EFTA Document EFTA01981552

To: Undisclosed recipients:MI From: US GIO Sent Sat 7/12/2014 1:31:37 AM Subject: The J.P. Morgan View : What if we are in a 2% world? JPM The J.P. Morgan View 2014-07-11 1438533.pdf J.P. Morgan Global Asset Allocation The J.P. Morgan View: What if we are in a 2% world? • Asset allocation — We investigate the risk scenario that global growth stays with a 2% handle, instead of the rebound to 3% plus we project. Impact would make us favor income over growth assets and for the moment keep us OW EM. • Economics — Further cuts in Q2 Euro area and Japan bring global growth to 1.9%, after already dismal 1.4% in Ql. • Fixed Income — Despite weaker near-term data, our medium-term growth outlook for the Euro area improves, keeping us long periphery vs. core. • Equities — Divergent macro and flow momentum keep us OW EM. • Credit — The US HG sector that has lagged the broader HG market most is 30yr single A non- Financials. • FX — We still expect the USD index to rise 1% in Q3, plus 1.5% in Q4. • commodities -Oil price to average $115/bbl and S120/bbl in 2015-16. • Click here for video. • Risk assets are down from the peaks reached only last week, and bonds rallied on little news beyond problems with a Portuguese bank. EM outperformed DM in equities and currencies. The move does underline that many investors expect a pullback in risk markets after the almost straight-line rally of the last few months if not years. But most of these same market participants also say they plan to buy on pullbacks. • We are less worried about near-term disturbances and flows and more about the medium-term outlook for economic growth. Over the past three years. the world economy has grown only at a 2.5% pace. below potential and thus not able to make up for what we lost in the recession. Each year. we keep EFTA_R1_00470154 EFTA01981552 forecasting that growth will rise to a 3% handle, but have been steadily disappointed. Until last year, we had at least clear explanations for this, largely from fiscal tightening in Europe and the US and fading productivity growth in EM. This year, though, growth has collapsed even more, to a 1.6% pace in HI, with even fewer explanations aside from the Japanese tax hike. • The forecast remains that growth rebounds to over 3% from this quarter on, but as investors, we need to investigate the risk scenario that we may instead be in a, say, 2% growth world. The trending behavior of forecast revisions, and thus surprises, would suggest there is more down than upside risk on growth assumptions (chart p. 2), even as surveys do not confirm this. This is not to say that we can eliminate upside risk of growth rising to a 4% handle, as the 1990s US experience similarly saw steady up grades in the second half of the cycle, after downgrades in the first (same chart). • With the consensus steadily projecting 3% US and global growth, this view should be in the price and instead a 2% growth pace should thus be a surprise that requires asset repricing. We see two broad drivers of weak growth — weak demand and/or weak supply — and both have similar market implications: they favor income over growth assets. • Weak demand would essentially reflect unfinished post-crisis balance sheet delevering by households, banks and governments. The market impact would be relatively easy to judge as it is very close to, though not as bad as, what happened in Japan post its leverage boom and bust over twenty years ago. Economic growth in Japan fell to less than I% above population growth, deflation set in, bond yields fell, credit spreads went to nothing, and equities saw no capital gains throughout. We have argued here that low growth keeps both volatility and policy rates low and is thus bullish for risk assets. But we also mentioned that growth can become so low as to depress earnings and to create deflation, inducing investors to prefer bonds, as happened in Japan. • If indeed economic agents continue to delever balance sheets, then monetary policy has no further impact on growth, as we learned in Japan. Only fiscal policy, supply side reform, and/or time can redress growth. G4 central banks would indefinitely delay rate hikes; bond yields would fall again; the search for yield would intensify: equities would at best perform on par; Value and income stocks would outperform. • A weak supply side, from low labor supply, a low supply of new capital, and low productivity growth, is an alternative driver of a 2% growth risk scenario. And indeed, we have seen these forces at work already in this cycle. Our economists have lowered their estimates of potential global growth by 0.5% since 2008. Taking out the effect of the growing share of EM, which has higher potential, the drop in global potential is over 1%. So far, this did not prevent global asset price inflation. If we continue to sec lower growth than what we expect and it all seems due to a fall back in potential, then we create neither price deflation nor inflation. It will, though, significantly reduce the return on capital, and with that, equilibrium real interest rates. In the US. it would likely keep fed funds well below 2% for years. • What do we do about these risks? Both weaker demand and supply have in common that they would boost income assets — better yielding fixed income and income stocks again growth assets, primarily cyclical stocks. In our mind, it should boost the currencies and assets issued by countries that pursue better supply side reform. For the moment, this analyst thinks it should still support an OW of EM assets, as they are better yielding and better valued, would escape the threat of fast Fed tightening, and at least this year have relatively better macro momentum. Fixed Income • DM bonds rallied this week, with 10yr yields 6-14bp lower in the US, Euro area and the UK, on weaker than expected macro data and negative headlines surrounding the parent company of a Portuguese bank. On the latter, we think a lot of bad news has been priced on this story, and do not see major negative implications on the Portuguese sovereign. EFTA_R1_00470155 EFTA01981553 • The weaker than expected industrial production data in the Euro area this week led our economists to revise down their expectations for Euro area GDP growth for 2Q14 and 3Q14 by 0.75% and 0.5% respectively to 1.0% and 1.5%. However, while these growth revisions reflect a more moderate near term profile, medium-term we continue to see a broadening of Euro area growth across sectors and countries. Indeed, we revise our growth forecast for next year from 2Q15 to 4Q15 from 2.0% to 2.25% as drags from fiscal tightening, weak credit and a high exchange rate fade (Taking stock of Euro area growth: 2014 down, 2015 up, Greg Fuzcsi ct al, Jul II). • US headline inflation has bottomed out and has been rising over the first half of 2014, driven by rising core prices and a pickup in food and energy inflation. We expect US inflation to moderate over the second half, to around 2.4%, while our economists do not expect core inflation in the Euro area to pick up until 2015 at the earliest. We remain bullish on 10yr US TIPS, and hold 10yr TIPS breakeven wideners, on a view that both inflation expectations and risk premia priced in the TIPS curve should be higher (see Monthly Inflation Outlook, Francis Diamond et al, Jul 10). • Taking together the outlook in the Euro area for weaker near-tenn growth, but stronger and broader medium-term growth. subdued inflation and support from the ECB's upcoming TLTROs, we retain our medium-term view for tighter periphery spreads and stay long 10yr Spanish government bonds vs. German Builds, despite the near-term noise. Equities • EM equities were about flat this week, while DM equities were down 1.5%. Our DM economic growth expectations have been lowered significantly over the past two weeks. We have lowered Q2 US growth from 3% to 2.5%, Q2 Euro area growth from 1.75% to I% on the slump in May IP and PM1s, and in Japan, weaker than expected consumption and capex made us revise down our Q2 GDP -6.5% from - 4.5%. • In EM, economic data have improved, especially relative to DM. EM Asia looks particularly constructive, supporting our OW in Asia within EM. We have revised up our Q2 GDP growth forecast for China from 6.8% to 7.2% given the positive momentum in PMIs. This lilt is expected to build into the rest of EM Asia this quarter (GDW, July 3). Additionally, flows into EM equities remain steady. In the week to July 9. there were net inflows of S1.3bn into EM equity funds, greater than $0.7bn into US equity funds. • Euro area core and peripheral equities fell this week, driven by bank stocks. Sentiment remains negative on banks given recent litigation and the events unfolding in Portugal. These developments support our recent exit from the peripheral equity and bank trades and our refocus on DAX within euro area equities. Credit • Credit spreads are wider this week, with HY underperforming, especially in Europe. HG spreads are about flat on the week. Comparing current spreads for different market segments to the trading range over the past 10 years. our US HG credit strategists identify opportunities within HG credit where spreads have not rallied as much as the broader market. Using this approach, the tenor/rating bucket that has lagged the most is 30yr single A non-Financials. Next cheapest is 30YR BBB non-Financials. 10YR non-Financials have also lagged, but less than 30YR. The short end in non-Financials is very tight, at or very close to I0YR tights (CMOS, Beinstein et al., Jul 7). • As discussed in the commodity section below, our oil strategists have raised their price forecasts. Higher oil prices are likely to be a net negative on EM corporates as a whole due to the relatively low weight of oil companies as well as the high weight of net oil importing countries. The oil & gas sector accounts for 18.4% of the CEMBI Broad, but not all of the issuers in the sector are beneficiaries of higher oil prices. Only about 22% of the CEMBI Broad is made up of issuers in countries that EFTA_R1_00470156 EFTA01981554 are net oil exporters and where the economy would benefit from higher oil prices WPM EM DOM. Hong and Beinstein, Jul 7). Foreign Exchange • Today we published the monthly Key Currency Views detailing our forecast rationale across currencies. There are no significant forecast changes this month. We still expect the USD index (JPMQUSD) to rise 1% in Q3 and another 1.5% in Q4, with significant dispersion across pairs. Those currencies that should fall by year-end include (Q4 target in parenthesis) EUR (1.30), JPY (106), CAD (1.12), AUD (0.91), NZD (0.85), BRL (2.35). RUB (35.46), and IDR (12,100). Those that should rise include MXN (12.80), CNY (6.15), KRW (1000), and INR (57.5). • Aside from the bottoming out of global inflation little has occurred at the systemic level over the past month to affect the baseline view. We have always held tame targets for the dollar index in 2014 given that Fed tightening was more than a year away, thus leaving the dollar in that awkward phase this year between the hope of being a high-yielder at some point and the reality of being a low yielder now. Relative to the historical norm over the past four Fed tightening cycles in 87, 94.99 and 04. the current lead up to end of easy money is proving just as erratic. The precondition for that rate normalisation is consistent US economic growth each quarter and price pressures sufficient to shift Fed expectations. That story is unfolding, but at a tediously slow pace. • On a pairwise basis, dollar strength was and remains projected mainly against GIO currencies where central banks are easing (JPY, EUR, SEK) or likely to lag the Fed (AUD, CAD). For currencies whose central banks lead the Fed now (NZD) or will do so in early 2015 (GBP), forecasts show limited movement to convey a range. (The cable rate declines only because the EUR/USD forecast does; otherwise sterling outperforms most currencies). For the emerging markets, poor balance of payments positions were the core driver for most of our bearish forecasts, such as for ZAR, RUB and TRY. • Importantly over the past two months, inflation appears to have bottomed globally and in the majority of countries. For currencies, inflation as a stand-alone variable isn't inherently good or bad. What matters is the real interest rate environment created by central bank policy as that inflation trend evolves. From this perspective, US real rates look low now since the Fcd seems committed to another year of zero policy rates while inflation is turning up. but should firm later since the front end of the US bond market is so mispriced versus the Fed dots (about 75bp for December 16). We expect this repricing higher in real rates to occur by year end and support the dollar, but are less confident near- term while inflation ticks higher and the Fed talks dovish. Commodities • This week, our commodity strategists raised their oil price forecasts from $105/bbl in Q3 and Q4 to SI 15/bbl and $112/bbl, respectively. Forecasts for the average price in 2015 and 2016 arc S115/bbl and $120/bbl. respectively. Oil price volatility is also expected to return to more normal levels over this period. The move higher in price over the coming two years should be driven by higher global demand as the global economy expands at a faster growth rate as well as weaker supply growth, largely in Iraq and Libya. • Recent reports of a peace agreement in Libya between the rebels and the government caused Brent to fall by around 5%. We think a quick and full recovery in production is unlikely and we also think overall production capacity is now lower due to damage to the oil fields. We also lower our expectation for Iraqi supply because increased operational risks to foreign oil companies mean investment in production will now likely be lower. In 2017, the oil team assumes a global recession arrives, and expects Brent to average between $60/bbl and S70/bbl depending on the severity of the recession (Oil Market Monthly: Sweet 'Sixteen, Sour 'Seventeen, Fenton ct al., Jul 9). EFTA_R1_00470157 EFTA01981555 Click here for the full Note and disclaimers. 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