From: US GIO

From: US GIO To: Undisclosed recipients:; Subject: Morgan Eye on the Market, April 17, 2012 Date: Tue, 17 Apr 2012 14:43:34 +0000 Attachments: 04-17-2012_ EOTM - Rocket Man.pdf Inline-Images: image002.png; image004.png; image006.png; image010.png; image01 1 .png; image012.png; image013.png; image014.png; image016.png; image018.png Eye on the Market, April 17, 2012 (PDF easier to read this week, lots of charts) Topics: On sonic market and economic trends that are skyrocketing Rocket Man ("it k lonely out in Spain... '). While the US and China converge up and down to 2.5% and 8% growth, respectively, Europe has not lost its capacity for disrupting financial markets. The Spanish experiment is not doing well (see table in Appendix), prompting Spain to rely more on the ECB to finance sovereign debt. Throughout my career, central banks having to buy or finance sovereign debt to avoid a debt crisis was like going to the prom with your sister: there's something very unnerving about it, even though it looks normal from a distance. Markets apparently agree: as Spanish bank holdings of government bonds financed by the ECB skyrocket higher, so has the perceived credit risk of Spain. It did not take long for the honeymoon following the ECB's 2nd LTRO (collateralized lending) operation to end, as shown by the collapse in Spanish and Italian equity markets. Today's T-bill auction in Spain was well-subscribed, but to allay market concerns, Spain will have to issue longer paper than 12-month bills. Spanish bank holdings of Spanish government bonds, EUR billions 240 220 - 200- 180 160 140 120 100 2009 2010 2011 2012 Source: Spanish Treasury, ECB, DataSiream. Spanish banks: ECB lending to total liabilities. Percent 10% 9% 8% 7% 6% 5% 4% 3% 2% 1% 2008 2009 2010 Source: Bank of Spain, ECB. 2011 2012 Spain: credit spreads 5-yearCDS. basis points 500 • 450 - 400 350 300 Sep-11 Nov-11 Jan-12 Mar-12 Sou ce: Bloomberg. The other thing that's rocketing higher in Spain: non-performing corporate loans (see chart). Interestingly, as my friends at Hamiltonian pointed out to me recently, consumer and residential delinquencies are flat, despite a surge in unemployment. I recommend taking this data with a giant grain of salt, given what one would normally expect. I know that Spanish bank residential home loans were generally made at lower LTVs than in the US, and are usually full-recourse. But still, it's hard to understand at face value. Markets are also skeptical, which is why Spanish banks trade at less than tangible book value; a bit less than 1.0x for BBVA and Santander, around 0.5x for the domestically-focused Cajas. Note: Caixabank recently purchased Civica at around 0.35 times book value. EFTA01176179 LTR-Over? Equity markets, US vs. Periphery Index.total return. 10/2/2011=100 135 130 125 LTRO #1 LTRO #2 • 120 US 115 110 Italy 105 100 95 90 Spain 65 Oc Nov-11 Dec-11 Jan-12 Feb-12 Mar-12 Apr-12 Source: Bloomberg. Spanish unemployment and non-performing loans Percent Percent of gross loan balance! 23% 21% 19% 17% 15% 13% 11% 9% 7% 1999 2002 2005 2008 2011 Source: DataStream, Bank of Spain, HamikorianAssodates. 123‘ - 1091 - 8% - 6% • 4% - 2% 0% We have been underweight European equities since the crisis broke in November 2009; German mid-cap companies (represented by the MDAX Index) have been our preferred market exposure in the region. As explained in our 2012 Outlook, most investors are underweight Europe, valuations are quite low, and ECB liquidity will slow the rate of deleveraging. However, while contrarian market calls are sometimes the best ones, in this case it's not a call we're prepared to make. We remain underweight Europe, and overweight the US. As shown in the table, being underweight European equities is the gift that keeps on giving. Total return MSCI Europe MSCI Europe (through Apr.16) (Euro) (USD) S&P 500 2010 11.9% 4.4% 15.1% 2011 -7.5% -10.3% 2.1% 2012 4.5% 5.5% 9.6% Source: Bioorrberg. From a 10,000-foot perspective, the North-South imbalances created by the Euro are skyrocketing (see below). They are far greater than any that preceded the Euro, even during the bouts of inflation and devaluation which beset the South in prior decades. Nevertheless, the region appears committed to soldiering on with it, despite the costs. Our sense is that Europe will slog through a period of low growth and complicated politics, and that the ECB may have to resuscitate both its 3-year bank repo operations (LTRO) and outright bond purchases (SMP) later this year. These developments are amazing for a project like the Euro, which was designed to harmonize and sustain Europe's post-war social, political and economic integration. Unemployment rate, Periphery minus Germany Percent. Peripheral rates weighted bypopulation 10% 8% 6% 4% 2% 0% -2% Euro exchange rate fixed Real GDP growth, Core minus Periphery Percent,YoY, as of O4 2011 3% - 2% - 1% - 0% Euro exchange rate fixed Gap due to German unification -1% • -4% -2% 1971 1975 1979 1983 1987 1991 1995 1999 2003 2007 2011 1971 1976 1981 1986 1991 1996 2001 2006 2011 So urce: J.P. Morgan Private Bank, Ban kof Spain, Bank of PortugalOECD, Source: Statistical Office of th e European Communities, OECD, IMF, J.P. CSO, NSS, IMF, Statistical Office°, the European Communities. MorganPrivateBank. United States: nianv of the skyrocketing trends are positive Spending on equipment and software has been on a tear, accounting for roughly 35%-40% of the (admittedly subpar) US growth rate since March 2009. And despite the weak March payroll report, the cyclical component of payrolls (excluding government, construction and finance) continues to march higher, a trend confirmed by other reports showing increasing labor demand, more voluntary separations, and fewer firings (see Appendix). These trends are improving off of a very low base, but suggest a labor market that's getting better rather than worse. The retail sales report was also strong, but as EFTA01176180 mentioned last week, parts of the US experienced the warmest March in recorded history, so we need to wait and see if there is payback later in the year. US business spending on equipment and software Improving "cyclical" payrolls Billions, Real 2005 USD Total payrolls excluding construction. government. & finance. Millions 1,200 100 1,100 99 ' Y r/ 1 1,000 900 800 700 600 500 400 1995 98 - 97 • 96 - 95 • 93 • 92 • 91 1998 2001 2004 2007 2010 1998 2000 2002 2004 2006 2008 2010 2012 Source: Bureau of Economic Analysis. Source: BLS. I was also struck by the following chart on skyrocketing housing affordability. It computes the percentage of metropolitan statistical areas in which buying is cheaper than renting. It uses monthly rental data, 30 year mortgage rates from Freddie Mac, median home prices and a constant 20% down-payment assumption. Of course, financing conditions tightened substantially in the last 3 years and labor incomes are still very weak, so the universe of potential buyers is not as large as it might seem. But the economics of housing are finally stabilizing, a process we expect to take shape over the next couple of years. We expect the accumulation of household cash balances to eventually drive up residential investment from a low base. Percent of MSA's where buying is cheaper than renting Housing crash has sidelined household cash MSA = I,letropolitan Statistical Area Percentof GDP Percent of GDP 60% - 7% 1291 50% ' 40% • 30% • 20% 10% - Residential 6% , investment 4- 5% 8% 3% - Household 4% 0% - 2% 2000 2002 2004 2006 2008 2010 1985 1990 1995 2000 Sou ce:J.P. Morgan Securities LLC, AxioMetrics, Cootog c, Freddie Mac. Source: BEA, J .P. Morgan Private Bank. 2005 2010 2% Corporate profits continue to march higher as well. It's early in the quarter (only 10% of companies reporting), but so far, 86% and 77% of companies are beating revenue and earnings estimates. The challenge for 2013: according to analyst estimates, the % of companies whose margins are expected to expand skyrockets to unprecedented levels. Earnings expectations for 2013 may eventually have to come down; this can be offset by a modest expansion in PIE multiples from their currently low levels. EFTA01176181 S&P 500 Operating earnings per share Dollars. rolling 4-quarter sum. log scale 120 60 30 15 1988 1991 1994 1997 Source: Standard & Poor's Profit margin expectations for 2013 Percent of top 1500 US stocks with YoY net margin increases • 100% • '12 & '13 90% estimates go% 70% 2000 2003 2006 2009 2012 60% 50% 40% 30% 20 1970 1974 1978 1982 1986 1990 1994 1998 2002 2006 2010 Source: FactSet, klorgan Stanley Research. 2013E i The biggest fly in the ointment is of course the fiscal situation. After having skyrocketed, deficits have not come down meaningfully (below they are measured for the first 6 months of the fiscal year), and are remarkably high three years into a recovery. The "current law" fiscal drag scheduled for 2013 skyrockets as well, although we would be surprised if anything close to current law were actually implemented. We covered this issue in detail last time, and will refrain from doing so again this week, other than to note that bull markets usually do not spring into existence until issues like these are partially resolved. Fiscal deficits Scheduled austerity for 2013 First six months of fiscal year. peroent of annualized GDP. inverted Change in cyclically-adjusted federal deficit. %of potential GDP -6 — — -4 - -5 A -4 -1 - -3 0 .2 I - .1 2 . 0 • • 3 " 4 5 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 Source: Treasury.BEA.J P. Morgan Private Bank. Fiscal drag 2013 estimate I assuming I current law 11. I I le I Milk 11 II I ' I I I Fiscalstimulus 1963 1968 1973 1978 1983 1988 1993 1998 2003 2008 2013 Source: CBO, IMF, Goldman Sachs, J.P. Morgan Private Bank. China: a skyrocketing nation of spenders? While Chinese GDP growth is slowing to — 8% (see our China Dashboard from March 15, 2012), the contribution of Chinese consumption to GDP growth has been rising, and is now at its highest level since the late 199O's. This computation benefits from a declining denominator, and furthermore, it would take many quarters like this to move the needle of East-West global imbalances; but it's a start. These results are consistent with our experience in China, having invested in 2010 in an Asian private equity fund focused on consumer oriented businesses. Last year, the Chinese companies in the portfolio grew revenues and operating cash flow at 48% and 59%, respectively. Contribution of Chinese consumption to GDP growth Percent 100% 90% 80% 70% 60t, 50% 40% 30a 1977 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010 Sour e ChineNetonel Bureau of Statistics. Hever. EFTA01176182 On portfolios, no changes to the overall allocations outlined in our March 8 EoTM. Michael Cembalest Appendix: a Spanish horse race, and some data from the US Bureau of Labor Statistics V/in. Place and Show: The problem of Spain Number or amaings to population Non-financial corporate debt to GDP Corporate sector debt to cash flow Construction sector debt/assets Banking sector branches per 1,000 people Reliance on foreign capital (Net Int. Inv. Pos. Real estate as % of household assets Housing overhang (as per CEPS) Commercial RE exposure % of bank assets Encumbered banking system assets, % World Bank labor rigidity, Europe titra-European real effecthe exchange rate Shadow economy, % of GDP, OECD Unemployment rate Production time per unit Reline on Eat to finance sovereign debt Bank renting to HFUNFC, last 12 months NH/WC= households and non-financial oornabons Sources. ME, OECD, EU, World Bank, CEPS The only country I can find that's In wane shape than Spain it Greece Wand Portugal None None keland Podugd None Ireland None Greece None Italy Italy, Greece None Italy None None US laborconditions improving from a very low base Percent.6-month moving average. sa 4 1% 3.9% 3.7% 3.5% 3.3% 3.1% 2.9% 2004 2006 2008 2010 2002 Hiring Source: Bunnuof Labor Statistics. Voluntary separations 2.2% 2.0% 1.8% 1.6% 1.4% 1.2% 2012 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. Afergan research and should not be treated as such. Ilirther, the views evinced herein may differ from that contained in J.P. Morgan research reports. 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