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Contents
1
Economics
Asset Classes
Growth
Multi-Asset
Employment
Equity
Trade
Fixed Income
Debt
Currencies
Money supply / Deflation
Commodities
Economics
2
ECB intervention is helping to keep yields down but is
not a long-term solution
Ever present anxiety

Bailouts only postpone inevitable reckoning; explains
why Greece yields remain so high

ECB hoped to offload Irish bank risk by forcing
bailout; instead they’ve been obliged to increase
market support

Spanish risk seems to have moderated, at least for
the moment

Recent auctions went off well, but doesn’t really
change outlook
Government 10-year bond spreads over German bunds
1,000
Greek bailout /
EFSF →
bps
800
Greece
←Irish
bailout
Ireland
600
Portugal
Spain
Stress
←tests
400
200
0
Dec 08
Dec 09
Dec 10
Note: Ten year bonds. Latest data 21 January 2011. Source: Bloomberg, J.P. Morgan.
3
What’s unusual is not the spreads now but the spreads of
five years ago
Just like old times

Governments like Greece and Spain should never
have been lent money at the same rate as Germany

Adjustments in markets now are simply a reappraisal
of country risk

Country budget forecasts likely do not reflect this new
reality

Unless there are eurozone bonds, individual
countries will pay differing interest rates in the future
Government 10-year bond spreads over German bunds
1,000
← Euro launch
bps
800
Spain
Portugal
Greece
600
Ireland
400
200
0
1992
1996
2000
2004
Latest data 21 January 2011. Source: Bloomberg, J.P. Morgan.
4
2008
Bailouts involve more than just cross-border exposure
Big banks

Exposure of eurozone countries to Greece, Ireland,
Portugal and Spain is roughly €1 trillion
40

But the banking sectors are several times larger than
their economies — about three times on average

So a rescue sufficient to restore banking sector
health would be even larger
%
30
Country GDP / Eurozone GDP
Banking Sector Assets /
Eurozone GDP
20
10
0
Greece
Ireland
Portugal
Latest data June 2010. Source: ECB, BIS, J.P. Morgan.
5
Spain
QE and eurozone crisis battling each other to affect
relative value of currencies
Real broad effective exchange rate
120
Stronger
Euro Trade-Weighted Index

On balance, euro not weakening further against its
trading partners because of crisis

Dollar likely to suffer longer term as inflation
expectations rise and money flows to emerging
markets

Euro is currently trading at its long-run average

Devaluation has been 16% in just two years
110
102
100
90
Weaker
80
Dec 70
Dec 80
Dec 90
Dec 00
Dec 10
Note: Relative to average since 1970. Synthetic euro prior to 1999. Latest data 20 January 2011.
Source: J.P. Morgan.
6
–
Previous major decline of 29% took place over five
years from Dec-79 to Mar-85
–
Still time for improved competitiveness to feed
through to eurozone exports
Fourth quarter GDP shows wide divergence in eurozone
growth
German growth rates well ahead of the rest

German economy benefitting disproportionately from
rebound in global trade and China stimulus

Longer term outlook weaker; bulk of exports go to
eurozone but growth there is low
Fourth quarter 2010 GDP estimates, QoQ %, SAAR
Germany
4.3
France
Italy
Forecast for 2011 GDP is +1.4% for eurozone exGermany, +2.6% for Germany
1.4
€ ex-Germany

Divergence of economic performance adds to stress
on euro

If dollar weakens because of QE, euro and EM
currencies will appreciate more because of yuan peg
1.1
Portgual
0.8
Ireland
0.6
Spain
0.3
0
1
2
Latest data 21 January 2011. Source: Bloomberg, J.P. Morgan.
7
–
1.6
3
4
5
Changes in global growth forecasts are not evenly
spread
Change in 2011 GDP Growth Forecasts —
Last 3 Months
2011e
GDP
Developed Asia
1.9%
EM ex-China
5.0%
Europe ex-Germany
1.4%
China
9.0%
Germany
2.6%
United States
3.1%
-0.1%
0.2%
Latest data 17 January 2011. Source: Bloomberg, J.P. Morgan.
8
0.5%
0.8%

US perspective improving thanks to QE and tax
package, but forecast still down from earlier this year

Emerging market growth to suffer from tightening to
ward off inflation plus strengthening currencies

China’s annualised growth rate in 4q estimated to be
13%
–
Risk of overheating is rising
Exports has been very disappointing; preliminary data
suggested positive contribution
Contribution to 3q10 UK GDP Growth

Most important component of GDP growth is fixed
capital formation as it lays groundwork for the future
4%

Inventory rebuild not likely to last

Hopefully net export growth will be able to offset
coming fall in government consumption

Forecast for growth in fourth quarter is similarly 2.9%
3%
2%
Gov't
Consumption
Household
Consumption
Net
Exports
Change In
Inventories
TOTAL 2.9%
1%
Fixed Capital
Formation
0%
*Transportation, Storage, and Communications. Latest data Sept. 2010, SAAR. Source: UK
Office for National Statistics, J.P. Morgan.
9
Increase in business fixed investment is good sign for
the economy
Contribution to Gross Fixed Capital Formation
Fixed
Capital
Formation
16%
12%
8%
Business
(58%)
Government
(22%)
4%
+
+
Dwellings
(20%)
=
0%
Note: Value in parenthesis is weight of sector in over index. Latest data September 2010, SAAR.
Source: UK Office for National Statistics, J.P. Morgan.
10

This is the third consecutive quarter of positive
business investment

Government still spending though this should slow
down soon

Fortunately not the most important component of
overall capital spending
Sterling is still very competitive despite fall in value of
both dollar and euro
Real broad effective exchange rate
130
Stronger
Sterling Trade-Weighted Index

Sterling’s decline has yet to substantially benefit UK
exports

Since global growth is weak outside China, and UK
doesn’t export want China wants (unlike Germany)

Currency is back to level last seen in 1979; exports
should pick up eventually

UK’s independent monetary policy is significant
advantage relative to Europe
120
110
100
94
90
80
Weaker
70
Dec 70
Dec 80
Dec 90
Dec 00
Dec 10
Note: Relative to average since 1970. Latest data 20 January 2011. Source: J.P. Morgan.
11
US GDP for third quarter was weak, but largely due to fall
in net exports; fourth quarter forecast 3.2%

Growth excluding change in Net Exports and
Residential Investment was 5%

Consumer demand below average — normally it is
over 2%

Imports increased 17% compared to a 5% gain in
exports
Contribution to 3q10 US GDP Growth
5%
4%
3%
Residential
Investment
Government
Expenditure
Business
Investment
Net
Exports
Inventory
Change
2%
1%
Consumer
Demand / PCE
TOTAL 2.5%
0%
Latest data September 2010, SAAR. Source: BEA, J.P. Morgan. Second revision.
12
–
Suggests room for further dollar declines
Risks for market: Gains seem to be very dependant on ever
rising supply of money; what happens when the party’s over?
Huge Increase In Money Supply Driving Market

Hope is that money supply growth plus low interest
rates stimulate economy. Hasn’t happened yet
1.95

Could lead to asset bubbles, particularly in emerging
markets (both equity and debt)

Stock of money has to come out of the system
eventually

Latest round of QE just stores up problems for the
future
$tr
1,700
Money Supply, M1 (lhs)
Level
S&P 500 (rhs)
1.85
1,450
1.75
1.65
1,200
1.55
950
1.45
1.35
Dec 04
Dec 07
700
Dec 10
Latest data available as at 21 January 2011. Source: US Federal Reserve.
13
Quantitative easing could raise inflation expectations in
the US once growth accelerates
Expected Inflation Rates

5
Global growth may be restrained, but deflationary
scenario unlikely
–
US property bubble nowhere near as big as
Japan’s
–
Inflation excluding housing is 1.4%
%
4
UK
3
US
2
1
Germany

Risk is that inflation (both realized and expected)
gets out of hand

QE distorts price signals from market

UK expectations not rising despite recent report

Germany may be next to see rising expectations
0
-1
Japan
-2
-3
May 07
May 08
May 09
May 10
Note: For Eurozone, UK and US, calculation is for five year inflation rate in five years (5YR5YR). Japan is average of 5-10 year breakevens. Data as at 20 January 2011.
Source: Bloomberg, J.P. Morgan.
14
Japan suffered decades of deflation because it’s housing
bubble was huge
What goes up….

Residential property values* as % of GDP
6
5
4
–
Japan (+17 yrs)
US
UK
Spain
Ireland
3
2
1
0
1977
1987
1997
2007
2017
2027
*Japan: Land Underlying Buildings and Structures; US: Household Real Estate Assets; UK:
Residential Buildings; Spain: Residential Household Wealth; Ireland: Dwellings. Source: OECD,
Japan Land and Water Bureau, Ministry of Land, Infrastructure and Transport, Cabinet Office
(Government of Japan), US Federal Reserve, S&P/Case-Shiller, OFHEO, UK Office for National
Statistics, Bank of Spain, Ireland Central Statistics Office, Permanent TSB/ESRI, J.P. Morgan.
15
From 1955 to 1973, house prices in Japan increased
13 times, versus just 6 times from 1973 to 1990
Land under Japan’s Imperial Palace worth more
than California

First period (1955-73) was largely matched by GDP
growth, but the second wasn’t

By this measure, US looks okay, but Spain is scary
Falling inflation in the US is primarily a function of
declining house prices
Non-house inflation is not low

Most headlines have focused on low core CPI rates,
just 0.6% in December (YoY)

But most of this is explained by a fall in house prices
3

Excluding housing, prices are still rising by
1.4%/year; low but not deflationary
2

House prices in US may be stabilising

In Japan, prices have fallen almost across the board
Year on year change in CPI index
4
%
1.4
Housing
1
All items less
energy & housing
0
-1
Dec 02
-0.1
Dec 04
Dec 06
Latest data December 2010. Source: BLS, J.P. Morgan.
16
Dec 08
Dec 10
Job losses during this recession were unprecedented
and recoveries are taking progressively longer
Indexed US Employment Levels* From Beginning of
Recession

Employment levels fell over 7% during the course of
the recession, substantially worse than in previous
downturns

Distressingly, rebounds are taking ever longer
100
Employment Level
98
–
Prior to 1980, it took less than two years to return
to pre-recession employments levels
1957
–
Every recovery since has been slower
1981
–
Likely due to growing service sector orientation of
economy
Recession
96
1990
2001
94

In 1990 and 2001 recession, jobs grew at a 1.7%
annualized rate from bottom

So far growth for 2008 recession has been 1.3%

Return to baseline (100) will take 4 years at 1.7%
pace; 5 years at 1.3% pace
2008
92
0
12
24
36
48
Months Into Recession
*Note: US Non-Farm Private Payrolls. Latest data December 2010. Source: BEA, J.P. Morgan.
17
Still, current recession is dramatically less severe than
the Great Depression
Indexed US Employment Levels From Beginning of
Recession
100
96%
Employment Level
93
86
Recession
79
1929
72
2008
65
0
2
4
Years Into Recession
Latest data December 2010. Source: NBER, BEA, USDA, J.P. Morgan.
18
6
8

This chart actually overstates impact of decline in
employment

In 1930, 22% of the US population was employed in
agriculture, versus 2% today
Labour markets are suffering because of negative equity
in housing
Mortgages in Negative Equity and Delinquency
Rates
12
%
25
Seriously Delinquent
Loans (lhs)

Negative equity of $2.4 trillion equals almost 20% of
mortgage debt outstanding

Foreclosures initially surged but only account for 5%
of existing loans and have now slowed

People can’t move because they can’t sell their
home, so unemployment is higher than normal

If the debt is not written off (or assumed by
government), will take years to work through

Reminiscent of Japan’s zombie companies
%
20
9
Homeowners in
Negative Equity (rhs)
15
6
10
3
0
Jun 98
5
Jun 02
Jun 06
0
Jun 10
Source: Negative equity data from Mark Zandi and Robert Shiller, Mortgage Bankers
Association, J.P. Morgan. Latest data available as at 14 January 2010.
19
Asset Classes
20
Index performance may be getting ahead of earnings growth
Earnings Growth — S&P 500
30

1,400
96
QoQ
%
1,200
15
Earnings growth is lagging
–
Fourth quarter earnings typically grow by 3% QoQ
–
Expectations for this quarter are below this when
should be above
–
Year-ago comparison appears high — up 33% —
because of base effect
1.2%
1,000
0
Earnings Growth (lhs)
-15
800

QE II is very beneficial for risk assets, particularly
equities

The risk is that it inflates assets without benefitting
equally the underlying economy

Markets may weaken once money stops flowing
Expected (4q10)
S&P Index Level (rhs)
-30
Jun 08
600
-66
Jun 09
Latest data 21 January 2011. Source: IBES, J.P. Morgan.
21
Jun 10
Given low earnings growth expectations, surprises may
have a large impact this quarter
Earnings Surprises — S&P 500

Tech has generally done well, though outlook cloudy
for Apple

Financials have been mixed

Trend so far well below previous quarters
Cumulative for quarter
24
1,350
$b
12
1,150
0
Surprise Amount (lhs)
-12
-24
950
Surprise QTD (lhs)
S&P 500
(1q ahead, rhs)
-74
750
2q08 4q08 2q09 4q09 2q10 4q10
Note: For 4q10, 52 companies have reported accounting for 17% of index market capitalization.
Latest data 21 January 2011. Source: IBES, J.P. Morgan.
22
It’s still early days, but initial company guidance is
starting out weaker than last quarter
Positive Changes to Earnings Guidance

Trend over the last year has been for guidance in
each quarter to be higher than the previous

Earnings season has only just begun, but so far
companies are not raising their projections for future
earnings growth substantially

Suggests earnings revisions may suffer
As percent of total changes
65
% Up
3q10
55
4q10
2q10
45
4q09
35
25
1
1
2
3
Week in Earnings Season
Latest data as at 21 January 2011. Source: Bloomberg, J.P. Morgan.
23
4
Net income growth has slowed as margins have fallen
and sales growth lags
Sales, Net Income and Margin Trends — S&P 500
175
Net Income (lhs)
Index
Sales (lhs)

Earnings growth since the market bottom in 1q09 has
been impressive, but it came from cost cutting and
margin expansion

This process has a natural limit. Companies can’t cut
forever and need revenue growth to power future
earnings

Sales growth in 4q10 is forecasted to be just 7.3%
higher than the year-ago quarter; in 3q10 growth was
9.%

Difficult with modest GDP expansion to increase
revenues
10
%
Margin (rhs)
150
8
125
6
100
75
1q06 4q06 3q07 2q08 1q09 4q09 3q10
4
Note: Excludes financial stocks. Sales and net income indexed to Q1 2006. Latest data 21
January 2011. Source: Worldscope, J.P. Morgan. Latest quarter forecast assumes
commensurate change in sales and earnings for 15% of companies that have not yet reported for
quarter.
24
Valuations are attractive for developed markets remain
attractive despite rally; revisions improving
-80%
Relative Valuation
Cheaper Valuation
-60%
-40%
-20%
Developed
Asia
Europe
Emerging
Asia
Developed
Markets
Emerging
Markets
North
America
0%
Latin America
20%
40%
60%
100.0
100.5
101.0
Earnings Revision Index
Stronger Earnings Growth
Latest data available as at 21 January 2011. Source: IBES, J.P. Morgan.
25
EMEA
101.5
102.0
Mexico joining Brazil in expensive territory but with poorer
earnings outlook
-60%
Finland
Japan
Taiwan
-40%
Relative Valuation
Cheaper Valuation
Spain
-20%
Portugal
0%
Germany
Austria
France
UK
China
US
Norway
Belgium
India
20%
Turkey
Mexico
Hong Kong
Brazil
40%
99.0
99.5
100.0
100.5
101.0
Earnings Revision Index
Stronger Earnings Growth
Latest data available as at 21 January 2011. Source: IBES, J.P. Morgan.
26
101.5
102.0
102.5
Commodity plays seeing largest positive moves
-50%
Financials
Relative Valuation
Cheaper Valuation
-40%
-30%
Health
Telecom Care
Services
Consumer
Discretionary
-20% Consumer
Staples
Value
Tech
Growth
Energy
Industrials
Materials
-10%
Utilities
0%
99.5
100.0
100.5
101.0
101.5
Earnings Revision Index
Stronger Earnings Growth
Latest data available as at 21 January 2011. Source: IBES, J.P. Morgan.
27
102.0
102.5
103.0
How risky is inflation for emerging market equity
performance?
Emerging Market Index and Inflation Rates
400
Emerging Markets Index (log, lhs)
Inflation Rate (rhs)
10

The correlation between inflation rates and emerging
market index performance is not strong

Equities generally benefit from (moderately) rising
prices

Risk is rather from inappropriate monetary policy
response
%
8
200
–
Either central bank tightens too much and economy
slows dramatically
–
Or it does not tighten enough (perhaps to avoid
currency appreciation) and economy overheats
6
100
4

50
Dec 95
Dec 00
Dec 05
2
Dec 10
Note: Index in USD terms. Inflation rate weighted by MSCI market capitalization. Last data 21
January 2001. Source: FactSet, J.P. Morgan.
28
High commodity weightings offer extra protection
Watch both inflation and policy rates to see where
balance lies
Emerging Market Inflation and Policy Rates
Country
China
Brazil
Korea
Taiwan
India
South Africa
Russia
Mexico
Indonesia
Thailand
Chile
1 Year Best Lending Rate - China
Selic Overnight Target - Brazil
Base Rate - South Korea
Discount Rate - Taiw an
Repo Rate - India
Repo Rate - South Africa
29
Weight in
MSCI EM
18%
16
14
12
8
8
7
5
2
2
2
1 Week Deposit Rate - Russia
O/N Govt Rate - Mexico
BI Rate - Indonesia
1 Day Repo Rate - Thailand
Discount Rate - Chile
Inflation Rate
Change
vs 6
Now Mo. Ago
4.6%
1.6%
5.6
0.8
3.5
0.9
1.3
0.1
8.3
-5.4
3.6
-0.6
8.8
3.1
4.4
0.7
7.0
2.0
2.8
-0.5
3.0
1.8
Policy Rate
Change
vs 6
Now Mo. Ago
5.8%
0.5%
11.3
1.0
2.8
0.8
1.6
0.2
6.3
1.0
5.5
-1.0
3.0
0.3
4.5
-0.1
6.5
0.0
2.3
1.1
3.3
2.3
Latest data 21 January 2011. Source: Bloomberg, FactSet, J.P. Morgan.
China inflation not as bad as headline figures suggest but too
strong GDP growth is a worry
Excluding food, China inflation under control

Food prices have a disproportionate weight in
Chinese CPI calculations

Excluding food, inflation appears contained

Negative reaction of market to prospect of
government tightening shows how dependent market
sentiment and growth is on China
Chinese inflation indices, annual change, %
10
Headline inflation
%
Inflation excluding food
8
6
4
2
0
-2
Dec 06
Dec 07
Dec 08
Dec 09
Latest data December 2010. Source: China Economic Information Network.
30
Dec 10
The case for emerging markets is the same as in the past,
but risks have fallen; inflation is major worry
Emerging Market Index Performance

The opportunity in developed markets has always
been catch up, convergence, aspiration and
urbanisation

It’s only been crises which have spoiled the story

We believe things are different this time

The risks of currency or debt crises like those in the
past have fallen
5
%
4
3
2
1
Mexico, Russia
Argentina (1995) (1998)Argentina
(2001)
Emerging
Markets
Index
(log, no scale)
Asia
(1997)
0
-1
-2
Latin
America
(1980-83)
-3
Dec 75
Cumulative 12-Month Fund
Flow as % of Assets
Dec 85
Dec 95
Dec 05
Latest flow data November 2010. Index as at 17 December 2010, USD terms.
Source: S&P/IFC, J.P. Morgan.
31
–
No fixed exchange rates
–
Low foreign currency debt
–
Smaller current account deficits
Low yields in US have not yet lead to a major outflow of
funds
US investment in foreign securities
60
$ bn
Foreign Security Purchases (lhs)
US 10-yr Treasury Yield (rhs)
%
4.5
30
4.0
15
3.5
0
3.0
-15
2.5
-30
Aug 03
2.0
Aug 05
Aug 07
Aug 09
Latest flow data October 2010. Treasury yields as at 17 December 2010.
Source: US Treasury, J.P. Morgan.
32
One of the concerns about QE (I and II) is that a
search for yield will drive investors abroad, in
particular to emerging markets

Cross-border flow data does not show this happening
5.5
5.0
45

Emerging markets are not as volatile as you might think
Annualised market volatility

Historically emerging markets have been more
volatile than developed markets
20

The performance over the last two years has shown
the opposite

Traditional risks in emerging markets have declined
%/
yr
Developed Markets
Emerging Markets
15
10

5
0
Late 1980s 1990s Early 2005- 200970s
20s
08
10
Note: Monthly frequency in USD terms until 1987, daily frequency in local currency terms
subsequently. Data as at 31 December 2010. Source: IFC, MSCI, J.P. Morgan.
33

–
Fixed exchange rates
–
Foreign currency debt
While developed market risks have increased
–
Quantitative easing
–
Sovereign debt
Investors are getting higher prospective returns for
less risk
Government bonds yields have risen markedly since
August
Government Bond Yields (10-year)
6
%
UK
US

Extreme bond valuations have lessened, but the
asset class still offer poor value

Yields are simply normalizing

High correlation between the three markets, even
though each has different dynamics
Germany
5
4

3
2
Jun 07
Jun 08
Jun 09
Latest data as at 21 January 2011. Source: Bloomberg, J.P. Morgan.
34
Jun 10
–
Germany: Europe liability + growth
–
UK: Inflation + growth
–
US: QE + tax package = inflationary growth
UK likely to be first country to raise interest rates
The great moderation in government bond yields over the
last 30 years is over
Government Bond Yields
15%
Nominal Government
Bond Yield
15%

Developed market central banks have won their war
against inflation over the last 30 years

Fixed income returns from government debt till now
have come from:
Real Yield
10%
10%

5%
0%
Dec 81
5%
Dec 91
Dec 01
0%
Dec 11
Latest data as at December 2010. Source: Federal Reserve Bank of England, Barclays Capital,
J.P. Morgan.
35
–
High nominal (and real yields)
–
Plus price appreciation
Now neither is likely
High yield debt presents the best opportunities
Bond Spreads
1,800
1,500
High Yield: 555 bps

Prospects for company cash generation still strong
even if economy slows

Still, limited room for spread compression
Emerging Markets: 239 bps
–
Current spread is 100 bps below long run average
Investment Grade: 155 bps
–
At average if credit crunch is excluded
1,200

Emerging market debt has gone from high yield to
investment grade in risk; both good and bad

QE is helping to bring down EM spreads

Local currency EM debt offers currency appreciation
to offset rise in interest rates

Duration risk for Investment Grade debt
900
600
300
0
Dec 99
Dec 02
Dec 05
Latest data 21 January 2011. Source: Merrill Lynch, J.P. Morgan.
36
Dec 08
Investors seeking inflation hedge will help support
commodity prices in the short term
As Goes China…
105
S&P GSCI Industrial Metals
MSCI China
100
95
90
85
80
Jan 02
Jan 05
Jan 08
Latest data 20 January 2011. Source: MSCI, Standard & Poors.
37
Jan 11

Chinese equity market still likely to outperform
relative to developed markets

Economy should slow down enough to avoid
overheating

Commodity prices will continue to benefit from China
growth though changes in China sentiment will weigh
as well
J.P. Morgan Asset Management
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Prepared by:
Kerry Craig, Dan Morris and Tom Elliott
38