EFTA01071132.pdf

Eye on the Market I October 3.2011 J.P.Morgan Topics: Market and economic risks still tilted to the downside With weak US personal income and German business surveys rounding out September, if the US and Europe avoid a mild recession in 2012, they will do so narrowly. Our sense is that a recession is more likely in Europe, given the continued collapse in the periphery. As a result, markets now spend a lot of time waiting, wondering, postulating, tea-leaf reading and hoping for further assistance from the official sector. On most days, investment professionals come to work and first check to see what the Federal Reserve, European Central Bank, Bundestag, German Constitutional Court, Bank of Japan, Bank of England or Bank of China did overnight. In doing so, investors are Waitingfor Godot: as in the play, investors don't know what he looks like; they don't know what he would do if he got there; they might not have ever seen him before; they just hope he shows up soon. The US Godot is unlikely to offer fiscal stimulus (quite the opposite, as shown in the chart on p2, 2012 US fiscal tightening), but might offer monetary stimulus instead, via the possible Fed strategies below. I put an asterisk next to the ones mentioned in Bernanke's 2002 speech "Deflation: making sure it doesn't happen here', so you don't think I got them from a Ouija board. • More purchases of long-duration treasury or agency bonds (*), or a cap on long-term interest rates en • Attempts to lower perceptions of future real interest rates, perhaps by doing one of the following: inflation targeting, GDP targeting, or by stating that rates would be zero until unemployment falls below a given threshold • Purchase of private credit (corporate or municipal bonds), assuming funding can be obtained from Congress (*) • Direct or indirect loans to businesses, with the goal of targeting a given percentage loan growth • Purchase of European government bonds (*), although Bernanke probably meant "riskless" bonds when he wrote it • Fixed-term loans to banks at low or zero interest, with a wide range of private assets such as corporate bonds, commercial paper, bank loans, and mortgages deemed eligible as collateral (In • The Fed could in principle target an even lower dollar, but this is more of an anti-deflation policy than a pro-growth policy, which is what the Fed faces now. The growth benefit would be muted given that trade is a small % of US GDP (-15%). In Europe, a modestly larger version of the sovereign bailout mechanism was approved in Germany (the EFSF). But the more positive tone in Europe last week resulted from rumors coming out of the IMF meetings in DC that Godot had showed up there. When you cut through the haze, a European Godot would take the form of a policy decision that either jeopardizes the inflation- targeting mandate of the European Central Bank, or jeopardizes French/German AAA credit ratings. I am not sure the US or European versions of Godot will show up until there is more pressure to do so, either from a further deterioration in financial markets, in the real economy, or both. As a result, market risks still appear more to the downside than upside, despite the apparent cheapness of global equity markets, and the prospect of another quarter of double digit earnings growth in Q3. Perhaps Godot will show up sooner; if so, we would consider such policy measures an unexpected windfall. We expect some interesting opportunities ahead, but as things stand now, we maintain the cautious outlook we have held all year. The most discouraging outcome has been in Asia, where equity and currency markets have been clobbered despite superior economic performance. As shown in the chart, positive economic surprises in Asia continue to outpace the G10, but for the first time in years, the economic outperformance Despite better economic performance, Asia underperforms has coincided with underperformance of Asian equities. Difference in economic surprise and equity market indices, USD Among the opportunities we are looking at right now: 75 20% European subordinated bank debt at yields of -8%; US 50 rl 15% bank trust preferred stock trading at or below Par; short 10% dated high yield bonds; the Brazilian Real, after an 18% 25 5% decline; EM currencies more broadly, which are down 0 0% —10% since May, roughly half of their Spring 2009 decline; and equity strategies which provide downside -25 -5% Economic Asia vs G7 protection, paid for by taking advantage of the doubling of surprise Index, -10% - equities,Illy equity market volatility since May 2011. 50 Asia vsMO(Ihs) (rhs) -15% Michael Cembalest -75 -20% Mar-03 Mar-05 Mar-07 Mar-09 Mar-11 Chief Investment Officer Source:GaveKal, Citigroup, MSCI, Bloomberg. The irony of the timing of this November 2002 speech: it's when the Fed cut rates to 1.25%. This step was arguably one of the three heads of the housing boom-bust Cerberus, which resulted in the very de-leveraging Bernanke always feared. The other two heads: 1 l l underwriting lapses by banks, broker-dealers, mortgage underwriters and rating agencies: and 121 the unintended consequences of Housing and Urban Development policies which by 2002 required banks to make 50% ofall loans to low and moderate income borrowers, and pushed GSEs to underwrite hundreds of billions of non-standard loans despite having 1% in capital (see Eye on the Market, May 3, 2011). EFTA01071132  Eye on the Market I October 3, 2011 J,P, Morgan Topics: Market and economic risks still tilted to the downside Charts of the week For the US, weak disposable income. and the fiscal tightening projected in the US for 2012. In Europe, note the weakness in German surveys of financial market participants compared to surveys of non-financial businesses (not so bad). In the past few years. the ZEW survey has led the IFO: if this trend is maintained. there may be more weakness ahead for Germany. The r i chart shows Germany's ••vendor financing problem" (e.g.. German banking sector loans to the Periphery). While such exposures are declining, they still represent around 3 times the level of capital in the German banking system. Last two charts: the spike in equity market volatility. and the selloff in emerging market currencies, both of which are around half of what took place in 2009. US: sharp decline in real personal income Germany: financial markets more bearish than businesses Percent YoY Index Index 8% 80 120 IFO survey of non-financial 6% 60 businesses (RHS) 40 110 4% 20 2% 0 100 09/ -20 -2% ZEW survey of Decline not unprecedented outside -40 90 financial -4% recessions, but poses a risk to consumption -60 markets (LHS) -6% -80 80 Jan-99 Feb-01 Mar-03 Apr-05 Jun-07 Jul-09 Aug -11 2005 2006 2007 2008 2009 2010 2011 Source: Bureau of Economic Analysis. Source: Bloomberg. Germany's vendor financing problem is declining US will feel fiscal pain in 2012 German bank exposure to Italy. Portugal.lreland.Spain and Greece Change in cyclically-adjusted federal fiscal deficit, Percent of GDP $1.000 4% Billions, USD Fiscal tightening $900 3% $800 $700 2% I 1% $600 0% I $500 •1% $400 ..but Is still roughly 3x the level of bank -2% $300 $200 capital -3% -4% $100 Fiscal easing -5% $0 Jun -63 Jun-70 Jun-77 Jun-84 Jun-91 Jun-98 Jun-05 Jun-12 1998 2000 2002 2004 2006 2008 2010 Source: Bank for International Settlements. Source:J.P. Morgan Securities LLC. Sharp selloff in EM currencies Spike in equity market volatility J.P. Morgan Emerging Markets Index. level Implied vol. on 12-month at-the-moneycall options on the S&P 500 425 50 400 45 40 375 35 - 350 30 • 325 25 300 20 - 275 15 Jun-07 Jan-08 Aug -08 Apr-09 Nov-09 Jul-10 Feb-11 Sep-11 Jan-08 Jul-08 Jan-09 Aug-09 Feb-10 Sep-10 Mar-11 Sep-11 Sou ce:J.P. Morgan. Bloomberg. Source: Bloomberg. 2 EFTA01071133  Eye on the Market I October 3.2011 J.P.Morgan Topics: Market and economic risks still tilted to the downside EFSF European Financial Stability Facility iFO institut far Wirtschaftsforschung An der Universitat Munchen (Institute for Economic Research at the U of Munich) ZEW Zentrum ftir Europaische Wirtschaftsforschung (Centre for European Economic Research) 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 constitutes J.P. Morgan research and shouldnor be treated as such. Further. the views expressed herein may differfrom that containedin J.P. Morgan research reports. The above summary/prices/quotes/statistics 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 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 by J.P. Morgan Chase Bank. N.A. and its affiliates. Securities are offered through J.P. Morgan Securities LLC(JPMS). Member NYSE. FINRA and SIPC. Securities products purchased or sold through JPMS are not insured by the Federal Deposit Insurance Corporation ("FDIC"): are nor deposits or other obligations ofits 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 ofany financial instrument. Private Investments may engage in leveraging and other speculative practices that may increase the risk of investment 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 tar information. Typically such investment ideas can only be offered to suitable investors through a confidential offering memorandum whichfishy describes all terms. conditions. and risks. IRS Circular 230 Disclosure: JPMorgan Chase & Co. and its affiliates do nor provide tax advice. Accordingly. any discussion of U.S. tax matters containedherein (including any attachments) is nor 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. of any of the matters addressed herein orfor the purpose ofavoiding U.S. tax-related penalties. Note that J.P. Morgan is not a licensed insurance provider. 0 2011 JPMorgan Chase & Co: All rights reserved 3 EFTA01071134