that causes a sustained pullback. So if you think about some of the points you made earlier, if we were to see a reversal in the ROI conversations and companies were to say, I'm really going to start to pull back on the spending there, I don't need as much of this, that could cause more material shift. But if it's just, you know what, it's a little bit pricey and everyone likes it right now, it usually doesn't lead to a prolonged reduction. I think where the opportunities really are is if you were to get something more concrete in the Middle East in terms of a resolution, there are a lot of areas where clients do want to broaden out, it seems, and want to make other types of investments, but are unwilling to do so with that big headwind still there and the uncertainty around when that all gets resolved.

So to me, broadening out trade is something that people talk a lot about, haven't done a lot of work in their portfolios to actually make a shift, but that could be some of the things that really change what works for the next few months.

Drew Tyler: Sticking with the topic of broadening out, how would you think about that both inside the U.S. and maybe outside the U.S., or maybe it's better characterized as a rotation rather than a broadening out? How do you think about this and how should our listeners be thinking about this?

John Schlegel: So I think from the outside of the U.S. perspective, there could be a shift back into some regions like Europe, for instance, which is arguably one of the most hard hit by what's going on in the Middle East. So I think Europe could potentially outperform tactically, although probably not structurally, the U.S. for a short period of time. I think pockets of some of the consumer-related goods in particular, which Europe has, some of their big companies like the luxury companies could tend to do better as well.

And then there would be a lot of consumer-related groups that haven't beaten down a lot because the costs have been pretty high because of the inflation pockets on the commodity side and the concerns around real wage growth going potentially negative or declining that have been significantly hampered, which could see a bit of revival. But broadly speaking, it's your typical non-AI cyclicals that could do a bit better if we were to see that resolved a bit.

Drew Tyler: Excellent, because that matches a lot from what we're hearing in our client conversations as well. So things that worked in terms of, remember the COVID reopening trade is almost very similar to kind of the Strait of Hormuz reopening trade.

John Schlegel: No, that makes a lot of sense. So maybe just to sum up, broadly speaking between you and I, Drew, there's still a pretty constructive outlook for where markets could go with some notable risks in the next few months, be it on some of the catalysts or even some of the seasonal trends that we see. But overall, I think there's a lot on the positive side that could continue to kind of move us higher throughout the next few months.

Drew Tyler: Fully agree.

John Schlegel: Thank you, Drew, for joining me.

Drew Tyler: Well, thanks for having me. Wonderful seeing you as always.

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