Outlook 2014

OUTLOOK 2014
J.P. Morgan Private Bank
EYE ON THE MARKET
The Great Race. Markets have zoomed ahead since 2009, anticipating that eventually the worlds economies would catch up. Thanks to extra fuel from the Fed, the U.S. is running at a steady pace and should accelerate modestly in 2014. China has hit some potholes but is still moving, just more slowly. Japans experimental model is designed to overtake EM surplus countries; still a work in progress. The Eurozone is moving again, but its design is economically and aerodynamically awed. The EM debtors are temporarily off-road. See inside for more details.
The countries and regions depicted on the cover make up 75%-80% of the world on both a GDP and equity market capitalization basis. The remainder is primarily made up of developed countries of two kinds: commodity exporters like Canada and Australia, and countries in Europe that do not use the Euro (UK, Denmark, Sweden, Norway, Switzerland, etc.). With the exception of Australia (which has been affected by the China slowdown), all these countries are in growth mode as 2013 comes to a close. From an artistic license perspective, they would have been depicted on the cover near the front of the pack. These countries are all different, but similar in one important way: they set their own monetary policy and do not suffer from the albatross of a common currency. Countries referred to as Emerging Markets do not rely on the same economic model. Some still rely on substantial foreign capital for growth (India, Brazil, Indonesia and Turkey), while others run a trade surplus (exporters of Southeast Asia), or run small trade decits and no longer require large inows (Mexico, Poland and the Czech Republic). The eventual return to a higher interest rate world is a bigger risk for the rst group than the second or third. Returns shown on the front cover represent the period from January 1, 2010 to November 30, 2013. Note: Past performance is not indicative of future returns. See sources and denitions at the end of this publication.
Cover illustration by Matthieu Forichon
MARY CALLAHAN ERDOES

Chief Executive Officer J.P. Morgan Asset Management
How do you summarize a year that was in many respects indenable? On one Happy New Year. As we enter 2014, we remind ourselves of how much has changed in the past hand, the European sovereign debt crisis, contracting housing markets and high two unemployment years, from 2012s uncertain landscape 2013s increased stability and markets moving weighed heavy on allto of our minds. But at the same time, record corporate prots and strong emerging markets growth left reason for optimism. quickly as a result. But even as markets surged, corporate prots, employment and economic
growth have struggled to back, keep pace. So rather than look wed like to look ahead. Because if theres one thing that weve learned from the past few years, its that while we cant predict the future, we can certainly help you prepare for it. So where do we go from here? What needs to happen in the coming year to close these gaps? Thats what you Michael Cembalest, our Chairman of Market and Officer Investment Strategy, Toexactly help guide in the coming year, our Chief Investment Michael has spent the past several working with our investment sets Cembalest out to answer in his Outlook 2014 , The months Great Race. Michael and team take a closer look leadership across Asset Management worldwide to build a comprehensive view at the that will determine the markets continued progress, and most importantly the of factors the macroeconomic landscape. In doing so, weve uncovered some potentially exciting investment we opportunities, as as some areas where we see reason to investment opportunities can expect as a well result. proceed with caution. The Sharing 2014 Outlook reects our view of the global investment and focuses on the these perspectives and opportunities is partlandscape of our deep commitment to you and what we focus on It each and every leadership day. We are grateful for your continued opportunities in the year ahead. is our thought and sound investment guidance trust and condence, and look forward to working with you in 2011. that have enabled us to provide our clients with the most effective solutions for the last
Most sincerely, 175 years.

Thank you, as always, for your continued trust and condence in J.P. Morgan. Most sincerely,
EYE 2014 E Y E ON O N THE T H E MARKET M A R K E T OUTLOOK OUTLOOK 2014
1, JJANUARY ANUARY 1 , 2014 2014
The Great Race: Growth and profit improvements needed to propel financial assets further
Markets zoomed ahead of the facts on the ground over the last year and were taking a pit stop as the year came to a close. After a recession, markets often rally first, profits follow and economic growth brings up the rear; theres nothing unique about that. But as shown in a note we sent last year1, the current gap between markets and economic/profit conditions is larger than in the past. For equity market gains to be sustained and built upon, profits and economic growth will have to catch up to what markets are anticipating. The outcome of this Great Race is what we believe will drive market returns in 2014. Lets take a closer look. In 2013, GDP growth and earnings growth were both in low single digits, and the pace of positive economic surprises slowed. Equities rallied anyway, and price-to-earnings multiples rose back to long-term historic averages. A variety of other indicators also moved back to pre-crisis levels (see box).
2013 was a year of low profit and GDP growth, globally and in the U.S.
Y/Y percent change in 12-month forward earnings per share
40% 30% 20%
Y/Y percent change in real GDP

6% 5% 4% 3% 2% 1% 0% -1% -2% -3% -4% 1998
S&P 500 MSCI World
Global
10%
0% -10% -20%
U.S.
-30% 1998
2001
2004
2007
2010
2013
2001
2004
2007
2010
2013
Source: J.P. Morgan Securities LLC. November 2013.
Source: International Monetary Fund. Q3 2013.
Global equities diverging from economic surprises

Index level
1600 1500 1400 1300 1200 1100 80
MSCI World Equity Index
60
40
20
0
-20
-40
1000 -80 Jan-10 Jul-10 Dec-10Jun-11 Dec-11Jun-12 Dec-12Jun-13 Dec-13 Source: Bloomberg. December 2013.
Economic Surprise Index, Major Economies
-60
Indicators back at pre-crisis levels (see page 24 for details) Speculative long equity / short bond positions on the Chicago Futures exchange The volatility of U.S. and European equities California home and condo sales executed within 6 months of purchase Investment grade and high yield corporate bond yields Discount rates applied by purchasers of U.S. and European commercial properties
Eye on the Market, September 3, 2013
A major factor contributing to the equity rally has been easy monetary policy almost everywhere. One purpose of low Central Bank policy rates was to accelerate the post-recessionary rise in financial asset prices; that part worked. Central Bank policy rates will probably not change much in 2014, apart from a few places like China. But at this stage, it will probably take more than another year of cheap money to drive markets higher. We will have to see concrete improvements in economic and profit conditions.
Central Bank policy rates expected to remain low...
Percent
14% 12% 10% 8% 6% 4% 2%
...while longer term rates rise modestly higher

10-year gov't bond yields less core inflation, percent
5% 4%
Aus
Can
Fra
Emerging markets
3%
2%
1%
UK
US Swi Jpn Ger
Developed markets
0% -1% 1998 2000 2002 2004 2006 2008 2010 2012 Curr. 2014
0% 2000 2002 2004 2006 2008 2010 2012 Source: Various central banks, J.P.Morgan Asset Management. Sept 2013.
Source: Various central banks and statistical offices. November 2013.
Thats why manufacturing surveys are the most important indicator were looking at. These surveys are useful in forecasting economic and profits growth. In the U.S., the recent uptick drives our expectation of a 2014 profits rebound of 8%-10%. In Europe, leading indicators have also risen but the gains are smaller. We are not expecting a sharp European profits rebound; the profits spike of 2003-2007 was a temporary by-product of the doomed Southern European consumption boom. Nevertheless, the Eurozone is emerging from a recession, and its corporate sector is seeing sequential profits growth again.
Rising U.S. business surveys point to rebound in earnings
Purchasing Managers' manufacturing survey
65 60 55 50 45 40 35 30 1989 1993
Y/Y % change
50% 40% 30% 20% 10% 0%
Similar but more muted outcome in the Eurozone

Purchasing Managers' manufacturing survey
65 60 55 50
Y/Y % change
50% 40% 30% 20% 10% 0% -10% -20%
PMI business activity survey
PMI business activity survey
-10% 45 -20% 40 -30% 35 -40%
U.S. earnings growth (4 months lag)

1997 2001 2005 2009
-50% 30 2013 1998
Eurozone earnings growth (2 months lag)

2000 2002 2004 2006 2008 2010 2012
-30% -40% -50%
Source: ISM, J.P. Morgan Securities LLC. November 2013.
Source: Markit, J.P. Morgan Securities LLC. December 2013.
1, 2014 JJANUARY ANUARY 1 , 2 014
Global business surveys also show a world gradually getting back to normal. The two-fisted combination of a global recession in 2008-2009 and the European debt crisis two years later took its toll. As 2013 came to a close, leading indicators suggested a return to 3.5% global growth in 2014, and a rising number of countries in expansion mode. A decline in fiscal austerity should help; in the developed world, the 2014 fiscal drag should be around half of what it was in 2012 and 2013.
Rising number of countries in expansion mode
% of PMI leading indicator universe > 50, or 6-month change 4
100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 2005 2006 2007 2008 2009 2010 2011 2012 2013 Source: Based on Markit's 35-country universe using data as of November 2013. PMI of 50 denotes expansion.
The potholes: the Eurozone (still) and Emerging Markets debtor nations. The latter are undergoing a traditional balance of payments problem, defined by falling growth, the exodus of foreign capital, rising interest rates and a period of retrenchment. Less liquidity from the U.S. Federal Reserve is a challenge for capital importers like the EM debtor nations. As for the Eurozone, recent improvements are notable, but the region is still suffering from deleveraging, sub-trend growth, and sharply diverging fortunes between Germany and the Periphery (and France). Net private sector credit creation is a clear indicator of whether a region is getting back to normal, and in the Eurozone, its still zero. 2014 looks like a better year for Europe, but there are reasons to be concerned about its long-term growth.
U.S. leads in the private sector credit recovery
100%
80% 60% 40% 20%
Net private sector credit creation as % of public plus private UK
A growing gap between EM debtor nations and the rest

25% 20% 15%
6-month annualized % change in industrial production EM excluding debtor nations
10%
Eurozone
U.S.
5% 0% -5% -10%
-15%
Japan
2001 2003 2005 2007 2009 2011 2013
EM debtor nations
0% 1999
Source: JPMAM, FRB, ECB, Bank of England, Bank of Japan. Q2 2013.
-20% 2007 2008 2009 2010 2011 2012 2013 Source: Haver Analytics, JPMAM. GDP-weighted aggregates. Sept 2013.
EYE ON THE MARKET OUTLOOK 2014 EYE 2014 E Y E ON O N THE T H E MARKET M A R K E T OUTLOOK OUTLOOK 2014
JANUARY 1, 2014 1, 2014 JJANUARY ANUARY 1 , 2 014
On regional equity markets, last year was a break in the trend of U.S./Emerging Markets On regional equity markets, last year was a break in the trend of U.S./Emerging Markets portfolios outperforming Europe/Japan. This was mostly a by-product of Emerging Markets portfolios outperforming Europe/Japan. This was mostly a by-product of Emerging Markets underperformance at a time when investors re-embraced Europe and an unorthodox policy underperformance at a time when investors re-embraced Europe and an unorthodox policy experiment in Japan. Keep in mind that Japans experiment is not just monetary: As outlined on page experiment in Japan. Keep in mind that Japans experiment is not just monetary: As outlined on page 16, Japan is attempting to steer hundreds of billions (in USD) of Japanese household and pension 16, Japan is attempting to steer hundreds of billions (in USD) of Japanese household and pension assets into equities. With more Japanese stimulus coming and the problems of the EM debtor assets into equities. With more Japanese stimulus coming and the problems of the EM debtor nations, 2014 looks like another year of developed market equity outperformance vs. EM equities. nations, 2014 looks like another year of developed market equity outperformance vs. EM equities.
Equity markets total return index, 12/31/2008 = 100 230 230 U.S. 205 U.S. 205 EM EM 180 Operation EUR 180 Operation Twist EUR 155 Twist 155 JPN JPN 130 130 105 Abenomics Draghi's Speech 105 Abenomics Draghi's Speech 80 80 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13 Jan-09Bloomberg. Jan-10 Jan-11 Jan-12 Jan-13 Source: Q3 2013. Source: Bloomberg. Q3 2013. Note: S&P 500 index used for U.S., MSCI indices for other regions. Note: S&P 500 index used for U.S., MSCI indices for other regions.
The era of Central Bank-driven equity rallies The era of Central Bank-driven equity rallies Equity markets total return index, 12/31/2008 = 100
We expect 2014 to mark a return to more traditional We expect relationships 2014 to mark a return to more traditional risk/return risk/return relationships
Time period Time period
Annualized Annualized Annualized Return Annualized Volatility Return Volatility
Post Bretton Woods to pre-crisis Post Bretton Woods to pre-crisis 10/1972 to 05/2008 10/1972 to 05/2008 Financial crisis Financial crisis 05/2008 to 03/2009 05/2008 to 03/2009 Volatile, high-return post-crisis recovery Volatile, high-return post-crisis recovery 03/2009 to 12/2011 03/2009 to 12/2011 Easy money spreads to ECB, BoJ Easy money spreads to ECB, BoJ 12/2011 to 11/2013 12/2011 to 11/2013
Source: Bloomberg. November 2013. Source: Bloomberg. November 2013.
10.9% 10.9% -53.0% -53.0% 22.9% 22.9% 23.1% 23.1%
16.0% 16.0% 48.0% 48.0% 21.4% 21.4% 12.1% 12.1%
To summarize, we expect the markets car to slow down from its break-neck pace as the To summarize, we expect the markets car to slow down from its break-neck pace as the economic vehicles catch up, and for 2014 to be a year of more modest appreciation in economic vehicles catch up, and for 2014 to be a year of more modest appreciation in equity, credit and real estate markets. After the surge since the spring of 2009, we anticipate a equity, credit and real estate markets. After the surge since the spring of 2009, we anticipate a gradual return to high single-digit equity market gains and double-digit market volatility. As for fixed gradual return to high single-digit equity market gains and double-digit market volatility. As for fixed income, we are emerging from a period when Central Banks drove government bond yields to or income, we are emerging from a period when Central Banks drove government bond yields to or below the rate of inflation; long-term interest rates are now starting to rise modestly. Consequently, below the rate of inflation; long-term interest rates are now starting to rise modestly. Consequently, 2014 also looks like another year in which cash and lower-risk fixed income dont add much to 2014 also looks like another year in which cash and lower-risk fixed income dont add much to portfolios2 . If so, investors would benefit in 2014 from maintaining many of the portfolio portfolios2. If so, investors would benefit in 2014 from maintaining many of the portfolio allocations that have been working since the global recession ended in 2009. allocations that have been working since the global recession ended in 2009. This years Eye on the Market Outlook walks through our views on markets by region, followed by an This years Eye onof the Market Outlook walks our views on markets by region,bonds, followed by an in-depth analysis certain investment topicsthrough (public equity, private equity, municipal hedge in-depth analysis of certain investment topics (public equity, private equity, municipal bonds, hedge funds and credit markets). Keep an eye out for Richard Madigans Market Thoughts later this funds and credit markets). Keep eye out for Richard Madigans Market Thoughts later this month, which takes a look at howan our market and strategy views impact client portfolios. month, which takes a look at how our market and strategy views impact client portfolios. Michael Cembalest Michael Cembalest J.P. Morgan Asset Management J.P. Morgan Asset Management
2 2
Lets take the U.S. Barclays Aggregate Index of government, agency and corporate bonds as an example, and Lets take the U.S. Barclays Aggregate Index of government, agency and (including corporate the bonds as an function example,of and incorporate its current yield of 2.4% and sensitivity to rising interest rates reaction incorporate its current yield of 2.4% and sensitivity to rising interest rates (including the reaction function of mortgage prepayments). Assuming a 0.50% parallel shift higher in the Treasury curve in 2014, we estimate mortgage prepayments). Assuming a 0.50% parallel higher in the Treasury curve in 2014, we estimate that the Index would return 0.5%-1.0% for the year. shift If interest rates were unchanged, that estimate would rise that the Index would return 0.5%-1.0% for the year. If interest rates were unchanged, that estimate would rise to 2.5%-3.0%. In 2013, through December 16, the Index returned -1.9%. to 2.5%-3.0%. In 2013, through December 16, the Index returned -1.9%.
4
4 4
Table of Contents United States: Post-austerity growth improvements to show up by mid-year Europe: Enjoy the intermission Emerging Markets: Debtor nation balance of payment crises not as severe as prior episodes Japan: The experiment continues, but so far, only weakening the Yen seems to work In-depth investment topics Risk and opportunity in credit markets A revised look at private equity performance, and some themes for 2014 On recent underperformance of hedge funds vs. equities, and outperformance vs. bonds Tracking performance trends in active equity management How different are the countries of the European Monetary Union? Indicators cited in the preface that have returned to pre-crisis levels U.S. fiscal outlook: Quieter in 2014, with long-term battles ahead U.S. municipal bond outlook and the constitutional question of Detroit 6 9 12 15 19 20 21 22 23 24 25 26
United States: Post-austerity growth improvements to show up by mid-year

It would be great to be able to say that the U.S. economy is doing well enough for monetary policy to get back to normal, but this is not the case. As shown by the motorcycle on the cover, the Feds support for growth is still substantial. While the pace of Fed asset purchases will slow in 2014, there are two important things to remember: The Fed will be around for a long time. The size of the Feds balance sheet will not probably peak until late 2014, and we expect it to remain above 2011 levels until 2020. Remember, the Fed has stated that it has some tolerance for a period of inflation in excess of its long-term targets. Fed tapering was mitigated by a recommitment to low policy rates for a long period. The output gap (a proxy for spare capacity in the economy) is substantially larger than in comparable post-recession periods. In more concrete terms, zero percent real wage growth and a large cohort of involuntarily unemployed people are still problems for the Fed. Bottom line: We expect policy rates at or close to zero until 2016.
Fed's stock of securities holdings should remain high
Fed securities holdings, USD trillions
4.0 3.0 2.0 1.0 U.S. Treasuries U.S. Treasuries U.S. Treasuries U.S. Treasuries Agency debt Agency MBS (< 1yr) (1-5 yrs) (5-10yrs) ( > 10yr)
A proxy for excess capacity explains the Fed's go-slow approach so far, output gap, percent of potential GDP
4%
Projection FOMC participants' expectations for when the target federal funds rate will be 1%
2% 0% -2% -4% -6% -8% -3 -2 1981
1973
1990 CBO projection 6 7
2007 -1 0 1 2 3 4 5 Number of years from business cycle peak
0.0 2007 2009 2011 2013 2015 2017 Source: Federal Reserve, J.P. Morgan Asset Management. November 2013. FOMC: Federal Open Market Committee.
Source: NBER, CBO, J.P. Morgan Asset Management. September 2013.
Another reason we think the Fed will go slow: in addition to a large output gap, the recovery has been driven so far by interest-rate-sensitive sectors. This is typical for a recovery, but highlights the risk of interest rates rising prematurely. As things stand now, real hourly earnings have experienced no material rise since 2008; weak wage growth is the largest single factor behind the corporate profits boom. GDP growth is still in the 1.5%-2.0% range.
The importance of low interest rates to the recovery
115 112 109 106 103 100 97 2009 2010 2011 2012 2013 Source: BEA, JPMAM. *Durable goods consumption plus structures. Q3 2013.
GDP contribution, index, Q2 2009 =100
The pillars of U.S. economic growth

16% 12% 10% 8% 6% 4% 2% 0% -2%
Three-month annualized rate of change, percent

Production Housing
30% 25%
Interest-rate-sensitive sectors* Everything else
14%
20%
15% 10%
5%
0%
Consumption -4% Jan-11 Jun-11 Nov-11 Apr-12
Employment Sep-12 Feb-13 Jul-13
-5%
-10%
Source: NAR, BLS, BEA, Census, JPMAM. October 2013.
With that backdrop, why is the U.S. car in the lead in the Great Race? Because we believe 2014 will show signs of improvement after last years austerity. When taking into account increased taxes (payroll, income and Obamacare) and spending cuts, 2013 was the third-largest fiscal drag in the past 50 years. Furthermore, there was the distraction of a government shutdown. Without these roadblocks in 2014, we expect growth to improve. The long-term fiscal situation is still a problem, but after the 2011 Budget Control Act and the 2013 tax act, the 10-year deficit outlook has stabilized since the August 2011 rating agency downgrade (see page 25). Other reasons for optimism: U.S. household and corporate balance sheets have undergone substantial healing. There are two ways to look at this: on a debt/GDP basis (the Eurozone is shown for comparison purposes), and based on debt service to household income. The latter has fallen to early-1990s levels, courtesy of low interest rates. To be clear, there are few signs of households or small businesses adding much credit right now; credit growth is primarily confined to student loans and borrowing by large businesses. But the deleveraging trend has slowed.
U.S. deleveraging appears to be slowing
150% 145%
Debt of households and nonfinancial corporations, % of GDP
Debt service declining more sharply than debt levels

220% 130%
Percent of household disposable income
14.5% 14.0% 13.5%
140%
135% 130%
210% 120%
200% 110%
Household debt service
13.0% 12.5%
12.0% 11.5% 11.0%
125%
120% 115% 110%
U.S. Eurozone
190% 100%
180%
170% 160% 2009 2011 2013
90% 80% 70%
Household debt
10.5%
2010 10.0%
105% 1999 2001 2003 2005 2007 Source: FRB, BEA, Eurostat. Q2 2013.
150%
60% 1980 1990 2000 Source: Federal Reserve, BEA. Q2 2013.
EYE ON THE MARKET OUTLOOK 2014 EYE 2014 E Y E ON O N THE T H E MARKET M A R K E T OUTLOOK OUTLOOK 2014
More ammunition for a U.S. recovery: 3 More ammunition for U.S. recovery: A lot of cash held bya households and companies3, and low corporate debt levels lot of held by households companies , and low corporate debt levels A Signs of cash continual easing in bank and lending standards of continual easing in bank lending for standards Signs State and local payroll growth increasing the first time since the financial crisis; state and local State and local payroll growth increasing for the firstin time since the financial crisis; state and local consumption and investment are now the strongest four years consumption and investment are now the strongest in four years Cheaper electricity costs in the U.S., a topic discussed in detail in last years annual energy piece4 4 Cheaper electricity and on page 20 costs in the U.S., a topic discussed in detail in last years annual energy piece page 20 and Evenon after accounting for shadow inventory, new and existing homes for sale as a percentage of Even after accounting shadow inventory, new and existing for sale as a percentage of households is very lowfor (a by-product of several years of limitedhomes new construction). The number households is very low (a by-product of several years of limited new construction). The number of 25-34 year olds living with their parents is at a 35-year high of 25-34 year olds living with their parents is at a 35-year high Some believe that elevated cash balances and low business capital spending are structurally Some believe that elevated cash balances and low business capital are structurally permanent by-products of an aging population, zero interest rates spending and/or the long-term Federal debt permanent by-products of an aging population, zero interest rates and/or the long-term outlook. I see a mix of structural and cyclical forces at work, with structural issues being Federal more ofdebt a outlook. I see a mix of structural and cyclical forces at work, with structural issues being more ofrate a problem for businesses than households. All things considered, by mid-2014, a 3% growth problem for businesses than households. All things considered, by mid-2014, a 3% growth rate in the U.S. is within reach. in the U.S. is within reach.
26% Household and corporate cash balances, % of tangible assets 26%
Lots of cash, everywhere Lots of cash, everywhere Household and corporate cash balances, % of tangible assets
23% 23%
20% 20%
17% 1952 1962 1972 1982 17% 1952 Federal 1962 Source: Reserve.1972 Q2 2013. 1982 Source: Federal Reserve. Q2 2013.
1992 1992
2002 2002
Percent 50% 50% 45% 45% 40% 40% Ex-financials & tech 35% Ex-financials & tech 35% 30% 30% 25% 25% Ex-financials 20% Ex-financials 20% 15% 15% 10% 1990 1993 1996 1999 2002 2005 2008 2012 10% 1990 UBS 1993 1996 1999 2002 2005 2008 2012 Source: Securities LLC. Q3 2013. Source: UBS Securities LLC. Q3 2013.
S&P 500 net debt to market cap S&P 500 net debt to market cap Percent
2011 2011
Falling vacancy rates will eventually lead to new Falling vacancy rates will eventually structures, lead to new construction, investment in commercial % of GDP construction, investment in commercial structures, % of GDP 1.0%
1.0%
0.8% 0.8%
0.6% 0.6%
Tax boom Tax boom
0.4% 0.4%
0.2% 0.2%
Office buildings Office buildings
Shopping Shopping malls malls
Tech boom Tech boom Credit Credit boom boom
Hotels 0.0% 1947 1954 1961 1968 1975 1982 1989 1996 2003 2010 0.0% 1947 BEA. 1954 1961 1968 1975 1982 1989 1996 2003 2010 Source: 2012. Source: BEA. 2012.
Hotels
Electricity prices by region, USD per MWh 350 Households 350 300 Households Industrial users 300 Industrial users 250 250 200 200 150 150 100 100 50 50 0 U.S. CHN FRA UK GER JPN 0 U.S. CHN FRA UKCommission. GER Q2 2012. JPN Source: IEA, National Development and Reform
Source: IEA, National Development and Reform Commission. Q2 2012.
The U.S. electricity advantage The U.S. prices electricity advantage Electricity by region, USD per MWh
3 3
While global M&A activity has been weak, the stock buyback story has generally been positive. In September While global noted M&A activity has been weak, stock buyback story generally been positive. In September 2013, FactSet that the number of S&Pthe companies engaging inhas both a dividend and a buyback over the 2013, FactSet noted that the number of S&P companies engaging in both a dividend and a buyback over thein trailing twelve-month period reached its highest level since 2005 (71% of the S&P 500 index). Q2 buybacks trailing twelve-month period reached its highest level since 2005 (71% of the S&P 500 index). Q2 buybacks dollars were up 24.2% from Q1, and up 12.3% vs. 2012. However, y/y growth when measured in dollars in dollars were been up 24.2% from and up 12.3% vs. 2012. However, y/y growth when measured in dollars would have roughly flatQ1, without Apple. would have been roughly flat without Apple. 4 Reality Check: Annual Energy Eye on the Market, October 28, 2013 4 Reality Check: Annual Energy Eye on the Market, October 28, 2013
8
8 8
Europe: Enjoy the intermission

Signs of improvement appeared on a number of fronts in the Eurozone last summer. Manufacturing surveys started rising again and we began to see foreign capital returning, even in Spain and Greece. Examples include foreign capital seeking non-performing loan sales by European banks, and distressed real estate and bank acquisitions in Spain. In the U.S., these kinds of transactions have historically signaled that the worst is over.
Eurozone rebound: everywhere but France
Purchasing Managers' Composite Index, level
65 60 55 50 45 40 2010
"Non-Eurozone Europe" doing better

65
Purchasing Managers' Manufacturing Index, level Germany
France Germany
UK
60 55 50
Denmark, Poland, Norway, Sweden, Switzerland, UK
Periphery
2011 2012 2013
45 40 2010
Rest of the Eurozone

2011 2012 2013
Source: Markit, J.P. Morgan Securities LLC. December 2013.
Source: Markit, J.P. Morgan Securities LLC. November 2013.
Other positive news: European countries that dont use the Euro (Denmark, Norway, Poland, Sweden, Switzerland, UK, etc.) are doing better, in large part a result of having their own independent monetary policies Consumer confidence is rising, and leading indicators on hiring are picking up Current account deficits in Spain, Greece and Portugal are in balance after having registered massive gaps of 10%-14% of GDP in 2008. These indicators suggest on paper that Southern Europe has finally shed its reliance on foreign capital Unit labor cost gaps versus Germany, a primary feature of the Eurozone for over a decade, have declined by half in Ireland, Portugal, Spain and Greece (not Italy or France) Fiscal austerity in Europe will be considerably smaller next year: In 2012, the fiscal drag on growth was 1.7% of GDP; in 2013 0.9%; and in 2014, is estimated at 0.7% Low-cost ECB lending reduced near-term default risk: Spanish and Italian banks borrowed from the ECB and bought the lions share (50%-60%) of government debt issuance since 2008 Germany is setting a pro-growth agenda (higher minimum wage, more government spending, tax incentives for housing and R&D). The German IFO business survey surged into year-end
Germany goes for growth; Eurozone job outlook improves
58 54 50 46 42 38
Eurozone PMI on employment
IFO Index
120 115 110 105 100 95 90 85 80
135 130 125 120 115 110 105
Competitiveness improvements in Portugal, Spain and Greece, unit labor costs relative to Germany, index, Q4 2000=100
Eurozone employment PMI
less competitive labor market

Italy France Spain Portugal Greece
German IFO Business Climate Index

2009 2011 2013
34 1997 1999 2001 2003 2005 2007 Source: Markit, IFO Institute. November 2013.
100 2000 2002 2004 2006 2008 2010 2012 Source: Eurostat, J.P. Morgan Asset Management. Q3 2013.
EYE ON THE MARKET
OUTLOOK 2014
The problem: these improvements may only result in a growth rebound of ~1.5%, which mayproblem: not improve conditions much. may Even only where surveys are rising, actual consumption and The these improvements result in a growth rebound of ~1.5%, which production have not picked up as much. If GDP growth peaks at 1.5%, Eurozone employment may may not improve conditions much. Even where surveys are rising, actual consumption and 5 . On remain weak with little improvement to unemployment rates, which are at all-time highs production have not picked up as much. If GDP growth peaks at 1.5%, Eurozone employment may 5 improved current accounts, a collapseto inunemployment consumption and imports has a at lot to do with how these remain weak with little improvement rates, which are all-time highs . On 6 deficits closed ; this was nota just an export-led result. Finally, European has improved current accounts, collapse in consumption and imports has corporate a lot to dodeleveraging with how these 6 further to fall (see page 7), and the Euros rise vs. the Yen is not going to help European exports. deficits closed ; this was not just an export-led result. Finally, European corporate deleveraging has further to fall (see page 7), and the Euros rise vs. the Yen is not going to help European exports.
Employment: two ships passing in the night
Index of employment, Q1 2007 = 100 Index of employment, Q1 2007 = 100
Death in Venice Death in Venice
Employment: two ships passing in the night 102

101 102 100 101 99 100 98 99 97 98 96 97
Industrial Production Index, 2000 = 100

140 130 140
European Union European Union Eurozone
Industrial Production Index, 2000 = 100 Euro exchange rate fixed Euro exchange 120 130 rate fixed
110 120 100 110 90 100
Germany Germany
Eurozone
U.S.
2010 2010 2011 2011 2012 2012 2013 2013
95 96
80 90 70 80 1982 1986 1990 1994 1998 2002 70 Source: OECD, GaveKal Securities. September 2013. 1982 1986 1990 1994 1998 2002 Source: OECD, GaveKal Securities. September 2013.
Italy Italy
2006 2006 2010 2010
U.S. 94 95 2007 2008 2009 94 Source: BLS, Eurostat. Q2 2013. 2007 2008 2009
Source: BLS, Eurostat. Q2 2013.
Lets put the cyclical issues aside for a moment. The fundamental challenge for the Eurozone remains: reconcile macroeconomic and microeconomic differences between Lets puthow the to cyclical issues aside for a moment. The fundamental challenge formember the Eurozone countries. We have published dozens of charts about this, and the one that resonates most is the remains: how to reconcile macroeconomic and microeconomic differences between member one on industrial production in Germany and Italy. After moving in tandem for decades, they countries. We have published dozens of charts about this, and the one that resonates most is the were driven apart by the Euro. On page 23, we include some work we have done on regional one on industrial production in Germany and Italy. After moving in tandem for decades, they divergence, including a chart showing how cross-country differences inwe thehave Eurozone as high as were driven apart by the Euro. On page 23, we include some work done are on regional for a hypothetical monetary union comprised of all countries in the world beginning with the letter divergence, including a chart showing how cross-country differences in the Eurozone are as high as M . Where this issue becomes more tangible: if these differences prevent more aggressive, for a hypothetical monetary union comprised of all countries in the world beginning with the letter proactive ECB action regarding European deflation risks. prevent ECB monetary policy even as it M. Where this issue becomesSouthern more tangible: if these differences more aggressive, now stands is causing concerns about inflation risk and stealth expropriation of savers in even Germany. proactive ECB action regarding Southern European deflation risks. ECB monetary policy as it These challenges explain why the Euro is depicted on the cover as an albatross following the region. now stands is causing concerns about inflation risk and stealth expropriation of savers in Germany. These challenges explain why the Euro is depicted on the cover as an albatross following the region.
5 5
6 6
In real terms, import contraction the current account inrisks Portugal, 23% in Spain, and extremist parties in parts ofexplains Europe. 19% This of is a different issue, but improvement one that bears of its own. 15% in Italy and 30% in Greece, with rising exports accounting for the rest. However, in Asia ( 1990s and In real terms, import contraction explains 19% of the current account improvement in Portugal, 23%) in Spain, Latin America ( 1980s ), import contractions accounted for 0%-10% of current account improvements. In 15% in Italy and 30% in Greece, with rising exports accounting for the rest. However, in Asia (1990s) and other words, (it is rare that an import collapse plays such a big of role. Latin America 1980s ), import contractions accounted for 0%-10% current account improvements. In other words, it is rare that an import collapse plays such a big role.
10
Despite very high levels of unemployment, an explicitly anti-Euro party has not succeeded at the polls. However, as cited Germanys Friedrich Ebert Foundation, there been noticeable rise in right -wing Despite very highby levels of unemployment, an explicitly antiEuro has party has a not succeeded at the polls. and extremist parties in parts of Europe. This is a different issue, but one that bears risks of its own. However, as cited by Germanys Friedrich Ebert Foundation, there has been a noticeable rise in right-wing
10 10
EYE ON THE MARKET
OUTLOOK 2014
JANUARY 1, 2014 JANUARY J A N U A R Y 1, 1 , 2014 2014
EYE OUTLOOK 2014 E Y E ON O N THE T H EMARKET MARKET OUTLOOK 2014
On investments in Europe. In 2011, when financial markets were pricing in a high certainty of negative outcomes, much cheaper thanwere U.S. pricing counterparts. The Draghi of On investments in European Europe. equities In 2011,were when financial markets in a high certainty whatever it takes speech in Ju ly 2012 immediately lowered perceptions of disintegration risk and negative outcomes, European equities were much cheaper than U.S. counterparts. The Draghi the equity valuation gap versus the U.S. began to close. This revaluation process is mostly complete whatever it takes speech in July 2012 immediately lowered perceptions of disintegration risk and with perhaps a bit more go in 2014, if the This ECB revaluation engages in process the kindis of large-scale the equity valuation gap to versus the U.S.particularly began to close. mostly complete 7 securities purchases undertaken by the Federal Reserve . So far, the ECB is saying these measures will with perhaps a bit more to go in 2014, particularly if the ECB engages in the kind of large-scale only be taken if theres another shock. As a reminder, growth rates in France, Spain and securities purchases undertaken by the Federal Reserve7long . So-term far, the ECB is saying these measures will 8 Italy are at their lowest levels since the 1820s (ex-wartime). only be taken if theres another shock. As a reminder, long-term growth rates in France, Spain and
8 Italy are at their lowest levels sinceis the 1820s (ex-wartime). To conclude, our view on 2014 that investors should enjoy the intermission during which Eurozone economic growth and financial asset prices improve. As shown on page 2, rising To conclude, our view on 2014 is that investors should enjoy the intermission during which business surveys do point to better earnings growth. However, if a 1.0%-1.5% GDP growth Eurozone economic growth and financial asset prices improve. As shown on page 2, rising rebound surveys proves insufficient, the structural issues will return to the forefront. As shown on business do point to many betterof earnings growth. However, if a 1.0%-1.5% GDP growth the cover, the Eurozone as currently is not built forreturn speed. rebound proves insufficient, many ofconfigured the structural issues will to the forefront. As shown on
the cover, the Eurozone as currently configured is not built for speed.
European equity discount to U.S. continues to fall
European P/E ratio divided by U.S. P/E ratio European P/E ratio divided by U.S. P/E ratio Premium
Two indices are most often referred to as European equities: the EuroStoxx 50 and the MSCI Europe Index.are They are quite different: There only a 26%equities overlap in companies due toand the the higher Two indices most often referred to asisEuropean : the EuroStoxx 50 MSCI concentration and larger market capitalization sizes in the EuroStoxx. The other big difference: The MSCI Europe Index. They are quite different: There is only a 26% overlap in companies due to the higher Europe Index has large exposures to the UK (34%) Switzerland (14%), while the EuroStoxxThe hasMSCI none. concentration and larger market capitalization sizesand in the EuroStoxx. The other big difference: Europe Index has large exposures to the UK (34%) and Switzerland (14%), while the EuroStoxx has none.
MSCI Europe 30% 40% to U.S. Premium 20% MSCI Europe 30% to U.S. 10% 20% 0% 10% -10% 0% -20% -10% -30% -20% Discount -40% -30% EuroStoxx 50 to U.S. -50% Discount -40% 1969 to U.S. 1975 1981 1987 1993 1999 2005 EuroStoxx 50 -50% Source: MSCI, Datastream, Factset. November 2013. 1969 1975 1981 1987 1993 1999 2005 Source: MSCI, Datastream, Factset. November 2013.
European equity discount to U.S. continues to fall 40%
2011 2011
S&P 500 50% 30% MSCI Europe 40% S&P 500 20% 30% 10% 20% 0% 10% -10% 0% -20% EuroStoxx 50 -10% -30% -20% EuroStoxx 50 -40% -30% -50% -40% 1998 2001 2004 2007 2010 2013 -50% Source: J.P. Morgan Securities LLC. November 2013. 1998 2001 2004 2007 2010 2013 Source: J.P. Morgan Securities LLC. November 2013.
European earnings growth crawling back to positive territory, Y/Y percent change, 12-month forward earnings per share European earnings growth crawling back to positive 50% territory, Y/Y percent change, 12-month forward earnings per share MSCI Europe 40%
According to an analysis by J.P. Morgan Securities LLC, a European bond-buying program would need to be around 550 billion Euros, derived in order to maximize employment without jeopardizing price stability. 7 According to an analysis by J.P. Morgan Securities LLC, a European bond-buying program would need to be 8 See Eye550 on the Market , April 1, 2013, for to a chart on 7-year real growth since 1826 in France, and Italy. around billion Euros, derived in order maximize employment without jeopardizing priceSpain stability.
8
See Eye on the Market, April 1, 2013, for a chart on 7-year real growth since 1826 in France, Spain and Italy.
11
11 11
Emerging Markets: Debtor nation balance of payments crises not as severe as prior episodes, but still painful
For once, the main story in emerging markets is not about China. Theres an old-fashioned balance of payments crisis going on in the debtor nations (Brazil, India, Indonesia and Turkey). A combination of factors makes this episode less problematic than prior ones in Latin America in the 1980s and Asia in the 1990s, but we dont think the adjustments are over yet. Whats a balance of payments crisis? The next three charts tell the abbreviated story. First, capital floods into a country, allowing interest rates to fall and consumption to rise. The country typically experiences a large current account deficit due to rising imports and falling exports. Then, if capital inflows do not result in sufficient growth and productivity improvements, eventually growth declines and investors want their money back.
Rising vulnerability to capital outflows in the Big 4: Brazil, India, Indonesia and Turkey, percent of GDP
Net capital inflows
Nominal GDP growth of EM debtors

30%
25% 20% 15% 10%
Y/Y percent change
8%
6%
Indonesia
India
4%
2% 0% -2% -4%
5%
Turkey
-6% 2002 2004 2006 2008 2010 2012 Source: National Central Banks, J.P. Morgan Asset Management. Q3 2013.
Current account
0%
Brazil
-5% 2006
2008
2010
2012
Source: National statistical agencies. Q3 2013.
Capital outflows generally cause a decline in growth and asset prices, and a decline in the currency. It would be tempting for a Central Bank to lower interest rates to reinvigorate growth, but if the country is running close to full capacity, lower interest rates could cause inflation. Instead, affected countries often have to raise interest rates to defend their currencies and prevent inflation from rising too much. That is what has happened so far.
Debtor nation bond yields rising sharply
5-year government bond yields, percent
13% 12% 11% 10% 9% 8% 7% 6% 5% 4% Jan-11
Brazil Turkey
India Indonesia
Jul-11 Jan-12 Jul-12 Jan-13 Jul-13
Source: Bloomberg. December 2013.
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12
Fortunately, there are two major differences compared to prior crises. First, countries involved have a lot of foreign exchange reserves, allowing them to defend their currencies as capital flees. This prevents a collapse in their exchange rates, and reduces risks of inflation and domestic bankruptcy. The second difference is that these countries do not have fixed exchange rates, making the rush for the exit problem less acute. 2014 should be another difficult year of adjustment, but we expect the process to play out with less damage to their economies and to the rest of the world than in the past.
EM external account measures, past and present, with key differences vs. prior episodes circled in red
1980's: ARG, BRL, MEX, VEN External Debt (% of Exports) Interest on External Debt (% of Exports) Reserves (% of External Debt) Current Account (% of GDP) Exchange Rates vs. the USD Exchange Rate Type 401% 39.7% 7.7% -5.1% -97.5% Managed 1996: INDO, KOR, MAL, THA 130% 6.6% 28.8% -4.5% -61.1% Managed Today*: BRL, IND, INDO, TUR 156% 4.6% 61.6% -3.7% -13.7% Floating
Source: IMF, Economist Intelligence Unit, JPMAM. *2013 YTD. December 2013.
As for China, recent data have been positive, with GDP growth at 8%-9%. Manufacturing surveys show signs of modest improvement and key indicators like electricity production have picked up. Production growth is at the strongest level since 2010 and fixed investment growth is stable. The risk in China relates to the credit expansion that took place after the global recession. Chinas real growth is lower than reported after adjusting for credit expansion and loose fiscal policy. While inflation is low, there are signs of rapid growth in real estate prices, rising wages and tight labor markets. Short and medium-term interest rates have risen sharply and will probably remain high, which will likely reduce growth to ~7%. Tighter monetary policy appears to be part of the plan announced by Chinas Central Bank, which has referred to periods of deleveraging and capacity reduction. Chinas plan re-emphasizes market mechanisms and a reduced presence for inefficiently run state-owned enterprises. Sounds good on paper, but the immediate future entails tighter monetary policy to address asset inflation and credit risks.
Chinese manufacturing surveys point to modest expansion, Purchasing Managers' Index, level Electricity production confirms positive momentum
Y/Y % change in electricity production
25% 20% 55 15%
60
50
10%
5%
45
Markit PMI
China NBS PMI
0%
-5%
40 2005 2007 2009 2011 2013 Source: Markit, National Bureau of Statistics of China. November 2013.
-10% 2005 2007 2009 2011 Source: International Strategy & Investment Group LLC. Q3 2013.
2013
13
13
Are EM debtor countries worth buying? The debtor nations underperformed the rest of EM in 2013 by ~15%, but their P/E multiples are still higher. This is partially explained by sector differences, since debtor markets are more heavily weighted to consumer and technology stocks that trade at higher multiples. Nevertheless, markets might be too sanguine about 2014, particularly as the Fed reduces its asset purchases, which in turn reduces global liquidity. We prefer countries that run a current account surplus, or at most a small deficit (Mexico, Korea, the Czech Republic, Taiwan, the Philippines) for the reasons discussed above. We also see 2014 as another year in which emerging market equities trail developed markets. Even in some EM surplus nations, exports have slowed down and the general commodity price decline is taking a toll. As discussed in the next section, Japans stimulus plan is designed in part to recapture export market share from other emerging Asian countries through a weak Yen.
EM debtor nations trade at higher multiples than surplus nations, P/E multiple,12-month forward
Brazil, India, Indonesia and Turkey
Private equity has outperformed public equity in Asia and Latin America, 5-year annualized return through Q2 2013, percent
10% 8% 6% 4% 2% 0%
13.0x 12.5x 12.0x 11.5x 11.0x 10.5x 10.0x 9.5x 9.0x
Rest of the Emerging Markets

Jul-11 Jan-12 Jul-12 Jan-13 Jul-13
-2% -4% MSCI Pacif ic MSCI EM Asia PE & Asia Index VC Index Asia EM PE & VC Index MSCI EM LatAm & Latin Caribbean America PE & VC Index
8.5x Jan-11
Source: MSCI. JPMS LLC. November 2013. Sector neutral P/Es used.
Source: Cambridge Associates LLC.
One last observation on investing in emerging markets. Investors are often focused on rising household wealth and consumption in emerging countries. In many countries, however, there arent enough publicly tradable consumer discretionary and consumer cyclical companies, leaving equity markets to be dominated by industrials, exporters, banks, utilities, etc. As a result, investors often look to private equity markets as well. Private equity has outperformed public equity in both Asia and Latin America over the past five years. In our experience, one of the primary reasons is a greater focus on consumer-related investments by EM private equity managers.
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E Y E ON O N T H E MARKET MARKET OUTLOOK 2014 EYE 2014 E Y E O N THE T H E M A R K E T OUTLOOK OUTLOOK 2014
JANUARY 1 , 2014 2014 1, JJANUARY ANUARY 1 , 2 014
Japan: The The experiment experiment continues, continues, but but so so far, far, only only weakening weakening the the Yen Yen seems seems to to work work Japan:
At the the end end of of 2012, 2012, Japan Japan was was still still mired mired in in its its 25-year 25-year malaise malaise9. . A A radical radical approach approach was was launched launched At that involves monetary stimulus that dwarfs what the Fed and ECB have done. Goals: 3% nominal that involves monetary stimulus that dwarfs what the Fed and ECB have done. Goals: 3% nominal GDP growth growth and and 2% 2% real real GDP GDP growth, growth, levels levels that that havent havent been been seen seen in in Japan Japan in in 20 20 years years. . GDP Japans leaders point to similar efforts during the 1930s by Finance Minister Takahashi that ended Japans leaders point to similar efforts during the 1930s by Finance Minister Takahashi that ended deflation. Takahashis Takahashis p policies olicies included included a a 40% 40% decline decline in in the the Yen, Yen, lower lower tax tax revenue revenue and and a a rise rise in in deflation. public works spending (note: the only spending Takahashi cut was military spending, which led to his his public works spending (note: the only spending Takahashi cut was military spending, which led to assassination by by Japanese Japanese military military officers officers in in 1936). 1936). assassination
Japan's massive money experiment Japan's massive money experiment
120% 120% 90% 90%
9
Central Banks' balance sheets, percent of GDP Central Banks' balance sheets, percent of GDP
The end of Japanese deflation in the 1930's The end of Japanese deflation in the 1930's
Y/Y percent change Y/Y percent change
30% 30%
contingent contingent
committed committed Bank of Bank of Japan Japan ECB ECB Federal Reserve Federal Reserve
Inception of the Takahashi Inception of the Takahashi financial policy financial policy
20% 20%
10% 10% 0% 0% -10% -10%
Real GNP Real GNP
Nominal Nominal GNP GNP
60% 60% 30% 30%
GNP deflator GNP deflator
Period of severe Period of severe deflation 1926-1931 0% -20% deflation 1926-1931 0% 2000 2004 2008 2012 2016 2020 -20%1920 1922 1924 1926 1928 1930 1932 1934 1936 1938 2000 2004 2008 2012 2016 2020 1920 1922 Japan's 1924 1926 1928 1930 Agency. 1932 1934 1936 1938 Source: Federal Reserve, ECB, Bank of Japan, JPMS LLC. November 2013. Source: Nomura, Economic Planning Source: Federal Reserve, ECB, Bank of Japan, JPMS LLC. November 2013. Source: Nomura, Japan's Economic Planning Agency.
Is it it working? working? The The Japanese Japanese stock stock market market liked liked the the idea idea and and took took off. off. It It sure sure looked looked like like the the program program Is was working during the spring and summer of 2013 when exports, machinery orders, consumer was working during the spring and summer of 2013 when exports, machinery orders, consumer spending and and consumer consumer confidence confidence jumped. jumped. Unfortunately, Unfortunately, this this bump bump appears appears to to simply simply spending coincide (as it has over the last 25 years) with a period of Yen depreciation. As soon as as the the coincide (as it has over the last 25 years) with a period of Yen depreciation. As soon Yens slide slide ended, ended, most most economic economic data data rolled rolled over over as as well, well, and and (as (as in in the the U.S.) U.S.) cheap cheap money money had had a a Yens more durable impact on the Nikkei than on Ja pans economy: more durable impact on the Nikkei than on Japans economy: Its Its monetary monetary base base grew grew by by 50%, 50%, but but money money supply supply (reflecting (reflecting private private sector sector activity) activity) is is up up < < 5% 5% Most Most signs signs of of rising rising inflation inflation are are more more related related to to energy energy costs costs than than wages wages Rising corporate profits have led to an increase in capital spending by Japanese companies, companies, but but Rising corporate profits have led to an increase in capital spending by Japanese almost all the increase has been outside Japan rather than domestic almost all the increase has been outside Japan rather than domestic Most Most of of the the increase increase in in hiring hiring has has been been related related to to part-time part-time rather rather than than full-time full-time workers workers
The temporary summer 2013 improvement in Japan... The temporary summer 2013 improvement in Japan...
3-month % change 3-month % change Index level Index level
45 45
...coincided with a weaker Yen ...coincided with a weaker Yen

105 105
30% 30% Exports 25% Exports 25% Consumer 20% Machinery orders Consumer confidence 20% Machinery orders confidence 15% 15% 10% 10% 5% 5% 0% 0% -5% -5% Consumer Consumer -10% spending -10% spending -15% -15% Jan-11 Jul-11 Jan-12 Jul-12 Jan-13 Jul-13 Jan-11 Jul-11 Jan-12 Jul-12 Jan-13 Jul-13 Source: BoJ, Cabinet Office of Japan, Chain Stores Assn. October 2013. Source: BoJ, Cabinet Office of Japan, Chain Stores Assn. October 2013.
JPY per USD JPY per USD
100 43 100 43 95 41 95 41 90 39 90 39 37 85 37 85
35 35
33 33
80 80
75 75 Jan-11 Jul-11 Jan-12 Jul-12 Jan-11 Jul-11 Jan-12 Jul-12 Source: Bloomberg. December 2013. Source: Bloomberg. December 2013.
Jan-13 Jan-13
Jul-13 Jul-13
9 9
On March March 18, 18, 2013, 2013, we we reviewed reviewed the the dismal dismal state state of of Japanese Japanese nominal nominal and and real real GDP GDP growth, growth, corporate corporate On profits, cash earnings per employee and net exports. In level terms, Japan is a rich nation but the growth in in profits, cash earnings per employee and net exports. In level terms, Japan is a rich nation but the growth these variables has been negligible, which is what deflation is all about. these variables has been negligible, which is what deflation is all about.
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E YE O N T H E MARKET M A R K E T O U T L O O K2014 2014 EYE E Y E ON O N THE T H E M A R K E T OUTLOOK OUTLOOK 2014
J JANUARY ANUARY 1 , 2 014 1, 2014 JANUARY 1 , 2 014
Japans Japans government government is is using using more more than than monetary monetary policy policy to to try try and and boost boost its its financial financial markets: markets: The Nippon Investment Savings Account allows notoriously equity-averse Japanese The Nippon Investment Savings Account allows notoriously equity-averse Japanese households households to to buy buy ~US$10K ~US$10K per per year year of of risky risky assets assets and and exempts exempts them them from from taxation taxation for for five five years as long as the account is invested in equities or mutual funds. This plan could prompt years as long as the account is invested in equities or mutual funds. This plan could prompt hundreds hundreds of of billions billions of of dollars dollars to to shift shift from from bank bank deposits deposits to to equities equities over over the the next next five five years years (Japanese households have ~US$8 trillion of deposits). Nomura estimated last May (Japanese households have ~US$8 trillion of deposits). Nomura estimated last May that that NISA NISA accounts could reach ~US$260 billion by 2018. If Toshin investment funds are any guide, accounts could reach ~US$260 billion by 2018. If Toshin investment funds are any guide, Japanese Japanese households households would would invest invest around around half half of of their their NISA NISA balances balances in in Japanese Japanese securities. securities. A November 2013 report from a government-appointed panel proposed new guidelines A November 2013 report from a government-appointed panel proposed new guidelines for for Japans Japans US$3 US$3 trillion trillion Government Government Pension Pension Investment Investment Fund Fund that that would would raise raise weights weights in in domestic domestic and and non-Japanese non-Japanese equities equities from from 24% 24% to to 40%. 40%. The The proposal proposal is is still still under under consideration, consideration, and and would would represent represent another another source source of of demand demand for for Japanese Japanese equities equities if if adopted. adopted. To debt To be be clear, clear, Japan Japans s demographic demographic and and10 debt outlook outlook is is still still terrifying. terrifying. In In the the next next few few years, years, 10 Japans Japans net net debt debt will will reach reach 150% 150% of of GDP GDP and and its its demographics demographics are are awful. awful. The The government government assumes assumes it it will will be be able able to to generate generate what what II would would describe describe as as a a productivity productivity miracle: miracle: substantial substantial benefits benefits from from increased increased business business capital capital spending spending and and a a free free trade trade deal deal that that involves involves major major changes changes to to Japans Japans service service and and manufacturing manufacturing sectors. sectors. Furthermore, Furthermore, the the plan plan assumes assumes a a large large increase increase in in female female labor labor force participation, presumably achieved by introducing more maternity leave, child care programs, force participation, presumably achieved by introducing more maternity leave, child care programs, etc. etc. None None of of this this will will be be as as easy easy in in reality reality as as it it is is on on paper, paper, particularly particularly in in Japan. Japan.
Japan's plan: a productivity and labor force miracle Japan's plan: a productivity and labor force miracle
Productivity Productivity (output per (output per hour) hour) 0.80% 0.80% + + Labor force Labor force growth growth -0.20% -0.20%
due to due to aging aging
= =
Real GDP Real GDP (output (output growth) growth) 0.60% 0.60%
2000-2010 2000-2010 Actual Actual 2010-2020 2010-2020 Baseline Baseline 2010-2020 2010-2020 Abenomics Abenomics
0.80% -0.60% 0.80% productive cap -0.60%
increased productive cap increased spending and female labor spending and female labor Trans-Pacific force participation Trans-Pacific force participation Partnership 2.00%Partnership 0.00% 2.00%
0.20% 0.20%
2.00%
0.00%
2.00%
Source: Japan Cabinet Office, Gavekal Research. Source: Japan Cabinet Office, Gavekal Research.
10 10
The The debt debt bubble bubble is is why why Japan Japan is is seeking seeking to to increase increase inflation. inflation. If If Japan Japan had had been been able able to to run run just just 3% 3% nominal nominal GDP growth instead of 0% since 1990, its gross debt to GDP would be 100%-130% instead of 230%. GDP growth instead of 0% since 1990, its gross debt to GDP would be 100%-130% instead of 230%.
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Nevertheless, it seems risky to be underweight Japanese equities. Japanese equity valuations are not low compared to other countries, and poor return on equity has been a problem (see table). However, earnings growth estimates are rising for 2014, and the cyclical aspect of the governments plan has the potential to override Japans structural problems for another year. Thats what we think will happen in 2014. If global exports are a zero-sum game, its also risky to be underweight Japan if its short-term success comes at the expense of other industrialized export nations in Asia and Europe.
Global equity market valuations
Asia Pacific Japan ex-JPN 1.3x 1.6x 8.0% 12.4% 14.4x 13.5x EM Asia 1.6x 13.4% 11.0x EM Latam 1.7x 11.7% 12.6x EM EMEA 1.2x 13.5% 8.6x
Price-to-Book Return on Equity (2013E) Price-to-Earnings (12m Fwd)
U.S. 2.7x 14.6% 15.4x
UK Europe 1.9x 1.8x 13.8% 10.9% 12.4x 13.2x
EMU 1.5x 8.5% 12.9x
Source: MSCI, J.P. Morgan Securities LLC. December 2013.
Japanese TOPIX forward price-to-earnings ratio

80x
70x 60x
Multiple
50x
40x 30x 20x 10x 1993 1997 2001 2005 2009 2013
Source: FactSet. December 2013.
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Beyond the Great Race

The remainder of this years Outlook provides further analysis of some market and investment themes that are part of our portfolio thinking for 2014. I: II: III: IV: V: VI: VII: VIII: Risk and opportunity in credit markets A revised look at private equity performance, and some themes for 2014 On the recent underperformance of hedge funds relative to equities, and outperformance vs. bonds Tracking performance trends in active equity management How different are the countries of the European Monetary Union? Indicators cited in the preface that have returned to pre-crisis levels U.S. fiscal outlook: Quieter in 2014, with long-term battles ahead U.S. municipal bond outlook and the constitutional question of Detroit
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1, 2014 J JANUARY ANUARY 1 , 2 014
I: Risk and opportunity in credit markets Five years into the Feds zero interest rate policy, the search for yield continues. In addition to the decline in credit yields (see page 24), covenant-lite loan issuance has risen above 2007 levels, the riskier CCC-rated component of the high yield market is rising, and the number of loans and bonds trading below a price of 80 is shrinking. On the plus side, credit fundamentals are positive: cash flow coverage of debt service is high, default rates are low and as shown on page 8, the S&P 500 debt-tomarket cap is low as well. The concern is not one of recession or debt service coverage, but whether credit market enthusiasm has gone too far. 2014 might be a good year to make sure portfolios do not own too much credit that is priced for perfection.
Tracking underwriting standards in high yield, leveraged loan and leveraged buyout markets
50% 40% 30% 20% 10% 0%
Percent of total annual issuance
40% 35% 30% 25% 20% 15% 10% 5%
Covenant-lite leveraged loans HY bonds with PIK/Toggle features
HY issues rated CCC and lower as % of HY total issuance
Debt/cash flow 6x LBO senior debt-to-cash flow multiple

5x
4x
3x
02
03
04
05
06
07
08
09
10
11
12
13
Source: J.P. Morgan Securities LLC. October 2013.
0% 1998 2001 2004 2007 2010 2013 Source: J.P. Morgan Securities LLC, Capital IQ. November 2013.
2x
U.S. HY bonds and loans trading <= 80% of face value

Percent of all outstanding loans and bonds
50% 45% 40% 35% 30% 25% 20% 15% 10% 5% 0% 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 Source: J.P. Morgan Securities LLC, Standard and Poor's, S&P/LSTA Leveraged Loan Index. November 2013.
Debt issuance by mid-market firms (EBITDA <= $50mm)

140 120 100 80
Number of deals, quarterly
Bonds
Peak levels (Nov. '08) Bonds: 77% Loans: 81%
Loans
60 40 20 0 1997 1999 2001 2003 Source: S&P Capital IQ. Q3 2013. 2005 2007 2009 2011 2013
The flood of money into public credit markets has resulted in tighter spreads and modestly weaker underwriting standards. The same dynamics are less prevalent in private credit markets. Many small and mid-size companies (and real estate entities) that used to have access to public credit markets find that access is harder now, and borrow from private credit and mezzanine debt markets instead. Private credit portfolios generally entail less diversification and less liquidity in exchange for higher lending rates and at times, call protection, debt service coverage, escrow requirements and change of control provisions sometimes absent in public credit markets. As outlined in a November Eye on the Market, bank loan sales in Europe are finally picking up across countries. This process has accelerated as rising earnings allow banks to absorb more losses. As an example, Lloyds, Unicredit, BBVA, Commerzbank and Socit Gnrale took asset charges equal to 90% of gross operating profit in 2012. PricewaterhouseCoopers cites bank loan sales at 10 to 40 cents on the Euro in Ireland, and UK/German real estate loan sales at 40 to 50 cents. Loan-todeposit ratios of European banks are still high, so we expect bank loan sales to continue for an extended period.
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E Y O T M O 2 EYE 2014 OUTLOOK E YE E ON ON N THE TH HE E MARKET MA AR RK KE ET T OU UT TL LO OO OK K 20 01 14 4
J A , 0 1, 2014 JJANUARY AN NU UA AR RY Y 1 1 , 2 2 01 14 4
II: A revised revised look look at at private private equity equity performance, performance, and and some some themes themes for for 2014 2014 II: A
11 11 In of2013, 2013,we wewrote wroteaadetailed detailedpaper paperon onprivate privateequity equity partof ofwhich whichfocused focusedon onrecent recent In June July of ,,part findings by an Oxford lecturer regarding problems with a commonly used private equity performance findings by an Oxford lecturer regarding problems with a commonly used private equity performance database. Due Due to to stale stale records, records, missing missing cash cash distributions distributions and and incomplete incomplete fund fund records, records, widely widely read read database. prior studies factored in a downward performance bias for private equity. After the exclusion of prior studies factored in a downward performance bias for private equity. After the exclusion of incomplete fund fund records, records, the the previously previously estimated estimated private private equity equity underperformance underperformance of of 3%-6% 3%-6% incomplete against the the S&P S&P 500 500 turns turns into into outperformance outperformance of of 4% 4% per per year. year. against
A separate separate 2013 2013 paper paper from from academics academics in in Virginia, Virginia, Oxford Oxford and and Chicago Chicago confirms confirms these these findings. findings. A The authors found that buyout funds outperformed the S&P 500 in each of the last three three The authors found that buyout funds outperformed the S&P 500 in each of the last decades . Venture capital funds, on the other hand, had a great run in the 1990 s, after which decades. Venture capital funds, on the other hand, had a great run in the 1990s, after which industry performance performance has has been been below below equity equity markets. markets. The The authors authors also also found found that that performance performance of of industry buyout funds funds did did not not differ differ substantially substantially by by fund fund size, size, and and that that there there is is no no identifiable identifiable relationship relationship buyout between manager manager fees fees or or GP GP ownership ownership levels levels and and buyout buyout fund fund performance. performance. between Subsequent to to our our papers papers release, release, the the most most frequent frequent questions questions we we received received were: were: Subsequent How How do do buyout buyout funds funds perform perform relative relative to to public public equity equity when when using using benchmarks benchmarks other other than than the the S&P S&P 500 (to reflect the small/mid-cap nature of companies often acquired by private equity firms)? 500 (to reflect the small/mid-cap nature of companies often acquired by private equity firms)? The The authors authors of of the the paper paper cited cited above above also also computed computed buyout buyout fund fund performance performance using using the the Russell Russell 2000, the Russell 2000 Value Index and the NASDAQ. Buyout fund outperformance using 2000, the Russell 2000 Value Index and the NASDAQ. Buyout fund outperformance using an an S&P S&P 500 500 benchmark benchmark was was 1.22x; 1.22x; using using the the Russell Russell 2000, 2000, Russell Russell 2000 2000 Value Value Index Index and and NASDAQ, NASDAQ, the the ratios ratios were were 1.22x, 1.22x, 1.16x 1.16x and and 1.20x, 1.20x, respectively. respectively. In In other other words, words, basically basically the the same. same. How How does does buyout buyout fund fund outperformance outperformance look look when when applying applying leverage leverage to to the the S&P S&P 500 500 benchmark benchmark (to (to reflect the high level of leverage often used by buyout funds)? reflect the high level of leverage often used by buyout funds)? The The authors authors reran reran their their analyses analyses using using a a leveraged leveraged S&P S&P 500 500 benchmark. benchmark. Buyout Buyout outperformance outperformance fell fell to to 1.08x; 1.08x; still still positive, positive, but but less less than than the the original original results. results. Interestingly, Interestingly, this this measure measure was was 1.28x 1.28x for for the the 2000s, 2000s, 1.09 1.09x x for for the the 1990s 1990s and and 0.76 0.76x x for for the the 1980s 1980s. . Applying Applying leverage leverage to to the the S&P S&P during during a a decade decade with with two two 40%+ 40%+ declines declines in in the the market market created created a a lot lot of of distress distress in in the the benchmark. benchmark. Private Private equity equity in in 2014 2014 If If our our views views on on leading leading indicators indicators are are correct, correct, global global GDP GDP growth will pick up in 2014 close to pre-crisis averages. growth will pick up in 2014 close to pre-crisis averages. If If so, so, one one theme theme that that we we expect expect to to continue continue is is the the increase in energy-related investments in private increase in energy-related investments in private equity equity portfolios. is broad, broad, and and portfolios. The The phrase phrase energy-related energy-related is refers to to projects projects designed designed to to increase increase proven proven and and refers producing oil/gas oil/gas reserves reserves that that are are subsequently subsequently sold sold to to producing integrated and independent energy companies; integrated and independent energy companies; 12 infrastructure and and logistics logistics companies companies12 ; infrastructure ; and and recapitalization and associated associated service service recapitalization of of manufacturing manufacturing and companies. The chart chart shows companies. The shows electricity electricity costs costs for for industrial industrial users users and and domestic/import domestic/import prices prices for for natural natural gas across countries. gas across countries.
The The U.S. U.S. energy energy advantage advantage
$300 $300
$250 $250
Industrial Industrial electricity electricity price, price, USD USD per per MWh MWh
Italy Italy Japan Japan
$200 $200
$150 $150
Germany Germany
U.S. U.S.
$100 $100
$50 $50
China China
France France
UK UK
India India Korea* Korea*
$0 $0
$2 $2
Natural Natural gas/LNG gas/LNG price, price, USD USD per per mmbtu mmbtu
$6 $6
$10 $10
$14 $14
$18 $18
* Another * Korean Korean industrial industrial electricity electricity prices prices are are heavily heavily subsidized. subsidized. Another trend trend to to watch: watch: theres theres increasing increasing pressure pressure on on companies with slowing earnings growth and elevated companies with slowing earnings growth and elevated cash cash balances balances to to sell sell non-core non-core businesses, businesses, often often at at the the urging urging of of shareholder shareholder activists. activists. Private Private equity equity firms firms aim aim to to restructure restructure these these underperforming underperforming units units as as stand-alone stand-alone entities entities with with revitalized revitalized growth growth prospects prospects and and greater greater management management focus. focus.
11 11 12 12
Source: Source: Bloomberg, Bloomberg, FERC, FERC, China China NDRC, NDRC, World World Bank, Bank, IEA, IEA, Reuters. Reuters.
Eye Private Private Investigations Investigations, , July July 9, 9, 2013 2013 Eye on on the the Market Market In In 2012, 2012, the the U.S. U.S. completed completed 45,000 45,000 oil oil and and gas gas wells wells compared compared to to 4,000 4,000 in in the the rest rest of of the the world, world, excluding excluding Canada. The Shale Oil Boom: A U.S. Phenomenon , Leonardo Magueri, Harvard Belfer Center, Canada. The Shale Oil Boom: A U.S. Phenomenon, Leonardo Magueri, Harvard Belfer Center, June June 2013. 2013.
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JANUARY J A N U A R Y 1, 1 ,2014 2014
III: On the recent underperformance of hedge funds relative to equities, and outperformance vs. bonds For the first time since the late 1990s, the hedge fund industry has lagged equities. This assessment is based on two methods commonly used to evaluate performance. The first compares hedge funds to a stock-bond portfolio, and the second compares hedge funds to equities on a risk-adjusted basis. In the charts, when the lines are positive, hedge funds are outperforming and vice versa. For the bulk of the 2000s, hedge funds (measured by the HFRI Composite) held their own. Over the last two years, relative performance moved into negative territory, indicating hedge fund underperformance.
Hedge Funds vs. Stock/Bond portfolio
20% 15% 10% 5% 0% -5% -10% Hedge f unds underperf orm
Hedge fund return less stock/bond return, rolling 2 years

HFRI Composite - 60% S&P / 40% Barc Agg HFRI Composite - 60% MSCI AC World / 40% Barc Agg
Hedge Funds vs. Equity Markets

6 5 4 3 2 1 0 -1 Hedge f unds underperf orm
Hedge fund return/risk less equity return/risk, rolling 2 years

HFRI Composite vs. S&P HFRI Composite vs. MSCI AC World
-15% 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 Source: Bloomberg. HFRI. October 2013. Monthly portf olio rebalancing.
-2 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 Source: Bloomberg. HFRI. October 2013. Volatility based on monthly returns.
MSCI AC World is an all-country index of global equities including emerging markets. "S&P" refers to the S&P 500 Index. "Agg" refers to the Barclays U.S. Aggregate, an index of U.S. government, agency and corporate bonds. "Hedge funds" denotes the HFRI Composite Index, a fundweighted index of over 2,200 hedge funds.
Individual hedge fund portfolios will of course differ from the HFRI Composite, which measures performance across the entire industry. Even so, the charts demonstrate the extent to which many hedge funds trailed investor performance objectives during the double-digit, low-volatility equity rally. The unwinding of Central Bank liquidity should help level the playing field for hedge funds, which are typically less long than equity managers. In any case, before monetary policy normalizes, it seems premature to assume that there has been a permanent and structural shift in the performance of hedge funds relative to equities. Investors who bought diversified hedge funds of funds as replacements for overpriced government bonds, on the other hand, have seen better results. When thinking about a portfolio proxy for bonds, we need to switch from the HFRI Composite to the HFRI Fund of Funds Diversified Index, since the latter has a lower volatility that is more consistent with bonds and credit. Over the last two years, the HFRI Fund of Funds Index has outperformed the Barclays Aggregate Index both on a nominal and risk-adjusted basis. In the next section, we review how the pair-wise correlation of stocks is finally coming down after spiking to the highest levels in several decades. We expect a decline in correlations to benefit long-only active equity managers, and long-short hedge fund managers as well. As shown in the chart, there is a clear pattern in which rising correlations correspond to lower returns on the HFRI Equity Hedge Index since the early 1990s.
Percent
50% 40% 30% 20% 10% 0% -10% HFRI Equity Hedge annualized returns, 3-year rolling 1993 1997 2001 2005 2009 2013 Source: Bloomberg, Empirical Research Partners. November 2013.
Rising correlations and falling long-short HF returns

Large Cap pair-wise correlations
21
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IV: Tracking performance trends in active equity management Well over 70% of all managed investments in U.S. equity markets are actively rather than passively managed. The question of whether active management has been delivering excess returns to investors is an important one. However, the mechanics of such an analysis are complex. Lipper has extensive databases of mutual fund performance by investment style (by market cap, region, growth vs. value, etc.). Unfortunately, its database includes funds with very different fee characteristics (no load, institutional load, front-end load, back-end load, level load, etc.). Furthermore, a given manager may have multiple institutional load share classes, such that an equal-weighted analysis would overrepresent some fund companies relative to others. Asset-weighted analyses are even more fraught with problems, given the timing issues involved (e.g., investors chasing performance). Theres a cleaner way to answer these questions about manager performance, using a database of $7 trillion in institutional assets across multiple equity investment styles. The fee dynamics are more homogenous, and each manager is typically only represented once. While some aspects of institutional and individual equity investing are different, we thought it would be interesting to share the results of our analysis, which appear below. Among the important findings: the relationship between correlations and manager outperformance. If history is any guide, the recent decline in pair-wise correlations across stocks should result in a period of more consistent manager outperformance in some styles. The other broad conclusion: in spite of these difficult conditions, well over 50% of active managers outperformed their respective investible benchmarks in most investment styles on a trailing 5-year basis.
Pair-wise stock correlations falling...
50% 45% 40% 35% 30% 25% 20% 15% 10% 5% 0% 1964
%, 1-year average cap-weighted return correlations
% of managers outperforming ETF, 1-year basis, 1996-2013 100% 80% 60%
... which in the past coincided with higher outperformance
U.S. Large Cap
40%
20%
U.S. Small Cap

1972 1980 1988 1996
International
2004 2012
0%
5%
Source: Empirical Research Partners. September 2013.
Source: J.P. Morgan, eVestment, Empirical Research Partners. June 2013.
15% 25% 35% 45% U.S. stocks pair-wise return correlation, %
55%
We believe that five years are needed to assess managers' performance skill given the impact of market cycles, technical market changes and recessions/recoveries Over the last five and seven years, manager outperformance trends were strongest in U.S. value styles (across large, mid and small cap) and in non-U.S. investment categories (Emerging Markets, Europe, Japan, Asia ex-Japan and broader categories encompassing non-U.S. regions) The weakest outperformance trends were found in U.S. growth categories. However, before the correlation spike, manager outperformance trends in these categories were typically over 50% Manager outperformance frequency is a good proxy for net excess return: As the frequency of manager outperformance increases, corresponding excess returns increase as well We did not find any material relationship between fund size and outperformance (large funds performed similarly to smaller ones) Most fund managers that outperform on a 5-year basis underperform in 2 or 3 of those 5 years The results were similar on a risk-adjusted basis. In other words, manager outperformance trends did not change materially when taking into account ex-post measures of portfolio risk
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V: How different are the countries of the European Monetary Union? The Death in Venice chart on page 10 is an example of what can happen when two countries with different levels of productivity are joined in the same monetary union. How pervasive is this problem in Northern and Southern Europe? While some of the important gaps are closing (e.g., unit labor costs versus Germany), there are material differences that remain. The table below shows country rankings for select categories from the World Economic Forum, with a rank of 1 = best and 144 = worst. Southern Europe has some stark differences with Northern Europe in terms of the dayto-day life of a citizen, a consumer or a business owner.
World Economic Forum Report, 2012-2013: 1=Best, 144=Worst

Diversion Public Property of public trust in rights funds politicians Northern Europe Germany France Netherlands Belgium Finland Southern Europe Spain Italy Greece Portugal 14 18 9 31 1 16 29 8 21 3 33 44 10 40 12
Legal Irregular Judicial Gov't Burden of framework to Bus. costs pmnts / Independ officials gov't settle Gov't policy of crime / Organized ence favoritism regulations crime bribes disputes transparency violence 18 32 12 27 2 7 37 3 28 2 15 39 4 27 7 71 126 34 133 6 20 37 8 45 2 27 47 14 62 2 21 47 32 22 3 32 39 21 27 4
48 69 73 49
53 85 119 45
79 131 141 67
40 68 104 34
60 68 98 67
54 116 114 67
120 142 141 129
69 139 135 121
77 139 122 71
34 91 81 15
46 131 68 26
Using all the factors analyzed by the World Economic Forum, we took this one step further: How does the European Monetary Union compare to other monetary unions, either real or imagined? As shown below, the European Monetary Union has around the same cross-country factor dispersion as a hypothetical monetary union composed of all countries beginning with the letter M. The rest, including monetary unions composed of countries that were members of the Ottoman Empire or the Soviet Union, exhibit more cross-country similarities than Europe. The European Monetary Union, for all its successes and pitfalls, is a road less traveled.
More different
60%
The European Economic and Monetary Union (EMU): A Road Less Traveled
Measuring the dispersion of hypothetical and actual monetary unions
Dispersion measures the standard deviation of country-specific factors in each union. Factors reflect over 100 economic, social and political characteristics. Source: World Economic Forum Global Competitiveness Report, J.P. Morgan Asset Management. May 2012.
52.6 52.9
50%
40%
30%
20%
Less different
10%
0%
Market economies of Latin America
United Kingdom and its English speaking offshoots
Central America
Gulf state Reconstit. of Northern Reconstit. of Eastern and East Asian All countries Countries Major GCC Union of Europe Ottoman Southern Tigers on Earth at beginning countries of countries Soviet including Empire, Africa the 5th with the European Socialist Scandinavia circa 1800 parallel letter "M" Monetary Republics north Union, EMU latitude
Hypothetical monetary unions
23
23
VI: Indicators cited in the preface that have returned to pre-crisis levels In the charts below, we show the items cited in the preface whose valuations or levels have returned to where they were in 2007. On corporate bonds, usually we look at credit spreads over Treasuries. Given the intervention by Central Banks (directly and indirectly) in government bonds, credit yields are probably a better measure of value right now.
Global and U.S. trailing price-to-earnings ratios
Multiple
35x 30x 25x 20x 15x 10x 5x 1970 1978 1986 1994 2002 2011 Source: Bloomberg, Empirical Research. JPM Securities. November 2013.
Speculative stock-bond position

15%
Net CFTC stock-bond futures position, percent
S&P 500
MSCI World
10% 5%
0% -5% -10% -15% 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013
Source: CFTC, J.P. Morgan Securities LLC. November 2013.
U.S. and European volatility indices

50
45 40 35 30 25 20
Index
Homes resold within 6 months of purchase in California

2,000
1,600
Number of units
EuroStoxx 50
1,200
S&P 500
800
15 10 1990 1994 1998 2002 2006 2010
400
0 2001
2003
2005
2007
2009
2011
2013
Source: Chicago Board Options Exchange, Bloomberg. November 2013.
Source: Empirical Research Partners, PropertyRadar.com. October 2013.
U.S. corporate investment grade and high yield bonds

Yield to worst (both axes)
10% 9% 8% 7% 6% 5% 4% 3% 2% 2002 2004 21%
23% 10% 19% 17% 15% 13% 11% 9%
Discount rates for newly underwritten core real estate transactions, percent U.S. unlevered real estate discount rates
U.S. corporate investment grade
9%
8%
7% 6% 2007 2009 2011 Source: J.P. Morgan Asset Management. November 2013.
U.S. corporate high yield

2006 2008 2010 2012
7% 5%
Source: Bloomberg. November 2013.
2013
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VII: U.S. fiscal outlook: quieter in 2014, with long-term battles ahead After a tumultuous couple of years in Washington, it looks like 2014 will be quieter on the fiscal policy front. In 2011, the budget outlook was pretty dire: the Alternative Fiscal Scenario from the Congressional Budget Office projected the federal debt at 109% of GDP by 2023. Since then, the 2011 Budget Control Act and 2013 tax act significantly contributed to deficit reduction and the 2023 debt outlook has fallen to 70%-80% of GDP. The trajectory of the federal debt has stabilized for now, and the budget deficit should improve for cyclical reasons to 3.3% of GDP in 2014. In 2014, we do not foresee any major tax policy legislation, any material changes to the Sequesters net impact over a 10-year period, or any significant change in entitlements. We expect a budget deal to push debates about the debt ceiling and other fiscal issues into 2015.
Federal debt held by the public
Percent of GDP
110% 100% 90% 80% 70% 60% 50% 40% 30% 20% 1940 1950 1960 1970 1980 1990 2000 2010 2020
2011 Alternative Fiscal Scenario 2013 Alternative Fiscal Scenario
Baseline (current law)
Source: CBO. September 2013.
The long-term battle in Washington is now about the mix of government spending as well as the level. The Budget Control Act cuts non-defense discretionary spending as a % of GDP to the lowest level in 40 years. This category of spending includes the items in the table below, which in aggregate impact the productivity and future of the U.S. economy (infrastructure, worker retraining, renewable energy R&D, general science research). The prioritization of entitlements over nondefense discretionary spending has taken over. As shown, the ratio of entitlement to discretionary spending began at 1:1 in the 1970s; has risen to 2.5:1 today; and is headed to 4:1 by the end of the decade. The concept of generational theft has entered the American policy lexicon, and the battles should heat up as the line in the chart below keeps rising.
Ratio of entitlement spending to non-defense discretionary spending
4.0x
3.5x 3.0x 2.5x 2.0x 1.5x
Components of non-defense discretionary spending at the federal level:

-Job training and worker dislocation programs -All elementary, secondary and higher education -Health research and training -Consumer and occupational health and safety -Federal law enforcement and federal judicial system -Pollution control and abatement -Air, ground and water transportation -U.S. Army Corps of Engineers -General science research, NASA -Energy R&D and demonstration projects -NIH/CDC spending on disease control and bioterrorism -International drug control and law enforcement
CBO projection
1.0x 1973 1977 1981 1985 1989 1993 1997 2001 2005 2009 2013 2017 2021 Source: CBO. September 2013.
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E Y E ON O N T H E MARKET MARKET OUTLOOK 2014 EYE 2014 E Y E O N THE T H E M A R K E T OUTLOOK OUTLOOK 2014
JJANUARY ANUARY 1 , 2014 2014 1, JANUARY 1 , 2014
VIII: U.S. municipal bond outlook and the question of Detroit VIII: U.S. municipal bond outlook and the question of Detroit Over the past few years, there has been a proliferation of dire warnings on Over the past few years, there has been a proliferation of dire warnings on the U.S. municipal bond market. While there have been a few highthe U.S. municipal bond market. While there have been a few highprofile defaults, properly diversified municipal portfolios should not profile defaults, properly diversified municipal portfolios should not be experiencing too much stress. Over the long haul, municipal default be experiencing too much stress. Over the long haul, municipal default rates have been low. Looking at all investment grade municipal bonds rated rates have been low. Looking at all investment grade municipal bonds rated by Moodys that were issued from 1970-2012, 5-year and 10-year cumulative by Moodys that were issued from 1970-2012, 5-year and 10-year cumulative default rates were 0.03% and 0.07%, respectively. These levels compare to default rates were 0.03% and 0.07%, respectively. These levels compare to 1.07% and 2.78% for investment grade corporate bonds over the same 1.07% and 2.78% for investment grade corporate bonds over the same period. Municipal Chapter 9 filings have risen in the last three years from period. Municipal Chapter 9 filings have risen in the last three years from 7 cities per year to a little over 10, but these levels are still very low for a 7 cities per year to a little over 10, but these levels are still very low for a market with tens of thousands of issuers. market with tens of thousands of issuers.
Y/Y percent change 20%
Average number of Average number of Chapter 9 filings per year Chapter 9 filings per year 1980-1989 7.1 1980-1989 7.1 1990-1999 10.4 1990-1999 10.4 2000-2009 6.8 2000-2009 6.8 2010-2012 10.3 2010-2012 10.3
Source: Chapman and Cutler LLP Source: Chapman Cutler based on available and court and LLP based on available court and governmental records. 2013. governmental records. 2013.
Income taxes driving state tax revenues higher Income taxes driving state tax revenues higher Y/Y percent change
20% 15% 15% 10% 10% 5% 5% 0% 0% -5% -5% -10% -10% -15% -15% -20% -20%1995 1998 2001 2004 1995 1998 2001 2004 Source: U.S. Census Bureau. Q2 2013. Source: U.S. Census Bureau. Q2 2013.
2007 2007
2010 2010
2013 2013
Y/Y percent change 14% 14% 12% 12% 10% 10% 8% 8% 6% 6% 4% 4% 2% 2% 0% 0% -2% -2% -4% -4%1995 1998 2001 2004 1995 1998 2001 2004 Source: U.S. Census Bureau. Q2 2013. Source: U.S. Census Bureau. Q2 2013.
Slower rebound in property tax collection on local level Slower rebound Y/Y percent changein property tax collection on local level
2007 2007
2010 2010
2013 2013
State and local taxes have begun to rebound at a national level. Some of the increase may be State and local taxes have begun to rebound at a national level. Some of the increase may be a consequence of accelerated income recognition by investors anticipating higher capital gains taxes a consequence of accelerated income recognition by investors anticipating higher capital gains taxes on the top two brackets last year. However, withheld taxes on ordinary income have been increasing on the top two brackets last year. However, withheld taxes on ordinary income have been increasing at a 7%-8% rate, indicating that the trends are real. We look at both state and local property taxes at a 7%-8% rate, indicating that the trends are real. We look at both state and local property taxes when thinking about municipal risk. When evaluating city issuers, the property tax base is more when thinking about municipal risk. When evaluating city issuers, the property tax base is more useful. According to the U.S. Census Survey of State and Local Governments, property taxes make useful. According to the U.S. Census Survey of State and Local Governments, property taxes make up ~75% of total city tax receipts. At the state level, property taxes are less important: 83% of state up ~75% of total city tax receipts. At the state level, property taxes are less important: 83% of state tax revenues come from sales and income taxes. What about bond insurance? A decade ago, tax revenues come from sales and income taxes. What about bond insurance? A decade ago, municipal bond insurers such as AMBAC and MBIA wrapped around 50% of the entire market. municipal bond insurers such as AMBAC and MBIA wrapped around 50% of the entire market. Today, virtually no new issues are insured, and the insured component of the outstanding stock has Today, virtually no new issues are insured, and the insured component of the outstanding stock has fallen to 30%. This argues for more rigorous credit analysis applied to municipal portfolios. fallen to 30%. This argues for more rigorous credit analysis applied to municipal portfolios. The difficult questions for some municipalities lie in the long-term rather than the shortThe difficult questions for some municipalities lie in the long-term rather than the shortterm. Some challenges relate to underfunding of certain pension plans. While financial assets have term. Some challenges relate to underfunding of certain pension plans. While financial assets have rallied since their 2009 lows, public plan liabilities grew uninterrupted throughout the prior decade. rallied since their 2009 lows, public plan liabilities grew uninterrupted throughout the prior decade. Theres around a $1 trillion negative gap between plan assets and liabilities, assuming a 7.5% Theres around a $1 trillion negative gap between plan assets and liabilities, assuming a 7.5% discount rate on liabilities. To close this gap over time starting today, annual pension plan returns of discount rate on liabilities. To close this gap over time starting today, annual pension plan returns of 13 9% would be needed13. Bridgewater estimates that if the contribution-outlay relationship of public 9% would be needed . Bridgewater estimates that if the contribution-outlay relationship of public plans remains unchanged, in 10 years, this annual required return would rise to 13%. If so, and if plans remains unchanged, in 10 years, this annual required return would rise to 13%. If so, and if such returns were not achieved, there may be a need for (a) higher taxes, (b) revised pension such returns were not achieved, there may be a need for (a) higher taxes, (b) revised pension formulas and/or (c) reductions in non-pension spending. formulas and/or (c) reductions in non-pension spending.
13 13
26
Bridgewater Daily Reports, November 21, 2013. Bridgewater Daily Reports, November 21, 2013.
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Investor focus is now understandably on Detroit where an emergency manager has been appointed by the state to sort things out. The emergency manager proposed write-downs of 80%-90% on holders of Detroit unsecured general obligation bonds, as well as reductions in unfunded pension fund and healthcare obligations to retirees. The latter are 2-3 times larger than the former. The more relevant issue for municipal investors: how similar is Detroit to the rest of the city-level municipal market? That is an issue we addressed in depth last year in How Different is Detroit?, Eye on the Market, August 6, 2013. We examined where Detroit stands relative to other cities in terms of growth (gross metropolitan product), income per capita, labor force growth, population growth, property tax base per capita, etc. As shown by the black lines in each chart, Detroit is considerably worse. In the view of our municipal bond managers, portfolios with much better economic fundamentals can be constructed. The blue lines depict a mapping of our largest general obligation holdings based on balances held as of August 2013.
Growth in Gross Metropolitan Product
210
190 170 150 130 110
Index, 2001=100, with percentiles
Growth in personal income per capita

250
Index, 1990=100, with percentiles
95%ile
95%ile
225 200
175
80%ile
20%ile 5%ile
80%ile 20%ile
5%ile
150 125 100 1990 1993 1996 1999 2002
Detroit
90 2001
Detroit
2003 2005 2007 2009 2011
2005
2008
Source: Bureau of Economic Analysis. JPMAM. 2011.
Source: Bureau of Economic Analysis. JPMAM. 2009.
Labor force growth (employed + unemployed)

140
130 120 110 100 90 80 2000 2002 2004 2006
Index, Jan. 2000 = 100, with percentiles
MSA-level population growth

400
Index, 1970 = 100, with percentiles 95%ile
95%ile
80%ile
350 300 250 200 150 100
80%ile
20%ile
5%ile Detroit
2008 2010 2012
50 1970 1975 1980 1985 1990 1995 2000 2005 2010

Source: U.S. Census Bureau, JPMAM. 2012.
Detroit
20%ile 5%ile
Source: Bureau of Labor Statistics, JPMAM. May 2013.
Our August Eye on the Market goes into more detail, but to summarize, our view is that Detroit is more an outlier than a paradigm. While Cleveland, Youngstown, Dayton and Toledo share some of Detroits problems, Detroit in aggregate stands alone. There may be more city bankruptcies in the years ahead, but the visibility around Detroits problems and those of similarly positioned cities should allow defensive-minded municipal portfolio managers to avoid large exposures to the countrys biggest problems.
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EYE ON THE MARKET
OUTLOOK 2014
JANUARY 1, 2014
JANUARY J A N U A R Y1, 1 ,2014 2014
The Detroit case surfaces the issue of States rights versus Federalism. As background, a municipality only file forthe bankruptcy Chapter if its state authorizes it background, to do so. Around The Detroit can case surfaces issue ofunder States rights9versus Federalism. As a half of U.S. states allow for municipalities to file for bankruptcy; the rest do not. Chapter 9Around is only for municipality can only file for bankruptcy under Chapter 9 if its state authorizes it to do so. cities; notfor permitted to file for bankruptcy. Historically, Chapter 9 Chapter has mostly been half ofU.S. U.S.states statesare allow municipalities to file for bankruptcy; the rest do not. 9 is only for used by small municipalities, but recent filings by Vallejo (CA), Jefferson County Central cities; U.S. states are not permitted to file for bankruptcy. Historically, Chapter 9(AL), has mostly been Falls (RI), Stockton (CA) and San (CA) changed that. County (AL), Central used by small municipalities, but Bernardino recent filings by have Vallejo (CA), Jefferson Falls (RI), Stockton (CA) and San Bernardinoto (CA) have changed that. Some states have made minor adjustments pension schemes for existing employees and retirees. They have been minor since the laws of most states make efforts to alter obligations toand current Some states have made minor adjustments to pension schemes for existing employees retirees. retirees difficult. Even in bankruptcy, the ability to alter claims is unclear. How should federal They have been minor since the laws of most states make efforts to alter obligations to current bankruptcy law,Even which argues for the equal treatment of all creditors, judged against state retirees difficult. in bankruptcy, ability to alter claims is unclear. be How should federal 14 ? law indicating that one creditor class (e.g., retirees) is effectively untouchable bankruptcy law, which argues for equal treatment of all creditors, be judged against state 14 ? law indicating that one creditor class (e.g., is case effectively untouchable In what may be a landmark ruling, the judge in retirees) the Detroit ruled that pension benefits are a obligation a municipality and entitled to any heightened protection in In contractual what may be a landmarkof ruling, the judge in thenot Detroit case ruled that pension benefits are bankruptcy . The judges of ruling appears to draw the Supremacy Clause (Article VI, Clause 2), in a contractual obligation a municipality and on not entitled to any heightened protection which holds that state governments cannot pass laws that override the U.S. Constitution. What bankruptcy. The judges ruling appears to draw on the Supremacy Clause (Article VI, Clause 2), remains to be seen is whether courts in California and other states cite it as precedent or come to a which holds that state governments cannot pass laws that override the U.S. Constitution. What 15 different conclusion . Counsel for non-bondholder creditors have announced an appeal, but the remains to be seen is whether courts in California and other states cite it as precedent or come to a 15 that the appeal cannot delay the bankruptcy proceeding. judge in Detroit ruled different conclusion . Counsel for non-bondholder creditors have announced an appeal, but the judge in Detroit ruled that the appeal cannot delay the bankruptcy proceeding.
14 14
See our August 6, 2013 Eye on the Market for a discussion of the legal debate around Chapter 9 and the Constitution, Article IX, Section 24. 15 involvement of Federal courts in state and local proceedings, and thearound ability of states 9 and See our August 6, 2013 Eye on the Market forbankruptcy a discussion of the legal debate Chapter and the municipalities to declare their obligations as being inviolable (not subject to restructuring). involvement of Federal courts in state and local bankruptcy proceedings, and the ability of states and municipalities to declare their obligations as being inviolable (not subject to restructuring). 28
15
Federalist argument: U.S. Constitution Article 1, Section 8 Clause 4, and U.S. Bankruptcy Law, Chapters 9 and th U.S. 8 Constitution, and (for example), Law, the Michigan 11. States argument: Rights argument: 10 amendment Federalist U.S. Constitution Article of 1, the Section Clause 4, and U.S. Bankruptcy ChaptersState 9 and th Constitution, Article IX, Section 24. 11. States Rights argument: 10 amendment of the U.S. Constitution, and (for example), the Michigan State
28 28
Cover art data sources Leveraged Loans S&P Leveraged Loan; High Yield Barclays U.S. Corporate High Yield; U.S. Commercial Property NCREIF Property Index; Hedge Funds HFRI Composite; Emerging Markets MSCI EM; USD EM Debt J.P. Morgan EMBI Global. Note: NCREIF Property Index cumulative returns are for the period from January 1, 2010 to September 30, 2013. Acronyms ACWI All Country World Index; AMBAC American Municipal Bond Assurance Corporation; BEA Bureau of Economic Analysis; BLS Bureau of Labor Statistics; CBO Congressional Budget Office; CFTC Commodity Futures Trading Commission; EAFE Europe, Australasia and Far East; ECB European Central Bank; EM Emerging Market; ETF Exchange-Traded Fund; FRB Federal Reserve Bank; GDP Gross Domestic Product; HFRI Hedge Fund Research, Inc; IEA International Energy Agency; IMF International Monetary Fund; ISM Institute for Supply Management; MBIA Municipal Bond Insurance Association; MBS Mortgage Backed Security; MSCI Morgan Stanley Capital International; MWh Megawatt hour; NAR National Association of Realtors; NBER National Bureau of Economic Research; OECD Organisation for Economic Co-operation and Development; P/E Price-to-earnings; PIK Payment in Kind; PMI Purchasing Managers Index; VC Venture Capital; Y/Y Year-over-Year
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EYE ON THE MARKET OUTLOOK 2014
JANUARY 1, 2014
MICHAEL CEMBALEST is Chairman of Market and Investment Strategy for J.P. Morgan Asset Management, a global leader in investment management and private banking with $1.5 trillion of client assets under management worldwide (as of September 30, 2013). He is responsible for leading the strategic market and investment insights across the firms Institutional, Funds and Private Banking businesses. Mr. Cembalest is also a member of the J.P. Morgan Asset Management Investment Committee and a member of the Investment Committee for the J.P. Morgan Retirement Plan for the firms 260,000 employees. Mr. Cembalest was most recently Chief Investment Officer for the firms Global Private Bank, a role he held for eight years. He was previously head of a fixed income division of Investment Management, with responsibility for high grade, high yield, emerging markets and municipal bonds. Before joining Asset Management, Mr. Cembalest served as head strategist for Emerging Markets Fixed Income at J.P. Morgan Securities. Mr. Cembalest joined J.P. Morgan in 1987 as a member of the firms Corporate Finance division. Mr. Cembalest earned an M.A. from the Columbia School of International and Public Affairs in 1986 and a B.A. from Tufts University in 1984.
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Outlook 2014 - The Great Race - PB

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J.P. Morgan Private Bank

EYE ON THE MARKET

MARY CALLAHAN ERDOES

Most sincerely, 175 years.

EYE 2014 E Y E ON O N THE T H E MARKET M A R K E T OUTLOOK OUTLOOK 2014

1, JJANUARY ANUARY 1 , 2014 2014

Y/Y percent change in real GDP

S&P 500 MSCI World

Source: J.P. Morgan Securities LLC. November 2013.

Source: International Monetary Fund. Q3 2013.

Global equities diverging from economic surprises

MSCI World Equity Index

Economic Surprise Index, Major Economies

Eye on the Market, September 3, 2013

EYE 2014 E Y E ON O N THE T H E MARKET M A R K E T OUTLOOK OUTLOOK 2014

1, JJANUARY ANUARY 1 , 2014 2014

...while longer term rates rise modestly higher

Source: Various central banks and statistical offices. November 2013.

Similar but more muted outcome in the Eurozone

PMI business activity survey

PMI business activity survey

-10% 45 -20% 40 -30% 35 -40%

U.S. earnings growth (4 months lag)

-50% 30 2013 1998

Eurozone earnings growth (2 months lag)

-30% -40% -50%

Source: ISM, J.P. Morgan Securities LLC. November 2013.

Source: Markit, J.P. Morgan Securities LLC. December 2013.

EYE 2014 E Y E ON O N THE T H E MARKET M A R K E T OUTLOOK OUTLOOK 2014

1, 2014 JJANUARY ANUARY 1 , 2 014

Net private sector credit creation as % of public plus private UK

A growing gap between EM debtor nations and the rest

6-month annualized % change in industrial production EM excluding debtor nations

Source: JPMAM, FRB, ECB, Bank of England, Bank of Japan. Q2 2013.

JANUARY 1, 2014 1, 2014 JJANUARY ANUARY 1 , 2 014

Annualized Annualized Annualized Return Annualized Volatility Return Volatility

10.9% 10.9% -53.0% -53.0% 22.9% 22.9% 23.1% 23.1%

16.0% 16.0% 48.0% 48.0% 21.4% 21.4% 12.1% 12.1%

EYE 2014 E Y E ON O N THE T H E MARKET M A R K E T OUTLOOK OUTLOOK 2014

1, 2014 JJANUARY ANUARY 1 , 2 014

EYE 2014 E Y E ON O N THE T H E MARKET M A R K E T OUTLOOK OUTLOOK 2014

1, JJANUARY ANUARY 1 , 2014 2014

United States: Post-austerity growth improvements to show up by mid-year

2% 0% -2% -4% -6% -8% -3 -2 1981

1990 CBO projection 6 7

2007 -1 0 1 2 3 4 5 Number of years from business cycle peak

Source: NBER, CBO, J.P. Morgan Asset Management. September 2013.

EYE 2014 E Y E ON O N THE T H E MARKET M A R K E T OUTLOOK OUTLOOK 2014

1, 2014 JJANUARY ANUARY 1 , 2 014

GDP contribution, index, Q2 2009 =100

The pillars of U.S. economic growth

Three-month annualized rate of change, percent

Interest-rate-sensitive sectors* Everything else

Consumption -4% Jan-11 Jun-11 Nov-11 Apr-12

Employment Sep-12 Feb-13 Jul-13

Source: NAR, BLS, BEA, Census, JPMAM. October 2013.

Debt of households and nonfinancial corporations, % of GDP

Debt service declining more sharply than debt levels

Percent of household disposable income

14.5% 14.0% 13.5%

Household debt service

90% 80% 70%

60% 1980 1990 2000 Source: Federal Reserve, BEA. Q2 2013.