J.P. Morgan market commentary on European sovereign risk and U.S. equity multiples (April 2012)

Eye on the Market | april 9, 2012 J.P Morgan Q&A on the USA, with a watchful eye on the risk of giant man-eating plants; Spain Now that P/E multiples have risen off the bottom, what’s the outlook for P/E multiples and earnings from here? The return on the S&P this year has been a function of P/E multiples rising (from 11.3x to 12.9x), a big part of which has been Apple (3% of the S&P index, 15% of S&P’s YTD returns). As shown below, earnings revisions have been negative for 2012, but analysts are still optimistic about 2013. According to Morgan Stanley, analysts are forecasting the highest percentage of companies posting 2013 margin expansion since 1970, and by a very wide margin. In our view, it will be difficult for multiples to rise further unless earnings outperform expectations, particularly if Europe’s structural problems take center stage again. Revisions to consensus EPS by quarter Win, Place and Show: The only country | can a 12/30/2011 = 100 The problem of Spain find that's in worse AQE +1% shape than Spain is: 400 Number of dwellings to population Greece Non-financial corporate debt to GDP Ireland 99 3QE -1% Corporate sector debt to cash flow Portugal FY12 -1%| Construction sector debt/assets None 98 2QE -2% | Banking sector branches per 1,000 people None Reliance on foreign capital (Net Int. Inv. Pos.) Ireland, Portugal 97 Real estate as % of household assets None 1QE -3% | Housing overhang (as per CEPS) Ireland 96 Commercial RE exposure % of bank assets None 12/30/2011 01/31/2012 02/29/2012 03/28/2012 Encumbered banking system assets, % Greece Source: FactSet. World Bank labor rigidity, Europe None The place that worries me the most: Spain. It ranks at or |!ntra-European real effective exchange rate Italy close to the bottom in a lot of categories (see table), and |Shadow economy, % of GDP, OECD Italy, Greece its growth outlook is poor. Historically, this kind of Unemployment rate None thing has not ended well. Spain has defaulted 13 times Production time per unit Italy since 1500 AD; it’s probably going to take a lot of Reliance on ECB to finance sovereign debt None bilateral aid and ECB financing to prevent another one. _| Bank lending to HH/NFC, last 12 months None . HH/NFC = households and non-financial corporations Michael Cembalest Sources: IMF, OECD, EU, World Bank, CEPS Chief Investment Officer Sources “States of Bankruptcy, Part I: The Coming State Pensions Crisis”, Jot Economic Committee Republicans, Representative Kevin Brady and Senator Jim DeMint, December 8, 2011 “The Trillion Dollar Gap, Underfunded State Retirement Systems and the Roads to Reform”, Pew Center, February 2010 “Fiscal Policy in a Depressed Economy”, DeLong (Berkeley) and Summers (Harvard), March 20, 2012 Moody’s US Municipal Bond Defaults and Recoveries, 1970-2011 IMF Country Report 11/216. “Spain: Selected Issues”, July 2011 The material contained herein is intended as a general market commentary. Opinions expressed herein are those of Michael Cembalest and may differ from those of other J.P. Morgan employees and affiliates. This information in no way constitutes J.P. Morgan research and should not be treated as such. 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