From: US GIG

From: US GIG To: Undisclosed recipients:; Subject: JPM Eye on the Market, July 17, 2012 Date: Tue, 17 Jul 2012 15:14:57 +0000 Attachments: 07-17-2012 - EOTM _ - The Big Screen.pdf _ _ _ Inline-Images: image001.png; image002.png; image004.jpg; image006.jpg; image008.png; image01 1 .png; image013.png; image015jpg; image017.png; image018.png; image003.png; image005.png Eye on the Market, July 17, 2012 (attached PDF file is much easier to read this week, particularly the last 2 charts) Topics: US equity markets holding in despite poor economic data; which fiscal cliff is worse; European Credit Divorce; will China respond to economic CPR; After 50 The Big Screen. Given all the monetary and fiscal stimulus thrown around, recent data has been weak in the US (low readings on retail sales, payrolls, small business surveys and GDP), China (declining manufacturing surveys and imports) and Europe (recessionary conditions in all places between the Po River, the Aegean Sea and the Strait of Gibraltar). Nevertheless, equity markets have held up better than they otherwise might have. US equities are up 7%, Asia ex-Japan is up 5% and Europe is flat (heroic given the circumstances). It's difficult to know for sure, but in addition to low valuations, this might reflect the fact that institutional and individual investors, now well-versed in the macroeconomic train wrecks of the day, have reduced equity positions to those they are comfortable holding from here. It's like staying in the theater watching a bad movie since there's nothing better playing anywhere else. In that context, here's what we're watching this summer to see if we should shift portfolio risk more towards elation or despair; right now, we are in the middle. The Lion in if (1968) and the sluggish response of the US economy to monetary and fiscal stimulus Despite all the stimulus, this is the weakest US post-war recovery on record. A couple of years ago, some argued that the deeper the recession, the more the economy would roar back. Not this time: the US economy is a lion in winter, struggling to maintain a 2% growth rate. Saving grace: profits have outpaced GDP, a function of demand from faster-growing emerging economies, and a shift in compensation from labor to capital (see next section). To be more optimistic, we need to see growth > 2.5%. US real GDP growth following post-war recessions Index, quarter of GDP trough = 100 130 15x 143x 125 120 115 110 105 100 95 0 1 2 3 4 6 6 7 8 9 10 11 12 13 14 16 16 -10x Quarters since GDP trough 1952 Source:Bureau of Economic Analysis Source:Standard& Poor's, BEA, J.P. Morgan Asset Management. Earnings still outperforming the economy Ratio of 2-year earnings growth to 2-year nominalGOPgrowth 10x Average peak: 2.1x Current recovery 5.4x Average sk: 4.2x 1950 1966 1973 1980 1987 1994 2001 2038 fagags.pf Wrath (MO. low labor compensation ac the pthllary driver behind fat priamargins The last time I showed these charts, they were picked up by a journalist at the Washington Post who is the vice-chair of the National Political Committee of the Democratic Socialists of America. In other words, they mean different things to different people. While the implications are debatable, the picture is clear: extremely weak labor compensation has been a large driver of the profits boom this time. High profit margins are likely to be sustained for a while longer, but the consequences of what drives them (weak consumer spending, large government transfers to households and political acrimony) may keep P/E multiples low. I can only imagine what Steinbeck would have said about this. Any signs of a pickup in labor compensation would be good news, but we haven't seen much yet. The employment cost index and average hourly earnings are growing at 2% y/y (nominal). EFTA01179060 Corporate profit cycle - past 5 US recoveries Change since profit trough - billions of 2005 dollars 51,100 1958.1974.1982.1990. 2001 5900 $700 $500 $300 $100 Sales Labor compensation Profits -$100 Quarterssince profit trough 0 1 2 3 4 5 6 7 8 9 10 II 12 13 Soiree: Bureau of Econonic Anabei% J.P. Morgan Asset Management. Corporate profit cycle - current US recovery Change since profit trough -billions of 2005 dollars 5500 5700 5500 $300 5100 -5100 Labor Ore plofitg compensation Profits 4300 0 I 2 3CW/in ? 9" rough 10 11 12 13 Source: Bureau of Econonic Analysis. J.P. Morgan Asset Managemant Sales One other point: the chart (below, left) shows how labor costs in most US manufacturing sectors dwarf energy costs. With high unemployment, this means little pressure on margins from labor. But it also means that you might want to temper enthusiasm regarding the benefit of cheap natural gas, since energy makes up less than 5% of total expenses. There are some multiplier benefits not accounted for here, but I think it's worth waiting to see what they really are. Labor and energy intensity In US manufacturing snareof total expenses. percent 35% 30% 25% 20% or Labor Costs sEnergy Costs O I -1 1 z i E k I 05 c 0 6 Source: Survey of Man dactun- ng. Emp wcalResearch Partners 8 05 S&P 500 operating earnings per share estimates USD $30 50 $29.00 S27 50 526.00 524.50 No Apr-12 O Aug-10 Jan-11 Jun-11 Source: FactSet. Standard and Pouts. Yet ated:lb 042012: +16.3% 022012: +0.9% O2 2012 The Man Who Fell to Earth (1.27_6): realism sets in on US cornimat nistillsALIrgat for O2 2012 With the onset of Q2 earnings season, US equities should hold up over the next few weeks if the pattern since January 2010 is any guide. Since that time, the S&P 500 is up a cumulative 28%: 13% during profits reporting seasons, 13.5% immediately after quantitative easing announcements by the Fed and ECB, and 1.5% during the rest of the time. Furthermore, Q2 profits do not have to do much to hit expectations. As shown above (right), Q2 earnings estimates have come crashing to earth since their highs last summer. Analysts now expect 0% y/y profits growth in Q2 2012, which as hurdles go, is a low one. A higher hurdle is the 16% y/y earnings growth analysts expect in Q4 2012 (Great Erpeetations, 1946). Thelma and Louise (1991): which fiscal cliff is worse? A lot of people hope that the US does not, like Susan Sarandon and Geena Davis, drive off the 2013 (fiscal) cliff to a grisly end. While I understand the reasoning, take a look at the 2 charts below. The first shows the 2013 fiscal cliff (the austerity impact if all legislated tax increases were to take place). The second looks at the other cliff, which is the increase in US federal debt over the next decade, shown on an inverted scale to capture its cliff-ness. Just as scary, right? These dueling cliffs are essentially a generational battle. By completely avoiding the first cliff, the US would be passing the buck to the next generation, violating Washington's farewell address which warned against "ungenerously throwing upon posterity the burden which we ourselves ought to bear". So far, the US has not paid much of a price for its escalating debt burden, other than the shock of last year's S&P downgrade. Will its luck continue? A lot may depend on the game plan for bringing the debt down over time. Given current gridlock, almost any signs of progress would be taken positively by financial markets. EFTA01179061 Fiscal cliff #1: 2013 Change in cyclically-adjusted federal deficit %of potential GDP 5 Final stimulus 3 1 0 1 -2 3 Ascal drag 2013 estimate assuming current taw Fiscal cliff #2: 2013 and beyond Net debt b GOP. percent. inverted 30% 40% 50% 60% 70% 80% 90% 100% 1963 1968 1973 1978 1983 1908 1993 1998 2003 2008 2013 2004 Source: cao. J.P. Henan Asse4Minagenint. As dJuk 2011. 060 Baseline • • • • • • • • • $ • • Post-BCA case • e • • C80 Alternative Case • 2006 2008 2010 2012 2014 2016 2018 2020 2022 Source:030. J.P. Morgan Asset hbnagerrent. Sometimes a Great Notion (1971): how did the US dig itself out of wartime debt levels after WWII? I find that there is a lot of misreporting about how US debt levels were halved during the 1950's. As shown in the table below, government spending was not cut sharply; there was no radical increase in tax collections, either from businesses or from households; and the Fed did not engineer negative long-term real interest rates to jumpstart growth. In addition to the competitive advantage the US had over recovering Axis Powers, the US of the 1950's benefited from pro-business policies that resulted in over 4% annualized GDP growth throughout the decade. This approach is not in play now, raising questions about how the US will deal with 80% net debt to GDP for only the second time in its 200+ year history. 1951 sum W12 MEE SEM Net debt Mot GDP 80% 67% 62% 59% 60% 57% 52% 49% 49% 48% 46% Comp. anal gr: Sane: c*t. SEA. %ten Shier data set. &rem et Leta Statnta. Net debt (bn) $219 $273 $273 16% 14% 1.3% $214 $320 $302 14% 16% -5.3% $215 $349 5322 19% 19% 0.5% $218 $373 $341 21% 19% 2.0% $224 5377 5343 19% 19% 2.1% $227 $396 5354 17% 17% 3.1% $222 $427 $368 17% 18% 1.7% $219 5451 5377 17% 18% 0.3% $226 5460 5377 18% 17% 0.6% $235 $490 $398 19% 16% 3.3% $237 $519 $415 18% 18% 2.7% 0.8% 6.6% 4.3% Nominal GDP (bn Real GDP (bn 1950 USD) Outlays (' of GDP) Receipts (% of GDP) Average real 10 year rate 1950's time capsule: taxes were regarded as a greater cause for small business failures than tight money. Eisenhower championed legislation which eased tax burdens on small business and which culminated in a bill eliminating double-taxation (Subchapter S); he also eliminated wage and price controls. In the 1950's, the private sector accounted fora post-war peak of 86% of all employment, a level not seen since. A brief detour: The 1971 film chosen above is about rugged individualism, the power of small business and the lack of reliance on government or organized labor to solve problems. It's actually hard to find a pro-business or pro-capitalist film. According to Larry Ribstein at the University of Illinois College of Law (see page 6 for details), US filmmakers have a long history of disliking profit-maximization, and have generated a huge volume of work depicting evil, soulless corporations and heartless capitalists. He quotes Joseph Schumpeter and theorizes that filmmakers are an intelligentsia over-produced by the bounties of capitalism which directs its resentment at a society that refuses to value what they do. Ouch! Scenes from a Marriagt(1973): the European Credit Divorce keep&getting more worse A decade of European monetary integration continues to unravel. As shown below, Eurozone banks are cutting their cross- border credit exposure as fast as they can. Unsurprisingly, the rest of the world is not any more anxious to lend to the European Periphery, and is cutting its exposures as well. The ECB is providing the stop-gap to finance all of this capital flight, which helps prevent an outright Depression. But to be more optimistic on Europe, we need to see some improved economic conditions in the Periphery, and evidence that structural reforms are paying off. As things stand now, there are still serious questions about how the ECB and the EU will come up with the money to finance all the maturing Peripheral sovereign and bank debt that investors no longer want to hold. Total Periphery sovereign and bank debt: almost 7 trillion Euros. EFTA01179062 Flight of the Bumblebee Tuitions. USD 7 6.5 6 5.5 5 4.5 4 3.5 3 25 2004 2005 2006 2007 Source.. BIS. Dataas o104 2011. 2008 2009 2010 2011 Non-Euro zone lending to the Periphery Peripheral sovereign and financial debt Euros 7 0 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Source: J.P. MorganSectrieesU.C. Death in Venice (1971): will the Italian economy ever grow again? Spain is the fulcrum of the crisis now, given the dreadful condition of its economy and banks. But Italy is a lingering concern, given its low growth and massive debt burden, the third largest in the world. Italy runs a very tight primary (pre- interest) budget surplus, among the best in Europe. But the size of its debt burden (120% gross, 99% net) means that there is little room for error. The second chart is as stark an example as you will ever see on how a seemingly benign political idea can negatively affect economic reality. In terms of its private sector economy, Italy is even less like Germany than Spain (third chart), raising questions about whether southern European economies can be Germanified. Keeping the Euro together at any cost probably means the cost will be very high. It's unlikely that markets will get a sustained respite from this melodrama in 2012 or 2013. 20-year growth rates, 1881-2011 Death in Venice Percent Industrial Production Mex. 1998 = 100. sa 140 7% 2% hill] 5% 4% 3% nary 0% ap l1 W 6t;'14 '7% “ 1" g li/ Eli'lri t -• Source: W. ° 6% How different are Eurozone countries from Germany? Sum of country specific tactx differentials 14 12 £ 10 8 6 4 2 0 130 120 110 100 90 80 2 1 a Source: Mild &atonic Panto G al Conpettveness Repod 70 1982 1906 1990 1994 1998 2002 2006 Source: StaSstisches Birdesarrt, islituio7bzisnale di Statistica. I Euro exchange rate fixed' I I Germany Can stimulus turn the tide in China Percent change. YoY 35% 25% 15% 2010 Bectricity production 4_ 25% 20% 5% Money supply 15% -15% 10% 2001 2002 2003 2004 2006 2006 2007 2008 2009 2010 2011 2012 Source: National Bureau of Statistics, F130C. lag the Bullets F(LTh 2010)- will China's economy pond to stimulus? In the last chart above, we show everyone's new favorite China indicator: electricity production, which presumably cannot be easily fudged or massaged. The sharp drop confirms what we are seeing elsewhere, which is a slowdown in China to around EFTA01179063 Men Women a 6%-7% growth rate. The government is responding with an impressive array of bullets: ** Reduction in bank lending and deposit rates; reduction in bank reserve requirements; PBOC injection of liquidity through reverse repo ** Increasing bond issuance limit for the Ministry of Railways, and infrastructure projects pulled forward ** Incentives to acquire energy-efficient appliances and automobiles ** First-time homebuyer restrictions eased, tax relief for small and medium sized companies ** Easing rules for domestic and foreign investment in Chinese equities As shown in the chart, there has been a recent pickup in the money supply, which is a good start. We are watching intently to see if this momentum builds, which would be critical for a growth rebound in the second half of 2012. We are guardedly optimistic on the chances for success here; we will know more by the fall. No Counoyfor Old Men (2007 : what happens after you turn 50? Having crossed this threshold recently, I have been asked what it feels like. I don't sense anything concrete just yet, other than more and more young people not understanding references to HR Haldeman or Ursula Andress. However, based on some research I have seen, I intend to (a) keep working, and (b) acknowledge that my spouse is right if we disagree on remembering something. Why? A 2010 study on cognitive abilities and aging shows some pretty striking results. As shown in the top set of charts, mental faculties fade rapidly with age once you hit 50, with women maintaining a steady lead over men in all categories except numeracy. And in the second set of charts, all things being equal, cognitive abilities remain in much better shape the longer you work and do not retire. That, and zero interest rates, makes working the better option. Ade-profiles of avenge test scores by gender 064162361011 Imm•cft• Delayed Fluency Numeracy moat recall 00 00 i0 4 do le lb to de 40 4 to Sacco Wens cagotweataesandletretnenr Fabnao Iftmonta A90 Fro= Penedo IlanchCento lot theEcenoncsolAg rs. January 10.20t2 Agpopre414 of minor test scores by employment SOWS Onsotatoo • Immediate Delayed Fluency Numeracy recall t retie Retired - Employed X 15 00 05 '0 ,) 66 03 65 70 SO 06 Of 65 '0 50 56 00 Of '0 50 54 Of OS 70 A90 Sotrce kw .* ccgneve>tdieos aximfrorncer. Febrile° Alton na FraemPeracde IlbreichCrece for the Econarricsof Ages Jawy 10,2113 Michael Cembalest J.P. Morgan Asset Management Sources "Wall Street and Vine: Holbnvood:s New of Business", March 2009, Larry Ribstein, University of Illinois College of Law. Examples of anti-business sentiment examined in the paper: Erin Brockovich, Silkwood, The Insider, The Constant Gardener, Michael Clayton, Mission Impossible II, The Hudsucker Proxy, Executive Suite, Network, Wall-E, The Graduate and Star Trek: First Contact, in which Captain Picard tells a citizen of the 21st century that "the economics of the 24th century are EFTA01179064 different — people are no longer motivated by money, but rather by the good of mankind." I'd like to see how that economy would work. IRS Circular 230 Disclosure: JPMorgan Chase & Co. and its affiliates do not provide tax advice. Accordingly, any discussion of U.S. tax matters contained herein (including any attachments) is not intended or written to he used, and cannot be used. in connection with the promotion, marketing or recommendation by anyone unaffiliated with JPMorgan Chase & Co. of any of the matters addressed herein or for the purpose of avoiding U.S. tar- related penalties. Note that J.P. 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