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Eye on the Market Outlook 2017

J.P. MORGAN PRIVATE BANK

True Believers. Two groups of true believers are driving changes in the developed world. The first: single-minded central bankers
who spent trillions of dollars pushing government bond yields close to zero (and below). While this unprecedented monetary
experiment helped owners of stocks and real estate, its regressive nature did little to satisfy the second group: voters who are
disenfranchised by globalization and automation, and who are on the march. What next? The fiscal experiments now begin (again).
Prepare for another single digit portfolio return year in 2017.

Click on the video to watch Michael Cembalest, Chairman of Market and Investment Strategy,
as he discusses how the themes he covers in True Believers shape his outlook for 2017.

Cover art by Robin Mork.

MARY CALLAHAN ERDOES


Chief Executive Officer
J.P. Morgan Asset Management

Expect the unexpectedthat was the worlds lesson from 2016. From the U.K.s decision to
leaveHow
the European
Union to the
U.S. presidential
surprising
results, citizens
of the
do you summarize
a year
that was in elections
many respects
indefinable?
On one
world
voiced
desire for
change. debt
As investors,
such major shifts
require
our reassessment
hand,
thetheir
European
sovereign
crisis, contracting
housing
markets
and high
unemployment
weighed
heavy
alltoofinflation,
our minds.
But at
the and
samealltime,
record
of almost
every assumption,
from
tax on
rates
to global
trade,
the subsequent
corporate profits and strong emerging markets growth left reason for optimism.
spillover effects. Thinking through portfolios and any associated balance sheet borrowings are
moreSoimportant
nowlook
thanback,
in many
rather than
wedyears
like past.
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 end,
can certainly
help
you prepare
To that
Im pleased
to share
with youfor
ourit.ever thought-provoking 2017 Outlook. As
depicted on the cover, Michael Cembalest and his team analyze the duality of pitchfork
To help guide you in the coming year, our Chief Investment Officer Michael
problems:
the rise
anti-establishment
parties
around
the world
andour
theinvestment
continued central
Cembalest
hasofspent
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working
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at the problems
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worldwide
togrowth.
build a Both
comprehensive
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of the macroeconomic
landscape.
In doing
so, weve
uncovered
potentially
a comprehensive
portfolio review
to ensure
your assets
are headed
in thesome
right direction.
exciting investment opportunities, as well as some areas where we see reason to
proceed with caution.
We thank you for your continued trust and confidence in all of us at JPMorgan Chase.

Sharing these perspectives and opportunities is part of our deep commitment to


and what we focus on each and every day. We are grateful for your continued
Mostyou
sincerely,
trust and confidence, and look forward to working with you in 2011.
Most sincerely,

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M A R K E T MICHAEL
M I C H A E LCEMBALEST
C E M B A LE ST
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2017
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Executive Summary: True Believers


INTRODUCTION

Political upheavals and unorthodox central bank actions persist, but it looks like more of
the same in 2017: single digit returns on diversified investment portfolios as the global
economic expansion bumps along for another year.
How we got here. By the end of 2014, central bank stimulus lost its levitating impact on markets, GDP
and corporate profits, all of which have been growing below trend. Proxies for diversified investment
portfolios1 generated returns of just 1%-3% in 2015 and 6%-7% in 2016.
A slow growth world

The fading impact of central bank government bond


purchases on global equity returns

Y/Y % change (both axes)


220

MSCI Developed World


Equity Index level

44%
42%

200

8%

180

7%

40%

160

38%

140

36%

120

% of developed world
gov't bond market owned
by all central banks

34%

32%
30%
2008

2009

2010

2011

2012

2013

2014

2015

100

2016

9%

Global
corporate
profits

6%
5%

3%

60

2%

40%
20%

0%

4%

80

Source: National stats offices, Haver, MSCI, Bloomberg, JPMAM. Dec. 2016.

60%

Global
nominal
GDP

Hundreds

46%

-20%

'98

'00

'02

'04

'06

'08

'10

'12

'14

'16

-40%

Source: J.P. Morgan Securities LLC. Q3 2016.

The biggest experiment in central bank history ($11 trillion and counting as of November 2016) helped
employment recover in the US and UK, and more recently in Europe and Japan. Across all regions,
however, too many of the benefits from this experiment accrued to holders of financial assets rather than
to the average citizen. As a result, the political center of a slow-growth world has begun to erode,
culminating with the election of a non-establishment US President with no prior political experience, and
the UK electorates decision to leave the European Union. The market response to Trumps election has
been positive as investors factor in the benefits of tax cuts, deregulation and fiscal stimulus and ignore
for now potential consequences for the dollar, deficits, interest rates, trade and inflation (see US section
on the American Enterprise Institute Presidency).
Employment growth in the developed world

Erosion of the political center

Index (Q1 2006 = 100)


110

United Kingdom

108
106

104

Vote share, average of developed world countries


38%
36%
34%

Eurozone

102

30%

100

Japan

98
96
94
2006

Center left

32%

2010

2012

Center right

26%

United States
2008

28%

2014

Source: National statistics offices, Haver Analytics. Q3 2016.

2016

24%

'71 '74 '77 '80 '83 '86 '89 '92 '95 '98 '01 '04 '07 '10 '13 '16

Source: Barclays Research. October 2016.

Weights and indices used for diversified portfolio proxies: 60% equities (using the MSCI All-Country World Equity
Index, including emerging markets), and 40% fixed income (using the Barclays US Aggregate for US$ investors, and
the Barclays Global Aggregate hedged into Euros for Euro investors).
Investment products: Not FDIC insured No bank guarantee May lose value

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True Believer central banks have created unprecedented distortions in government bond
markets. Bond purchases and negative policy rates by the ECB and Bank of Japan led to negative
government bond yields. Whatever their benefits may be, they also resulted in profit weakness and stock
price underperformance of European and Japanese banks. The poor performance of European and
Japanese financials was a driver of lower relative equity returns in both regions in 2015/20162.
Government bonds trading below 0% yield

Bank earnings in the developed world

60%

2.0%

50%

1.5%

% of total government bonds by market value

Trailing 12-month earnings as a % of risk-weighted assets

Portugal

Italy

Spain

Denmark

Belgium

France

Ireland

Austria

Finland

10%

Sweden

20%

Netherlands

30%

0%
Source: J.P. Morgan Securities LLC, JPMAM. December 15, 2016.

US

1.0%

Japan

0.5%
0.0%

Japan

40%

Eurozone countries

Non-Eurozone Europe

Germany

INTRODUCTION

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-0.5%

Eurozone
'05

'06

'07

'08

'09

'10

'11

'12

'13

'14

'15

'16

Source: Bloomberg, JPMAM. Q3 2016.

For the last few years, I have written about a preference for an equity portfolio thats overweight the US
and Emerging Markets, and underweight Europe and Japan3. This has been one of the most consistently
beneficial investment strategies Ive seen since joining J.P. Morgan in 1987 (see chart below, right). It
worked again in 2016, and despite the negative consequences of rising interest rates and a rising dollar
for US and EM assets, I think it makes sense to maintain this regional barbell for another year as Europe
and Japan once again snatch defeat from the jaws of victory.
Eurozone and Japanese banks have underperformed
Cumulative total return, US$
20%

10%

MSCI World

10%

8%
6%

0%

4%

-10%
-20%

Benefits of overweighting US/EM, underweighting


Europe/Japan, 3-year rolling out (under) performance

2%
0%

MSCI Japan banks

-30%
-40%
Jan-14

-2%

MSCI Eurozone banks


Jul-14

Jan-15

Jul-15

Source: Bloomberg, MSCI. December 28, 2016.

Jan-16

Jul-16

-4%
1991

1994

1997

2000

2003

2006

2009

2012

2015

Source: Bloomberg, J.P. Morgan Asset Management. Dec. 15, 2016.


Portfolio is quarterly rebalanced and assumes no currency hedging.

Eurozone and Japanese bank stocks rallied sharply in Q3 2016, mostly a reflection of steepening yield curves
which portend improved bank profitability. As the ECB gradually slows bond purchases in 2017, Eurozone bank
stocks could rise further. However, the rest of the Eurozone markets might suffer with less stimulative conditions.

Computations are based on an all-equity portfolio that is overweight the US by 10%, underweight Europe by
10%, overweight EM by 5% and underweight Japan by 5%. All overweights and underweights are expressed
relative to prevailing MSCI index weights.
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While global consumer spending has held up, global business fixed investment remains weak, in part
a consequence of the end of the commodity super-cycle and slower Chinese growth

We expect the emerging market recovery to be gradual, particularly if Trump policies lead to
substantially higher interest rates and a higher US dollar

We expect a near-term US growth boost (amount to be determined based on the composition of tax
cuts, infrastructure spending and deregulation), but trend growth still looks to be just 1.0% in Japan
and 2.0% in Europe
Components of global real GDP

Stable, slow global growth


Y/Y real GDP growth

1.6%

10%

Consumer spending

1.2%

6%

1.0%

4%

0.8%

2%

Fixed investment

0%

0.4%

-2%

0.2%
2012

2013

2014

2015

Developed markets

-4%
1997

2016

2000

2003

2006

2009

2012

2015

Source: J.P. Morgan Securities LLC. Q3 2016. Dotted lines show GDP
growth estimates through Q4 2017.

Source: J.P. Morgan Securities LLC. Q3 2016.

The global productivity conundrum continues, leaving many unanswered questions in its wake

Even though private sector debt service levels are low, high absolute amounts of debt may constrain
the strength of any business or consumer-led recovery
The global productivity slowdown

Developed world private sector debt

Productivity proxy (change in output per unit of employment)

Debt to GDP

5%
4%
3%

2%
1%

DM

0%
-2%
-3%
-4%

EM

'02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12 '13 '14 '15 '16

Source: J.P. Morgan Securities LLC. Q3 2016. EM excludes India and China.

Debt service to income

180%

18.0%

Debt service ratio

170%

17.5%
17.0%

160%

16.5%
150%

-1%

Hundreds

0.6%

0.0%

Emerging markets

8%

Hundreds

Hundreds

Percentage point contribution to Y/Y real GDP growth


1.4%

INTRODUCTION

We had a single digit portfolio return view for 2015 and 2016 (which is how things turned out),
and were extending that view to 2017 as well. There are some positive leading indicators which I
will get to in a minute, but first, the headwinds:

16.0%

Debt to GDP

140%
130%
1991

15.5%
1995

1999

2003

2007

2011

2015

15.0%

Source: J.P. Morgan Securities LLC, BIS, IMF. Q2 2016.

Is productivity mis-measured since economists cant measure benefits of new technology? This is a
complicated question, but the short answer is I dont think so. I read two papers on the subject in 2016, one
from the Fed/IMF and the second from the University of Chicago. In the first paper, the authors state that we find
little evidence that the [productivity] slowdown arises from growing mismeasurement of the gains from innovation
in IT-related goods and services. And in the second, the authors conclude as follows: evidence suggests that the
case for the mismeasurement hypothesis faces real hurdles when confronted with the data. One smoking gun:
the productivity slowdown is similar across countries regardless of the level of their ICT penetration (information
and communication technology).
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INTRODUCTION

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And finally, even before Trump takes office, were already seeing a rise in protectionism as global
trade stagnates. The degree to which Trump follows through on campaign proposals on trade is a
major question mark for 2017
Global trade stagnant for the last decade

Global rise in trade protectionism

% of world GDP

# of discriminatory trade measures


800

60%
55%

700

50%

600

45%

500

40%

400

35%
30%

300

25%
20%

200

2009
2010
2011
2012
2013
2014
Source: Center for Economic and Policy Research. July 2016.

2015

'60

'65

'70

'75

'80

'85

'90

'95

'00

'05

'10

'15

Source: World Bank. 2015.

So, with all of that, why do we see 2017 as another year of modest portfolio gains despite the
length of the current global expansion, one of the longest in history? As 2016 came to a close,
global business surveys improved to levels consistent with 3% global GDP growth, suggesting that
corporate profits will start growing at around 10% again after a weak 2016. More positive news: a rise
in industrial metals prices, which is helpful in spotting turns in the business cycle (see Special Topic #8).
Global business surveys (PMI) point to higher growth
Output PMI, 50+ = expansion

Q/Q % change, annualized

56

4.0%

55

PMI survey

54

3.5%

53

3.0%

52

2.5%

GDP growth

51

2012

2013

2014

2015

2016

Source: J.P. Morgan Securities LLC, Haver Analytics. November 2016.

Index level

500
450
400
350
300
250
200

2.0%

50
49
2011

Industrial metals prices are stabilizing

1.5%

150
100
2000 2002 2004 2006 2008 2010 2012 2014 2016
Source: Bloomberg. December 15, 2016. Index tracks aluminum, copper,
zinc, nickel and lead.

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US, Europe and Japan equity valuations

Fiscal policy projected to ease

Combined price-to-sales ratio on MSCI US, Europe and Japan


equities, ex-financials and energy

Government impact on growth

0.50%

2010-16 average

Forward estimate

1.6x

0.25%

1.4x

0.00%

1.2x

-0.25%

1.0x

-0.50%

0.8x

-0.75%

Japan Eurozone
US
UK
Canada Australia
Source: Bridgewater Associates. August 2016.

0.6x
China

So, to sum up, heres what we think 2017


looks like:

INTRODUCTION

Furthermore (and I understand that theres plenty of disagreement on the benefits of this), many
developed countries are transitioning from monetary stimulus only to expansionary fiscal
policy as well. Political establishments are aware of mortal threats to their existence, and are looking to
fiscal stimulus (or at least, less austerity) as a means of getting people back to work. The problem: given
low productivity growth and low growth in labor supply, many countries are closer to full capacity than
you might think. If so, too much fiscal stimulus could result in wage inflation and higher interest rates
faster than you might think as well. That is certainly one of the bigger risks for the US.

A modest growth bounce in the US from some


personal and corporate tax cuts, deregulation
and infrastructure spending, with tighter labor
markets, rising interest rates and a stronger
dollar eventually taking some wind out of the
US economys sails. If Im underestimating
something, it might be the potential increase in
confidence, spending and business activity
resulting from a slowdown in the pace of
government regulation (see chart, right, and
page 13)

Forward 12 months

'04

'05

'06

'07

'08

'09

Trailing 12 months

'10

'11

'12

'13

'14

'15

'16

'17

Source: IBES, Datastream, Bloomberg, JPMAM. December 15, 2016.

"Ease of starting a new business": in the US, getting


less easy, US percentile rank relative to world and OECD

100

90

Easier

US vs. World

80
70

US vs. OECD

60
50
40

Harder
'05

'06

'07

'08

'09

'10

'11

'12

'13

'14

'15

'16

'17

Source: World Bank Doing Business, JPMAM. October 2016. N = 189.

A little better in Europe and Japan in 2017, but no major breakout from recent growth trends

China grows close to stated goals, supported by multiple government bazookas firing at once

Emerging markets ex-China continue recovering after balance of payments adjustments; while
countries with high exposure to dollar financing will struggle, overall risks around a rising dollar have
fallen markedly since 2011

The world grows a little faster in 2017 than in 2016, but as shown above, a lot of that is already in
the price of developed market equities. So, another single digit portfolio year ahead

Michael Cembalest
J.P. Morgan Asset Management

EYE ON THE MARKET

MICHAEL CEMBALEST

OUTLOOK 2017

EYE ON THE MARKET MICHAEL CEMBALEST OUTLOOK 2017

2017 Eye on the Market Outlook: Table of Contents

JANUARY 1, 2017

JANUARY 1, 2017

Chapter links

Executive Summary: True Believers

Page 1

United States: what will Trumpism look like in practice?


A modest growth boost from corporate tax cuts and deregulation, as Trump is only
able to deliver on parts of his proposed agenda; tighter labor markets, a stronger
dollar and higher interest rates cool things off in the latter half of the year

Page 7

Europe: modest recovery, underperforming corporate sector and a heavy political calendar
Ignore the politics for now, its the growth dynamics that constrain upside for
investors; Europe should muddle along at 2% growth for another year, but is
fundamentally changed compared to its pre-crisis self

Page 14

Japan: delusions of inflationary grandeur


Much ado about nothing: Abenomics is not delivering the goods. Japanese equities
remain a one-trick pony linked to the fortunes of the Yen

Page 20

China: stabilization, courtesy of coordinated stimulus


After a blizzard of stimulus from multiple sources in 2015, China stabilized last year
after consecutive years of weakening data. Markets are getting closer to pricing in
the realities and constraints China now faces

Page 21

Emerging markets ex-China: recovering from balance of payment adjustments


Concerns about a rising dollar and protectionism are justified, but the sensitivity to a
rising dollar has declined sharply since 2010 through restructuring and capital
spending adjustments; buy on weakness in 2017

Page 24

Special topics

Page 26

Leverage

What amount of leverage can survive a world of volatile markets? Now that the
window for low-cost borrowing may be closing, we look at history and the future

Active management

The end of peak central bank intervention may reduce distortions and help
active managers

LNG

Rising US natural gas prices due to large-scale US LNG exports? Unlikely on both
counts. What Dept of Energy LNG export approvals mean, and what they dont

Tax efficient investing

How to simultaneously employ tax loss harvesting and generate market returns

Infrastructure

The role for public-private partnerships: PPPs have their critics, but the Obama
administration is not among them. When should investors participate?

Clean coal/CCS

The biggest problem with clean coal: scope. Infrastructure required to make
carbon capture and storage a meaningful contributor is vastly underestimated

Internet-based
business models

How helpful have user growth metrics been in assessing new internet-based
business models? Not very

Commodity prices

Markets are looking past inventory gluts given huge declines in capex;
remembering the commodity surge of the 1970s and Richard Nixon

Sources and acronyms

Page 40
Investment products: Not FDIC insured No bank guarantee May lose value

Brief videos of Michael discussing each of these special topics are available on the True Believers webpage.
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United States: what will Trumpism look like in practice?


While S&P 500 EPS growth was up 4% in Q3 2016 (8% ex-energy), some of that growth was driven by
debt-fueled stock buybacks as companies re-engineered balance sheets rather than upgrading fixed
assets. Q3 2016 revenue growth was lower: 2%, and 4% ex-energy.
Dividends and buybacks increasing... ...along with leverage...
% of net income

...and age of company assets

Net debt to EBITDA multiple

150%

Median asset age, # of years

1.80x

7.5
7.0

1.60x
1.50x

100%

6.5

1.40x

1.30x

75%

UNITED
S TAT E S

1.70x

125%

6.0

1.20x
50%

'09

'10

'11

'12

'13

'14

'15 '16*

Source: Goldman Sachs Research. Q3 2016.

1.10x

'09

'10

'11

'12

'13

'14

5.5

'15 '16*

Universe for all charts: Russell 1000 ex-financials.

'09

'10

'11

'12

'13

'14

'15

'16*

*Trailing 12-months through Q3 2016.

A healthier labor market is good news, but rising wage inflation may create pressure on the Fed to
normalize rates faster than markets expect. Theres rising pressure on profit margins, since pricing power
is still weak; higher wages need to translate into spending gains for equities to sustain end-of-year gains.
Measures of US inflation

Signs of a healthy US labor market

Y/Y % change, 3-month average

4%

Margin pressure building for US small businesses


3-month average
Hundreds

1.6%
1.5%
1.4%
1.3%
1.2%

1.5%

Core CPI & Core PCE


1%
1997
2000
2003
2006
2009
2012
2015
Source: BLS, BEA, FRB Atlanta, JPMAM. Note: prior to 2010, average hourly
earnings are only for production and nonsupervisory workers. Nov 2016.

Net % raising wages

20%

1.1%

Firing rate
1.3%
2001

2003

2005

2007

2009

2011

2013

1.0%

2015

Source: Bureau of Labor Statistics, Haver Analytics. October 2016.

Market currently expecting a slower rate hike cycle


than the median FOMC member, Fed funds target rate

6%

5%
4%

10%

3%

0%

Median FOMC member

2%

-10%
-20%

1.7%

1.8%

2%

30%

1.8%

Voluntary quit rate

2.0%

3%

40%

2.3%

1.9%

Hundreds

Median wages
Average hourly earnings
Employment cost index

5%

Hundreds

% of labor force, 3-month average


2.5%

1%

Net % raising prices

-30%
1986 1989 1992 1995 1998 2001 2004 2007 2010 2013 2016
Source: NFIB, Cornerstone Macro, Haver Analytics. November 2016.

0%
2005

Market
2007

2009

2011

2013

2015

2017

2019

Source: Bloomberg, Federal Reserve, JPMAM. December 16, 2016.

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Heres another way to look at it: employment, housing and consumer activity are doing OK, but
businesses remain cautious, even with all-time lows in real interest rates. That yields trend GDP
growth of around 2.5%. Fiscal multipliers from government spending are much higher than for tax cuts,
so we will have to see what policy mix emerges before making substantial changes to our US growth
expectations. The outcome of the infrastructure debate (direct government spending financed through
taxes on offshore profits vs. public-private partnerships; see Special Topic #5) will affect our answer.
Divergence between employment and investment

US consumer activity

5%

PCE contribution to real GDP growth, 2-quarter average

3%
2%
1%
0%
-1%
-2%
-3%
-4%
-5%

4%

15%

3%

Hundreds

Employment

4%

20%
10%
5%
0%
-5%

Real business
fixed investment
'60

'65

'70

'75

'80

'85

'90

'95

'00

'05

'10

'15

2%
1%
0%

-10%

-1%

-15%

-2%

-20%

-3%

'96

'98

'00

'02

'04

'06

'08

Source: BLS, BEA, Haver Analytics. November 2016.

Source: BEA, Haver Analytics, JPMAM. Q3 2016.

US private residential investment

What helps GDP growth the most?

'12

'14

'16

Estimated fiscal multiplier range

% of GDP
8%

Corporate tax cut

7%

Tax cuts
Spending

Homebuyer credit
1 yr tax cut higher income

6%

2 yr tax cut lower/middle income

5%

One-time payments to retirees


Transfer payments to individuals

4%

Transfers to state/local (non-infra)

3%
2%

'10

Direct infrastructure

Fed gov goods/service purchases


'50

'55

'60

'65

'70

'75

'80

'85

'90

'95

'00

'05

'10

0.0x

'15

Index (Jan. 2000 = 100)


180
170

160
150
140
130
120
110
100
90
80

1.0x

1.5x

2.0x

2.5x

Source: Congressional Budget Office. February 2015.

Source: Bureau of Economic Analysis, Haver Analytics. Q3 2016.

Risks for housing from higher rates

0.5x

Mortgage rate

Housing affordability index

8%

7%

Hundreds

UNITED
S TAT E S

Y/Y % change (both axes)

6%

30-year mortgage rate

5%
4%

'00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12 '13 '14 '15 '16

3%

Source: Natl Assoc. of Realtors, Bloomberg. December 28, 2016.

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Plenty of deregulation (healthcare, energy, finance, internet5, etc)

Corporate tax cuts and little disruption from some very transformational tax proposals

A small amount of personal tax reform that creates a modestly larger budget deficit, but not
a massive one

Limited (if any) action on trade, tariffs and deportations of undocumented workers

Large military expansion combined with an isolationist foreign policy

Infrastructure financed through taxes on offshore profits and public-private partnerships

Gradual, non-disruptive dismantling of the Affordable Care Act

Given all of the above, a modestly higher and steeper yield curve thats great for banks, but
not high enough to derail the housing expansion or worsen corporate debtor solvency

UNITED
S TAT E S

What markets are pricing in

The big question for 2017: how will Trump policies affect this backdrop? Financial markets appear to be
pricing in a benign American Enterprise Institute Presidency:

Whether this benign view is accurate or not is the big question for 2017. The right mix could be
stimulative, adding 0.2% to 0.4% to GDP growth without much damage. But too much emphasis on
tax cuts, government spending or tariffs could result in large budget deficits, higher interest rates, a spike
in the dollar, rising Federal debt ratios (and a possible ratings downgrade) and higher inflation. There are
a lot of tea leaves to read, since the outcome depends on the President-elects intentions, the disposition
of House/Senate majority leaders and the degree to which Democrats filibuster Trump policies.
The charts below show estimates of the deficit and debt consequences of Trump tax and spending plans
assuming theyre enacted in full, but I dont think thats a good central scenario. I think we will end
up somewhere in between, with a mix of infrastructure spending (in sizes way below figures Trump has
cited), corporate tax cuts, small personal tax cuts (if any), some trade restrictions on Mexico, deregulation
of healthcare/financials/energy, a modestly higher budget deficit and 3%+ on the 10-year Treasury by
the end of 2017. Higher interest rates create risks for housing and P/E multiples more broadly, but the
impact on corporate income statements should be gradual given the weighted average maturity of S&P
debt at 10.4 years, only 14% of which is floating rate.
Estimated impact of Trump tax plan on budget deficit
Ten-year cumulative revenue impact , USD trillions
$0.0

120%

-$1.0

100%

-$2.0

80%

-$3.0

TPC estimate based


on Trump tax plan
CBO baseline

60%

-$4.0
-$5.0
-$6.0
-$7.0

Federal debt held by the public and the impact of the


Trump tax plan, % of GDP

Tax Policy Center

Static

40%

Dynamic

20%

Tax Foundation

Source: Tax Policy Center (October 2016), Tax Foundation (September 2016).
Note: assumes income from pass-through entities is taxed at corporate rates.

0%

'40 '45 '50 '55 '60 '65 '70 '75 '80 '85 '90 '95 '00 '05 '10 '15 '20 '25

Source: CBO, Tax Policy Center, Haver, JPMAM. October 2016.

In November, we wrote about a potential shift at the Federal Communications Commission to end net neutrality,
and its impact on content providers and cable companies/internet service providers. This ecosystem represents 12%
of the stock market. Substantial changes could happen, and happen fast:
https://www.jpmorgan.com/directdoc/eotmfccease.pdf.
9

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1 , 2017
2017

When combining our base case scenario with pre-existing conditions and current equity
valuations, 2017 looks to me like a year of single digit profits growth and equity market
returns (i.e., 6%-8%). However, there are substantial changes taking place underneath the hood. The
second chart shows some of the changing fortunes in the US equity market since the election.
Shift in the US equity market since the election

US equity valuation: cyclically adjusted P/E ratio


Price to 10-year trailing real earnings

Performance of top third vs. bottom third exposure to factor


10%
8%
6%
4%
2%
0%
-2%
-4%
-6%
-8%
-10%
-12%

45x

UNITED
S TAT E S

40x

35x
30x
25x

20x
15x
10x
5x

'50

'55

'60

'65

'70

'75

'80

'85

'90

'95

'00

'05

'10

Source: Shiller, S&P, Haver, Bloomberg, JPMAM. December 15, 2016.

'15

Jan 2016 to election


Since election
High
volatility

Value
(Low P/E)

High
corporate
taxes

High
operating
leverage

High
domestic
sales

Low
dividend
yield

Source: RBC Capital Markets. December 9, 2016. Universe: S&P 500.

Some market factors have been improving since the US Presidential election:

Value stocks (with low P/E ratios), such as banks and industrials (presumed beneficiaries of a steeper
yield curve, deregulation and greater infrastructure investment)

Companies with high tax rates (given the prospects for corporate tax reform)

Companies with high domestic sales (given the possibility of rising tariffs and trade disputes
negatively affecting multinational stocks; see next page)

Higher operating leverage (given the prospects for modestly higher economic growth)

Stocks with low dividends and higher volatility (since higher interest rates could reduce the frenzy for
bond proxy stocks)

Many of these factors have further to run given how distorted market preferences had become due to
zero interest rates and the scarcity of organic revenue growth. Once these market factors began to shift
in Q3 2016, excess returns in actively managed large-cap, mid-cap and small-cap equity mutual funds
improved6, a possible sign that Fed-induced distortions have been negatively impacting active manager
performance (for more on active management prospects, see Special Topic #2).
While the markets look to us to have already priced in corporate tax reform, the details are not
clear yet, and some proposals are quite transformational. While lower statutory rates are a
commonly stated goal (a corporate tax rate of 25% could lift S&P earnings by 8%-10%), there are a lot
of details to sort out. The House GOP proposal entails fairly radical changes in the corporate tax code.
We wrote about it at the end of December in a detailed note; heres a summary.

The elimination of interest deductibility, and the ability to immediately expense capital expenditures

Imports would no longer be deductible, and exports would be exempt from taxation (a step which
would raise revenue on a net basis and support a reduction in the statutory rate)

One-time tax of 10% or less applied to accumulated, non-repatriated offshore profits

J.P. Morgan Securities Equity Strategy and Quantitative Research, November 21, 2016.

Most versions of these proposals grandfather deductibility of existing debt, and create carve-outs for financial
firms. But what does this mean for short-term obligations like commercial paper; would they no longer be
deductible when rolled? Unclear. Note that immediate expensing of capital expenditures for tax purposes is only a
timing benefit, and nothing more.
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While in the long run these policies could eliminate distortions in the tax code, encourage capital
spending, reduce excessive leverage and reduce incentives to shelter income or move HQ offshore
through tax inversions, the adjustment period could be disruptive. There are likely to be winners and
losers from such changes, particularly if the dollar does not rally as expected by some economists8.

UNITED
S TAT E S

On trade, domestically-oriented stocks should get the benefit of the doubt. The President has varying
degrees of unilateral influence on trade policy. While campaign promises of across-the-board tariffs of
35% and 45% are unlikely, I believe Trump will take steps which raise tariffs on foreign goods.
The risk: more expensive imports and a profit squeeze at import-dependent companies. The Peterson
Institute modeled a full trade war by assuming that the US imposes 35% tariffs on Mexico and 45%
on China, and that these countries retaliate in kind with similar tariffs. The result: roughly stagnant real
US GDP for three years, from 2017-2020. The last time that happened: 1979-1982, a period of
economic malaise, high unemployment and fragile financial markets. Again, I think the full trade war
scenario is highly unlikely, even considering the unilateral power the President has to provoke one.
Rising interest rates should help banks, whose share prices have been negatively impacted by falling
rates and a flatter yield curve since 2010. The perception of a changing regulatory environment is also
contributing to rising bank valuations, which are still well below pre-crisis levels.
Since 2010, bank stocks hurt by lower rates

Correlation of relative returns with the total return of treasuries

US bank valuations

Price-to-book value ratio

80%

2.2x

60%

2.0x

40%

1.8x

20%

1.6x

0%

1.4x

-20%

1.2x

-40%

1.0x

-60%

0.8x

-80%

'30 '35 '40 '45 '50 '55 '60 '65 '70 '75 '80 '85 '90 '95 '00 '05 '10 '15

Source: Empirical Research Partners. November 2016.

The technology sector outlook is mixed. While higher


global growth should help, a higher dollar and trade
barriers could hurt since the tech sector has the
highest percentage of foreign sales. Tech also has the
lowest effective tax rate, reducing relative benefits
from any corporate tax reform. The underperformance
of tech stocks vs. the market since the election may
also reflect rotation out of heavily crowded positions
into under-owned bank and industrial names.

0.6x

'05

'06

'07

'08

'09

'10

'11

'12

'13

'14

'15

'16

Source: MSCI, Datastream, JPMAM. December 15, 2016.

Sector

Foreign
Sales

Effective
Tax Rate Sector

Foreign
Sales

Effective
Tax Rate

Tech

59%

21.2% Cons Disc

27%

28.5%

Materials

49%

25.3% Health Care

20%

24.6%

Energy

41%

25.9% Financials

18%

27.9%

Industrials

36%

28.1% Utilities

6%

31.7%

Staples

28%

29.5% Telecom

1%

28.0%

Source: Compustat, Deutsche Bank. 2015.

The elimination of import deductibility is assumed by some economists to result in no disadvantages for
importers, or material changes to trade flows, since the dollar is assumed to rally in such a scenario by an amount
equal to the value of the foregone tax deductibility of imported goods. If the policy were adopted under a 20%
corporate tax rate regime, it would require a roughly 25% appreciation (!!) of the US dollar, pushing it to its
highest level since 1990. As I type this, Im imagining all the ways that real life could intrude on this assumption.
For example: will this work in a world of fixed and managed exchange rates of US trading partners? If for whatever
reason, exchange rate adjustments do not work as planned, the following sectors have the highest degree of
import content, and stand to be hurt the most: apparel, computers, autos and electrical equipment.
Another remarkable thing about destination-basis taxation: some people like it explicitly because they believe
that it is protectionist, and other people like it because they resolutely believe that its not.
11 11

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UNITED
S TAT E S

Policy changes are also afoot in healthcare. The internals of the Affordable Care Act are unstable
(sharply rising premiums and deductibles, falling number of insurers on state exchanges), and remind me
of the video of the undulation and ultimate collapse of the Tacoma Narrows Bridge in the 1940s. The
GOP controls many of the legislative levers needed to change/repeal it. What might the future look like?
As per Ryans plan, it could be composed of tax credits to purchase private health insurance, interstate
competition and Medicaid grants. The proposal eliminates employer and individual mandates, and
widens allowable premium variation based on age from 3:1 to 5:1 to encourage younger, healthier
people to participate. Most likely timeline: implementation after the 2018 midterm elections.
Should the GOP make changes to the Affordable Care Act, insurers, biotech and large-cap pharma could
benefit at the expense of hospitals and medical device companies. As shown below, on a broad sector
basis, healthcare valuations are close to the lowest levels relative to the overall market since 1990.
Healthcare versus the market

Price-to-forward earnings ratio relative to S&P 500, 3-month average


1.6x
1.5x
1.4x
1.3x
1.2x
1.1x

1.0x
0.9x
0.8x
0.7x

'90

'92

'94

'96

'98

'00

'02

'04

'06

'08

'10

'12

'14

'16

Source: Bloomberg, J.P. Morgan Asset Management. December 15, 2016.

Biotech stocks plummeted in 2015 when Clinton indicated that she would act on multiple fronts after
Turings price increase on Daraprim. Her plan included (a) creation of a drug pricing oversight committee
with the ability to impose fines, (b) acceleration of FDA generic approvals9 and (c) approval of emergency
imports. Trump also commented on the need to rein in drug price increases, but if his solutions are
focused on (b) and (c) and not (a), the market impact may be smaller. If so, biotech may recover some of
what was lost in the prior couple of years when its valuations converged to large-cap pharma.
Nasdaq Biotech performance following Clinton and
Trump comments, 100 = index level on day before comment

100

Biotechnology and pharmaceutical stocks priced at


similar levels, Price-to-forward earnings ratio

65x

Trump (December 7, 2016)

95

45x

85
80

35x

Clinton (September 21, 2015)

75

25x

70
65

15x

10

20

30
40
50
60
70
Days after comment on drug prices

80

Source: Bloomberg, Twitter, Time, JPMAM. December 28, 2016.

US biotechnology

55x

90

90

100

5x

US pharmaceuticals
'88 '90 '92 '94 '96 '98 '00 '02 '04 '06 '08 '10 '12 '14 '16

Source: Morgan Stanley Research. December 15, 2016.

In 2015 and 2016, pending FDA approvals were 6x-8x the rate of actual FDA approvals.

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What about a Clinton Presidency?

UNITED
S TAT E S

There are multiple pathways by which Trump policies could result in adverse outcomes given deficit and
tariff issues, and his lack of experience. Still, its also worth thinking about the counter-factual: how
would a Clinton administration have delivered a positive jolt to an aging, highly indebted US economy
that has lost its productivity mojo, and whose entitlement payments are increasingly crowding out
10
discretionary spending that contributes to future growth ? Clintons agenda included high frequency
trading fees and risk fees on banks; a drug pricing oversight committee with the ability to impose fines
and penalties; regulations impeding corporate tax inversions11; regulations on a variety of niche for-profit
industries; Federal support for labeling guidelines and soda/sugar taxes; further Medicaid expansion; new
regulations on paid leave; revised energy efficiency standards; expansion of insurance coverage
requirements; and policies Clinton described as effectively eliminating hydraulic fracturing, even though
she also described natural gas as a bridge fuel to a renewable energy future in one of the debates.
While each proposal has its merits, they would have further expanded the regulatory footprint of the
Federal Government. Compared to B. Clinton and G. W. Bush, the pace of Obama regulation was
considerably faster, a trend which has been affecting small business sentiment. As the business cycle
ages, productivity becomes more important as a means of preventing inflation. Its unclear how
Secretary Clintons regulatory agenda would have helped on this front.
Fewer active workers relative to retirees and rising debt
6.5x

80%

6.0x

Entitlement and non-defense discretionary spending

Federal debt to GDP


70%

Active to retired workers

% of GDP, with ratio of entitlement to non-defense spending


14%

Current

Hundreds

Ratio of active to retired workers

12%

Entitlement spending

5.5x

60%

5.0x

50%

8%

4.5x

40%

6%

30%

4%

20%

2%
1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 2020 2025

Debt to GDP

4.0x
3.5x

'67 '70 '73 '76 '79 '82 '85 '88 '91 '94 '97 '00 '03 '06 '09 '12 '15

10%

Budget Control Act

1.0x

3.2x

Non-defense discretionary spending

Source: BLS, Social Security Administration, OMB, JPMAM. Nov. 2016.

Source: CBO, JPMAM. March 2016. Dotted lines are CBO projections.

Cumulative number of economically significant


regulations published during equivalent periods in office

What's the largest problem facing small business?

Fall 2016 Unified Agenda

450

President Obama

400

President Bush

350
300
250
200
150
100
50
0
2009

% of respondents, 6-month average


Hundreds

500

President Clinton

35%
30%
25%

Regulation

Poor sales

Taxes

20%
15%
10%
5%

2010

2011

2012

2013

2014

2015

2016

Source: George Washington University Regulatory Studies Center. 2016.

0%
1986

Quality of labor
1990

1994

1998

2002

2006

2010

2014

Source: NFIB, Haver Analytics, JPMAM. November 2016.

10

Examples of discretionary spending: job training/worker dislocation programs; Federal spending on education;
consumer and occupational health and safety; Federal law enforcement/judiciary; pollution control and abatement;
air, ground, water infrastructure; US Army Corps of Engineers; science research, NASA; energy R&D demonstration
projects; NIH/CDC spending on disease control and bioterrorism; international drug control and law enforcement.
11

See our December 20, 2016 Eye on the Market for more on corporate tax inversions, and the House GOP
proposal for a destination-based cash flow corporate tax as a means of reducing the incentive to engineer them.
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Europe: a modest recovery, an underperforming corporate sector and a heavy political calendar
Europes economy is stable, but trend growth is still well below pre-crisis levels. While business surveys
have been in expansion territory since the beginning of 2015 and consumer confidence has risen, all of
this simply corresponds to GDP growth of around 2.0%. The growth news is better in Spain (3% in Q3
2016), but at just 10% of Eurozone profits, GDP and employment, lets not get carried away with its
overall importance. While Italy has its problems (see box) and 50% of Italian bank retail bonds mature in
2017, I expect Italy and the European Commission to find ways of avoiding an unwanted banking crisis
by coming up with a variety of accommodations.
Eurozone business surveys: manufacturing/services

Composite output PMI, Index (50+ = expansion), 3-month average


65

Net balance of positive and negative response


0%
-5%

60

EUROPE

Eurozone consumer confidence

Spain

55

-10%

Germany

Italy

Average
since 1985

-15%
-20%

50

-25%

France

45

-30%

40
2010

2011

2012

2013

2014

2015

-35%

2016

Source: Markit, Haver Analytics. December 2016.

'05

'06

'07

'08

'09

'10

'11

'12

'13

'14

'15

'16

Source: European Commission, Haver Analytics, JPMAM. December 2016.

Eurozone real GDP growth: cresting at 2%?

Y/Y % change, history extended from individual countries


6%
4%
2%
0%
-2%
-4%

-6%
1980

1985

1990

1995

2000

2005

2010

2015

Source: Eurostat, Bloomberg, J.P. Morgan Securities, Haver. Actual data


through Q3 2016; dots are consensus estimates for Q1 and Q3 2017.

La Forza del Destino. The Italian referendum no vote reduced the likelihood of Italy enacting structural
reforms to close its productivity gap with Germany. A short list of Italys problems include the weakest growth and
productivity trends in the region; slow uptake of information and communication technology (Italy ranks alongside
Romania and Bulgaria); a high share of small and medium-size enterprises which limits economies of scale,
particularly compared to the UK, Germany and France; labor market rigidities, low labor participation rates,
inefficiency of public administration, archaic legal treatment of non-performing loans, etc, etc.
In last years Outlook, we showed some broad measures of economic vibrancy and competitiveness by country.
The gap between Italy and Germany was around the same as the gap between Mexico and the US. Currency
unions make strange bedfellows.

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Bank lending has picked up now that the ECB has provided banks with incentives to lend, but still, this is
another Eurozone trend thats growing at just 2%. The charts below on bank lending are perhaps
the best way of understanding how the Eurozone is fundamentally changed compared to its
pre-crisis self: much less reliance on explosive growth in household and corporate borrowing in the
European periphery. When I look at Italy and Spain from 2005 to 2008, it brings to mind a sentiment
attributed to Marcel Proust: Remembrance of things past is not necessarily a remembrance of things as
12
they were . The mid-decade surge in Southern European growth was never as real as it seemed, and
was built on the faulty edifice of monetary union among countries with radically different growth and
productivity characteristics.
Eurozone bank lending to households

Eurozone bank lending to non-financial corporations

Y/Y % change, adjusted for loan sales and securitizations


20%

Spain

20%
10%

France

Italy

5%

Germany

0%

0%

Germany

-5%
'05

'06

'07

EUROPE

France

15%

10%

-5%

Spain

25%

Italy

15%

5%

Y/Y % change, adjusted for loan sales and securitizations


30%

'08

'09

'10

'11

'12

'13

'14

'15

'16

Source: European Central Bank, Haver Analytics. October 2016.

-10%

'05

'06

'07

'08

'09

'10

'11

'12

'13

'14

'15

'16

Source: European Central Bank, Haver Analytics. October 2016.

Fiscal stimulus in Germany might help, but Im not sure how much we will see. Germanys Council of
Economic Experts wrote in its annual report to Merkel that the extent of monetary easing is no longer
appropriate, and that additional fiscal stimulus is currently not appropriate either. While German
home prices are rising after a couple of decades of stability, German wage growth and other inflation
measures are stable. As a result, when it chooses to, the ECB should be able to slowly step back from its
stimulus campaign, rather than abruptly. Still, its striking to see the continued outperformance of
Germany vs. France, which is not a healthy dynamic between the Eurozones two largest countries.
German inflation showing up in housing, but not in
wages or prices, Y/Y % change

6%
5%
4%

Hourly
wages

2%

GDP deflator

0%

1.10

1.00
0.95

Unit labor cost


2011

2012

2013

2014

2015

2016

Source: Bundesbank, Statistisches Bundesamt, Haver, JPMAM. Q3 2016.

12

1.15

1.05

1%

-2%
2010

Germany divided by France, ratio


1.25

1.20

House prices

3%

-1%

Germany vs. France real per capita GDP, 1850-2016

0.90
1850 1865 1880 1895 1910 1925 1940 1955 1970 1985 2000 2015
Source: "Statistics on World Population, GDP and Per Capita GDP",
University of Groningen, Conference Board, JPMAM. May 2016.

Proust was a Neuroscientist, J. Lehrer, 2007.


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Earnings. Over the last 10 years, Europe posted its worst EPS growth vs. the US since the 1970s. An
illustrative data point: through November, European EPS was still 46% below its pre-crisis peak, while
US EPS was 10% higher. Europe has lagged the US on every component of profitability since 2007,
particularly stock buybacks

Return on equity. Europes relative return on equity is also close to the lowest levels since the 1970s.
Currently, the ROE of the median European industry group is 4.4% lower than its US counterpart. Of
24 industry groups, only 3 have ROEs which are higher in Europe than in the US (the largest positive
difference in favor of Europe is for a sector that only has a 0.5% index weight)

Multiples. Despite all of this, European P/E multiples are actually not trading at much of a discount
vs. US equities (less than 1 P/E point lower during November and December 2016)
Europe vs. US: equity performance

Europe vs. US: earnings per share growth

10-year rolling relative equity performance, local currency


100%

10-year rolling relative EPS growth

Europe outperforms

75%

25%
0%

0%

-25%

-25%
-50%
1980

-50%

Europe underperforms
1984

1988

1992

1996

2000

2004

2008

2012

2016

Source: MSCI, Datastream, JPMAM. December 15, 2016.

Europe vs. US: return on equity

Difference in ROE by sector, Europe minus US

20%

10%
5%

-15%

Energy
Utilities
Software
Househ. Prod
Healthcare
Cons Dur
Banks
Real Estate
Cap Goods
Food Retail
Media
Food & Bev
Div Fin
Materials
Telecomms
Retailing
Semis
Transport
Autos
Tech Hardware
Cons Serv

-10%

-20%
Source: MSCI, Bloomberg, JPMAM. November 2016.

16

-75%
1980

Europe underperforms
1984

1988

1992

1996

2000

2004

2008

2012

2016

Source: MSCI, Datastream, JPMAM. November 2016.

Europe vs. US: profitability components

Contribution to earnings per share growth since 2007


Buybacks

0%
-5%

Europe outperforms

100%
50%

25%

15%

125%
75%

50%

Comm Serv
Pharma
Insurance

EUROPE

European equities underperformed again in 2016, culminating in its worst decade of relative
performance vs. the US since we can track both series in 1970. This outcome has tempted many
strategists to recommend Europe as a non-consensus pick every year over the last few years. However,
Europes underperformance is almost entirely explained by inferior corporate results, rather than by
pessimistic pricing of European equities:

Effective Tax Rate


Non-Operating Income
Amount Of Debt
Cost Of Debt

US
Europe
Cumulative EPS
growth since 2007:
US: 78%
Europe: -27%

Depreciation
Operating Margins
Sales Growth
-30% -20% -10% 0% 10% 20% 30% 40%
Source: MSCI, Bloomberg, Morgan Stanley Research. June 2016. Excluding
commodities and financials.

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ON
2017
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N TTHE
H E MARKET
M A R K E T MICHAEL
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C E M B A LE ST OUTLOOK
OUTLOOK
2017

JANUARY
JA
N U A R Y 11,
, 22017
017

What about European politics?


For active readers of Eye on the Market, youre probably aware of our research indicating that politics
(whether local or global) tend not to have a large impact on markets. Thats why we generally
pay more attention to the business cycle than to politics.
That said, half of the Eurozones population will vote in Presidential elections in 2017. If populist parties
take control, it could result in heightened market volatility, since in addition to risks around Eurozone
referendums, most European populist parties (unlike Trump) are generally not advocating deregulation,
lower corporate tax rates and other pro-business policies as the core part of their agenda. To be clear,
however, most of these parties are still in the minority and not on the cusp of being asked to be
part of a majority government. Also, popular support for the Euro remains at 70%.
French, Italian, Spanish, and Greek real GDP per capita

Support for populist parties in Europe


% of support in polls (3-month average)
50%

7-year annualized % change, population-weighted


6%

Austria (Freedom Party)


Netherlands (Party for Freedom)
Italy (5-Star Movement)
France (National Front)
Spain (Podemos)
Greece (Syriza)
Germany (AfD)
UK (UKIP)

25%
20%
15%
10%

5%

EUROPE

45%
40%
35%
30%

4%
3%
2%
1%
0%

5%
0%
2010

-1%
2011

2012

2013

2014

2015

2016

-2%

'55

'60

'65

'70

'75

'80

'85

'90

'95

'00

'05

'10

'15

Source: The Conference Board, JPMAM. May 2016.

Source: Various national polls. November 30, 2016.

Why did anti-establishment parties emerge in Europe, despite recent economic improvements?
First, the improvement is pretty modest if you look over a longer period. The chart (above, right) shows
per capita GDP growth in France, Italy, Spain and Greece. The last few years have been terrible, similar
to results seen during WWII, WWI, the Spanish Civil War (1930s), the Franco-Prussian War (1870s) and
the Phylloxera epidemics in France (1880s) and Spain (1890s). Secondly, if we take Eurobarometer
surveys at face value, Europeans are very concerned about immigration and the surge of asylum-seekers.
What do you think are the two most important issues
facing the EU?, % of respondents

70%
60%

Economic
situation

50%
40%

Immigration

Unemployment

2012

Source: Eurobarometer. 2016.

Illegal migration into


the EU

0.7
0.5
0.3

2013

2014

2015

1.8
1.6
1.4
1.2
1.0

EU ex-Germany
asylum seekers

0.2

Terrorism
Crime

2011

2.0

0.8

0.4

10%
0%
2010

Number of people, millions


0.9

0.6

State of the member


state's public

30%
20%

Asylum-seekers and illegal migration to Europe

0.1
0.0
2008

0.8
0.6
0.4

Asylum seekers in Germany


2009

2010

2011

2012

0.2
2013

2014

0.0
2015

Source: Eurostat, Frontex, Pew. 2015.

17 17

OUTLOOK
O U T L O O2017
EEYE
Y E ON
O N THE
T H E MARKET
M A R K E T MICHAEL
M I C H A E LCEMBALEST
C E M B A LE ST
K 2017

JJANUARY
A N U A R Y 11,, 22017
017

At a client event we held in Paris last November, Henry Kissinger and I debated why Europe is doing little
in the Middle East to slow the pace of asylum-seekers. We concluded that two factors help explain why:
[1] gradual European disarmament (only 4 of 24 European countries are meeting NATO military spending
targets), and [2] increasing European reliance on Russian oil and gas, which now accounts for almost as
much energy as Europe produces for itself.
Combined forces: UK, Germany, Italy, France, Spain
Thousands

Manpower (mm) Combat aircraft

1.4

2,000
1,800

1.2

1,600

1.0

6,000

120

5,000

0.8

1,200

0.6

800

60

600

40

400

0.2
0.0

200
2000 2013

2000 2013

2000 2013

Source: Roland Berger Strategy Consultants, Statista. 2013.

Thousand barrels a day of oil equivalents


14,000

8,000

3,000

6,000

2,000

4,000

European oil and gas production

10,000

2,000

1,000

20

European reliance on Russian oil and natural gas

12,000

4,000

80

1,000

Battle tanks

140

100

1,400

0.4

EUROPE

Warships

0
2000 2013

European oil and gas imports from Russia


'80 '82 '84 '86 '88 '90 '92 '94 '96 '98 '00 '02 '04 '06 '08 '10 '12 '14

Source: BP Statistical Review of World Energy, Gazprom, Eurostat, Perovic


et al, JPMAM calculations. 2015.

Bottom line on the Eurozone. 2% GDP growth, stable bank lending, a modestly steeper yield curve
(which helps bank stocks), improved earnings at commodity companies and a weak Euro should deliver
single digit earnings growth, and single digit growth in equities as well. If so, Europe should muddle
through another year in 2017 without too much drama. The next big existential challenge for the
Eurozone will probably be the Italian General election in late 2017/early 2018, assuming that the
National Front13 does not win the French Presidential election in May 2017 (if it does, all bets are off).
But to be clear, even if the Eurozone survives these challenges, it is fundamentally changed when
compared to its pre-crisis self, a model which had relied on unsustainable leverage and consumption
in the European periphery to drive growth and profitability.

13

For some French citizens, as my friend Louis Gave says, the National Front is an intellectual descendant of Vichy
France and not an acceptable option. If Thatcherite candidate Francois Fillon is elected and is able to
liberalize Frances labor laws (ending the 35-hour work week), cut corporate tax rates, reduce pension
burdens on companies and abolish the wealth tax, there could be a positive market reaction.
18

18

O U T L O O 2017
EEYE
Y E ON
O N THE
T H E MARKET
M A R K E T MICHAEL
M I C H A E LCEMBALEST
C E M B A LE ST OUTLOOK
K 2017

J JANUARY
A N U A R Y 11,, 22017
017

Brexit: the hard part lay ahead, but so far, UK economy holding up better than expected
Its too soon to tell, but as I wrote before the vote, some commentary on Brexit seems overwrought. In
much of the Brexit research I read, I cant tell how much of the fears expressed by the authors are based
on dispassionate assessments of the risks, and how much is based on their anger and frustration at the
votes outcome.
After a prolonged period of de-industrialization, it will be hard for the UK to immediately reap the
benefits of a weaker pound (which has further to fall in 2017, and which is already feeding into higher
inflation). However, since Brexit, business surveys and commercial property enquiries bounced back from
their initial swoon, retail sales are holding up and job listings reflect logical responses to a weaker pound.
Measures of UK economic surprises rose sharply in November 2016, mostly since dire outcomes expected
by many economists didnt happen. Perhaps the most important thing to watch is business investment
plans, which plummeted after the vote. More recently these plans have improved a little, as businesses
wait and see what the deal with the EU will look like once Article 50 is triggered.
EUROPE

The gradual de-industrialization of the UK

UK business surveys

Manufacturing as a % of total gross value added

PMI level, Index (50+ = expansion)

30%

65

25%

Construction

Brexit

60

UK ranks 30th out


of 34 countries in
the OECD

20%
15%

Services

55
50

10%
5%
1970

1975

1980

1985

1990

1995

2000

2005

2010

2015

45
2011

Manufacturing
2012

2013

2014

2015

2016

Source: Office for National Statistics, Haver Analytics, JPMAM. Q3 2016.

Source: Markit, Haver Analytics. November 2016.

UK retail sales volume growth

Post-Brexit rebalancing in UK job market reflects impact


of a weaker Pound, Y/Y growth in # of jobs advertised

20%

4%

15%

3%

10%

2%

5%
0%

1%

-5%

0%

-10%

-1%
-2%

-15%

'05

'06

'07

'08

'09

'10

'11

'12

'13

'14

'15

Source: UK Office for National Statistics, Haver Analytics. Nov. 2016.

'16

Banking

25%

5%

Retail

30%

Manufacturing

Brexit

6%

Automotive

7%

Total

Y/Y % change, 3-month average

-20%
Source: Reed Job Index. Q3 2016.

19 19

OUTLOOK
O U T L O O 2017
EEYE
Y E ON
O N THE
T H E MARKET
M A R K E T MICHAEL
M I C H A E LCEMBALEST
C E M B A LE ST
K 2017

J JANUARY
A N U A R Y 11,, 22017
017

Japan: delusions of inflationary grandeur


Abenomics was designed to reflate Japan. Inflation picked up in 2014, but then rolled over. While the
Bank of Japan has been projecting higher inflation (brown dots, right chart), their forecasts have been
way too optimistic. Im not going to spend too much time this year dissecting all the Japanese data,
since the core objective of Abenomics isnt working.
Japanese core inflation

Y/Y % change, both adjusted for 2014 VAT

Bank of Japan overestimated the inflationary benefits


of quantitative easing, Y/Y % change, ex-fresh food

2.0%

2.0%

Prime Minister
Abe elected

1.5%

Ex-food
and energy

1.0%
0.5%

0.5%

0.0%

0.0%
-0.5%

Ex-fresh food

-1.0%
'10

'11

'12

'13

'14

'15

'16

Source: Japan MIC, Haver Analytics, JPMAM. November 2016.

JAPAN

1.0%

-0.5%

-1.5%

Prime Minister
Abe elected

1.5%

Adjusted for
2014 VAT

-1.0%
-1.5%

'10

'11

'12

'13

'14

'15

Forecast realization
Year forecast made
'16

'17

'18

'19

Source: Japan MIC, Bank of Japan, Haver Analytics, JPMAM. Nov. 2016.

For investors, I leave you with this. Where I grew up, every few years, insects called cicadas emerged
after spending a decade or more underground, and then flew around for a few weeks before dying. In
Japan, the cicada is known as the higurashi, and its a good metaphor for the Japanese equity market.
The chart below (left) shows the benefits of overweighting Japanese equities and underweighting a mix
of US, Europe and Emerging Markets equities14 since 1988. For a few short periods over the last 28
years, Japanese equities had their place in the sun, flying around for a while before submerging again.
Otherwise, they werent really worth owning on a relative basis.
Renewed weakness in the Yen should help Japanese exporters in 2017, fiscal spending is rising, and
investors may benefit from Japanese companies increasing buybacks and M&A (cash holdings in Japan
are roughly 3x US levels as a % of market capitalization). Id be comfortable with a neutral position in
Japan in 2017 but not an overweight, since I dont think 2017 will be the year of the higurashi,
particularly if the Yen starts to rally again.
Higurashi Moments: the benefits of overweighting Japan
3-year rolling out (under) performance
2%

0%

Japan outperforms

-2%
-4%
-6%
-8%
-10%
-12%

Japan underperforms
-14%
1991 1994 1997 2000 2003 2006 2009 2012 2015
Source: Bloomberg, J.P. Morgan Asset Management. Dec. 15, 2016.
Portfolio is quarterly rebalanced and assumes no currency hedging.

Japan equities and the Yen: a one-trick pony


Exchange rate
125

115
110
105
100
95
90
85
80
75
2010

1000

USD/Yen FX rate

120

Index level

900

800
700
600

MSCI Japan equities


2011

2012

2013

2014

2015

2016

500
400

Source: Bloomberg. December 16, 2016.

14

Computations are based on an all-equity portfolio that is overweight Japan by 7.5%, underweight the US by
3.5%, underweight Europe by 2.5% and underweight emerging markets by 1.5%. All overweights and
underweights are expressed relative to prevailing MSCI index weights.
20

20

OUTLOOK
O U T L O O2017
EEYE
Y E ON
O N THE
T H E MARKET
M A R K E T MICHAEL
M I C H A E LCEMBALEST
C E M B A LE ST
K 2017

JJANUARY
A N U A R Y 11,, 22017
017

China: stabilization, courtesy of coordinated stimulus


2016 was a year of stabilization in China, and 2017 looks like it will be more of the same. As shown
below (left), a massive, coordinated stimulus effort involving bank lending, government spending and
fixed investment by state-owned enterprises took place towards the end of 2015. In response, the
Chinese economy stabilized in 2016 (see 2nd chart on employment, exports, business surveys, corporate
earnings, GDP, industrial production, retail sales, etc).
Pump Up the Volume

China: stabilization in 2016

Y/Y % change
30%

Government spending

25%

Legend: employment surveys, exports,


business conditions, GDP, corporate earnings,
industrial production, retail sales, non-state
owned enterprise fixed asset investment

Mortgage lending

Total social financing

20%

15%
10%

Fixed asset investment: SOE

5%
2011

2012

2013

2014

2015

2016

2011

2012

2013

2014

2015

2016

Source: CFLP, Markit, CC, PBOC, CNBS, MSCI, Haver, JPMAM. Nov 2016.

Source: JPMS, PBOC, CNBS, Haver Analytics. March 2016.

Long-term appreciation of the Chinese RMB

Corporate debt levels in China

Non-financial corporate debt, % of GDP


180%
170%
160%
150%
140%
130%
120%
110%
100%
90%
80%
70%

RMB real effective exchange rate index


130

Stronger

120
110

REER: exchange rate index weighted by


trading partner size, adjusted for inflation

100
90
80
'94

'96

'98

'00

'02

'04

'06

'08

'10

'12

'14

Source: Bank for Int'l Settlements, Haver, Gavekal, JPMAM. Q3 2016.

15

CHINA

While stabilization is welcome, parts of Chinas corporate sector are still highly indebted and suffering
from both chronic overcapacity and an overvalued exchange rate. Chinas corporate debt surge is now
by some measures as large as the Japanese version of the 1980s. Some consequences: 25% of listed
Chinese companies have cash flow that is less than the interest they owe to banks and bondholders15;
and a meager 1.5% return on assets at state-owned enterprises. All things considered, and given the
difficulties involved with running massive stimulus indefinitely, Chinese GDP growth is probably headed
to 5.5%-6.0% by 2018.

'16

70
1995

Weaker
2000

2005

2010

2015

Source: J.P. Morgan Securities LLC, Bloomberg. December 16, 2016.

China avoiding the Japanese sinkhole?, Lombard Street Research, May 10, 2016.
21 21

OUTLOOK
O U T L O O2017
EEYE
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O N THE
T H E MARKET
M A R K E T MICHAEL
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C E M B A LE ST
K 2017

JJANUARY
A N U A R Y 11,, 22017
017

The good news: markets have come closer to pricing in the realities of Chinese fundamentals.
The premium for A shares (onshore stocks trading in Shanghai and Shenzhen) relative to H shares (Hong
Kong-listed) has come down by half, indicating less of a frenzy in the local markets. Furthermore, margin
balances declined sharply after the boom-bust fiasco in 2015, and institutional protections were put in
place (higher reserve requirements, limits on structured finance vehicles). Finally, many of the circuit
breakers and trading suspensions have been lifted. As a result, equity-raising has resumed in China,
allowing many companies to recapitalize and pay down debt.
However, some remnants of Chinas reaction to the 2015 equity market collapse remain:
corruption investigations into market manipulators continue, regulators still tightly control the IPO
market, and the government still appears to own a lot of the stock it bought as the equity market was
declining. Eventually, the depth of the Chinese equity market should improve as domestic institutional
investors such as pension funds increase their allocations. Currently, individuals still account for 80% of
the trading and 70% of free float ownership.
China: margin debt vs. onshore equity prices
Price index level

Outstanding margin debt, % of GDP

5,500
5,000

Index of
onshore equity
prices (CSI 300)

4,500

4,000

26x

3.0%

22x

2.5%

1.5%

3,000

Margin debt

2,500

CHINA

Forward price-to-earnings ratio, equal weighted by sector

3.5%

Onshore
(A shares)

18x

Offshore
(H shares)

2.0%

3,500

2,000
Jan-14

China price-to-earnings multiples

Jul-14

Jan-15

Jul-15

Jan-16

Jul-16

1.0%
0.5%

Source: National statistics offices, Bloomberg, JPMAM. December 16, 2016.

14x
10x
6x

'04

'05

'06

'07

'08

'09

'10

'11

'12

'13

'14

'15

'16

Source: MSCI, Bloomberg, Datastream, JPMAM. December 16, 2016.

Investors should also remember that the Chinese financial system is a work in progress, and that the
government continues to clean up the shadow banking system. The government is currently imposing
new capital charges and risk provisions on distributors of asset management products. Good news in the
long run, but potentially destabilizing in the short run.

22

22

OUTLOOK
O U T L O O2017
EEYE
Y E ON
O N THE
T H E MARKET
M A R K E T MICHAEL
M I C H A E LCEMBALEST
C E M B A LE ST
K 2017

JJANUARY
A N U A R Y 11,, 22017
017

The gradual rebalancing of the Chinese economy should continue in 2017, with consumption
growing relative to capital spending. Real incomes and real consumption are still growing at 6%7% per year, and for investors, its worth paying attention to the continued rapid growth in the number
of affluent Chinese households. One illustrative consequence: faster growth in SUV purchases than
sedan purchases, faster growth in overseas travel, preference for fresh coffee (vs. instant) and maturation
in the internet penetration rate at around 55%16.
Chinese household consumption expenditures
Share of GDP & GDP growth, %
55%

Million households
400
350

50%
45%

Share of GDP

40%

35%

300

Affluent (RMB136,000)

250

Established (RMB89,000)

200

Emerging (RMB54,000)

150

Below all 3 thresholds

100

30%
25%

Chinese households by wealth level

50

Share of GDP growth


'00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12 '13 '14 '15

Source: China National Bureau of Statistics. 2015.

'95
'00
'05
'10
'15
'20
'25
Source: Gavekal Dragonomics Chinese Consumer Outlook, Nov. 2016.

CHINA

For investors interested in China/Asia consumption, I always caution against looking to Chinese
17
public equity markets as a way of expressing this view. In countries like China , Taiwan and Hong
Kong, the combined weight of consumer staple and consumer discretionary stocks is less than 10% of
stock market capitalization. What makes more sense to me: a targeted strategy, either in public or
private equity markets. As shown below, on an industry-wide basis, private equity and venture capital
managers have outperformed public equity markets in Asia. Part of the explanation lay in manager
decisions to overweight consumer-related companies and underweight state-owned enterprises, banks,
heavy industry, airlines and utilities.
Private equity performance versus public equity in Asia

China dominates emerging markets private investments

14%

70%

12%

60%

10%

50%

8%

40%

6%

30%

4%

20%

2%

10%

0%

0%

10-year annualized return through Q2 2016

MSCI
MSCI
Asia DM
Asia EM
Pacific
EM Asia
PE & VC
PE & VC
Source: Cambridge Associates LLC, MSCI, Bloomberg, JPMAM.

Index weight

South Korea
India
South Korea
China

India
China

Emerging Markets
MSCI Emerging Markets
PE/VC Index
Source: Cambridge Associates, MSCI, Bloomberg. December 2015.

16

Gavekal Dragonomics Consumer Chartbook, November 2016.

17

This comment is based on the MSCI China Index, which includes H shares, B shares, Red chips and P chips.
23 23

OUTLOOK
O U T L O O2017
EEYE
Y E ON
O N THE
T H E MARKET
M A R K E T MICHAEL
M I C H A E LCEMBALEST
C E M B A LE ST
K 2017

JJANUARY
A N U A R Y 11,, 22017
017

Emerging markets ex-China: recovering from balance of payment adjustments


Emerging market equities and currencies declined after the US election due to fears of a rising dollar and
protectionism emanating from the US. These concerns are well-founded (particularly with respect to
Mexico18), and I expect more weakness in EM FX rates in the next few months as markets price in
implications of higher US interest rates as well. The reason a rising dollar worries investors is generally
nd
due to EM reliance on US dollar financing. However, as shown in the 2 chart, EM and global
reliance on foreign capital has declined over the last few years. So, a rising dollar may hurt EM
borrowers, but not as much as it would have 3-4 years ago when balance of payments and balance sheet
adjustments were just beginning. As a result, buying EM on any pronounced weakness seems like the
best strategy for 2017.
How did sensitivity to dollar financing decline? Mostly via sharp capital spending cuts by EM commodity
companies that are very large dollar borrowers, which in turn contributed to stabilization in commodity
prices (see Special Topic #8). In aggregate, their free cash flow is now positive after being sharply
negative in 2015. Signs of reduced stress are seen in the sharp declines in credit default swap rates for
Petrobras, Pemex, Vale, Rosneft and Gazprom.
Emerging markets foreign exchange and equities selloff after the US election, Index level (both axes)

70
69

EM FX

68

Declining sensitivity to dollar financing


105
100

67
66
65
64

95

EM equities
(in LC terms)

63
62
61
60
Jan-16

90
85

US Election
Apr-16

Jul-16

80

Oct-16

100

% of EM countries significantly
reliant on foreign capital

80%
70%

90

80
70

60%

60

50%

50

40%

40

30%

30

20%

20

Global sensitivity 10
to US$ liquidity
0

10%
0%
1975

1980

1985

1990

1995

2000

2005

2010

2015

Source: Bridgewater Associates. October 2016.

Source: J.P. Morgan Securities, MSCI, Bloomberg. December 15, 2016.

The chart below (left) is a rough measure of sensitivity to dollar financing conditions for EM countries.
EM Asia is generally better positioned than Latin America to ride out another surge in the US dollar.
Sensitivity to dollar financing by country

Sharp rise in the dollar parallels early 1980s rise

Index, 100 = highest sensitivity

Real effective US dollar exchange rate index

100

125

90
80

120

70

115

60

110

50

South Korea

Thailand

India

China

Argentina

Taiwan

0
Source: Bridgewater Associates. October 2016.

Philippines

Indonesia

Brazil

Russia

South Africa

Turkey

Peru

Saudi Arabia

Malaysia

Colombia

10

Mexico

30
20

Stronger

1980-1984

105

40

Chile

EMERGING
MARKETS

90%

2012-2016

100
95
90
2012

Weaker
2013

2014

2015

2016

Source: J.P. Morgan Securities LLC, BIS, Bloomberg. December 15, 2016.

18

As of December 15, the MSCI EM equity index (in local currency terms) is roughly flat since the election. Mexico
is a possible target for some of Trumps trade agenda, which explains the 5% decline in the MSCI Mexico equity
index and another 8.5% decline in the Peso. Russian equities, on the other hand, are up the most. Plenty of room
for some interesting conclusions, should you want to draw them.
24

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OUTLOOK
O U T L O O2017
EEYE
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T H E MARKET
M A R K E T MICHAEL
M I C H A E LCEMBALEST
C E M B A LE ST
K 2017

JJANUARY
A N U A R Y 11,, 22017
017

In two prior cycles, after a sharp decline in EM currencies, EM equities outperformed the developed
markets (shaded area in the first chart). Then, as EM exchange rates rose over the next few years, EM
assets eventually underperformed again. In theory, structural reforms could reduce the magnitude of
these cycles, but I dont think were anywhere near that point. As a result, EM is best thought of as a
value play that makes the most sense after a balance of payments crisis, when imports and
unit labor costs have declined, and when competitiveness has been (temporarily) restored.
Signals that indicate that this view is on track: the stabilization of portfolio inflows into EM countries, and
a modest improvement in earnings estimates for the EM corporate sector. We will have to watch both
closely now that the dollar has started rising again.
EM portfolio inflows: stabilizing

When EM exchange rates bottomed, EM equities


improved, EM real exchange rate index vs. US$, 1991=100

120

% of GDP, 2-quarter average, ex-China


6%

Shaded area:
outperformance of
EM vs. DM equities

115
110

5%
4%
3%

105

2%

100

1%

95

0%

90

-1%

85

-2%

80

'84 '86 '88 '90 '92 '94 '96 '98 '00 '02 '04 '06 '08 '10 '12 '14 '16

-3%
1980

1985

1990

1995

2000

2005

2010

Source: J.P. Morgan Securities LLC, JPMAM. November 30, 2016.

Source: National statistics offices, IMF, Haver Analytics. Q2 2016.

EM corporate earnings estimates: improving

Brazil credit spread on external sovereign debt


5-year credit default swap, basis points

12-month forward consensus earnings, ex-China


60%

550

40%

500
450

20%

400

0%

350

-20%

EMERGING
MARKETS

300

-40%
-60%

2015

250
'05

'06

'07

'08

'09

'10

'11

'12

'13

'14

'15

Source: IBES, JPMAM. December 9, 2016. Indexed to January 2016.

'16

200
Jan-15 Apr-15

Jul-15

Oct-15 Jan-16 Apr-16

Jul-16

Oct-16

Source: Bloomberg. December 28, 2016.

A good example of post-crisis deep value investing: Brazil. In last years Eye on the Market
Outlook, we discussed how Brazils economy was as bad as anything I had seen since 1994 (growth,
current account deficit, trade balance). Nevertheless, I wrote that the risk of Brazilian sovereign default
on external debt was lower than in 2002, primarily due to a shift in sovereign financing from external to
domestic debt. In other words, while Brazil has a lot of problems, unlike Greece (2009) and Argentina
(2001), Brazilian sovereign external debt is NOT the core problem, and defaulting on it would probably
not be a part of a solution. The chart above shows the rally in Brazilian sovereign external debt that
began in January 2016.

25 25

OUTLOOK
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EEYE
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M A R K E T MICHAEL
M I C H A E LCEMBALEST
C E M B A LE ST
K 2017

2017 Eye on the Market Outlook Special Topics

2017
JJANUARY
A N U A R Y 11,, 2
017

Chapter links

Leverage

What amount of leverage can survive a world of volatile


markets? Now that the window for low-cost borrowing may
be closing, we look at history and the future

Page 27

Active
management

The end of peak central bank intervention may reduce


distortions and help active managers

Page 29

LNG

Rising US natural gas prices due to large-scale US LNG exports?


Unlikely on both counts. What Dept of Energy LNG export
approvals mean, and what they dont

Page 31

Tax efficient
investing

How to simultaneously employ tax loss harvesting and


generate market returns

Page 33

Infrastructure

The role for public-private partnerships: PPPs have their critics,


but the Obama administration is not among them. When
should investors participate?

Page 34

Clean coal/CCS

The biggest problem with clean coal: scope. Infrastructure


required to make carbon capture and storage a meaningful
contributor is vastly underestimated

Page 36

Internet-based
business models

How helpful have user growth metrics been in assessing new


internet-based business models? Not very

Page 37

Commodity prices

Markets are looking past inventory gluts given huge declines in


capex; remembering the commodity surge of the 1970s and
Richard Nixon

Page 38

Brief videos of Michael discussing each of these special topics are available on the True Believers webpage.

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M A R K E T MICHAEL
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C E M B A LE ST
K 2017

JJANUARY
A N U A R Y 11,, 22017
017

[1] What amount of portfolio leverage can survive a world of volatile markets?
In our study of state pension plans, we found that median expected long-term returns on plan assets
were around 7.5%. While corporate plans discount liabilities at lower rates than state plans, Milliman
cites a funding ratio of 76% for the 100 largest corporate plans, indicating that many may need higher
returns. As a result, some pensions, endowments, foundations and individuals have contemplated
leverage (in one form or another) to increase portfolio returns. Since the window of opportunity to
borrow at historically low levels may be closing, we wanted to take a closer look at leverage this year.
How much leverage can a portfolio sustain in a world of volatile markets, particularly since
correlations among asset classes can rise close to 1.0 during a crisis? For purposes of this analysis,
we define successful use of leverage as a scenario in which a portfolio does not experience failure over
a 10-year period. We also assume that leverage is implemented through long-term fixed rate borrowing,
and that leverage proceeds are used to gross up existing portfolio holdings on a pro-rata basis.
We looked at leverage from two perspectives: historical, and forward-looking. Our definitions of failure
differ in each approach. The goal: develop some rough estimates of how much leverage a portfolio
could carry without causing regret and recriminations at some point down the road.
The empirical, historical analysis
In the first approach, we start with a representative diversified portfolio of marketable securities that is
rebalanced quarterly. We then compute the following: over each ten-year period, using actual daily
returns on each asset class, what is the maximum amount of leverage that the portfolio could have
employed without experiencing failure? In this approach, failure is defined using a margin call
concept, one which is imposed by the provider of the financing, and which is triggered when/if the
portfolio declines to a 75% loan to value.
As shown in the chart, during the 1990s, our prototype portfolio could have employed 60%-70%
leverage and not hit the margin call trigger19. However, as you might imagine, the tech collapse and the
financial crisis then redefined the universe of bad market outcomes. In early 2008, based on this
analysis, the diversified portfolio could not have taken on more than 40% leverage. To be clear, while
the portfolio could have carried 40% leverage, that doesnt mean that leverage would always have
delivered positive returns. We are simply measuring the portfolios ability to sustain a market decline and
keep going, without forced sales of assets along the way.
Maximum leverage possible to avoid margin call
Leverage, defined as a % of the gross portfolio value
75%
70%

60%
55%
50%
45%
40%
Jan-90

Ten-year period beginning in...

Jan-94

Jan-98

Jan-02

Jan-06

Index
S&P 500 Total Return
Russell 2000 Total Return
MSCI EAFE Total Return
MSCI EM Total Return
US Aggregate Total Return
US Corp HY Total Return
S&P GSCI Total Return
S&P/LSTA LL Total Return
JPM EMBI Global Total Return
DJ Equity REIT Total Return

Weight
30%
5%
10%
10%
20%
10%
5%
5%
0%
5%
3.5%

Source: JPMAM, Bloomberg. Assumes margin call at loan-to-value of 75%.

19

This is a theoretical exercise in portfolio leverage; rules around maximum allowable collateralized leverage differ
by jurisdiction.
27 27

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TOPICS

65%

Asset class
Large-cap US equities
Small-cap US equities
International equities
Emerging mkt equities
Investment grade bonds
US high yield
Commodities
Leveraged loans
Emerging mkt debt
REITs
Cost of debt

OUTLOOK
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EEYE
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K 2017

JJANUARY
A N U A R Y 11,, 22017
017

Should the universe of bad market outcomes forever be impacted by the implosion in 2008,
given increases in bank capitalization, the reduction in the shadow banking system, the migration of
certain derivative contracts to centralized exchanges, the decline in non-conforming mortgages, etc?
That is something that every portfolio manager, risk manager, chief investment officer and investor has
to grapple with. If your answer is yes, then leverage of 40% would be as high as you would go based
on the historical analysis.
The forward-looking analysis
In this approach, future returns are based on J.P. Morgans Long-Term Capital Markets Assumptions, and
are subject to various non-normal and fat left tail shocks20. In this approach, financing is assumed
to be non-recourse. As a result, failure is effectively defined by the CIO, who would have to decide if it
was a good or bad idea in hindsight to have used leverage. This is obviously a subjective question, but
we can try to put some parameters around it. We define failure as follows: when the portfolios value
falls to the point where, given the time remaining and our expected returns, it would be very unlikely to
earn its way back21.
The chart below shows the rising probability of failure at different levels of leverage. The bar is higher
here since, unlike the prior analysis which simply has to avoid a margin call, this portfolio needs to
generate a return at least equal to the cost of its leverage over the entire horizon. Thats one reason why
the failure rate is never zero. Looking again at the 40% leverage case, is an incremental 15% failure rate
too high? Thats a subjective determination that has to be considered against the consequences of
unlevered portfolio returns that are below target levels, the ability to restructure pension obligations if
needed, and the ability of the plan and/or its workers to make emergency contributions. Our Multi-Asset
Solutions Quantitative Research and Strategies group looks closely at these questions on behalf of our
institutional clients, and can go into greater detail regarding the calculations and assumptions used in
this part of the analysis.
Failure rate as a function of leverage

Change in failure rate vs. 0% leverage baseline


35%
30%
25%

20%
15%
10%
5%
0%

10%

20%

30%

40%

50%

60%

SPECIAL
TOPICS

Leverage, as a % of gross portfolio value

70%

Asset class
Global equities
US investment grade bonds
US high yield bonds
Diversified hedge funds
US private equity
Commodities
US real estate
Cash
Cost of debt

Weight
40%
30%
5%
5%
5%
5%
10%
0%
3.5%

Source: J.P. Morgan Asset Management. December 2016.

20

For more information on modeling such scenarios, see Non-Normality of Market Returns: A Framework for Asset
Allocation Decision-Making, Abdullah Sheikh, J.P. Morgan Asset Management.
21

In each scenario, we assume a target return of at least the cost of the debt on the entire portfolio over the 10year window. We then assume failure occurs when the investor has less than a 20% chance of achieving the
stated goal based on the portfolios value at that point and future expected returns.
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M A R K E T MICHAEL
M I C H A E LCEMBALEST
C E M B A LE ST OUTLOOK
K 2017

J JANUARY
A N U A R Y 11,, 22017
017

[2] Prospects for improved active equity management performance


The last few years have been difficult for some large-cap US active equity managers. In my view, this
outcome is partially explained by distortions resulting from the most extreme monetary policy experiment
in history. Now that markets are beginning to price in gradual exits from these policies, prospects for
active equity management may improve.
While its hard to generalize, the typical large-cap US active equity manager employs many of the
following approaches:

Prefers low P/E stocks to high P/E stocks

Prefers to equal-weight portfolios rather than market-cap weight them

Underweights high-dividend, low-volatility stocks such as consumer staples, REITs, telecom and
utilities (the bond proxy stocks)

Does not prefer stocks simply based on their positive price momentum

Holds some cash rather than being fully invested

Often has an out-of-index position in European, Asian or US mid-cap stocks

Prefers stocks with high degrees of idiosyncratic risk (i.e., stocks whose returns are not easily
explained as a function of other factors)

The first chart shows how many of these 10 factors that worked over time (blue bars). There have
been 3 swoons in factor performance since 2006. These swoons fit reasonably well with the percentage
of large-cap US equity managers that outperformed on a net of fee basis (red line). With the US Federal
Reserve moving slowly toward rate normalization, the ECB announcing its tapering plans and the BoJ
moving to a yield targeting regime, I believe we are now past peak monetary intervention, which may
explain improving factor performance since the middle of 2016. The second chart shows the return for
each of the ten factors since June 30, 2016.
US large-cap core equity manager outperformance
closely related to factor performance

10%

0%
'96
'98
'00
'02
'04
'06
'08
'10
'12
'14
'16
Source: JPMAM, Morningstar. November 2016. Performance net of fees.

-4%

Cash vs. S&P 500

-2%

O/W Idiosyncratic risk

20%

EAFE vs. US

30%

0%

Low vs. High div yield

40%

2%

U/W Mega-caps

50%

Mid-cap vs. S&P 500

60%

4%

Equal vs. mkt-cap wgt

70%

6%

Low vs. High P/E

# of factors w/ positive rolling 12M


return

80%

High vs. Low volatility

% of managers
outperforming

SPECIAL
TOPICS

10
9
8
7
6
5
4
3
2
1
0

% outperforming, 1-year basis

Low vs. High momentum

# of factors

Factor returns since June 30, 2016

-6%
Source: JPMAM, Morningstar, Factset. November 30, 2016.

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A N U A R Y 11,, 22017
017

As additional signs that market conditions are changing in ways that may help active managers, consider
the following charts on sector dispersion (rising), realized correlation amongst stocks (falling) and implied
correlations between stocks (falling). These patterns may be signaling a return to a more normal stockpicking environment for active managers.
...as realized stock correlation is falling...

Sector dispersion is rising...

Average 3-month correlation

Hundreds

4-day difference in top vs. bottom sector performance

0.8

25%

0.7

20%

0.6

15%

0.5

10%

0.4
0.3

5%
0%

0.2
'01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12 '13 '14 '15 '16

0.1

'05

'06

'07

'08

'09

'10

'11

'12

'13

'14

'15

'16

Source: Goldman Sachs Research. December 7, 2016.

Source: Bloomberg. November 14, 2016.

...and implied stock correlation is also falling


CBOE implied correlation index
90
80
70

60
50
40
30
20

'07

'08

'09

'10

'11

'12

'13

'14

'15

'16

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Source: Bloomberg. November 18, 2016.

30

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2017
JJANUARY
A N U A R Y 11,, 2
017

[3] Rising US natural gas prices due to large-scale US LNG exports? Unlikely on both counts
I was reading reports that mentioned how the US Department of Energy has approved applications for
US firms to export 50 billion cubic feet per day of liquid natural gas (LNG), an amount equal to 2/3 of
current US natural gas production. Some analysts see this as a catalyst for much higher US natural gas
prices. A closer look: first, it would be surprising if US LNG exports were to exceed 20% of production,
and second, much of the US LNG export arbitrage opportunity disappeared over the last three years as
Asian LNG import prices fell.
The chart shows Japanese and Korean LNG import prices on the left axis, and on the right axis, US
natural gas production (green line) and current export applications (blue dots), both in billions of cubic
feet (bcf) per day.
LNG: Asian import prices and US export applications
$ per MMBtu
$22
$18

Billion cubic feet per day


90

US natural gas
production

80

US export
applications

$14

Japan-Korea LNG
import price

$10

70
60
A
B

C
D

2011

2012

2013

40

A: Applications approved by DoE to export LNG to FTA


B: Applications received by DoE to export LNG to non-FTA

30

$6
$2
2010

50

2014

2015

2016

2017

20
10
0

C: Applications approved by DoE to export to non-FTA


(less contingent approvals)
D: LNG export facilities under construction

Source: DoE, EIA, FERC, J.P. Morgan Securities, JPMAM. Dec. 12, 2016.

Heres how we see it:


Understanding what DOE approvals really mean. The DOE has approved 50 bcf per day of
US LNG exports to Free Trade Agreement countries (point A on the chart). However, approvals to
FTA countries are basically a rubber stamp and do not entail substantial documentation requirements.
Korea is the only FTA country of 20 with large LNG import demand22, and now Korean LNG import
prices have fallen, reducing the arbitrage potential which existed three years ago. A large price
differential vs. the US is needed to justify LNG exports given the high cost of constructing LNG
import/export facilities and shipping costs.

We mostly focus on DOE approvals to NON-FTA countries. What matters more are DOE
approvals to non-FTA countries that are large LNG importers: China, Taiwan, Japan and India. While
the DOE has received export applications for 46 bcf per day (point B), they have only approved 14-15
bcf (point C). Around 2/3 of these approved projects are now under construction at 6 US LNG
facilities (point D).

Some non-FTA projects are unlikely to proceed given Asian LNG price declines, and rising
costs of project approval. What about the 31 bcf of non-FTA LNG export applications that have
been received but not approved? Given the decline in Asian LNG import prices, wed be surprised to
see many of these projects proceed, particularly given new rules which require DOE applicants to first
obtain costly approvals from the Federal Energy Regulatory Commission. A shortage of investmentgrade counterparties is also a challenge for LNG project developers, given the need for long-term
bond/bank financing.

22

SPECIAL
TOPICS

Most FTA countries import natural gas via pipeline from Russia, Norway and the Netherlands.
31 31

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2017
JJANUARY
A N U A R Y 11,, 2
017

How does the DOE make decisions on LNG export projects? The DOE takes a lot of things into
account when considering non-FTA approvals, including the adequacy of the domestic natural gas
supply, US energy security, impacts on the US economy (particularly the cost of electricity23 and gasrelated input costs for manufacturers), international considerations and environmental impacts. As
part of this process, the DOE issued a study in October 2015 that considered the macroeconomic
impact of US LNG exports reaching 20 bcf per day, which may represent an upper bound in their
thinking on the subject. Their primary conclusion: any increase in US LNG exports would mostly
result from increases in US domestic production, and not result in much higher US prices or
constrained demand.

The bottom line: given the decline in Asian LNG import prices, lower-cost gas import options for
Eastern and Western Europe (pipelines from Russia, Norway and the Netherlands, and LNG from Algeria),
the high costs of constructing LNG plants, the need for high-quality counterparties to secure long-term
financing, the cost and complexity of the US approval process and the likelihood that higher US natural
gas prices would unleash a domestic production response, wed be surprised to see US LNG exports
exceed 20% of US production. We also do not expect US natural gas prices to change much when LNG
facilities under construction come online.
As for the increase in natural gas prices since February 2016 (their all-time low), this appears to be more
a reflection of falling US shale production than of the prospect of rising US LNG exports.
Natural gas price and US production
$ per MMBtu

Billion cubic feet per day

$13

85
80

Production

$11

75

$9

70

$7

65

Price

$5

55

$3
$1

60
50

'06

'07

'08

'09

'10

'11

'12

'13

'14

'15

'16

45

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Source: EIA, Bloomberg. December 28, 2016.

23

Residential and commercial electricity prices in the US are roughly 30%-40% lower than in Europe and China.

32

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JJANUARY
A N U A R Y 11,, 22017
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[4] For taxable US investors: how to track a benchmark on a tax-aware basis


Tax-loss harvesting has been around for a long time. The general premise: securities sold at a loss can be
used to offset capital gains for tax purposes. This technique particularly benefits investors with large
short-term capital gains, which are taxed at almost twice the rate of long-term gains. This asymmetry
suggests that accelerating short-term losses can be valuable for investors.
However, mutual funds and exchange-traded funds are typically not ideal vehicles for individuals to use
for tax-loss harvesting. The reason: when units are sold, tax consequences are based on the changing
price of the unit itself, which reflects all of the gains and losses in the fund and not just the losses. In
many years (see 1st chart), S&P stocks with substantial declines are offset by stocks that rise sharply. To
isolate the tax losses inside a portfolio, it makes more sense to use a separately managed account.
Heres the goal of this exercise: can a separately managed equity account isolate tax losses while
still tracking a specific equity index closely? We asked a manager we work with that specializes in
nd
this approach to illustrate how it can be done. As shown in the 2 chart, the performance of indicative
separately managed portfolios is almost identical to the S&P 500 (the performance series are practically
superimposed on each other).
Very little performance deviation between portfolio &
benchmark, Pre-tax quarterly total return

Intra-index price dispersion in the S&P 500


% of stocks

100%

20%
15%
10%
5%
0%
-5%
-10%
-15%
-20%
-25%

stocks w/ return > 15%

80%
60%
40%

20%
0%
-20%

-40%
-60%
-80%

-100%

stocks w/ return < -15%


'94

'96

'98

'00

'02

'04

'06

'08

'10

'12

'14

'16

Source: Bloomberg, JPMAM. December 16, 2016.

Portfolio
'02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12 '13 '14 '15 '16

Source: Parametric Portfolio. Q3 2016. Shown for illustrative purposes only.


Average annualized tracking error of 0.73% vs. 4.1% for active US large-cap
equity funds and 0.04% for passive S&P 500 tracker ETFs.

Distribution of realized tax events

% of all realized tax events by vintage year, cumulative through 2015


ST capital loss

100%

LT capital gain

LT capital loss

ST capital gain

80%

60%
40%

SPECIAL
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Low return dispersion vs. the benchmark is a


good sign, but what about the portfolios taxloss harvesting capabilities? A manager of such a
strategy tries to realize short-term capital losses, and
when gains must be taken to rebalance the portfolio,
they are generally deferred until they qualify as longterm. As shown in the final chart, illustrative taxaware portfolios have done exactly that: the tax
realizations are dominated by short-term capital
losses and long-term capital gains. Ultimately, this
is all about maximizing tax efficiency while minimizing
return deviation from an index. The ample liquidity
and depth of the US equity market enables these
kinds of strategies to pursue both goals.

S&P 500

20%
0%

'02
'03
'04
'05
'06
'07
'08
'09
'10
Source: Parametric Portfolio, JPMAM. Q4 2015. Shown for illustrative
purposes only. Past performance is not indicative of future results.

Even if some parts of Trumps tax plan are enacted,


tax-aware investing will still make sense given the
spread between tax rates on short-term gains and
long-term gains.

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M A R K E T MICHAEL
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C E M B A LE ST
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JJANUARY
A N U A R Y 11,, 22017
017

[5] Infrastructure investing and the role for public-private partnerships


The GOP and Democrats seem to agree that infrastructure investment is a high priority. However, theres
disagreement about how to do it. Clintons plan relied on direct government spending on infrastructure,
financed through taxes on accumulated and untaxed offshore corporate profits. Trumps plan appears to
rely more on private sector investment by offering tax breaks to private enterprises to construct and
operate new revenue generating projects in concert with public agencies (i.e. public-private partnerships,
or PPPs). Some commentators have criticized Trumps plan (Krugman called it basically fraudulent24
and Sanders described it as corporate welfare25). However, there are ways that PPPs can drive
infrastructure investing, particularly if the use of proceeds is to finance new greenfield projects. It all
depends on the details.

SPECIAL
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Strong PPP endorsement from the Obama administration

Lets start with the recognition that the current system does not produce the necessary amount of US
infrastructure spending26. Since Federal debt ratios are close to the highest levels since WWII and since
most municipalities are constrained on spending (due to unfunded pension and retiree healthcare costs),
some analysts believe that PPPs can play an important role. In fact, Obamas Treasury department
issued a report in 2015 on the subject which strongly endorses PPPs as a means of building
infrastructure for the future27. Here are some of its conclusions:

The need to reverse years of underinvestment in infrastructure, despite tighter budgets at


every level of government, calls for us to rethink how we pay for and manage infrastructure
investment

When the private sector takes on risks that it can manage more cost-effectively, a PPP may
be able to save money for taxpayers and deliver higher quality or more reliable service over a
shorter timeframe compared to traditional procurement

When sponsors contract with private partners that support strong labor standards, PPPs can
also provide local economic opportunity and create good, middle-class jobs that benefit
current and aspiring workers alike

While PPPs cannot eliminate the need for government spending on infrastructure, we can
help meet our nations infrastructure needs by expanding the sources of investment and
using those dollars, whether public or private, as effectively as possible to advance the
publics interest

Other advanced economies, including Australia, Canada, and the United Kingdom, rely
more heavily than the United States on PPPs to secure equity financing for infrastructure

Although the role of PPPs in the US market is limited, the US Department of the Treasurys
research and engagement with stakeholders indicate that significant private capital could be
mobilized for infrastructure investment

However, in order to attract this capital, US public infrastructure assets will have to support
higher rates of return than are currently generated through 100 percent low-cost debt
financing in the municipal bond market

24

Build He Wont, Paul Krugman, New York Times, November 21, 2016.
Lets Rebuild our Infrastructure, Not Provide Tax Breaks to Big Corporations and Wall Street, Bernie Sanders,
Medium.com, Nov. 21, 2016.
26
In 2013, the American Society of Civil Engineers graded the United States infrastructure in a 74-page report. The
grades: B- for solid waste, C+ for bridges & railways, C for ports, D+ for energy, D for aviation systems, dams,
drinking and waste water, schools, transit, and roads, and D- for inland waterways and levees.
27
Expanding the market for infrastructure public-private partnerships: alternative risk and profit sharing approaches
to align sponsor and investor interests, US Department of the Treasury, April 2015.
25

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2017

I asked our infrastructure group at J.P. Morgan Asset Management to weigh in on the subject. Heres
what they had to say about PPPs:

PPPs require some combination of federal grants, taxes and user fees to incent private capital to
participate. This framework has to exist before PPPs can be launched, and must often be preceded
by political outreach to gain support from taxpayers and other constituents. While user fees often
seem like a nuisance or private sector profiteering, they are essentially a replacement for public sector
spending and related taxes paid by citizens

While the privatization of existing assets may not appear to generate much in the way of investment
or hiring on the asset privatized, the use of proceeds can accelerate greenfield (new) projects
that have higher multiplier effects

In principle, a PPP that allocates responsibilities optimally would have governments deal with
legislation, jurisdictional considerations, procurement, permitting, siting, appeals, etc28. Then, private
sector operators would focus on project delivery and management

There are examples of successful PPPs, some of which have taken place outside the US, as noted
in the Treasury report:
Local privatization of 11 Canadian airports, with the Ministry of Infrastructure quid pro quo that
it be able to use proceeds for new greenfield projects

Australian infrastructure program, in which existing infrastructure assets are sold to finance the
construction of new projects at the national and local level (similar in concept to Canada)

In the UK, the 4.2 billion Thames Tideway wastewater project was financed through a PPP
which took advantage of low interest rates on project financing. The UK government took the
timing and construction cost overrun risk (immunizing private sector capital from a Boston-esque
Big Dig outcome), which then lowered the return requirement for private capital. The UK
intends to use the same approach for future electricity transmission and aquifer projects

In Texas, with guidance and direction from government entities, private capital (a combination of
utilities, cooperatives and private investors) financed $7 bn of wind farm transmission lines from
2007 to 2013, supporting Texas 18.5 GW of installed wind capacity, the highest in the US

In Los Angeles, major public transit projects are being financed in part by an increase in the sales
tax until 2062, based on a bill approved this fall. Projects include extending light rail to LAX,
extending the subway to Westwood, earthquake retrofits and highway improvements. Projected
tax proceeds of $120 bn will be used as the governments contribution to projects that also entail
private sector capital and private sector project management and construction (thereby limiting
permanent employment increases for Californias public sector)

Denvers airport train system received a $1 bn Federal grant as part of a larger PPP in which
private sector bidders identified design efficiencies that resulted in significant cost savings (one
example: double tracking wasnt necessary for the entire route given train frequencies); the grant
would not have been available if it were a public-only project

SPECIAL
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28

A good example of the constructive role that government can play: the Path-15 electricity transmission
project in California. An impasse between the California Energy Commission and the California Public Utilities
Commission had prevented improvement of transmission bottlenecks that led to blackouts in 1996 and 2001. The
Western Area Power Administration (a Federal entity) was able to use the threat of jurisdiction and eminent domain
to get both parties to the table to complete the project.
35 35

EYE
OUTLOOK
O U T L O O2017
E Y E ON
O N THE
T H E MARKET
M A R K E T MICHAEL
M I C H A E LCEMBALEST
C E M B A LE ST
K 2017

JJANUARY
A N U A R Y 1,
1 , 2017
2017

[6] The biggest problem with clean coal: scope


Clean coal is a euphemism for coal powered electricity in which carbon capture and storage of CO2
takes place (CCS). By the end of 2016, CCS facilities in operation will be able to capture and store just
0.1% of the worlds CO2 emissions. Lets put aside issues of large cost overruns on recent projects29, the
Department of Energy withdrawing support from several large projects (FutureGen in Illinois), project
cancellations in Europe, legal uncertainties about liability associated with CO2 leaks, evidence of leakage
and earthquake risk from CCS operations in the Middle East and the North Sea, and the ~30% energy
drag on coal facilities required to perform CCS in the first place.
Lets assume that all of these problems can be solved via technological innovation and legislation (an
aggressive assumption, for sure). The bigger problem with CCS is the scope required to make a
difference. To see why, lets assume the world aims to sequester just 15% of global CO2 emissions.
In 2015, global CO2 emissions were 33.5 billion tonnes
To sequester 15%, that would mean capturing, transporting and burying 5.0 billion tonnes of CO2
That amount of CO2 by weight is equivalent to 6.3 billion cubic meters of CO2 by volume (assuming
0.8 tonnes per cubic meter of CO2 when compressed)
How much volume is that? Global crude oil extraction in 2015 was 4.4 billion tonnes by weight,
which is equivalent to around 5.1 billion cubic meters of oil by volume
Compare the two bolded numbers above, and you can see the problem. Even capturing a small
portion of global CO2 emissions would require a CO2 compression/transportation/storage industry whose
throughput is even greater than the one used for the worlds oil transportation and refining, which has
taken 100 years to build (see map); and thats without the benefit that oil provides as an energy input to
vehicle transportation and industry. There may be applications where CCS makes sense (enhanced oil
recovery, and meeting small amounts of commercial CO2 demand). But as a big picture solution to CO2
emissions, CCS infrastructure needs and costs are very daunting.

SPECIAL
TOPICS

Global oil pipeline and refining networks

Source: Rextag. November 2016.

29

According to the New York Times, the Kemper clean coal plant in Mississippi is more than two years behind
schedule, more than $4 billion over its initial budget of $2.4 billion, and still not operational.
36

36

OUTLOOK
O U T L O O2017
EEYE
Y E ON
O N THE
T H E MARKET
M A R K E T MICHAEL
M I C H A E LCEMBALEST
C E M B A LE ST
K 2017

JJANUARY
A N U A R Y 11,, 22017
017

[7] User-based digital business models and the monetization challenge


How helpful is information about user growth when digital internet companies go public? The answer:
not very, or at least not without a lot of other accompanying information. The 1st chart shows growth in
active users for a variety of different internet-based companies that went public over the last few years30.
For each one, user growth is indexed to 100 at month zero (the time of the IPO). The companies whose
stocks eventually fell well below their IPO price are shown in red; the winners are shown in green.
Among stocks that performed poorly after IPO, Zynga is actually the exception: a poorly performing stock
whose declining user base was a clear, coincident signal. For many of the other poorly performing
stocks, user growth was strong both before and also after the IPO, at least during the first year or
two. Some examples: Pandora, Zulily, Groupon, Etsy, Angies List and Twitter had rapid user growth out
of the gate post-IPO, sometimes faster than user growth at Yelp, Facebook and LinkedIn. Nevertheless,
the former groups stocks substantially underperformed the latter.
User growth: an insufficient metric for investors

Consensus projections versus actual performance

Index of user growth (final private observation = 100)

50
0

ZYNGA

-36 -30 -24 -18 -12 -6

6 12 18 24 30 36 42 48 54 60 66

Months before/after last private observation

Source: Company filings, Bloomberg, JPMAM. October 2016.

217%

0%
-50%

Groupon

Zynga

RetailMeNot

Angie's List

Twitter

50%

Etsy

100

FACEBOOK
GROUPON

Actual performance to date

Zulily

TWITTER
ETSY RETAILMENOT

100%

Pandora

GRUBHUB

Stocks below
IPO price

150%
LINKEDIN

GrubHub

150

ZULILY

YELP

Consensus proj. 12-month


price change at IPO

Yelp

200

Stocks above
IPO price

PANDORA

335%

250

ANGIE'S
LIST

Facebook

Last obs.
before IPO

300

Stock price change, %


200%

LinkedIn

350

-100%
Source: Bloomberg. December 15, 2016.

It might seem with the benefit of hindsight that some of the red-lined stocks in the chart on the left were
challenged from the beginning. But at the time these stocks went public, that wasnt the case, at least
not among the analyst community that covered them. The chart on the right shows consensus price
forecasts for each company. With the exception of Groupon and Pandora, the consensus was that these
stocks would either remain stable or rise sharply after IPO.

SPECIAL
TOPICS

Heres some additional information that we look for when evaluating pre-IPO and post-IPO investments
in companies like these: lifetime customer value, which incorporates churn rates, revenues and variable
costs; user engagement, measured either in time or in features accessed; daily active users (rather than
monthly active users); customer acquisition costs, which include total marketing expenses; and data on
both bookings and revenues, with the latter recognized only when service is provided.
However, this kind of information is often not available before or at the IPO, requiring investors
to make a lot more assumptions than usual about what the future holds for these businesses. Thats one
reason (among many) why J.P. Morgan Asset Management has generally not included pre-IPO positions
in its equity mutual funds, despite a small allowable allocation to do so. The liquidity, disclosure and
overall risk of pre-IPO positions, particularly in digital/internet companies, are better suited to vehicles
specifically designed for them.

30

We collected the user metric that each company reports. Facebook, Pandora, Twitter, LinkedIn, and Yelp report
monthly active users. Other companies report daily active users (Zynga), trailing twelve month active users
(GrubHub, Zulily, Groupon, Etsy), quarterly visits (RetailMeNot) or paid memberships (Angies List).
All companies referenced are shown for illustrative purposes only, and are not intended as a recommendation or
endorsement by J.P. Morgan in this context.
37 37

OUTLOOK
O U T L O O2017
EEYE
Y E ON
O N THE
T H E MARKET
M A R K E T MICHAEL
M I C H A E LCEMBALEST
C E M B A LE ST
K 2017

JJANUARY
A N U A R Y 11,, 22017
017

[8] A large capex decline set the stage for rising industrial metals prices
In January 2016, some colleagues showed me a report on commodity super-cycles dating back to 1779,
and how on average, they took 15 to 30 years to bottom after the peak. The implication: theres a long
way to go before the damage from the current super-cycle ends, since were only 4-5 years into its
unwinding. However, as I wrote in February 2016, commodity prices typically declined by 50%-70%
when these prior super-cycles unwound. In that regard, the damage had been done: commodity
prices had already declined by roughly half from their peak by the end of 2015. For investors, I
think price is more important than time, which is why we became more optimistic on industrial
metals prices in early 2016.
The 1st chart shows the stabilization in industrial metals prices. Why did prices stabilize if inventories are
still at or close to multi-year highs (2nd chart)? Note: while zinc is an outlier given its declining inventory
levels, it is much less important than the other three: the dollar value of zinc inventory is only 7% of the
total inventory value of the 4 metals shown.
Industrial metals prices are stabilizing

Global copper, aluminum, nickel and zinc inventories

Index level

Index, 1985 = 100

500

350

450

300

Nickel

350

250

Aluminum

300

200

400

250

Zinc

150

200

150

Copper

100

100
2000 2002 2004 2006 2008 2010 2012 2014 2016
Source: Bloomberg. December 15, 2016. Index tracks aluminum, copper,
zinc, nickel and lead.

50

'85

'88

'91

'94

'97

'00

'03

'06

'09

'12

'15

Source: Wood Mackenzie, JPMAM. Dec 2015. Dot is an estimate for 2016.

In our view, markets are looking past the current inventory glut and paying more attention to
the sharp decline in capital spending on industrial metal extraction. This capex decline is very
similar to the one taking place in oil, which is also having a stabilizing effect on oil prices. Our view on
commodity prices is stabilization rather than a sharp upward spike like 2006 or 2009; that should be
sufficient to stabilize conditions in many EM commodity exporters as well.
Global copper, aluminum, nickel, zinc and oil capex
Index, 2000 = 100

SPECIAL
TOPICS

1,600
1,400
1,200
1,000
800

Zinc
Copper
Nickel
Oil
Aluminum

600
400
200
0

'00

'02

'04

'06

'08

'10

'12

'14

'16

Source: Wood Mackenzie, Barclays. Dec 2015. Dot is an estimate for 2016.

38

On Oil. In our 2016 Outlook, we wrote that the


supply-demand adjustment in oil would be well
underway by 2017, which pointed to higher prices.
In June 2016, we wrote again about the oil capex
decline, large investor short positions, rising nonOPEC field decline rates, stable oil demand growth
and the utter irrelevancy of renewable energy when
discussing prospects for oil markets. Where to
from here? An oil supply deficit is now in plain sight
by the end of 2017, particularly if OPEC countries
adhere to their historical 50% compliance rate with
announced cuts. Peaking shale oil productivity per
rig is another factor which may contribute to further
tightening in supply-demand conditions.

38

OUTLOOK
O U T L O O2017
EEYE
Y E ON
O N THE
T H E MARKET
M A R K E T MICHAEL
M I C H A E LCEMBALEST
C E M B A LE ST
K 2017

JJANUARY
A N U A R Y 11,, 22017
017

Time capsule on the 1970s: what if True Believer central banks lost control of inflation?
I dont think it will get nearly this bad, but as a reminder, this is what can happen if central banks lose
control of inflation and are forced to play catch-up from behind. During the 1970s, real returns on
commodities were substantial, particularly when compared to the zero real returns earned on stocks and
bonds over the course of the decade. Richard Nixon may have opened the door to China, but he also
opened the door to stagflation, through the imposition of wage/price controls, and through interference
in the inner workings of the Federal Reserve (see box).
Real total return on stocks, bonds and commodities in
the 1970s, January 1970 = 100

400
350

Commodities
(S&P GSCI)

300
250
200

Intermediate
US treasuries

150
100
50

S&P Composite
'70

'71

'72

'73

'74

'75

'76

'77

'78

'79

'80

Source: Shiller, Ibbotson, S&P, Bloomberg, JPMAM. December 1979.

Remembering Richard Nixon


Interference at the Federal Reserve. When Fed chairman Arthur Burns resisted pressure from Nixon to
guarantee full employment, the White House planted negative stories about Burns in the press. Nixons
people also floated stories about diluting the Fed Chairmans power by doubling the Boards members.
Nixon wrote to Burns: There is no doubt in my mind that if the Fed continues to keep the lid on with
regard to increases in money supply and if the economy does not expand, the blame will be placed squarely
on the Fed. In 1971, H.R. Haldeman spoke about the effectiveness of Nixons strategy: We have Arthur
Burns by the [expletive deleted] on the money supply.
Sources:
"Secrets of the Temple: How the Federal Reserve Runs the Country" by William Greider
"Before the Fall: An Inside View of the Pre-Watergate White House" by William Safire
"Monetary Policy and the Great Inflation in the United States: The Federal Reserve System and the Failure of
Macroeconomic Policy" by Thomas Mayer

SPECIAL
TOPICS

Political shenanigans. Its hard to talk about Nixon without also recalling how he and his operatives
conducted themselves during elections; Watergate was not an isolated event. Some examples: President
Nixon and an aide discussed planting McGovern campaign literature in the apartment of the man who shot
George Wallace; Nixon operatives produced counterfeit mailings on Muskie letterhead that were critical of
Ted Kennedy, and that accused Hubert Humphrey and Henry Jackson of sexual misconduct; Nixon aides
hired phony Muskie volunteers to call people at home in the middle of the night, ringing back multiple
times with the same questions; Nixon aides hired a woman to strip outside Muskies hotel room yelling I
Love Ed Muskie!; and invitations to non-existent events with (alleged) free food and alcohol were
distributed by Nixon operatives on behalf of other candidates, angering people when there was none.
Sources:
New York Times, December 14, 1992
William Manchester and J. Anthony Lucas in Nightmare: The Underside of the Nixon Years

39 39

OUTLOOK
O U T L O O2017
EEYE
Y E ON
O N THE
T H E MARKET
M A R K E T MICHAEL
M I C H A E LCEMBALEST
C E M B A LE ST
K 2017

2017
JJANUARY
A N U A R Y 11,, 2
017

LinkedIn updates
Since August 2016, we have posted the following market and economic updates on LinkedIn:
12/12/2016
11/30/2016:
11/11/2016:
11/2/2016:
10/26/2016:
10/12/2016:
10/5/2016:
9/28/2016:
9/21/2016:
9/14/2016:
9/7/2016:
8/30/2016:
8/25/2016:
8/23/2016:

Life Away from Home, Part 2 (Holiday Eye on the Market)


Japan equities: Higurashi moments are rare
Orange is the New Tack: Implications of a Trump Presidency
Why voter clustering matters and the battle for the House
Electric cars: a 1% solution? (with commentary on renewable energy)
The tell-tale heart of the Buffett Rule
After the fall, own some emerging markets
Presidential debate chart-watch
The distant meteor of unfunded pensions
War on savers retirement kit
Worst moments from the Party conventions
Chinas environmental mess
The high price of bond-like stocks
The limited impact of geopolitics on markets

Sources and acronyms


Challenges to mismeasurement explanations for the US productivity slowdown, Chad Syverson,
University of Chicago, NBER Working Paper, February 2016.
Does the United States have a productivity slowdown or a measurement problem?, Byrne et al, Federal
Reserve and the IMF, Brookings Paper on Economic Activity, March 2016.
Piles of Dirty Secrets Behind a Model Clean Coal Project, New York Times. July 5, 2016.
The Chinese Consumer: Outlook and Trends 2016, Gavekal Research. November 2016.
The truth behind 10 years of earnings underperformance, Morgan Stanley Research, June 7, 2016.
Theres actually a way for Trump to help coal and still help the climate, Washington Post, Nov. 17, 2016.
AfD: Alternative for Deutschland; bcf: billion cubic feet; BEA: Bureau of Economic Analysis; BLS: Bureau
of Labor Statistics; BOJ: Bank of Japan; CBO: Congressional Budget Office; CBOE: Chicago Board
Options Exchange; CC: China Customs; CCS: carbon capture and storage; CFLP: China Federation of
Logistics & Purchasing; CNBS: China National Bureau of Statistics; DOE: Department of Energy; EBITDA:
earnings before interest, taxes, depreciation and amortization; ECB: European Central Bank; EIA: Energy
Information Administration; EM: emerging markets; EPS: earnings per share; ETF: exchange-traded fund;
FDA: Food and Drug Administration; FERC: Federal Energy Regulatory Commission; FOMC: Federal
Open Market Committee; FRB: Federal Reserve Board; FTA: free-trade agreement; ICT: Information and
Communication Technologies; IMF: International Monetary Fund; IPO: Initial Public Offering; LNG:
liquefied natural gas; LT: long-term; NATO: North Atlantic Treaty Organization; NFIB: National
Federation of Independent Business; OECD: Organization for Economic Cooperation and Development;
P/E: price-to-earnings ratio; PBOC: Peoples Bank of China; PCE: personal consumption expenditures;
PMI: Purchasing Managers Index; PPP: public-private partnership; QE: quantitative easing; ROE: return
on equity; SOE: state-owned enterprise; ST: short-term; UKIP: UK Independence Party; VAT: value
added tax

40

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OUTLOOK
O U T L O O2017
EEYE
Y E ON
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T H E MARKET
M A R K E T MICHAEL
M I C H A E LCEMBALEST
C E M B A LE ST
K 2017

JJANUARY
A N U A R Y 11,, 22017
017

IMPORTANT INFORMATION
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The views, opinions, estimates and strategies expressed herein constitutes Michael Cembalests judgment based on current market
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1016-0947-01

41 41

EYE ON THE MARKET MICHAEL CEMBALEST OUTLOOK 2017

JANUARY 1, 2017

MICHAEL CEMBALEST is the Chairman of Market and Investment Strategy for
J.P. Morgan Asset Management, a global leader in investment management and
private banking with $1.8 trillion of client assets under management worldwide (as
of September 30, 2016). 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 more than 250,000 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.

42

AMERICAS

ASIA

EUROPE

MIDDLE EAST

Brazil
Chile
Colombia
Mexico
Peru
United States

Hong Kong
Singapore

France
Germany
Italy
Spain
Switzerland
United Kingdom

Dubai