The S&P 500 Index saw declines of 1% or more on 22 days this year, with four in the past month. While the index is down 2.9% for the year to date, it lost 6% in August. Still, investors may want to consider riding out the bumps—if not view the volatility as a potential buying opportunity—according to Paul Quinsee, chief investment officer of JP Morgan’s US equity group. “Every year, corrections happen,” he explains. Since 1980, the S&P has averaged a maximum intrayear drawdown of 10.7%. “We still think we've got several years of growth left in this cycle, because the starting point was so depressed,” he says. Quinsee recently spoke with Morgan Stanley Wealth Management Senior Markets Strategist Jon Mackay. The following is an edited version of their conversation.

JON MACKAY (JM): What are your US economic growth expectations for the remainder of this year and into next year?

PAUL QUINSEE (PQ): We are reasonably optimistic. When we look at the fundamentals and talk with companies, it seems that although we are now several years into a recovery, some of the parts of the economy that have been most depressed, like housing, are really only just getting going. We believe there still are several years of growth left in this cycle.

We have started what we call “recession watch,” which is looking at a bunch of things to indicate when it's time to start to become more cautious. None of these indicators are giving us any warning yet. When we look at employment trends, housing, consumer demand, all of the latest data points seem to be getting just a little bit stronger. So we are reasonably constructive.

JM: A common refrain is that valuations are rich—that even if we get a positive growth environment, equities are going to struggle. How do you feel about US valuations, and how do you feel about US valuations relative to global stocks?

PQ: I would say US valuations are pretty full, but not ridiculous. There's no question in my mind that the tremendous run that we've seen in the S&P 500 over the last five years is coming to an end. We have a compound return in the S&P of about 14% a year for the past five years. That's an incredibly strong result by historic standards.

Returns have to moderate because you don't find too many times in history when the overall market multiple has been much higher than the mid-to-high teens. You've got to go back to the craziness around the internet boom of the late '90s to find a much higher overall market multiple.

On the other hand, when you think about the main investible alternative— fixed income, for most investors—stocks [would] continue to look positive, even if 10-year Treasury yields were a full percentage point higher.

What does that look like in a global context? Well, I think it is: America is the high-quality, lower-risk, lower-reward choice. In many ways, the path of the US is much clearer.

If you look at debt to GDP, China is probably about 20th in the world, and the growth rate has been fast and concerning. But the majority of debt is held by the government or government-controlled companies. Privately owned companies have actually been deleveraging.

Unlike in the US, the medicine to fix the debt problem in China is not going to be broad deleveraging, which strangled credit access for the small and midsize companies that drive the US economy. It's going to be another round of reform of state-owned enterprises, and it shouldn't affect the private companies that account for 80% of employment—and all the new job and wealth creation. Fixing the debt problem may lead to more volatility and steadily slower growth, but I don't see a crisis or a hard landing.

JM: What potentially could go wrong?

PQ: The ill wind that's blowing from the rest of the world could get worse and, although that doesn't make so much of a difference to the US economy, it makes a big difference to the stock market. As we all know, American companies have been enthusiastically expanding their businesses in the rest of the world for the last few decades, so it matters that much more.

The big rise we see in the dollar is the worst thing that's happened for corporate profitability in America since the implosion of the financial system in 2008. It's a big problem and a very serious one for some companies. I think that the more pessimistic view that China is not a superhigh- growth economy that can just sort of cruise along at 7%, 8%, regardless, is now being widely accepted. A lot of that’s in the prices, but it could still get worse.

You've also always got to point to interest rates as a potential risk, but it feels to me like, (a) everyone is saying that the increases are going to be very modest and slow; and (b) we haven't really seen any kind of aggressive borrowing activity in recent years that makes companies or consumers vulnerable to a rise in interest rates. In fact, it's been much more about reversing the sins of the previous decade. The one exception to that, of course, is the energy sector, where now we are seeing a pretty painful credit cycle, not because interest rates have gone up, but because of the collapse in commodity prices. What’s Ahead for US Stocks? T Please refer to important information, disclosures and qualifications at the end of this material. September 2015 13

For the long run, our research team sees corporate profits being sustainable and able to grow at a 7% to 8% compound rate in the next several years. What I'm watching for is any kind of unwinding of the benefits of globalization, which our analysis tells us has been one of the huge drivers of profitability. Globalization has created new markets; it's created great ways for companies to reduce their costs. JM: Is what's going on, with the US markets related to China? Is that an earnings story or is it purely negative sentiment and uncertainty about what China's going to do?

PQ: I think it's an earnings story. I think if you look at where the market has been weakest recently, it lines up with where companies either have the most direct exposure to China or where they have broad commodity exposure, including energy. I do think that the market is getting itself into a bad mood.

The underlying fundamentals are not so bad that we're going to see stock prices really fall apart. We think that we are going to experience what I would call a more typical type of setback—i.e., 8% to 10%—as opposed to really serious setbacks of 20% to 30%.

JM: Do you think the volatility that we're seeing in the market is something investors can expect going forward, and should they think of bouts of volatility as buying opportunities?

PQ: There will always be drawdowns. I would not be surprised if the level of the drawdowns didn't start to increase as we move into the later stage of the cycle because, first of all, that's just mean reversion and, secondly, prices are higher now and it's scarier when things start to go wrong. So I would expect more volatility, but I would not expect a 20% to 25% drop until we get closer to the end of the cycle.

JM: How might the Fed rate hike, when it happens, impact equity markets?

PQ: In terms of what it means for the market broadly, I just think that's really tough. There cannot ever have been a more discussed and more analyzed prospective increase in interest rates than the one we're about to have.

Going back to the fundamentals, we try to model what higher rates will do for companies. Interestingly, in many cases, it leads companies to make more money, not less. In the broader financial sector, higher rates would be a significant positive. They had been doing well, relative to the broad market, earlier this year as investors looked forward to higher rates. Recently, however, they've been selling off in part because people think what's happening in China will delay that rate hike.

Companies with of a lot of cash on their balance sheets would look forward to higher rates as well. As I mentioned earlier, we don't see too many highly indebted companies that are struggling to survive as it is, and couldn't live without an increase in their borrowing costs.

A rate hike can't come as a surprise to anyone, I would think. In some ways, I would be more worried if rates don't go up because I think investors would take that as a signal that growth is weak and they'd worry more. So I hope they do go up, and I suspect that, if/when they do, investors will live with that pretty comfortably.

JM: Do you think oil and currencies will continue to be headwinds, or will they become less of a focus going forward?

PQ: We're getting to the point at which energy prices are so low that any drag from here will be less. If we look at the earnings of the S&P 500 companies, energy contributed almost $13 worth of earnings in 2014. We're down to around $5 for 2015. Maybe $5 is still too high, but the base is now so much lower that it can't do as much damage. I also think that the positives of lower oil really haven't showed up yet—and they will.

We have been assuming that the dollar stays on the strong side. It's been one of the fastest appreciations of the dollar on record, but the most violent part of the ride is over. We're assuming that that those gains stick around for a while, partly based on our more optimistic view on the US economy versus everything else. All of that adds up to an upward bias to the dollar, so we have to watch for that. I think there may be some more pain to come, particularly for those companies that make stuff in America and have to export it.

Some of the companies in the capital goods sector, for example, tell us that these days, they're suddenly seeing a whole host of competitors back in the American marketplace that they haven't seen around for 20 years. We're cautious to make sure that's in our numbers.

JM: What do you like in the market? Which sectors, capitalizations and styles are presenting attractive opportunities?

PQ: Though stock prices are up 30% on average from the previous peak in the last cycle, financials are a part of the market that still hasn't recovered. We think that the fundamentals in the financial sector are slowly going to improve. Higher interest rates will be a positive; market activity and M&A are a positive, too. We think financials have room to outperform.

Other areas that we're focused on are a little bit more on the cyclical side. We've been looking at some of the auto stocks, for example. Housing is also a theme that we very much believe in, whether it's home-improvement retailers, suppliers to the housing companies or even some of the homebuilders themselves.

We've also got our favorite points within technology, which is always the hardest sector to generalize about because it's so much about individual companies and where they stand within their product cycles and stages of development.

We've had a pretty strong focus on many semiconductor stocks. In particular, we think semiconductor equipment manufacturers win, as semiconductor companies themselves spend more money. This is an area that is seen as more centered on what’s going on in China, and rightly so, but we think there's enough growth and multiples are low enough that it's worth sticking with them.

Paul Quinsee is not an employee of Morgan Stanley Wealth Management. Opinions expressed by him are solely his own and may not necessarily reflect those of Morgan Stanley Wealth Management or its affiliates.

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