The JP Morgan View
Global Asset Allocation October 31, 2008
The J.P. Morgan View Where are we in the crisis? • Economics –– We now expect developed economies to contract by an annualized rate of 3% in Q4 08 and 1.8% in Q1 09, levels not seen since the 74 recession.
• Asset Allocation –– Stay with recession trades overall. Overweight Banks and underweight Cyclical sectors in both equities and credit.
• Fixed Income –– Keep long in 2-year Govts in both Europe and the US. We see more upside in Gilts.
• Equities –– Stay defensive, underweighting sectors most exposed to the global recession: Industrials, Materials and Energy.
Jan LoeysAC (44-20) 7325-5473 [email protected]
John Normand (44-20) 7325-5222 [email protected]
Nikolaos Panigirtzoglou (44-20) 7777-0386 [email protected]
Ruy Ribeiro (44-20) 7777-1390 [email protected]
• Credit –– Overweight Banks. Underweight Industrial and Cyclical names, US CMBS, consumer ABS, and CCCs within HY.
• FX –– The yen has modest downside near-term. We reenter a short in EUR vs JPY but are sidelined in USD/JPY due to near-term event risk.
• Alternatives –– HF redemptions are likely to increase next year. Commodities are up this week, but base metals remain vulnerable.
YTD Returns % in local currency
Global Gov Bonds Europe Bonds US cash
• It is now a consensus that we are in a severe world financial and economic crisis. The debate is settled. Now the focus has shifted to how deep and how long the crisis will be. The financial crisis is in no doubt the worst since WWII. The depth of the economic crisis is harder to gauge. It is clear that the global recession will be worse than the last two (early 90’s and 00’s) which can be classified as “shallow”. We view the current contraction as more akin to the early 80’s if not the mid-70’s, both of which were severe.
• How much longer? Where are we in these crises? We feel strongly that the worst of the financial crisis has past, but also that we have not seen the worst of the economic crisis yet. Following the Lehman collapse, money markets virtually froze over, bringing us to the verge of a meltdown. Since then, an avalanche of heroic public measures to inject capital and liquidity have started to bring some form of life in money and credit markets. But activity has recovered a modest amount only of what was lost post-Lehman. More importantly, public authorities are not waiting for markets to get their act together and are themselves becoming the largest financial intermediary, taking in flight-to-quality money and lending it directly to industry.
JGBs US Bonds EM Local Gov Bonds EM FX G7 FX EMBIG JPMCCI Energy JPMCCI ex energy US High Yield S&P500 MSCI Europe Topix MSCI EM -50 -40
• Where does this leave us in the deleveraging cycle? Banks are close to finished. Governments who have put equity into banks will not want banks to shirk on their domestic lending duties. Corporates on average had low leverage, but will likely turn more cautious on spending. Households have started to delever, by raising savings rates, but we do not believe they are The certifying analyst is indicated by an AC. See page 6 for analyst certification and important legal and regulatory disclosures.
-30 -20 -10
0
Source: J.P. Morgan. * Global Bonds is JPM GBI hedged into $, EM Local Bonds is GBI-EM unhedged in $, US Bonds is the Lehman aggregate, Europe Bonds is JPM Maggie, JGBs is JPM GBI - Japan local currency, EM FX is JPM ELMI+ in $, G7 FX is GBI cash index in $
www.morganmarkets.com
Global Asset Allocation The J.P. Morgan View
halfway in this process yet. Pension funds are just starting to delever, or better to de-risk, as only this month were their surplus hit very badly. We are seeing duration matching flows, but do not expect a selling wave as equity weightings are already well down and pension funds only change strategic allocations slowly. At the same time, the loss of surplus (of assets over liabilities) will likely keep pension funds from rushing back to their old equity weightings.
Index of riskier market and carry trade performance
• That leaves hedge funds. Although hedge funds have deleveraged for over a
130
year now, the real threat comes instead from redemptions rather than an increasing need to reduce leverage ratios. During the 2001-03 stock market crash, hedge funds did produce positive returns, thereafter pitching themselves as the best protection in a bear market. The likely over 15% loss YTD on hedge funds shattered this myth, inducing dissatisfaction among investors. There are massively differing estimates of Q4 redemtpions circulating. Our guesstimate remains low in the range (about $150bn), but we do see significantly more next year. Hence, hedge funds are very advanced in reducing leverage but not in shrinking their AUM to meet reduced demand. We expect that over time, hedge funds involved on less liquid assets will gravitate to a private equity platform.
125
• Our strategy is little changed. We remain overweight Banks in both credit and equities. Beyond banks, broadly we hold recession trades through long duration and curve steepeners in fixed income, underweights in credit, and underweights of cyclical sectors in equities. Very short term though, we expect the US presidential election to sustain this week’s positive momentum in risky markets for a bit longer.
120 115 110 105 100 95 2005
2006
2007
2008
Source: J.P. Morgan. Excess return index over cash constructed as a weighted average of daily excess returns of 7 asset classes: G7 equities in $, EM vs G7 equities in $, GBI EM vs GBI Global, HY vs USTs, EMBIG vs USTs and JPM’s CarryMAX and IncomeFX indices as a proxy for carry trades in bonds and currencies. The weights in each asset class are adjusted daily based on the inverse of past 3-month volatility, so that 100bp risk is targeted for each asset class on an ex-ante basis. The annualised volatility of the index has been 4% since 1 April02.
Economic outlook • Continued poor economic data has led us to once again lower growth forecasts. We now expect developed economies to contract by an annualized rate of 3% in Q4 and 1.8% in Q1 09, levels not seen since the 1974 recession. Most notably, record low business surveys are forcing us to slash Japanese growth forecasts from -1% to -3.5% in Q4 and from -0.5% to -3% in Q1 09.
• In the UK, we forecast a 100bp cut to 3.5% next week on a view that the MPC does not want to be perceived as dragging its feet as the economy enters a recession. We see rates going as low as 2% by June 2009.
• The Fed and IMF this week enacted measures to provide liquidity to EM economies. The Fed’s limitation of $ swap lines to fundamentally sound economies is a responsible use of taxpayer money, but risks creating a twotiered system that could be detrimental to non-qualifying countries. The IMF’s new Short-Term liquidity Facility is also likely to be positive for EM, but it is not clear the IMF currently has sufficient funds to meet all potential needs.
Fixed income • Government bonds sold off modestly this week in developed markets, led by the long-end. The short-ends rallied by around 10-20bp across majors bond markets on expectations of more central bank easing.
• We remain bullish at the short-ends, on the view that central banks will have
More details in ... Global Data Watch, Bruce Kasman and David Hensley It is back -- deflation risks and the US outlook, Paul Meggyesi, Mike Feroli, Oct 24 Global Markets Outlook and Strategy, Jan Loeys, Bruce Kasman, et al. US Fixed Income Markets Outlook, Terry Belton and Srini Ramswamy. Global Fixed Income Markets, Pavan Wadhwa and Fabio Bassi.
to ease by more than is priced in. We target a 2-year Govt yield of 1.05% in the Oct 31, 2008
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Global Asset Allocation The J.P. Morgan View
US, 2% in Euros and 2.15% in UK Gilts. We see more upside in Gilts and are long vs Euros in 5s and vs USTs in 2s. In Europe, we stay with steepening trades and expect the 2s10s curve to steepen to 150bp in Euros and 185bp in Gilts. In the US, we are neutral on the curve, but have a bias towards steepening as the short end rallies further and as unwinding of previous swap spread widening trades continues.
• US Agency MBS, Agency debt and off-the-run USTs are all suffering in tandem from worsening liquidity in US bond markets and persistent fails in the repo market. We remain long in the medium term as we see a lot of value, but we recognize that it will take several more weeks for these illiquidity risk premia to tighten.
Equities • Equity markets rallied strongly this week as economic data stopped surprising to the downside and on further policy support in the form of rate cuts and Fed dollar swap lines with the EM. Our US Economic Activity Surprise Index has slightly improved, from a 7-year low of -38 last week to -33 this week. Daily volatility, which has been deterring major institutional investors, is receding. The VIX has fallen sharply to below 60% from an intraday high of 89% at the end of last week. This positive momentum could spillover to next week, fuelled by the US presidential election.
• Further out though, we are more negative. The economic crisis has effectively just began and we believe that the worst is yet to come. As a result we are reluctant to abandon our overall defensive stance even as it produced an overall loss this week. We stay underweight cyclical sectors such as Industrials, Materials and Energy. We overweight Banks in both developed markets and EM, focusing on the largest banks. We favour countries with greater policy flexibility, and are thus long China vs India, long Mexico vs Russia and long Taiwan vs Korea.
Credit • We stay underweight Industrial and Cyclical names, US CMBS, consumer ABS, and CCCs within HY. We are more positive on banks, where we recommend a long both outright and against Industrials. We also like Tier 1 subordinated bank debt of high quality names in Europe, especially the ones with low chances of scraping their dividends.
• This week saw healthier issuance. In Europe, total issuance was robust at €6.6bn this week. This exceeds last week's €5.6bn and is only 25% lower from the €8-€9bn per week pace seen pre-Lehman. In the US, a total of $6.3bn of corporate bonds were issued so far this week. This compares with $6.7bn last week and $15bn per week before the Lehman bankruptcy. New issues are sold at large discounts of 100+bp to secondary market levels, putting pressure on cash bond spreads. This week we also saw the first HY issue in a month and the first sizeable ($750m) HY issue post Lehman bankruptcy.
Foreign Exchange • The rally in stocks and sell-off in the yen this week has stopped us out of short USD/JPY and EUR/JPY, though at a considerable profit since inception on October 3 (12.6% and 17.6%, respectively). The yen has modest downside near-term on two counts. First, US activity data appear to be losing their Oct 31, 2008
VIX index 80 70 60 50 40 30 20 10 Jul 31
Aug 31
Sep 30
Oct 31
Source: Bloomberg
Value vs Growth Relative price index, MSCI World $
115 110 105 100 95 90 2005
2006
2007
2008
Source: Datastream, J.P. Morgan
Cyclicals vs Non-cyclicals Relative price index, MSCI World $ 110
100 90 80 70 2005
2006
2007
2008
Source: Datastream, J.P. Morgan.
More details in ... Key trades and risk: Emerging Market Equity Strategy, Adrian Mowat et al. Emerging Markets Outlook and Strategy, Joyce Chang EM Corporate Outlook and Strategy, Warren Mar et al. US Credit Markets Outlook and Strategy, Eric Beinstein et al. High Yield Credit Markets Weekly, Peter Acciavatti et al. European Credit Outlook & Strategy, Steven Dulake et al.
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Global Asset Allocation The J.P. Morgan View
sticker shock as suggested by stabilisation in our Economic Activity Surprise Index (EASI), and USD/JPY is the most correlated pair with this sentiment measure. Second, next Tuesday should bring clarity around who will run America and with what legislative backing for the next four years. While McCain and Obama have endorsed policy measures announced to date, there are still considerable uncertainties about the scale and composition of a second fiscal package, as well as key cabinet appointments such as Treasury. We are not convinced that a Blue or a Red win is inherently dollar positive, but we suspect the reality of regime change in America is worth a short-term fillip for risky markets.
• Regardless of who occupies the White House, the one certainty for the next six months is a move to a sub-1% Fed funds rate, much lower ECB rates, recession-inspired credit stress and further deleveraging from the hedge fund community. In that environment it would be difficult to bet against renewed yen strength, and so we average back in to the yen longs from which we were stopped out this week by reselling EUR/JPY and staying sidelined in USD/ JPY due to near-term event risk. We still view intervention as likely only to smooth yen appreciation given constraints on financing bill issuance in Japan and some domestic opposition to extensive reserve accumulation.
US HG net issuance $bn, monthly data 80
60 40 20 0 -20 -40 Feb-06 Aug-06 Feb-07 Aug-07 Feb-08 Aug-08 Source: J.P. Morgan
Foreign exchange % change vs USD this week 5%
0%
• We have been short Asia since late August through THB (cash) and KRW (options), and now recommend rotating into long USD/TWD as the preferred recession trade. USD/TWD’s correlation to local and global growth is the highest amongst the regional currencies, and TWD has lagged others in the region in terms of its year-to-date decline. The CBC typically resists abrupt moves, but intervention will likely be more for smoothing purposes. Take advantage of this week’s drop in USD/TWD – a reaction to extension of the Fed’s USD swap lines to the region – to sell TWD.
Alternatives • Hedge funds had their worst month ever in October (-9% according to daily indices), and many styles had double-digit losses. Poor performance this month adds upside risk to our redemption forecasts, but effects will be mostly seen next year. We believe that most market impact of quarterly fund of fund redemptions has been realized. Single-manager funds can, however, provide more fuel to position unwinds. We estimate that 70% of Equity LS funds have notice periods shorter or equal to 30 days. • Our current estimates indicate net outflows of, at least, $150bn during Q4. Given poor October returns and our redemption forecast, AUM of the hedge fund industry would shrink to under $1.4 trillion ($1.9 trillion in 2007 Q4). Additional Q4 redemptions requests are likely to be limited by new redemption constraints recently imposed by fund managers. At the same time, we see inflows into top performing hedge funds. We expect an increase in redemption requests early next year, as investors realize that HF investments are less liquid than originally perceived. A significant number of funds have changed their terms in the past weeks or imposed “gates” that limit total outflows. These changes are likely to limit redemptions in Q4, but will have a negative long-term effect. • Commodities were up 5% this week. Base metals are likely to stay under pressure, as demand remains weak. Copper remains most exposed given that it Oct 31, 2008
-5% USD JPY EUR
GBP CHF
CAD AUD
TWI Source: J.P. Morgan
12-month rolling returns for hedge funds annualized returns 20%
Hedge funds
15% 10% 5% 0% -5% -10% -15% -20%
Bond-Equity Portfolio
-25% Jul-03
Jul-04
Jul-05
Jul-06
Jul-07
Jul-08
Source: J.P. Morgan, HFR, CS/Tremont. Hedge Funds index is a composite of HFR and CS/Tremont hedge fund indices. Bond-equity portfolio is 55% Lehman Agg US and 45% S&P 500 (weight selected to match the volatility of the composite hedge fund index).
More details in ... Alternative Investments Outlook and Strategy FX Markets Weekly, J Normand et al Energy Monthly, L Eagles et al Global Metals Quarterly, M Jansen Grains & Oilseeds Monthly, L Hagedorn
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Global Asset Allocation The J.P. Morgan View Vadim di Pietro (44-20) 7777-4408
is trading above the top end of the marginal cost curve. Production cuts in most metals should continue but will not reverse the downward price trend. We are neutral in Agriculture near term, but selectively bullish medium-term. Corn inventories remain relatively low in light of upcoming ethanol mandates. Soybeans and their products have upside next year due to the contraction in South American crops and expansion of biodiesel capacity.
Interest rates United States Euro area United Kingdom Japan
Fed funds rate 10-y ear y ields Refi rate 10-y ear y ields Repo rate 10-y ear y ields Ov ernight call rate 10-y ear y ields
Credit Markets US high grade (bp ov er UST) US high grade (bp ov er sw aps) Euro high grade all (bp ov er sw aps) USD high y ield (bp v s. UST) Euro high y ield (bp ov er Euro gov ) EMBIG (bp v s. UST)
Commodities WTI ($/bbl) Gold ($/oz) Copper ($/metric ton) Corn ($/Bu)
Current 1.00 3.95 3.75 3.89 4.50 4.52 0.30 1.46
Dec-08 0.75 3.30 2.75 3.60 3.25 4.00 0.30 1.60
Current 564 485 239 1484 1762 678 Current 64.2 722 4194 3.98
Mar-09 0.75 3.35 2.25 3.45 2.50 3.70 0.10 1.60
Jun-09 0.75 3.40 2.00 3.40 2.00 3.60 0.10 1.80
Sep-09 0.75 3.55 1.50 3.40 2.00 3.80 0.10 2.00
GBI YTD Return 4.6% 7.2% 3.6% 1.5%
Index JPMorgan US Index (JULI)
YTD Return -12.0%
JPMorgan Euro Credit Index (MAGGIE) JPMorgan Global High Yield Index JPMorgan Euro Credit Index (MAGGIE) EMBI Global 08Q4 79.0 4100 4.30
Quarterly Averages 09Q1 09Q2 75.0 70.0 875 875 4250 4250 4.45 5.30
09Q3 75.0 875 4500 5.15
-3.1% -24.3% -29.8% -21.0%
Index JPMCCI Energy JPMCCI Precious Metals JPMCCI Industrial Metals JPMCCI Agriculture
YTD Return -23.1% -19.3% -29.1% -22.1% 3m
Foreign Exchange EUR/USD USD/JPY GBP/USD AUD/USD USD/CAD
Current 1.27 98.3 1.62 0.67 1.20
YTD Return Current (local ccy) Sector Allocation Energy S&P 974 -33.9% Materials Topix 867 -37.9% Industrials FTSE 100 4377 -31.2% Discretionary MSCI Eurozone 136 -42.1% Staples MSCI Europe 930 -37.6% Healthcare DAX 4988 -39.6% Financials CAC 3487 -37.3% Information Tech. MSCI EM 26669 -47.0% Source: Bloomberg, Datastream, IBES, Standard & Poor's Services, J.P. Morgan estimates Telecommunications MSCI EM $ 561 -53.8% Utilities
Equities*
Oct 31, 2008
Dec-08 1.18 87 1.48 0.64 1.20
Mar-09 1.18 87 1.48 0.67 1.18
Jun-09 1.20 93 1.50 0.69 1.16
US
YTD ($) Europe YTD ($)
N UW UW OW UW N OW OW OW UW
-33.1% -39.3% -37.1% -32.2% -14.4% -23.5% -47.9% -37.1% -34.6% -28.4%
UW N N UW N N OW OW OW UW
-47.2% -58.5% -53.3% -42.1% -37.5% -24.0% -55.8% -49.2% -43.0% -44.7%
Sep-09 1.22 95 1.53 0.71 1.14
cash EUR JPY GBP AUD CAD
YTD Return in USD -8.1% 15.7% -14.0% -18.4% -16.3%
Japan
YTD (¥)
EM
YTD ($)
N OW N UW UW OW N UW UW
-44.3% -48.6% -39.8% -40.3% -24.3% -21.8% -42.3% -46.5% -25.6% -5.2%
UW UW N N N N OW N UW UW
-59.3% -60.0% -65.4% -49.1% -38.7% -22.4% -55.7% -43.5% -45.8% -45.5%
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Global Asset Allocation The J.P. Morgan View Vadim di Pietro (44-20) 7777-4408
Real GDP United States Latin America Japan Asia ex -Japan Euro area United Kingdom Emerging Europe Global Dev eloped markets Emerging markets
Consumer Prices United States Euro area United Kingdom Japan Dev eloped markets Emerging markets
%q/q saar 08Q2 08Q3 2.8 4.8 -3.0 6.3 -0.7 0.0 6.3 1.7 0.6 5.9
-0.3 1.9 -0.7 4.1 -1.0 -2.0 4.2 0.3 -0.6 3.5
% over year ago 08Q2 08Q3 4.3 5.3 3.6 3.8 3.4 4.8 1.4 2.2 3.5 4.2 7.8 7.7
08Q4
09Q1
09Q2
09Q3
-4.0 1.4 -3.5 4.3 -2.0 -3.0 2.2 -1.7 -3.0 3.1
-2.0 0.0 -3.0 4.8 -1.0 -2.5 2.0 -0.8 -1.8 3.1
0.0 1.8 -2.0 6.4 0.5 -1.5 2.4 0.8 -0.2 4.5
2.5 3.6 0.3 7.4 1.0 0.0 3.0 2.4 1.5 5.6
08Q4 2.9 3.2 4.4 1.3 2.9 6.8
09Q1 1.6 2.9 3.8 0.9 2.1 6.1
09Q2 0.7 2.3 2.1 0.1 1.3 5.1
09Q3 -0.5 2.0 1.0 -0.6 0.5 4.8
% over year ago 2007e 2008e 2.0 5.2 2.0 8.8 2.6 3.0 6.5 3.4 2.4 7.5
1.3 3.8 0.3 6.9 0.9 0.8 5.6 2.0 1.0 5.8
% over year ago 2007e 2008e 2.9 4.2 2.1 3.5 2.3 3.7 0.1 1.4 2.1 3.5 4.9 7.4
2009e -0.6 1.7 -1.9 5.7 -0.5 -1.7 2.8 0.2 -0.8 4.1
2009e 0.7 2.3 1.9 0.1 1.3 5.2
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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 to JPMSI 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 the securities discussed, unless otherwise stated. Opinions and estimates constitute our judgment as of the date of this material and are subject to change without notice. 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 financial instrument. The opinions and recommendations herein do not take into account individual client circumstances, objectives, or needs and are not intended as recommendations of particular securities, financial instruments or strategies to particular clients. The recipient of this report must make its own independent decisions regarding any securities or financial instruments mentioned herein. JPMSI distributes in the U.S. research published by nonU.S. affiliates and accepts 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 Oct 31, 2008 6 information. Clients should contact analysts and execute transactions through a J.P. Morgan subsidiary or affiliate in their home jurisdiction unless governing law permits otherwise. “Other Disclosures” last revised September 29, 2008. Copyright 2008 JPMorgan Chase & Co. All rights reserved. This report or any portion hereof may not be reprinted, sold or redistributed without the written consent of J.P. Morgan.
The J.P. Morgan View Where are we in the crisis? • Economics –– We now expect developed economies to contract by an annualized rate of 3% in Q4 08 and 1.8% in Q1 09, levels not seen since the 74 recession.
• Asset Allocation –– Stay with recession trades overall. Overweight Banks and underweight Cyclical sectors in both equities and credit.
• Fixed Income –– Keep long in 2-year Govts in both Europe and the US. We see more upside in Gilts.
• Equities –– Stay defensive, underweighting sectors most exposed to the global recession: Industrials, Materials and Energy.
Jan LoeysAC (44-20) 7325-5473 [email protected]
John Normand (44-20) 7325-5222 [email protected]
Nikolaos Panigirtzoglou (44-20) 7777-0386 [email protected]
Ruy Ribeiro (44-20) 7777-1390 [email protected]
• Credit –– Overweight Banks. Underweight Industrial and Cyclical names, US CMBS, consumer ABS, and CCCs within HY.
• FX –– The yen has modest downside near-term. We reenter a short in EUR vs JPY but are sidelined in USD/JPY due to near-term event risk.
• Alternatives –– HF redemptions are likely to increase next year. Commodities are up this week, but base metals remain vulnerable.
YTD Returns % in local currency
Global Gov Bonds Europe Bonds US cash
• It is now a consensus that we are in a severe world financial and economic crisis. The debate is settled. Now the focus has shifted to how deep and how long the crisis will be. The financial crisis is in no doubt the worst since WWII. The depth of the economic crisis is harder to gauge. It is clear that the global recession will be worse than the last two (early 90’s and 00’s) which can be classified as “shallow”. We view the current contraction as more akin to the early 80’s if not the mid-70’s, both of which were severe.
• How much longer? Where are we in these crises? We feel strongly that the worst of the financial crisis has past, but also that we have not seen the worst of the economic crisis yet. Following the Lehman collapse, money markets virtually froze over, bringing us to the verge of a meltdown. Since then, an avalanche of heroic public measures to inject capital and liquidity have started to bring some form of life in money and credit markets. But activity has recovered a modest amount only of what was lost post-Lehman. More importantly, public authorities are not waiting for markets to get their act together and are themselves becoming the largest financial intermediary, taking in flight-to-quality money and lending it directly to industry.
JGBs US Bonds EM Local Gov Bonds EM FX G7 FX EMBIG JPMCCI Energy JPMCCI ex energy US High Yield S&P500 MSCI Europe Topix MSCI EM -50 -40
• Where does this leave us in the deleveraging cycle? Banks are close to finished. Governments who have put equity into banks will not want banks to shirk on their domestic lending duties. Corporates on average had low leverage, but will likely turn more cautious on spending. Households have started to delever, by raising savings rates, but we do not believe they are The certifying analyst is indicated by an AC. See page 6 for analyst certification and important legal and regulatory disclosures.
-30 -20 -10
0
Source: J.P. Morgan. * Global Bonds is JPM GBI hedged into $, EM Local Bonds is GBI-EM unhedged in $, US Bonds is the Lehman aggregate, Europe Bonds is JPM Maggie, JGBs is JPM GBI - Japan local currency, EM FX is JPM ELMI+ in $, G7 FX is GBI cash index in $
www.morganmarkets.com
Global Asset Allocation The J.P. Morgan View
halfway in this process yet. Pension funds are just starting to delever, or better to de-risk, as only this month were their surplus hit very badly. We are seeing duration matching flows, but do not expect a selling wave as equity weightings are already well down and pension funds only change strategic allocations slowly. At the same time, the loss of surplus (of assets over liabilities) will likely keep pension funds from rushing back to their old equity weightings.
Index of riskier market and carry trade performance
• That leaves hedge funds. Although hedge funds have deleveraged for over a
130
year now, the real threat comes instead from redemptions rather than an increasing need to reduce leverage ratios. During the 2001-03 stock market crash, hedge funds did produce positive returns, thereafter pitching themselves as the best protection in a bear market. The likely over 15% loss YTD on hedge funds shattered this myth, inducing dissatisfaction among investors. There are massively differing estimates of Q4 redemtpions circulating. Our guesstimate remains low in the range (about $150bn), but we do see significantly more next year. Hence, hedge funds are very advanced in reducing leverage but not in shrinking their AUM to meet reduced demand. We expect that over time, hedge funds involved on less liquid assets will gravitate to a private equity platform.
125
• Our strategy is little changed. We remain overweight Banks in both credit and equities. Beyond banks, broadly we hold recession trades through long duration and curve steepeners in fixed income, underweights in credit, and underweights of cyclical sectors in equities. Very short term though, we expect the US presidential election to sustain this week’s positive momentum in risky markets for a bit longer.
120 115 110 105 100 95 2005
2006
2007
2008
Source: J.P. Morgan. Excess return index over cash constructed as a weighted average of daily excess returns of 7 asset classes: G7 equities in $, EM vs G7 equities in $, GBI EM vs GBI Global, HY vs USTs, EMBIG vs USTs and JPM’s CarryMAX and IncomeFX indices as a proxy for carry trades in bonds and currencies. The weights in each asset class are adjusted daily based on the inverse of past 3-month volatility, so that 100bp risk is targeted for each asset class on an ex-ante basis. The annualised volatility of the index has been 4% since 1 April02.
Economic outlook • Continued poor economic data has led us to once again lower growth forecasts. We now expect developed economies to contract by an annualized rate of 3% in Q4 and 1.8% in Q1 09, levels not seen since the 1974 recession. Most notably, record low business surveys are forcing us to slash Japanese growth forecasts from -1% to -3.5% in Q4 and from -0.5% to -3% in Q1 09.
• In the UK, we forecast a 100bp cut to 3.5% next week on a view that the MPC does not want to be perceived as dragging its feet as the economy enters a recession. We see rates going as low as 2% by June 2009.
• The Fed and IMF this week enacted measures to provide liquidity to EM economies. The Fed’s limitation of $ swap lines to fundamentally sound economies is a responsible use of taxpayer money, but risks creating a twotiered system that could be detrimental to non-qualifying countries. The IMF’s new Short-Term liquidity Facility is also likely to be positive for EM, but it is not clear the IMF currently has sufficient funds to meet all potential needs.
Fixed income • Government bonds sold off modestly this week in developed markets, led by the long-end. The short-ends rallied by around 10-20bp across majors bond markets on expectations of more central bank easing.
• We remain bullish at the short-ends, on the view that central banks will have
More details in ... Global Data Watch, Bruce Kasman and David Hensley It is back -- deflation risks and the US outlook, Paul Meggyesi, Mike Feroli, Oct 24 Global Markets Outlook and Strategy, Jan Loeys, Bruce Kasman, et al. US Fixed Income Markets Outlook, Terry Belton and Srini Ramswamy. Global Fixed Income Markets, Pavan Wadhwa and Fabio Bassi.
to ease by more than is priced in. We target a 2-year Govt yield of 1.05% in the Oct 31, 2008
2
Global Asset Allocation The J.P. Morgan View
US, 2% in Euros and 2.15% in UK Gilts. We see more upside in Gilts and are long vs Euros in 5s and vs USTs in 2s. In Europe, we stay with steepening trades and expect the 2s10s curve to steepen to 150bp in Euros and 185bp in Gilts. In the US, we are neutral on the curve, but have a bias towards steepening as the short end rallies further and as unwinding of previous swap spread widening trades continues.
• US Agency MBS, Agency debt and off-the-run USTs are all suffering in tandem from worsening liquidity in US bond markets and persistent fails in the repo market. We remain long in the medium term as we see a lot of value, but we recognize that it will take several more weeks for these illiquidity risk premia to tighten.
Equities • Equity markets rallied strongly this week as economic data stopped surprising to the downside and on further policy support in the form of rate cuts and Fed dollar swap lines with the EM. Our US Economic Activity Surprise Index has slightly improved, from a 7-year low of -38 last week to -33 this week. Daily volatility, which has been deterring major institutional investors, is receding. The VIX has fallen sharply to below 60% from an intraday high of 89% at the end of last week. This positive momentum could spillover to next week, fuelled by the US presidential election.
• Further out though, we are more negative. The economic crisis has effectively just began and we believe that the worst is yet to come. As a result we are reluctant to abandon our overall defensive stance even as it produced an overall loss this week. We stay underweight cyclical sectors such as Industrials, Materials and Energy. We overweight Banks in both developed markets and EM, focusing on the largest banks. We favour countries with greater policy flexibility, and are thus long China vs India, long Mexico vs Russia and long Taiwan vs Korea.
Credit • We stay underweight Industrial and Cyclical names, US CMBS, consumer ABS, and CCCs within HY. We are more positive on banks, where we recommend a long both outright and against Industrials. We also like Tier 1 subordinated bank debt of high quality names in Europe, especially the ones with low chances of scraping their dividends.
• This week saw healthier issuance. In Europe, total issuance was robust at €6.6bn this week. This exceeds last week's €5.6bn and is only 25% lower from the €8-€9bn per week pace seen pre-Lehman. In the US, a total of $6.3bn of corporate bonds were issued so far this week. This compares with $6.7bn last week and $15bn per week before the Lehman bankruptcy. New issues are sold at large discounts of 100+bp to secondary market levels, putting pressure on cash bond spreads. This week we also saw the first HY issue in a month and the first sizeable ($750m) HY issue post Lehman bankruptcy.
Foreign Exchange • The rally in stocks and sell-off in the yen this week has stopped us out of short USD/JPY and EUR/JPY, though at a considerable profit since inception on October 3 (12.6% and 17.6%, respectively). The yen has modest downside near-term on two counts. First, US activity data appear to be losing their Oct 31, 2008
VIX index 80 70 60 50 40 30 20 10 Jul 31
Aug 31
Sep 30
Oct 31
Source: Bloomberg
Value vs Growth Relative price index, MSCI World $
115 110 105 100 95 90 2005
2006
2007
2008
Source: Datastream, J.P. Morgan
Cyclicals vs Non-cyclicals Relative price index, MSCI World $ 110
100 90 80 70 2005
2006
2007
2008
Source: Datastream, J.P. Morgan.
More details in ... Key trades and risk: Emerging Market Equity Strategy, Adrian Mowat et al. Emerging Markets Outlook and Strategy, Joyce Chang EM Corporate Outlook and Strategy, Warren Mar et al. US Credit Markets Outlook and Strategy, Eric Beinstein et al. High Yield Credit Markets Weekly, Peter Acciavatti et al. European Credit Outlook & Strategy, Steven Dulake et al.
3
Global Asset Allocation The J.P. Morgan View
sticker shock as suggested by stabilisation in our Economic Activity Surprise Index (EASI), and USD/JPY is the most correlated pair with this sentiment measure. Second, next Tuesday should bring clarity around who will run America and with what legislative backing for the next four years. While McCain and Obama have endorsed policy measures announced to date, there are still considerable uncertainties about the scale and composition of a second fiscal package, as well as key cabinet appointments such as Treasury. We are not convinced that a Blue or a Red win is inherently dollar positive, but we suspect the reality of regime change in America is worth a short-term fillip for risky markets.
• Regardless of who occupies the White House, the one certainty for the next six months is a move to a sub-1% Fed funds rate, much lower ECB rates, recession-inspired credit stress and further deleveraging from the hedge fund community. In that environment it would be difficult to bet against renewed yen strength, and so we average back in to the yen longs from which we were stopped out this week by reselling EUR/JPY and staying sidelined in USD/ JPY due to near-term event risk. We still view intervention as likely only to smooth yen appreciation given constraints on financing bill issuance in Japan and some domestic opposition to extensive reserve accumulation.
US HG net issuance $bn, monthly data 80
60 40 20 0 -20 -40 Feb-06 Aug-06 Feb-07 Aug-07 Feb-08 Aug-08 Source: J.P. Morgan
Foreign exchange % change vs USD this week 5%
0%
• We have been short Asia since late August through THB (cash) and KRW (options), and now recommend rotating into long USD/TWD as the preferred recession trade. USD/TWD’s correlation to local and global growth is the highest amongst the regional currencies, and TWD has lagged others in the region in terms of its year-to-date decline. The CBC typically resists abrupt moves, but intervention will likely be more for smoothing purposes. Take advantage of this week’s drop in USD/TWD – a reaction to extension of the Fed’s USD swap lines to the region – to sell TWD.
Alternatives • Hedge funds had their worst month ever in October (-9% according to daily indices), and many styles had double-digit losses. Poor performance this month adds upside risk to our redemption forecasts, but effects will be mostly seen next year. We believe that most market impact of quarterly fund of fund redemptions has been realized. Single-manager funds can, however, provide more fuel to position unwinds. We estimate that 70% of Equity LS funds have notice periods shorter or equal to 30 days. • Our current estimates indicate net outflows of, at least, $150bn during Q4. Given poor October returns and our redemption forecast, AUM of the hedge fund industry would shrink to under $1.4 trillion ($1.9 trillion in 2007 Q4). Additional Q4 redemptions requests are likely to be limited by new redemption constraints recently imposed by fund managers. At the same time, we see inflows into top performing hedge funds. We expect an increase in redemption requests early next year, as investors realize that HF investments are less liquid than originally perceived. A significant number of funds have changed their terms in the past weeks or imposed “gates” that limit total outflows. These changes are likely to limit redemptions in Q4, but will have a negative long-term effect. • Commodities were up 5% this week. Base metals are likely to stay under pressure, as demand remains weak. Copper remains most exposed given that it Oct 31, 2008
-5% USD JPY EUR
GBP CHF
CAD AUD
TWI Source: J.P. Morgan
12-month rolling returns for hedge funds annualized returns 20%
Hedge funds
15% 10% 5% 0% -5% -10% -15% -20%
Bond-Equity Portfolio
-25% Jul-03
Jul-04
Jul-05
Jul-06
Jul-07
Jul-08
Source: J.P. Morgan, HFR, CS/Tremont. Hedge Funds index is a composite of HFR and CS/Tremont hedge fund indices. Bond-equity portfolio is 55% Lehman Agg US and 45% S&P 500 (weight selected to match the volatility of the composite hedge fund index).
More details in ... Alternative Investments Outlook and Strategy FX Markets Weekly, J Normand et al Energy Monthly, L Eagles et al Global Metals Quarterly, M Jansen Grains & Oilseeds Monthly, L Hagedorn
4
Global Asset Allocation The J.P. Morgan View Vadim di Pietro (44-20) 7777-4408
is trading above the top end of the marginal cost curve. Production cuts in most metals should continue but will not reverse the downward price trend. We are neutral in Agriculture near term, but selectively bullish medium-term. Corn inventories remain relatively low in light of upcoming ethanol mandates. Soybeans and their products have upside next year due to the contraction in South American crops and expansion of biodiesel capacity.
Interest rates United States Euro area United Kingdom Japan
Fed funds rate 10-y ear y ields Refi rate 10-y ear y ields Repo rate 10-y ear y ields Ov ernight call rate 10-y ear y ields
Credit Markets US high grade (bp ov er UST) US high grade (bp ov er sw aps) Euro high grade all (bp ov er sw aps) USD high y ield (bp v s. UST) Euro high y ield (bp ov er Euro gov ) EMBIG (bp v s. UST)
Commodities WTI ($/bbl) Gold ($/oz) Copper ($/metric ton) Corn ($/Bu)
Current 1.00 3.95 3.75 3.89 4.50 4.52 0.30 1.46
Dec-08 0.75 3.30 2.75 3.60 3.25 4.00 0.30 1.60
Current 564 485 239 1484 1762 678 Current 64.2 722 4194 3.98
Mar-09 0.75 3.35 2.25 3.45 2.50 3.70 0.10 1.60
Jun-09 0.75 3.40 2.00 3.40 2.00 3.60 0.10 1.80
Sep-09 0.75 3.55 1.50 3.40 2.00 3.80 0.10 2.00
GBI YTD Return 4.6% 7.2% 3.6% 1.5%
Index JPMorgan US Index (JULI)
YTD Return -12.0%
JPMorgan Euro Credit Index (MAGGIE) JPMorgan Global High Yield Index JPMorgan Euro Credit Index (MAGGIE) EMBI Global 08Q4 79.0 4100 4.30
Quarterly Averages 09Q1 09Q2 75.0 70.0 875 875 4250 4250 4.45 5.30
09Q3 75.0 875 4500 5.15
-3.1% -24.3% -29.8% -21.0%
Index JPMCCI Energy JPMCCI Precious Metals JPMCCI Industrial Metals JPMCCI Agriculture
YTD Return -23.1% -19.3% -29.1% -22.1% 3m
Foreign Exchange EUR/USD USD/JPY GBP/USD AUD/USD USD/CAD
Current 1.27 98.3 1.62 0.67 1.20
YTD Return Current (local ccy) Sector Allocation Energy S&P 974 -33.9% Materials Topix 867 -37.9% Industrials FTSE 100 4377 -31.2% Discretionary MSCI Eurozone 136 -42.1% Staples MSCI Europe 930 -37.6% Healthcare DAX 4988 -39.6% Financials CAC 3487 -37.3% Information Tech. MSCI EM 26669 -47.0% Source: Bloomberg, Datastream, IBES, Standard & Poor's Services, J.P. Morgan estimates Telecommunications MSCI EM $ 561 -53.8% Utilities
Equities*
Oct 31, 2008
Dec-08 1.18 87 1.48 0.64 1.20
Mar-09 1.18 87 1.48 0.67 1.18
Jun-09 1.20 93 1.50 0.69 1.16
US
YTD ($) Europe YTD ($)
N UW UW OW UW N OW OW OW UW
-33.1% -39.3% -37.1% -32.2% -14.4% -23.5% -47.9% -37.1% -34.6% -28.4%
UW N N UW N N OW OW OW UW
-47.2% -58.5% -53.3% -42.1% -37.5% -24.0% -55.8% -49.2% -43.0% -44.7%
Sep-09 1.22 95 1.53 0.71 1.14
cash EUR JPY GBP AUD CAD
YTD Return in USD -8.1% 15.7% -14.0% -18.4% -16.3%
Japan
YTD (¥)
EM
YTD ($)
N OW N UW UW OW N UW UW
-44.3% -48.6% -39.8% -40.3% -24.3% -21.8% -42.3% -46.5% -25.6% -5.2%
UW UW N N N N OW N UW UW
-59.3% -60.0% -65.4% -49.1% -38.7% -22.4% -55.7% -43.5% -45.8% -45.5%
5
Global Asset Allocation The J.P. Morgan View Vadim di Pietro (44-20) 7777-4408
Real GDP United States Latin America Japan Asia ex -Japan Euro area United Kingdom Emerging Europe Global Dev eloped markets Emerging markets
Consumer Prices United States Euro area United Kingdom Japan Dev eloped markets Emerging markets
%q/q saar 08Q2 08Q3 2.8 4.8 -3.0 6.3 -0.7 0.0 6.3 1.7 0.6 5.9
-0.3 1.9 -0.7 4.1 -1.0 -2.0 4.2 0.3 -0.6 3.5
% over year ago 08Q2 08Q3 4.3 5.3 3.6 3.8 3.4 4.8 1.4 2.2 3.5 4.2 7.8 7.7
08Q4
09Q1
09Q2
09Q3
-4.0 1.4 -3.5 4.3 -2.0 -3.0 2.2 -1.7 -3.0 3.1
-2.0 0.0 -3.0 4.8 -1.0 -2.5 2.0 -0.8 -1.8 3.1
0.0 1.8 -2.0 6.4 0.5 -1.5 2.4 0.8 -0.2 4.5
2.5 3.6 0.3 7.4 1.0 0.0 3.0 2.4 1.5 5.6
08Q4 2.9 3.2 4.4 1.3 2.9 6.8
09Q1 1.6 2.9 3.8 0.9 2.1 6.1
09Q2 0.7 2.3 2.1 0.1 1.3 5.1
09Q3 -0.5 2.0 1.0 -0.6 0.5 4.8
% over year ago 2007e 2008e 2.0 5.2 2.0 8.8 2.6 3.0 6.5 3.4 2.4 7.5
1.3 3.8 0.3 6.9 0.9 0.8 5.6 2.0 1.0 5.8
% over year ago 2007e 2008e 2.9 4.2 2.1 3.5 2.3 3.7 0.1 1.4 2.1 3.5 4.9 7.4
2009e -0.6 1.7 -1.9 5.7 -0.5 -1.7 2.8 0.2 -0.8 4.1
2009e 0.7 2.3 1.9 0.1 1.3 5.2
Source: J.P. Morgan Analyst certification: The research analyst(s) denoted by an “AC” on the cover of this report (or, where multiple research analysts are primarily responsible for this report, the research analyst denoted by an “AC” on the cover or within the document individually certifies, with respect to each security or issuer 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 and all 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 specific recommendations 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, the recommended risk position is expected to outperform the relevant index, sector, or benchmark), Neutral (over the next three months, the recommended risk position is expected to perform in line with the relevant index, sector, or benchmark), and Underweight (over the next three months, the recommended risk position is expected to underperform the relevant index, sector, or benchmark). J.P. Morgan’s Emerging Market research uses a rating of Marketweight, which is equivalent to a Neutral rating. Valuation & Methodology: In J.P. Morgan’s credit research, we assign a rating to each issuer (Overweight, Underweight or Neutral) 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 rating agencies and the market prices for the issuer’s securities. 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