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From: US GIO To: Undisclosed recipients:; Subject: Macro Skinny: The S&P as a policy tool, revisited Date: Tue, 09 Apr 2013 14:46:49 +0000 Attachments: 2013-04-09_S&P_as_a_policy_tool,_revisited.pdf I nline-Images: image003.png; image004.png; image005.png; image006.png; image007.png; image009.png; image010.png; image0ll.png; image012.jpg; image00 Ljpg Macro Skinny J.P Morgan April 9, 2013 The S&P as a policy tool, revisited Fiscal drag: it's here, but not here to stay. With all of the uncertainty surrounding the fiscal cliff last year, no one thought first quarter growth in the US would exceed 3%. It's now quite likely, but context is critical. Growth in the fourth quarter was dragged down by a sharp inventory de-stocking and a sudden drop in defense spending (both could be related to the fiscal cliff). The rebound in Q1 hence reflects a one-time positive payback. The story is different for Q2: it is broadly anticipated that the drag from the payroll tax and sequester will finally take effect and push sequential growth to below 2% (weaker growth signs are already seen in the March data). However, looking to the second half of the year, the fiscal drag should fade and growth will likely gradually accelerate. Excluding the inventory noise, the underlying growth picture looks more like 2-2.5% for 2013, better than the 1.5-2.0% we penciled coming into the year. The weak March jobs report tells us the labor market will likely see a bumpy ride as well. Only 88k jobs were added in March, but the trend is still within our expectations of 150-175k per month this year (right chart). Put in the context of healthy hiring months recently and tightened fiscal policy, the broader trend is still encouraging. Looking through the noise, US growth ranging 2.0-2.5% The trend in payrolls remains in the 150-175k range Contributions to QoQ annualized% mange in real GDP, ppb Monthly thange In US nonfarm payrolls,000s (3-month avg) 5 300 4 Real GDP forecasts 250 3 200 168 2 150 0 100 -1 ■Inventones -2 ■National defense 50 ■Rest of the economy -3 0 12:O1 12:O2 12:O3 12:O4 13:O1 13:O2 13:O3 13:O4 Ilar-12 Jun-12 Sep-12 Dec-12 Mar- 13 Source: BEA. J.P. Morgan Securities LLC forecasts. Sou ce: 8LS. J.P. Morgan1:13Econcinics. Last summer the Fed signaled its intention to take wealth effects more seriously (See Macro Skinny: "Fed policy: carry today, growth tomorrow" and "When the S&P becomes a policy tool"). Since then, stocks have rallied hard with the S&P 500 recently touching a new record. The Fed appears to have had more influence than the gradual growth rebound. Indeed, stock returns were strikingly correlated with dividend yields; translation: bond-like stocks have generally done better than growth stocks (charts below). This unusual phenomenon was not seen during QEI/QE2; rather it started when the Fed shifted its asset purchases towards long-term securities. This aggressive duration buying policy nudged the traditional holders of long-term securities to sell them at low yields (great profits) and look for a source of cash flow elsewhere.1 As for investors overweight cash, rebuilding risk has typically started in US Treasuries, but not this time given how flat the yield curve is. They too, are nudged to head straight for riskier assets. Chairman Bemanke reiterated following EFTA01144260 the March meeting that the Fed does not target higher stock prices, although he conceded in the past that asset prices may compensate for the fact that zero rates are not accommodative enough.2 Time will tell whether higher asset prices trigger positive wealth effects (as the Fed hopes), but for now, the Fed is happy to give it a try. Bond-like equities benefited the most ....and cyclical sectors underperformed P/E multiple expansion, 06/30/2011 to 03/21/2013 Total return, 06/30/2011 to 04/02/2013, annualized, % 7x 20 - * Heatthcare *Consumer • gx Telecom • 18 - Consumer 5x 16 - taples Telecom • Materials R2 =0.5965 discretionary 4x Consumer 14 - • UfilRies UP 5N 12 - Industrials 3x discretionary Healthcare Financials IT • 2x • * 10 - rr • 8- • R2 =0.191 ox 6- -lx Energy • *Industrials a- •Energy Materials -2x * 2- • a Financials 0 06 1.0 1.6 2.0 2.6 3.0 3.6 4.0 4.5 6.0 0.4 0.6 0.8 1.0 12 1.4 DividendyiekIon05/30/2011,% BetatotheS&P 600: 2003-2007 Source: Bloomberg. Markers dendethe S&P 600 and its 10 GICS1sectors. Source: Bloomberg. Markers denctethe SAP500 and its 10 GICS1sectors. At the heart of these policy initiatives is the notion that, compared to past cycles, the recent recession has inflicted much more damage on the labor market. The implication is that there is a lot of room for growth in employment and the broader economy before inflation becomes a real issue. Crucially, this means that monetary policy will stay unusually loose for an extended period, as the economy gradually recovers. To be clear, the Fed hinted in January that it may stop purchasing securities by year-end or early next year. But like the last part of every fireworks show, the Fed QE program is ending with a big bang; this year, the Fed will be buying an estimated 70% of the net duration supply from the Treasury and Agency MBS market (I). Moreover, the end of Fed bond-buying, which is likely next year, doesn't imply a start to active bond- selling. Rather, the next move from the Fed is likely to be policy rate hiking (not before late-2015 in our view), while holding its existing securities until maturity.3 This means that the exit will be smoothed over a very long period (beyond 2020). If the Fed can clearly communicate its pace of policy firming and resolve any confusion around the mechanisms it will use to drain liquidity, this kind of gradual exit should not trigger a violent move in the bond market.4 The central bank liquidity surge is not limited to the Fed: the BoE has taken a similar path, and the BoJ, under its new leader Kuroda, just embarked on a grand beginning (in its long-standing battle with deflation). Taking a page from the Fed's book, the BOJ is now focused on scooping long-dated securities from the market and will be significantly extending the average maturity of the JGBs it purchases (from under three years currently to about seven years). ...and the Sal followed with its own "Operation Twist" The Fed showed the BOJ the power of buying duration... 30-year government bond yield % (both axes) Govt bond purchases',% of net debt supply (10-yr equivalents) 4.5 Japan 2.0 80 Alter April meeting __•,. Announcement of matutty extension programs 70 Bel ore April 40 50J- 4April 2013 1.8 60 meeting \ Fed:21 September 2011 50 35 1.6 40 30 30 1.4 20 10 25 12 0 -90 -60 -30 0 30 60 201Q 2011 2012 2013f Days from announcement Note: Tell72ReserveputcresesInatxleAgency MSS. Source: Federal Source: Bloomberg, J.P. MorganPB Economics,Dete es ofApril 5,2013 Reserve 60J,Nomunt.J.P.MorgenIVEconomcs. If there is a near-term threat for the bond market, it is that Fed tightening could happen sooner and at a faster pace than currently anticipated. This would arise from either growth surprising significantly on the upside or from inflation (and inflation expectations) rising sharply. But in past cycles, higher yields and the start of a Fed rate cycle, especially when driven by stronger growth, have not signaled the turning point in risk markets. For instance, credit spreads—a good barometer for risk appetite—remained tight long after rates rose (chart below). A challenging and more dangerous scenario, albeit a less likely one, is if yields were to pick up in response to mounting supply-side inflation instead of growth. The unexpected recent decline in the unemployment rate, despite relatively anemic growth in output and jobs, may worry markets in this regard. Yet, we see the decline in the unemployment rate as a technical move.5 BemanIce thinks so, too. The FOMC did explicitly tie the timing of the first rate hike to unemployment in December 2012 (vowing to keep rates low as long as the unemployment rate exceeds 6.5% and inflation risks are muted). Further declines in the unemployment rate, if EFTA01144261 driven by technical and not economic factors, might muddle the Fed's message but won't force them to tighten policy. Mr. Bemanke made it clear that the unemployment rate informs their rate decisions but it's by no means a trigger.6 Rather, it is a sustained recovery in jobs growth that is likely to lead the FOMC to reassess its policy stance. Credit cycles end long after the Fed starts tightening Pe tentage points (both axes) 29 - - 10 16 - 8 Federal funds rate -a. 12 6 4 2 0 1987 1989 1991 1993 1996 1997 1999 2001 2003 2006 2007 2009 2011 2013 Source: Bloomberg,FRB. Data as ofMarch 20, 2013. ShadinghigNightshistoricalp °Flamenco ofHY spreads Owing fed findratehikes. Aside from the monetary engine, the growth engine will remain supportive in the coming years. But as we argued in recent publications (See Macro Skinny: "Stabilizing at healthy levels" and "A good start to the New Year"), the global cycle has been set to pause at healthy levels in the next couple of quarters (after an impressive run-up in growth momentum since last summer), before it reaccelerates later in the year. The global PMI rose slightly in March and was supported by improvements in the US and China (left chart). This strength was offset by surveys in the Eurozone, where manufacturing activity appears to have slowed further. Despite this weakness, growth momentum in Europe is still tracking above the pre- OMT lows from last July, and remains consistent with our expectation that growth in the region will turn positive in the second half of this year. Zooming out, we still strongly feel that the world economy is in the midst of a broader cyclical recovery. We won't go back to the hey-days of 2005-2007 where world growth was tracking at 5%, but certainly more cyclical momentum is likely in the coming years (right chart). Business surveys suggest the global cycle has paused G obal growth set to push higher later this year Global manufacturing PNII 50•= expansion Real GDP growth, YoY % change 67 - 6 C urre nt trac king 56 - estimate 55 - 54 - 53- 52 - 51 - 50 - 49 - 48 4., Jan-10 Jul-10 Jan.11 Jul-11 Jan.12 Jul-12 Jan-13 2006 2008 2010 2012 2014 Source: Marlcit, J.P. Morgan. Data as of March, 2013. Source J.P MorganPB Economies data andforecasta PPPweighted 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] A preferred substitute for many investors who sold these bonds appears to have been dividend stocks: they provide a long stream of cash flow at a relatively attractive yield, offer upside of capital appreciation, and provide a better hedge against inflation. [2] Chairman Bemanke made this justification for QE2 in a 3 November 2010 Washington Post op-ed: " [QE] eased financial conditions in the past and, so far, looks to be effective again. Stock prices rose and long-term interest rates fell when investors began to anticipate the most recent action. Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And EFTA01144262 higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion" (emphasis added). [3] We know from discussions around the exit strategy in summer 2011 and Chairman Bernanke has since confirmed that asset sales wouldn't happen until at least a year after the first rate hike. FOMC participants are currently reassessing their exit strategy views and it's likely we'll have more clarity in the coming months. One potential, and increasingly likely, outcome is the Fed decides it will never actively unwind its portfolio. It's important to keep in mind that most FOMC participants are confident that, when it's time to tighten, the target rate (not the balance sheet) is the way to do that. The authors of a recent Fed pam found that asset sales would lead the Fed to realize more potential losses rather than just holding everything to maturity. This assessment — along with the view that selling assets might "destabilize markets" — has led some FOMC members, such as Jerome Powell, to push for a "not for sale" assignment to the assets. [4] The expectations that the exit won't be violent for the bond market makes sense given that the Fed is not selling long-term maturity bonds anytime soon and given that the only other major players in this high-duration markets are those who are mandated to own duration, such as pension funds and life insurers. This is consistent with ow Treasury valuation models, which accounts for the zero bound in Fed Funds and the shift to QE territory. Absent a sharp unwind of the Fed's balance sheet, these models estimate a very gradual pick-up in yields—broadly in line with the forwards. [5] Recent declines in the unemployment rate have been driven by a collapse in labor force participation. Our models suggest that as the US recovery continues the cyclical decline in participation should slow, if not reverse. This means further declines in the unemployment rate from here should be more challenging. [6] He also noted all of the other labor market indicators he's watching in his Wednesday, March 20th press conference: "I would say that we will be looking for sustained improvement in a range of key labor market indicators, including obviously, payrolls, unemployment rate, but also others like the hiring rate, claims for unemployment insurance, quit rates, wage rates and so on, looking for sustained improvement across a range of indicators, and in a way that is taking place throughout the economy." Acronyms: BEA - Bureau of Economic Analysis BoE — Bank of England BoJ - Bank of Japan BLS - Bureau of Labor Statistics FOMC — Federal Open Market Committee FRB — Federal Reserve Board GICS — Global Industry Classification Standard HY — High Yield MBS — Mortgage Backed Securities OMT — Outright Monetary Transactions PMI — Purchasing Managers Index S&P — Standard & Poor's 500 Index — a value-weighted equity index of 500 large US companies QE — Quantitative Easing IRS Circular 230 Disclosure: JPMorgan Chase & Co. and its affiliates do not provide tax advice. According!): any discussion ofU.S tar 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. tar-relatedpenalties. Note that J.P. Morgan is not a licensed insurance provider. 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