85129169 Jp Morgan Global Markets Outlook and Strategy

Global Markets Outlook and Strategy

Global Asset AllocationMarch 7, 2012

www.morganmarkets.comThe certifying analyst is indicated by an AC. See page 31 for analyst certificationand important legal and regulatory disclosures.

Contents

Economic Outlook 2

Market Forecasts 6

Global Market Strategy 7

Long-only ETF portfolio 15

FX Strategy 17

Fixed Income Strategy 21

Credit Strategy 24

Equity Strategy 26

Commodity Strategy 29

Jan LoeysAC

(1-212) 834-5874

[email protected]

J.P.Morgan Chase Bank NA

Bruce Kasman(1-212) 834-5515

[email protected]

J.P.Morgan Chase Bank NA

John Normand(44-20) 7325-5222

[email protected]

J.P. Morgan Securities Ltd.

Nikolaos Panigirtzoglou(44-20) 7777-0386

[email protected]


Seamus Mac Gorain(44-20) 7777-2906

[email protected]


Matthew Lehmann(44-20) 7777-1830

[email protected]


Leo Evans(44-20) 7742-2537

[email protected]


• The economyOur 2012 global growth forecast remains at an anaemic 2.2%, but PMIsare suggesting mild upside risk.

• Asset AllocationWe remain long equities, EM and credit against safer assets. Of the sixdrivers of the rally, two are now closer to neutral (positions and riskperceptions), and one has gained (momentum). We analyse the impact ofhigh relative supply of safe assets, cash and gov’t debt, and concludeequities and credit need to rally some 6% over the coming 12 months justto keep pace with rising cash and gov’t debt outstanding. The portfolionow includes hedges against oil and inflation.

• Long-only ETF portfolioWe recommend a higher allocation to equities (48%) than bonds (42%).In equities, focus exposure on ETFs that give exposure to DAX, BRICs,US Preferred stocks and among sectors to Technology/Industrials/Energy.In bonds, focus exposure on US HY corporate bond and US TIPS ETFs.

• Fixed incomeWe hold modest tactical shorts in DM, and select longs in EM local mar-kets, Poland and South Africa. Position for tighter Euro area peripheralspreads, wider inflation breakevens, and a steeper AUD front-end curve.

• CreditWe lower our allocation to outright longs in US HY, US HG and EMBIG,and take more risk on less directional trades on relative price conver-gence and relative carry-to-risk: Long iTraxx XO vs. CDX.HY, an over-weight in EU HY vs. EM $ Sovereigns, and long CDX.HY vs. LCDX.

• EquitiesBoth the macro and the position support have faded. We keep a positivestance overweighting Cyclical sectors, but we hedge via a long in equityvolatility via J.P. Morgan’s Macro Hedge Index and an OW in the Energysector. The search for yield should support higher-yielding stocks.

• CurrenciesThe first signs of currencies delinking from the global risk trade provideopportunities for country-specific exposures. We are therefore long NOKvs. USD, and EUR vs. GBP and NZD.

• CommoditiesSeasonally weaker demand over the coming months should see oil pricesgive back some of their recent gains. We stay long gold on further buyingby central banks and retail in EM.

2

Global Markets Outlook and StrategyMarch 7, 2012

JPMorgan Chase BankDavid Hensley (1-212) [email protected]

Carlton Strong (1-212) [email protected]

Economic Research

Global Economic Outlook Summary

Source: J.P. Morgan

Note: For some emerging economies, 2011-2013 quarterly forecasts are not available and/or seasonally adjusted GDP data are estimated by J.P. Morgan.

Bold denotes changes from last edition of Global Markets Outlook and Strategy, with arrows showing the direction of changes. Underline indicates

beginning of J.P. Morgan forecasts.

2011 2012 2013 3Q11 4Q11 1Q12 2Q12 3Q12 4Q12 1Q13 4Q11 2Q12 4Q12 2Q13

The Americas

United States 1.7 2.3 2.2 1.8 3.0 2.0 2.5 3.0 2.0 1.5 3.3 1.9 1.5 1.4

Canada 2.5 2.3 2.5 4.2 1.8 2.1 2.6 2.3 2.4 2.7 2.7 1.7 1.7 2.0

Latin America 4.3 3.6 4.0 3.1 2.3 2.9 5.5 3.9 3.5 4.4 7.2 6.8 6.8 7.3

Argentina 9.2 4.5 4.0 4.5 6.5 0.0 5.5 6.5 5.0 3.0 9.5 10.0 11.0 11.0

Brazil 2.8 3.1 4.5 -0.2 1.5 2.6 5.7 5.5 5.7 4.5 6.7 5.1 5.1 5.3

Chile 6.3 4.5 4.8 2.6 3.0 5.0 5.0 6.0 6.0 4.5 4.0 3.6 3.4 3.2

Colombia 5.8 4.5 5.0 7.1 3.7 4.2 4.5 3.5 3.0 5.5 3.9 3.6 3.3 3.0

Ecuador 8.0 4.0 4.0 7.1 1.0 2.0 3.5 4.0 4.0 4.0 5.5 5.3 4.7 4.7

Mexico 3.9 3.3 3.5 5.1 1.7 2.5 5.5 0.6 1.0 5.0 3.5 4.2 4.0 3.8

Peru 6.9 5.0 7.0 5.3 2.8 4.0 5.0 6.5 7.6 8.0 4.5 3.3 2.4 3.0

Venezuela 4.2 4.0 1.0 6.7 3.5 6.0 6.0 4.0 -3.0 0.0 28.5 29.1 30.3 36.5

Asia/Pacific

Japan -0.9 1.4 1.3 7.0 -2.3 2.2 1.6 1.2 1.0 1.2 -0.3 -0.2 -0.1 -0.2

Australia 1.9 3.1 3.2 3.9 1.8 2.8 2.9 3.5 3.7 3.3 3.8 3.2 3.3 3.0

New Zealand 1.7 2.5 2.9 3.2 2.9 1.0 4.4 2.4 1.8 1.0 2.9 2.2 2.5 2.7

Asia ex Japan 7.0 6.5 7.2 6.3 5.0 7.3 6.9 7.4 7.7 7.3 5.0 4.1 4.1 4.4

China 9.2 8.4 9.1 8.4 9.2 7.2 7.8 9.5 10.0 9.1 4.6 3.0 3.1 3.9

Hong Kong 5.0 2.8 4.2 0.4 1.6 3.0 4.0 5.5 6.0 3.0 5.7 4.5 3.6 3.2

India 7.0 7.3 8.0 7.5 5.5 7.7 7.2 7.7 8.0 8.3 9.0 8.5 7.8 7.6

Indonesia 6.5 5.2 5.4 5.9 9.9 5.0 4.5 5.0 5.0 5.5 4.1 8.0 9.1 9.2

Korea 3.6 3.3 4.0 3.3 1.4 3.0 4.0 4.5 5.0 4.0 4.0 3.4 3.5 3.5

Malaysia 5.1 3.9 3.2 6.1 4.8 5.0 2.0 2.0 2.5 4.0 3.2 1.5 1.3 1.4

Philippines 3.7 4.3 4.8 3.4 3.5 4.3 4.9 5.7 4.9 4.5 4.7 3.9 4.0 4.0

Singapore 4.9 2.3 3.7 2.0 -2.5 4.9 6.6 2.0 1.2 4.5 5.5 4.3 3.2 3.0

Taiwan 4.0 2.8 5.1 -0.2 -0.6 3.3 4.8 5.8 6.5 4.5 1.4 1.3 1.7 1.2

Thailand 0.1 5.1 3.5 3.4 -36.4 45.0 20.0 2.0 0.5 5.0 4.0 2.8 1.4 1.4

Africa/Middle East

Israel 4.8 2.9 4.4 3.8 3.2 0.8 3.2 6.1 7.4 4.5 2.5 2.3 2.5 2.1

South Africa 3.1 2.7 3.6 1.7 3.2 2.3 2.6 2.8 3.2 3.8 6.1 6.0 6.2 5.9

Europe

Euro area 1.5 -0.4 0.3 0.2 -1.1 0.0 -1.5 -0.3 0.3 0.5 2.9 2.1 1.9 1.6

Germany 3.1 0.7 1.3 2.3 -0.7 1.0 0.0 1.0 1.0 1.5 2.6 2.0 1.9 1.6

France 1.7 0.1 0.3 1.3 0.9 0.0 -1.0 0.0 0.0 0.5 2.6 2.0 1.7 1.4

Italy 0.4 -1.8 -0.7 -0.7 -2.9 -2.0 -2.5 -1.5 -1.0 -0.5 3.7 2.7 3.0 2.7

Norway 2.7 1.4 1.8 3.1 2.5 0.0 0.0 1.0 1.0 2.0 0.9 0.9 1.4 1.7

Sweden 4.0 -0.3 1.7 3.5 -4.4 -0.5 -0.5 0.5 1.0 2.0 2.3 1.1 1.1 1.5

United Kingdom 0.8 0.8 1.9 2.2 -0.8 2.0 -1.0 2.5 1.5 2.0 4.6 2.5 2.0 1.8

Emerging Europe 4.7 2.7 3.5 3.5 4.9 2.2 1.2 2.5 3.7 3.3 6.3 4.9 5.4 5.9

Bulgaria 1.7 1.5 2.5 … … … … … … … … … … …

Czech Republic 1.7 0.5 1.7 -0.3 -1.2 0.0 0.8 2.0 2.0 1.5 2.4 2.7 2.9 2.5

Hungary 1.7 0.5 1.5 1.6 1.2 -0.3 0.3 1.0 1.5 1.5 4.1 5.3 5.4 3.5

Poland 4.3 3.2 3.0 4.1 4.5 2.8 2.0 2.5 3.0 3.0 4.6 3.3 3.3 2.9

Romania 2.5 0.8 2.7 7.4 -0.8 -1.2 -1.5 0.8 2.4 2.5 3.4 3.3 4.4 4.0

Russia 4.3 3.5 3.7 3.5 7.0 3.0 1.5 3.0 4.5 4.0 6.8 4.4 6.3 6.8

Turkey 8.2 2.5 4.5 … … … … … … … 9.0 8.1 6.2 7.9

Global 2.6 2.2 2.6 2.9 1.5 2.4 2.1 2.7 2.5 2.5 3.6 2.6 2.5 2.5

Developed markets 1.3 1.2 1.5 2.2 0.5 1.3 0.8 1.6 1.3 1.3 2.8 1.8 1.5 1.4

Emerging markets 5.8 5.0 5.6 5.0 4.3 5.2 5.5 5.6 5.9 5.8 5.8 4.9 5.0 5.4

Memo:

Global — PPP weighted 3.5 3.2 3.6 3.6 2.5 3.3 3.1 3.7 3.7 3.7 4.1 3.2 3.1 3.1

% over a year ago

Consumer prices

% over previous period, saar

Real GDP

% over a year ago

Real GDP

3


-2

0

2

4

6

43

46

49

52

55

58

61

98 00 02 04 06 08 10 12

GDP=-21.4 + 0.45*PMIR-sq=0.71

All-industry PMI

Real GDP

Economic Research

Economic Outlook

• Still looking for a sub-par 2.2% annualized gain inglobal GDP in 1H12, but risks are shifting.

• Aggressive policy actions have trimmed downside tailrisks, most importantly in Europe.

• Manufacturing bounce is underway and our global PMIis pointing to 1%-point stronger global GDP growth.

• Oil has become the largest near-term downside risk,but a sluggish consumer in the US is also a concern.

Signs of global lift tempered by oil risk

Since the start of the year, our baseline view has been thatthe deceleration in global economic activity into the turn ofthe year would continue in the first half of this year. Thisoutlook has been premised on the belief that the Euro areacrisis would be contained but that sufficient damage hadbeen done to push the region into a mild recession and pullthe UK to a halt; that the US would decelerate to a 2.2% an-nualized pace in 1H11 after an inventory-induced jump in4Q11 returns to more modest final demand growth; and thatChina would continue to struggle with its real estate adjust-ment and post a weak 7.5% annualized gain in the first half.Aside from an upward revision to the lift from reconstructionefforts in Japan, our global outlook has not changed muchfrom the last GMOS. We expect global GDP to expand at a2.2% annualized pace in 1H11, 0.2%-point stronger than inlast month’s GMOS and roughly the same pace set in thesecond half of last year.

These relatively small changes, however, mask bigger move-ments beneath the surface. First, activity in the manufactur-ing sector is lifting sharply after contracting outright 3% an-nualized in the 3 months through November last year, theweakest showing since the global financial crisis. The latestdata from Asia reinforce this view. Coupled with a boomy8.6% gain in the US, global manufacturing output looks setto post a robust 5% annualized gain in the three monthsthrough January. To be sure, growth is being boosted tempo-rarily as the damaging effects of Thai flooding fade. The un-derlying pace is better captured by our global PMI, which istracking closer to a 2% pace of global IP growth. Still, withlast week’s February reading, the manufacturing PMI hasincreased for three consecutive months and as such confirmsan important momentum shift in the global industrial cycle.

The second dynamic underway beneath the forecast is a trim-ming of downside tail risks in response to aggressive policyactions around the world. The ECB has pumped roughly

JPMorgan Chase BankBruce Kasman (1-212) [email protected]

David Hensley (1-212) 834-5516 Joseph Lupton (1-212) [email protected] [email protected]

Source: J.P. Morgan

Chart 1: Global PMI and GDPDI, sa %q/q, saar (1Q12 fcst boxed)

€500bn of net liquidity into the banking sector with its twoLTROs, effectively short circuiting a more disruptivecredit crunch that had been building last quarter. Also, acredible effort is underway to expand the liquidity hospitalto a size that could potentially admit the likes of Spain and/or Italy. While medium- and longer-term challenges re-main, and further writedowns—this time on official sectordebt—are likely for Greece, the region has stepped awayfrom the brink as the crisis moves to a presumably moremanageable chronic stage.

At the same time, the extension of “low for long” through2014 by the Fed along with additional QE from the BoEand a surprising commitment by the BoJ to target a 1% in-flation rate have added to the sense in which G-4 centralbanks remain intent on backstopping the recovery as fiscalauthorities struggle with the timing surrounding their owndeleveraging process. In the EM, easing in China—albeittargeted and nothing like in 2009—is expected to set thestage for a sharp acceleration in activity later this year. Asimilar call is set for Brazil, where we continue expect theselic rate to fall to 9.25%.

Global PMIs pose near-term upside risk

The trimming of downside risks to our global outlook isbeing complemented by our global business surveys, whichare underscoring upside risk to our forecast for global GDPto expand 2.2% annualized this quarter. The January-Feb-ruary average of our all-industry PMI output index (aweighted average of manufacturing and services) is nowtracking 3.4% global GDP growth. To be sure, the standarderror of this relationship is sizable, at 1.4%-point. Still, theupside is broadly based across countries, with the largestdiscrepancies found in the US, UK, Japan, and Brazil. Asmaller, though still positive gap also exists for China. TheEuro area forecast is very close to what is implied by thePMI. In addition to its breadth, the lack of any evidence forpositive serial correlation in the global PMI’s predictionerrors of late gives validity to the risk.

4


Economic ResearchJPMorgan Chase BankBruce Kasman (1-212) [email protected]

David Hensley (1-212) 834-5516 Joseph Lupton (1-212) [email protected] [email protected]

Chart 2: Oil price and retail sales volumes, global%3m/3m change (fcst assumes $123/bbl) %3m/3m, saar

Source: J.P. Morgan

To be sure, recent positive surprises in the January andFebruary PMIs already have had an impact on our 1Q GDPgrowth estimate. In late January, our 1Q global GDP forecaststood at 1.7%. Since that time, we have raised 1Q forecastsin the Euro area, the UK, Japan, and numerous EM Asianeconomies. The PMIs played a role in motivating many ofthese revisions. Put differently, the discrepancy between thePMIs’ prediction and our own GDP forecast would be 1.7%-points, or well over one standard error, had we not alreadybeen making GDP revisions. Notably, one place where theupside risk was quite large—the Euro area—is where thelargest 1Q revision has occurred in recent weeks. One fore-cast that has not been changed in response to positive PMIsurprises is the US. Our US team has access to more timelyand accurate expenditure data compared with any othercountry, and has maintained that 1Q growth will be subpardue to weak growth in consumer spending and a fall-offfrom last quarter’s contribution of inventory building.

Although we tend to view the PMIs and GDP growth con-temporaneously, it is possible that the current, 1Q strength ofthe PMIs is signaling upside risk for 2Q12. In the US, forexample, a host of supply-side indicators—including theISM surveys, IP, and hours worked—point to strong GDPgrowth that seems unlikely to be realized this quarter. Ifthese indicators continue to impress, we may come to believethat they are signaling a much better GDP growth outcomefor 2Q12. Alternatively, the stretch of soft expendituregrowth could induce a downshift in production and employ-ment growth, much as happened in 1H11.

Oil has become a key downside risk

The forecast is not without its downside risks, however.Clearly, events in the Euro area can flare up at any time, asthey did last year. Also, the Lunar New Year has made datatracking in Asia very difficult and thus increases uncertaintyabout our call for a soft landing in China. But the mostvisible risk at present is the potential for a sharp spike in oilprices. The price of Brent crude oil has moved above $120/bblfor the first time since early May of last year, reflecting a

roughly 10% rise since the start of this year. Although some ofthis increase reflects shifting expectations about economicgrowth, the latest move up also likely reflects concerns surround-ing a possible oil embargo on Iran. In response to Iran’s nuclearambitions, the US and European Union have agreed to impose aset of aggressive sanctions on Iran. In addition to the Europeanplans to curb imports starting in May (roughly 500kbd), the USwill impose sanctions, due to take effect at the end of March, thatwould deny access to the US payments system to anyone thatdoes not show an effort to reduce trading activities with Iran.

Companies have begun curtailing trading activities with Iran andthere is precautionary stockbuilding in advance of a more adversescenario. With roughly 16mbd shipped through the Strait ofHormuz, military action that temporarily disrupts flows wouldproduce a material oil price shock. Our analysis suggests that each1mbd removal of oil supply (sustained for a full year) would raiseoil prices by 26% and reduce global GDP by 0.5%-pt. Libyan pro-duction is coming on line faster than anticipated and the Saudissuggest they will compensate European countries for Iranian oil assanctions against Iran take effect. However, recent events illus-trates why the oil market—and thus our global economic out-look—remains closely linked to Middle Eastern supply risks.

A cautious eye on the global consumerIn assessing the contours of lift we are keenly focused on theglobal consumer. The foundation for the turn in global industrywas laid last summer by the pickup in consumption as shocksrelated to commodity price increases and the Tohoku earthquakefaded. The restoration of household purchasing power and arebound in global auto demand helped firms align inventoriescloser to desired levels. It also provided a pleasant surprisecountering growing recession concerns. However, this founda-tion for lift appears to have weakened in recent months. Follow-ing a 5% annualized gain in global retail sales volume fromJuly-October, increases since appear to have slowed to a crawl.

The fundamentals for global spending to grow solidly are in placeas labor markets continue to improve and confidence is rebound-ing. Consistent with this view, global auto sales were strong inJanuary and are on track to record another solid gain in February.The combination of rising oil prices and a stall by consumers intothe new year concentrates risks on the US but there are good rea-sons to think that US household spending will rebound. RecentUS weakness is concentrated in utilities (related to mild weather)and an unusual dive in gasoline consumption—developments notindicative of underlying trends. There is also positive news in thesustained strength in durable spending (with auto sales barrelingfurther ahead in February), a rise in consumer confidence, andsigns that the household saving rate has been broadly stable formore than a year. Against this backdrop, the mantra “give themincome and they will spend” looks to be the right one for fore-casting US consumer spending this year. If this week’s labormarket forecast is right, it will market the first 4-month periodof above-200k on payrolls since the recovery started.

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Crude oil price

Real retail sales

5


Official Current Forecast

rate rate (%pa) 05-07 avg Peak1

Trough1

next change Mar 12 Jun 12 Sep 12 Dec 12 Mar 13

Global 2.09 -223 -292 45 2.08 1.97 1.95 1.97 1.99

excluding US 2.88 -146 -236 61 2.86 2.70 2.68 2.70 2.73

Developed 0.58 -278 -363 5 0.58 0.50 0.50 0.50 0.51

Emerging 6.16 -89 -181 144 6.11 5.94 5.88 5.93 5.97

Latin America 7.46 -367 -625 134 7.22 6.83 6.83 6.83 6.83

CEEMEA 6.07 -12 -271 211 6.05 5.76 5.51 5.46 5.61

EM Asia 5.71 -14 -124 143 5.71 5.67 5.67 5.80 5.80

The Americas 1.31 -408 -470 26 1.28 1.22 1.22 1.22 1.24

United States Fed funds 0.125 -430 -513 0 16 Dec 08 (-87.5bp) 13 Mar 12 On hold 0.125 0.125 0.125 0.125 0.125

Canada O/N rate 1.00 -269 -350 75 8 Sep 10 (+25bp) 8 Mar 12 On hold 1.00 1.00 1.00 1.00 1.25

Brazil SELIC O/N 10.50 -490 -925 175 18 Jan 12 (-50bp) 7 Mar 12 7 Mar 12 (-50bp) 10.00 9.25 9.25 9.25 9.25

Mexico Repo rate 4.50 -342 -525 0 17 Jul 09 (-25bp) 16 Mar 12 On hold 4.50 4.50 4.50 4.50 4.50

Chile Disc rate 5.00 38 -325 450 12 Jan 12 (-25bp) 15 Mar 12 15 Mar 12 (-25bp) 4.75 4.50 4.50 4.50 4.50

Colombia Repo rate 5.25 -199 -475 225 24 Feb 12 (+25bp) 23 Mar 12 23 Mar 12 (+25bp) 5.50 5.50 5.50 5.50 5.50

Peru Reference 4.25 24 -225 300 12 May 11 (+25bp) 8 Mar 12 Apr 12 (-25bp) 4.25 3.75 3.75 3.75 3.75

Europe/Africa 1.83 -191 -320 37 1.82 1.60 1.56 1.55 1.57

Euro area Refi rate 1.00 -189 -325 0 8 Dec 11 (-25bp) 8 Mar 12 Jun 12 (-25bp) 1.00 0.75 0.75 0.75 0.75

United Kingdom Bank rate 0.50 -444 -525 0 5 Mar 09 (-50bp) 8 Mar 12 On hold 0.50 0.50 0.50 0.50 0.50

Czech Republic 2-wk repo 0.75 -160 -300 0 6 May 10 (-25bp) 29 Mar 12 On hold 0.75 0.75 0.75 0.75 0.75

Hungary 2-wk dep 7.00 -19 -400 175 20 Dec 11 (+50bp) 27 Mar 12 3Q 12 (-50bp) 7.00 7.00 6.50 6.00 6.00

Israel Base rate 2.50 -174 -300 200 23 Jan 12 (-25bp) 26 Mar 12 Mar 12 (-25bp) 2.25 2.25 2.25 2.25 3.00

Poland 7-day interv 4.50 -6 -200 100 8 Jun 11 (+25bp) 4 Apr 12 3Q 12 (-25bp) 4.50 4.50 4.25 4.00 4.00

Romania Base rate 5.50 -300 -475 0 2 Feb 12 (-25bp) 29 Mar 12 29 Mar 12 (-25bp) 5.25 5.25 5.25 5.25 5.50

Russia Repo rate 5.25 N/A N/A N/A 14 Sep 11 (-25bp) Mar 12 1Q 13 (+25bp) 5.25 5.25 5.25 5.25 5.50

South Africa Repo rate 5.50 -265 -650 0 18 Nov 10 (-50bp) 29 Mar 12 On hold 5.50 5.50 5.50 5.50 5.50

Turkey 1-wk repo 11.50 -439 -600 575 21 Feb 12 (-100bp) 27 Mar 12 May 12 11.50 10.00 9.00 9.00 9.00

Asia/Pacific 3.53 -58 -130 54 3.53 3.51 3.51 3.58 3.58

Australia Cash rate 4.25 -164 -300 125 6 Dec 11 (-25bp) 3 Apr 12 2Q 13 (+25bp) 4.25 4.25 4.25 4.25 4.25

New Zealand Cash rate 2.50 -482 -575 0 10 Mar 11 (-50bp) 8 Mar 12 3Q 12 (+25bp) 2.50 2.50 2.75 3.00 3.25

Japan O/N call rate 0.05 -15 -47 0 5 Oct 10 (-5bp) 13 Mar 12 On hold 0.05 0.05 0.05 0.05 0.05

Hong Kong Disc. wndw 0.50 -542 -625 0 17 Dec 08 (-100bp) 14 Mar 12 On hold 0.50 0.50 0.50 0.50 0.50

China 1-yr working 6.56 48 -91 125 6 Jul 11 (+25bp) - 4Q 12 (+25bp) 6.56 6.56 6.56 6.81 6.81

Korea Base rate 3.25 -85 -200 125 10 Jun 11 (+25bp) 8 Mar 12 On hold 3.25 3.25 3.25 3.25 3.25

Indonesia BI rate 5.75 -412 -700 0 9 Feb 12 (-25bp) 8 Mar 12 2Q 13 (+25bp) 5.75 5.75 5.75 5.75 5.75

India Repo rate 8.50 164 -50 375 25 Oct 11 (+25bp) 15 Mar 12 2Q 12 (-25bp) 8.50 8.25 8.25 8.25 8.25

Malaysia O/N rate 3.00 -22 -50 100 5 May 11 (+25bp) 9 Mar 12 On hold 3.00 3.00 3.00 3.00 3.00

Philippines Rev repo 4.00 -307 -350 0 1 Mar 12 (-25bp) 19 Apr 12 On hold 4.00 4.00 4.00 4.00 4.00

Thailand 1-day repo 3.00 -75 -200 175 25 Jan 12 (-25bp) 21 Mar 12 On hold 3.00 3.00 3.00 3.00 3.00

Taiwan Official disc. 1.875 -63 -175 63 30 Jun 11 (+12.5bp) Mar 12 3Q 13 (+12.5bp) 1.875 1.875 1.875 1.875 1.8751

Chg sinceNext meetingLast change

Forecast (%pa)

Economic Research

Central Bank Watch

JPMorgan Chase BankDavid Hensley (1-212) [email protected]

Michael Mulhall (1-212) [email protected]

1. ‘Peak’ refers to highest rate between 2007-08, ‘trough’ refers to lowest from 2009-presentBold denotes move since last GMOS and forecast changes. Aggregates are GDP-weighted averages.Source: J.P. Morgan

6


Market Forecasts

Global Asset Allocation

Source: Bloomberg, Datastream, IBES, Standard & Poor’s Services, J.P. Morgan estimates

Interest rates Current Mar-12 Jun-12 Sep-12 Dec-12 YTD Return*

United States Fed funds rate 0.125 0.125 0.125 0.125 0.125

10-year yields 1.97 2.50 2.50 2.50 2.50 -0.1%

Euro area Refi rate 1.00 0.75 0.75 0.75 0.75

10-year yields 1.77 2.15 2.00 1.95 1.90 0.3%

United Kingdom Repo rate 0.50 0.50 0.50 0.50 0.50

10-year yields 2.14 2.25 2.10 2.10 2.10 -1.0%

Japan Overnight call rate 0.05 0.05 0.05 0.05 0.05

10-year yields 0.98 1.15 1.05 1.05 1.15 0.2%

GBI-EM hedged in $ Yield - Global Diversified 6.35 6.30 1.9%

Credit Markets Current Index YTD Return*

US high grade (bp over UST) 199 JPMorgan JULI Porfolio Spread to Treasury 2.9%

Euro high grade (bp over Euro gov) 258 iBoxx Euro Corporate Index 3.8%

USD high yield (bp vs. UST) 647 JPMorgan Global High Yield Index STW 4.5%

Euro high yield (bp over Euro gov) 832 iBoxx Euro HY Index 10.9%

EMBIG (bp vs. UST) 353 EMBI Global 5.0%

EM Corporates (bp vs. UST) 391 JPM EM Corporates (CEMBI) 5.9%

Quarterly Averages

Commodities Current 12Q1 12Q2 12Q3 12Q4 GSCI Index YTD Return*

Brent ($/bbl) 124 115 112 120 125 Energy 11.6%

Gold ($/oz) 1684 1725 1825 1900 1925 Precious Metals 9.7%

Copper ($/metric ton) 8287 8000 8500 8875 9000 Industrial Metals 12.6%

Corn ($/Bu) 6.38 6.70 7.00 6.80 6.30 Agriculture 2.0%

YTD Return*

Foreign Exchange Current Mar-12 Jun-12 Sep-12 Dec-12 in USD

EUR/USD 1.34 1.30 1.34 1.36 1.38 EUR 1.5%

USD/JPY 81.2 76 76 74 72 JPY -4.6%

GBP/USD 1.57 1.55 1.57 1.58 1.60 GBP 1.6%

USD/BRL 1.76 1.75 1.77 1.78 1.80 BRL 7.8%

USD/CNY 6.31 6.45 6.35 6.30 6.10 CNY 0.3%

USD/KRW 1125 1210 1080 1070 1090 KRW 3.1%

USD/TRY 1.78 1.75 1.75 1.70 1.65 TRY 7.0%

3m cash

index

YTD Return

Equities Current (local ccy)

S&P 1353 10.5%

Nasdaq 2934 15.3%

Topix 823 13.5%

FTSE 100 5791 7.6%

MSCI Eurozone* 141 12.2%

MSCI Europe* 1086 9.7%

MSCI EM $* 1041 17.8%

Brazil Bovespa 65729 18.8%

Hang Seng 20628 12.6%

Shanghai SE 2395 8.8%

*Levels/returns as of Mar 06, 2012

Local currency except MSCI EM $

US Europe Japan EMSector Allocation * YTD YTD YTD YTD ($)

Energy 8.4% 5.6% 10.2% 22.4%

Materials 12.0% 15.4% 14.5% 20.1%

Industrials 10.3% 12.8% 14.9% 22.7%

Discretionary 11.7% 17.3% 23.1% 13.1%

Staples 1.8% 3.2% 7.2% 10.4%

Healthcare 4.9% 1.4% 6.0% 13.6%

Financials 14.9% 17.4% 28.7% 19.6%

Information Tech. 16.4% 11.8% 13.0% 19.5%

Telecommunications 1.2% -2.6% 1.1% 7.3%

Utilities -2.7% 3.9% 8.9% 16.4%

Overall 10.5% 9.7% 13.5% 17.8%

7


J.P. Morgan Chase Bank NAJan LoeysAC (1-212) [email protected]


Global Market Strategy

• Our portfolio remains comfortably long equities andcredit against safer asset classes.

• Of the six drivers of the rally, momentum hasstrengthened as volatility has come down.

• Defensive positions and falling risk perceptions are nowmuch closer to neutral as drivers of the rally. Economicforecast momentum remains only slightly positive.

• The value driver has lost a bit of its edge as a positive,but remains strong given the still wide spread to cashand government yields.

• We add a new driver of the rally, taken from themassive excess supply of safe versus risky assets.World equities and credit needs to gain 6% in valuethis year just to keep up its market share against cashand government bonds.

• The portfolio now includes an OW in energy stocks,and longs in VIX, and inflation as hedges against themain risks threatening asset reflation.

The long risk strategy continued to perform well in Februarywith most riskier asset classes repeating their price gainsfrom January. March is starting dangerously with Tuesdayof this week delivering the biggest 1-day loss in equitiessince November, rudely interrupting the almost straight-linerally of the past three months. This week’s correction tookplace without a lot of fundamental news, though, aside fromnervousness around the Greek restructuring, and thussuggests it reflects largely short-term profit taking.

Our overall portfolio strategy remains long risk assetsagainst safer ones –– cash and government debt. And wecontinue to add non- or less-directional sectoral and regionalrelative value allocations to reduce the risk-beta of ourportfolio. From this month on, we include also positions thatwe consider hedges against the directionality of the portfolio.

What are the drivers of the long risk position? They are1. Economic growth: forecasts are showing little

momentum, but global PMIs suggest modest upside.2. Value: still high risk premia, even if lower than last

year.3. Risk perceptions have come down, but can fall more.4. Momentum on returns and vol is strengthening.5. Positions: not as defensive anymore, but far from

stretched.6. Massive supply of safe assets versus a little or

negative issuance of risky assets.

The GMOS strategy and model portfolio

GMOS focuses on cross market, tactical asset allocation across

bonds, currencies, emerging markets, credit, equities and

commodities. Recommendations are presented in the form of a

model portfolio. Strategies focus on a medium-term investment

horizon, and deal with asset classes rather than relative value

across securities, which are presented by our many sister

publications. Any intra-month updates to our strategies are

published in the weekly The J.P. Morgan View. We endeavour

consistency with our economists and sector strategists, but may

have gaps due to differences in timing, investment horizons and

hedging. We express trades only in three sizes: small, medium and

large, and denote these with one, two and three stars (, and ). For performance measurement, they constitute,

$5 million, $10 million and $20 million in value-at-risk.

Source: J.P. Morgan, Consensus Economics. Consensus Economics forecasts are for regions and countries

that we averaged using the same 5-year rolling USD GDP weights that we use for our own global growth

forecast.

Chart 1: 2012 J.P. Morgan global GDP growth forecast: J.P. Morganvs. consensus%

1.8

2.2

2.6

3.0

3.4

3.8

Jan-11 Mar-11 May-11 Jul-11 Sep-11 Nov-11 Jan-12

JPM

Consensus

Our global growth forecasts for 2012 are unchanged overthe past month and are only 0.1% higher than they were sixmonths ago (Chart 1). By now, our projections are flat onconsensus. However, global PMIs, which in the past havebeen the best signal on near-term growth momentum, bythemselves are more consistent with about 1% global Q1growth than our or consensus bottom-up country forecasts(see also pp. 3-4). While hinting at upside, the bullish casefor risk assets does not get that much support fromeconomic momentum.

Value: Each day a market rallies, it becomes moreexpensive against longer-term fundamentals. But the long-term deviation means that is at the core of high risk premiain the world, remains fully in place –– the zero nominalyield on cash and zero real yield on safe government debt in

8


GOVT, 28tr

CREDIT, 12tr

CASH, 59tr

EQUITIES,

43tr

0 4 8 12 16

US cash

Europe Fixed Income*

US Fixed Income

Global Gov Bonds**

EM Local Bonds**

US High Grade

EMBIG

EM $ Corp.

US High Yield

EM FX

MSCI Europe*

S&P500

Gold

GSCI TR

MSCI AC World*

MSCI EM*

Topix*

Global Asset AllocationJ.P. Morgan Chase Bank NAJan LoeysAC (1-212) [email protected]

the G4, relative to significantly higher credit and earningsyields. On an outright basis, there is no great value in creditand equities as both HG and HY yields are near or athistoric lows, and earnings yields on equities are nearhistoric means. But comparisons with past valuation levelsare not of the greatest relevance as investors can only buywhat is in store today. Relative value among currentlyavailable IRRs is thus the only metric that matters and onthis basis, credit and equities remain very cheap againstcash and government debt.

Risk perceptions have greatly improved over the past threemonths as Europe sidestepped each of the traps it couldhave fallen into; US Congress was able to show bettercompromise on tax alleviation than it displayed before themarket fall in August last year; and China has so far main-tained its growth pace despite a dramatic contraction in itshousing industry.

Over the next 1-2 months, risk perceptions will likely notfall as dramatically as they have so far this year, quite likelyas market participants have already downgraded the risk ofimminent trouble from Europe or the US. And the risk frommilitary conflict around Iran and thus to oil prices has risen.Risk of conflict seems low for Q2, but should rise into Q3.However, every day that we pass without accidents, andevery day we move further away from the financial crisis isa day that medium-term risk perception will fade further.Overall, fading risk perception is thus from here only asmall contributor to the bullish case for risk assets.

Momentum, in contrast, is not weakening, and hasbecome stronger. For asset allocation, we have found that 6months is the most reliable lookback period, providing thebest trade-off between getting in too early and too late into anew trend. Six-month rolling returns on all risky assetclasses are now solidly positive and they are coming in withless and less volatility.

Defensive positioning among many market participants wasa very important driver for our decision in early Decemberto get back into the risk asset class. By now, much of thetactical underweights of risk assets have likely been cov-ered, and converted into mildly overweight positions.Macro hedge funds resisted the first part of the rally, buthave since joined the fray (see Charts 1 and 2 in EquityStrategy section). But looking also at still low leverageindicators, it does not feel as if hedge funds are yet fullycommitted to the rally.

Relative supply is a last reason to remain long riskassets, but arguably one of the strongest ones. The mainway that end investors can adjust the overall risk exposureof their portfolios is through the relative allocation to safer

Chart 2: 2012 YTD returns%, equities are in lighter colour.

Source: J.P. Morgan, Bloomberg. Returns in USD except: (H) is hedged into USD, (U) is unhedged in dollars

and (LC) is local currency. US HG, HY, EMBIG and EM $ Corp are JPM indices. EM FX is ELMI+ in $.

Chart 3: Global outstandings of bonds, equities, and cashFeb 12. Govt is the GBI-global index + US MBS and munis + global linkers from theBarcap Multiverse. Equities are the Datastream World equity index. Cash is M2

across the 16 largest countries.

Source: J.P. Morgan, Datastream

Chart 4: 2011 USD Change in global stock of equities, bonds and cashChange in market value in 2011 adjusted for FX and price changes. Govt is the GBI-global

index + US MBS and munis + global linkers from the Barcap Multiverse. Equities are theDatastream World equity index. Cash is M2 across the 16 largest countries.

$tr

0

1

2

3

4

5

6

CASH GOVT CREDIT EQUITIES

Source: J.P. Morgan, Datastream

9



versus riskier assets. Chart 3 shows the current portfolioallocation for the global investors, who represent the sumof all investors in the world. We do not adjust for doublecounting here caused by some intermediaries, such as banksthat both issue bonds and hold them. Of $152 trillion inoutstandings, only $55 trillion consists of riskier assetclasses –– equities and corporate bonds.

Chart 4 shows the relative net supply (issuance) of theseassets during 2011. Last year, $6.6 trillion was supplied tothe market in the form of cash and government bonds, whileless than one eighth of that ($0.8 trillion) was issued in theform of equity and credit.

For 2012, we think the relative supply of these assets willbe of a similar order of magnitude, although the supply ofsafer assets will likely be slightly less overwhelming –– i.e.,less than 8 times the supply of riskier assets. QE by majorcentral banks implies continued heavy printing of money.Government deficits are shrinking only slowly. Our analystsexpect conventional net supply of G10 government bonds toshrink from $2,051bn last year to $1,711bn this year(Salford and Chordia, Global government issuance 2012,Jan 11). Matching these changes, our US credit strategistsexpect net issuance of US high-grade bonds to shrink thisyear to $90bn, from $225bn last year (Eric Beinstein, CreditMarket Outlook and Strategy, Feb 24, p. 30). Last year saw$0.3bn of equity net issuance, consisting of about $1tr inIPOs and rights issuance and about $640bn in buybacks. Wehave no forecasts here, but think it is reasonable to expectsimilar net issuance of equities this year. Bringing theseforecasts together, the new supply of cash and governmentdebt will continue to be orders of magnitude larger than thatof equity and credit.

The implication of the heavy relative supply of safe versusrisky assets is that, all else constant, the increasingscarcity of riskier assets should make them morevaluable. If nothing else changes, then end investors willwant to keep the risk exposure of their portfolio unchanged.When the supply of safe assets increases relative to riskierassets, then investors have to bid up the price of the riskierassets to keep them at an unchanged allocation versus safeassets. Assuming for the moment the same relative suppliesas last year, as a percent of outstandings, then the worldvalue of equities and corporate bonds has to appreciate by6% over the next year just for them to keep up theirportfolio share for the global investor.

In sum, of the six factors supporting a long risk portfolio,one has gained (momentum); two remain largely unchangedand strong (Value and relative supply); two have weakened

to almost neutral (defensive positions and falling riskperceptions); and one remains only slightly positive (eco-nomic momentum). It is hard to add up these differentfactors, but our qualitative assessment says we shouldstay solidly long risk assets.

When momentum builds in markets, one should always beon the outlook for adverse events that can change themarket’s direction. Investors should try to hedge part of themain risks through options or side positions, when suchhedges are affordable. We will start with this month includ-ing smaller hedge positions against the main adverse eventsthat we can identify and where we think the cost is manage-able. Such hedges are ideally done with options, which wewill pursue in the future.

The most important risk into Q3 is likely a military conflictwith Iran over its nuclear program. We thus include inour portfolio an OW in energy stocks, and a long the USequity vol index, the VIX, through the J.P. Morgan MacroHedge Index.

The main long-term risk is that the liquidity machine that isdriving asset price reflation stops and is reversed due to arise in inflation and/or inflation expectations. The largeremaining output gap in the world suggests this risk is faraway. But the running inflation rate is well above what asimple output gap model would suggest. In addition,central banks and economies are becoming ever moredependent on further QE injections, and may becometoo confident that these will not create inflation. Marketparticipants have put on inflation hedges after the first QEefforts, but these have not paid off as inflation expectationshave remained remarkably stable. We include in ourportfolio a long position in both UK and US break-evens,and continue to hold a long in gold.

As we have tried in past months, we continue to includepositions that we believe have little directionality to riskmarkets. These include most bonds positions, but inparticular those based on our rule-based strategies that canbe followed in our Investment Strategies series. A combina-tion of carry and reversal now suggests receiving in 10years in euros and dollars against CHF and AUD. Inequities, these systemic rules using momentum andpositions remain long Utilities and Discretionary againstFinancials and Staples. In credit, they suggestoverweighting EU against US HY in CDS, while relativevalue indicates being long CDX HY against LCDX (loans).In commodities, we go long WTI against Brent futures asthe price gap has widened too much.

10



GMOS performanceInvestors who held our recommended positions gained42bps since last GMOS, on 82bp of ex ante annualized risk,largely due to a bullish position on risk. The largest gainscame from longs in US equities, and broad-based creditlongs, with US high-yield standing out. Fixed incomebenefited from cross-country trades, including cross-marketshorts in Australia. FX gains were broad-based, with thebiggest gain on longs in NOK. Commodities howeverposted a loss, due to a long in gold.

Performance (cumulative return, basis points)

since last GMOS (1 Feb) YTD

Total 42 88

Equities 8 41

Bonds 7 6Credit 10 15

Currency 8 10

Commodity -3 -4Cross-asset 12 19

* The GMOS performance reported is calculated as of closing on the date of the GMOS publication. Any

necessary adjustment for market movements today will be made in the following GMOS, reflected in the YTD

GMOS performance. Source: J.P. Morgan

J.P. Morgan model portfolio performancequarterly performance*, bp, not annualized

-100

-50

0

50

100

150

200

250

300

95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12

11



Trades and overall risk allocation

Source: J.P. Morgan

Overall risk allocation$mn risk capital on y-axis, directional risk contributions to the portfolio in light grey bars

HedgesThese trades may be repeated from other sections if there is a fundamentalrationale along with the trade being a good hedge. This does not mean the trade

size has been doubled.

$mn risk capital on x-axis

Cross Asset Positions$mn risk capital on x-axis

Source: J.P. Morgan

0 5 10 15 20

Long EM FX

Long MSCI AC

WORLD vs GBI

$mn

0 5 10 15 20

Long Gold

Overweight

Energy

Long Equity

Volatility

Long US & UK 5yr

Breakeven

$mn

-20

0

20

40

60

80

100

120

Total

Equitie

s

Fixed I

ncom

eCre

dit FX

Comm

odity

Cross

-ass

et

Hedge

s

The GMOS model portfolio

The overall risk, or value at risk, is the annualised standard

deviation of the set of trades in each asset class, in $mn. We aim

for an average VaR of $100mn over the year, undershooting when

we see fewer tactical opportunities in the coming month, and

overshooting when we see more. The directional risk, or beta to

the market, in each asset class is this total VaR times the

correlation of these trades with the market portfolio. The latter

means MSCI World in equities, GBI, MBS and Pfandbriefe in

Fixed Income, Barcap Multiverse minus the FI benchmark in

credit, GSCI in commodities, and DXY in FX.

Trade rationale

Price momentum, value, and the high relative supply (flood)of cash and gov't debt are the main drivers of our overweightin equities, and EM FX against cash and safe gov't debt.Economic momentum is a small positive while positions andrisk perception are now closer to neutral.

We will start, this month, including smaller hedge positionsagainst the main adverse events that we can identify, andwhere we think the cost is manageable.

The most important risk into Q3 is likely a military conflictwith Iran over its nuclear program. We thus include in ourportfolio an OW energy position in equities, and one that islong the US equity vol index, the VIX, through theJPMorgan Macro Hedge Index. We are also long breakevensin the US and UK as well as being long gold to protectagainst any rise in inflation expectations.

Trade rationale

12



Equity Strategy$mn risk capital on x-axis

Country / regional trades

Sector / style trades

Source: J.P. Morgan

Directional trades

- 5 10 15 20

Long US

Convertible Bonds

Long MSCI AC

World

$mn

- 5 10 15 20

OW MSCI Brics vs.

MSCI EM

OW SP500 vs.

MSCI AC World

OW Dax vs.

Eurostoxx

OW MSCI EM$ vs

MSCI World$

$mn

- 5 10 15 20

OW S&P

preferred stock

vs. S&P500

JPM sustainable

yield basket vs.

EuroStoxx 600

OW Cyclicals vs

Defensives

Sector

momentum &

position strategy

Trade rationale

Momentum, the search for yield and asset reflation shouldsupport equities.

Convertible bonds will benefit from both the rally in equitiesand credit.

2-month momentum favoures overweighting EM vs. DMequities.

Growth outperformance in Germany and a hedge against anyescalation in the Euro area crisis.

Growth outperformance in the US and a hedge against anyescalation in the Euro area crisis.

A more pronounced policy reversal in BRIC countriesrelative to the rest of EM.

Long utilities and consumer discretionary vs. financials andconsumer staples on positions and momentum.

The 2-month change in the global PMI is still positive.

The search for yields should benefit high dividend yieldingand preferred stocks.

13



Fixed Income Strategy$mn risk capital on x-axis

Source: J.P. Morgan

Country trades

Directional trades

Curve trades

0 5 10 15 20

Long 3Y Spain

Long UK 5yr

Breakeven

Short GBI

Long 10YR Poland

Long South Africa

30y

$mn

0 5 10 15 20

AUD money

market curve

steepener

$mn

Source: J.P. Morgan

FX Strategy$mn risk capital on x-axis

0 5 10 15

NOK vs USD

EUR vs NZD

EUR vs GBP

$mn

0 5 10 15 20

Long EUR & USD

vs AUD & CHF 10y

Swap

Trade rationale

Due to recent relative underperformance and a supportivebudget

On falling credit and inflation risk premia, and supportivepositions

Bonds have not reflected the lessening in tail risk so far thisyear.

Attractive valuations given our inflation forecast, and ahedge for higher oil prices.

On the view that the LTRO-fuelled domestic bid can causeperipherals to rally a little further.

Based on combined carry and reversal signals.

With roughly trend growth in prospect, RBA looks unlikelyto ease further this year

Positioning on global growth and continued, demand-drivenincreases in the oil price.

Hedge for a destabilising spike in the oil price.

GBP is at risk from the substantial compression of euro zonecredit risk.

Trade rationale

14



Credit Strategy$mn risk capital on x-axis

Source: J.P. Morgan

Commodity Strategy$mn risk capital on x-axis

Source: J.P. Morgan

Relative Value

0 5 10 15 20

Long Dec12 WTI vs

Dec12 Brent

Long Gold

Directional trades

0 5 10 15 20

OW EU HY vs US

HY

OW EU HY vs EM

$ Sovereigns

Long Risk CDX.HY

vs LCDX

$mn

0 5 10 15 20

OW US HY credit

OW US HG credit

OW EMBIG vs USTs

Long Risk iTraxx Snr

Fins

$mn

Trade rationale

We remain bullish on credit in light of the recent grab foryield, driven by the massive liquidity injections of theLTROs.

We remain bullish gold on further buying by EM centralbanks and EM retail as well as still positive 12-month pricemomentum.

A pipeline reversal later in the year should alleviate thebottleneck that has built up at the WTI pricing point and helpreconnect WTI to world oil markets, i.e. Brent.

But by scaling back our longs, we take more risk on lessdirectional trades based on relative price convergence andrelative carry-to-risk: Long iTraxx XO vs CDX.HY, anoverweight in EU HY vs. EM $ Sovereigns, and longCDX.HY vs. LCDX.

Trade rationale

15


Long-only ETF portfolio

• We recommend a modestly higher allocation to equities(48%) than bonds (42%). This compares to neutral ormarket-cap weights of 43% and 47%, respectively.

• In equities, focus exposure on DAX, BRICs, USPreferred stocks and Technology/Industrials/Energyamong sectors.

• In bonds, focus exposure on US HY corporate bondand US TIPS ETFs.

• Overweight gold (7.5%) vs cash (2.5%). This comparesto neutral weights of 5% for both. Gold is benefitingfrom strong EM demand and cleaner positions.

Equities continued to outperform bonds. We continue torecommend a higher allocation to equities than bonds, butonly modest, by 5%. This modest overweight is justified asboth the macro and investor positioning support for riskyassets have faded. Indeed, our US Economic ActivitySurprise Index is negative. And various position indicatorssuggest that investors’ equity exposures continued to riseand perhaps around 50%-75% of the position retrenchmentseen between April and September last year has beenreversed so far.

To protect ourselves against a potential re-escalation of theEuro debt crisis, we continue to OW US equities within ourequity portfolio. Within Europe we focus on Germany due tomore favourable financial conditions and higher exposure toexporters. Within EM, we focus on BRICs as the latter arebenefiting from a more pronounced policy shift frominflation fighting towards supporting growth.

Sectorally we prefer to focus on Cyclical sectors and highdividends/income stocks. The 2-month change in the globalmanufacturing PMI still favours Cyclical sectors. ETFs thattrack the Technology and Industrial sectors are our preferredCyclical exposures. The search for yield should allowhigher-yielding stocks to outperform. US preferred stocksoffer a dividend yield of 6% vs. 2% for the S&P500. Supplylimits the downside for oil prices and the Energy sector. BuyETFs which track the Alerian MLP Index. This indexcombines exposure to the Energy sector with a dividendyield of close to 5%. Fears that the steady expansion ofcentral balance sheets and the rise in money supply breedinflation problems for the future, justify focus on inflationlinked bonds. As a result we overweight ETFs that invest inUS TIPS. In addition, the search for yield justifies an OW inHY corporate bonds within the bond ETF universe.

Global Asset AllocationJ.P. Morgan Securities Ltd.Nikolaos PanigirtzoglouAC (44-20) [email protected]

In this section we construct a long-only portfolio amongthe biggest and most liquid ETFs by incorporating ourtactical views across asset classes. This is different fromthe other GMOS sections where the focus is on long-shorttrade ideas, many of which are not accessible to long-onlyinvestors. Similar to the other GMOS sections, the sizes ofthese long-only ETF trades are mostly a reflection of ourconfidence and do not take into account the correlationsbetween the different asset classes.

Our long-only portfolio selects among the 100 biggestETFs by AUM. These include government bonds, HG andHY corporate bonds, commodities and equities of differentcountries, regions and sectors. Table 2 shows the indicestracked by the 100 biggest ETFs along with the AUM.

Our allocation is a two step process. In the first step wedecide the overall allocation among main asset classes, i.e.bonds, equities, commodities and cash. The starting pointor neutral allocations is currently 43% equities, 47% bonds(based on market capitalizations), 5% commodities and5% cash.

Deviations from the neutral allocation of 5% denote lowconfidence, of 10% denote medium confidence and of 20%denote high confidence.

In the second step, within the equity or the bond portfolio,we construct an equally weighted portfolio of the equity orbond ETFs based on the regions/countries/sectors we feelmore confident about, as explained in the other GMOSsections. Our overall allocation is shown in Table 1.

Allocation Neutral Strategy

48% 43%

S&P US Preferred Stock Index 6.9% 0.2% OW US/ OW High DY Stocks

DAX 6.9% 1.5% OW DAX

MSCI BRAZIL 6.9% 1.4% OW BRICs

FTSE/XINHUA CHINA 25 6.9% 3.8% OW BRICs

Alerian MLP Energy Index 6.9% 5.7% OW Energy/OW High DY Stocks

S&P500 Technology Sector 6.9% 4.2% OW Cyclical sectors

S&P500 Industrial Sector 6.9% 5.7% OW Cyclical sectors

42% 47%

US TIPS 14.0% 2.0% OW inflation linkers

US HY Corporate bonds 14.0% 2.6% OW HY credit

US Aggregate Index 14.0% Broad Bond Index exposure

Commodity funds

Gold 7.5% 5% OW Gold

Cash 2.5% 5% UW cash

Bond funds

Equity funds

Table1: Our preferred portfolioWeights in %. In this publication we do not recommend any specific ETF. We ratherrecommend exposure to indices tracked by ETFs.

Source: J.P. Morgan

16



Table 2: Indices tracked by the 100 biggest ETFs along with the total AUM invested in these ETFsEquity index AUM ($bln) Exchange Region Asset Class Sub SectorS&P 500 Index 137.2 NYSE/ASX/London/Frankfurt USA/EMEA Equity USMSCI Emerging Markets Index 93.0 NYSE/ASX/London/Frankfurt USA/EMEA Equity EMMSCI EAFE Index 45.5 NYSE/ASX USA Equity EAFE/EuropeNasdaq 100 Index 29.2 NASDAQ USA Equity USDAX Index 23.0 Frankfurt EMEA Equity GermanyMSCI US Broad Market Index 20.5 NYSE USA Equity USS&P Mid Cap 400 Index 19.5 NYSE/ASX USA Equity USNikkei 225 Index 16.5 Osaka/Tokyo APAC Equity JapanTopix Index 15.9 Tokyo APAC Equity JapanRussell 2000 Index 14.9 NYSE/ASX USA Equity USRussell 1000 Growth Index 14.8 NYSE USA Equity USDJ Eurostoxx 50 Index 13.9 EN Paris/Frankfurt EMEA Equity EuropeDJ Industrial Average Index 12.3 NYSE USA Equity USRussell 1000 Value Index 11.8 NYSE USA Equity USHang Seng Index 10.5 Hong Kong APAC Equity HKMSCI Brazil Index 10.3 NYSE USA Equity BrazilMSCI REIT Index (Div Yld 3.3%) 9.8 NYSE USA Equity USDJ Select Dividend Index (Div Yld 3.3%) 9.7 NYSE USA Equity USMergent Dividend Achievers Select Index (Div Yld 2.0%) 9.5 NYSE USA Equity USS&P HY Dividend Aristocrats Index (Div Yld 3.1%) 8.7 NYSE USA Equity USS&P IT Select Sector Index 8.6 NYSE USA Equity USAmex Gold Miners Index 8.5 NYSE USA Equity USMSCI Us Prime Market 750 Index 8.5 NYSE USA Equity USS&P 500 Energy Sector Index 8.1 NYSE USA Equity USS&P Small Cap 600 Index 7.3 NYSE/ASX USA Equity USUS Utilities Select Sector Index (Div Yld 3.9%) 7.2 NYSE USA Equity USFTSE/Xinhua China A50 Index 6.7 Hong Kong APAC Equity ChinaS&P 500 Growth Index 6.6 NYSE USA Equity USRussell 1000 Index 6.6 NYSE USA Equity USFTSE/Xinhua China 25 Index 6.5 NYSE/ASX USA Equity ChinaMSCI Us Prime Market Growth Index 6.3 NYSE USA Equity USRussell Mid Cap Index 6.3 NYSE USA Equity USFTSE All-World Ex-Us Index 6.2 NYSE USA Equity Global ex-USUS Financial Select Sector Index 6.2 NYSE USA Equity USDAX Global Agribusiness Index 6.0 NYSE USA Equity GlobalMexbol Index 5.7 Mexico LATAM Equity MexicoS&P Consumer Staples Select Sector Index 5.6 NYSE USA Equity USMSCI Japan Index 5.3 NYSE/ASX USA Equity JapanFTSE 100 Index 5.3 London EMEA Equity USMSCI Canada Index 4.7 NYSE USA Equity CanadaS&P 500 Value Index 4.3 NYSE USA Equity USRussell 2000 Value Index 4.3 NYSE USA Equity USUS Health Care Select Sector Index 4.0 NYSE USA Equity USMSCI Us Small Cap 1750 Index 3.9 NYSE USA Equity USSwiss Market Index 3.7 SIX Swiss Ex EMEA Equity SwitzerlandS&P Industrial Select Sector Index 3.7 NYSE USA Equity USAlerian MLP Index (Div Yld 4.8%) 3.7 NYSE USA Equity USRussell 2000 Growth Index 3.7 NYSE USA Equity USMSCI US Mid Cap 450 Index 3.4 NYSE USA Equity USTSEC Taiwan 50 Index 3.4 Taiwan APAC Equity TaiwanMSCI World Index 3.4 London/Frankfurt EMEA Equity GlobalS&P 100 Index 3.4 CBOE USA Equity USMSCI Pacific Ex-Japan Index 3.3 NYSE USA Equity AUS, HK, NZ, SGRussell 3000 Index 3.3 NYSE USA Equity USMSCI South Korea Index 3.3 NYSE/ASX USA Equity South KoreaSSE50 Index 3.2 Shanghai APAC Equity ChinaDJ U.S. Real Estate Index 3.1 NYSE USA Equity USCAC 40 Index 3.1 EN Paris EMEA Equity FranceBond index AUM ($bln) Exchange Region Asset Class Sub regionBarclays Us Aggregate Index 29.1 NYSE USA Debt USBarclays Us Treasury Inflation Notes Index 22.6 NYSE USA Debt USiBoxx $ Liquid IG Index 18.0 NYSE USA Debt USiBoxx $ Liquid HY Index 12.3 NYSE USA Debt USBarclays 1-3Yr Treasury Index 10.9 NYSE USA Debt USBarclays Brothers HY Very Liquid Index 9.8 NYSE USA Debt USBarclays 1-3Yr U.S. Credit Index 9.2 NYSE USA Debt USS&P U.S. Preferred Stock Index (Div Yld 6.1%) 7.6 NYSE USA Debt USBarclays 1-5Yr Govt/Credit Index 7.5 NYSE USA Debt USBarclays 20+ Yr Treasury Index 6.2 NYSE USA Debt USBarclays 7-10Yr Treasury Index 4.7 NYSE USA Debt USBarclays Intermediate US Credit Index 4.6 NYSE USA Debt USBarclays US MBS Index 4.2 NYSE USA Debt USiBoxx Liquid Corporates Index 3.7 London/Frankfurt EMEA Debt EuropeJPMorgan EMBI Global Core Index 3.6 NYSE USA Debt EMCommodity AUM ($bln) Exchange Region Asset Class Sub Sector

Gold 162.3NYSE/London/Tokyo/SIX

Swiss/FrankfurtUSA/APAC/EMEA Cmdty Gold

Silver 9.7 NYSE USA Cmdty SilverCommodity Index 5.7 NYSE USA Cmdty DiversifiedSource: J.P. Morgan. Note: AUM as of Feb 29, 2012

17


-0.4

-0.3

-0.2

-0.1

0.0

0.1

0.2

0.3

0.4

0.5

0.6

Apr-02 Apr-04 Apr-06 Apr-08 Apr-10

-0.4

-0.3

-0.2

-0.1

0.0

0.1

0.2

0.3

0.4

0.5

0.6

Nov-11 Dec-11 Jan-12 Feb-12

CAD EUR

AUD NZD

J.P. Morgan Securities Ltd.Paul MeggyesiAC (44-20) [email protected]

Global FX Strategy

FX Strategy

• The correlation between G10 exchange rates and riskmarkets continues to weaken, reflecting the lesseningin systemic risk and the resultant re-emergence ofcurrency-specific factors as drivers of exchange rates(i.e. interest rates, terms of trade). This decorrelationis likely to result in more tactical trade opportunitiesin coming weeks.

• Our long euro basket has suffered over the pastweek — whereas we had emphasised the currencypositive impact of reduced credit stress, the markethas reacted to the interest-rate negative consequencesof the ECB's second LTRO.

• Reduce euro longs in recognition of the currency’simpaired interest rate support (take profits onEUR/USD) but stay long EUR/NZD as a hedge to asupply-driven spike in the oil price and shortEUR/GBP just ahead of its stop.

• Stay short USD/NOK as a core trade on global growthand continued, demand-driven increases in the oilprice. The dollar may be spared QE3 but it is hard tosee the dollar recovering on a trend basis without therealistic prospect of Fed tightening. The dollar is notmorphing into an investment currency.

• Closed trades: Take profits on long EUR/USD.

• Stay short USD/NOK, long EUR/NZD and longEUR/GBP, all in cash. Hold a USD/JPY 1x2 putspread (this is now a very cheap anti-risk hedge).

For anybody, and that surely is everybody, who hasdespaired of the debilitating tyranny of the 'risk-on, risk-off'paradigm, whereby a view on virtually all currencies boileddown to a single view on the prospects for risk, the last fewweeks have offered the tantalising prospect of exchangerates starting to move once more on independent, country-specific factors. Charts 1 and 2 highlight how the unusuallytight linkage between exchange rates and equity marketshas loosened in recent weeks following the removal, or atleast reduction, in euro-centric systemic tail risk, not tomention the increase in global economic momentum. Yendepreciation is the most striking but by no means onlyexample of an idiosyncratic move: 1) Petro-currenciescontinue to reap the benefits of terms of trade gains (thisremains a low volatility, and hence benign, run-up in the oilprice); 2) the euro, contrary to our expectation, hasstruggled in the immediate aftermath of the second LTRO asthe negative impact of additional liquidity on short-terminterest rates has overpowered the positive benefits from a

further reduction in euro credit risk; 3) dollar-bloccurrencies have benefited from meaningful improvements infront-end interest rate support (chart 3), reflecting leverageto the US (Canada) and a still robust domestic economywhich in the absence of a Euro area collapse is unlikely towarrant further monetary easing (Australia).

Of these trends we have been on the right side of oil forquite a few weeks (a sizeable basket long in NOK which wescaled back last week to a sole position in USD/NOK) buton the wrong side of the euro this week. In hindsight weunderestimated the impact which the second injection ofthree year liquidity would have on front-end rate spreads, orat least the significance which the FX market would attachto this shift in rate differentials rather than the more positive

Source: J.P. Morgan

Chart 2: Equity betas have fallen for many currencies, not only EURBetas from 1-month, pair wise regressions of G10 FX/USD against the S&P500.

Source: J.P. Morgan

Chart 1: The average beta between G10 currencies and equitymarkets has fallen sharply, indicating that local stories are moreinfluential now that systemic Euro area risk has dissipatedAverage beta from pair-wise regressions of G10 FX/USD against the S&P500. Dailyreturns, 1-month rolling window. A positive beta indicates that the G10 currencies onaverage appreciate vs USD when equities rally, and vice versa

18


-3

-2.5

-2

-1.5

-1

-0.5

0

0.5

1

1.5

2

70

75

80

85

90

95

100

Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12

USD TWI US-G10 2Y spread

-15

-10

-5

0

5

10

15

20

25

30

35

40

EUR JPY USD CHF GBP SEK NOK CAD NZD AUD

1 week 1 month

Global FX StrategyJ.P. Morgan Securities Ltd.Paul MeggyesiAC (44-20) [email protected]

ramifications for the euro of the significant reduction incredit risk (10Y BTP yields have slumped by 55bp thisweek). We are scaling back euro longs this week, inrecognition of this move in rates, but suspect that the euroshould find its feet next week should the ECB fail to cutinterest rates whilst simultaneously downplaying theprospects for LTRO v3.0 (as Chancellor Merkelemphatically did today, adding key political support to theBundesbank President who himself has aired deepmisgivings about the LTRO strategy). Hence we are stayinglong of EUR/GBP and EUR/NZD this week even whiletaking profits on EUR/USD. EUR/NZD can also be seen asa defensive hedge to any form of disruptive spike in oilprices that starts to adversely impact our NOK exposure.As for the dollar generally, our strong inclination is still toregard this as a funding rather than investment currency.Acceleration in US growth is a necessary but by no meanssufficient condition for a trend recovery in the dollar. Thekey remains with Fed policy — the dollar doubtless tooksome encouragement from Bernanke’s Congressionaltestimony this week, which omitted any discussion of futurepolicy easing, but policy tightening remains a dim anddistant prospect. Without the prospect of higher policy ratesfor a good two years, it is hard to see how a deficit anddebtor currency can sustain a meaningful appreciation(chart 4). Tactically the dollar might get another boostshould next week's labor data reveal another meaningfuldrop in the unemployment rate but we are not convincedthat there is sufficient upside to justify buying the dollar.

Trades

• Take profits on long EUR/USD. Stay long euro vsGBP and NZDThe euro was undermined this week by the contrastbetween the ECB, which was eager to pump an extraEUR 300bn of liquidity into the banking system, and theFed, which increasingly is reluctant to countenancefurther stimulus of its own (chart 5). The ECB's liquidityinjection may not be dislodging inflation Euro areaexpectations but it has nonetheless weakened the eurothrough the more the direct channel of softer front-endrate spreads (chart 3). We certainly under-appreciated thiseffect but are reluctant to embrace a view that the ECBactions have condemned the euro to a life as the G10’schief funding currency. We are locking in (reduced)profits on a long EUR/USD position initiated the otherside of the Greek bail-out but keep long euro exposureversus sterling and kiwi dollar. The ECB meeting nextweek is key for the currency — a rate cut or any nodtowards further long-term liquidity injections would bepunished by the market. Conversely, steady rates and anattempt to dispel speculation of further LTROs should

help to steady the ship. As for EUR/GBP, we still believethat GBP is at risk from the substantial compression ofeuro zone credit risk. Foreign investors were renewedbuyers of Gilts in January but this does not disprove thehypothesis that as a safe haven currency GBP isvulnerable from capital outflows as credit risk recedes. Inaddition, the market is strangely indifferent to the realityof the BoE’s QE, which as a percent of GDP is larger thanthe ECB’s two LTRO operations (chart 6).

Take profits on long EUR/USD. Bought Jan 27 at1.3120. Closed at +0.8%.

Stay long EUR/NZD – bought Feb 24 at 1.6050,marked at -1.3%

Chart 3: Interest rate differentials – remember those? The fading ofsystemic risk means that more traditional fundamentals such as ratespreads have a greater chance of influencing exchange rates. Theeuro needs the ECB not to cut next week in order to stabilise2Y swap rates, change over 1-week and 1-month

Chart 4: The dollar may be spared QE3 but a further recovery inUSD TWI still requires an implausible reappraisal of short-term rateexpectations. It takes a 25bp rise in 2Y swaps to lift USD by 2.75%.

Source: J.P. Morgan

Source: J.P. Morgan

19


-12.0%

-10.0%

-8.0%

-6.0%

-4.0%

-2.0%

0.0%

0.75

0.8

0.85

0.9

0.95

Jan-08 Jan-09 Jan-10 Jan-11 Jan-12

EUR/GBP

BoE-ECB balance sheet, % GDP

-15%

-10%

-5%

0%

1.20

1.25

1.30

1.35

1.40

1.45

1.50

1.55

1.60

Jan-08 Jan-09 Jan-10 Jan-11 Jan-12

EUR/USD

Fed-ECB balance sheet, % GDP

Global FX StrategyJ.P. Morgan Securities Ltd.Paul MeggyesiAC (44-20) [email protected]

Chart 5: The ECB’s LTRO injected additional liquidity worth around3% of Euro area GDP. While we have emphasised its positive impacton the euro through a reduction of credit risk, the market is puttingmore emphasis on the negative impact through nominal interest ratedifferentials. The euro needs Draghi to downplay the prospects ofLTRO v 3.0, otherwise this week’s sell-off could well extend.

Stay long EUR/GBP. Bought Feb 24 at 0.8480, now

worth -1.8%.

• Stay short USD/NOK

Last week we cut back our NOK exposure on the basisthat the higher the oil price goes, the closer it gets to theinflexion point beyond which investors start to worryabout the implicit tax on economic growth andconsequently shy away from cyclical assets, includingpetro-currencies. We argued that this threshold was stillsome 5-10% away, so kept a residual NOK long vs USD.That the oil price has cooled by a few dollars this weekshould if anything be read as supportive for the currentlevels of NOK as even petro-currencies can have toomuch of a good thing.

Stay short USD/NOK – sold Feb 13 at 5.7210.Marked at 1.9%.

• Hold USD/JPY 1x2 put spread

The market has embraced with enthusiasm the triplethemes of structural current account compression, moreaggressive BoJ easing, and funding currency status, to theextent that the yen is now highly oversold on virtually allcrosses. This undervaluation should start to support theyen, especially as the Treasury market remains firmlywithin its range parameters and year-end repatriationflows remain within the pipeline. And even if anindependent recovery in the yen fails to materialise, thistrade can still be seen as a cheap hedge to the possibilitythat risk markets succumb to fatigue.

Hold a 6-mo 76-72.50 USD put/JPY call spread in

1x2 notional. Cost 0.15%, worth 0.13%.

Chart 6: The market may be obsessed by ECB balance sheetexpansion but it remains curiously apathetic about the BoE’s QE.The scale of the BoE’s asset purchases since October exceeds thenew cash injected by the ECB’s two LTROs. Relative balance sheetexpansion is now supportive of EUR/GBP

Source: National central banks; J.P. Morgan

Source: National central banks; J.P. Morgan

20


Exchange rates vs. U.S dollar

Current

Majors Mar 7 Mar 12 Jun 12 Sep 12 Dec 12 forward rate Consensus** Past 1mo YTD Past 12mos

EUR 1.31 1.30 1.34 1.36 1.38 4.9% 7.2% 0.0% 1.3% -5.6%

JPY 80.8 76 76 74 72 11.7% 8.3% -5.2% -4.8% 2.4%

GBP 1.57 1.55 1.57 1.58 1.60 1.7% 2.3% -0.6% 1.2% -2.7%

AUD 1.06 1.06 1.08 1.10 1.08 5.6% 6.4% -1.6% 3.4% 4.6%

CAD 1.00 1.00 0.98 0.96 0.98 2.9% 2.7% -0.6% 2.0% -3.0%

NZD 0.82 0.80 0.82 0.84 0.82 2.4% 2.1% -1.9% 5.2% 10.5%

JPM USD index 81.3 80.7 79.3 78.9 79.2 1.3% -1.5% 2.1%

DXY 79.8 79.8 78.0 76.7 75.7 0.9% -0.5% 3.8%

Europe, Middle East & Africa

CHF 0.92 0.93 0.90 0.88 0.87 5.1% 11.9% 0.1% 2.2% 1.9%

ILS 3.81 3.75 3.70 3.65 3.65 5.5% 3.3% -2.4% 0.0% -6.1%

SEK 6.79 6.85 6.68 6.54 6.38 7.5% 7.9% -1.0% 1.4% -6.3%

NOK 5.67 5.92 5.71 5.59 5.47 4.9% 7.5% 2.6% 5.4% -1.5%

CZK 18.93 18.85 18.28 18.01 17.61 7.5% 10.1% 0.4% 4.3% -7.8%

PLN 3.17 3.19 3.07 3.01 2.97 9.8% 9.0% 0.2% 8.6% -10.0%

HUF 225 223 216 210 207 12.9% 10.6% -1.0% 7.9% -13.0%

RUB 29.75 29.96 29.23 29.43 29.46 5.1% 5.3% 1.2% 8.0% -5.0%

TRY 1.79 1.75 1.75 1.70 1.65 14.8% 7.3% -1.6% 5.8% -11.1%

ZAR 7.66 7.40 7.60 7.70 7.70 3.8% 1.0% -1.4% 5.7% -10.2%

Americas ARS 4.34 4.50 4.60 4.80 4.90 1.7% 1.0% 0.0% -0.8% -7.1%

BRL 1.77 1.75 1.77 1.78 1.80 3.6% -2.2% -2.5% 5.5% -6.5%

CLP 493 530 510 490 480 5.9% 3.9% -2.7% 5.4% -3.6%

COP 1781 1950 2000 1950 1900 -3.8% -1.4% 0.4% 8.9% 6.0%

MXN 12.67 12.80 13.20 12.80 12.00 10.9% 6.5% -2.4% 7.4% -7.5%

PEN 2.68 2.75 2.80 2.75 2.72 -1.0% 0.4% 0.5% 0.8% 3.5%

VEF 4.29 4.30 4.30 4.30 4.30 -0.1% 11.7% 0.0% 0.0% 0.0%

LACI 110.1 108.8 107.3 108.5 110.8 -1.9% 5.4% -5.2%

Asia CNY 6.31 6.25 6.20 6.20 6.10 3.4% 0.4% 0.0% -0.2% 4.1%

HKD 7.76 7.76 7.75 7.75 7.75 0.1% 0.4% -0.1% 0.1% 0.3%

IDR 9118 8950 8900 9250 9480 0.5% -7.0% -1.4% -0.5% -3.6%

INR 50.3 48.0 47.0 50.0 48.0 10.2% 1.5% -2.4% 5.5% -10.3%

KRW 1125 1120 1080 1070 1090 4.7% -0.9% -0.4% 2.5% -0.6%

MYR 3.03 3.00 2.97 3.00 2.98 3.1% 0.5% -0.3% 4.6% 0.1%

PHP 42.92 42.00 41.50 43.00 42.50 2.0% -1.4% -0.8% 2.2% 1.3%

SGD 1.26 1.23 1.21 1.24 1.23 2.3% -0.1% -1.0% 2.8% 0.5%

TWD 29.54 29.25 29.75 31.25 31.50 -6.9% -7.1% 0.1% 2.5% -0.5%

THB 30.78 30.75 30.25 30.50 30.75 1.4% -1.7% 0.6% 2.5% -1.4%

ADXY 117.0 116.6 119.6 121.1 121.1 -0.4% 1.6% 0.2%

EMCI 98.7 99.2 99.9 100.0 101.91 -1.0% 5.8% -5.6%

Exchange rates vs Euro

JPY 106 99 102 101 99 6.5% 1.0% -5.2% -6.0% 8.4%

GBP 0.835 0.840 0.855 0.860 0.865 -3.1% -4.6% -0.6% -0.2% 3.1%

CHF 1.21 1.21 1.21 1.20 1.20 0.2% 4.3% 0.1% 1.0% 7.9%

SEK 8.91 8.90 8.95 8.90 8.80 2.5% 0.6% -1.0% 0.0% -0.7%

NOK 7.44 7.70 7.65 7.60 7.55 0.0% 0.2% 2.6% 4.0% 4.3%

CZK 24.85 24.50 24.50 24.50 24.30 2.5% 2.7% 0.4% 3.0% -2.3%

PLN 4.16 4.15 4.12 4.10 4.10 4.7% 1.6% 0.2% 7.2% -4.7%

HUF 296 290 290 285 285 7.7% 3.2% -1.0% 6.6% -7.8%

RON 4.36 4.37 4.40 4.35 4.35 2.1% -0.8% -0.2% -0.7% -3.8%

TRY 2.35 2.28 2.35 2.31 2.28 9.4% 0.1% -1.6% 4.4% -5.8%

RUB 39.06 38.94 39.17 40.03 40.66 0.2% -1.8% 1.2% 6.8% 0.6%

indicates rev ision resulting in stronger local FX , indicates rev ision resulting in w eaker local FX

* Negativ e indicates JPM more bullish on USD than consensus,** Consensus Economics Publication: Foreign Exchange Consensus Forecasts Feb 2012

Source: J.P.Morgan

JPM forecast gain/loss vs Dec-12* Actual change in local FX vs USD

Actual change in local FX vs EUR

Global FX StrategyJ.P. Morgan Securities Ltd.John NormandAC (44-20) [email protected]

Paul MeggyesiAC (44-20) [email protected]

J.P. Morgan FX Forecasts vs. Forwards & ConsensusExchange rates vs. U.S. dollar

Source: J.P. Morgan

21



Fixed Income Strategy

• We are modestly bearish on duration in DM, asbonds have not reflected the lessening in tail risk sofar this year.

• Hold select longs in EM local markets, focussing onSouth Africa and Poland.

• Position for steeper AUD money market curve,higher inflation breakevens, and tighter Euro areaperipheral spreads.

• Tight ranges for outright yields highlight theimportance of cross-market signals in generatingmarket-neutral returns. We hold duration longs inEUR and USD 10yr swaps vs AUD and CHF, oncombined carry and reversal signals.

Bonds are about flat on the month. The strongest start to ayear for global equities since 1998, even after this week’ssetback, has left bonds largely unmoved, and maintainingthe tightest ranges in recent times (Chart 1). This is thethird time in the past few years that bonds have not followeda sharp equity rally (Chart 2). The 2010 bond-equitydivergence, sparked by the onset of QE2, was resolved by asharp backup in yields towards the end of the year. But afterthe 2009 divergence, also fuelled in part by easier monetarypolicy, bonds held their gains.

We think bonds offer little value to investors with long-term time horizons. For example, 5-year USD swap rates,five years ahead, are a shade above 3% (and at similar levelsin EUR and GBP). By comparison, the FOMC’s expectationof the Fed Funds rate in the ‘longer run’ is 4-4.5% nominal,or 2-2.5% real. Thus, even before accounting for Libor-OISspreads and term premia, at face value the forward curveprices a considerable likelihood of prolonged Japan-likestagnation.

Our tactical view on duration is modestly bearish,reflecting the fact that bonds have not reflected the lesseningin tail risks so far this year, especially in Europe. Even so,we do not expect a sharp near-term move higher in yields,with monetary policy remaining so supportive. Quite apartfrom flooring short-term yields, central banks have beenpushing down longer-term rates explicitly via QE, while lowshort-term rates encourage investors to extend duration insearch of carry, to the same effect.

Underlying our mildly bearish duration view is theexpectation that Euro area concerns will remain on theback burner for the immediate future. Spain’s increase in

J.P. Morgan Securities Ltd.Seamus Mac GorainAC (44-20) [email protected]

Chart 1: Three-month high-low range of DM 10-year yieldsPer cent, average of 3-month high-low range for 10-year US Treasuries, German

Bunds and UK gilts.

Source: Bloomberg, J.P. Morgan

150

200

250

300

350

400

09 10 11 12

1.75

2

2.25

2.5

2.75

3

3.25

MSCI World (LHS)

GBI Global yield

(RHS)

0

0.25

0.5

0.75

1

1.25

1.5

1.75

2

90 92 94 96 98 00 02 04 06 08 10 12

Source: Bloomberg, J.P. Morgan

Chart 2: Global equities vs government bond yieldsIndex Per cent

As discussed on p. 7, GMOS focuses on global tacticalasset allocation. In this section, we focus on medium-termasset allocation across G10 and EM rates markets. Moreshort-term and detailed recommendations are presented inour sister publications, US Fixed Income Weekly, GlobalFixed Income Markets Weekly, Emerging MarketsOutlook and Strategy, and EM Top Trade Ideas.

its deficit forecast to 5.8%, with the previous 4.4% targetunrealistic against the backdrop of economic contractionand a big deficit miss last year, highlights that the region’sstructural problems will take a long time to resolve. But forthe near term, the balm of LTRO-fuelled domestic bankdemand should support the periphery, biasing intra-EMUspreads tighter.

22


Global Asset AllocationJ.P. Morgan Securities Ltd.Seamus Mac GorainAC (44-20) [email protected]

Indeed, after taking roughly a net €114bn of borrowingfrom the first LTRO, Spanish and Italian banks boughtclose to €70bn of domestic government debt inDecember and January alone. We think that Spanish andItalian banks also accounted for around half the net newborrowing in the second LTRO (i.e. a net €80bn each). Thesolid foreign demand for peripheral bank debt issuance thisyear also testifies to the thawing in financing conditions(Chart 3).

Even at this late stage, the Greek PSI remains uncertain. Weexpect participation to be high enough to push through thePSI, but low enough that collective action clauses areinvoked to apply the restructuring to holdouts (see PavanWadhwa, Handicapping potential outcomes of the Greekdebt restructuring, 6 Mar).

• Small duration short in DM (), select longs in EMlocal bonds (South Africa, Poland) ()As discussed above, we have a mildly bearish outlook onDM duration.

EM local bonds have backed up a little from near-recordlow yields, thus underperforming DM over the pastmonth (Chart 4). Foreign inflows into EM bonds havepicked up this year, after a lull in late 2011, but areheavily tilted towards hard currency rather than localcurrency bonds (Chart 5). The thrust of monetary policyremains supportive, though higher EM currencies and oilprices reduce the room to ease at the margin. We stayselectively long in EM local markets (and thus also OWvs DM). Focus longs on Poland (on falling credit andinflation risk premia) and South Africa (on recent relativeunderperformance, and a supportive budget). See MikeTrounce, EMEA EM :Local Market Strategy, 5 March,for details.

• Position for a steeper AUD money market curve ()AUD short rates have been rising over the past month,since the RBA surprised the market by not easing. Welook for the money market curve to continue to disinvert,with the RBA requiring a material softening in theoutlook to ease further, and thus likely to remain onhold for the rest of the year, despite this week’ssurprisingly weak GDP print. See Sally Auld, TheAntipodean Strategist, for details.

• OW Euro area peripheral via 3yr Spain CDS ()We are biased to a further narrowing of credit andliquidity premia in the Euro area, though the verystrong rally in recent months has diminished the upsidesignificantly. We recommend selling protection on Spain(with CDS spreads having lagged the narrowing in cash),

Chart 3: Foreign buying of peripheral bank debtPer cent of book taken by foreign buyers for a range of 2012 issues, bonds ordered left toright by pricing date

Source: Bloomberg, J.P.Morgan

Chart 5: Monthly flows into EM bond funds$bn. See Trang Nguyen and Laura Bierer, EM fixed income flows weekly, for details

Source: EPFR, J.P.Morgan

0%

20%

40%

60%

80%

100%

Santander

Intesa

Sabadell

BB

VA

Caixa

Intesa

MP

S

Unicredit

BP

E

Chart 4: EM and DM government yieldsPer cent

Source: J.P.Morgan

6

6.5

7

7.5

Jan-10 Jul-10 Jan-11 Jul-11 Jan-12

1.75

2.25

2.75

3.25

EM local bonds (LHS)DM government bonds

(RHS)

-6

-4

-2

0

2

4

6

8

08 09 10 11 12

Local currency

Hard currency

23


Global Asset AllocationJ.P. Morgan Securities Ltd.Seamus Mac GorainAC (44-20) [email protected]

and also expect two-year swap spreads to narrow,reflecting the unprecedented excess liquidity in themoney market.

• Long UK 5yr inflation breakevens ()We are broadly positive on breakevens, consistent with abullish view on risk, and bearish view on duration, butalso because of the tail risk of an oil price spike, asMiddle East tensions remain high. Hold longs in UK 5yrbreakevens, whose valuation looks attractive against ourinflation forecast.

• Long duration in 10yr EUR and USD swaps vs shortin 10yr CHF and AUD swaps, on combined carry andreversal signals ()Range-trading markets highlight the importance of cross-market strategies in generating market-neutral returns.One such strategy which has been consistently profitable(including over the past year) is cross-market carry:overweighting markets with steep curves against thosewith flat curves (see Nikolaos Panigirtzoglou, A cross-market bond carry strategy, March 2006).

Another consistent pattern in cross-market bond returns isthat markets which have underperformed recentlytend to outperform subsequently, as some cross-marketdivergences reflect temporary factors such as issuance,positioning, or short-lived economic divergences.

One way to take advantage of this pattern is tooverweight markets whose curves have steepened mostover the recent past, against those whose curves haveflattened most. That avoids positioning for meanreversion when large moves in long-term yields arematched by similar movements in short-term yields,suggesting that monetary policy fundementals are behindthe move, and so that it is more likely to persist. (That isless so, however, when movements in short rates are verylimited, as in the G-4 at present).

Combining the carry and reversal signals wouldhistorically have produced a risk to return of 1.2, net oftransactions costs, across 10-year DM swaps (Chart 6). Atpresent, the combined signal argues for duration longs inEUR and USD vs shorts in AUD and CHF.

Chart 6: Cumulative return of reversal and carry strategiesIndex, 1995 = 100

Source: J.P. Morgan

0

100

200

300

400

500

600

95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11

Combined

Reversal

Carry

24


Credit Strategy

• We lower our allocation to outright longs, US HY,US HG and EMBIG, and take more risk on lessdirectional trades that look to exploit relative valueon either a carry-to-risk, or price convergence, basis.

• We add a rule based, co-integration strategy fortrading EU HY vs. US HY via CDS. The strategycurrently suggests to be long risk iTraxx XO vs.CDX.HY.

• We overweight EU HY corporate bonds vs. EM $Sovereigns on more attractive carry-to-risk. EU HYcredit offers twice the expected income for a lowervolatility of realized returns.

• We open a long position in CDX.HY vs. LCDX aswe believe the recent overperformance of LCDXis overdone.

Spreads continued to move tighter through February and agrab for yield has clearly taken place across fixed incomeand credit markets. Similar to January, the risk-on mood hasbenefited the higher beta sectors in credit: European HY,EM $ Sovereigns and US HY did particularly well (Chart 1).

The major driving force has of course been a dramatic reduc-tion in perceptions about systemic/tail risk via the LTROswhich has given investors both the confidence, and need, toadjust their holdings towards these higher yielding assets.

Our move from a medium-beta risk profile in January to afull risk-on (high-beta) stance last month saw good gains inthe credit portfolio. We remain bullish as the aforementionedcredit-supportive forces are still firmly in place, but chooseto scale back the amount of risk in our outright directionaltrades, and add some relative value overlays, given that asignificant spread compression has already taken place.These new trades are based on relative price convergenceand relative carry-to-risk.

Relative price convergence: we add Euro HY vs. US HYin CDS based on the results of a statistically motivatedco-integration trading rule. We also add US HY vs.US HY Loans in CDS, where we look for the recentunderperformance of CDX.HY vs LCDFX to correct.

Relative carry-to-risk: Euro HY vs. EM $ Sovereigns, assuggested by our carry-to-risk metric (Chart 2). Carry-to-riskgives a measure of the expected return per unit of realizedrisk for a sector and thus highlights the most attractivesectors for income.

Global Asset AllocationJ.P. Morgan Securities Ltd.Leo EvansAC (44-20) [email protected]

Source: J.P. Morgan, Bloomberg, Markit

Chart 1: February’s Total ReturnsThe black bars are February’s returns, the dark blue bars are January’s returnsand light blue bars are the historical average return for February.

%

0

1

2

3

4

5

6

7

EU High

Yield

EM $ Sov. US High

Yield

EM $ Corp. EU High

Grade

US High

Grade

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

Mar-02 Sep-04 Mar-07 Sep-09 Mar-12

Source: J.P. Morgan, Bloomberg

Chart 3: Future US HY upgrades likely to outnumber downgradesMoody’s + S&P’s downgrade watchlist additions / Moody’s + S&P’s upgradewatchlist additions. Data is quarterly.

0.00

0.25

0.50

0.75

1.00

1.25

EU HY US HG US HY EM $ Corp. EU HG EM $ Sov.


Chart 2: Carry-to-Risk in CreditSpread - expected credit loss / 12-month vol. of excess returns. Credit losses aredefined as S&P’s rating transition probability, from the average rating of the index

to default, multiplied by 1 - 40% recovery. Excess returns are defined relative to

similar duration governement bonds.

25


Global Asset AllocationJ.P. Morgan Securities Ltd.Leo EvansAC (44-20) [email protected]

Directional Trades

• Overweight in US HY vs. USTs ()

50 basis points of tightening through February meantsolid gains for this trade, and HY demand remains animportant theme in risk markets on the back of threemonths of inflows. Going forward, the key metrics wetrack 1) trailing default rates (1.9%) 2) corporate creditmetrics and 3) watchlist ratios (a measure of future ratingactions) are all looking healthy. The latter measure ispushing towards the decade-long lows recorded in 1Q11(Chart 3). US HY is also one of the more attractivesectors on a carry-to-risk basis (Chart 2) and we stayoverweight.

• Overweight in EMBIG vs. USTs ()

As we suggested last month, EM $ Sovereigns had beenlagging the credit rally due to heavy issuance in January,but the asset class made up ground through February aswe anticipated (Chart 1). The pace of the rally in EMassets has waned this week, but we believe a bullishstance is still warranted. Policy support remains accom-modative and technicals have been improving. EM bondfunds have seen €9.9bn of inflows YTD, 86% of whichhave been to hard currency funds.

• Overweight in US HG vs. USTs ()

HG spreads fell 20bp in February despite heavy supply of$90bn, testament to the strong demand for the asset class.Credit fundamentals remain solid, although some deterio-ration occurred to revenue growth in 4Q11. Importantlythough, interest expense is stable as companies arereplacing higher coupon debt with newly issued lowercoupons and we look for spreads to tighten towards our175bp spread target.

• Sell protection on iTraxx Senior Financials ()

The positive impact of term liquidity provided via LTROII keeps us OW Senior Financials, as Euro banks havelikely used ECB funds to retire some of their existingliabilities, a bullish force for senior debt.

Sector Trades

• Open long risk in iTraxx XO vs. CDX.HY on relative

price convergence ()Historically EU vs. US HY has exhibited a negative betato credit markets as US HY was the more volatile market.This trend reversed in 2011 as concerns about Europedrove risky asset prices down, and European HY creditdown more so. The subsequent risk-on mood has seenEuro HY significantly outperform YTD. Given that theseassets have historically exhibited strong co-integration inthe CDS space, deviations from a historical relationship

Chart 4: Rule based strategy suggests long EU vs US HY via CDSThe blue lines are the one-standard-deviation confidence interval on the level of theiTraxx XO based on CDX.HY. The strategy goes long iTraxx XO vs. CDX.HY if the

iTraxx spread is greater than the model implied spread and short if it is below it.

Bp


100

300

500

700

900

1100

1300

Aug-06 Feb-08 Aug-09 Feb-11

CDX.HY Implied Spread iTraxx XO Spread

are likely short-lived and profitable to bet against. We testa monthly strategy that uses rolling 2-year regressions togive a one standard-deviation confidence band for thelevel of iTraxx XO based on the level of the CDX.HY.The strategy goes long (short) if iTraxx XO is above(below) the bands and holds the position until it falls backwithin them (Chart 4). Since 2003, the strategy has traded10 times, held a position for an average of 2 months,given a mean holding period return of 1.5%, a successratio of 67% and an information ratio of 0.8. The signalcurrently suggests long risk in iTraxx XO vs. CDX.HY

• Open: Long risk CDX.HY vs. LCDX (2:1 ratio) on

relative price convergence ()CDX.HY has underperformed LCDX recently, withCDX.HY trading about 46bp wider, and LCDX 19bptighter, since Feb 23. The usual trading relationship is 1bpto 0.7bp, suggesting LCDX is about 35bp too tight. Thistrade is positive on both carry and slide, and benefits inthe case of default of a reference entity in the LCDX thatis not in the CDX.HY.

• Open Overweight EU HY corporate bonds vs. EMBIG

on relative carry-to-risk ()On a carry-to-risk basis, EU HY (including financials) isthe most attractive sector and EM $ sovereigns is the leastattractive. EU HY offers twice the expected income (7.2%vs. 3.4%) for a lower volatility of realized returns (6.6%vs. 8.9%). On a volatility-weighted basis, this trade ispositive carry.

26



Equity Strategy

• Both the macro and the position support have faded.We keep a positive stance, but we hedge via longs inequity volatility.

• Our PMI signal, i.e. the 2-month change in theGlobal Manufacturing PMI overall index, is stillpointing to an overweight in Cyclical vs. Defensivesectors.

• We continue to like the longer theme of OW highdividend yield stocks. The search for yield shouldallow higher-yielding stocks to outperform. In theUS, OW S&P US preferred stock vs. S&P500 index.In Europe, OW the J.P. Morgan EuropeanSustainable Yield Basket vs. STOXX Europe 600.

• As hedges, we introduce an OW in the Energy sectorvia the Alerian MLP index and a long in equityvolatility via J.P. Morgan’s Macro Hedge Index.

The equity rally continues. The S&P500 hit a new post-crisis high of 1374 last week. The macro support hassomewhat faded due to negative surprises in USeconomic data. Indeed, our US Economic Activity SurpriseIndex is negative. But globally, the macro picture is betterand our PMI signal, i.e. the 2-month change in the GlobalManufacturing PMI overall index, is still pointing to anoverweight in Cyclical vs. Defensive sectors (seeREVISITING: Using the Global PMI as trading signal, N.Panigirtzoglou, Jan 12).

The position factor is also fading. Most positionindicators suggest that investors’ equity exposurescontinued to rise and perhaps around 50%-75% of theposition retrenchment seen between April and Septemberlast year has been reversed so far (Charts 1 and 2).

The rise in oil prices has started raising concerns, though,as investors remember the negative impact that the spike inoil prices had on the real economy a year ago. The 15%rise in oil prices over the past few months is not yetcomparable to the more than 50% rise seen between Sep2010 and Mar 2011, but an escalation of Iran tensions is aserious risk worth hedging.

So while we keep most of our trades and a bullish bias inour portfolio, to protect our portfolio for example fromhigher oil prices or potential re-escalation of the Euro debtcrisis, we introduce two hedges:

Chart 1: Macro HF beta to equities21-day rolling beta of HFRX Macro HF beta index vs. S&P500

Source: Datastream, J.P. Morgan

Chart 2: CFTC spec position indicatorNet spec position is USD amount of long positions minus short positions across a

range of futures contracts; including commodities, equities, bonds and currencies. The

net positions are aggregated and scaled by open interest. The chart shows this scaleddifference between net positions in risky minus safe haven assets.


-0.4

-0.2

0.0

0.2

0.4

0.6

0.8

Jan-10 Jun-10 Nov-10 Apr-11 Sep-11 Feb-12

Macro HF: beta to S&P500

-0.2

-0.1

0.0

0.1

0.2

0.3

0.4

0.5

Jun-06 Mar-07 Dec-07 Sep-08 Jun-09 Mar-10 Dec-10 Sep-11

1) Overweight Energy () The Energy sector has provideda good hedge to last year’s spike in oil prices. In oursectoral recommendations, we prefer to combine Energysector exposure with high dividends via the Alerian MLPEnergy Index. This index tracks the performance of the 50most prominent Energy Master Limited Partnerships. LikeREITs, these companies enjoy tax advantages and typicallydistribute most of their earnings as dividends. As a result theAlerian MLP Index offers a dividend yield of 5%.

2) Longs in equity volatility () The problem with simplelong VIX strategies is that they have a negative carry whichover time becomes problematic. A way to avoid this

27



negative carry is to hedge via the J.P. Morgan Macro HedgeIndex (JPMZMHUS Index). This index picks up premiumthrough its short exposure to the 1st month along the VIXfutures curve, yet allows for tail risk protection through itslong position in the 2nd month. It takes off the short legopportunistically and systematically.

DIRECTIONAL TRADES

• Keep long in MSCI AC World ()See discussion in the cross asset section.

• Keep long in US Convertible Bonds ()Convertible bonds posted another gain in February. Westay long as US Convertible bonds are still at the bottomof the 2-year range vs. the S&P500. Convertible bondsare hybrid instruments with debt and equity-like features.As an asset class they benefit from both the rally inequities and credit. But their low beta to equities meansthat they are more suited for investors who have no strongdirectional view on equities or appetite to take pure equityrisk, and instead look at investing in bond-like equities,i.e. midway between equities and bonds.

REGIONAL ALLOCATION

• OW DAX vs. Eurostoxx50 () This trade continued to print money with DAX

outperforming Eurostoxx50 by more than 6% YTD. Thelifting of the short sale ban in bank stocks in France, Italy,Spain and Belgium is helping this trade not only bymaking it easier to implement directly, but also byremoving the incentive to use the DAX as a sellingvehicle during periods of stress. The main reason itunderperformed by so much last August was the introduc-tion of the short sale ban which forced sellers to use theDAX to express a negative view on Euro areaequities.The escalation of the euro debt crisis remains aserious risk for 2012, reminding us of the importance ofhaving peripheral hedges in an equity portfolio.Overweighting DAX vs. Eurostoxx50 is such a hedge.

Although this trade works well as a hedge against Europeripheral risk, the main motivation for this trade is thegrowth outperformance of Germany vs. the rest of theEuro area. This theme is still in place as healthier balancesheets (both private and public) in Germany allow thecountry to escape the painful adjustments that other Euroarea countries have to make. German exports are cush-ioned by their large exposure to EM, even if a recessionmaterialises.

• OW in MSCI EM$ vs MSCI World$ ()Investors are returning to EM equities as shown by


Chart 3: MSCI BRICs vs. MSCI EMRelative total return index based on MSCI $ indices


Chart 4: MSCI World Cyclicals vs. non-CyclicalsRelative total return index based on MSCI World$ sector indices.

80

85

90

95

100

105

Dec-07 Oct-08 Aug-09 Jun-10 Apr-11 Feb-12

MSCI BRIC vs. MSCI EM total return index

35

40

45

50

55

60

65

98 00 02 04 06 08 10 12

70

90

110

130

150Global PMI

Global Cyclicals vs.

NonCyclicals

inflows into EM equity fund flows in January/February vs.outflows in December and November. YTD EM equity fundshave seen inflows of $21bn vs. outflows of $34bn in 2011.Positive flow momentum, coupled with still positive 2-month return momentum, keeps us with an OW in MSCI EMvs. MSCI World.

• OW in MSCI BRICs$ vs MSCI EM$ ()The shift in EM policy priorities from inflation to growth ismore pronounced in BRICs, including China. BRICs havebeen underperforming steadily since the end of 2009, mostlydue to overheating and tightening fears. These fears aregradually fading creating a support for BRICs (Chart 3).

• OW S&P500 vs. MSCI AC World currency hedged ()US equities were the clear winners among regions in 2011,outperforming MSCI AC World by almost 9% in local

28


currency terms. As we explained before, this was drivenby economic and earnings growth outperformance in theUS. This year the S&P500 is up by 6.8%, only marginallybelow the MSCI AC World local index (+7.2). So most ofthe underformance in US equities YTD in commoncurrency terms is currency driven, i.e. stems from thedecline in the dollar.

While the higher beta of Euro area and EM equitiesmakes this trade unattractive in a bullish environment, webelieve that the risk return/tradeoff is still better for USequities. The Euro debt crisis will likely linger, creatingmore downside for European economies and equities.

We also believe this trade is a good hedge to a potentialmarket disruption from a re-escalation of the eurodebt crisis.

SECTORAL ALLOCATION• Keep OW in Cyclical versus Defensive sectors ()

The latest reading in the global manufacturing PMI pointsto a positive stance in Cyclical vs Defensive sectors (seeREVISITING: Using the Global PMI as trading signal,N. Panigirtzoglou, Jan 12). The 2-month change in theglobal manufacturing PMI is the signal we follow to tradeCyclical vs Defensive equity sectors. As Chart 4 showsCyclicals have recaptured half of the retrenchment thatoccurred between March and November last year. Sothere is room for further outperformance.

• OW High DY stocks. In the US, OW S&P USpreferred stock vs. S&P500 index. In Europe, OW theJ.P. Morgan European Sustainable Yield Basket vs.STOXX Europe 600 ()We continue to like the longer theme of OW highdividend yield stocks. Such stocks greatly outperformedlast year, but they are lagging this year as equitymanagers have moved into higher-beta growth stocks thatpay little in dividends. With our bullish view on equitiesnot based on economic growth and instead on assetreflation and the search for yield, we think that investorsthis year will again focus on yield and should thus permithigher-yielding stocks to outperform.

US Preferred stocks offer much higher income, 6.9% vs2.2% for the S&P500. The outperformance of USpreferred stocks over the past month suggests this tradecan also perform in a bullish environment.


Our colleagues in European Quant Strategy (D. Silvestriniand M. Dion) are recommending a basket of high andsustainable dividend yield stocks, i.e. stocks with highDY, modest and stable payout ratios, and debt/equityratios under 100%. The J.P. Morgan EuropeanSustainable Yield Basket (JPDEUSYB <Index>)contains European stocks with sustainable dividendsaccording to the above filters and an average forecastyield of 4.7%.

• Combining positions with momentum to trade USequity sectors. Be long in Utilities, Discretionary vs.Financials and Staples ()

We introduced in Flows & Liquidity Apr 15 a US equitysector trading model based on a combination of sectorshort interest, a contrarian indicator, and 11-month returnmomentum. The short interest strategy OWs the sectorwith the highest short interest, and UWs the sector withthe lowest short interest. This means being longDiscretionary vs. Staples. A momentum strategy on USequity sectors, which OW the sector with the highestreturn and UW the sector with the lowest return overthe past 11 months, is currently long Utilities andshort Financials.

29



Commodity Strategy

• Oil led commodities higher in February as supplyissues combined with low inventories and OPEC sparecapacity were exacerbated by the risk of a conflictbetween Israel and Iran.

• Oil prices should come down seasonally with thearrival of spring.

• Open a long Dec-12 WTI vs. Dec-12 Brent trade asthe spread should narrow to $4/bbl by year end from$11/bbl currently.

• We remain bullish gold on further buying by EMcentral banks and EM retail as well as still positive12-month price momentum.

• Agriculture prices should fall through the year helpingsupport pro-growth policies in EM but there areupside risks to prices in Q3.

Commodities rallied 6.5% in February led higher by oilwhich was up over 8%. Recent strength in the oil marketreflects four things: low inventories, low OPEC sparecapacity, supply problems across a range of producercountries and stronger than expected demand due to a coldsnap across Europe and Asia. This was then exacerbated byan increase in geopolitical risk from Israel and Iran.

Looking forward, we expect oil demand to declineseasonally with the arrival of spring, which should pullprices lower before they rebound along with the globaleconomy in Q2. Production issues in the North Sea havenow subsided but outages remain in Yemen, Syria, Sudan,China and Canada. This lost supply makes up around 1% oftotal world oil production. However, warmer weather hascaused demand for oil products to start to wane, hurtingrefinery margins and even causing some credit-constrainedrefiners to temporarily reduce production, which hasweakened crude oil demand further.

The potential for a strike by Israel on Iran is a risk worthwatching. We are not military or diplomatic experts and thuswe make no attempt to forecast when or how such an eventmay occur. Instead, we focus on the likely impact oncommodity prices. Table 1 shows the performance of arange of major commodities during past oil supply shocks.Apart from oil, gold has been the best performingcommodity having posted a positive return in each of the sixsupply shocks. Agriculture has produced a positive returnon average but less consistently than gold. And base metals,unsurprisingly given their link to global economic growth,have performed the worst historically.

J.P. Morgan Securities Ltd.Matthew LehmannAC (44-20) [email protected]

J.P. Morgan Chase Bank, NAColin P. Fenton (1-212) [email protected]

Chart 1: S&P GSCI 2011 total returns and forecasts for 2012% total return.


Chart 2: OECD crude oil inventories

Oil shock Oil Gold Agriculture Base metals

Arab-Israeli War/OPEC embargo 279% 50% 11% N/A

Iranian revolution 105% 119% 25% 23%

Iran-Iraq War 78% 29% 22% -19%

First Gulf War 88% 5% -3% -10%

Second Gulf War 36% 10% -6% 3%

Arab Spring 24% 15% 4% -4%

Median 83% 22% 7% -4%

950

970

990

1,010

1,030

1,050

1,070

1,090

1,110

Jan-05 Jul-06 Jan-08 Jul-09 Jan-11

Mn bbl

Source: J.P. Morgan commodities research

Table 1: Commodities during oil shocksSpot price change during trough-to-peak oil price rises during oil supply shocks. Until

1983 oil prices are Arabian gulf Arab light crude spot prices. After 1983 oil prices areWTI spot prices.


-5% 0% 5% 10% 15%

GSCI Agriculture

GSCI Ind. Mtls

GSCI Livestock

GSCI Prec. Mtls.

GSCI

GSCI Energy

YTD total return

12 month forecast

For investors who do wish to hedge a serious supplydisruption from Iran, we believe owning out-of-the-moneycalls on Brent would be the most effective trade. In such ascenario, prices would likely only briefly peak somewherebetween $160/bbl and $180/bbl before a significant policyresponse would bring prices back down sharply (see

30


Global Asset AllocationJ.P. Morgan Securities Ltd.Matthew LehmannAC (44-20) [email protected]

J.P. Morgan Chase Bank, NAColin P. Fenton (1-212) [email protected]

Commodity Memento, Feb 23, Colin Fenton). This meansthat an option position, which would also benefit from thelikely spike in volatility, would be a more efficient hedgethan a pure long via futures.

As we have discussed previously (see J.P.Morgan View,18 Nov, 2011), a pipeline between the US Midwest,where WTI is priced, and the US Gulf Coast should bereversed later this year. This is significant because it willhelp to alleviate the bottleneck that had built up at the WTIpricing point, which had depressed WTI relative to worldoil prices (i.e. Brent).

In November, the announcement itself resulted in thespread between Brent and WTI prices narrowing toaround $8/bbl from the peak of $27/bbl previously. It hassince widened to around $17/bbl currently as the timing ofthe pipeline reversal as been pushed out to Q3 from Q2.There is also concern that increased supply from Canadaand the US midwest may end up being too much for thepipeline to handle, leading to further inventory buildingat Cushing.

We think this is unlikely and expect the spread to narrow toonly $4/bbl by the end of the year. We thus open a longDec-12 WTI vs Dec-12 Brent trade in futures. The spreadbetween the two December contracts is currently $11/bbl,implying an almost three-fold gain over the next ninemonths. This trade also has a low correlation to risky assetsas its drivers are independent of the drivers of risk premia inequities, credit and other commodities.

Gold has fallen almost 4% since the end of Januaryalthough most of this came following Fed chairman BenBernanke’s testimony to congress. The Fed chairman gaveno indication of any further QE in the US given the state ofthe economy is not currently bad enough to warrant it.

We remain bullish gold. With the second LTRO, the ECBhas joined the other G4 central banks in a notable expansionof its balance sheet. This action revives the potential forinflation further down the road and should support demandfor the yellow metal. In China, the government is makingefforts to improve access to the gold market throughout thecountry. EM central banks, who have relatively small goldreserves compared to their DM counterparts, also appearlikely to increase their holdings. We expect average pricesto reach $1925/oz by the end of 2012.

Another reason to stay long gold is momentum. A simplemonthly strategy that goes long gold when the 12-monthprice momentum is positive and short gold when it isnegative has produced an annualised excess return of 10%since 1971 with a success rate of 59% (Chart 3). This

Chart 3: Gold price momentum trading ruleA strategy that goes long gold when the 12-month price return is positive and shortwhen it is negative.


0

1000

2000

3000

4000

5000

6000

71 73 75 77 79 81 83 85 87 89 91 93 95 97 99 01 03 05 07 09 11

Excess return index

12-month momentum strategyPassive long

gold

Strategy Passive

RTN: 10% 3%

VOL: 20% 20%

IR: 0.5 0.17

Success rate: 59% 49%

compares to simply being long gold which produced anannualised 3% return and a success rate of 49%. Bothstrategies have 20% annualised volatility over the period.This echoes the work of Ribeiro et al. in Momentum inCommodities, Sep 06, who found that 12-month momentumis a profitable signal for trading commodities. Currently thegold strategy suggests a long position in gold as the12-month price momentum is still positive.

Agriculture was slightly up in February but has essentiallybeen in a range so far this year and remains some 20%down from its Q1 2011 peak. This is positive for the globaleconomy through lower inflation, especially in emergingmarkets as it allows policy makers there to make the shiftfrom fighting inflation to supporting growth. Ouragriculture outlook for this year is relatively benign and weexpect the sector to finish the year lower than it started. Wedo believe there is some upside risk to prices in Q3 ascurrent USDA corn yield forecasts appear somewhatoptimistic compared to estimates by our commodityresearch team.

High protein wheat is also vulnerable to a price spikegiven increased Chinese demand. Bread is becoming morepopular in China as the population becomes wealthierleading to higher imports of the higher protein wheatneeded to make bread. The Chinese government hasincentivised the planting of higher protein varieties of wheatbut not necessarily the higher quality varieties. Thus, afurther increase in consumption would necessitate imports(see Agriculture Weekly, Jonah Waxman, 2 Mar 2012).

Allocations

• Long Dec-12 WTI vs. Dec-12 Brent ()See discussion above.

• Long Gold ()See discussion above.

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Analyst certification: The research analyst(s) denoted by an “AC” on the cover of this report certifies (or, where multiple research analysts are primarilyresponsible for this report, the research analyst denoted by an “AC” on the cover or within the document individually certifies, with respect to each security orissuer that the research analyst covers in this research) that: (1) all of the views expressed in this report accurately reflect his or her personal views about any andall of the subject securities or issuers; and (2) no part of any of the research analyst’s compensation was, is, or will be directly or indirectly related to the specificrecommendations or views expressed by the research analyst(s) in this report.

Explanation of Ratings: Ratings System: J.P. Morgan uses the following sector/issuer portfolio weightings: Overweight (over the next three months, therecommended risk position is expected to outperform the relevant index, sector, or benchmark), Neutral (over the next three months, the recommended riskposition is expected to perform in line with the relevant index, sector, or benchmark), and Underweight (over the next three months, the recommended riskposition is expected to underperform the relevant index, sector, or benchmark). J.P. Morgan’s Emerging Market research uses a rating of Marketweight, whichis equivalent to a Neutral rating. Valuation & Methodology: In J.P. Morgan’s credit research, we assign a rating to each issuer (Overweight, Underweight orNeutral) based on our credit view of the issuer and the relative value of its securities, taking into account the ratings assigned to the issuer by credit ratingagencies and the market prices for the issuer’s securities. Our credit view of an issuer is based upon our opinion as to whether the issuer will be able service itsdebt obligations when they become due and payable. We assess this by analyzing, among other things, the issuer’s credit position using standard credit ratiossuch as cash flow to debt and fixed charge coverage (including and excluding capital investment). We also analyze the issuer’s ability to generate cash flow byreviewing standard operational measures for comparable companies in the sector, such as revenue and earnings growth rates, margins, and the composition of theissuer’s balance sheet relative to the operational leverage in its business. Analysts’ Compensation: The research analysts responsible for the preparation of thisreport receive compensation based upon various factors, including the quality and accuracy of research, client feedback, competitive factors and overall firmrevenues. The firm’s overall revenues include revenues from its investment banking and fixed income business units. MSCI: The MSCI sourced information isthe exclusive property of Morgan Stanley Capital International Inc. (MSCI). Without prior written permission of MSCI, this information and any other MSCIintellectual property may not be reproduced, redisseminated or used to create any financial products, including any indices. This information is provided on an'as is' basis. The user assumes the entire risk of any use made of this information. MSCI, its affiliates and any third party involved in, or related to, computing orcompiling the information hereby expressly disclaim all warranties of originality, accuracy, completeness, merchantability or fitness for a particular purposewith respect to any of this information. Without limiting any of the foregoing, in no event shall MSCI, any of its affiliates or any third party involved in, or relatedto, computing or compiling the information have any liability for any damages of any kind. MSCI, Morgan Stanley Capital International and the MSCI indexesare services marks of MSCI and its affiliates.

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J.P. Morgan Chase Bank NAJan LoeysAC (1-212) [email protected]


ownership disclosure as of the previous month end satisfies the requirements under Paragraph 16.5(a) of the Hong Kong Code of Conduct for PersonsLicensed by or Registered with the Securities and Futures Commission. (For research published within the first ten days of the month, the disclosure may bebased on the month end data from two months' prior.) J.P. Morgan Broking (Hong Kong) Limited is the liquidity provider/market maker for derivativewarrants, callable bull bear contracts and stock options listed on the Stock Exchange of Hong Kong Limited. An updated list can be found on HKEx website:http://www.hkex.com.hk. Japan: There is a risk that a loss may occur due to a change in the price of the shares in the case of share trading, and that a lossmay occur due to the exchange rate in the case of foreign share trading. In the case of share trading, JPMorgan Securities Japan Co., Ltd., will be receivinga brokerage fee and consumption tax (shouhizei) calculated by multiplying the executed price by the commission rate which was individually agreedbetween JPMorgan Securities Japan Co., Ltd., and the customer in advance. Financial Instruments Firms: JPMorgan Securities Japan Co., Ltd., Kanto LocalFinance Bureau (kinsho) No. 82 Participating Association / Japan Securities Dealers Association, The Financial Futures Association of Japan, Type IIFinancial Instruments Firms Association and Japan Securities Investment Advisers Association. Korea: This report may have been edited or contributed tofrom time to time by affiliates of J.P. Morgan Securities (Far East) Ltd, Seoul Branch. Singapore: JPMSS and/or its affiliates may have a holding in any ofthe securities discussed in this report; for securities where the holding is 1% or greater, the specific holding is disclosed in the Important Disclosures sectionabove. India: For private circulation only, not for sale. Pakistan: For private circulation only, not for sale. New Zealand: This material is issued anddistributed by JPMSAL in New Zealand only to persons whose principal business is the investment of money or who, in the course of and for the purposesof their business, habitually invest money. JPMSAL does not issue or distribute this material to members of “the public” as determined in accordance withsection 3 of the Securities Act 1978. The recipient of this material must not distribute it to any third party or outside New Zealand without the prior writtenconsent of JPMSAL. Canada: The information contained herein is not, and under no circumstances is to be construed as, a prospectus, an advertisement,a public offering, an offer to sell securities described herein, or solicitation of an offer to buy securities described herein, in Canada or any province orterritory thereof. Any offer or sale of the securities described herein in Canada will be made only under an exemption from the requirements to file aprospectus with the relevant Canadian securities regulators and only by a dealer properly registered under applicable securities laws or, alternatively,pursuant to an exemption from the dealer registration requirement in the relevant province or territory of Canada in which such offer or sale is made. Theinformation contained herein is under no circumstances to be construed as investment advice in any province or territory of Canada and is not tailored to theneeds of the recipient. To the extent that the information contained herein references securities of an issuer incorporated, formed or created under the lawsof Canada or a province or territory of Canada, any trades in such securities must be conducted through a dealer registered in Canada. No securitiescommission or similar regulatory authority in Canada has reviewed or in any way passed judgment upon these materials, the information contained herein orthe merits of the securities described herein, and any representation to the contrary is an offence. Dubai: This report has been issued to persons regarded asprofessional clients as defined under the DFSA rules.

General: Additional information is available upon request. Information has been obtained from sources believed to be reliable but JPMorgan Chase & Co.or its affiliates and/or subsidiaries (collectively J.P. Morgan) do not warrant its completeness or accuracy except with respect to any disclosures relative toJPMS and/or its affiliates and the analyst’s involvement with the issuer that is the subject of the research. All pricing is as of the close of market for thesecurities discussed, unless otherwise stated. Opinions and estimates constitute our judgment as of the date of this material and are subject to change withoutnotice. Past performance is not indicative of future results. This material is not intended as an offer or solicitation for the purchase or sale of any financialinstrument. The opinions and recommendations herein do not take into account individual client circumstances, objectives, or needs and are not intended asrecommendations of particular securities, financial instruments or strategies to particular clients. The recipient of this report must make its own independentdecisions regarding any securities or financial instruments mentioned herein. JPMS distributes in the U.S. research published by non-U.S. affiliates andaccepts responsibility for its contents. Periodic updates may be provided on companies/industries based on company specific developments or announcements,market conditions or any other publicly available information. Clients should contact analysts and execute transactions through a J.P. Morgan subsidiary oraffiliate in their home jurisdiction unless governing law permits otherwise.

“Other Disclosures” last revised January 6, 2012.

Copyright 2012 JPMorgan Chase & Co. All rights reserved. This report or any portion hereof may not be reprinted, sold or redistributed without thewritten consent of J.P. Morgan.

85129169 Jp Morgan Global Markets Outlook and Strategy

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