Eye on the Market I July 17.2012

Eye on the Market I July 17.2012 J.P.Morgan 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 Winter (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 Earnings still outperforming the economy Index, quarter of GDP trough = 100 Ratio of 2-year earnings growth to 2-year nominal GDP growth 130, 15x 125 120 115 110 105 100 95 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 -10x Quarters since GDP trough 1952 1959 1966 1973 1980 1987 1994 2001 Source: Bureau of Economic Analysis. Source: Standard 8 Poor's. BEA. J.P. Morgan Asset Management. 10x Average peak: 2.1x — — — 14.3x 5.4x Average • ak: 4.2 x 2008 Graves of Wrath (1940): low labor compensation as the primary driver behind fat profit margins 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 PIE 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% yly (nominal). Corporate profit cycle - past 5 US recoveries Change since profit trough - billions of 2005 dollars $1,100 1958,1974,1982, 1990, 2001 $900 $700 $500 $300 $100 Sales Labor compensation -$100 Quarters since profit trough 0 1 2 3 4 5 6 7 8 9 10 Profits 11 12 13 Corporate profit cycle - current US recovery Change since profit trough - billions of 2005 dollars $900 $700 $500 $300 $100 -$100 Labor -$300 Quarters since profit trough compensation 0 1 2 3 4 5 6 7 8 9- 10 11 12 13 Profits Sales Source:Bureau of Econonic Analysis. J.P. Morgan Asset Management. Source: Bureau of Economic Analysis. J.P. Morgan As set Management. EFTA01069760 Eye on the Market I July 17.2012 J.P.Morgan 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 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 Share of total expenses, percent 35% 30% 25% 20%• 15% • 10% - 5% - 111.11.11.1.111 a >. a• e u, e l . O 40 -6 c" o a .F .O s o . - a . .g g • 2 Ts u. . . ea O 2 0 o 0 o F (.1 Source: Survey of Mamlacturing, Empirical Research Partners. laabor Costs • Energy Costs S&P 500 operating earnings per share estimates USD $30.50 $29.00 • $27.50 • $26.00 • $24.50 Nov-11 Apr-12 Aug •10 Jan-11 Jun.11 Source: FactSet, Standard and Poor's. botgrowth Q4 201 2: +16.3% Q2 201 2: +0.9% O2 2012 The Man Who Fell to Earth (1976): realism sets in on US corporate profits. at least for Q2 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 Expectations, 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. Fiscal cliff #1: 2013 Change in cyclically-adjusted federal deficit, % of potential GDP 5 Pscal stimulus 4 3 2 1 0 .2 Fiscal drag 2013 estimate assuming _•,. current law 100% - Fiscal cliff #2: 2013 and beyond Netdebt to GDP, percent, inverted 30% 40% - 50% - 60% - 70% - 80% - 90% - CB0 Baseline • • • $ • • Post-BCA case • • • • , "' • • • • • • • • A, CB0 Alternative Case • • 1963 1968 1973 1978 1983 1988 1993 1998 2003 2008 2013 2004 2006 2008 2010 2012 2014 2016 2018 2020 2022 Source: CEO, MF, J.P. Morgan Asset Management. As of July 2011. Source: CBO, J.P. Morgan Asset Management. 2 EFTA01069761 Eye on the Market I July 17.2012 J.P.Morgan 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 Sometimes a Great Notion (1971): how did the US die 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. Net debt (% of GDP) Net debt (bn) Nominal GDP (bn) Real GDP (bn 1950 USD) Outlays (Qc. of GDP) Receipts (°.) of GDP) Average real 10-year rate 1950 80% $219 $273 $273 16% 14% 1.3% 1951 67% $214 $320 $302 14% 16% -5.3% 1952 62% $215 $349 $322 19% 19% 0.5% 1953 59% $218 $373 $341 21% 19% 2.0% 1954 60% $224 $377 $343 19% 19% 2.1% 1955 57% $227 $396 $354 17% 17% 3.1% 1956 52% $222 $427 $368 17% 18% 1.7% 1957 49% $219 $451 $377 17% 18% 0.3% 1958 49% $226 $460 $377 18% 17% 0.6% 1959 48% $235 $490 $398 19% 16% 3.3% 46% $237 $519 1960 $415 18% 18% 2.7% Comp. ann'l gr: 0.8°k 6.6% 4.3% Source:OMB. BEA. Robert Shiler data sel. Bureau of Labor Statistics. 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 for a 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 Marriage (1973): the European Credit Divorce keeps 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. Flight of the Bumblebee Trillions, USD 7 6.5 6 5.5 5 4.5 4 3.5 3 2.5 2004 2005 2006 2007 Source: BIS. Data as of 042011. Non-turo zone lending to the Periphery Cross-border lending within the Euro zone 4- 2008 2009 2010 2011 1.1 1.0 0.9 0.8 0.7 0.6 0.5 0.4 Peripheral sovereign and financial debt Trillions, Euros 7 - 6 5 4 3 2 0 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Source: J.P. Morgan SecurthesLLC. 3 EFTA01069762 Eye on the Market I July 17.2012 J.P.Morgan 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 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 Germanifiedi. 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, 1991-2011 Death in Venice Percent Industrial Production Index,1998= 100, sa 7% 140 Euro exchange rate fixed Source: IN. How different are Eurozone countries from Germany? Sum of country specific factor differentials 14 More different —to 12 10 8 6 4 2 0 moni11111111 .2 9 sr8 g8. 5 .5 ;1 a < ez tr. J. _ 3, 2 -1 Tc; oi 1 r2co O •15% 10% 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Source: World Economic Forum Gabel Corrpetitiveness Report. co Source: National Bureau of Statistics, PB0C. Let the Bullets Fly (ti+Mit, 2010): will China's economy respond 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 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 130 120 110 100 90 80 70 1982 1986 1990 1994 1998 2002 2006 Source: Statistisches Bundesarrt. Istituto Nazionale di Statistica. I Germany Bectricity production 2010 30% 25% 20% 15% Can stimulus turn the tide in China Percent change, YoY 35% 25% 15% 5% 50/ Money supply p 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. I Based on the same set of 104 economic factors from the World Economic Forum Global Competitiveness Report that we used when analyzing the dispersion of different monetary unions in our May 2 Eye on the Market. The results are remarkable. 4 EFTA01069763 Eye on the Market I July 17. 2012 J.P.Morgan Topics: US equity markets holding in despite poor economic data; a hich fiscal cliff is NI orse; European Credit Divorce; will China respond to economic CPR; After 50 No Country for 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. In 0 Age-profiles of average test scores by gender Orientation Immediate recall Men Women Delayed Fluency recall Numeracy t . t t 50 55 00 65 70 50 55 80 65 70 50 55 60 66 70 50 55 60 66 70 50 55 60 65 70 Age Source: "Ageing. cognitive abilities and retiremenr. Fabrizio Mazzonna, Franco Peracchi, Munich Center fo rthe Economics of Aging. January 10,2012. Age-profiles of average test scores by employment status Orientation Immediate recall Retired Employed Delayed Fluency Numeracy recall 50 55 50 65 70 50 55 60 65 70 60 55 60 65 70 50 55 60 65 70 50 55 80 65 70 Age Source: "Ageing. cognitive abohlies and retirement", Fabrizio Mazzonna. Franco Peracchi, Munich Center fo rthe Economics of Aging. January 10,2012. Michael Cembalest J.P. Morgan Asset Management 5 EFTA01069764 Eye on the Market I July 17.2012 J.P.Morgan 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 Sources "Wall Street and Vine: Hollywood's View 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 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 tar advice. Accordingly, any discussion of U.S. far matters contained herein (including any attachments) is not intended or written to be 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. tat-related penalties. Note that J.P. 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