EFTA01070756.pdf

Eye on the Market I September 10, 2012 J.P.Morgan Topics: The ECB feast is set to continue; all that sidelined cash; the cheapness of technology stocks and reflections on a strange year; the 71% solution (a top tax bracket to solve the US budget deficit problem) "Das Kapitulation" t, part II. The ECB announced plans to The European Creosote Bank: The feast continues further expand its balance sheet last week, and as expected, Central bank balance sheets, percent of GDP markets love the idea since it puts off any restructurings to 45% ECB plus El trillion • another day. The European Creosote Bank'- plan involves 40% conditionality, austerity and loss of face for borrowing countries, 35% but as Malcolm X used to say, Europe's leaders intend to 30% preserve the Euro "by any means necessary". Monetary and 25% fiscal policy have always played a role after recessions but never to this degree before, which is perhaps why there's so much 20% sidelined cash held by sovereign wealth funds, commercial 15% banks, corporations and households waiting to see how it all to% turns out (see below). It is the partial deployment of this cash, 5% which has been earning negative real returns for 4 years running, 2008 2009 2010 2011 2012 2013 that is driving the rise in risky asset prices3. This has been a Source: FRB, BEA, ECB, Eurostat, BoE, UK Office for National Statistics, BoJ,Japan Cabinet Office. deliberate strategy on the part of the Fed (debase cash to compel investment in higher-risk assets), and now the ECB is playing its part by deferring the risk of a Euro-pocalypse to another day. German resistance to debt monetization has effectively collapsed, a remarkable capitulation after two prior German ECB members resigned in protest. Here is part of the "wall of cash" as we see it: Foreign exchange reserves US commercial bank excess deposits US cash balances Trillions,USD Tnllions,USD 12% - 12% Household 9 cash to GDP 8 Deposits 7 Emerging Marke 8 6 7 8% 5 8% - 4 6 Loans 6% 3 Japan 2 5 6% - 4% 4 0 70 '80 '90 '00 '10 3 4% 2i Source: Mi nistry o I FinanceJapan, IFS, 2000 2002 2004 2006 2008 2010 2012 1960 1968 1976 1984 1992 2000 2008 J.P. Morgan Securities LLC. Source: Federal Reserve Board. Source: Federal Reserve Board, BEA. Here's another look at how cautiously investors have been positioned: the last couple of years of mutual fund flows, out of stocks and into bonds. As some of this reverses, P/E multiples are rising even as S&P earnings estimates are falling (2nd chart). US mutual fund net flows 2012 S&P500 rise driven by multipleexpansion, not earnings Billions, USD USD Multiple 1.200 107.0 2012 14.0 Price to 2012 1.000 106.5 consensus EPS 13.8 800 106.0 EPS 13.6 4- 13.4 600 105.5 13.2 400 105.0 13.0 200 104.5 12.8 0 104.0 12.6 -200 103.5 12.4 -400 103.0 12.2 -600 102.5 . 12.0 2006 2007 2008 2009 2010 2011 Jan-12 Mar-12 May-12 Jul-12 Sep-12 Source:Investment Company Institute. Source: FactSet, Bloomberg. The first capitulation by Germany: two large ECB bank lending programs in late 2011 and early 2012. For language geeks, yes, I know that "Die" goes with Kapitulation, but then that wouldn't be as funny as "Das", given the reference to Manes book. Consider it German humor. 2 If it wasn't clear, this reference [introduced last week] refers to the film character Mr. Creosote. See Youtube for the grisly details. 3 Hedge funds are getting more invested as well: the latest Flows & Liquidity report from I.P. Morgan Securities shows that after a period of low beta vs the S&P 500, macro hedge fund returns are tracking rising equity markets more closely. EFTA01070756  Eye on the Market I September 10, 2012 J.P.Morgan Topics: The ECB feast is set to continue; all that sidelined cash; the cheapness of technology stocks and cyclicals; reflections on a strange year; the 71% solution (a top tax bracket to solve the US budget deficit problem) As for stocks themselves, as discussed last week, we think the - death of equities" theme is misplaced and consider equities a cornerstone of portfolios seeking to generate returns above inflation, spending, mandatory outlays and taxation. Within US equity markets, one of our preferred sectors is technology. S&P technology earnings have more than doubled since 2007, yet the sector's PIE has fallen in half. Technology cash flow yields are high, return on equity looks good and rising sales per employee demonstrates continued productivity gains. Stepping back from the tech sector, cyclical stocks more broadly are trading at their largest discount to defensive stocks in decades (3id chart), another sign of extreme caution. Technology stock valuations Technology sector productivity and capital efficiency 55 - 15 - 900 50 35 - Cash flow yield, 800 48 13 percent 30 - 40 Return on equity, percent 700 P E multiple 11 4 35 25 - 600 30 9 25 20 - 500 Sales per employee, 20 thousands USD 7 15- 400 15 10 5 70 - 300 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Source: Bloomberg. Source: Bloomberg. Cyclicals trading very cheaply vs. Defensives Remembrance of things past: negative returns on cash Cyclicals/ Defensivestrailing WE Ex-post real return on US t-bills. percent 1.8 - 10% 8% 1.6 - 1.4 - 1.2 - 1.0 - 0.8 - Negative for 5 consecutive months 0.6 - with no end in sight, particularly 100/ after Woodford speech 0.4 - 1974 1978 1982 1986 1990 1994 1998 2002 2006 2010 1934 1945 1956 1967 1978 1989 2000 2011 Source:J.P. Morgan Securities LLC. Source: St. Louis Federal Reserve. Bureau of Labor Statistics. It has been a strange year. If you were concerned about the global economy this year, you were right: • Leading indicators of manufacturing, such as new orders, are weakening just about everywhere • Chinese, Korean and Taiwanese exports are slowing sharply; China may be growing at only 6% • European growth is -0%, with the periphery in recession. Germany business surveys also fading • Last week's US jobs report was weak across the board (payrolls, work week, labor force participation and wages) • US capital spending trends are slowing (e.g., capital goods orders ex-aircraft) • Countries like Brazil are showing signs of industrial fatigue due to an overly strong currency in 2010-2011 • The US election does not look like it will bring clarity to the US fiscal/debt ceiling divide (polls show Democrats keeping the White House and Republicans keeping the House of Representatives) • US housing is staging a modest recovery, but it's not a game-changer given its smaller contribution to employment • Corporate profits are high, but the trend in EPS revisions is negative and profits growth is slowing However, global equity markets have done well, up 13% so far in 2012. The bottom line: with the world drowning in liquidity, the right portfolio moves this year have been to take advantage of low equity valuations, look through all the economic weakness and expect that continued monetary stimulus will eventually bear fruit. We have done some of that but not as much as we might have, and as things stand now, global equity markets have outperformed what I had expected. The 2 EFTA01070757  Eye on the Market I September 10, 2012 J.P.Morgan Topics: The ECB feast is set to continue; all that sidelined cash; the cheapness of technology stocks and cyclicals; reflections on a strange year; the 71% solution (a top tax bracket to solve the US budget deficit problem) world's Central Banks have made it clear that inflating their way out is preferable to the alternatives, an environment that is conducive to risky assets that are priced very cheaply, until and unless they lose control of inflation. I still expect Europe to deliver negative surprises, and am not convinced they can ring-fence Spain that easily. By shortening the maturity of Italian and Spanish debt, the ECB may create another (possibly larger) concern three years from now. However, since many investors positioned for an EU blow-up sooner than that, there was room for a rally which pushed US PIE multiples from 12 to 14, as shown on page 1. After 4 straight years of negative real returns on cash shown above (and few prospects for a change after Woodford's Jackson Hole speech), I understand the desperation to earn a return on accumulated savings. Spanish Armada runs aground, again Relianceon foreign "Defeat of the Spanish Armada" Euro inception capitol, Nip of Non-performing loans. GDP %of total lending X • Industrial Unit labor cost o production Unemployment rate 'Spain to Germany less Spain tGeimany • 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010 Philip James de Loutherbourg. 1796. UK National Maritime Museum. NIIP = Net International Investment Position. Sources: See appendix. Greenwich Hospital Collection. Depicts events from August 1588. The 71% solution to the US budget deficit problem: tax the heck out of the rich As I was watching the two political conventions, I began to wonder: what if.... • Something like the CBO's Alternative Case scenario came to pass (see Appendix for details) • Debt markets were no longer willing to fund trillion dollar deficits, so the deficit had to be reduced to 3% of GDP by 2020 • Taxing the rich was the only thing the country could agree on doing If this happened, how high would top marginal Federal income tax rates have to go? The answer, after some number- crunching: 71% for the top bracket, and 57% for the second highest bracket's. Add state and local taxes and payroll taxes, and pretty soon, taxes on income would approach 80% in Blue states like New York and California. This is not a projection, but an illustration that there are not enough Americans subject to the top brackets to reduce the deficit to 3%. Eventually, the US will more likely have to adopt broader-reaching tax reform (e.g., raising taxes on the middle class), larger spending cuts than those already adopted, and/or Federal Reserve monetization of the public debt. Another option: a set of pro-growth policies that solve the problem by ramping up the denominator. The challenge: under the CBO Alternative Case, real GDP growth would have to average 8.6% per year (rather than the 2.9% that is currently assumed) to get the deficit to 3% by 2020. After seeing what has happened in Europe, it seems likely that debt monetization would be a part of a US solution (in addition of course to the $1.7 trillion in Treasury bonds the Fed already owns). One more thing on taxation. There was a lot of discussion around both conventions about the progressivity of the tax code. On the following page, I have included some history on effective tax rates by bracket, from the CBO. The first table shows income tax rates, the second shows total Federal tax rates (including payroll and excise taxes). Progressivity, apparently, is in the eye of the beholder. To me, the tables suggest a substantial increase in progressivity since 1979. Michael Cembalest J.P. Morgan Asset Management 4Before anyone says, "well, tax rates used to be that high", consider the details. Marginal tax rates were 8096+ in the 1950's, but applied to the mega-wealthy (income of $3 million+ in today's dollars), rather than the $388,350 that marks today's top bracket. In other words, people had to be 10x wealthier in the 1950's to be subject to ultrahigh marginal rates. There were also more deductions then. For example, in 1979, while the top statutory income tax rate was 70%, the effective tax rate for the top 1% was less than 25%. See December 13, 2011 EoTM. 3 EFTA01070758  Eye on the Market I September 10, 2012 J.P.Morgan Topics: The ECB feast is set to continue; all that sidelined cash; the cheapness of technology stocks and cyclicals: reflections on a strange year; the 71% solution (a top tax bracket to solve the US budget deficit problem) A look at the progressivitv of the US tax system over time, by bracket Average Effective Federal Income Tax rate Average Effective Federal Total Tax rate Quintile: Low Second Middle Fourth High Top 1% Quintile: Low Second Middle Fourth High Top 1% 1979 0.0% 4.0% 7.4% 10.1% 15.9% 22.7% 1979 7.5% 14.5% 18.9% 21.5% 27.1% 35.1% 1984 0.7% 3.9% 6.5% 8.9% 14.0% 19.6% 1984 9.4% 14.3% 17.8% 20.3% 23.8% 27.0% 1989 -1.3% 2.9% 5.9% 8.3% 14.7% 20.2% 1989 7.6% 13.5% 17.7% 20.6% 25.1% 28.3% 1994 -3.2% 1.9% 5.2% 7.7% 15.1% 23.6% 1994 6.8% 12.5% 17.1% 20.5% 27.1% 34.8% 1999 -4.5% 1.7% 4.9% 8.0% 17.2% 24.3% 1999 6.5% 12.6% 16.6% 20.6% 27.7% 32.8% 2004 -5.4% -0.5% 2.8% 5.8% 14.0% 20.1% 2004 5.1% 9.6% 13.7% 17.4% 24.9% 30.1% 2009 -9.3% -2.6% 1.3% 4.6% 13.4% 21.0% 2009 1.0% 6.8% 11.1% 15.1% 23.2% 28.9% Source: C8O (both tables) Note: effective income tax rates for the bottom two quintiles are actually negative due to the value of transfers and tax credits. Appendix: assumptions for the top tax bracket analysis The Congressional Budget Office (CBO) projects something called the Baseline Case, which assumes that everything that is legislated will come to pass. But in a nod to reality, they also maintain an Alternative Case, which assumes that people may put off difficult fiscal decisions/costs to another day. The Alternative Case assumes: • All tar cuts are extended, no change to current capital gains and dividend rates. • Payroll tax holiday in effect since 2011 expires. The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 provided a two percentage point payroll tax cut for employees, reducing their Social Security tax withholding rate from 6.2 percent to 4.2 percent of wages paid, with no effect on the employee's future Social Security benefits. • Alternative Minimum Tax (AMT) exemption continues to be indexed to inflation, keeping the number of taxpayers subject to the AMT constant. AMT has been indexed to inflation since 2006 so that the number of taxpayers subject to higher AMT taxes does not rise. • Medicare payments to physicians remain unchanged despite scheduled decreases, which were supposed to start in 2002. Deficit reduction law passed in 1997 called for Medicare physician payments to be set using a sustainable growth rate (SGR). For the first several years, Medicare expenditures did not exceed the target and doctors received modest pay increases. But in 2002, payments dictated by SGR did not keep up with the market rate. So, Congress staved off effective cuts to doctors and has repeated this decision every year since. Medicare payments based on the SGR would be -27% below current rates. • Budget Control Act sequester, designed to reduce defense and non-defense expenditures (excluding Medicaid and other mandatory spending), does not take effect. When the Joint Select Committee on Deficit Reduction failed to reach agreement on $1.5 trn of deficit cutting measures in 2011, an automatic sequester of $1.2 trn was set to take place in January 2013. Most cuts will come from defense spending, and the Office of Management and Budget will allocate non-defense spending cuts each year. 4 EFTA01070759  Eye on the Market I September 10, 2012 J.P.Morgan Topics: The ECB feast is set to continue; all that sidelined cash; the cheapness of technology stocks and cyclicals; reflections on a strange year; the 71% solution (a top tax bracket to solve the US budget deficit problem) Sources for Spanish macro -economic imbalances: Institute Nacional de Estadistica, Banco de Espatia, Statistical Office of the European Communities, Organization for Economic Cooperation & Development. IRS Circular 230 Disclosure: JPMorgan 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 JPMorgan Chase & Co. ofany ofthe matters addressed herein orfor the purpose ofavoiding U.S. tat-related penalties. Note that J.P. Morgan is not a licensed insurance provider. The material contained herein is intended as a generalmarker commentary. Opinions expressedherein are those ofMichael Cembalest andmay differfrom those ofother J.P. Morgan employees and affiliates. This information in no way constitutesIP. 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. 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