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For professional advisers only – not for onward distribution Navigator Analysis of current issues in markets and investing www. jpmorganassetmanagement. com/insight
Contents 1 Economics Asset Classes Growth Multi-Asset Employment Equity Trade Fixed Income Debt Currencies Money supply / Deflation Commodities
Economics 2
ECB intervention is helping to keep yields down but is not a long-term solution Ever present anxiety n Bailouts only postpone inevitable reckoning; explains why Greece yields remain so high n ECB hoped to offload Irish bank risk by forcing bailout; instead they’ve been obliged to increase market support n Spanish risk seems to have moderated, at least for the moment n Recent auctions went off well, but doesn’t really change outlook Government 10 -year bond spreads over German bunds Note: Ten year bonds. Latest data 21 January 2011. Source: Bloomberg, J. P. Morgan. 3
What’s unusual is not the spreads now but the spreads of five years ago Just like old times n Governments like Greece and Spain should never have been lent money at the same rate as Germany n Adjustments in markets now are simply a reappraisal of country risk n Country budget forecasts likely do not reflect this new reality n Unless there are eurozone bonds, individual countries will pay differing interest rates in the future Government 10 -year bond spreads over German bunds Latest data 21 January 2011. Source: Bloomberg, J. P. Morgan. 4
Bailouts involve more than just cross-border exposure Big banks Latest data June 2010. Source: ECB, BIS, J. P. Morgan. 5 n Exposure of eurozone countries to Greece, Ireland, Portugal and Spain is roughly € 1 trillion n But the banking sectors are several times larger than their economies — about three times on average n So a rescue sufficient to restore banking sector health would be even larger
QE and eurozone crisis battling each other to affect relative value of currencies Real broad effective exchange rate Note: Relative to average since 1970. Synthetic euro prior to 1999. Latest data 20 January 2011. Source: J. P. Morgan. 6 n On balance, euro not weakening further against its trading partners because of crisis n Dollar likely to suffer longer term as inflation expectations rise and money flows to emerging markets n Euro is currently trading at its long-run average n Devaluation has been 16% in just two years – Previous major decline of 29% took place over five years from Dec-79 to Mar-85 – Still time for improved competitiveness to feed through to eurozone exports
Fourth quarter GDP shows wide divergence in eurozone growth German growth rates well ahead of the rest n German economy benefitting disproportionately from rebound in global trade and China stimulus n Longer term outlook weaker; bulk of exports go to eurozone but growth there is low Fourth quarter 2010 GDP estimates, Qo. Q %, SAAR – Latest data 21 January 2011. Source: Bloomberg, J. P. Morgan. 7 Forecast for 2011 GDP is +1. 4% for eurozone ex. Germany, +2. 6% for Germany n Divergence of economic performance adds to stress on euro n If dollar weakens because of QE, euro and EM currencies will appreciate more because of yuan peg
Changes in global growth forecasts are not evenly spread Change in 2011 GDP Growth Forecasts — Last 3 Months n US perspective improving thanks to QE and tax package, but forecast still down from earlier this year n Emerging market growth to suffer from tightening to ward off inflation plus strengthening currencies n China’s annualised growth rate in 4 q estimated to be 13% – Latest data 17 January 2011. Source: Bloomberg, J. P. Morgan. 8 Risk of overheating is rising
Exports has been very disappointing; preliminary data suggested positive contribution Contribution to 3 q 10 UK GDP Growth *Transportation, Storage, and Communications. Latest data Sept. 2010, SAAR. Source: UK Office for National Statistics, J. P. Morgan. 9 n Most important component of GDP growth is fixed capital formation as it lays groundwork for the future n Inventory rebuild not likely to last n Hopefully net export growth will be able to offset coming fall in government consumption n Forecast for growth in fourth quarter is similarly 2. 9%
Increase in business fixed investment is good sign for the economy Contribution to Gross Fixed Capital Formation Note: Value in parenthesis is weight of sector in over index. Latest data September 2010, SAAR. Source: UK Office for National Statistics, J. P. Morgan. 10 n This is the third consecutive quarter of positive business investment n Government still spending though this should slow down soon n Fortunately not the most important component of overall capital spending
Sterling is still very competitive despite fall in value of both dollar and euro Real broad effective exchange rate Note: Relative to average since 1970. Latest data 20 January 2011. Source: J. P. Morgan. 11 n Sterling’s decline has yet to substantially benefit UK exports n Since global growth is weak outside China, and UK doesn’t export want China wants (unlike Germany) n Currency is back to level last seen in 1979; exports should pick up eventually n UK’s independent monetary policy is significant advantage relative to Europe
US GDP for third quarter was weak, but largely due to fall in net exports; fourth quarter forecast 3. 2% n Growth excluding change in Net Exports and Residential Investment was 5% n Consumer demand below average — normally it is over 2% n Imports increased 17% compared to a 5% gain in exports Contribution to 3 q 10 US GDP Growth – Latest data September 2010, SAAR. Source: BEA, J. P. Morgan. Second revision. 12 Suggests room for further dollar declines
Risks for market: Gains seem to be very dependant on ever rising supply of money; what happens when the party’s over? Huge Increase In Money Supply Driving Market Latest data available as at 21 January 2011. Source: US Federal Reserve. 13 n Hope is that money supply growth plus low interest rates stimulate economy. Hasn’t happened yet n Could lead to asset bubbles, particularly in emerging markets (both equity and debt) n Stock of money has to come out of the system eventually n Latest round of QE just stores up problems for the future
Quantitative easing could raise inflation expectations in the US once growth accelerates Expected Inflation Rates Note: For Eurozone, UK and US, calculation is for five year inflation rate in five years (5 YR-5 YR). Japan is average of 5 -10 year breakevens. Data as at 20 January 2011. Source: Bloomberg, J. P. Morgan. 14 n Global growth may be restrained, but deflationary scenario unlikely – US property bubble nowhere near as big as Japan’s – Inflation excluding housing is 1. 4% n Risk is that inflation (both realized and expected) gets out of hand n QE distorts price signals from market n UK expectations not rising despite recent report n Germany may be next to see rising expectations
Japan suffered decades of deflation because it’s housing bubble was huge What goes up…. n Residential property values* as % of GDP From 1955 to 1973, house prices in Japan increased 13 times, versus just 6 times from 1973 to 1990 – *Japan: Land Underlying Buildings and Structures; US: Household Real Estate Assets; UK: Residential Buildings; Spain: Residential Household Wealth; Ireland: Dwellings. Source: OECD, Japan Land Water Bureau, Ministry of Land, Infrastructure and Transport, Cabinet Office (Government of Japan), US Federal Reserve, S&P/Case-Shiller, OFHEO, UK Office for National Statistics, Bank of Spain, Ireland Central Statistics Office, Permanent TSB/ESRI, J. P. Morgan. 15 Land under Japan’s Imperial Palace worth more than California n First period (1955 -73) was largely matched by GDP growth, but the second wasn’t n By this measure, US looks okay, but Spain is scary
Falling inflation in the US is primarily a function of declining house prices Non-house inflation is not low n Most headlines have focused on low core CPI rates, just 0. 6% in December (Yo. Y) n But most of this is explained by a fall in house prices n Excluding housing, prices are still rising by 1. 4%/year; low but not deflationary n House prices in US may be stabilising n In Japan, prices have fallen almost across the board Year on year change in CPI index Latest data December 2010. Source: BLS, J. P. Morgan. 16
Job losses during this recession were unprecedented and recoveries are taking progressively longer Indexed US Employment Levels* From Beginning of Recession *Note: US Non-Farm Private Payrolls. Latest data December 2010. Source: BEA, J. P. Morgan. 17 n Employment levels fell over 7% during the course of the recession, substantially worse than in previous downturns n Distressingly, rebounds are taking ever longer – Prior to 1980, it took less than two years to return to pre-recession employments levels – Every recovery since has been slower – Likely due to growing service sector orientation of economy n In 1990 and 2001 recession, jobs grew at a 1. 7% annualized rate from bottom n So far growth for 2008 recession has been 1. 3% n Return to baseline (100) will take 4 years at 1. 7% pace; 5 years at 1. 3% pace
Still, current recession is dramatically less severe than the Great Depression Indexed US Employment Levels From Beginning of Recession Latest data December 2010. Source: NBER, BEA, USDA, J. P. Morgan. 18 n This chart actually overstates impact of decline in employment n In 1930, 22% of the US population was employed in agriculture, versus 2% today
Labour markets are suffering because of negative equity in housing Mortgages in Negative Equity and Delinquency Rates Source: Negative equity data from Mark Zandi and Robert Shiller, Mortgage Bankers Association, J. P. Morgan. Latest data available as at 14 January 2010. 19 n Negative equity of $2. 4 trillion equals almost 20% of mortgage debt outstanding n Foreclosures initially surged but only account for 5% of existing loans and have now slowed n People can’t move because they can’t sell their home, so unemployment is higher than normal n If the debt is not written off (or assumed by government), will take years to work through n Reminiscent of Japan’s zombie companies
Asset Classes 20
Index performance may be getting ahead of earnings growth Earnings Growth — S&P 500 Latest data 21 January 2011. Source: IBES, J. P. Morgan. 21 n Earnings growth is lagging – Fourth quarter earnings typically grow by 3% Qo. Q – Expectations for this quarter are below this when should be above – Year-ago comparison appears high — up 33% — because of base effect n QE II is very beneficial for risk assets, particularly equities n The risk is that it inflates assets without benefitting equally the underlying economy n Markets may weaken once money stops flowing
Given low earnings growth expectations, surprises may have a large impact this quarter Earnings Surprises — S&P 500 n Tech has generally done well, though outlook cloudy for Apple n Financials have been mixed n Trend so far well below previous quarters Cumulative for quarter Note: For 4 q 10, 52 companies have reported accounting for 17% of index market capitalization. Latest data 21 January 2011. Source: IBES, J. P. Morgan. 22
It’s still early days, but initial company guidance is starting out weaker than last quarter Positive Changes to Earnings Guidance n Trend over the last year has been for guidance in each quarter to be higher than the previous n Earnings season has only just begun, but so far companies are not raising their projections for future earnings growth substantially n Suggests earnings revisions may suffer As percent of total changes Latest data as at 21 January 2011. Source: Bloomberg, J. P. Morgan. 23
Net income growth has slowed as margins have fallen and sales growth lags Sales, Net Income and Margin Trends — S&P 500 Note: Excludes financial stocks. Sales and net income indexed to Q 1 2006. Latest data 21 January 2011. Source: Worldscope, J. P. Morgan. Latest quarter forecast assumes commensurate change in sales and earnings for 15% of companies that have not yet reported for quarter. 24 n Earnings growth since the market bottom in 1 q 09 has been impressive, but it came from cost cutting and margin expansion n This process has a natural limit. Companies can’t cut forever and need revenue growth to power future earnings n Sales growth in 4 q 10 is forecasted to be just 7. 3% higher than the year-ago quarter; in 3 q 10 growth was 9. % n Difficult with modest GDP expansion to increase revenues
Cheaper Valuations are attractive for developed markets remain attractive despite rally; revisions improving Stronger Earnings Growth Latest data available as at 21 January 2011. Source: IBES, J. P. Morgan. 25
Cheaper Valuation Mexico joining Brazil in expensive territory but with poorer earnings outlook Stronger Earnings Growth Latest data available as at 21 January 2011. Source: IBES, J. P. Morgan. 26
Cheaper Valuation Commodity plays seeing largest positive moves Stronger Earnings Growth Latest data available as at 21 January 2011. Source: IBES, J. P. Morgan. 27
How risky is inflation for emerging market equity performance? Emerging Market Index and Inflation Rates n The correlation between inflation rates and emerging market index performance is not strong n Equities generally benefit from (moderately) rising prices n Risk is rather from inappropriate monetary policy response n Note: Index in USD terms. Inflation rate weighted by MSCI market capitalization. Last data 21 January 2001. Source: Fact. Set, J. P. Morgan. 28 – Either central bank tightens too much and economy slows dramatically – Or it does not tighten enough (perhaps to avoid currency appreciation) and economy overheats High commodity weightings offer extra protection
Watch both inflation and policy rates to see where balance lies Emerging Market Inflation and Policy Rates Latest data 21 January 2011. Source: Bloomberg, Fact. Set, J. P. Morgan. 29
China inflation not as bad as headline figures suggest but too strong GDP growth is a worry Excluding food, China inflation under control n Food prices have a disproportionate weight in Chinese CPI calculations n Excluding food, inflation appears contained n Negative reaction of market to prospect of government tightening shows how dependent market sentiment and growth is on China Chinese inflation indices, annual change, % Latest data December 2010. Source: China Economic Information Network. 30
The case for emerging markets is the same as in the past, but risks have fallen; inflation is major worry Emerging Market Index Performance Latest flow data November 2010. Index as at 17 December 2010, USD terms. Source: S&P/IFC, J. P. Morgan. 31 n The opportunity in developed markets has always been catch up, convergence, aspiration and urbanisation n It’s only been crises which have spoiled the story n We believe things are different this time n The risks of currency or debt crises like those in the past have fallen – No fixed exchange rates – Low foreign currency debt – Smaller current account deficits
Low yields in US have not yet lead to a major outflow of funds US investment in foreign securities Latest flow data October 2010. Treasury yields as at 17 December 2010. Source: US Treasury, J. P. Morgan. 32 n One of the concerns about QE (I and II) is that a search for yield will drive investors abroad, in particular to emerging markets n Cross-border flow data does not show this happening
Emerging markets are not as volatile as you might think Annualised market volatility n Historically emerging markets have been more volatile than developed markets n The performance over the last two years has shown the opposite n Traditional risks in emerging markets have declined n n Note: Monthly frequency in USD terms until 1987, daily frequency in local currency terms subsequently. Data as at 31 December 2010. Source: IFC, MSCI, J. P. Morgan. 33 – Fixed exchange rates – Foreign currency debt While developed market risks have increased – Quantitative easing – Sovereign debt Investors are getting higher prospective returns for less risk
Government bonds yields have risen markedly since August Government Bond Yields (10 -year) n Extreme bond valuations have lessened, but the asset class still offer poor value n Yields are simply normalizing n High correlation between the three markets, even though each has different dynamics n Latest data as at 21 January 2011. Source: Bloomberg, J. P. Morgan. 34 – Germany: Europe liability + growth – UK: Inflation + growth – US: QE + tax package = inflationary growth UK likely to be first country to raise interest rates
The great moderation in government bond yields over the last 30 years is over Government Bond Yields n Developed market central banks have won their war against inflation over the last 30 years n Fixed income returns from government debt till now have come from: n Latest data as at December 2010. Source: Federal Reserve Bank of England, Barclays Capital, J. P. Morgan. 35 – High nominal (and real yields) – Plus price appreciation Now neither is likely
High yield debt presents the best opportunities Bond Spreads Latest data 21 January 2011. Source: Merrill Lynch, J. P. Morgan. 36 n Prospects for company cash generation still strong even if economy slows n Still, limited room for spread compression – Current spread is 100 bps below long run average – At average if credit crunch is excluded n Emerging market debt has gone from high yield to investment grade in risk; both good and bad n QE is helping to bring down EM spreads n Local currency EM debt offers currency appreciation to offset rise in interest rates n Duration risk for Investment Grade debt
Investors seeking inflation hedge will help support commodity prices in the short term As Goes China… Latest data 20 January 2011. Source: MSCI, Standard & Poors. 37 n Chinese equity market still likely to outperform relative to developed markets n Economy should slow down enough to avoid overheating n Commodity prices will continue to benefit from China growth though changes in China sentiment will weigh as well
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