EFTA00593393.pdf

Eye on the Market I November 19, 2012 J.P.Morgan A case-dependent Thanksgiving for investors: credit, portfolio investing, cash, Congress, Iran and your blood pressure Be thankful for the Fed, if you invest in credit You should be thankful for the Federal Reserve if you invest in credit. By reducing rates to zero, the Fed unleashed a wave of interest in a variety of credit products: high grade bonds, high yield, leveraged loans, municipals, asset-backed securities, mezzanine debt, other private credit and distressed debt. So far this year, distressed debt is at or near the top of the hedge fund total return tables I have seen; as shown in the I II chart, the universe of high yield bonds and loans trading below a dollar price of 80 has declined again as the rising tide in credit has lifted all boats. Among the distressed debt winners in 2012: recoveries after liquidation (Lehman, MF Global); converted equity stakes obtained during a Chapter 11 reorg (Capmark, Delphi); and debt gains after a restructuring that avoided bankruptcy (Realogy, Clear Channel, MGM). Corporate cash flow is generally in good shape, so the rally in spreads seems reasonable. In addition, the "quality" of the new issue market has been stable (20%-30% of all high yield issuance was rated B- or lower in 2011 and 2012, compared to 40%-60% during the credit bubble). However, given the rally in spreads, it looks like investors are in for carry instead of capital gains. In addition, while global and US default rates are low, they have already bottomed (2nd chart), and are expected to tick up by 0.5% or so in 2013. As a result, while we have been aggressive advocates of credit positions since the fall of 2008, return expectations have come down. US HY bonds and loans trading <= 80% of face value Corporate default rates low but already bottoming Percent Last 12-month default rate, issuer-weighted 50% Peak levels fNov. '08) 14% 45% Bonds: 77% S&P global US bonds speculative grade 40% Bonds Loans: 81% default rate 35% 30% 25% 20% 15% 10% 5% 2% 0% 0% 1994 1996 1998 2000 2002 2004 2006 2008 2010 1981 1984 1987 1990 1993 1996 1999 2002 2005 2008 2011 Source: J.P. Morgan Securities LLC. Standard and Pool's, S8P/LSTA Leveraged Loan Index. Sou ce:J.P. Morgan Securities LLC, Standard & Porn's. Be thankful for a long-term investment approach during the crisis; and that this cash-trashing_era is not that bad (yet) It hasn't been easy, but many portfolios that stuck to a balanced approach survived the crisis, and generated returns in excess of inflation. The 1' chart below shows a balanced portfolio comprised of various indices, rebalanced either quarterly or not at all. Owning enough duration in the wake of the crisis turned out to be critical, given the collapse in interest rates. Among the steps one might have taken to improve returns further: own less European or Japanese equities and more US or EM equities; and have a higher allocation to precious metals, which clobbered everything else. On cash: it is now presumed worthless given the level of rates. To be sure, cash has been losing purchasing power for 4 years running. However, in the scheme of historical cash- trashing, this latest episode is not that bad. As shown, there have been times when inflation completely destroyed the value of cash (Civil War, WWI, WWII and 1970's). In that context, losing 5%-10% purchasing power on cash over the last 4 years isn't that bad. However, it would be brave to even guess the year in which policy interest rates set by the Fed will rise again. A balanced portfolio during and after the storm As cash-trashing episodes go, this one is mild Portfolio total return Index,June 2007= 100 4-year cumulative real return on T-bills and commercial paper 130 40% Rebalanced quarterly 120 20% 110 0°/ No rebalancing 100 -20% 45% Global Equity (MSCI) Index 90 28% Barclays Agg. Gov/Credit Index -40% 12% Dow Jones Credit SuisseIF Index 80 5% Barclays High Yield Index -60% 5% Dow Jones Precious Metals Index •80% 70 1834 1851 1868 1885 1902 1919 1936 1953 1970 1987 2004 Jun-07 Jun-08 Jun-09 Jun-10 Jun-11 Jun-12 Sou ce: Bloomberg, J.P. Morgan Asset Management. It is notpossibleto Source: What Was the Interest Rate Then?", University of Illinois at invest directly in an index. Chicago, Lawrence Officer, 2011. Reinhart and Rogott. 1 EFTA00593393  Eye on the Market I November 19, 2012 J.P.Morgan A case-dependent Thanksgiving for investors: credit, portfolio investing, cash, Congress, Iran and your blood pressure Be thankful if you are not a member of the US Congress in the next 10 years... ...since you would have to figure this out whether you like it or not. Social Security, Medicare and Medicaid spending are gradually crowding out the kind of discretionary spending that help shape a country's future: energy, education at all levels, teacher and worker retraining, and ground and air transportation infrastructure. The table to the right of the chart below shows the OMB's estimated dollar amount for each category in 2017 relative to its historical peak. These declines are measured in nominal dollars, so in real terms the declines are even worse. Legislators could of course decide to raise taxes on the wealthy to pay for it all. However, to reduce the deficit to 3% by 2022 and not touch any of these expenditures, it would take a plan that raises (through tax rate increases and deduction curtailment) four times more revenue than the plan the President proposed to Congress last year. And then after 2022, entitlement spending accelerates again. This is the Boiling Frog problem that lay inside the budget projections. They don't call it the third rail of American politics for nothing. The Boiling Frog Percentof GDP The crowding out of discretionary spending 25% Other mandatory spending Estimated 2017 level / CatepoN vs. historical peak IS 33% Energy Education 69% 15% Social Security, Medicare, Medicaid Teacher and worker retraining 86% 10% Transportation infrastructure: Ground transportation 4% 5% Air transportation 9% 0% 1972 1976 1980 1984 1988 1992 1996 2000 2004 2008 2012 2016 2020 Source: CBO, OMB, J.P. Morgan Asset Management. Be thankful if you sit down for Thanksgiving a year from now. and the issue below has not vet erupted into conflict Despite crippling sanctions that appear to be causing substantial economic damage in Iran, such sanctions have not slowed the pace of uranium enrichment. If anything, the pace appears to be accelerating now that new facilities are on-line. As Henry Kissinger wrote last week, "once the requisite amount of fissile material has been produced, constructing and equipping a warhead is a relatively short and technologically straightforward process, almost certainly impossible to detect in a timely fashion". Over the last few months, almost all of our contacts in Washington have told us the same thing, which is that the US defense establishment has little interest in military confrontation with Iran, and has doubts about its effectiveness' were it to happen, even with the use of massive ordnance penetration bombs. But this issue could clearly take on a life of its own. Iranian enrichment marches on despite crippling Estimated penetration depth of massive ordnance sanctions, 19.75% enriched uranium stockpile (kg) penetration weapons, Cumulative meters penetrated 160 140 140 • Minimum required for Base case nuclear weapon production 120 Estimated depth of mission 120 • space at Fordow / 100 100 - Additional capacity from Fordow on top of Natanz Projected 80 80 • 60 • 60 40 - 40 Denser soil and more gravel collapse Drawdown to 20 replenish reactor fuel 20 0 1 2 3 4 5 6 7 Feb-10 Nov-10 Aug-11 May-12 Feb.13 Missile number (assumed fired at the same location) Source: International Atomic Energy Agency. Bipartisan Policy Center. Source: Columbia University School of International and Public Affairs. I The most powerful conventional weapon in the US arsenal is the Massive Ordnance Penetration device (MOP), a 30,000 pound bomb with 5,000 pounds of explosives. It travels at twice the speed of sound, and is designed to penetrate rock and concrete before detonating. However, it might require 4 MOPs, dropped in succession by B-2s in the same exact spot, to destroy Fordow. That's the base case that Austin Long at Columbia University walked me through (see bio in notes). His Fordow calculations are a function of soil hardness/density, the MOP's mass and impact velocity, its cone shape, and the percentage of each penetration that collapses back in as "spoil", blocking the hole created by previous weapons. Higher soil density and gravel collapse estimates could require 2-3 more MOPs, as indicated in the chart. 2 EFTA00593394  Eye on the Market I November 19. 2012 J.P.Morgan A case-dependent Thanksgiving for investors: credit, portfolio investing, cash, Congress, Iran and sour blood pressure Home for the Holidays The holiday season is approaching, which some people describe Forgiveness can be good for your health as being more stressful than it sounds given family dynamics. Product of heart rate and blood pressure Here's something to help you get through it: evidence that 103 - FP= Forgiving forgiveness is good for your health. People who demonstrate Personaky Inventory, 101 - high scores on a Forgiving Personality inventory measure and acharacter Low forgiveness assessment rating 33 an Acts of Forgiveness scale also show considerably less stress, 99- individuals (FR AF) items on a Likerl scale measured by the product of one's heart rate and systolic blood 97 - pressure. The evidence is from a study in which participants AF = Acts of 95 - Forgiveness Scale, were asked to talk about instances of family betrayal involving which assesses 45 a relative. Their physiological measurements were taken at 93 • High forgiveness responses to specific Individuals (FP, AF) offenses different times during the interview, and are plotted in the chart. 91 Beginning Middle End Have a good start to the holiday season. Timing of measurement during Interview Michael Cembalest Source: "Joirnal of Behavioral Medicine. Volume 26. No. 5" J.P. Morgan Asset Management Notes. Austin Long is an Assistant Professor at the School of International and Public Affairs and a Member of the Arnold A. Saltzman Institute of War and Peace Studies at Columbia University. Long previously worked at the RAND Corporation where he authored reports for the Carnegie Corporation. Marine Corps Intelligence Activity, and the Office of the Secretary of Defense. While at RAND. he was an analyst and adviser to Multinational Force Iraq's Task Force 134/Detention Operations and the I Marine Expeditionary Force. In 2011 he was an analyst and adviser to Combined Forces Special Operations Component Command Afghanistan. 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 containedherein is intended as a generalmarker commentary. Opinions expressedherein are those ofMichael Cembalest and may differfrom those ofother J.P. Morgan employees and affiliates. 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