EFTA01077283.pdf

EYE ON THE MARKET OUTLOOK 2011 J.P. Morgan Private Bank Figure I: Printing Press The illustration represents the money created by various central banks since January 2008 to buy their own government bonds. or bonds of other countries to limit exchange rate adjustments. Crates are labeled by amount created. and expressed as a percentage of GDP. See inside cover for more details. J.P.Morgan EFTA01077283 What is "money"? If you go to the Bureau of Printing and Engraving at the U.S. Treasury, you won't actually see the machines running in overdrive. In an era of electronic money, the Federal Reserve can increase the monetary base (also known as "high•powered money") by increasing bank reserves to pay for the Treasury bonds that it purchases. The same applies to government bond purchases in the United Kingdom. The other countries shown engage in a different kind of money creation: an expansion of the monetary base to fund the purchase of foreign assets instead of domestic ones, with the goal of limiting exchange rate appreciation. Most of these countries drain domestic liquidity to try and prevent inflation, but still create two separate distortions. The first is domestic: By maintaining an undervalued currency and very low real interest rates, they risk inflation of wages, goods and asset prices. The second is international: These actions contribute to the global pool of central bank savings invested in U.S. government bonds. What used to be a functioning private sector market with price signals regarding inflation and growth risks is now increasingly subject to price controls and systemic shocks. By the time QE2 is over, more than half of all Treasuries will be owned by U.S. and non•U.S. central banks. Note how the representative from the European Monetary Union, which is not engaging in this kind of activity to any large degree, looks on in despair from outside the building. EFTA01077284  MARY CALLAHAN ERDOES Chief Executive Officer J.P. Morgan Asset Management How do you summarize a year that was in many respects indefinable? On one hand, the European sovereign debt crisis, contracting housing markets and high unemployment weighed heavy on all of our minds. But at the same time, record corporate profits and strong emerging markets growth left reason for optimism. So rather than look back, we'd like to look ahead. Because if there's one thing that we've learned from the past few years, it's that while we can't predict the future, we can certainly help you prepare for it. To help guide you in the coming year, our Chief Investment Officer Michael Cembalest has spent the past several months working with our investment leadership across Asset Management worldwide to build a comprehensive view of the macroeconomic landscape. In doing so, we've uncovered some potentially exciting investment opportunities, as well as some areas where we see reason to proceed with caution. Sharing these perspectives and opportunities is part of our deep commitment to you and what we focus on each and every day. We are grateful for your continued trust and confidence, and look forward to working with you in zoii. Most sincerely, EFTA01077285  Eye on the Market I OUTLOOK 2O11 , 1.2011 J.P.Morgan The Printing Press As we head into 2011, global profits are rising, U.S. household incomes and debt burdens are improving, the Asian production boom continues, global services are starting to rebound, and Germany is seeing its largest manufacturing and consumer revival since reunification. The twin engines of world growth, the U.S. and China, are in expansion mode again (el). (0) U.S. and China manufacturing (c2) Excess capacity in the U.S. and (c3) Asia ex-Japan and Latin inflation output surveys, Index level. sa Asia, Output gap, GDP vs potential Percent, YoY change 65 - 4%- EPA -- Asia: no 9% excess 8% capacity 7% 6% 5% U.S.: lots 4% of excess capacity 3% 2% 6% 1% 2003 2005 2007 2009 2005 2006 2007 2008 2009 2010 Given pressures for fiscal tightening in the West, it's hard to blame monetary authorities around the globe for trying to keep these things moving. That's why the global monetary experiment captured by the cover art continues uninterrupted. But it may be beyond traditional linear thinking to grasp all the ways this could turn out. The lowest inflation since 1958 and a large output gap in the U.S. (an inexact measure of spare labor/productive capacity) give the Fed justification for its approach (c2). The same cannot be said for Asia, where the output gap is smaller (or may not exist at all), and where inflation is rising. The chart below is something we have been thinking a lot about (c4). It's a measure of global imbalances: the extent to which some countries spend more than their incomes, and rely on other countries to finance the difference; how much they intervene in their currency markets; and how much they offset inadequate private sector demand through budget deficits. Does this matter given the good news above? When PIE multiples on global equity markets (c5) are so low? And when mountains' of household, corporate and Sovereign Wealth Fund cash are capable of driving asset prices higher? We think it does, since the risks of unintended consequences are higher when the magnitude of imbalances (and experimentation) is this high as well. (c4) An index of global imbalances (a) Global equity multiples (c6) Cost of money = zero Percent of global GDP Forward PIE ratio Policy rates adjusted for inflation, percent 1 12% 16 Current account and 15 "Avg since 1988 EM countries 10% fiscal deficits/surpluses III Current value 14 8% 13 - 6% 12 11 • 4% 10 • 2%, 9 • 0% 8 1970 1978 1986 1994 2002 2010 MSCI Europe MSCI USA MSCI EM 1981 1985 1989 1993 1997 2001 2006 2010 We have invested client portfolios around the globe in the belief that the world will not suffer a major relapse, with significant holdings in public and private equity, credit, hedge funds, commodities and real estate. We expect 2011 to be like 2010: volatile, rising equity markets, and modest returns on a balanced portfolio of financial assets. That these returns are made more attractive by the world's Printing Press policy, which renders cash savings useless as a store of value (c6), is a mixed blessing at best. This publication reviews our market, investment and portfolio stance as 2011 begins. Michael Cembalest Chief Investment Officer A ratio of US corporate sector cash/tangible assets is at its highest level on record. A measure of household cash and bonds as a % of discretionary financial assets is not far off. Sovereign Wealth Fund balances have grown from $1 trillion to $4 trillion since 2005. Sources for all charts and tables, as well as a list of acronyms used, appears on page 12. 1 EFTA01077286  Eye on the Market I OUTLOOK 2011 January 1.2011 J.P.Morgan Fast growth, inflation pressures: a better set of problems in Asia and the emerging world If we are not in an Asia-dominated world yet, we may be there soon. Asia's share of world output, even when excluding Japan, is now double that of the U.S. and still growing (c7). As a result, the Asian/EM inflation question is a very important one. As shown on page 1, headline and core inflation in Asia and Latin America are rising. Inflation pressures are mostly food-driven (c8, c9), but are beginning to impact wages and prices as well. China's inflation controls (increased bank reserve requirements, Central Bank bill issuance and legions of administrative measures) may be losing their effectiveness, as shown by frequent large spikes in its residential property markets (c10). This may be why China raised its inflation target to 4% in December. Why so much discussion about China? Like a giant tractor beam (c11), China pulls the emerging world into its orbit. A positive view of the world must assume China can continue to control inflation and deliver —8% growth, unorthodox model and all (c12). (c7) Post-war share of world GDP (c8) Brazilian Inflation fueled by food (a) Chinese inflation driven by food Percentof total world PPP GDP 3 month percentage change, annualized as well, Percent change - YoY 35% 9% Headline 25% Asia ex-Japan 8% 20% 30% US 7% 6% 15% 25% 5% 10% 4% 20% 3% 5% 15% 2% 0% 1% 10°/ 0% 5% 1950 1959 1967 1975 1983 1991 1999 2008 2007 2008 2009 2010 2005 2006 2007 2008 2009 2010 (00 Frequent overheating In Chinese (ell) Most EM counties correlated to (c12) How Chinese monetary policy property markets, Avg. dailysates, 1mma China, correlation to China GDP YoY growth works In one slide, Billions, USD 1,000 100% $2,500 FX RESERVES: China 900 80% accumulates reserves to 800 $2,000 prevent Its exchange rate Shanghai 60% • 700 from rising 600 40% 51,500 500 20% 0% 51,000 STERILIZATION: China issues Central -20% $500 Bank bills and raises -40% 14 EM countries bank reserve re • ulrements 60% SO Nov-09 Apr-10 Sep-10 1991 1997 2003 2009 2003 2005 2007 2009 We expect EM Central Banks to cool things down, after which we expect EM growth to continue. Asian exports are already rising after their fall slowdown, particularly in countries like Korea, Taiwan and Singapore. EM ex-China bank credit is growing (c13), supporting the business cycle and employment growth (c14). This is in stark contrast with the West, where de- leveraging still rules. Should EM countries overdo monetary tightening, fiscal deficits and debt ratios are generally low enough (el 5) o support additional stimulus, with some exceptions (India, Czech Rep.). In China, bank loan and money supply growth of 20% (down from 30% in 2009) indicate that the risk of over-investment and capital misallocation remains high. As in 2010, we hold positions in Asian currencies (funded vs G3 currencies), as we believe they are undervalued. (c13 Private sector bank credit (c14 Developed and emerging world (c15) 2010 fiscal deficits growth, Percent of GDP, annualized emp oyment growth, % change- Goo Percent of GDP 11% 4% 0% Developed Emerging 9% 3% 2% ■ Markets 2% 7% 1% 5% 0% 3% -1% Developed 1% -2% -3% -1% -4% Brazil Day EM Europe Japan US 2000 2002 2004 2006 2008 2005 2006 2007 2008 2009 2010 Asia Asia 2 EFTA01077287  Eye on the Market I OUTLOOK 2O11 Januar , 1.2011 J.P.Morgan The United States: modest private sector recovery trumps fiscal problems, for now... With many emerging economies limiting FX appreciation, a rebalancing of demand to the East will happen more slowly. As a result, the world still relies on the US consumer, whose discretionary and non-discretionary purchases make up 70% of US GDP. Recent spending data have been positive, despite weak job creation. This may reflect two factors. First, labor incomes have risen faster than job growth (c16), and second, household debt service burdens have now erased the last 15 years of excess, courtesy of both lower interest rates and defaults (c17). Credit card and early-stage mortgage delinquency rates are showing marked improvements as well. Based on a variety of recent indicators and surveys, we expect payroll gains of --200k per month in 2011, and 3.0%-3.5% GDP growth. Corporate sector cash balances are at a 50-year high, and are finally being spent. Business and equipment spending (c19) and productivity (c20) will probably slow but remain positive. Commercial construction, at its lowest level since 1958, should stop declining. These gains will be partially offset by $80 bn of belt-tightening at the state/local level. NY is one example; absent changes to current law, its structural deficit for 2012 is $9 bn on $90 bn in expenditures. Housing is still a mess (30% of mortgages underwater, shadow inventory 2x the number of homes for sale), and credit creation remains low. (c16) A proxy for labor Income (c17) Household financial obligations (c18) U.S. retail sales growth Percentchange, 3 month rolling average ratio, Percent of disposable income, sa Percentchange YoY 10% Payroll proxy: hours 19.0% - 15% worked times hourly 18.5% - income 10% 5% 18.0% - 5% 17.5% - 0% 17.0% - j 0% 16.5% - Decade of Ern p loymont household excess -5% -5% 16.0% - unwound 15.5% -10% -10% 15.0% 15% 2007 2008 2009 2010 '80 '83 '86 19 '92 '95 '98 '01 '04 '07 '10 1993 1996 1999 2002 2005 2008 2011 (c19) Business equipment and (c20) Nonfarm business productivity (c21) An expensive recovery software spending, YoY - % change Percent change - 3 year In Increase In Federal Debt/GDP(%) 16% n Increase In ISM manufacturing Survey (pts) 25% 38 14% I 34 • Through 12% 30 - yearend % 010 15%It 5% ' Bo 22 26 • 1 II .1. IJ 2 if 6ok 18 - JJ -5% 14 - 10 • 6• 2• -2 -25% -2% 52- 53- 58- 60- 70- 74- 80- 82- 91- 01- 08- 1955 1963 1971 1978 1986 1994 2002 2010 1952 1960 1968 1976 1984 1992 2000 2008 52 55 59 61 73 76 80 83 93 04 10 The elephant in the room: the eventual need for fiscal tightening. The production rebound was consistent with prior ones, but cost a lot more in terms of Federal debt to generate (c21). Tax cut extensions and payroll tax reductions will increase 2011- 2012 deficits by $800 bn compared to current law. If this "all-in" strategy results in consistent 4% growth, 2015 budget deficits could fall to 3%. Otherwise, the US will eventually need to make tough choices (c22) Short & long-term fiscal (the IMF estimates required US 2010-2020 fiscal adjustments that are greater than pressures from goy' t spending, %GDP Spain's). Bowles-Simpson recommendations tried to spread the pain equitably (tax 25% increases and spending cuts), but were rejected by legislators on the Commission that drafted them. How does the US fiscal picture look to China? A recent paper 20% published by Peking University was entitled "Eying the Crippled Hegemon: China's 15% All other spending Grand Strategy Thinking in the Wake of the GlobalFinancial Crisis". A lot of faith resides in the Fed's "portfolio rebalancing channel" theory of 10% lowering interest rates, driving up equity markets, increasing confidence and Healthcare spending consumer spending, and eventually, employment. In its interim stages, it lifts 5% financial asset prices more than employment, destroys the purchasing power of nodal security 0% savings, and may result in much higher commodity prices. Jury: still out. 1974 1986 1998 2010 2022 2034 3 EFTA01077288  Eye on the Market I OUTLOOK 2O11 January 1.2011 J.P.Morgan Europe: Irreconcilable Differences? Our writings on Europe in 2010 might have been as long as the EU Constitution2. Here's an abbreviated 5-point summary: 1. Germany is rebounding impressively (c23), but in Q2 and Q3, net exports were the largest contributors to German growth (c24). German export performance does not help pull other EMU countries along. 2. The periphery is stuck in austerity as a quid pro quo for bilateral EU and IMF assistance (c25), which is worsening GDP, unemployment (see c57 on page 11, worst on record) and VAT tax declines. Can it be sustained? In contrast, over in Iceland, real wages, employment, exports, stock markets and tourism are rising after their default/devaluation. 3. During crises in Latin America (1980s) and Asia (1990s), Argentina (1984) and Thailand (1997) were first thought to be exceptions, and that problems could be ring-fenced. In both cases, a broken paradigm applied to more countries. 4. Spain is now the Maginot Line. Its international banks should be able to survive a period of low growth, and its regional banks could be fixed for 5%-10% of Spanish GDP. But there's still all the Spanish private sector non- financial debt, which is among the highest in the world. This is not just a sovereign debt or banking sector problem. 5. Germany and France might have to agree to more direct subsidies, larger bilateral aid facilities or something more explicit, like "European Union government bonds". Will they do it? Last month, former EU President Jacques Delors said in response to the crisis that Europe needs to find its "soul". In 2011, we will find out whether the soul of Europe is based on its national identities, or a new Federal one. See page 11 for more on this topic. (c23) German retail & manufacturing (c24) German GDP driven by exports (c25) Core vs. periphery GDP surveys, Index, sa Percent contribution to 2010 GDP Index,100 = 2007 110 - 4% 105 Manufacturing 104 • 105 •02 103 • 100 •03 102 - 95 101 • 100 • 90 99 - 85 98 • 97 - 80 96- -2% 75 . . . Exports Captai Household Govt 95 1991 1994 1997 2000 2003 2006 2009 Spending Speocing Consumpt. 2007 2008 2009 2010 Bottom line: while there are some safe zones (e.g., the health of banks and less reliance on foreign bond buyers in Italy; lower public debt in Spain), the concentration of red flash points in our Sovereign Risk Scorecard is high. We expect the question of the periphery to overshadow the German recovery until it is resolved in some way. Oct 2010 Interest Gross Domestic Req. Fiscal 2010 Net Intl Unempl. Lebec Payments! Debt/GDP Ownership Fiscal Adjustment Current Investment Rate Mobility Tax Receipts 2012E of Govt Debt Deficit 2010 2010-2020 Acct %GDP Pos. %GDP Portugal 11.0% 7.4% 7.9% (7.3%) 8% -10.3M- (114%) Ireland 14.E &2% 9.5% 116% 17% (11.7%) 10% -0.3% (102%) Italy 8.6% 0.8% 10.6% 133% 48% (5.0%) 4% -3.3% (20%) Greece 12.2% 0.7% 13.1% 142% 33% 416%) a 9% -10.5% (87%) Spain 20.7% 0.7% 4.2% 80% 56% 3%),M 10% -5.5% (98%) Price/wage Q3 2010 O3 2010 03 GDP, Bank foreign World cup / World differential Tradables ECB Bore. % PMI PMI 000 lender Euro cup reserve s Germany %GDP Bank assets Senices Manufact. Annualized reliance ,Actories currency in: Portugal 11% 13% 62% 7.2% N/A N/A 1.6% .28% 0 1450.1530 Ireland 25% -3% 164% 7.8% 50.8 51.2 N/A 32% 0 N/A Italy 10% 35% 46% 0.8% 54.4 52.0 0.7% 8% 5 200BC-275AD Greece 19% 20% 42% 17.5% MA 43.9 (4.5%) 1 15% 1 500BC-200BC Spain 20% 33% 53% 2.1% 48.3 49.1 0.1% 15% 3 1530.1640 Notes: "Net International Investment Position" measures external debt less external assets (loans, bonds, equity). A larger negative number ind sates a greater net external liability; those shown are among the highest in the world. Price/wage differentials vs Germany as of Q3 2010 based on consumer prices and unit labor costs for manufacturing, both indexed to December 1998. The OECD considers the wage measure more relevant for assessing competitiveness. Ireland was never the world's reserve currency, but according to author Thomas Cahill, its monks safeguarded Western civilization during the Dark Ages by transcribing works before Barbarians burned them. 2 The original "Treaty for a Constitution in Europe" was 784 pages. The 2009 Lisbon Treaty was whittled down to 280 pages. 4 EFTA01077289  Eye on the Market I OUTLOOK 2011 January 1.2011 J.P. Morgan On our investment portfolios Equities: pricing in a fair bit ofpessimism The prior pages refer to challenges the world is still facing; the good news is that equity markets are pricing a lot of them in. Forward P/E multiples for the US, Europe and the Emerging Markets are clumped together around 10x-13x (c26). That's why we are comfortable holding 35%-45% equities in Balanced and Growth portfolios (both figures exclude additional equity exposure through private equity and certain hedge fund categories). Growth stocks in particular look cheaply priced (c27), although there is something strange going on in the large cap technology space, where P/E multiples are low and cash holdings are extremely elevated (c28). A ratio of P/E to earnings growth is at a 20-year low for the S&P 500, another sign of market pessimism. Flows into equities have been negative this year, suggesting a lot of underweight positions. (c26) Forward PIE equity multiples (c27) Growth stocks price in a lot of (c28) Cash balances and PIE multiples Ratios pessimism, PE relative to market of mega-tech stocks, Billions, USD 20 - 2.5x 70x 8220 18 Price to Earnings 11200 Emerging 2.3x 60x Ratio (LHS) 16 Markets 11180 US 2.0x 50x Cash& 14 11160 Equivalents 1.8x 40x (RHS) 11140 12 30x 11120 10 1.5x 11100 8 1.3x 20x S80 6 1.0x 10x 560 2003 2004 2005 2006 2007 2008 2009 2010 1978 1986 1994 2002 2010 2000 2001 2003 2005 2006 2008 2010 US profits growth and margins are in good shape, which is why the US is our largest regional equity allocation. Keep this in mind: S&P 500 revenues over the last 15 years have been more linked to World GDP growth than US GDP growth (c29), driving offshore profits higher as a % of GDP (c30), and to 35% of total US profits. Another positive: the S&P 500 tends to have less exposure to the US consumer than the US economy does, and more exposure to capital spending, energy and healthcare. In terms of valuation, technology and healthcare appear most attractively priced. We prefer large cap to small cap as the latter trades at a 30% P/E premium, and generally prefer growth over value. (c29) S&P revenues tied to global (c30) U.S. corporate profits from the (c31) Share of S&P 500 earnings by growth, not U.S. growth, Avg 1996-2010 rest of the world, Percent of GDP end-market Medical 6.5% 3.5% Consumer 3.0% Business 14% Staples 6.0% • U.S. 2.5% 5.5% • 21% 18 20% 5.0% • 1.5% 4.5% • 4.0% S&P 500 World GDP Ciao •I GOP Final Sales to Domestic 1.0% 0.5% 0.0% En erg y & Commoditie 16% 14% Consumer Disc. Revenues Purchasers 1948 1960 1973 1985 1997 2010 Financials Analysts have underestimated S&P 500 earnings by around 10% per quarter (C32) U.S. profit drivers since Jan 2009. During the recession, US companies kept costs down as demand Percent plunged. Now, as demand rises, incremental margins on new revenues are high. 70% We expect this to continue in 2011. We expect 8%-10% earnings growth and 68% • stock buybacks (now running at 2% of market cap) to deliver roughly 10% S&P 65% • 63% - 0 44‘144A.V 500 returns in 2011, with some bumps along the way. 60% • Labor Cost as %of Sales \ i‘ While US profit margins are high, US corporate sales are at a 50-year low (c32). 58% • How can these 2 things co-exist? Because labor costs as a % of revenues are 55% - 53% • at their lowest levels, by some measures since 1929. That's why we're reluctant 50% • Salesas %of GDP to forecast much higher multiples; earnings are too reliant on low real wages. 48% - 45% 1947 1959 1972 1984 1997 2010 Stocks used for this analysis include: Microsoft, IBM, Apple, Intel, Hewlett-Packard, Cisco, Oracle, Google, Qualcomm, Coming EFTA01077290  Eye on the Market I OUTLOOK 2O11 hnuaii, 1.2011 J.P.Morgan After the US, emerging markets are our next largest equity allocation, followed by Europe and then Japan. Over the last 1 and 3 years, these equity tilts have worked well (c33). We expect these relative rankings to continue in 2011; we are more inclined to suffer the risk of inflation in the emerging world than the risk of deflation in Europe. Within Europe, most of our equity exposure is tied to German exporters, whose stock prices generated strong gains in 2010. We hold Asia as the bulk of our emerging markets exposure, with smaller exposures in Latin America and Eastern Europe. On Brazil, we are encouraged by the development of the middle class (c34), and increased international trade (its mining, oil and agricultural exports to China have quadrupled since 2004). But there are some risks related to inflation, an overvalued exchange rate, and reliance on portfolios inflows rather than foreign direct investment. Our preferred approach to Latin America and Brazil in particular involves long and short positions; private equity investments, particularly in consumer-related companies which are only 10%45% of the Bovespa (see page 8); and investments in local Brazilian credit and interest rate markets. (c34) Ascent of Brazil's middle class BRAZIL: Pluses and Minuses (c33) Global equity returns consumer, Millionsof people Positives Negatives Total returns through 12/10/10 Local anew/ 720 • Household credit low • Wage & price initaion risks USD tonna tams ■ 2003 100 ■ 2009 • Rapidly growing trade • Real exchange rat: 1 war 3year 1 year 3 year • 2014 80 veil China/Asia looking expensive S&P 500 15% (4%) 15% (4%) " Higher ins7tIonal • Increased relance on MSCI EM 18% (2%) 15% (1%) 40 parkipalion in equity portfolio lows over breign markets direct investment MSCI EM Asia 19% (2%) 16% (0%) 20 "RE multples: 12x ' High corporat tax rat MSCI Europe 5% (10%) 11% (6%) 0 • Arrong world's highest MSCI Japan 9% (7%) 4% (16%) Upperdass Middle Lower Bottom 50% poverty decline class class class &WV+ real intrest rat Fixed income: government bonds and credit The global Printing Press creates money that needs to find a home. At the same time, total issuance in the US has been negative: while Federal and municipal issuance grew, companies and households reduced issuance at an even faster pace (c35). The result: a supply-demand imbalance that supported global bond prices. Think about this: by the time QE2 is finished, the Fed will own 1/3 of all Treasuries outstanding in 4-20 year maturities, and finance 94% of the 2011 Treasury deficit. We expect G3 banks and EM Central Banks to continue to buy Treasuries. However, our sovereign and municipal durations remain low, given limited yield benefits of longer duration paper, and the risk of higher yields at some point (see page 10for more on bond market risks). Our current underweight to government bonds is one of the largest active positions in portfolios. We expect another year of stable credit spreads, although returns will be markedly lower than in 2009 and 2010 given how much spreads have already tightened. We hold senior bank loans alongside high yield, which is still reasonably priced at a spread of 600 bps after last year's rally. We expect to trim high yield positions in 2011 as spreads tighten further. The current decline in default rates (c36) helps explain why spreads have tightened this much, but liquidity conditions are undeniably affecting the pricing of credit. (c35) Net issuance of U.S. Credit (c36) U.S. corporate default rates (c37 Property decline cushion, AAA Instruments over last 12 months ($bins) Percentof par value CMBS subordination adjusted for LTVs 76% 45% Treasuries $1,468 14% 40% Agencies -$70 A 5% property decline Municipals $94 12% Bonds 35% would have exposed Corporate & Asset Backed -$129 10% 30% AAA Investors to losses Mortgages -$598 8% 25% Bank Loans -$424 20%• 6% Consumer Credit -$47 15% 4% 10% Commercial Paper -$249 Other loans -$241 2% 5% Total -$195 0% 2000 2002 2004 2006 2008 2010 2001 2603 2045 2607 2010 The structured credit market reached its cams moment in 2007, when it offered little value to investors. At that time, a AAA- CMBS investor could barely sustain any property losses before losing principal (c37). We did not recommend structured credit to clients during this period for this reason. Since then, subordination protections have improved substantially, and spreads are wider. As a result, we have been adding structured credit to portfolios since markets re-priced this kind of risk in early 2009. We also see opportunities in US bank preferred stock that may be called early as banks restructure their capital. 6 EFTA01077291  Eye on the Market I OUTLOOK 2O11 January 1.2011 J.P.Morgan US commercial real estate After having reduced allocations to commercial real estate in 2007, we are now reinvesting. Our preferences: where capital is scarce and where lending positions can be well-collateralized (commercial mortgage backed securities rollovers, mezzanine lending [c40] and distressed real estate). A silver lining of the biggest residential housing mess ever: there was less of a commercial overbuilding boom this time around. The worst commercial property boom took place in the mid 1980s (c38), after a 1981 tax reform bill which allowed active income to be offset by passive losses, a provision which ended with the Tax Reform Act of 1986. The next biggest mess: the tech boom of the late 1990s. In contrast, overbuilding during the credit boom (a different concept from overpaying) was less of an issue this time. The liquidity boom which has led to lower credit spreads has also pushed up real estate prices, but mostly for "bond-like" office and multi-family properties that are well leased, and in major market locations. Opportunities persist in properties with leasing, debt maturity or completion risks that require the experience of an operator and not just a financial buyer. It will take time for all the vacant space to be absorbed (CB Richard Ellis forecasts that office vacancy rates won't peak until the second quarter of 2011). But as is typical with most business cycles, asset prices tend to rise well before their respective fundamentals do. This has been the case over many decades, as US and European equities, bank stocks and high yield bonds started to rise well before improvements in unemployment, earnings declines, bank failures and corporate bankruptcies (See EoTM December 6, 2010for more details). (c38) New office supply, Pdvatefixed (c39) New retail center supply, Private (c40) Evolution in capital structures investment in office, PercentGDP fixed investment in retail, PercentGDP Illustrative exam pie 1.0% 0.30% $100 30% assumed decline in valuations 0.8% 0.25% $75 0.6% 0.20% $50 Senior Debt 0.4% 0.15% -75% $25 Senior Debt 0.2% 0.10% • 50 00% 0.05% Pm-