Navigator Analysis of current issues in markets and investing

NavigatorAnalysis of current issues in markets and investingwww.jpmorganassetmanagement.com/insight

For professional advisers only – not for onward distribution

2

Contents

Economics

Growth

Employment

Trade

Debt

Money supply / Deflation

Asset Classes

Multi-Asset

Equity

Fixed Income

Currencies

Commodities

3

Economics

44

ECB intervention is helping to keep yields down but is not a long-term solution

Bailouts only postpone inevitable reckoning; explains why Greece yields remain so high

ECB hoped to offload Irish bank risk by forcing bailout; instead they’ve been obliged to increase market support

Spanish risk seems to have moderated, at least for the moment

Recent auctions went off well, but doesn’t really change outlook

Note: Ten year bonds. Latest data 21 January 2011. Source: Bloomberg, J.P. Morgan.

Ever present anxietyGovernment 10-year bond spreads over German bunds

0

200

400

600

800

1,000

Dec 08 Dec 09 Dec 10

Greece

Ireland

Portugal

Spain

bps

Greek bailout /EFSF →

Stress←tests

←Irishbailout

55

What’s unusual is not the spreads now but the spreads of five years ago

Governments like Greece and Spain should never have been lent money at the same rate as Germany

Adjustments in markets now are simply a reappraisal of country risk

Country budget forecasts likely do not reflect this new reality

Unless there are eurozone bonds, individual countries will pay differing interest rates in the future

Latest data 21 January 2011. Source: Bloomberg, J.P. Morgan.

Just like old timesGovernment 10-year bond spreads over German bunds

0

200

400

600

800

1,000

1992 1996 2000 2004 2008

Spain

Portugal

Greece

Ireland

bps← Euro launch

66

Bailouts involve more than just cross-border exposure

Exposure of eurozone countries to Greece, Ireland, Portugal and Spain is roughly €1 trillion

But the banking sectors are several times larger than their economies — about three times on average

So a rescue sufficient to restore banking sector health would be even larger

Latest data June 2010. Source: ECB, BIS, J.P. Morgan.

Big banks

0

10

20

30

40

Greece Ireland Portugal Spain

Country GDP / Eurozone GDP

Banking Sector Assets / Eurozone GDP

%

77

QE and eurozone crisis battling each other to affect relative value of currencies

On balance, euro not weakening further against its trading partners because of crisis

Dollar likely to suffer longer term as inflation expectations rise and money flows to emerging markets

Euro is currently trading at its long-run average

Devaluation has been 16% in just two years

– Previous major decline of 29% took place over five years from Dec-79 to Mar-85

– Still time for improved competitiveness to feed through to eurozone exports

Note: Relative to average since 1970. Synthetic euro prior to 1999. Latest data 20 January 2011. Source: J.P. Morgan.

Real broad effective exchange rate

102

80

90

100

110

120

Dec 70 Dec 80 Dec 90 Dec 00 Dec 10

Stronger

Weaker

Euro Trade-Weighted Index

88

Fourth quarter GDP shows wide divergence in eurozone growth

German economy benefitting disproportionately from rebound in global trade and China stimulus

Longer term outlook weaker; bulk of exports go to eurozone but growth there is low

– Forecast for 2011 GDP is +1.4% for eurozone ex-Germany, +2.6% for Germany

Divergence of economic performance adds to stress on euro

If dollar weakens because of QE, euro and EM currencies will appreciate more because of yuan peg


German growth rates well ahead of the restFourth quarter 2010 GDP estimates, QoQ %, SAAR

0.3

0.6

0.8

1.1

1.4

1.6

4.3

0 1 2 3 4 5

Spain

Ireland

Portgual

€ ex-Germany

Italy

France

Germany

99

Changes in global growth forecasts are not evenly spread

US perspective improving thanks to QE and tax package, but forecast still down from earlier this year

Emerging market growth to suffer from tightening to ward off inflation plus strengthening currencies

China’s annualised growth rate in 4q estimated to be 13%

– Risk of overheating is rising


Change in 2011 GDP Growth Forecasts — Last 3 Months

-0.1% 0.2% 0.5% 0.8%

United States

Germany

China

Europe ex-Germany

EM ex-China

Developed Asia

3.1%

2.6%

9.0%

1.4%

1.9%

5.0%

2011eGDP

1010

Exports has been very disappointing; preliminary data suggested positive contribution

Most important component of GDP growth is fixed capital formation as it lays groundwork for the future

Inventory rebuild not likely to last

Hopefully net export growth will be able to offset coming fall in government consumption

Forecast for growth in fourth quarter is similarly 2.9%

*Transportation, Storage, and Communications. Latest data Sept. 2010, SAAR. Source: UK Office for National Statistics, J.P. Morgan.

Contribution to 3q10 UK GDP Growth

0%

1%

2%

3%

4%

Change InInventories

Fixed CapitalFormation

Gov'tConsumption

NetExports

HouseholdConsumption

TOTAL 2.9%

1111

Increase in business fixed investment is good sign for the economy

This is the third consecutive quarter of positive business investment

Government still spending though this should slow down soon

Fortunately not the most important component of overall capital spending

Note: Value in parenthesis is weight of sector in over index. Latest data September 2010, SAAR. Source: UK Office for National Statistics, J.P. Morgan.

Contribution to Gross Fixed Capital Formation

0%

4%

8%

12%

16% FixedCapital

Formation

Dwellings(20%)

Business(58%)

Government(22%)

+ + =

1212

Sterling is still very competitive despite fall in value of both dollar and euro

Sterling’s decline has yet to substantially benefit UK exports

Since global growth is weak outside China, and UK doesn’t export want China wants (unlike Germany)

Currency is back to level last seen in 1979; exports should pick up eventually

UK’s independent monetary policy is significant advantage relative to Europe

Note: Relative to average since 1970. Latest data 20 January 2011. Source: J.P. Morgan.

Real broad effective exchange rate

94

70

80

90

100

110

120

130


Stronger

Weaker

Sterling Trade-Weighted Index

1313

US GDP for third quarter was weak, but largely due to fall in net exports; fourth quarter forecast 3.2%

Growth excluding change in Net Exports and Residential Investment was 5%

Consumer demand below average — normally it is over 2%

Imports increased 17% compared to a 5% gain in exports

– Suggests room for further dollar declines

Latest data September 2010, SAAR. Source: BEA, J.P. Morgan. Second revision.

Contribution to 3q10 US GDP Growth

0%

1%

2%

3%

4%

5%

ConsumerDemand / PCE

Inventory Change

BusinessInvestment

ResidentialInvestment

GovernmentExpenditure

Net Exports

TOTAL 2.5%

1414

Risks for market: Gains seem to be very dependant on ever rising supply of money; what happens when the party’s over?

Hope is that money supply growth plus low interest rates stimulate economy. Hasn’t happened yet

Could lead to asset bubbles, particularly in emerging markets (both equity and debt)

Stock of money has to come out of the system eventually

Latest round of QE just stores up problems for the future

Latest data available as at 21 January 2011. Source: US Federal Reserve.

Huge Increase In Money Supply Driving Market

700

950

1,200

1,450

1,700

1.35

1.45

1.55

1.65

1.75

1.85

1.95

Dec 04 Dec 07 Dec 10

Money Supply, M1 (lhs)

S&P 500 (rhs)$tr Level

1515

Quantitative easing could raise inflation expectations in the US once growth accelerates

Global growth may be restrained, but deflationary scenario unlikely

– US property bubble nowhere near as big as Japan’s

– Inflation excluding housing is 1.4%

Risk is that inflation (both realized and expected) gets out of hand

QE distorts price signals from market

UK expectations not rising despite recent report

Germany may be next to see rising expectations

Note: For Eurozone, UK and US, calculation is for five year inflation rate in five years (5YR-5YR). Japan is average of 5-10 year breakevens. Data as at 20 January 2011. Source: Bloomberg, J.P. Morgan.

Expected Inflation Rates

-3

-2

-1

0

1

2

3

4

5

May 07 May 08 May 09 May 10

Japan

US

%

UK

Germany

1616

Japan suffered decades of deflation because it’s housing bubble was huge

From 1955 to 1973, house prices in Japan increased 13 times, versus just 6 times from 1973 to 1990

– Land under Japan’s Imperial Palace worth more than California

First period (1955-73) was largely matched by GDP growth, but the second wasn’t

By this measure, US looks okay, but Spain is scary

*Japan: Land Underlying Buildings and Structures; US: Household Real Estate Assets; UK: Residential Buildings; Spain: Residential Household Wealth; Ireland: Dwellings. Source: OECD, Japan Land and Water Bureau, Ministry of Land, Infrastructure and Transport, Cabinet Office (Government of Japan), US Federal Reserve, S&P/Case-Shiller, OFHEO, UK Office for National Statistics, Bank of Spain, Ireland Central Statistics Office, Permanent TSB/ESRI, J.P. Morgan.

What goes up….Residential property values* as % of GDP

0

1

2

3

4

5

6

1977 1987 1997 2007 2017 2027

Japan (+17 yrs)

US

UK

Spain

Ireland

1717

Falling inflation in the US is primarily a function of declining house prices

Most headlines have focused on low core CPI rates, just 0.6% in December (YoY)

But most of this is explained by a fall in house prices

Excluding housing, prices are still rising by 1.4%/year; low but not deflationary

House prices in US may be stabilising

In Japan, prices have fallen almost across the board

Latest data December 2010. Source: BLS, J.P. Morgan.

Non-house inflation is not lowYear on year change in CPI index

-0.1

1.4

-1

0

1

2

3

4


Housing

All items less energy & housing

%

1818

Job losses during this recession were unprecedented and recoveries are taking progressively longer

Employment levels fell over 7% during the course of the recession, substantially worse than in previous downturns

Distressingly, rebounds are taking ever longer

– Prior to 1980, it took less than two years to return to pre-recession employments levels

– Every recovery since has been slower

– Likely due to growing service sector orientation of economy

In 1990 and 2001 recession, jobs grew at a 1.7% annualized rate from bottom

So far growth for 2008 recession has been 1.3%

Return to baseline (100) will take 4 years at 1.7% pace; 5 years at 1.3% pace*Note: US Non-Farm Private Payrolls. Latest data December 2010. Source: BEA, J.P. Morgan.

Indexed US Employment Levels* From Beginning of Recession

92

94

96

98

100

0 12 24 36 48

Em

plo

yme

nt L

eve

l

Months Into Recession

1957

1981

1990

2001

2008

Recession

1919

Still, current recession is dramatically less severe than the Great Depression

This chart actually overstates impact of decline in employment

In 1930, 22% of the US population was employed in agriculture, versus 2% today

Latest data December 2010. Source: NBER, BEA, USDA, J.P. Morgan.

Indexed US Employment Levels From Beginning of Recession

65

72

79

86

93

100

0 2 4 6 8

Em

plo

yme

nt L

eve

l

Years Into Recession

1929

2008

Recession

96%

2020

Labour markets are suffering because of negative equity in housing

Negative equity of $2.4 trillion equals almost 20% of mortgage debt outstanding

Foreclosures initially surged but only account for 5% of existing loans and have now slowed

People can’t move because they can’t sell their home, so unemployment is higher than normal

If the debt is not written off (or assumed by government), will take years to work through

Reminiscent of Japan’s zombie companies

Source: Negative equity data from Mark Zandi and Robert Shiller, Mortgage Bankers Association, J.P. Morgan. Latest data available as at 14 January 2010.

Mortgages in Negative Equity and Delinquency Rates

0

5

10

15

20

25

0

3

6

9

12

Jun 98 Jun 02 Jun 06 Jun 10

Seriously Delinquent Loans (lhs)

Homeowners in Negative Equity (rhs)

% %

21

Asset Classes

2222

Index performance may be getting ahead of earnings growth

Earnings growth is lagging

– Fourth quarter earnings typically grow by 3% QoQ

– Expectations for this quarter are below this when should be above

– Year-ago comparison appears high — up 33% —because of base effect

QE II is very beneficial for risk assets, particularly equities

The risk is that it inflates assets without benefitting equally the underlying economy

Markets may weaken once money stops flowing

Latest data 21 January 2011. Source: IBES, J.P. Morgan.

Earnings Growth — S&P 500

600

800

1,000

1,200

1,400

-30

-15

0

15

30

Jun 08 Jun 09 Jun 10

Earnings Growth (lhs)

Expected (4q10)

S&P Index Level (rhs)

QoQ%

96

-66

1.2%

2323

Given low earnings growth expectations, surprises may have a large impact this quarter

Tech has generally done well, though outlook cloudy for Apple

Financials have been mixed

Trend so far well below previous quarters

Note: For 4q10, 52 companies have reported accounting for 17% of index market capitalization. Latest data 21 January 2011. Source: IBES, J.P. Morgan.

Earnings Surprises — S&P 500Cumulative for quarter

750

950

1,150

1,350

-24

-12

0

12

24

2q08 4q08 2q09 4q09 2q10 4q10

Surprise Amount (lhs)

Surprise QTD (lhs)

S&P 500 (1q ahead, rhs)

$b

-74

2424

It’s still early days, but initial company guidance is starting out weaker than last quarter

Trend over the last year has been for guidance in each quarter to be higher than the previous

Earnings season has only just begun, but so far companies are not raising their projections for future earnings growth substantially

Suggests earnings revisions may suffer

Latest data as at 21 January 2011. Source: Bloomberg, J.P. Morgan.

Positive Changes to Earnings GuidanceAs percent of total changes

25

35

45

55

65

1 1 2 3 4

4q09

4q10 2q10

Week in Earnings Season

% Up 3q10

2525

Net income growth has slowed as margins have fallen and sales growth lags

Earnings growth since the market bottom in 1q09 has been impressive, but it came from cost cutting and margin expansion

This process has a natural limit. Companies can’t cut forever and need revenue growth to power future earnings

Sales growth in 4q10 is forecasted to be just 7.3% higher than the year-ago quarter; in 3q10 growth was 9.%

Difficult with modest GDP expansion to increase revenues

Note: Excludes financial stocks. Sales and net income indexed to Q1 2006. Latest data 21 January 2011. Source: Worldscope, J.P. Morgan. Latest quarter forecast assumes commensurate change in sales and earnings for 15% of companies that have not yet reported for quarter.

Sales, Net Income and Margin Trends — S&P 500

4

6

8

10

75

100

125

150

175

1q06 4q06 3q07 2q08 1q09 4q09 3q10

Net Income (lhs)

Sales (lhs)

Margin (rhs)

Index %

Developed Markets

North America

Europe

Developed Asia

Emerging Markets

Latin America

EMEAEmerging Asia

-80%

-60%

-40%

-20%

0%

20%

40%

60%100.0 100.5 101.0 101.5 102.0

Re

lativ

e V

alu

atio

n

Earnings Revision Index

2626

Valuations are attractive for developed markets remain attractive despite rally; revisions improving

Latest data available as at 21 January 2011. Source: IBES, J.P. Morgan.

Stronger Earnings Growth

Ch

eap

er V

alu

atio

n

Austria

Belgium

Japan

France

Germany

Hong Kong

Finland

NorwayPortugal

Spain

UKUS

Brazil

India

China

Mexico

Taiwan

Turkey

-60%

-40%

-20%

0%

20%

40%

99.0 99.5 100.0 100.5 101.0 101.5 102.0 102.5

Re

lativ

e V

alu

atio

n


2727

Mexico joining Brazil in expensive territory but with poorer earnings outlook



Ch

eap

er V

alu

atio

n

Energy

Materials

Industrials

Consumer Discretionary

Consumer Staples

Health Care

Financials

TechTelecom Services

Utilities

Growth

Value

-50%

-40%

-30%

-20%

-10%

0%99.5 100.0 100.5 101.0 101.5 102.0 102.5 103.0

Re

lativ

e V

alu

atio

n


2828

Commodity plays seeing largest positive moves



Ch

eap

er V

alu

atio

n

2929

How risky is inflation for emerging market equity performance?

The correlation between inflation rates and emerging market index performance is not strong

Equities generally benefit from (moderately) rising prices

Risk is rather from inappropriate monetary policy response

– Either central bank tightens too much and economy slows dramatically

– Or it does not tighten enough (perhaps to avoid currency appreciation) and economy overheats

High commodity weightings offer extra protection

Emerging Market Index and Inflation Rates

Note: Index in USD terms. Inflation rate weighted by MSCI market capitalization. Last data 21 January 2001. Source: FactSet, J.P. Morgan.

2

4

6

8

10

50

100

200

400

Dec 95 Dec 00 Dec 05 Dec 10

Emerging Markets Index (log, lhs)

Inflation Rate (rhs)%

3030

Watch both inflation and policy rates to see where balance lies

Emerging Market Inflation and Policy Rates

1 Year Best Lending Rate - China 1 Week Deposit Rate - RussiaSelic Overnight Target - Brazil O/N Govt Rate - MexicoBase Rate - South Korea BI Rate - IndonesiaDiscount Rate - Taiw an 1 Day Repo Rate - ThailandRepo Rate - India Discount Rate - ChileRepo Rate - South Africa

Latest data 21 January 2011. Source: Bloomberg, FactSet, J.P. Morgan.

CountryWeight in MSCI EM Now

Change vs 6

Mo. Ago Now

Change vs 6

Mo. AgoChina 18% 4.6% 1.6% 5.8% 0.5%Brazil 16 5.6 0.8 11.3 1.0Korea 14 3.5 0.9 2.8 0.8Taiwan 12 1.3 0.1 1.6 0.2India 8 8.3 -5.4 6.3 1.0South Africa 8 3.6 -0.6 5.5 -1.0Russia 7 8.8 3.1 3.0 0.3Mexico 5 4.4 0.7 4.5 -0.1Indonesia 2 7.0 2.0 6.5 0.0Thailand 2 2.8 -0.5 2.3 1.1Chile 2 3.0 1.8 3.3 2.3

Inflation Rate Policy Rate

3131

China inflation not as bad as headline figures suggest but too strong GDP growth is a worry

Food prices have a disproportionate weight in Chinese CPI calculations

Excluding food, inflation appears contained

Negative reaction of market to prospect of government tightening shows how dependent market sentiment and growth is on China

Latest data December 2010. Source: China Economic Information Network.

Excluding food, China inflation under controlChinese inflation indices, annual change, %

-2

0

2

4

6

8

10


Headline inflation

Inflation excluding food%

3232

The case for emerging markets is the same as in the past, but risks have fallen; inflation is major worry

The opportunity in developed markets has always been catch up, convergence, aspiration and urbanisation

It’s only been crises which have spoiled the story

We believe things are different this time

The risks of currency or debt crises like those in the past have fallen

– No fixed exchange rates

– Low foreign currency debt

– Smaller current account deficits

Emerging Market Index Performance

Latest flow data November 2010. Index as at 17 December 2010, USD terms. Source: S&P/IFC, J.P. Morgan.

-3

-2

-1

0

1

2

3

4

5


Mexico,Argentina (1995) Argentina

(2001)

Asia(1997)

Russia(1998)

Latin America(1980-83)

Cumulative 12-Month FundFlow as % of Assets

Emerging Markets

Index (log, no scale)

%

3333

Low yields in US have not yet lead to a major outflow of funds

One of the concerns about QE (I and II) is that a search for yield will drive investors abroad, in particular to emerging markets

Cross-border flow data does not show this happening

US investment in foreign securities

Latest flow data October 2010. Treasury yields as at 17 December 2010. Source: US Treasury, J.P. Morgan.

2.0

2.5

3.0

3.5

4.0

4.5

5.0

5.5

-30

-15

0

15

30

45

60

Aug 03 Aug 05 Aug 07 Aug 09

Foreign Security Purchases (lhs)US 10-yr Treasury Yield (rhs) %$ bn

3434

Emerging markets are not as volatile as you might think

Historically emerging markets have been more volatile than developed markets

The performance over the last two years has shown the opposite

Traditional risks in emerging markets have declined

– Fixed exchange rates

– Foreign currency debt

While developed market risks have increased

– Quantitative easing

– Sovereign debt

Investors are getting higher prospective returns for less risk

Annualised market volatility

Note: Monthly frequency in USD terms until 1987, daily frequency in local currency terms subsequently. Data as at 31 December 2010. Source: IFC, MSCI, J.P. Morgan.

0

5

10

15

20

Late 70s

1980s 1990s Early 20s

2005-08

2009-10

Developed Markets

Emerging Markets%/yr

3535

Government bonds yields have risen markedly since August

Extreme bond valuations have lessened, but the asset class still offer poor value

Yields are simply normalizing

High correlation between the three markets, even though each has different dynamics

– Germany: Europe liability + growth

– UK: Inflation + growth

– US: QE + tax package = inflationary growth

UK likely to be first country to raise interest rates

Government Bond Yields (10-year)

Latest data as at 21 January 2011. Source: Bloomberg, J.P. Morgan.

2

3

4

5

6

Jun 07 Jun 08 Jun 09 Jun 10

UK US Germany%

3636

The great moderation in government bond yields over the last 30 years is over

Developed market central banks have won their war against inflation over the last 30 years

Fixed income returns from government debt till now have come from:

– High nominal (and real yields)

– Plus price appreciation

Now neither is likely

Government Bond Yields

Latest data as at December 2010. Source: Federal Reserve Bank of England, Barclays Capital, J.P. Morgan.

0%

5%

10%

15%

0%

5%

10%

15%


Nominal Government Bond Yield

Real Yield

3737

High yield debt presents the best opportunities

Prospects for company cash generation still strong even if economy slows

Still, limited room for spread compression

– Current spread is 100 bps below long run average

– At average if credit crunch is excluded

Emerging market debt has gone from high yield to investment grade in risk; both good and bad

QE is helping to bring down EM spreads

Local currency EM debt offers currency appreciation to offset rise in interest rates

Duration risk for Investment Grade debt

Latest data 21 January 2011. Source: Merrill Lynch, J.P. Morgan.

Bond Spreads

0

300

600

900

1,200

1,500

1,800


High Yield: 555 bps

Emerging Markets: 239 bps

Investment Grade: 155 bps

3838

Investors seeking inflation hedge will help support commodity prices in the short term

Chinese equity market still likely to outperform relative to developed markets

Economy should slow down enough to avoid overheating

Commodity prices will continue to benefit from China growth though changes in China sentiment will weigh as well

Latest data 20 January 2011. Source: MSCI, Standard & Poors.

As Goes China…

80

85

90

95

100

105

Jan 02 Jan 05 Jan 08 Jan 11

S&P GSCI Industrial Metals MSCI China

39

FOR PROFESSIONAL INVESTORS ONLY. NOT FOR PUBLIC DISTRIBUTION.

Any forecasts, figures, opinions or investment techniques and strategies set out, unless otherwise stated, are J.P. Morgan Asset Management’s own at date of publication. They are considered to be accurate at the time of writing, but no warranty of accuracy is given and no liability in respect of any error or omission is accepted. They may be subject to change without reference or notification to you. The views contained herein are not to be taken as an advice or recommendation to buy or sell any investment and the material should not be relied upon as containing sufficient information to support an investment decision. It should be noted that the value of investments and the income from them may fluctuate in accordance with market conditions and taxation agreements and investors may not get back the full amount invested. Both past performance and yield may not be a reliable guide to future performance. Changes in exchange rate may have an adverse effect on the value price or income of the product. Investments in smaller companies may involve a higher degree of risk as they are usually more sensitive to market movements. Investments in emerging markets may be more volatile and therefore the risk to your capital could be greater. Further, the economic and political situations in emerging markets may be more volatile than in established economies and these may adversely influence the value of investments made. You should also note that if you contact J.P. Morgan Asset Management by telephone those lines could be recorded and may be monitored for security and training purposes. J.P. Morgan Asset Management is the brand name for the asset management business of JPMorgan Chase & Co and its affiliates worldwide. Issued by JPMorgan Asset Management (Europe) Société à responsabilité limitée, European Bank & Business Centre, 6 route de Trèves, L-2633 Senningerberg, Grand Duchy of Luxembourg, R.C.S.Luxembourg B27900, corporate capital EUR 10.000.000. Material issued in the United Kingdom are approved for use by JPMorgan Asset Management (UK) Limited, 125 London Wall, London EC2Y 5AJ, England. JPMorgan Asset Management (UK) Limited is authorised and regulated by the Financial Services Authority. Registered in England No. 01161446. Registered address: 125 London Wall, London EC2Y 5AJ.

Prepared by:Kerry Craig, Dan Morris and Tom Elliott

J.P. Morgan Asset Management

Navigator Analysis of current issues in markets and investing

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