J.P. Morgan market commentary on global earnings, ECB policy, and China slowdown (Mar 15, 2012)

Eye on the Market | march 15, 2012 J.P Morgan Topics: Is US data as good as it looks? Is Chinese data as bad as it looks? Is European data as bizarre as it looks? There’s also some good news on the global profit outlook, or at least an end to the bad news. A measure of global earnings revisions had been running negative for 40 weeks in a row until last week when it turned slightly positive. Other corroborating evidence comes from conversations we’ve had with private equity firms, whose portfolio companies are generally planning for 10%-20% increases in capital spending budgets this year. Global earnings revisions vs. global equities Unfortunately, the ECB can't create jobs (# of upgrades minus# of downgrades)/ total revisions Level Employment, percent change, QoQ, saar 0.4 1,575 3% 0.3 08 1,475 abi Germany . 1,375 0.1 1 Q, 0.0 HN am 1,275 1% -0.1 1,175 0% -0.2 1,075 MSCI World on 975 -1% Euro Area ™ undexd -05 875 90 -0.6 775 -0.7 675 -3% 2008 2009 2010 2011 2012 2005 2006 2007 2008 2009 2010 2011 Source: Citigroup, Bloomberg. Source: Eurostat, Bundesbank. After four years that challenge some of the basic assumptions of efficient markets and laissez-faire capitalism, there is a pent-up demand for normalcy among individual investors, money managers, CEOs, corporate treasurers, pension funds, regulators, etc. Through massive money creation, Central Banks have provided the veneer of normalcy which has allowed the private sector to get moving again in the US, or at least in the case of Europe, to stop declining. Markets love it. Is the ECB’s Mario Draghi a genius? Only time will tell. The last time the term Maestro got thrown around, it was a case of premature exaltation. The latest from Europe: my head is hot and my feet are freezing Angela Merkel described Europe as being ‘“‘a good way up the mountain path” regarding the debt crisis. Courtesy of the ECB, there has been a dramatic improvement in sovereign and bank debt markets. However, in the real economy, improvements are much harder to find. In contrast to improving labor markets in the US, Europe still looks pretty bad outside Germany (see chart above; the declining Euro Area line includes the better data from Germany). Other variables related to production and consumption show the same regional divergences. The challenge for Spain looks particularly daunting, given a less open economy than countries like Ireland, escalating costs associated with bank recapitalization and municipal funding shortfalls, and the likely continued withdrawal of foreign capital from the private sector. Even with continued German assistance, it’s going to be a long and freezing mountain hike for the periphery. On investments, we saw a lot of things we recognized in a 76-page Morgan Stanley paper on bank deleveraging and real estate. This has been one of our primary investment themes over the last year. MS estimates 3 trillion Euros of deleveraging by European banks in the next 3-5 years, even with ECB repo facilities slowing the pace of asset dispositions, and a more relaxed approach to Basel 3. Europe’s greater reliance on banks to finance commercial property investments (versus capital markets) is a primary driver here. One example: amazingly, Spanish banks have more domestic commercial real estate loans than UK and German banks combined. There are likely to be opportunities in purchasing loan portfolios, and in providing capital to refinance existing loans. In an environment of low growth, perpetual austerity and rising consumer stress, and the lingering possibility of a devaluation in some countries, buyer portfolio discounts need to be large enough to make sense. Where is China heading? There is a roiling epistemological debate as to whether China’s current decline is structural or cyclical. As an aside, two of JP Morgan’s investment banking analysts (one an economist, the other an equity market strategist) have taken opposite sides of the debate, which is in and of itself a healthy thing. Like the question about whether Italy has a liquidity crisis or a solvency crisis, the answer depends on your definition, and definitions can change depending on how governments respond. On the following page, we include our own China Dashboard we use to track what’s going on. Now that we have February data as well as January and can adjust for some of the New Year effects, it’s pretty clear that China is slowing. Markets are still nervous, since Premier Wen stated that the government is still concerned about elevated home prices, and that they will continue tight policies on property markets. Home price to income ratios in some major cities exceed peak 2006 California levels. But with the collapse in Chinese inflation, the government has room to re-stimulate a bit. Recently, the Chinese government has injected more liquidity; expanded the quota for foreign equity investment; cut bank reserve requirements; delayed tighter capital 2 HOUSE_OVERSIGHT_024133