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Strategists at JP Morgan have done a remarkable job connecting the dots between the real economy and the equity market rebound.  After diving into the reflation trade before it became popular they then altered their trading strategy from the reflation trade to the recovery trade (see JPM’s top trades for 2010 here).  They continue to believe the recovery trade is viable:

In a sense, we are moving from asset reflation trade (where yields on all assets fall, i.e. all assets perform) to the recovery trade (where bond yields rise reflecting improving growth backdrop and equities move higher).

In this environment they see more moderate equity performance supported by an economic and earnings recovery:

We remain buyers of equities and think the near term backdrop is supportive of significant further gains. We expect a strong Q4 earnings season, accompanied by topline growth and not just bottom line delivery. The improvement in labour markets is adding to the sustainability of economic recovery and key central banks are not expected to rock the boat anytime soon.

Yields are likely to move higher as the dollar rallies and investors move money into equities after a record setting reallocation into bonds.  The dollar could rally in tandem with equities (as we’ve seen over the last few weeks):

As we argued in mid December, when we closed our tactical 3-month long call for a range-bound market, we believe we could be transitioning to a new regime, reflected in rising bond yields, potentially stabilising USD and rising equities. The last year’s inverse correlation between USD and stocks could break, with a return to the typical positive historical correlation.

In this rising rate recovery environment JP Morgan points to an interesting correlation between cyclicals and rising yields.   They find that cyclicals (tech, discretionary, materials and industrials) tend to outperform defensive stocks during periods of rising yields.  Defensive sectors (pharma, telecom, utilities and staples), on the other hand, show a negative correlation with rising yields.

Source: JPM

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