EFTA01181186.pdf

From: US GIO To: Undisclosed recipients:; Subject: J.P. Morgan Macro Skinny: when the S&P becomes a policy tool Date: Sun, 16 Sep 2012 20:18:23 +0000 Attachments: 2012-09-16_When_the_S&P_becomes_a_policy_tool.pdf Inline-Images: image002.jpg; image003.png; image010.png; image012.png; image013.png Macro Skinny J.P.Morgan September 16, 2012 When the S&P becomes a policy tool 1/ In the summer we argued that the Fed's purchases of high duration assets have been forcing a massive divergence between the economy and the stock market (see "Macro Skinny: Fed policy — carry today, growth tomorrow", available upon request). The decision to embark on `open ended' QE3I will likely make this divergence even greater in the coming years. At the risk of making our role a economists obsolete, we would argue that US data are now much less relevant for the stock market because the stock market itself is now used as a policy too12. By implication, stock prices will likely normalize faster than growth. 2/ The Bernanke Fed is betting on the existence of wealth effects: as stock and house prices rise, consumers feel wealthier and are more willing to spend3. But historically the wealth effect in the stock market has been weak. And since the housing bust, the transmission of monetary policy through the housing market has been severely constricted as well. With 31% of homeowners still in `negative equity', wealth extraction from housing will likely remain limited, at least over the next few years. Bottom line, the Fed is banking on wealth effects from stock and house prices, but it may need to create a lot more wealth for a unit of growth than what past research suggests. 3/There is a tendency to assume that markets are efficient and that QE3 is now almost fully priced into equities. The market has certainly rallied impressively into the FOMC announcement and right after it too. But based on prior rounds of Fed moves (QE2, Twist!, Twist2), it appears that once the knee-jerk response of stock prices to the news was over, the portfolio rebalancing effect kicked in. In this second stage, as the Fed buys securities, it commands duration shortfalls and massively lower yields. This forces investors to look for higher-yielding, higher-duration assets elsewhere, including in stock and corporate bond markets4. This suggests to us that QE3 is far from being fully priced in; portfolio rebalancing will likely continue in tandem with more Fed purchases. 4/ Several market commentators have been arguing that the equity market has delinked from economic growth, and as such, we are due for a market correction. We have two issues with this claim: (a) stocks are being used a policy tool and (b) stocks are rising but are still bearish on growth. The left chart below demonstrates why the last statement is true: the 'growthy' part of the S&P5 has been as weak as economic activity this past year, yet at the same time the stock market 'chose' to decouple. The right chart shows that the S&P has rarely diverged this much from its own growth view historically. EFTA01181186  S&P decoupled from its own growth view and actual growth 3milm annualized percentchange Index. 9/1/2010=100 145 4.3 Real c ons um ption 135 3.8 125 3.3 115 2.8 2.3 105 1.8 95 1.3 85 0.8 75 Sep-2010 Feb-2011 Aug-2011 Feb-2012 Aug-2012 Sou ce: Bloomberg. SEA J.P. MorganPB. Data as of Sep-13-2012. The S&P 500 rarely diverges this much from its growth view Index (both axes; 160 1800 140 1600 120 1400 100 1200 1000 80 800 60 600 40 400 20 200 0 0 1998 2000 2002 2004 2008 2008 20f0 2012 Sou ce: Bloomberg. Data as of Sep-13-2012. 5/ One way to see how portfolio rebalancing has promoted stocks is to look at stock performance outside the QE announcement windows (from when the market begins to expect the policy until after the announcement date). The chart below shows how the S&P 500 has fared relative to its own growth view as well as relative to the European market. What's striking, is that even outside of the policy announcement window, US equity prices have repeatedly outperformed market-implied economic growth. We think this portfolio rebalancing channel will likely remain active as the Fed begins the implementation phase of QE3. Even in between accouncement windows, US stocks have done better than US and European growth Index, 7/1/2008=100 170 Twist2 —C1E3 Twistl 60 - NA M-1 160 • S&P 500 14D itieM 130 120 110 100 90 S&P growth basket 80 70 Jul-2008 Jan-2009 Jul-2009 Jan-2010 Jul-2010 Jan-2011 Jul-2011 Jan-2012 Jul-2312 Source: Bloomberg. *STOXX 600. Data as of Sep-13-2012 Shading denotes the announcem ent windowfor each program t from ex p ecled to announced). 6/ For now, the output gap is still very wide, and it will take years of above-trend growth for inflation risks to surface in a meaningful way. But long-term inflation expectations, as implied by the TIPS market, already moved up last week (see chart below) and may well extend further in the coming days. The bigger focus from the Fed's perspective, however, is how consumers and businesses adjust their expectations, not financial markets. This makes the next installment of the University of Michigan inflation survey more important, but no need to get too excited: long term expectations by consumers and businesses won't move significantly higher so easily. EFTA01181187  The market reads Fed policy as more tolerant of inflation 5-year/5-yearforward market-implied inflation rate. percent 3.0 - 2005 2006 2007 2008 2009 Source: Bloomberg. Data es of Sep-14-2012. Michael Vaknin Chief Economist, J.P. Morgan Private Bank Paul Eitelman Associate Economist, J.P. Morgan Private Bank Jeff Greenberg Associate Economist, J.P. Morgan Private Bank (I) The Fed will buy even more duration, but this time they will only stop when the data tells them to. (2) Stocks should do better under two relatively extreme growth scenarios: (a) Data strengthens substantially from hem - Fed will slowdown its duration purchases, which means less support to the stock market, but this will be offset by a meaningful cyclical tailwind. (b) Activity stays relatively weak — no cyclical tailwind for stocks, but this will be compensated by the Fed, which will force a lot more portfolio rebalancing. Our preferred macro scenario is somewhere in between - more monetary tailwind for markets, along with moderately better cyclical support. (3) In his press conference yesterday, Chairman Bemanke commented that, "We do think that these [QE) policies...also affects stock prices. It affects other asset prices—home prices for example." He then commented that "There are a number of different channels (for QE]...lf house prices are rising, people may be more willing to buy homes...So house prices is one vehicle....Stock prices—many people own stocks directly or indirectly." (4) Chairman Bemanke's speech at the Jackson Hole Symposium has a detailed discussion on this channel. (5) A simplified version of this 'growth basket' is long cyclical vs. short defensives. Here though, the sector weights are chosen to best mimic economic growth historically. Acronyms: Fed — Federal Reserve FOMC — Federal Open Market Committee QE — Quantitative Easing S&P — Standard & Poor's IRS Circukr 230 Disclosure: JPAIorgan Chase A Co. and Its affiliates do not provide tat adWee. Accordingly; any discussion ofU.S. tax matters containedherein (including any attachments) is not intended or mitten to be used, and cannot be used, in connection with the promotion, marketing or recommendation by anyone unaffiliated with JPAlatgan Chase & Co. ofany ofthe matters addressed herein orfor the purse ofavoiding U.S. tax-related penalties. Note that J.P. Morgan is not a licensed insurance provider. The material containedherein is intended as a general market commentary. Opinions expressedherein are those ofMichael Vaknin and may differfrom those ofothers Morgan employees and affiliates. This information in no way constitutes J.P. Morgan research andshouldnot be treated as such. Further, the views expressedherein may differ from that containedin J.P. Morgan research reports. The abate summarrntrecesiguotewitatistres have been obtainedfrom sources deemed to be reliable, but we do not guarantee their accuracyor completeness, any yield referenced is indicative and subject to change. Past performance is not a guarantee offuture results. References to the performance or character ofour portfolios generally refer to our Balanced Model Portfolios constructed by J.P. Morgan. It is a pawl°, client performance andmay not represent actual transactions or investments in client accounts. The modelportfolio 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, trust and investment management services are provided byJP Morgan Chase Bank. `and its affiliates. Securities are offered through J.P. Morgan Securities LLC (JPAIS), Member NYSE, F/NRA and SIPC andits 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 ofits hank or thrift affiliates and are not guaranteed by its bank or thrift affiliates: and are subject to investment risks. including possible loss ofthe principal invested. Not all investment ideas referenced are suitablefor all investors. Speak with youfit'? Morgan Representative concerning your personal situation. This material is no 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 requited to provide periodic pricing or valuations to investors andmay involve complex tax structures and delays in distributing important tax information. 7)pically such investment ideas can only be offered to. uitable investors through a confidential offering memorandum whichfully describes all terms, conditions, EFTA01181188 and risks. This material is distributed with the understanding that JP Morgan is not rendering accounting, legal or tax advice. You should consult with your independent advisors concerning such matters. In the UnitedKingdom, this material is approved by J.P. Morgan International Bank Limited (JPMCB) with the registered office located at 25 Bank Street, Canary Wharf London £14 Su:: registeredin England No. 03838766 and is authorised and regulated by the Financial Services Authority In addition, this materialmay be distributed by: JP‘l an Chase Bank, N.A. (IPA:CB) Paris branch, which is regulated by the French banking authorities AuforitA de Contrele Prudentiel and Admire des Matches Financiers:In Morgan (Suisse) SA, regulated by the Swiss FinancialMarket Supervisory, AuthorioP: JPMCB Bahrain branch, licensed as a conventional wholesale bank by the Central Bank of Bahrain (for professional clients only); JPMCB Dubai branch, regulated by the Dubai Financial Services Authority In Hong Kong, this materially distributed by-IPA:organ Chase Bank. N.A. (JPMCB) Hong Kong branch except to recipients having an account atJPMCB Singa branch and where this material relates to a Collective Investment Scheme (other thanprivatefunds such as private equity and hedgefunds) in which case it is distributed by. Morgan Securities (Asia Pacific) Limited (JPAISAPL). Both JPMCB Hong Kong branch andJPAISAPL 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 privatefunds such as °private equity andhedgefunds) in which case it Is distributed byJ.P Morgan (S.EA) Limited (JPAISEAL). Both JPMCB Singapore branch and JPAISEAL are regulated by the Monetary Authority ofSingapore. This message has been prepared by personnel in the (Sales and Trading Departments)ofone or more affiliates of.I.P Morgan Chase & Co. andLs not the product of. Morgan3 Research Department. It is not a research report and is not intended as such. This materialIsfor the general information ofour clients and is a "solicitation" only as that term is used within CFTCRule 1.71 (a)(9)(v) and 23.605(a)(9)(v) promulgated under the U.S. Commodity Exchange Act. Each recipient ofthis presentation, and each agent thereof may disclose to anypenron. 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 orfranchise tax strategy provided to such recipient by-IPA:organ Chase & Co. and as subsidiaries. Shouldyou have anyquestions regarding the information contained in this material or about IP Morgan products and services. please contact your J.P. Morgan private banking representative. Additional information is mailable upon Aguas "JP. Morgan" is the marketing namefor JPAforgan Chase & Co. and its subsidiaries and affiliates worldwide. This material may not be reproduced °rein-dated without JP Motgan3 authority C 2012 JPAIonLan Chase & Co. All rights reserved. This email is confidential and subject to important disclaimers and conditions including on offers for the purchase or sale of securities, accuracy and completeness of information. viruses, confidentiality, legal privilege, and legal entity disclaimers, available at http://www.jpmorgan.comtpagesidisclosurestemail. EFTA01181189