Eye on the Market I October 31. 2012

Eye on the Market I October 31. 2012 J.P.Morgan The Storm; and my list of demands regarding global growth, US profits, the US Federal debt and China Some of our clients have suffered temporary or permanent damage from the storm. Please let your J.P. Morgan team know if there are ways they can help. It's a bit early to draw too many conclusions, but here are some thoughts on the economic and civil engineering aspects of the storm: • Comments on CNBC about positive multiplier effects from the storm defy the laws of economics. Natural disasters can change the contours of spending and investment (lower than trend today, higher than trend for a few months afterwards), but in general, natural disasters which destroy the capital stock are bad, not good'. Only in cases where a country responds to a disaster by radically improving productivity through innovation and more advanced technology could the balance be positive (along the lines of Joseph Schumpeter's theory of "creative destruction"). The best that most developed countries can shoot for is to re-attain pre-disaster growth levels as soon as possible, which the US has had a habit of doing. • Japan is a good example: industrial production collapsed and then rose sharply after the tsunami, but has since resumed its downward trend. As per last week's energy piece, Japan's transition from nuclear to offshore wind is not likely to yield creative destruction benefits. • Early estimates of the cost of Hurricane Sandy are —$20-$25 billion. Measuring natural disaster costs relative to GDP makes more sense than simply adjusting over time for inflation. As shown below, Sandy ranks with more severe hurricanes, but well below Katrina and Andrew even if cost estimates rise from current levels. The long-run economic impacts should not be very large if history is any guide. • However, there are some things for New York to think about: it has the worst "wealth to flood protection" ratio in the world. Studies by the OECD2 analyzed 136 coastal cities around the world with at least 1 million inhabitants. As shown in the table, Greater New York was #2 in terms of assets exposed to coastal flooding, only behind Miami. And more ominously, Amsterdam and Rotterdam are protected to a flood standard of the most severe storm every 10,000 years; Tokyo, Shanghai and London are protected to a 1,000 year standard; Osaka to a 300 year standard; and New York only to a standard of 100 years. If the UK is any example, it takes time to change: the Thames Barrier was 30 years in the making. • While electricity outages in metropolitan areas are mostly a function of coastal flooding, millions of suburban and rural customers are without power due to downed electrical wires. This has always struck me as a 19th-century kind of problem. These instances would be dramatically reduced if power lines and transformers were buried underground. However, the costs of underground electricity distribution systems can be 4-6 times higher than overhead wires. Can these costs be justified by the associated benefits: reduced repair costs after storms, fewer car accidents involving utility poles, reduced tree trimming costs and lower electricity line losses? Not really; in 2005, Virginia estimated the benefits of burying power lines and transformers as being only 40% of the $10 billion cost. Only if you are willing to assume large increases in property values can the numbers be made to work. Most US states that looked at this have come to similar conclusions. The Total 1.0% 15 costliest mainland US tropical cyclones estimated damage, percent of GDP Flood protection standard Cities ranked by assets exposed worst storm per ft of years to coastal flooding (bn, 2007$) '05 Amsterdam 1:10,000 Miami 416 0.8% • Rotterdam 1:10,000 New York 320 Shanghai 1:1,000 New Orleans 234 0.6% • London 1:1,000 Osaka-Kobe 216 0.4% • Tokyo 1:1,000 Tokyo 174 0.2% • '12 '04 .66 '89 ' '11 79 '70 '01 Osaka 1:300 Amsterdam 128 New York 1:100 Rotterdam 115 0.0% • • El Nagoya 109 Guangzhou 84 Shanghai 73 University of Southampton (UK) and OECD: see footnote 2 os gia• E gt. 5; 34 tio i cy cE 5 cl' ir2 . 0 0 Source: National Weather Service, Bureau of Economic Analysis. The Summer 2011 issue of International Economy Magazine had an article on the impact of natural disasters on growth, and the majority of contributors shared this point of view. 2 "Ranking of the world's cities most exposed to coastal flooding", 2007, and "A global ranking of port cities with high exposure to climate extremes", 2009. both from the OECD and the School of Civil Engineering and the Environment, University of Southampton (UK). EFTA01071186 Eye on the Market I October 31 2012 J.P.Morgan The Storm; and my list of demands regarding global growth, US profits, the US Federal debt and China OK, now for my list of demands. Each is related to the investment outlook for 2013 and beyond. Demand #1: More disclosure by US firms on non-US operations as global growth cools off The current mix of leading indicators is a mixed bag. The US is growing at 2% with the help of very easy monetary policy (10- yr interest rates below the rate of inflation) and easy fiscal policy (9% budget deficit). Elsewhere, China, Korea and Taiwan are getting a bit better, but Europe is still weak (German IFO survey, Euro/German PMI survey, etc.) As for France, its economy is reacting to its new President the way a French family I once lived with reacted when I put barbecue sauce on salad (2" chart). More on this next time, but France is the closest thing in the world to a worker's utopia', which is expensive to maintain. Manufacturing: stable in US; improving in China; sluggish in Euro area, Flash Markit Manufacturing PMI 60 58 56 54 52 50 48 46 44 Jan-10 May-10 Sep-10 Jan-11 May-11 Sep•11 Jan-12 May-12 Sep-12 Apr-11 France: Apres Sarkozy, le Deluge? Business confidence plunges 22 points Job seekers rise a" 13% (inverted) PMI survey falls from 57 to 42 Export growth falls from 13% to 4% Jan-11 Jul-11 OCt-11 Jan-12 Apr-12 Jul-12 Hollande takes 14% lead over Sarkozy in 2nd round poll Source: Banque de France. Markit. Ministers du Travail et de IsEmplol. So urce: HSBC, Markit, J.P. Morgan Asset Management. We introduced the next chart 2 years ago when corporate profits started outperforming GDP by a margin we hadn't seen before. The primary contributors to earnings outperformance: weak labor compensation, and rising profit contributions from outside the US. However, with the summer slowdowns in Europe, China and Japan, this factor has been working in reverse, leading to negative US earnings guidance for Q4 2012. 56 companies provided Q4 guidance, and 47 were negative (mostly tech and consumer discretionary). Street estimates for these companies were -9% higher than guidance provided. While most companies provide regional revenue breakdowns, they are often bucketed into "Americas", "Europe" and "Asia". That doesn't help much when there are huge differences between Mexico and the US, Spain and Germany, and China and Taiwan. A more detailed breakdown would help analysts so that some earnings surprises wouldn't be such a surprise. While earnings growth is slowing, Q3 was not a disaster; S&P earnings are down —I% vs 2011. There were larger disappointments on sales, offset by companies managing expenses and increasing share repurchases (the S&P share count divisor shrunk for the 5th quarter in a row). Unusual period of earnings outperformance ending US foreign-sourced corporate profits Percent of GDP 16.6x 3.0% - Ratio of 2-year earnings growth to 2-year nominal GDP growth 15x 10x Average peak: 2.1x •10x 1952 1960 1968 1976 1984 1992 2000 2008 Sou ce: S&P, BEA, JPMAM. Average peak:4.2x 2.5% ^ 2.0% - 1.5% - 1.0% - 0.5% 0.0% 1947 1960 1973 1986 1999 Source: Bureau of Economic Analysis. 2012 We need to see a more decisive upturn in non-US leading indicators to anticipate higher US profits momentum next year. The good news: companies have reduced inventories in response to lower growth, setting the stage for a possible rebound in the spring. As the year comes to a close, the S&P 500 at 1,400 is 13 times 2013 earnings. If earnings are re-converging to nominal US GDP growth, that's about as high as I would expect them to get until a stronger recovery is more evident. 3 Scanning the world, France ranks at or near the top in government transfers to households, vacation times and labor market rigidity, and at or near the bottom in hours worked per week, labor force participation rates and retirement age as a % of life expectancy. EFTA01071187 Eye on the Market I October 31 2012 J.P.Morgan The Storm; and my list of demands regarding global growth, US profits, the US Federal debt and China Demand #2: The CBO should stop publishing its Baseline Case for US Federal Debt since it is increasingly preposterous The US business sector would be relieved if the fiscal cliff were dispensed with after the election, based on all the letters to Washington pleading for this to happen. Some believe that this could jump-start business capital spending, which has fallen sharply (although part of the decline was related to a massive, still-unexplained decline in orders for I-IVAC equipment). Capital spending slows; fiscal cliff responsible? Bilrions.2005$ Composite index of Federal Reserve surveys 80 Planned capex 75 70 65 60 55 50 2005 2006 2007 2008 2009 2010 2011 2012 Source: KC, NY, PhiIly, and Richmond Feds, Census Bureau. 60 50 40 30 20 10 The fiscal cliff, in billions and percentage of GDP Increased Revenues from: I fl glslated #1 #2 Expking payroll tax holiday 115 115 115 Expiring personal tax provisions 27 Expking business tax provisions 75 New healthcare taxes 24 24 24 Alternative Mninbm Tax 40 Expiring 2001/2003 Upper income tax relief 83 83 Bcpiring 2001/2003 remaining tax relief 171 Total Increase in revenues 535 222 139 Reduced Expenditures from: Lower Medicare physician reimbursement 14 Ending extension of unenpbymeni bane! its 33 33 33 BCA spending reductions (Sequester) 85 Total expenditure reductions 132 I 33 I 33 Total fiscal adjustment 667 255 172 Total fiscal adjustment (%GCP) 4.3% 1.6% 1.1% ,,,,, sv • . sine. -• • .flan tee. v....an. Defusing the fiscal cliff (possibly through iterations #1 and #2 in the grid) would help growth in 2013. However, it would contribute to rising Federal debt unless the growth payoff was huge. As a result, the business sector is also requesting that something be done about the long-term fiscal outlook. Eighty US CEOs published a letter last week calling for Washington to strike a long-term fiscal "grand bargain" that includes higher tax revenues (but not in 2013). In that context, here's our updated Federal debt chart. The outer contours of the wedge represent the Congressional Budget Office Baseline Case and Alternative Case. The problem with the Baseline Case is that while it represents "current law", it has become increasingly preposterous, as it includes items that Congress passed but has been deferring for a decade (changes to the Alternative Minimum Tax and Medicare reimbursements), and a wholesale resumption of 2001 tax rates that Congress has no intention of implementing. The CBO should just stop publishing it, or put a unicorn next to it as an indication of how likely it is to happen. US long-term debt scenarios Netdebt to GDP, percent All tax cuts and subsidies extended, MIT and medicare • patches continue, no BCA sequester 70% - 60% • CBOAlternative Case •• • it • • • • • • • • • • • • • For AGI > $250k, tax rates return to 2001 levels • President's budgetas written: forAG1> S250k; • Tax to 2001 tax dividends rates return levels, as ordinary income, tax LTCG at 20% other deduction and exemption limits (PEP/Pease) • Limit the tax value of itemized deductions to 28% ' New tax on municipal bond income, contributions to 50% • CBO Baseline: Tax rates return to 2001 401k pla ns, a nd all health insurance premiums paid by levels; AMT exemption no longer indexed employees and employers (taxed at difference between 40% • to inflation; Medicare reimbursement cuts taxpayer's top statutory rate and 28%) 301Y 2004 2006 2008 2010 2012 2014 2016 2018 2020 2022 to Doctors proceed; BCA cuts proceed ' Bring estate tax exemption and rates back to 2009 levels A President's budget as written + BCA Sequester Source:CBO, JPMAM. AGI is acljustedgross income. What might a second Obama administration do about this? The President's proposal shown by the purple square stabilizes the Federal debt over a ten-year horizon according to CBO forecasts, and does so almost entirely through higher taxation of families with more than $250,000 in adjusted gross income. The plan does not appear to be politically feasible, even if there is a Democratic sweep. If the President is re-elected and only manages to pass increases in tax rates on the top two brackets, then as shown by the green diamond, the impact on the long-term debt is more modest. As we briefly mentioned last week, the President's tax plan (if enacted) would raise effective tax rates on high net worth families by 4% to 12%, based on some demographic examples we examined. 4 There are those who believe that the Fed could just write off the Treasuries that it owns. This view has been advanced by Ron Paul in H.R. 2768, and seconded by his ideological opposite Dean Baker, ultra-progressive founder of the Center for Economic and Policy Research. The economists that I trust the most describe the idea as "ludicrous". 3 EFTA01071188 Eye on the Market I October 31 2012 J.P.Morgan The Storm; and my list of demands regarding global growth, US profits, the US Federal debt and China As for Romney, there is no dot to plot given a lack of specifics. The candidate has proposed cutting tax rates and broadening the base by reducing itemized deductions. However, the Tax Policy Center concluded that reducing tax rates by 20% would result in lost revenue that is 3x higher than revenue gained by limiting itemized deductions at $25k. Romney also mentioned cutting discretionary spending by 5%, which would most likely fall on non-defense spending as a 10% cut. However, the first phase of the Budget Control Act already brings non-defense discretionary spending well below the lowest level in 40 years. As a result, like Obama's tax-the-mass-affluent plan, Romney's idea of further non-defense cuts may not be politically feasible. As a result, we don't have much insight on a Romney long-term debt outlook, other than the notion that pro-growth policies will reduce the debt. Before you dismiss this, it is exactly what happened during the 1950's, when US debt/GDP fell from 80% to 40%. The popular myths as to how this happened are wrong: as shown below, government expenditures were not gutted; tax receipts did not rise sharply; the government did not inflate the debt away (inflation was -2%); and the Fed did not rely on Greenspan-Bernanke market manipulation (ten year Treasuries were above the rate of inflation). The economy grew its way out, as 4.3% real growth solved the debt problem through rising growth instead of falling debt. Whether pro-business policies like those enacted by Eisenhower can accomplish the same result again is part of what the current election is about. It's also about the chart next to the table, showing that close to 100% of government revenues are already committed to entitlement programs, other mandatory programs and interest. The President's signature health care bill expanded the entitlement system, whereas his opponents have mentioned (in very abstract terms) efforts to reduce it. 1950's Federal debt reduction relied on growth, not austerity, inflation, taxation or artificall low interest rates Net debt Net debt GDP (bn) Nominal GDP bn Real Outlays% Receipts GDP bn of GDP %ititGDP Real 10 year Trees rate 110% 80% $219 $273 $273 16% 14% 100% 1950 1.3% 1951 67% $214 $320 $302 14% 16% -5.3% 90% 1952 62% $215 $349 $322 19% 19% 0.5% 59% $218 $373 $341 21% 19% 2.0% 80% 1953 1954 60% $224 $377 $343 19% 19% 2.1% 70% 1955 57% $227 $396 $354 17% 17% 3.1% 60% 1956 52% $222 $427 $368 17% 18% 1.7% 1957 49% $219 $451 $377 17% 18% 0.3% 50% 1958 49% $226 $460 $377 18% 17% 0.6% 40% 1959 48% $235 $490 $398 19% 16% 3.3% 46% $237 $519 $415 18% 18% 2.7% 30% 1960 1962 1967 1972 1977 1982 1987 1992 1997 2002 2007 2012 Comp. ann'l gr: 0.8% 6.6% 4.3% Sources:0UB. BEA. Acton SanerOm sec Bureau se Labor &MIMICS. Percent of US government revenue already committed to mandatory programs and interest expense Source:CBO,J.P. MorganAssotManagetnent. Demand #3: China should clean up contradictions in its reported data particularly as growth is slowing There have been press articles on the accuracy of Chinese Chinese equity valuations a shadow of their former dates, an important discussion given the debate about selves, Price to trailing earnings Chinese growth. China is partly to blame; measures of 60 - GDP, retail sales, electricity consumption, industrial profits - and fixed asset investment from China's National Bureau of 50 Statistics are at times internally inconsistent (i.e., 40 - extrapolations of monthly results from YTD data do not match those from year-on-year data). China also just 30 - reported the 9th quarter in a row of a magically unchanged 20 - unemployment rate (4.1%), and still does not report quarterly components of GDP (consumption, investment, 10 - etc) which are only provided annually. There are lots of factors involved, but these issues might be contributing to the apparently structural decline in Chinese P/E. These 2001 zoos Source:Bloombeig. issues did not matter much to investors in 2007, but as Chinese growth has slowed down, many people are taking a closer look at the numbers. Shanghai Composite Index 2005 2007 2009 2012 5 US data is considered much more reliable, but last month, Jack Welch described a report from the Bureau of Labor Statistics as "downright implausible" due to the spike in the number of people working part-time. and the increase in the number of government workers. 4 EFTA01071189 Eye on the Market October 31. 2012 J.P.Morgan The Storm; and my list of demands regarding global growth, US profits, the US Federal debt and China Given these concerns, a cottage industry has arisen which looks at contemporaneous, high-frequency Chinese data to see if it matches up with GDP. The grid below is part of what we look at (it doesn't make sense to just pick one of these and obsess on it, which some people do with electricity production). In aggregate, these data points tell a story of an economy that slowed this year but is now stabilizing, albeit at a reduced level of growth (around 7%), and with the help of government infrastructure spending (China ran a 600 bn RMB budget surplus through September, and intends on having an 800 bn RMB deficit through December). This may explain why some of our EM hedge fund managers have just turned positive on China equities. While Chinese growth is stable, there's a big difference between 7% and 10% for the rest of the world. High-frequency complements to Chinese GDP data EM domestic demand has held up well Real retail sales growth, 3m/3m annualized %change Cement production 15 Container throughput 13 Electricity consumption &ports 11 Floor space started 9 Fighway freight 7 Hong Kong Lu*iry sales HSBC Manuf. survey Macau gaming revenue Passenger car sales Rail freight Steel production Waterway freight Source: IS1, JP Morgan Asset Management Latest read Irrprmement in Aug/Sep to normal pace Small irrprovement in Sep No growth Small irrprovement in Aug/Sep Very volatile. weak after summer rebound Irrprmement in Aug/Sep Flat vs large gains in 2009.2011 Flat. no improvement all year Flat vs large gains in 2009.2011 Still weak after large gain in '09 and smaller gain in 2010 and 2011 lrrprovement in Sep after summer collapse Flat vs large gains in 2009 and 2010 Small irrprovement in Aug/Sep 5 3 1 1 -3 Jan-10 May-10 Sep-10 Jan-11 May-11 Sep•11 Jan-12 May-12 Sep-12 Source:J.P. Morgan Securities LLC. Emerging markets Developed markets Demand manazement My demands are pretty simple, at least compared to some riders I have seen from performing artists as part of their concert venue contracts6. However, I have few expectations they will be granted, and surfaced them to walk through the issues we are looking at as 2012 comes to a close. All things considered, financial markets digested these issues pretty well this year. Here's an optimistic read for 2013: easy monetary policy increases global growth from its current 2% pace to 3.0%-3.5% next Spring, with contributions from emerging economies where retail sales are still growing by 10%+; the US avoids the 2013 fiscal cliff and simultaneously strikes a grand bargain on long-term debt, making headway on both entitlements and tax reform; US companies respond by increasing capital spending and hiring in a virtuous circle; and with the ECB buying bonds and providing an incentive for others to join them, Spain and Italy start to grow again, France avoids another recession, and the EU crisis gradually fades away. I can't figure out which part of this outlook is more remote: a grand compromise in Washington, or the notion that all Spain and Italy ever needed was a more interventionist Central Bank. Michael Cembalest J.P. Morgan Asset Management (if you missed our annual energy issue last week, please ask your J.P. 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