EFTA00875398.pdf

From: US GIO To: Undisclosed recipients:; Subject: JPM : The J.P. Morgan View : Is risk-on, risk-off dead? Date: Fri, 08 Feb 2013 20:05:58 +0000 Attachments: JPM_TheJ.P._Morgan_View_2013-02-08_1049244.pdf Inline-Images: imagel.gif r 6;,'.1.P. Morgan Logo Global Asset Allocation The J.P. Morgan View: Is risk-on, risk-off dead? Click here for the full Note and disclaimers. • Asset allocation — Correlation between risky assets has fallen dramatically, as global tail risks have faded allowing local forces to become more important. Investors should focus increasingly on local idiosyncratic forces, but need to act globally, across markets. • Economics — US QI raised from 1.0% to 1.5%, with continued upside bias to global Ql. • Fixed Income — Focus on cross-market trades, including long Treasuries vs Bunds, and long EM vs DM. • Equities — We believe that the YTD underperformance of Materials and IT sectors is overdone. Stay OW Cyclical vs. Defensive equity sectors globally. • Credit — We go long risk Europe vs the US in CDS. • Currencies — Reduce Yen shorts. • Commodities — We expect the recent fall in correlation between commodity and equity returns to continue, supporting commodity investment. • Our investment strategy has performed well so far this year, but the overall return hides significant misses on some trades offset by bigger gains elsewhere. The last month has seen quite some confusing, if not inconsistent asset price movements. Equities rallied strongly, but credit spreads refused to come in further and widened in places. Bonds are up in yield, but nobody raised growth forecasts and the consensus still expects Fed QE to last through the middle of next year. We raised our Asian growth forecasts, and gained from longs in metals, but lost from ovenveights in EM Asian equities and global Cyclicals. Euro periphery sovereigns have tightened, but EU HY is wider. • Inconsistencies from one side imply lower correlations from the other side. The average correlation between six different major risk classes, US equities, EM equities, commodities, HY, EM FX, and the dollar reversed, has indeed fallen dramatically as a result. So has the correlation between individual stocks in the S&P500 (charts on p. 2). • Inconsistencies and lower correlations do not suggest to us an inability by investors to think consistently, but more the fading of global tail risks, and the relative rise of local idiosyncratic forces. Some of this reduction stems from greater EFTA00875398  divergences in policies if not policy reaction functions, with the US tightening fiscal policy this year, while Europe is expected to go softer on austerity and Japan moves to outright fiscal stimulus. But another part must, we believe, come from diverging positions, valuations, and issuance across markets, with fixed income being arguably over-owned, overvalued, and well-supplied and equities under-owned, undervalued, and undersupplied. These underlying differences are fundamental and are not going away soon, in our view. Hence, correlations at the asset class, sector, regional, and security level will likely remain lower than they have been over the past 5 years. • • Lower correlations imply that, more than before, we should make sure our portfolios are appropriately diversified, both strategically and tactically. It implies that we can again focus more on local and relative value factors, including currencies. Local risk factors and diversification across positions mean that we can fit larger position sizes within the same tactical risk budget, thus benefitting from what the industry calls alpha. • We started this already last month, with our positions spread across seven different investment themes. And we have seen the results with good returns in our portfolio from FX (short yen), commodities, bonds, and asset allocation offsetting losses within credit and equities. One such theme that we have considered, but not bought into yet, is the rotation from over- owned and overvalued fixed income to under-owned and undervalued equities. We had set two markers to indicate the start of this rotation: high leverage by issuers and/or lenders on one side; and rising growth expectations on the other side. The latter can start speculation about an earlier end to monetary stimulus, hurting bonds, and should lead to upgrades on earnings expectations, making equities more attractive. We could not yet put full ticks on these boxes last month. At best, we saw reduced downside risk on growth and initial signs of investor leverage through CLOs and leveraged funds. Much of this leverage is at still very subdued levels. And without an outright upgrade of our 2013 global growth forecast, we saw no reason for a value-based rotation from bonds to equities to start last month. • But the fact is that equities gained strongly over the past 4 weeks, bond yields backed up and credit spreads widened. This broke the positive relation between equity and credit returns we have seen over much of the past 3 years. The trigger for it was likely the release of the December FOMC. Minutes on Jan 3 that raised speculation of an H2 end to QE. Credit investor discussions and surveys suggest that they see higher bond yields and an early end of monetary stimulus as the main threats to the corporate bond market. • Given our views on growth, we think fears about an early end to QE are misplaced. At the same time, the cat is out of the bag and the discussions have started on when to transition from credit to equities. As a result, we switch some of our credit into equity risk in both our long-only and our long-short model portfolios, while still keeping overall net long, but with a reduced credit position versus the underlying government debt. Fixed Income • Government yields edged lower, with Germany outperforming after ECB President Draghi poured cold water on some larger forecasts of early LTRO repayment. Euro area peripherals were mixed, with Spain and Italy still under pressure, but Ireland rallying after concluding protracted negotiations on central bank funding of its failed banks. The deal boosts Ireland's liquidity significantly, but its solvency only modestly. We stay long Ireland, and continue to favour Spain over Italy ahead of the Italian election. • We focus risk mainly on cross-market allocations: long US Treasuries vs German Bunds, long Sweden vs Japan, based on the battery of systematic cross-market signals reported in our Ride-Based Fixed Income Monthly (Mac Gorain, 4 February), and long EM local bonds vs DM. EM local bonds have the structural supports of diversification benefits, and higher real yields in a world where yield pickup is scarce, and the near-term supports of heavy inflows, and the easing bias of a number of central banks. Focus EM longs on higher yielders like Brazil, Turkey and Indonesia (details in the new EM Local Markets Compass, Gochet and Pianetti, 6 February). Equities • Equity markets posted their first weekly decline this year. Euro area equities led the decline triggered by Draghi expressing growth concerns in this week's ECB press conference. We exited our Euro vs. US equity overweight a month ago. This week's movements would appear to vindicate this decision. • Our model equity portfolio continues to focus on relative rather than outright trades. This is because we are concerned by signs of overextension in position indicators and we thus avoid directional longs. The main trading themes are: OW EFTA00875399  Japanese equities vs. Korea and Taiwan, OW Cyclical vs. Defensive sectors globally, OW US housing sectors, i.e. US homebuilders and mortgage banks vs. the S&P500, OW EM equities vs. S&P500. • Of these four themes, it is the overweight in Cyclical vs. Defensive sectors which is more puzzling to us. This is because Cyclical sectors underperformed Defensive sectors globally in a month where manufacturing PM1s surprised on the upside. The global manufacturing PM1 for the month of January posted a strong I.4pt increase, vs. only 0.5pt in December. This was the highest monthly increase since the global PM1 started bottoming out last September. • The Cyclical sector underperformance is driven by Materials and IT. Consumer Discretionary and Industrials are actually outperforming YTD. We believe that the underperformance of Materials and IT sectors is overdone, especially for Materials, where investor shorts are more prevalent. Stay OW Cyclical vs. Defensive equity sectors. Credit • Spreads widened further this week and many markets are now trading wider than where they started the year. Europe continues to underperform the US, which we feel is overdone and so go long risk Europe vs the US in investment-grade CDS (See Sell iTraxx Non Financial, Buy CDXIG protection, Steve Dulake). The universe of European credit tracked by iTraxx has a higher average rating than that of CDX, but it currently trades around 25bp wider. • Our client surveys out today also suggest a more cautious mood in credit markets. Our US survey finds that investors are more bearish than last month, as only 24% now expect tighter spreads vs. 41% back then, and that insurance companies are more bearish than asset managers (see CMOS). Our US investor's top trade for 2013 is OW Financials. In Europe, almost a quarter of clients expressed a wish to cut exposure to credit (see European Credit Investor Survey, Tina Zhang). Foreign Exchange • Currencies are entering February with a narrow and partial reversal of January's moves. The euro has given back about half of its gains, the yen about a quarter of its losses and the Swiss franc half of its losses. Considering the froth in some currencies — in our view, the euro was a couple percent too high and the yen several percent too low entering this month — reality checks were inevitable. The ECB provided one on Thursday with a reminder that excess liquidity will remain substantial (above E200bn) this year, which limits the scope for front-end rates to rise and EURJUSD to trend higher. The G-20 summit may provide another next week on the yen, even though Japan's behavior appears to be well within the letter and spirit of previous communiqués. • Japan could be criticized on the grounds of excessive volatility and disorderly movements, something Japanese officials have acknowledged in recent weeks. Since any hint that government may be less committed to the policies driving the yen could prompt short-term profit-taking, we reduce yen shorts and optionalise some trades (EURJJPY) into the G-20 summer. It is very likely the Bank of Japan will deliver something dramatic in April, which could renew yen weakness. We just still doubt the government will succeed in creating inflation, which is why the forecast still envisions retracement higher in the yen by year-end. Commodities • Diversification was traditionally one of the key reasons for allocating some of a global portfolio to commodities. However, following the 2008 crisis, the correlation between commodity and equity returns rose to very high levels and stayed there (see Chart). This high correlation over the past five years has been a considerable obstacle for commodity investors, especially as over the past two years, returns have been poor. The GSCI light energy index is only up 1.5% in excess return terms since the end of 2010. However, there are some signs that the diversification benefit of commodities is returning. • The last few months have seen the correlation between commodity and equity returns fall to its lowest level since late 2008. This is not unique to commodities. As discussed in the main section of this report, correlations between all risky assets have fallen recently. In our view, the drivers are the removal of the potentially systemic risks facing global markets over the past few years, i.e. the Euro area crisis, a possible Chinese hard landing and to some extent the US fiscal cliff. All these risks, we believe, had the potential to derail the global economy and even the global financial system itself. Thus, expectations of how these "tail" risks might play out, along with how policy makers would respond to these threats became the main drivers of risk markets, and the more local, or idiosyncratic risks were less important drivers of returns. • With these systemic threats dealt with for now, idiosyncratic risks within the different commodity sectors are once again becoming more important drivers of commodity returns and thus the correlation with other risk markets is falling. We expect this to continue through 2013 and in yesterday's GMOS, we increased the cyclical bias of our commodity portfolio EFTA00875400  due to the upside risk on global GDP growth. The lower correlation to other risky assets means we can increase ow commodity positions sizes without increasing the overall portfolio risk. Jan Loeys (1-212) 834-5874 John Normand (44.20)7134-1816 Nikolaos Panigirtzoglou (44-20) 7134-7815 Seamus Mac Lorain (44-20) 7134-7761 Matthew Lehmann (44.20) 7134-7813 Leo Evans (44-20) 7742-2537 If you no longer wish to receive these e-mails then click here to unsubscribe www.jpmorganmarkets.com Analyst certification: I certify that: (1) all of the views expressed in this research accurately reflect my personal views about any and all of the subject securities or issuers: and (2) no part of my compensation was, is, or will be directly or indirectly related to the specific recommendations or views expressed herein. Important disclosures, including price charts, are available for compendium reports and all J.P. Morgan-covered companies by visiting Itups://mmjpinorgan.comfdisclosuresicommy, calling 1-800-477-0406, or e-mailing research.disclosure.inquiries(ajpinorgan.com with your request. J.P. 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