EFTA01069643.pdf

Eye on the Market I June 4.2012 JP Morgan The battle between rising profits/low equity valuations and those macro issues that just won't go away The Squid and the Whale. Our decision to maintain an underweight position in equities coming into 2012 was based on the view that the battle between the Squid (some of the worst macroeconomic imbalances on record) and the Whale (rising corporate profits, the lowest equity valuation multiples in decades, and a 50- year high in corporate cash balances) was not over yet. Our view looked too conservative in March, in the positive glow of ECB rescue operations and strong US employment gains. At the time, global equities were up more than 12%. Since then, as we feared and highlighted at the time, the bloom came off the rose in Europe, and the end of weather/census/other distortions brought US payroll growth back down to earth. The markets have followed them, with global equities flat for the year as of last Friday. The Squid The Whale Tentacles of macroeconomicimbalances Spanish reliance The cheapnessof corporate profits and piles of cash on foreign capital Unemployment OECD government Corporate cash to rate, Periphery S&P earnings yield debbGDP China capital tangible assets less Germany Industrial production. spen ing to GD Economy-wide Germany less Italy profits to GDP 1985 1988 1991 1994 1997 2000 2003 2006 2009 2012 Source: See appendix. Source: See appendix. As the squid-whale battle rages on, the global economy has improved in fits and starts. However, as shown below, as soon as periods of monetary stimulus fade, so have measures of global activity. For the third year in a row, we've had another Prague Spring, a metaphor for better springtime data melting as summer begins. Unsurprisingly, market chatter now shifts to the next rounds of stimulus in both OECD and non-OECD nations. Here we go again. In today's note, a look at Europe, the US and China. While industry Whale Watchers are always on the lookout for the next bull market, I have had the feeling that the squids will be around for a while, and that portfolios should be positioned accordingly. Another Prague Spring Global Composite Purchasing manager's index, 50+-expansion 60 - ps 55 so 45 40 35 2007 2008 2009 2010 2011 2012 Source:J.P. Morgan Asset Management, Markk,J.P. Morgan SecuritiesLLc. On Europe, some clients (and colleagues) wonder why we spend so much time on it every week. It's not every day that the monetary union of a highly indebted region runs aground, so I consider the answer to that question to be self-evident. In case it's not, here are another couple of things to think about. The first chart below shows the percentage of OECD banking system assets that are held by banks in some kind of distress. I define "distress" as banks with credit spreads of more than 3%. Other levels could have been used, but I chose 3% since it signifies a level of credit risk which offsets part of a bank's net interest and credit lending margins. Around one third of all OECD banking system assets fall into this category, and the vast majority of banks contributing to this chart are European. That alone should be enough to get your attention focused on Europe. I A fleeting renaissance of political and social freedoms in Czechoslovakia, abruptly terminated in 1968 by the former Soviet Union. EFTA01069643  Eye on the Market I June 4.2012 JP Morgan The battle between rising profits/low equity valuations and those macro issues that just won't go away Percentage of OECD banking system assets in Italy and a 4.2% primary surplus target: Ridicolo "distressed" banks, Percent. distress = credit spreads> 3% Primaryfiscal balance, percent of GDP 45% 6% 40% ERF proposal 35% 4% -II 30% 2% 25% 0% 20% •2% 15% 10% 5% •6% 0°A 8% Oct•07 Oct•08 Oct•09 Oct•10 Oct-11 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 Source: Bloomberg, Markk, J.P. Morgan Securities LLC, JPMAM. Source:OECD. The second chart deals with the latest trial balloon, drafted by a group of German Wise Meng: the "European Redemption Fund". Vladimir and Estragon covered the ERF in last week's Waitingfor Godot, but as a review, the idea is that Germany would sanction the temporary use of joint and severally guaranteed European government bonds if member countries adopt constitutional debt brakes and primary surplus targets that guarantee paydown of these bonds over time, and hit a 60% debt to GDP target after 25 years. In Italy, this would require a primary surplus of 4% every year for 25 years, and a constitutional 60% debt brake which would have been breached 70% of the time since Italian unification in 1861. If the preposterousness of such a plan is not apparent, refer to the second chart above on Italy's primary surplus since 1960. It was briefly above 4% at the end of the 1990's (based more on tax collections than spending cuts), but that's about it. There is little in European economic or political history that suggests that the ERF's primary surplus targets are achievable over the long run. Turning Greeks into Germans has proven to be a disaster; I am not sure that turning Italians into Germans will be any more successful. As shown in the table below, the money from the ECB's two rescue operations has now mostly been spent. People who expect Europe to "fix the problem" operate under the assumption that [a] they know how to do it, [b] that countries like Germany can afford it, and [c] that the political will exists to do it. I don't know about [a] or [c], but as reviewed in The German Question (May 21), given Germany's 80% debt to GDP ratio, I have reservations about [b]. Something is coming in Europe, perhaps a forced recapitalization of Spanish banks after the Bankia nationalization (see table), a banking license for the ESM bailout fund or a fortified bank deposit guarantee fund (deposits in Periphery banks are around 3.6 trillion Euros). But as we wrote last week, you would have to be a Panglossian optimist to assume it will be the defining turning point for the region. ECB funding for European banks Benicia Timeline: Spain's third largest bank Dec 2011- Feb 2012 Jul 2010: Bankia parent companies (Caja Madrid and Bancaja) given clean bill of LTR-Over: what banks did with ECB money since health in EBA stress test December, EUR, billions July 2011: Bankia IPO raises €3 bn as "good-bank- spinoff Spain Italy Dec 2011: European Banking Authority says Bankia parent needs another f1.3 bn LTRO funding from ECB 195 114 Feb 2012 Bankia annual report asserts - strong solvency and capital position, with a core capital ratio of 10.1%" - Purchase of govt. bonds/loans 102 73 May 2012: Spanish government converts C4.5bn of preferred shares into voting stock - Purchase of other bonds 0 26 of Bankia parent company - Paydown of interbank liabilities 48 45 May 2012: Spanish government announces another C19 bn needed at Bankia's parent - Paydown of bonds 25 18 company to cover current and future provisions Amount left 20 -48 May 2012: Bankia announces Q4 2012 rights offering of Cl2 bn Source: Bridgew ater Associates. May 2012: DeutscheBank CEO Fitschen describes Spanish bank capital needs as "staggering": Bankia shares down 72% since July 2011 WO Sources: European Banking Authority. Bankia corporate reports. FROB. London Telegraph. Bloomberg. In the United States, the payroll report was a letdown, particularly since higher US growth is one of the few things Europe could look to as a stabilizing force. As we head into summer, most economists are taking down US GDP growth numbers (again), with 2012 now converging to 2%. Disposable income growth is weakening, which typically means that business capital spending will remain subdued as well. The decline in gasoline prices and debt service costs has helped prevent a sharp decline in consumer cash flow, but the entire picture does not appear to add up to escape velocity for the US economy. 2 When I read about the Wise Men of Germany, I could not escape a vision of people who look like Gandalf and Albus Dumbledore 2 EFTA01069644  Eye on the Market I June 4.2012 IP Morgan The battle between rising profits/low equity valuations and those macro issues that just won't go away On the payroll report, recently improving labor surveys from the Conference Board, the Institute for Supply Management and the Bureau of Labor Statistics turned out to be misleading (first chart below). It's hard to pinpoint why, but it's important to understand that Conference Board and ISM surveys measure "whether it's easier to find a job", and "whether purchasing managers intend to hire more people". They measure direction but not magnitude. As a result, a reading of 55 on the ISM employment survey doesn't always mean the same thing. As shown in the second chart below, a model which predicts payrolls using Conference Board and ISM surveys did a decent job during the 1990's; its estimates ranged from +1- 100k around the monthly payroll report. But over the last decade, this model consistently overestimated payroll growth for reasons that are not easily explained. All we can do is pay attention to the results, and not over-extrapolate what surveys might be telling us about labor demand. We expect better payroll growth in the months ahead (120k or so per month), although that's a pretty low hurdle. Improving labor market surveys pointed to rising payrolls, A model predicting payrolls using employment surveystends to but overestimated the magnitude (again) overestimate them, PayrolpredicMn error, thousands. 6-month movingaverage iSM Cord ed BLS 300 65 so - overestimation 60 - 4o • 200 55 • 30 - 20 • 100 50 - 10 • as - 0• 40 - -10 - •100 35 - -20 - SD • 30- -200 25 • -40 • underestimation 300 20 -50 - 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010 Source: BLS.ISM,Conference Board, JPMAM. Source: BLS. ISM. Conference Board. JPMAM. China When I started at J.P. Morgan in 1987, China's share of global GDP was considerably less than Latin America's. Now, it's almost three times larger, so China deserves a lot of attention. The latest data suggest that Chinese growth is running around 6%, below the government's target and before presumed stimulus measures lift it back up again. The slowdown in China spans all the sectors we look at (investment, demand, production, exports, imports and housing). While China has the ammunition to add stimulus, so far, there appears to be little political desire to engage in anything like the money drop that took place in 2009. Reductions in bank reserve requirements, increased social housing investments, accelerated infrastructure investments, incentives for purchases of energy-efficient autos and appliances, and an expanded credit line for the Ministry of Railways are all notable, but not in the same zip code as 2009's 4 trillion RMB stimulus package. The China slowdown highlights the reality that in 2010 and 2011, Chinese growth became increasingly reliant on credit expansion (second chart). This credit expansion is now slowing, and so is Chinese GDP growth. The China slowdown Heavy reliance on credit Index of manufacturing surveys China's society-wide credit as % of nominal GDP 60 230% National Bureau of Statistics I Markit 45 150% - 40 130% - 35 2005 2006 2007 2008 2009 2010 2011 2012 110% 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Source: National Bureau of Statistics. Marla Source: PBOC. China Bureau of Statistics,:.. Morgan Asset Management. 3 EFTA01069645  Eye on the Market I June 4.2012 J.P.Morgan The battle between rising profits/low equity valuations and those macro issues that just won't go away Wrapping up Investor caution and elevated market and economic risks always go together; that part is not a surprise. But I cannot recall such an extreme dichotomy before, characterized by rising profits, mountains of sidelined cash and low equity valuations on one hand, and a set of almost biblical macroeconomic risks on the other. The most optimistic voices I read often come from people that either ignore the latter, or cannot bear to look at it. If there is one thing that characterizes our investment philosophy, I believe it is that we always try as hard as we can to acknowledge the squid. Government rescues of different kinds may be on the way at some point which will probably stabilize markets, but I find it hard to see the squid-whale battle being decisively resolved in 2012. We will be watching for oversold conditions in large cap stocks, credit and commodities. Michael Cembalest J.P. Morgan Asset Management ECB European Central Bank OECD Organization for Economic Cooperation and Development LTRO Long Term Refinancing Operations ERF European Redemption Fund ESM Exchange Stabilization Mechanism 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. IRS Circular 230 Disclosure: JPMorgan Chase & Co. and its affiliates do not provide tat advice. Accordingly. any discussion of U.S. far 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 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 summarylpriceslquotesInaristics 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. Past 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. trust and investment management services are provided by JP Morgan Chase Bank. NA. and its affiliates. Securities are offered through J.P. Morgan Securities LLC (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 affiliates: 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 your J.P. Morgan Representative concerning your personal situation. This material is nor 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 (JPMCB) with the registered office located at 125 London Wall EC2Y 5A.I. registered in England No. 03838766 and is authorised and regulated by the Financial Services Authority. In addition. this material may be distributed by: JPAforgan Chase Bank. NA. (JPMCB) Paris branch, which is regulated by the French banking authorities Autoritd de Contrble Prudentiel and Autorite des March& Financiers: J.P. Morgan (Suisse) SA, regulated by the Swiss Financial Market Supervisory Authority: 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: JPMCB Hong Kong branch. regulated by the Hong Kong Monetary Authority: JPMCB Singapore branch. 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 tar 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. "LP. Morgan" is the marketing namefor !Morgan Chase & Co. and its subsidiaries and affiliates worldwide. This material may not be reproduced or circulated without J.P. Morgan's authority. 0 2012 JPMorgan Chase & Co. All rights reserved. 4 EFTA01069646