From: US GIO

From: US GIO To: Undisclosed recipients:; Subject: The J.P. Morgan View : Eight questions. Fewer answers. Date: Fri, 15 Feb 2013 21:55:01 +0000 Attachments: JPM_TheJ.P._Morgan_View_2013-02-15_1054856.pdf Inline-Images: image I .gif W2,J.P. Morgan Logo Global Asset Allocation The J.P. Morgan View: Eight questions. Fewer answers. Click here for the full Note and disclaimers. • Asset allocation — Bullish retail sentiment and the mini cliff from sequestration pose near-term risks to risky assets. But our ability to anticipate short-term market moves is not great, and we thus stick with our value-based medium-term ovenveights of equities and credit against safe bonds and cash. • Economics — Global growth fell to a cycle-low of 1.3% in Q4, but recent data keep us confident with a 2.4% pace for QI with upside risk. Full sequestration is now very likely for March I. We lower US H2 from 2.75% to 2.25%, saar. • Fixed Income — Higher BoE inflation forecast likely to feed into higher inflation risk premia. • Equities — Fade US equity outperformance. The sequestration raises the risk of a US growth disappointment in Q2, thus favoring our OW EM vs. US. • Credit — Short interest in the major HY and EM credit ETFs is approaching record highs. • Currencies — No change in trades, despite G20 and next week's Bal succession: Short JPY vs USD and EUR, short GBP vs SEK and EUR, and long selective EM FX: KRW, BRL, and MXN. • Commodities — We go outright short Brent, and ow long Brent time spread. • Markets are little changed this week, but are still moving our way, with riskier assets still edging out safe assets. We use the opportunity to play Agony Aunt for the week, and try to answer a selection of your most frequent questions of the past month. We do not have full answers for all, but are not too concerned, given the adage the beginning of all wisdom is to know what you don't know. • Has the rotation out of bonds started? We are seeing a trial run, led by hedge funds, but not the real McCoy, which should come from higher growth and tighter monetary policy. We do not want to follow the recent negative momentum in bond prices, as we could easily repeat last year's saw-tooth pattern in yields. We need to see something fouling up the bond world. This could be leverage, or rate hikes. Leverage remains quite low, even as it has increased, at both the investor level and among issuers (corporates as well as EM sovereigns). And without any rise in growth or inflation expectations, we see no reason for an earlier end to easy money. EFTA00954951 • Has the equity rally gone too far? We are bullish on stocks and are happy with the strong start of the year, but recognize that bullish retail sentiment and high hedge funds beta could signal an overbought market. The looming sequestration on March 1, which does not seem to be broadly expected, could create a headwind. At the same time, last year taught us that our ability to anticipate market moves over the near term is limited, but better over periods of quarters. The high relative value of equities and credit versus cash and government debt is what keeps us medium-term long in riskier asset classes. • Will 2013 become the year of M&A? YTD, M&A announcements are up 24% versus on the same period last year, which was weak despite high corporate cash reserves and sky-high equity risk premia. This year should be much better. • • M&A last year was likely depressed by the same forces that kept capital spending and equity buybacks down from 2011, namely tail risk perceptions around Europe, China and US fiscal policy. EMU and China tail risks are now more subdued and US sequestration likely poses only a small downside risk to US growth. We have seen a strong rebound in global Capex already and the same is happening in M&A. Corporate buying of shares, either their own, through buybacks, or those of other companies, through M&A, should rebound strongly this year, in our view. • Has DM fallen into recession? DM economies shrank in Q4, at a 0.9% saar pace, and global growth fell to a cycle low of 1.3%. Arc markets wrong to ignore this? We don't ignore it as the lowered level of GDP prevents us from following the short duration trade. Forward-looking activity data keep us with an expectation of a rebound in Q I, with good upside risk. • Is the Euro crisis coming back? Euro equities are down 5% over the past few weeks, and are down outright so far this year. Q4 saw a disappointing 2.3% ar drop in euro area real GDP, despite falling periphery bond yields and rallying equities then. Italian elections next week create a risk of a return of Berlusconi, and a worsening North-South divide. We cut our EMU ovenveight at the start of the year, but have not gone underweight yet. Europe requires continued monitoring, even as we forecast a more peaceful 2013. • Has the FX war started? A 20% in JPY vs USD, and a 7% drop in GBP vs EUR have rekindled fears of competitive currency devaluations. But neither the UK nor Japan are intervening and are simply reacting to domestic conditions. Note also that neither the great recession nor the weak recovery since have started a move to protectionism. In our view, policy makers deserve credit for not repeating the mistakes of the Great Depression. • Is the Japanese reflation trade over? Both Topix and JPY are hesitating and hedge funds appear to be taking profit. Next week's announcement on who will be the new BoJ Governor risks a sell-the-fact correction. But more medium term, we believe that Japan has made a fundamental decision to exit deflation through monetary and fiscal stimulus. • Why have EM equities performed so poorly? See Equity section below. Fixed Income • Government yields are a touch higher, with UK gilts the underperformer, after the Bank of England forecast inflation at 0.3% above its 2% target in two years, the largest overshoot since the late 1990s. In a sense, the higher inflation forecast simply codifies the Bank of England's repeated narrative of being prepared to look through higher inflation with the growth backdrop so weak. Even so, it is likely to lead to higher inflation risk premia in the UK, and more broadly to encourage views that higher inflation will form a part of DM economies' deleveraging process. In the UK, we think bearish positions are best expressed via long end flatteners. • The combination of rising yields and rising equities this year has put the question of whether the long-trailed shift away from bonds is underway. Mutual fund flows are one high frequency indicator of bond demand, though clearly just one important investor group among many. So far, 2013 has brought a surge of inflows into equity funds, but also decent inflows into bond funds. • Over the past two decades, there have been two episodes of heavy outflows from US bond mutual funds (>5% of AUM yoy), in 1994/5 and 1999/2000 (see chart). Both were preceded by at least one quarter of zero or negative bond returns. Both coincided with strong inflows into equity funds. And both came in tandem with the start of a Fed tightening cycle, giving retail investors a clear signal to get out of bonds. Central bank tightening is of course no prerequisite to a shift out of bonds, but does still look a long way off. Equities EFTA00954952 • Equities are flat this week following a small decline last week. US equities continued to outperform beating all major equity markets YTD in common currency terms, with the exception of Switzerland and Sweden. • Our EM vs. US overweight suffered further in February. The traditional drivers of regional performance are not helping us to explain this loss. Economic data are improving in both the EM and the US. Our favorite macro signal for the EM vs DM trade -- the difference in oya growth rates of EM vs DM IP -- is above its 5% threshold, thus favoring EM currently. Rising relative profit margins favored the US over the previous two years but since the summer EM profit margins started to rebound while US margins have flattened. Finally, mutual funds investors, who tend to be a strong momentum force, are switching from the US to EM. • It is instead possible that US outperformance is driven by home-biased US institutional investors getting excited with the Great Rotation trade and deploying their excess cash into domestic equities. We have also seen a strong pickup in M&A, in particular in the US. YTD global M&A announcements are up 24% YTD over the same period last year, and 57% of that is in the US, versus 42% for all of last year. Two major buyouts in the US over the past two weeks surely have caught investor attention. But M&A volumes are volatile and it is hard to draw conclusions from one month's worth of data. • In all, the above arguments make us reluctant to abandon our EM vs US equity overweight which we still see as a theme for 2013. But also near term, into Q2, the sequestration raises the risk of a US growth disappointment in Q2, thus favoring this trade. Credit • This was a better week for credit, as spread tightened following on from two weeks of widening. US HG continues to trade within the 2bp range it has held for a month, but the higher-beta sectors outperformed. What is noticeable is that spreads managed to tighten as Treasury yields rose, which suggests a de-coupling of the recent relationship between the two. The exception was EMBIG, where spreads widened, which is surprising given modest issuance and supportive fund flows: The asset class continues its fall from the top of last year's YTD returns chart towards the bottom of this year's (chart on p. 1). • There has been a lot of focus on the flow picture in US HY bond funds, where there were further outflows from both mutual funds and ETFs this week, despite spreads tightening. This comes after last week saw the largest outflow from bond ETFs on record (S2bn) where US HY and EM sovereign bond ETFs contributed the lion's share to this total. Today's F&L reports that short interest in the major ETFs of these two markets are approaching their highest levels. Clearly, some managers believe that two of the best performing markets of 2012 have overheated. We feel that these asset classes should be viewed in terms of carry, not price appreciation, but do not see any fundamental reason for shorting credit. We stay long, although we did cut ow longs in GMOS last month as we feel spreads remain sensitive to selling pressure from all-in yield investors. Foreign Exchange • This week's semi-annual G-20 summit has provided the expected speed bump for currency markets. Since last Friday, the trade-weighted yen and yen volatility have stabilized, yen skews have collapsed, and yen-related currencies (USD/KRW, USD/FWD, 12-mo USD/CNY) have resumed their downtrend. The yen's respite will probably be brief since the G-20 message — at least as of publication time — is that domestic policy actions are acceptable; that Abenomics is domestic policy; and that spillover effects only deserve monitoring. That last clause is new in letter but not in spirit, since G-7 and G-20 communiqués have cautioned against excess volatility for years. The G-20 will likely not quell global currency skirmishes — calling it a global currency war misreads the objective, tactics, breadth and scale of what is transpiring — but it isn't obvious that this issue is so problematic systemically. Core views and trading themes are unchanged: short JPY vs USD and EUR, short GBP vs SEK and EUR, and long selective EM currencies (KRW, BRL, MXN). • The key policy event next week will be the nomination of the next Bank of Japan Governor. Iwata is most dovish (so WY- negative) followed by Kuroda and Muto. Dovish is relative, however, since achieving 2% inflation in a country like Japan (pass-through from the currency to CPI is only about 0.3% for every 10% trade-weighted currency decline) will likely require some herculean efforts in coming months. Use a WY rally on a Muto appointment to add to yen shorts. Early repayments for LTRO-II will be announced Friday, and we expect €100-€125bn. The higher the figure, the higher the curt), though peripheral banks may be reluctant to prepay much ahead of Italian elections on February 24-25. Thus EUR/USD, which overshot after LTRO.1 repayment, should stay in the low 1.30s.. Commodities EFTA00954953 • We have been long Brent time spreads (1st vs. 3rd contract) since early Sep. on the view that supply conditions would continue to tighten in the North Sea, boosting spot versus forward contracts. Since then, the spread has doubled. However, a current proposal for changes to the Brent pricing formula should allow greater competition between crude grades in the North Sea. This would likely loosen supply conditions and thus produce a smaller gap between spot and forward contracts. We thus take profit on this position. • Brent spot prices have surged some 7% over the past two months, outperforming both other industrial commodities and equities. Stronger PMIs and industrial activity data in Asia likely explain part of this move, but have not come with upgrades of broad growth expectations for 2013. It is true that ongoing production outages are keeping supply tight in the North Sea, but we see no evidence that this has materially worsened over the last two months. Our oil analysts expect Brent prices to average around $112/bbl over Q1, while spot is currently just under $117. We tactically open a short position in Brent. 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