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Eye on the Market Outlook 2017 J.P. MORGAN PRIVATE BANK True Believers. Two groups of true believers are driving changes in the developed world. The first: single-minded central bankers who spent trillions of dollars pushing government bond yields close to zero (and below). While this unprecedented monetary experiment helped owners of stocks and real estate, its regressive nature did little to satisfy the second group: voters who are disenfranchised by globalization and automation, and who are on the march. What next? The fiscal experiments now begin (again). Prepare for another single digit portfolio return year in 2017. MARY CALLAHAN ERDOES Chief Executive Officer J.P. Morgan Asset Management Expect the unexpected—that was the world’s lesson from 2016. From the U.K.’s decision to leaveHow the European Union to the U.S. presidential surprising results, citizens of the do you summarize a year that was in election’s many respects indefinable? On one world voiced desire for change. debt As investors, such major shifts require our reassessment hand, thetheir European sovereign crisis, contracting housing markets and high unemployment weighed heavy alltoofinflation, our minds. But at the and samealltime, record of almost every assumption, from tax on rates to global trade, the subsequent corporate profits and strong emerging markets growth left reason for optimism. spillover effects. Thinking through portfolios and any associated balance sheet borrowings are moreSoimportant nowlook thanback, in many rather than we’dyears like past. to look ahead. Because if there’s one thing that we’ve learned from the past few years, it’s that while we can’t predict the future, we end, can certainly help you prepare To that I’m pleased to share with youfor ourit.ever thought-provoking 2017 Outlook. As depicted on the cover, Michael Cembalest and his team analyze the duality of pitchfork To help guide you in the coming year, our Chief Investment Officer Michael problems: the rise anti-establishment parties around the world andour theinvestment continued central Cembalest hasofspent the past several months working with bankleadership attempts toacross shovelAsset money at the problems of anemic cause the need for Management worldwide togrowth. build a Both comprehensive view of the macroeconomic landscape. In doing so, we’ve uncovered potentially a comprehensive portfolio review to ensure your assets are headed in thesome right direction. exciting investment opportunities, as well as some areas where we see reason to proceed with caution. We thank you for your continued trust and confidence in all of us at JPMorgan Chase. Sharing these perspectives and opportunities is part of our deep commitment to and what we focus on each and every day. We are grateful for your continued Mostyou sincerely, trust and confidence, and look forward to working with you in 2011. Most sincerely, EYE • OUTLOOK O U T L O O2017 E Y E ON O N THE T H E MARKET M A R K E T• MICHAEL M I C H A E LCEMBALEST C E M B A LE ST K 2017 2017 JJANUARY A N U A R Y 11,, 2 017 Executive Summary: True Believers INTRODUCTION Political upheavals and unorthodox central bank actions persist, but it looks like more of the same in 2017: single digit returns on diversified investment portfolios as the global economic expansion bumps along for another year. How we got here. By the end of 2014, central bank stimulus lost its levitating impact on markets, GDP and corporate profits, all of which have been growing below trend. Proxies for diversified investment portfolios1 generated returns of just 1%-3% in 2015 and 6%-7% in 2016. A slow growth world The fading impact of central bank government bond purchases on global equity returns Y/Y % change (both axes) 220 MSCI Developed World Equity Index level 44% 42% 200 8% 180 7% 40% 160 38% 140 36% 120 % of developed world gov't bond market owned by all central banks 34% 32% 30% 2008 2009 2010 2011 2012 2013 2014 2015 100 2016 9% Global corporate profits 6% 5% 3% 60 2% 40% 20% 0% 4% 80 Source: National stats offices, Haver, MSCI, Bloomberg, JPMAM. Dec. 2016. 60% Global nominal GDP Hundreds 46% -20% '98 '00 '02 '04 '06 '08 '10 '12 '14 '16 -40% Source: J.P. Morgan Securities LLC. Q3 2016. The biggest experiment in central bank history ($11 trillion and counting as of November 2016) helped employment recover in the US and UK, and more recently in Europe and Japan. Across all regions, however, too many of the benefits from this experiment accrued to holders of financial assets rather than to the average citizen. As a result, the political center of a slow-growth world has begun to erode, culminating with the election of a non-establishment US President with no prior political experience, and the UK electorate’s decision to leave the European Union. The market response to Trump’s election has been positive as investors factor in the benefits of tax cuts, deregulation and fiscal stimulus and ignore for now potential consequences for the dollar, deficits, interest rates, trade and inflation (see US section on the “American Enterprise Institute Presidency”). Employment growth in the developed world Erosion of the political center Index (Q1 2006 = 100) 110 United Kingdom 108 106 104 Vote share, average of developed world countries 38% 36% 34% Eurozone 102 30% 100 Japan 98 96 94 2006 Center left 32% 2010 2012 Center right 26% United States 2008 28% 2014 Source: National statistics offices, Haver Analytics. Q3 2016. 2016 24% '71 '74 '77 '80 '83 '86 '89 '92 '95 '98 '01 '04 '07 '10 '13 '16 Source: Barclays Research. October 2016. 1 Weights and indices used for diversified portfolio proxies: 60% equities (using the MSCI All-Country World Equity Index, including emerging markets), and 40% fixed income (using the Barclays US Aggregate for US$ investors, and the Barclays Global Aggregate hedged into Euros for Euro investors). Investment products: Not FDIC insured • No bank guarantee • May lose value 1 1 JJANUARY A N U A R Y 11,, 22017 017 “True Believer” central banks have created unprecedented distortions in government bond markets. Bond purchases and negative policy rates by the ECB and Bank of Japan led to negative government bond yields. Whatever their benefits may be, they also resulted in profit weakness and stock price underperformance of European and Japanese banks. The poor performance of European and Japanese financials was a driver of lower relative equity returns in both regions in 2015/20162. Government bonds trading below 0% yield Bank earnings in the developed world 60% 2.0% 50% 1.5% % of total government bonds by market value Trailing 12-month earnings as a % of risk-weighted assets Portugal Italy Spain Denmark Belgium France Ireland Austria Finland 10% Sweden 20% Netherlands 30% 0% Source: J.P. Morgan Securities LLC, JPMAM. December 15, 2016. US 1.0% Japan 0.5% 0.0% Japan 40% Eurozone countries Non-Eurozone Europe Germany INTRODUCTION • OUTLOOK O U T L O O2017 EEYE Y E ON O N THE T H E MARKET M A R K E T •MICHAEL M I C H A E LCEMBALEST C E M B A LE ST K 2017 -0.5% Eurozone '05 '06 '07 '08 '09 '10 '11 '12 '13 '14 '15 '16 Source: Bloomberg, JPMAM. Q3 2016. For the last few years, I have written about a preference for an equity portfolio that’s overweight the US and Emerging Markets, and underweight Europe and Japan3. This has been one of the most consistently beneficial investment strategies I’ve seen since joining J.P. Morgan in 1987 (see chart below, right). It worked again in 2016, and despite the negative consequences of rising interest rates and a rising dollar for US and EM assets, I think it makes sense to maintain this regional barbell for another year as Europe and Japan once again snatch defeat from the jaws of victory. Eurozone and Japanese banks have underperformed Cumulative total return, US$ 20% 10% MSCI World 10% 8% 6% 0% 4% -10% -20% Benefits of overweighting US/EM, underweighting Europe/Japan, 3-year rolling out (under) performance 2% 0% MSCI Japan banks -30% -40% Jan-14 -2% MSCI Eurozone banks Jul-14 Jan-15 Jul-15 Source: Bloomberg, MSCI. December 28, 2016. Jan-16 Jul-16 -4% 1991 1994 1997 2000 2003 2006 2009 2012 2015 Source: Bloomberg, J.P. Morgan Asset Management. Dec. 15, 2016. Portfolio is quarterly rebalanced and assumes no currency hedging. 2 Eurozone and Japanese bank stocks rallied sharply in Q3 2016, mostly a reflection of steepening yield curves which portend improved bank profitability. As the ECB gradually slows bond purchases in 2017, Eurozone bank stocks could rise further. However, the rest of the Eurozone markets might suffer with less stimulative conditions. 3 Computations are based on an all-equity portfolio that is overweight the US by 10%, underweight Europe by 10%, overweight EM by 5% and underweight Japan by 5%. All overweights and underweights are expressed relative to prevailing MSCI index weights. 2 2 EYE • OUTLOOK O U T L O O2017 E Y E ON O N THE T H E MARKET M A R K E T• MICHAEL M I C H A E LCEMBALEST C E M B A LE ST K 2017 JJANUARY A N U A R Y 1, 1 , 2017 2017 While global consumer spending has held up, global business fixed investment remains weak, in part a consequence of the end of the commodity super-cycle and slower Chinese growth We expect the emerging market recovery to be gradual, particularly if Trump policies lead to substantially higher interest rates and a higher US dollar We expect a near-term US growth boost (amount to be determined based on the composition of tax cuts, infrastructure spending and deregulation), but trend growth still looks to be just 1.0% in Japan and 2.0% in Europe Components of global real GDP Stable, slow global growth Y/Y real GDP growth 1.6% 10% Consumer spending 1.2% 6% 1.0% 4% 0.8% 2% Fixed investment 0% 0.4% -2% 0.2% 2012 2013 2014 2015 Developed markets -4% 1997 2016 2000 2003 2006 2009 2012 2015 Source: J.P. Morgan Securities LLC. Q3 2016. Dotted lines show GDP growth estimates through Q4 2017. Source: J.P. Morgan Securities LLC. Q3 2016. The global productivity conundrum continues, leaving many unanswered questions in its wake Even though private sector debt service levels are low, high absolute amounts of debt may constrain the strength of any business or consumer-led recovery The global productivity slowdown Developed world private sector debt Productivity proxy (change in output per unit of employment) Debt to GDP 5% 4% 3% 2% 1% DM 0% -2% -3% -4% EM '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12 '13 '14 '15 '16 Source: J.P. Morgan Securities LLC. Q3 2016. EM excludes India and China. Debt service to income 180% 18.0% Debt service ratio 170% 17.5% 17.0% 160% 16.5% 150% -1% 4 Hundreds 0.6% 0.0% Emerging markets 8% Hundreds Hundreds Percentage point contribution to Y/Y real GDP growth 1.4% INTRODUCTION We had a single digit portfolio return view for 2015 and 2016 (which is how things turned out), and we’re extending that view to 2017 as well. There are some positive leading indicators which I will get to in a minute, but first, the headwinds: 16.0% Debt to GDP 140% 130% 1991 15.5% 1995 1999 2003 2007 2011 2015 15.0% Source: J.P. Morgan Securities LLC, BIS, IMF. Q2 2016. 4 Is productivity mis-measured since economists can’t measure benefits of new technology? This is a complicated question, but the short answer is “I don’t think so”. I read two papers on the subject in 2016, one from the Fed/IMF and the second from the University of Chicago. In the first paper, the authors state that “we find little evidence that the [productivity] slowdown arises from growing mismeasurement of the gains from innovation in IT-related goods and services”. And in the second, the authors conclude as follows: “evidence suggests that the case for the mismeasurement hypothesis faces real hurdles when confronted with the data”. One smoking gun: the productivity slowdown is similar across countries regardless of the level of their ICT penetration (information and communication technology). 3 3 EYE • OUTLOOK O U T L O O2017 E Y E ON O N THE T H E MARKET M A R K E T• MICHAEL M I C H A E LCEMBALEST C E M B A LE ST K 2017 INTRODUCTION JJANUARY A N U A R Y 1, 1 , 2017 2017 And finally, even before Trump takes office, we’re already seeing a rise in protectionism as global trade stagnates. The degree to which Trump follows through on campaign proposals on trade is a major question mark for 2017 Global trade stagnant for the last decade Global rise in trade protectionism % of world GDP # of discriminatory trade measures 800 60% 55% 700 50% 600 45% 500 40% 400 35% 30% 300 25% 20% 200 2009 2010 2011 2012 2013 2014 Source: Center for Economic and Policy Research. July 2016. 2015 '60 '65 '70 '75 '80 '85 '90 '95 '00 '05 '10 '15 Source: World Bank. 2015. So, with all of that, why do we see 2017 as another year of modest portfolio gains despite the length of the current global expansion, one of the longest in history? As 2016 came to a close, global business surveys improved to levels consistent with 3% global GDP growth, suggesting that corporate profits will start growing at around 10% again after a weak 2016. More positive news: a rise in industrial metals prices, which is helpful in spotting turns in the business cycle (see Special Topic #8). Global business surveys (PMI) point to higher growth Output PMI, 50+ = expansion Q/Q % change, annualized 56 4.0% 55 PMI survey 54 3.5% 53 3.0% 52 2.5% GDP growth 51 2012 2013 2014 2015 2016 Source: J.P. Morgan Securities LLC, Haver Analytics. November 2016. 4 Index level 500 450 400 350 300 250 200 2.0% 50 49 2011 Industrial metals prices are stabilizing 1.5% 150 100 2000 2002 2004 2006 2008 2010 2012 2014 2016 Source: Bloomberg. December 15, 2016. Index tracks aluminum, copper, zinc, nickel and lead. 4 EYE • OUTLOOK 2017 OUTLOOK 2017 E Y E ON O N THE T H E MARKET M A R K E T• MICHAEL M I C H A E LCEMBALEST C E M B A L E ST JJANUARY A N U A R Y 1, 1 , 2017 2017 US, Europe and Japan equity valuations Fiscal policy projected to ease Combined price-to-sales ratio on MSCI US, Europe and Japan equities, ex-financials and energy Government impact on growth 0.50% 2010-16 average Forward estimate 1.6x 0.25% 1.4x 0.00% 1.2x -0.25% 1.0x -0.50% 0.8x -0.75% Japan Eurozone US UK Canada Australia Source: Bridgewater Associates. August 2016. 0.6x China So, to sum up, here’s what we think 2017 looks like: • INTRODUCTION Furthermore (and I understand that there’s plenty of disagreement on the benefits of this), many developed countries are transitioning from “monetary stimulus only” to expansionary fiscal policy as well. Political establishments are aware of mortal threats to their existence, and are looking to fiscal stimulus (or at least, less austerity) as a means of getting people back to work. The problem: given low productivity growth and low growth in labor supply, many countries are closer to full capacity than you might think. If so, too much fiscal stimulus could result in wage inflation and higher interest rates faster than you might think as well. That is certainly one of the bigger risks for the US. A modest growth bounce in the US from some personal and corporate tax cuts, deregulation and infrastructure spending, with tighter labor markets, rising interest rates and a stronger dollar eventually taking some wind out of the US economy’s sails. If I’m underestimating something, it might be the potential increase in confidence, spending and business activity resulting from a slowdown in the pace of government regulation (see chart, right, and page 13) Forward 12 months '04 '05 '06 '07 '08 '09 Trailing 12 months '10 '11 '12 '13 '14 '15 '16 '17 Source: IBES, Datastream, Bloomberg, JPMAM. December 15, 2016. "Ease of starting a new business": in the US, getting less easy, US percentile rank relative to world and OECD 100 90 Easier US vs. World 80 70 US vs. OECD 60 50 40 Harder '05 '06 '07 '08 '09 '10 '11 '12 '13 '14 '15 '16 '17 Source: World Bank Doing Business, JPMAM. October 2016. N = 189. • A little better in Europe and Japan in 2017, but no major breakout from recent growth trends • China grows close to stated goals, supported by multiple government bazookas firing at once • Emerging markets ex-China continue recovering after balance of payments adjustments; while countries with high exposure to dollar financing will struggle, overall risks around a rising dollar have fallen markedly since 2011 • The world grows a little faster in 2017 than in 2016, but as shown above, a lot of that is already in the price of developed market equities. So, another single digit portfolio year ahead Michael Cembalest J.P. Morgan Asset Management 5 5 EYE ON THE MARKET MICHAEL CEMBALEST OUTLOOK 2017 EYE ON THE MARKET • MICHAEL CEMBALEST • OUTLOOK 2017 2017 Eye on the Market Outlook: Table of Contents JANUARY 1, 2017 JANUARY 1, 2017 Chapter links Executive Summary: True Believers Page 1 United States: what will Trumpism look like in practice? A modest growth boost from corporate tax cuts and deregulation, as Trump is only able to deliver on parts of his proposed agenda; tighter labor markets, a stronger dollar and higher interest rates cool things off in the latter half of the year Page 7 Europe: modest recovery, underperforming corporate sector and a heavy political calendar Ignore the politics for now, it’s the growth dynamics that constrain upside for investors; Europe should muddle along at 2% growth for another year, but is fundamentally changed compared to its pre-crisis self Page 14 Japan: delusions of inflationary grandeur Much ado about nothing: Abenomics is not delivering the goods. Japanese equities remain a one-trick pony linked to the fortunes of the Yen Page 20 China: stabilization, courtesy of coordinated stimulus After a blizzard of stimulus from multiple sources in 2015, China stabilized last year after consecutive years of weakening data. Markets are getting closer to pricing in the realities and constraints China now faces Page 21 Emerging markets ex-China: recovering from balance of payment adjustments Concerns about a rising dollar and protectionism are justified, but the sensitivity to a rising dollar has declined sharply since 2010 through restructuring and capital spending adjustments; buy on weakness in 2017 Page 24 Special topics Page 26 Leverage What amount of leverage can survive a world of volatile markets? Now that the window for low-cost borrowing may be closing, we look at history and the future Active management The end of “peak central bank intervention” may reduce distortions and help active managers LNG Rising US natural gas prices due to large-scale US LNG exports? Unlikely on both counts. What Dep’t of Energy LNG export approvals mean, and what they don’t Tax efficient investing How to simultaneously employ tax loss harvesting and generate market returns Infrastructure The role for public-private partnerships: PPPs have their critics, but the Obama administration is not among them. When should investors participate? Clean coal/CCS The biggest problem with “clean coal”: scope. Infrastructure required to make carbon capture and storage a meaningful contributor is vastly underestimated Internet-based business models How helpful have user growth metrics been in assessing new internet-based business models? Not very Commodity prices Markets are looking past inventory gluts given huge declines in capex; remembering the commodity surge of the 1970s and Richard Nixon Sources and acronyms Page 40 Investment products: Not FDIC insured • No bank guarantee • May lose value Brief videos of Michael discussing each of these special topics are available on the True Believers webpage. 6 1 • OUTLOOK O U T L O O2017 EEYE Y E ON O N THE T H E MARKET M A R K E T •MICHAEL M I C H A E LCEMBALEST C E M B A LE ST K 2017 JJANUARY A N U A R Y 11,, 22017 017 IMPORTANT INFORMATION Purpose of This Material: This material is for information purposes only. The views, opinions, estimates and strategies expressed herein constitutes Michael Cembalest’s judgment based on current market conditions and are subject to change without notice, and may differ from those expressed by other areas of J.P. Morgan. This information in no way constitutes J.P. Morgan Research and should not be treated as such. 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