J.P. Morgan Market Outlook Note Discussing Fiscal Cliff Risks Post-2012 Election

Jan Loeys Global Asset Allocation (1-212) 834-5874 The J.P. Morgan View jan.loeys@jpmorgan.com 09 November 2012 necessarily. Last summer, as equity markets rebounded in June and July, Cyclical sectors actually underperformed. The thin grey line in the top chart shows that Cyclical sectors have recaptured only a quarter of the underperformance seen between March and August and thus provide a better entry point. Position indicators suggest that investors are underweight Cyclicals and overweight Defensives which is turn means that Defensive sectors are more vulnerable to position unwinding. We introduced an underweight in US equities in mid October to position for the US fiscal cliff risk. Obama’s win makes it more likely that this risk will intensify into year-end. Across regions we favor EM Asia and Europe vs. the US. While the US is facing fiscal cliffrisks, Asian equities are benefiting from concrete signs that economic activity is rebounding in China. European equities are benefiting from greater improvement in financial conditions, although they are more vulnerable to noise around the Greek and Spanish issues. Credit US credit spreads edged wider in response to the fall in equity markets following the US elections. US HG widened 7bp to 160bp, undoing around half of October’s peak-to-trough moves. Similar moves registered in other USD credit markets. At 107bp, the CDX.IG is now back to early-August levels, even as the CDS-Bond basis moved back into negative territory with corporate bond spreads again moving above CDS. Credit spreads may be repricing the risk of a fiscal-cliff induced recession in 2013. For context, we expect the eventual outcome of the negotiations to lead to about 2% of GDP in fiscal contraction, not enough to tip the economy back into recession in itself, and considerably lower than the 4% drag under the full enactment of all revenue raising measures and spending cuts currently set to become law on Jan 1. From our point of view, the elections confirm the status quo both in Washington and in market conditions — i.e. we should expect more of the same and it has been a great year for credit. Therefore, we see the current dip as an opportunity to add risk, and expect spreads to continue to tighten into year end, albeit at a slower rate than in recent months. We stay down in quality and outline in GAZOS this week some relative value arguments for Euro HY vs US HY. On that front, European credit shrugged off the election outcome, tightening marginally in the HG space and widening very slightly in the HY space. Foreign Exchange The post-US election drama is unfolding as expected. Four more years with the same cast is delivering a higher USD versus most currencies but JPY due to deleveraging ahead of the fiscal cliff, and lower USD/CNY forwards due to avoidance of US-China trade conflict (see An FX guide to America’s toss-up election, FX Markets Weekly, Nov 2). The only surprise has been that FX volatility remains so subdued (VXY unchanged at 7.4%) in a week when the trade-weighted dollar and equity volatility have rallied. Chalk it up to positioning, as most indicators suggest that institutions investors entered the US polls with aggregate USD positions close to flat. Now, sausage-making season begins. US recession is guaranteed if the fiscal cliff is enacted on schedule, and neither Congress nor the President welcomes J.P Morgan More details in ... US Credit Markets Outlook and Strategy, Eric Beinstein et al. High Yield Credit Markets Weekly, Peter Acciavatti et al. European Credit Outlook & Strategy, Steven Dulake et al. Emerging Markets Cross Product Strategy Weekly, Eric Beinstein et al. HOUSE_OVERSIGHT_026574