J.P Morgan

J.P Morgan The J.P. Morgan View Will Europe be able to circle the wagons? • Asset Allocation —Greater political risk in Europe force us to reduce equity longs, while staying in credit, in ow asset allocation portfolio. • Economics — Weaker data for April delay the expected bounce back in the Chinese economy. Global growth forecasts unchanged from January. • Fixed Income — We add to Euro area hedges. • Equities — Stay long US vs. Euro area equities. • Credit — We continue to favour US credit and hold NEXGEM markets in EM. • Foreign exchange — Add to USD longs, as adverse Greek news should push the euro down much more than upside created by positive Greek news. • Commodities — Higher oil prices in H2, but with elevated two-sided risks. • Equity and commodity markets are down this week, and bonds and the dollar are up on political paralysis in Greece and weaker Chinese economic data. Credit, in contrast, performed better than other risk markets with spreads only a few basis points wider, largely offset by lower underlying bond yields. • Over the past month, equities are now down some 7%. though still up on the year (chart on right). This is close to the limit of what one can call a profit- taking correction, and now risks turning into a broader and deeper downside move. Relative to where we were a few weeks ago, there is now a near-term downside risk, but signals for 3.6 months out still sound positive to us. This suggests retaining upside exposure to equities and credit, while flat on commodities and bonds, focusing on the US market where there is least downside risk, adding some near-term downside protection, and keeping overall tactical risk below average. In our own GMOS asset allocation model portfolio, we cut the equity long position in half, while keeping net long exposures in credit. • How does one gauge the various forces driving risk markets? Starting with the economy, our 2012 and 2013 growth forecasts, at 2.2% and 2.6%, remain UNCH-ed since late January. Consensus is similarly not moving. The message on the world economy remains "low but stable". For the US, unchanged weekly claims and a pop in Michigan consumer confidence are neutralising downside risks from recent weakness in job growth. We are comfortable with our 2.5% call for Q2. Less encouraging were the April data from China that forced us to lower our Q2 forecast from 7.8% to 7.0% sear. IP and retail sales growth are slowing into Q2. Our own and consensus projections on a rebound in H2 depend on monetary and fiscal easing measures. The next reserve requirement cut should come next month, followed by fiscal stimulus in the SUMMer. • Price momentum is now slightly positive for risk assets, down from strongly so. That is because short-term momentum — the last month — is negative, but the more reliable 6-month momentum, that is the basis of our rule-based The certifying analyst is indicated by an AC. See page 7 for analyst certification and important legal and regulatory disclosures. Global Asset Allocation J.P. Morgan Chase Bank NA, J.P. Morgan Securities Ltd. May 11.2012 Jan LoeysAe (1-212) 834-5874 jan.loeyeelpmorgancom John Normand (44-20) 7325-5222 [email protected] Nikolaos Panigirtzoglou (44-20) 7777-0386 nikolaos.panigirtzoglourgqpinorgan.com Seamus Mac Gorain (44-20) 7777-2906 seamus.macgorainftmorgan.com Matthew Lehmann (44-20) 7777-1830 [email protected] Leo Evans (44-20) 7742-2537 leonard.a.evansftmorgan.com YTD returns through May10 %. equities are in lighter colour. S8P500 US High Yield EM $ Corp. MSC! EM EMBIG MSCI AC &rid I Top EM FX US HO Grade a MSCI Europe II EM Local Bonds !MEI US Fixed Income I Gold MI Global Gov Bonds" l= Europe Fixed Income' ■ US cash GSCI TR to SOute J.P Won. 8b0SK9. Helms n USD o:“ worry. **Hedged rib USO. Ewa Ford Intone rs ter( Omni Mee. US IC HY. EMIG am, EM S Car am JRI rn6ces. at Fxb FMK Ins. www.morganmarkets.com EFTA01176770 Global Asset Allocation The J.P. Morgan View J.P. Morgan asset allocation models, remains in positive territory. Buying or selling assets on just the last month's price movement is a dangerous game. • Value in risk markets — risk premia versus cash and safe gov't debt — has improved, but was already attractive to start with, in our view, and is unfortu- nately not a good timing signal. The Asset Reflation force — central bank liquidity supply —is also still in place. It is both a medium-term force, and a short-term put as growth shortfalls would likely induce renewed liquidity injections and or quantitative easing. Positions are now quite neutral as we find that tactical positions among short-term investors are now quite flat, even as they remain moderately long among more medium-term market participants. That leaves the main near-term negative for markets, tail risk perceptions, and one that has significantly worsened this past week, with Europe and Greece against the focus of global concerns. The failure of last week's Greek elections to produce a pro-EMU coalition has raised the risk of eventual EMU exit and massive contagion to the rest of the Euro area, with our strategists raising exit odds to 30.50%. The fear scenario is as follows: a new Greek government refuses the Troika conditions: Troika does not budge and stop new funding: massive capital flight in anticipation of exit force capital controls in Greece, and new IOUs to pay public workers, which starts the process to a new currency; capital flight from rest of periphery. If periphery countries then impose capital controls, the monetary union is effectively dead, as one country's curos are then not the same as another country's euros. To prevent this, the Euro area then needs to circle the wagons and accelerate moves to the joint funding of member governments and capital injections into banks. The cycle of crisis, midnight decision making, relief, quiet, gradual spread widening, and renewed crisis remains in place. We choose to protect against this cycle by undenveighting Europe, rather than being short risk on a global basis. Fixed income • Bonds are higher on the week, except in the Euro area periphery, where worries about Spanish banks and especially the inconclusive Greek election pushed spreads wider. One of the factors making it so difficult to call market direction in the past few years has been the increasing impact of political uncertainty, which investors have found much harder to predict than, say, the swings in the economic cycle. Greek politics, of course, have been harder to predict than most. If the likeli- hood that the electoral process leads to a breakdown of relations with the Troika, and a Greek exit from EMU, is anything close to 50%, then intra-EMU spreads would have significantly further to widen. Europe is surely unpre- pared for the scale of the consequent hedging flows from investors, corporates and depositors seeking protection against potential currency risk between EMU members, in our view. • What to do in the face of a risk which is so difficult to forecast? Many investors have pared back positions, as shown by our European Client Survey (Aditya Chordia. May 11). And indeed, we remain flat duration in the face of such a binary outlook. We do see merit in adding to hedges where prices have not yet moved too far, including undenveighting short-dated Italian bonds vs Germany, and positioning for wider German Bund swap spreads (see today's GFIMS for details). May11,2012 2012 global GDP growth forecasts: JPMorgan and Consensus 4.0 3.5 3.0 2.5 2.0 1.5 Jan-11 Apr-11 Jul-11 Oct-11 Jan-12 Am-12 Soiree. JP. Pkegort Ccmwsus Ecoranos.Ozmensus Ecornmes lOnnittS6R 'Of RV" gerl CO,ntriSS lhal w arpaJeJ or° to sore "yes roling US0 GDP sorts fat se use kt of on gtbS radi lararsl. More details in ... Global Data Watch, Bruce Kasman and David Hensley Global Markets Outlook and Strategy. Jan Loeys. Bruce Kasman. et al. US Fixed Income Markets. Terry Belton and Srini Ramaswamy Global Fixed Income Markets. Pavan Wadhwa and Fabio Bassi Emerging Markets Outlook and Strategy Joyce Chang Key trades and rut Emerging Market Equity Strategy. Adrian Mont et al. Flows and Liquidity. Nikos Panigitteogiou et al. 2 EFTA01176771 Global Asset Allocation The J.P. Morgan View J.P.Morgan Equities • The Greek political crisis is added to Spanish woes and weak economic data, creating a negative mix for equity markets. It is worth hedging against this mix via longs in equity volatility. The problem with simple long VIX strategies is that they have a negative carry which over time becomes problematic. A way to avoid this negative carry is to hedge via the J.P. Morgan Macro Hedge Index (JPMZMHUS Index). This index picks up premium through its short exposure to the 1st month along the VIX futures curve, yet allows for tail risk protection through its long position in the 2nd month. It takes off the short leg opportunistically and systematically. • OW US vs. Euro area equities is another obvious trade to hedge against a potential escalation of the Greek issue. But beyond its usefulness as a hedge, this trade is supported by a growing divergence of the profit margin picture in the US vs. Europe. • Unconvincing economic data justify a neutral stance on high beta exposures such a Cyclicals vs. non-Cyclical sectors and EM vs. DM equities. But within EM, we still likeoverweightitig M.SCI EM AsiaS vs MSCI EMS. This trade suffered this week due to weak economic data releases in China. As we explained last week, this is not a trade that will nencsarily perform immedi- ately. There is perhaps more upside in the summer as we expect that around July/August, two to three months before leadership change in China, a large FAI spending program will be announced. Frank Li, our Chinese equity strategist, stresses that monetary policy alone is not enough to engineer an economic pick up. Investors should keep a close eye on China's pace of the approval of new investment projects and on the timing of China's nomination of the standing committee of the politburo. Should there be delay in the nomination of the above standing committee, the timing of kicking off FAI projects could also be delayed. Credit • Uncertainty around the results of the Greek elections capped a torrid few weeks for equities. Yet credit has been significantly outperforming. Whilst spreads were wider across the board, US HG yields hit 3.96% on Wednesday, a new record low, EM $ sovereigns and corporates are approaching their record lows of 2010 and US HY isn't too far off the record lows of 2011. The negatives feeding into the Treasury rally have not led to a serious deterioration in credit spreads as strong technicals and credit metrics put downward pressure on secondary market levels. We continue to favour US credit and hold NEXGEM markets within EM (which have returned over 5% since the end of February). • Our colleagues gave some interesting colour on ESMA's proposed technical details around EU short selling restrictions yesterday (see Sovereign CDS Regulatory Update, Saul Doctor et al. Note that this is their interpretation of the text, not a legal opinion.). The European Commission has three months to endorse them. Highlights include: 1) Restrictions on uncovered CDS, such that an exposure that is sufficiently correlated with the sovereign's debt must be being hedged, which may threaten the future of SovX in its current format. 2) Bans on cross border hedging with CDS, i.e. exposure in Country X using CDS on Country Y (subject to some exemptions). 3) Increased power for regulators to suspend trading for a day if bond yields rises by a certain amount (7 %/% for Sovereign bonds and 10%/% for Corporate bonds). More details in ... EM Corporate Outlook and Strategy. Warren Mar et al. US Crethr Markers Outlook and Strategy. Enc Beinstein et ai. High Yield Credit Markets Weekly. Peter Acciavatti et al. European Credit Oudook B Strategy. Steven Dulake et al. Emerging Markets Cross Product Strategy Weekly. Eric Beinstein el al. May11,2012 3 EFTA01176772 Global Asset Allocation The J.P. Morgan View J.P, Morgan Foreign Exchange • Greece's bombshell election results last Sunday have given the world a lot to mull, none of which is comforting. For political pundits, it's the demise of mainstream parties; for the historians, it's Weimar Germany in the making; and for investors and corporates, it's Greece's EMU exit. This is the second time in six months Greece has found (or put) itself in this position. This occurrence is much more worrisome since the Left is in ascendance and some of its demands (debt moratorium, bank nationalization) could set off a chain of events result- ing in Greece's withdrawal or de facto ejection from EMU. • As disturbing as EMU exit is, it cannot occur automatically, accidentally or impulsively. Europe and Greece need to make several deliberate policy deci- sions to deliver the worst-case scenario, as traced in today's FX Markets Weekly. A centrist government would re-engage the troika and restore EUR/ USD to its previous range in the low I.30s all else equal. A leftist government which declares a debt moratorium risks its EMU membership and will prompt speculation about reintroducing the drachma, an event which would push the euro well below 1.20 and cause vols to spike to at least 15%. • Attaching odds to these scenarios entails considerable guesswork given how coalition-dependent the outcomes are. But if we accept the simple arithmetic that a centrist coalition is as likely as a leftist one, but EUR/USD downside is so much larger with leftists than euro upside with centrists, the euro should decline this summer. For now we increase long USD hedges; forecasts will be revised in next Friday's Key Currency Views. • Having positioned over the past two months for ranges on the dollar indices — roughly 78 - 81 on DXY and 80 — 82 on JPMQUSD — we add dollar longs given the direction in which Greek policy is lurching. To an existing cash short in GBP/USD, add a 12-mo EUR/CHF put spread (1.19 — 1.10 strikes); a 2-mo EUR/ USD put spread (1.25 —1.20 strikes); and a 2-mo USD/CAD at-expiry digital (1.0450 strike). Commodities • Another week of broad-based commodity decline& Both the EMU crisis escalation and the weak data out of China contributed. The steep fall for gold means that it is now only just up on the year. Our overall commodity alloca- tion remains neutral for the near term, and focused instead on spread trades. favouring natural gas, crude oil and corn, against gasoline, wheat, and cattle. • The downdraft in oil in the past two weeks has been striking. We had expected softer prices in Q2, partly due to refinery maintenance, and continue to anticipate stronger demand and higher prices in the second half of the year. The risks around this path are material, however. Our forecast calls for a pick- up in GDP growth, but recent economic momentum and the EMU crisis pose some downside risks here. Meanwhile, geopolitical uncertainty remains high in the Middle East, with either an escalation of tensions, or a diplomatic solution that brings Iranian oil back to the market, both possible. Thus the risk of a move of over S20/bbl in either direction appears elevated, and underpins the rise in oil implied volatility to around normal levels, having been unusually low. See today's Oil Market Monthly (Eagles et al.) for details. FX weekly change vs USD 2.0% 1.0% 0.0% -1.0% I -2.0% USD JPY EUR GBP CHF CAD AUD TWI SaLrce.J.P Malan More details in ... FX Markets Weekly. John Normand et al. Commodity Markets Outlook & Strategy. Cohn Fenton et al. Oil Markets Monthly. Lawrence Eagles et al. Metals Review and Outlook, Michael Jansen Global Metals Quarterly. Michael Jansen Ylay11,2Cri2 4 EFTA01176773 Global Asset Allocation The J.P. Morgan View .J.P.Morgan Interest rates Current Jun-12 Sep-12 Dec-12 Mar-13 YTD Return' United States Fed funds rate 0.125 0.125 0.125 0.125 0.125 10-year yields 1.84 2.40 2.50 2.50 2.50 0.5% Euro area Re0 rate 1.00 1.00 1.00 1.00 1.00 10-year yields 1.52 1.80 2.00 200 2.00 22% United Kingdom Repo rate 0.50 0.50 0.50 0.50 0.50 10-year yields 1.96 2.55 2.55 2.40 2.40 -0.6% Japan Overnight all ale 0.05 0.05 0.05 0.05 0.05 10-year yields 0.85 1.15 1.05 1.05 1.15 1.1% GBI-EM hedged in S Yield -Global Diversified 6.33 6.30 2.6% Credit Markets Current Index YTD Return' US high grade (bp over UST) 203 JPMorgan JULI Pablo Spread to Treasury 3.8% Euro high grade (bp over Euro gov) 265 Elmo( Euro Corporate Max 4.5% USD high yield (bp vs. UST) 628 JPMorgan Global Hogh Yield Index STW 7.0% Euro high yield (bp over Euro gov) 810 Eton Euro NY Max 11.8% EMBIG (bp vs. UST) 360 EMSI Global 6.6% EM Corporates (bp vs. UST) 396 JPIA EM Corporates (CEIABI) 7.1% Commodities Quarterly Avenges Current 1202 1203 12Q4 1301 GSCI Index YTD Return' Brent (SMN) 112 112 120 125 125 Energy 0.6% Gold (S!oz) 1586 1750 1850 1875 Precious Metals 1.5% Copper (Slmeblc ton) 8207 8150 8575 9000 Industrial Metals 2.7% Corn (S/Bu) Foreign Exchange 5.78 6.35 5.85 5.65 Current Jun-12 Sep-12 Dec-12 Mar-13 Agnoulture .5.3% 3m cash YTD Return' Index In USD EUR/USD 1.29 1.34 1.36 1.36 1.36 EUR 0.6% USOIJPY 79.9 78 80 78 80 JPY 3.7% GBP/USD 1.61 1.61 1.62 1.62 1.62 GBP 4.6% USD/BRL 1.95 1.90 1.90 1.90 1.90 BRL .14% USD/CNY 6.31 6.20 6.20 6.10 6.10 CNY 0.6% USD1KRW 1147 1120 1100 1090 1090 KRW 1.9% USDfTRY 1.78 1.75 1.75 1.70 1.70 TRY 9.0% YTD Return Equities Current focal ccy) US Europe Sector Allocation' YTD YTD Japan YTD EM YTD (5) SAP 1360 8.7% Energy -1.7% -64% -3.3% 2.1% Nasdaq 2948 12.9% Materials 5.5% 4.8% 2.9% 2.2% Toots 758 6.2% In0ushlals 6.5% 6.0% 3.5% 9.1% FTSE 100 5576 1.7% Discretionary 14.1% 13.1% 12.3% 8.8% MSCI Eurozone* 132 2.5% Staples 5.7% 4.5% 9.7% 10.3% MSCI Europe' 1031 2.7% Heallhcare 7.5% 2.5% 2.9% 11.8% MSCI EM 981 7.9% Finandals 15.8% 4.7% 13.0% 8.3% Brazil Bovespa 59800 5.4% Information Tech. 14.0% 4.1% 5.4% 16.6% Hang Seng 19965 8.3% Telecommunications 7.8% -5.3% -3.4% 7.6% Shanghai SE 2395 9.6% 'Levels/returns as of May 10.2012 Local currency except MSCI EM Mitres 0.9% -2.1% -0.7% 6.9% Overall 8.7% 2.7% 6.2% 7.9% Soucy* 191,:cr9rD, Dalastrwrn eES. Staldird 6 Poefl. SereuX4 J P go-ays May11.2012 5 EFTA01176774 Global Asset Allocation The J.P. Morgan View J. P Morgan Global Economic Outlook Summary Real GDP 5i Ott a tea ago Real GDP cner ;camas rein& sax Consumer prices i Ott a war ago 2011 2012 2013 4Q11 1Q12 2012 3012 4012 1013 2Q13 4011 2012 4012 2Q13 The Americas United States 1.7 2.4 22 3.0 2.2 2.5 3.0 2.0 1.5 2.3 3.3 2.0 1.8 1.6 Canada 2.5 2.3 2.5 1.8 2.1 2.6 2.3 2.4 2.7 2.4 2.7 1.7 1.7 2.0 Lao America 4.3 3.71 4.0 2.4 4.0 4.0 1 4.5 t 4.3 t 4.4 3.8 7.2 6.4 6.2 6.9 Argentina 8.9 4.01 391 32 43 t -2.01 8.0 t 8.0 t 3.0 4.0 9.6 10.0 10.0 11.0 Brazil 2.9 2.91 4.5 1.3 2.6 4.5 5.7 5.7 4.5 4.5 6.7 5.0 5.0 5.3 ChM 6.0 5.0 4.5 82 5.1 4.9 4.6 4.7 4.5 4.4 4.0 4.2 3.9 3.4 Colombia 5.9 5.0 5.0 SA 4.5 4.9 4.1 3.0 5.7 6.0 3.9 3.6 3.3 3.0 Ecuador 7.8 4.0 4.0 4.1 2.0 3.5 4.0 4.0 4.0 4.0 5.5 5.3 4.7 4.7 Mexico 3.9 3.8 3S 11 Ll 3.9 2.0 3.2 4.9 2.8 3.5 4.2 4.0 3.8 Peru 6.9 5.5 7.0 2.8 5.2 5.8 6.2 7.3 8.0 8.0 4.5 3.9 3.1 3.0 Venezuela 4.2 4.0 1.0 3.5 6.0 6.0 4.0 -3.0 0.0 0.0 28.5 23.9 23.4 31.7 AsiwPacific Japan -0.7 2.0 1.3 -01 2.8 2.0 1A 1.2 1.0 12 -0.3 0.1 0.1 -0.1 Australia 2.0 3.0 3.3 1.7 3.1 1.9 3.7 4.1 4.5 2.0 3.1 2.5 3.3 3.0 New Zealand 1.4 2.9 2.7 1.4 5.1 2.1 3.7 3.0 0.9 3.4 1.8 1.2 2.5 2.7 Asia ex Japan 7.0 6.31 7.0 1 4.51 Dap 5.31 7.01 7.11 7.0 7.0 4.9 3.8 1 4.3 4.8 China 9.2 8.01 891 8.8 6.8 jag 1 9.1 1 9.51 9.1 81 4.6 321 3.6 4.5 Hong Kong 5.0 2.41 42 1.6t 1.61 _301 6.0t 6.5t 3.0 3.01 5.7 4.4 3.5 3.4 India 7.0 7.1 7.3 3.8 13.0 5.5 6.3 6.5 6.7 7.5 8.4 7.8 8.2 8.5 Indonesia 6.5 5.3 5.5 8.81 4.81 5.0 4.5 5.0 5.5 5.5 4.1 3.9 7.4 7.3 Korea 3.6 3.3 4.0 1.3 3.7 4.Q 4.5 4.0 4.0 4.0 4.0 2.6 2.9 3.5 Malaysia 5.1 3.9 32 4.8 3„0 2.0 2.0 2.5 4.0 4.5 3.2 2.6 2.2 1.8 Philippines 3.7 4.3 4.8 3.5 4.3 4.9 5.7 4.9 4.5 4.5 4.7 3.9 4.0 4.0 Singapore 4.9 3.7 4.0 -2.5 9.9 6.6 3.2 2.0 4.5 4.5 5.5 4.6 3.4 2.8 Taiwan 4.0 2.4 5.0 -0.6 1.0 4.8 6.5 5.8 4.5 4.6 1.4 1.3 1.7 12 Thailand AfricalMiddle East 0.1 5.1 3.5 -36.4 45.0 20.0 2.0 0.5 5.0 6.5 4.0 3.7 3.5 3.2 Israel 4.8 2.9 4.4 32 0.8 3.2 6.1 7.4 4.5 2.8 2.5 2.3 2.5 2.1 South Africa Europe 3.1 2.7 3.6 32 2.3 2.6 2.8 3.2 3.8 3.5 6.1 6.0 6.2 5.9 Euro area 1.5 -0.4 0.4 -12 4Z.3 -0.8 -0.5 0.3 0.5 0.5 2.9 2.6 t 2.3 t 1.8 t Germany 3.1 0.6 1.4 -0.7 Q3 1.0 0.8 1.3 1.5 1.5 2.6 2.3 2.1 1.8 t France 1.7 0.3 0.7 0.6 0.0 0.0 0.3 0.5 0.8 1.0 2.6 2.6 2.3 1.9 Italy Norway Sweden 0.5 2.7 4.0 -1.9 1.4 -0.3 -0.7 1.8 I/ -2.6 25 -4.4 -2.5 0.0 4.5 -2.5 0.0 -0.5 -1.5 1.0 0.5 -1.0 1.0 1.0 -0.5 2.0 2.0 -0.5 25 2.3 31 0.9 2.3 3.8 t 0.9 1.1 4.2 t 1.4 1.1 3.8 t 1.7 1.5 United Kingdom 0.7 0.1 IS •12 -0.8 10 2.5 1.5 2.0 2.0 4.6 3.0 2.74 2.4 Emerging Europe 4.8 2.7 1 3.4 4.6 y3 1 1.3 1 3.0 3.0 1 3.3 3.1 6.4 5.0 5.5 6.1 Bulgaria 1.7 1.5 2.5 Czech Republic 1.7 -0.2 0.9 -0.5 0.8 -1.0 1.0 2.2 1.1 -1.7 2.4 2.7 2.9 2.5 Hungary 1.7 0.01 111 12 1.51 .0.5 1 0.01 0.81 1.24 1.51 4.1 5.8 5.9 3.8 Poland 4.3 3.2 3.0 4.5 2.5 1 2.0 2.5 3.0 3.0 3.0 4.6 3.9 3.5 2.8 Romania 2.5 0.8 2.7 -0.8 11,2 -1.5 0.8 2.4 2.5 3.0 3.4 3.3 4.4 4.0 Russia 4.3 3.7 3.7 6.4 1.5 2.0 4.0 3.5 4.0 4.0 6.8 3.9 6.1 6.8 Twkey 8.5 2.5 4.5 9.2 9.0 6.8 8.8 Global 2.6 2.2 2.6 1.5 2.4 2.1 1 2.61 2.5 2.4 2.6 3.6 2.7 2.7 2.7 Dembped markets 1.3 1.2 15 0.6 1.2 1.0 1.5 1.3 1.3 15 2.8 2.0 1.8 1.6 Emerging markets 5.8 4.91 5.5 1 4.0 51 4.8 1 5.7 5.7 1 5.7 5.5 5.7 4.7 5.0 5.51 Scrim: J,P My, May11,2012 6 EFTA01176775 Global Asset Allocation The J.P. 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