EFTA01069672.pdf

Eye on the Market I June 25.2012 J.P.Morgan Topics: The upcoming EU summit, the Fed's efforts to jumpstart growth, how hard a US budget compromise is going to be, and a look at one rare aspect of the 2012 US Presidential election (Another) EU summit. I think everyone understands by now why Europe matters. In a recent note, we showed how one third of all OECD banks are in some kind of distress, most of them being European (June 4). As for US corporate profits, Europe matters a lot as well. Around 15% of S&P 500 revenues and 23% of S&P industrial revenues come from Europe2. For technology companies, these numbers are even greater: roughly 30%, with some subsectors even higher (PWC estimates that 36% of global software sales are in Europe). The summit is likely to focus on bank recapitalization, easier repayment timetables for Greece, bank deposit guarantees and an alleged "roadmap" for EU integration. The challenge for Germany, as we have discussed before, is that it cannot afford a blank check given debt levels already over 80% of GDP. However, if policymakers don't do something about growth in the Periphery (bailouts primarily designed to aid German and French banks don't counts), the North-South divide will continue to widen, putting pressure on the ECB and EU taxpayers. Sometimes there are no easy answers. Italy, Spain, Greece and Portugal are contracting at a 2%-5% annualized pace, and unemployment in Spain and Greece is sky-rocketing (VI chart). These levels are notable from an historical perspective. As shown in the 2n' chart, 20%+ unemployment was the level at which National Socialists in Germany began to take seats away from liberal democratic parties during the 1930's. If the jobs picture does not improve, other EU policy decisions may not matter much: the Wyman/Berger loss estimates for Spanish banks would almost certainly be too low, lower GDP growth would continue to result in lower tax collections, fringe parties may gain further support in the Periphery, and the whole European project may seem way too risky to non-EU investors. Spanish and Greek unemploment Unemployment and the end of liberal capitalism, 1930's Percent German unemployment and Reichstag seals by party. percent 25% 40 ■Unemployment 20% ■Nallonal Socialists (Totalitarian) 30 ■German People's Party + German 15% 20 Democratic Party (Liberal) 10 10% 0 N c1" O O N. CO O) O C.1 (•) N N N C‘.1 C‘.1 N N N CO CO CO CO CO O) O) O) CA O O) O) O) O) 01 01 01 01 1985 1988 1991 1994 1997 2000 2003 2006 2009 2012 Source: hternational Hstorical Statistics. Europe 1750-1988, Historische Source: StatisticalOffice of the European Communities. Ausstellung Des Deutschen8undestages In its attempts to manage the crisis, the EU has taken steps which may impair its image in the eyes of institutional investors. Case in point: a Rating Agency Reform draft passed last week by the EU's Economic and Monetary Committee, designed to regulate rating agencies and reduce reliance on them. The draft requires banks, insurance companies and fund managers (!!) to develop their own internal ratings capacity instead, and states that rating agencies can be held liable for "methodological mistakes". Rating agencies aren't perfect, but at a time like this, such proposals are not a confidence builder, and suggest that EU policymakers do not want to hear opinions they might disagree with. In other related news, Galileo Galilei was posthumously exhumed and re-sentenced to house arrest for his heretical theories on the earth revolving around the sun. Anyway, back to the summit. Here's a worrisome data point they might discuss: Spanish banks are borrowing over 300 billion Euros from the ECB, but that only represents 12% of Spanish bank liabilities (a quote from the movie Jaws comes to mind: "you're going to need a bigger boar). While it is tempting to see Europe as facing a sovereign debt crisis and/or a banking system crisis, Europe's challenges are broader than that, encompassing the totality of its private sector economies and their incompatibility in a single monetary union, a concept best explained in our June 4h note/chart on the subject. I saw a chart this morning showing that even after all the austerity so far, the cyclically-adjusted current account deficits of the Periphery countries are not that different from what they were three years ago. Europe has a long, long way to go. I Distress defined as banks with credit spreads wider than 3% over risk-free interest rates 2 Companies lowering Q2 2012 earnings guidance: Pall, Nucor, Ryder, Proctor & Gamble, Cardinal Health, Texas Instruments, Starbucks, Autodesk, Fedex, Jabil Circuit and Adobe Systems. As per Goldman Sachs, problems in Europe rank at the top of the list of catalysts. 3 In a recent note. J.P. Morgan Securities estimated that of the €410bn of total rescue packages for Greece over the past two years, only fl5bn has likely entered the real economy in Greece. The rest was used to bail out or protect private and official creditors. EFTA01069672  Eye on the Market I June 25.2012 J.P.Morgan Topics: The upcoming EU summit, the Fed's efforts to jumpstart growth, hos% hard a US budget compromise is going to be, and a look at one rare aspect of the 2012 US Presidential election The Fed's efforts to jumpstart US growth, and what it would take to resolve the long-term US budget impasse It's not just Europe that has been posting weaker economic data recently: • The Is' chart shows a global purchasing managers survey through May, confirming that another 'Prague Spring' took place this year. The next data point is due on July 5'h; early estimates are weak for the US, China, Europe and Japan. • A high frequency coincident indicator we look at shows that the world is growing at around 1.5%-2.0%, compared with 5% during post-stimulus periods in 2009 and 2010. • Another measure shows that 80% of the world is seeing slower rather than higher growth rates right now. A lot of people want the Fed to do more, but with 10 year rates at 1.6%, what is left for the Fed to do except commit to keep them there forever? The idea behind quantitative easing is that low interest rates promote business formation, and also force investors into riskier portfolios. These riskier portfolios presumably lower the cost of capital and increase equity market returns, which in turn are presumed to promote capital spending, consumption, and eventually, hiring. Is this a bad time to point out that this sounds a lot like supply-side economics, which many of the Fed's supporters detested? Anyway, I don't blame the Fed for trying, but these tools may be less potent given where rates are now, which the Fed probably knows but cannot concede. In the US, profits have been outrunning GDP by the widest margin in decades (see 21'd chart on the ratio of profits to GDP growth), but it's hard to envision any multiple expansion unless growth and employment catch up to profits. Mother Prague Spring (PS) Earnings still outperforming the economy Global Composke Purchasing manager's index. SO +=e xpansion Ratio of 2-year earnings growth to 2-year nominal GDP growth 60 PS 15x 14.3x PS 55 10x 5Ax PS 5x Avers? ak:42x Average peak:2.1x Ox Period of n onetarystimuluS .5x -10x - 35 1952 1959 1966 1973 1980 1987 1994 2001 2008 2007 2008 2009 2010 2011 2012 Source:J.P. Morgan Asset Management. Markh. J.P. Morgan Securities LW. Source: Standard 8 Poor's, BEA. J.P. Morgan Asset Management. Is there something other than Fed easing that could jumpstart growth, confidence and the deployment of corporate cash? Let's look again at our Squid vs Whale charts on today's elevated macroeconomic risks, and how valuations and corporate cash balances have adjusted to reflect them (the S&P earnings yield is the inverse of the PIE ratio). The biggest US imbalance is the fiscal situation. While many market participants are anxious for the fiscal cliff to be deferred, the US cannot sustain a libertarian tax policy and a Scandinavian welfare state forever. This gap will have to be closed someday; so far, most bipartisan groups that look at the issue come up with something that looks like the Bowles Simpson plan. How reasonable is it to think that something like it can be passed, even after the election? The Squid The Whale Tentacles of macroeconomic imbalances Spanish reliance The cheapness of corporate profits and piles of cash on foreign capital Unemployment OECD government Corporate cash to rate, Periphery S&P earnings yield debtiGDP China capital tangible assets less Germany Industrial production. spending to GD Economy-wide Germany less Italy profits tp GDP 1980 1985 1990 1995 2000 2005 2010 1985 1988 1991 1994 1997 2000 2003 2006 2009 2012 Source: See appendix. Source: See appendix. 2 EFTA01069673  Eye on the Market I June 25.2012 IP Morgan Topics: The upcoming EU summit, the Fed's efforts to jumpstart growth, how hard a US budget compromise is going to be, and a look at one rare aspect of the 2012 US Presidential election The table below shows the $5 trillion in deficit reduction contemplated by the Bowles Simpson plan over 10 years, and how much has been accomplished so far through the Budget Control Acts (by spending caps, sequestration and related interest savings). After we adjust for the revenue increases and spending cuts proposed by Bowles Simpson that would not require major tax reform, there's still a huge hole of $1.8 trillion. In other words, to get to "US debt sustainability" along a Bowles Simpson path, comprehensive tax reform that incorporates revenue increases will be needed. If it happens, it could be a confidence builder for financial markets, but there is virtually no chance of this before the election and considerable uncertainty about it afterwards, since neither party looks like they are going to win decisively. How much of the original deficit reduction in the Bowles US: libertarian tax policy and Scandinavian expenditures Simpson (B/S) plan has already been accomplished, or could do not mix, Percent of GDP be accomplished without major tax reform? S bn 24% Expenditures Proposed BiS deficit reduction over 10 years 5.123 Deficit reduction accomplished by BCA, via spending 1.975 22% caps. sequestration and interest savings 20% Receipts Deficit reduction left to do 3.148 Implied interest savings 348 18% Non-interest deficit reduction left to do 2.800 16% Without major tax reform Spending cuts proposed by B/S (health care reform. 656 14% soc. sec. reform and other mandatory savings) 1950's 1960's 1970's 1980's 1990's 2000's 2011 2012 Revenue increases proposed by B/S (raise soc. sec. 348 estimate Source. Off ice of Management and Budget. taxable wage base. 15 cent gas tax hike, use chain weighted CPI for entitlement payments) Total deficit reduction passable without tax reform 1.004 Remaining deficit reduction that would have to be 1.796 accomplished via comprehensive tax reform National Commission on Fiscal Responsibility and Reform. IS! Group The reason for exploring these topics is simple: we are trying to figure out what set of policies would be conducive to a more vibrant US economic recovery. When the recession hit in 2008-2009, the estimated tax cut and government spending multipliers from the President's Council of Economic Advisors were 3:1 and 1.6:1. If this had been the case, the US would already have recovered vigorously. The Fed has brought the real cost of money to zero, so that's not holding things back either. Once you have thrown the fiscal and monetary kitchen sinks at the problem, it's time to consider other potential impediments. The possible confidence drag from the erosion in the long-term fiscal health of the US is a reasonable suspect. On investments, we have not made any material changes to our strategy articulated in January: overweight US equities vs other regions, modest underweight to equities vs normal levels, an overweight to credit, and considerable focus on investments we see as having less direct exposure to the global macro cycle. These investments include oil & gas property resuscitation (March 22), distressed real estate sold at deep discounts to replacement cost (January 31, 2012), and the provision of credit to private companies who lack access to public debt markets at a reasonable cost (June 11, 2012). On US equities, we consider them attractively priced at 1,300 or below on the S&P for long-term investors, but it could take 5-7 years to see if we're right. In the Appendix this week, a look at one unique aspect of the 2012 Presidential election: the relative lack of prior public sector experience of both candidates combined. Michael Cembalest J.P. Morgan Asset Management (see next page) 3 EFTA01069674  Eye on the Market I June 25.2012 IP Morgan Topics: The upcoming EU summit, the Fed's efforts to jumpstart growth, how ha rd a CS budget compromise is going to be, and a look at one rare aspect of the 2012 US Presidential election Appendix: Presidential Politics, 2012 Apart from substantial policy differences, the upcoming Presidential election is notable in another way as well. The upcoming election offers voters the least amount of prior "high level public service experience" (as defined in the chart below') in many decades. We started our analysis in 1912 (right before the 1913 adoption of the 171" Amendment providing for direct election of Senators), and added the combined prior experience of both candidates. Given Obaina's experience as a Senator and Romney's single term as Massachusetts governor, the 2012 election is as light on this front as the 1952 election between Eisenhower and Adlai Stevenson. However, the 1952 candidates had a lot more public sector heft than our chart shows. Our methodology excludes Eisenhower's military background as a senior staff officer for Generals Fox Connor, Moseley and MacArthur in the 1920s and 1930s, and Stevenson's experience in the State and Navy departments during WW II, and as a member of the US delegation to the UN during its formative years. So, to find an election this light on public sector experience, you have to go back to the 1924 election between Coolidge and John W Davis, the latter a compromise candidate who had spent 5 years as US Solicitor General. Both Coolidge and Davis had only spent a couple of years as either Governor or in Congress before running. That's one strange context of the 2012 election: a couple of "one-termers", with neither having much prior experience at the highest levels of public service (12 years combined, by our count). The implications are subject to debate, but there's no question that it's an anomaly; or at a minimum, a throwback to the elections of the 19ih century, when this kind of thing was more common. US Presidential Elections: prior years of high level public sector experience of both candidates combined, 1912-2012 60 - e-Category 1 plus Category 2: Supreme Court, Cabinet Posts and Major Mlitary (Supreme Commander of NATO, Army Chief of Staff, Commander of the European Theatre of Operations, CIA Director) 50 —0—Category 1: Governor, US Senate, US House, Vice President, President 40 Eisenhotier vs. Stevenson; see Coolidge vs. text for details 30 Davis: see text for details 20 10 0 10 0) O Fe a CO rO 1.; Source:J.P. Morgan Asset Management At a time when confidence in all institutions (non-financial business, banks, Congress, the Fed, etc) are close to multi-decade lows, this is not a surprise. Why should experience count for anything? Throw the bums out and hand the reins over to outsiders! Still, I find this chart disconcerting, even though it's hard to explain why. Do politicians who have not wielded substantial power underestimate the consequences of being wrong? It's easy to be dead sure about something if you haven't created a public policy train wreck of your own. We debated whether to include experience in State Legislatures as "high level public sector experience". We did not, mostly due to the gradual loss of power at the state legislative level during the 20ih century, ceded to Congress, the Executive Branch and the Federal Judiciary. This decision was perhaps influenced by my residence in the State of New York. The Brennan Center for Justice at NYU School of Law describes the New York State legislature as the least deliberative, most dysfunctional, and on many important counts, worst legislature in the country. See next page for details. 4 EFTA01069675  Eye on the Market I June 25, 2012 J.P.Morgan Topics: The upcoming EU summit, the Fed's efforts to jumpstart growth, how hard a US budget compromise is going to be, and a look at one rare aspect of the 2012 US Presidential election "The New York State Legislative Process: An Evaluation and Blueprint for Reform'", "Unfinished Business: New York State Legislative Reform", and "Still Broken: New York State Legislative Reform", Brennan Center for Justice at NYU School of Law, 2004, 2006 and 2008. The 2008 report reads like a Woody Allen satire: New York State legislators introduced more than 18,000 bills in 2008, triple the number introduced in the next highest state legislature, and 50% more than in the entire US Congress. However, more than 90% of these bills only made it as far as press releases, and then vanished without serious consideration. New York State legislative committees rarely meet but it doesn't matter anyway: the Assembly Speaker and Senate majority leader keep iron-fisted control over every decision, and get bills passed unanimously. Of 8,500 votes cast in the Assembly in 2006, only 76 were "no" votes. This represents a 99.1% approval rate, which roughly matches the re-election margins for Fidel Castro and Kim Jong II. Sources for The Squid chart: US Treasury, BEA, Bank of Spain, Bank of Portugal, OECD, CSO, NSS, IMF, Statistical Office of the European Communities, PBOC, China Bureau of Statistics, Spain National Institute of Statistics, J.P. Morgan Asset Management. Sources for The Whale chart: Federal Reserve Board, Standard & Poor's, BEA. Loss estimates for Spanish banks were derived by consulting firms Oliver Wyman and Roland Berger based on scenarios prepared by the Bank of Spain, the EU Commission, the European Banking Authority and the IMF. They have in general been overly optimistic since the crisis began in 2009. IRS Circular 230 Disclosure:!Morgan Chase & Co. and its affiliates do not provide tat advice. Accordingly, any discussion ofU.S. tat matters contained herein (including any attachments) is not intended or written to be used, and cannot be used, in connection with the promotion, marketing or recommendation by anyone unaffiliated with!Morgan Chase & Co. ofany ofthe matters addressed herein orfor the purpose ofavoiding U.S. tat-related penalties. Note thatJ.P. Morgan is not a licensed insurance provider. The material contained herein is intended as a generalmarket commentary. Opinions expressedherein are those ofMichael Cembatest and may differfrom those ofother J.P. Morgan employees and affiliates. This information in no way constitutes1P. Morgan research and should not be treated as such. Further. the views expressed herein may differ from that contained in J.P. Morgan research reports. The above summarylpricedquoies/statistics have been obtainedfrom sources deemed to be reliable. but we do not guarantee their accuracy or completeness. any yield referenced is indicative and subject to change. Pau performance is not a guarantee offuture results. References to the performance or character ofour portfolios generally refer to our Balanced ModelPortfolios constructed by J.P. Morgan. It is a proxyfor client performance and may nor represent actual transactions or investments in client accounts. The model portfolio can be implemented across brokerage or managed accounts depending on the unique objectives ofeach client and is serviced through distinct legal entities licensedfor specific activities. Bank. trot and investment management services are provided by JP Morgan Chase Bank. N.A. and its affiliates. Securities are offered through J.P. Morgan Securities LW (JPMS). Member NYSE. FINRA and SIPC. and its affiliates globally as local legislation permits. Securities products purchased or sold through JPMS are not insured by the Federal Deposit Insurance Corporation ("FDIC••); are not deposits or other obligations of its bank or thrift affiliates and are not guaranteed by its bank or thrift rffiliates: and are subject to investment risks. including possible loss of the principal invested. Not all investment ideas referenced are suitable for all investors. Speak with yourJ.P. Morgan Representative concerning your personal situation. This material is not intended as an offer or solicitation for the purchase or sale ofanyfinancial instrument. Private Investments may engage in leveraging and other speculative practices that may increase the risk ofinvestment loss. can be highly illiquid. are not required to provide periodic pricing or valuations to investors and may involve complex tax structures and delays in distributing important tax information. Typically such investment ideas can only be offered to suitable investors through a confidential offering memorandum which fully describes all terms conditions. and risks. This material is distributed with the understanding that J.P. Morgan is not rendering accounting. legal or tax advice. You should consult with your independent advisors concerning such matters. In the United Kingdom. this material is approved by J.P. Morgan International Bank Limited (JPMIB) with the registered office located at 25 Bank Street. Canary Wharf. London E14 5JP. registered in England No. 03838766 and is authorised and regulated by the Financial Services Authority. In addition. this material may be distributed by: !Morgan Chase Bank. NA. (JPMCB) Paris branch. which is regulated by the French banking authorities AidOlite de Contras Prudentiel and Autoriti des Marches Financiers: J.P. Morgan (Suisse) St. regulated by the Swiss Financial Market Supervisory Authority: JPMCB Bahrain branch. licensed as a conventional wholesale bank by the Central Bank ofBahrain (for professional clients only): JPMCB Dubai branch. regulated by the Dubai Financial Services Authority. In Hong Kong. this material is distributed by JPMorgan Chase Bank. NA. (JPMCB) Hong Kong branch except to recipients having an account at JPMCB Singapore branch and where this material relates to a Collective Investment Scheme (other than privatefunds such as private equity andhedge funds) in which case it is distributed by J.P. Morgan Securities (Asia Pacific) Limited (JPMSAPL). Both JPMCB Hong Kong branch and JPMSAPL are regulated by the Hong Kong Monetary Authority. In Singapore. this material is distributed by JPMCB Singapore branch except to recipients having an account at JPMCB Singapore branch and where this material relates to a Collective Investment Scheme (other than private funds such as a private equity and hedge funds) in which case it is distributed by J.P. Aforgan (S.EA.) limited (JPMSEAL). Both JPMCB Singapore branch and JPMSEAL are regulated by the Monetary Authority ofSingapore. Each recipient ofthis presentation. and each agent thereof may disclose to any person. without limitation. the US income andfranchise tax treatment and tax structure ofthe transactions described herein and may disclose all materials ofany kind (including opinions or other tax analyses) provided to each recipient insofar as the materials relate to a US income or franchise tax strategy provided to such recipient by JPMorgan Chase & Co. and its subsidiaries. Should you have any questions regarding the information contained in this material or about J.P. Morgan products and services. please contact your J.P. Morgan private banking representative. Additional information is available upon request. "J.P. Morgan" is the marketing namefor JPAforgan Chase & Co. and its subsidiaries and affiliates worldwide. This material may not be reproduced or circulated without J.P. Morgan's authority. C 2012 JPMorgan Chase & Co. All rights reserved. 5 EFTA01069676