EFTA01177405.pdf

From: US GIO <us.gio®jpmorgan.com> To: Undisclosed recipients:; Subject: J.P. Morgan Eye on the Market 6/4/2012: The Squid and the Whale Date: Mon, 04 Jun 2012 14:53:45 +0000 Attachments: 06-04-2012__EOTM_-_The_Squid_and_the_Whale.pdf Inline-Images: image002.png; image004.png; image006.png; image008.png; image010.png; image018jpg Eye on the Market, June 4, 2012 (attached PDF easier to read) 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 macroeconomic imbalances Spanish reliance The cheapness of corporate profits and piles of cash on foreign capital Unemployment OECD government Corporate cash to S&P earnings yield rate, Periphery debt/GDP I tangible assets less Germany China capital Industrial production span ing to GD Economy-wide Germany less Italy profits to GDP 1980 1985 1990 1995 2005 2010 1985 1988 1991 1994 1997 2000 2003 2006 2009 2012 Source:Seeappendix 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 (i), 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'sIndex, 50+=expansion 60 PS PS PS 45 40 Period of monetary stimulus 35 2007 2008 2009 2010 2011 2012 Source. J.P. Morgan Asset Man arrnent. Mark it, J.P. Morgan Securities LLC. EFTA01177405 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. Percentage of OECD banking system assets in Italy and a 4.2% primary surplus target: Ridicolo "distressed" banks. Percent. distress = credit spreads > 3% Primaryriscal balance. percentof GDP 45% 40% 6% 35% 4% 30% 2% 25% 0% 20% -2% 15% 10% -4% 5% -6% 0% -8% Oct-07 Ott-08 Oct-09 Oct-10 Oct-11 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 Source: Bloornbeig. Marlcit.J.P. Morgan Securities LI_C,JFMAM. Source: OB:D. The second chart deals with the latest trial balloon, drafted by a group of German Wise Men (ii): 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 ofjoint 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 Bankia Timeline: Spain's third largest bank Dec 2011- Feb 2012 Jul 2010: Bankia parent companies (Caja Madrid and Bancaja) given clean bill of LTR-cver what banks did with ECB money since health in EBA stress test December. EUR. billions July 2011: Bankia IPO raises E3 bn as "good-bank" spinoff Spain Italy Dec 2011: European Banking Authority says Benicia parent needs another E1.3 bn L1RO fuming from ECB 195 114 Feb 2012 Salta annual report asserts "strong solvency and capital position. with a - Purchase of gent. bonds/loans 102 73 core capital ratio of 10.1W May 2012: Spanish government converts E4.5bn 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 E19 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 ofE12 bn Sane: Bridgewater Associates. May 2012: DeutscheBank CEO Fitschen describes Spanish bank capital needs as "staggering": Bankia shares down 72% since July 2011 'PO Sources: European thaw Authority. Bankia corporate reports. EROS. London Telegraph. Bloomberg EFTA01177406 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. improving labor market surveys pointed to rising payrolls, A model predicting payrolls using employment surveys tends to but overestimated the magnitude (again) overestimate them, PayroI predclon error. thousands. 6-rnonth movngaverage isu Coral BLS 300 65 50 5500 overestimation Effoloymerelorcel 60 • 10 • 5000 200 55. 50 • 45 • oo 20 4590 10 • 4003 3500 100 0 ‘11 4/ -10 -100 35 • -20 3003 30 • ,30 -200 2500 25 4 -300 underestimation 20 a 2003 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010 2000 2001 2003 2001 20:6 2007 2003 2010 2012 Sane: BLS, ISM. Conference Board. JFIAAM. Soiree: BLS, ISM, Conference Board, JPMAM. 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 above). 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. 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. EFTA01177407  The China slowdown Heavy reliance on credit Index of manufactunng surveys China's society-wide credit as % of nominal GDP 60 1 230% National Bureau of Statistics 210% 55 190% SO Markit 170% 45 150% 40 130% • 35 110% 2005 2006 2007 2008 2009 2010 2011 2012 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Source: National Bureauof Statistics, Martel. Soine:P8OC.China Bureau of Statistics. J.P. Morgan Asset Management. 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 financial 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 FROB Fondo de Reestructuracion Ordenada Bancaria 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 & Pooes, BEA. Notes (i) A fleeting renaissance of political and social freedoms in Czechoslovakia, abruptly terminated in 1968 by the former Soviet Union (ii) When I read about the Wise Men of Germany, I could not escape a vision of people who look like Gandalf and Albus Dumbledore IRS Circular 230 Disclosure: JPMorgan Chase & Ca and its affiliates do not provide tax advice. 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