Eye On The Market Outlook 2019

Eye on the Market Outlook 2019
J.P. MORGAN PRIVATE BANK
The Decline of Western Centralization, Part II. This year’s cover repeats last year’s punch bowl theme, but with weather conditions worsening
now that the spigot is open and liquidity is being drained. For the first time in 20 years, markets will have to survive without support from
central banks. While equity valuations are much cheaper after the fall selloff, tighter monetary policy, shrinking excess capacity, slower global
growth and unresolved trade issues will limit the market rebound in 2019. While we expect US GDP and profits to continue to rise, they don’t
always translate into rising asset prices this late in the cycle, particularly with the shift by the Trump administration away from its market-
friendly 2017 policies. See inside cover for more details.
2018 Outlook: The Decline of Western Centralization, Part I
This year’s cover art repeats last year’s punch bowl theme, but with weather conditions worsening due to central bank liquidity
withdrawal. The punch bowl is inspired by Fed Chair William McChesney Martin, who explained to his audience in 1955 that the Federal
Reserve is often the chaperone who must remove the punch bowl just when the party starts to really warm up.
The returns shown in the banner on the front cover represent year-to-date returns through December 26, 2018 on a theoretical
portfolio with 65% in the MSCI World Equity Index or the S&P 500, and 35% in the Barclays Global Aggregate Fixed Income Index or
the Barclays US Aggregate Fixed Income Index.
Cover art by Gary Bullock.
INVESTMENT PRODUCTS ARE: • NOT FDIC INSURED • NOT A DEPOSIT OR OTHER OBLIGATION OF, OR GUARANTEED BY, JPMORGAN CHASE BANK,
N.A. OR ANY OF ITS AFFILIATES • SUBJECT TO INVESTMENT RISKS, INCLUDING POSSIBLE LOSS OF THE PRINCIPAL AMOUNT INVESTED
MARY CALLAHAN ERDOES
J.P. Morgan Asset & Wealth Management
At the start of every year, Michael Cembalest—our Chairman of Market & Investment
Strategy,
How and my investment
do you summarizepartner
a year of 22 was
that years—lays
in manyout an ever-entertaining
respects indefinable? and incredibly
On one
insightful
hand, summary of issues
the European to help debt
sovereign position portfolios
crisis, for thehousing
contracting coming markets
year. I always look
and high
unemployment
forward to this piece,weighed
and this heavy on allDecline
year’s “The of our of
minds. ButCentralization,
Western at the same time,Partrecord
II” is
corporate profits and strong emerging markets growth left reason for optimism.
especially thought-provoking.
So rather than look back, we’d like to look ahead. Because if there’s one thing that
As always, ensuringfrom
we’ve learned you are
thewell-positioned
past few years,for
it’sboth
thatthe nearwe
while andcan’t
longpredict
term is our
the top priority.
future,
weuscan
All of certainly
at J.P. Morganhelp you
stand prepare
ready foryou
to help it. make the most of this unique period in time.
We hope you enjoy this piece, and more importantly, we wish you good health, happiness and
To help guide you in the coming year, our Chief Investment Oﬃcer Michael
success in the coming
Cembalest year.the past several months working with our investment
has spent
leadership across Asset Management worldwide to build a comprehensive view
of the of
On behalf macroeconomic landscape.
all my colleagues, thank youIn
fordoing so, we’ve trust
your continued uncovered some potentially
and confidence in J.P. Morgan.
exciting investment opportunities, as well as some areas where we see reason to
proceed with caution.
Most sincerely,
Sharing these perspectives and opportunities is part of our deep commitment to
you and what we focus on each and every day. We are grateful for your continued
trust and confidence, and look forward to working with you in 2011.
Most sincerely,
EYE ON THE MARKET  M I C H A E L C E M B A LE ST  J.P. MORGAN 2019 Outlook
The Decline of Western Centralization, Part II January 1, 2019

EYE ON THE MARKET • MICHAEL CEMBALEST • J.P. MORGAN 2019 OUTLOOK
E Y E O N T H E M A R K E T  M I C H A E L C E M B A LE ST  J . P . M O R G A N 2019 Outlook
Executive Summary
While
The the world’s
Decline largestCentralization,
of Western economies are Partstill IIgrowing, the longest and largest eraJanuary of central1, 2019bank
intervention in history is coming to an end. For the first time in almost 20 years, demand for financial
assets willSummary
be based on institutional and individual investors, with almost no help from central banks.
EXECUTIVE
Executive
SUMMARY
Stocks and corporate bonds got cheaper during the fall selloff, but global growth and earnings revisions
While the over
are rolling world’s
now,largest economies
and I don’t are recent
think the still growing,
episode was the longest and largest era
just a run-of-the-mill of central
mid-cycle bank
correction.
intervention in history is coming to an end. For the first time in almost 20
Unresolved trade issues and a move by the Trump administration away from its 2017 market-friendly years, demand for financial
assets
policieswill
(seebepages
based on institutional
9-10) and aindividual
are likely to cap investors,
post-correction with almost
rebound. no help
All things from central
considered, it looksbanks.
like a
Stocks and corporate bonds got cheaper during the fall selloff, but global growth and
volatile, positive single-digit year for diversified portfolios in 2019, following 2018 when diversified stock-earnings revisions
are
bondrolling
mixesover now, andnegative
generated I don’t think thefrom
returns recent -7%episode
to -4% was1 just a run-of-the-mill mid-cycle correction.
. A trade deal with China could result in
Unresolved trade issues
substantial upside and a with
for markets, moveEM byassets
the Trump
likely toadministration
benefit the most. away from its 2017 market-friendly
policies (see pages 9-10) are likely to cap a post-correction rebound. All things considered, it looks like a
volatile, positive single-digit year for diversified portfolios in 2019, following 2018 when diversified stock-
The Decline of Western Centralization: a 20 year period of central bank intervention comes to an end
bond mixes
Developed generated
economy negative
and emerging returns
economy frombank
central -7% netto -4%1. ofAG4
purchases trade dealassets,
financial with %China could
of world GDP,result in
rolling 12m
substantial upside for markets, with EM assets likely to benefit the most.
6%
The
5% Decline of Western Centralization: a 20 year period of central bank intervention comes to an end
Developed economy and emerging economy central bank net purchases of G4 financial assets, % of world GDP, rolling 12m
4%
6%
3%
5%
2%
4%
1%
3%
0%
2%
-1%
1% '75 '78 '81 '84 '87 '90 '93 '96 '99 '02 '05 '08 '11 '14 '17
0% The G4 is normally comprised of the US, the Eurozone, the UK and Japan; we also include Switzerland. In the chart, we include G4 central bank
Note:
purchases by looking at changes in their own balance sheets, and include purchases of G4 assets by emerging economy central banks and by non-G4
developed
-1% country central banks by looking at changes in their foreign exchange reserves ex-gold. Sources include individual central bank disclosures, the
IMF’s International Financial Statistics database, a 2014 analysis from Niall Ferguson and Moritz Schularick and J.P. Morgan Asset Management. 2018.
'75 '78 '81 '84 '87 '90 '93 '96 '99 '02 '05 '08 '11 '14 '17
Note: The G4 is normally comprised of the US, the Eurozone, the UK and Japan; we also include Switzerland. In the chart, we include G4 central bank
purchases by looking at changes in their own balance sheets, and include purchases of G4 assets by emerging economy central banks and by non-G4
developed country central banks by looking at changes in their foreign exchange reserves ex-gold. Sources include individual central bank disclosures, the
IMF’s International Financial Statistics database, a 2014 analysis from Niall Ferguson and Moritz Schularick and J.P. Morgan Asset Management. 2018.
1
Based on a 65/35 split of the MSCI Developed World Equity Index and the Barclays Global Fixed Income Aggregate
Index, and a 65/35 split of the MSCI US Equity Index and the Barclays US Aggregate Fixed Income Index, as of
December 26, 2018.
1 INVESTMENT PRODUCTS ARE: ● NOT FDIC INSURED ● NOT A DEPOSIT OR OTHER OBLIGATION OF,
Based on a 65/35 split of the MSCI Developed World Equity Index and the Barclays Global Fixed Income Aggregate
OR GUARANTEED BY, JPMORGAN CHASE BANK, N.A. OR ANY OF ITS AFFILIATES ● SUBJECT TO 1
Index, and a 65/35 INVESTMENT
split of the MSCI
RISKS,US Equity Index
INCLUDING and LOSS
POSSIBLE the Barclays US Aggregate
OF THE PRINCIPAL FixedINVESTED
AMOUNT Income Index, as of
December 26, 2018.
1
INVESTMENT PRODUCTS ARE: ● NOT FDIC INSURED ● NOT A DEPOSIT OR OTHER OBLIGATION OF,
OR GUARANTEED BY, JPMORGAN CHASE BANK, N.A. OR ANY OF ITS AFFILIATES ● SUBJECT TO 1
Why is central bank stimulus coming to an end? Don’t central banks care about equity markets?
Central bank mandates are based on wage and price stability over the long run. G4 central bank asset
EXECUTIVE
SUMMARY
purchases are slowing since the weakest labor market conditions which existed a decade ago have
become the tightest conditions, as measured by unemployment rates and labor shortages. Consumer
price inflation and wage inflation aren’t soaring, but they are back to “normal” levels that do not require
abnormally easy monetary policy. In the US, a proxy for excess capacity (“the output gap”) shows that
there is none left. While markets were disappointed in December that the Fed raised rates and intends
to do so again in 2019, based on the charts below, I don’t know how any US central banker could now
avoid establishing a fed funds rate above the rate of inflation, as it was for most of post-war history.
Developed world unemployment and labor shortages Developed world consumer price inflation and wages
%, seasonally adjusted Deviation from average % y/y
9.0% -4 3.2
Hundreds
8.5% Labor shortages -3 Wages

2.8
8.0% (inverted) -2
2.4
7.5% -1
7.0% 0 2.0
6.5% 1
1.6
6.0% 2
1.2
5.5% Unemployment rate 3
Core CPI
5.0% 4 0.8
1983 1988 1993 1999 2004 2010 2015 2000 2003 2006 2009 2012 2015 2018
Source: OECD, Bloomberg, J.P. Morgan Economic Research. Sept 2018. Source: J.P. Morgan Economic Research. Q3 2018.
Developed world wage growth by region US "output gap" (a proxy for capacity constraints)
% y/y %
3.5% 4%
Hundreds
3% Shortage
US 2%
3.0%
1%
2.5% 0%
-1%
2.0% -2%
Eurozone -3%
1.5% -4%
-5% Abundance
1.0% -6%
'07 '08 '09 '10 '11 '12 '13 '14 '15 '16 '17 '18 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015
Source: BLS, ECB, Haver. November 2018. US series: average hourly Source: JP Morgan Economic Research. 3Q 2018. Grey bars indicate US
earnings. Eurozone series: compensation per employee. recession.
The real fed funds rate

Fed funds rate less trailing annual consumer price inflation, %
10
This is going to be debated for
8 a long, long time after it's gone
6
-2
-4
1958 1964 1969 1975 1980 1986 1991 1997 2002 2008 2013
Source: Fed, BEA, BLS, JPMAM. December 30, 2018.
2
2
Emerging market central banks are slowing purchases of G4 assets as well2
Emerging market
In recent years, central market
emerging banks are slowing
central bankspurchases
also boughtof G4
G4 assets
assets. asThe
well 2
goal: increase rainy-day
reserves,
In recent and/or
years, prevent
emerging FX market
appreciation.
centralNow
banks they’re slowing G4
also bought theirassets.
purchasesTheasgoal:
well: increase rainy-day
EXECUTIVE
SUMMARY
reserves, and/or
Reversal of USprevent
rate FX appreciation.
cycle. When USNow ratesthey’re
were slowing
close totheir
zero,purchases
many EM as countries
well: intervened to
prevent their higher-yielding currencies from appreciating. This process is
 Reversal of US rate cycle. When US rates were close to zero, many EM countries intervenednow working in reverse to
as
US rates rise, reducing the need for EM intervention. EM currencies declined by ~10%
prevent their higher-yielding currencies from appreciating. This process is now working in reverse as in 2018
following
US a 30%
rates rise, declinethe
reducing from 2012
need fortoEM
2016. Biggest decliners
intervention. in 2018: declined
EM currencies Turkish Lira
by (-29%),
~10% inRussian
2018
Ruble (-16%), South African Rand (-15%), Brazilian Real (-15%), and Chilean Peso (-11%)
following a 30% decline from 2012 to 2016. Biggest decliners in 2018: Turkish Lira (-29%), Russian
 Ruble
Credit (-16%), South
concerns. African
Investor Rand (-15%),
concerns Brazilian
about asset Realled
quality (-15%), and Chilean
to capital outflowsPeso (-11%)
in many EM countries,
 forcingconcerns.
Credit EM centralInvestor
banks to liquidateabout
concerns their asset
reserves
quality led to capital outflows in many EM countries,
 forcing
DecliningEMoilcentral banks
and other to liquidate
commodity their reserves
prices. The decline in oil prices forced Saudi Arabia to draw down
 on its FX reserves by roughly $235 bn from
Declining oil and other commodity prices. The 2014 to 2017
decline in oiltoprices
fund forced
entitlement
Saudi spending. Declines
Arabia to draw downin
industrial metals prices over the same period led to similar dynamics elsewhere in the EM
on its FX reserves by roughly $235 bn from 2014 to 2017 to fund entitlement spending. Declines in world, and
now industrial
industrial metalsmetal
pricesand oil prices
over are period
the same declining
ledagain
to similar dynamics elsewhere in the EM world, and
now industrial metal and oil prices are declining again
EM countries no longer worried about too much FX EM foreign-exchange reserves ex-gold
appreciation, EM currency index, Dec 31, 2009 = 100 US$ trillions
EM countries no longer worried about too much FX
120
EM foreign-exchange reserves ex-gold
appreciation, EM currency index, Dec 31, 2009 = 100 $10
US$ trillions
Millions
$9
120
110 $10
$8
Millions
$9
110
100 $7
$8
$6
100
90 $7
$5
$6
$4
90
80 $5
$3
$4
80
70 $2
$3
$1
70 $2
60 $0
2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 $12000 2002 2004 2006 2008 2010 2012 2014 2016 2018
60 $0
Source: Bloomberg. December 24, 2018. Source: IMF, J.P. Morgan Asset Management. October 2018.
2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018
Source:Arabian
Saudi Bloomberg. December 24,
Monetary 2018.
Agency balance sheet Source:
Oil andIMF, J.P. Morgan
industrial Asset prices
metals Management. October 2018.
Saudi Riyals billions US$/Barrel, brent Index level
Saudi
3,000 Arabian Monetary Agency balance sheet Oil and
$150 industrial metals prices 550
Saudi Riyals billions US$/Barrel, brent Index level
Thousands
Industrial 500
3,000
2,500 $150
$125 metals 550
450
Thousands
Industrial 500
2,500
2,000 $125
$100 metals 400
450
350
2,000
1,500 $100
$75 400
300
350
1,500
1,000 $75
$50 250
300
Oil 200
1,000
500 $50
$25 250
150
Oil 200
500
0 $25
$0 100
150
2000 2003 2006 2009 2012 2015 2018 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018
0 $0 100
Source: Saudi Arabian Monetary Agency. October 2018. Source: Bloomberg. December 24, 2018.
2000 2003 2006 2009 2012 2015 2018 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018
Source: Saudi Arabian Monetary Agency. October 2018. Source: Bloomberg. December 24, 2018.
2
Of all central bank purchases and sales of G4 assets since 2000, roughly 60% were driven by developed world
central banks, with the remainder driven by EM central banks. EM countries with the largest central bank purchases
2
Of all central bank purchases and sales of G4 assets since 2000, roughly 60% were driven by developed world
and sales: China, Russia, Saudi Arabia, India, Brazil and Korea.
central banks, with the remainder driven by EM central banks. EM countries with the largest central bank purchases
and sales: China, Russia, Saudi Arabia, India, Brazil and Korea. 3
3
3
What will the Decline of Western Centralization look like?

The G4 central bank balance sheet decline is expected to be gradual, but markets often react to changes
EXECUTIVE
SUMMARY
in flows, rather than changes in stock. The chart on the right shows the “cold turkey” aspect of G4
central banks slowing their asset purchases: only Japan is still a small net buyer.
G4 central bank balance sheets G4 central bank asset flows by central bank
US$ trillions US$ trillions, 12-month change
$3.5
Bank of England Projections
Thousands
$15 $3.0 European Central Bank

$2.5 Bank of Japan
$13 Federal Reserve
$2.0
$11
$1.5
$9 $1.0
$7 $0.5
$0.0
$5
-$0.5
$3 -$1.0
2008 2010 2012 2014 2016 2018 2020 2022 2008 2010 2012 2014 2016 2018 2020
Source: National central banks, J.P. Morgan Economic Research. Sep 2018. Source: National central banks, J.P. Morgan Economic Research. Sep 2018.
On policy rates, the Fed intends to raise them only twice in 2019, leaving the funds rate 50-75 bps above
the rate of consumer price inflation. Some economist estimates for the funds rate are higher, although
they have been falling recently. Even the modest rate hikes so far have begun to negatively affect US
growth through a slowdown in housing. On Europe, markets expect short rates to be below 2% for
another ten years. This latter expectation creates scope for disappointment if rising German inflation
forces the ECB’s hand.
Number of Fed hike expectations Markets expecting another decade of low rates in Europe
Number of 25bp rate hikes expected through year-end 2019 Overnight rate, %
3 6%
Hundreds
Futures market expects 0 hikes
5% Eurozone policy rate

4% Euro policy rate
forward curve
Median FOMC Projection
Macroeconomic Advisers
2
3%
Current US rate
2%
Bank of America
Goldman Sachs
Deutsche Bank
1 1%
J.P. Morgan
Wells Fargo
0%
HSBC
-1%
0 2000 2004 2008 2012 2016 2020 2024 2028
Sources: Bloomberg, WSJ, listed firms, JPMAM. December 31, 2018. Source: Bloomberg. December 24, 2018. Dotted line indicates forward pricing.
On fiscal stimulus. US fiscal stimulus is peaking and now set to decline. In the rest of the developed
world, fiscal stimulus peaked a couple of years ago and is now around neutral.
4
4
Why does the Decline of Western Centralization matter so much?

Stimulus withdrawal is easier for markets to withstand when growth is stable/improving. Unfortunately,
EXECUTIVE
SUMMARY
global growth is softening. Manufacturing surveys are not indicating recession, but since last year’s
Outlook, global growth looks to have declined from ~3.75% to 3.00%. On the margin, that’s a lot in
terms of corporate revenue and earnings growth, which explains why earnings revisions are rolling over
(second chart). While most developed and developing economies are still expanding, a falling number of
countries are experiencing above-trend growth.
Global business surveys Global earnings revisions

Business survey level, 50+ = expansion # of positive revisions less negative revisions as % of total companies
56 30%
Developed world
55 20%
equities
Services
10%
54
0%
53
-10%
52
-20%
51
-30% Global equities
Manufacturing
50 -40% (including EM)
2014 2015 2016 2017 2018 '10 '11 '12 '13 '14 '15 '16 '17 '18
Source: J.P. Morgan Economic Research. November 2018. Source: IBES, JPMAM. December 2018. Series are 3m moving averages.
World still expanding, but fewer countries above trend

% of 19 developed and emerging economy business surveys
100%
Survey > 50
75%
50%
25%
Survey > trend

0%
2000 2004 2008 2012 2016
Source: JPMAM, Factset. Trend = 2-year average. November 2018.
5
5
Stimulus withdrawal combined with slower growth leads to repricing of overpriced assets. The
clearest example of central bank intervention driving up asset prices: the ECB, whose purchases of
Stimulus
sovereign withdrawal
and corporatecombined
bonds have withbeenslower growth
greater than leads
amounts to repricing of overpriced
issued by European assets. The
governments and
clearest example of central bank intervention driving up asset prices: the ECB,
companies. This degree of financial repression was (a) bizarre, (b) resulted in 20%-50% of Eurozone whose purchases of
EXECUTIVE
sovereign and corporate bonds have been greater than amounts issued by European governments and
SUMMARY
gov’t bonds trading with yields below 0%, and (c) led to a shift in risk-taking to absurd levels. The
companies.
second chart This
showsdegree
how ofbyfinancial
the middlerepression
of 2017,wasalmost(a) bizarre, (b) resulted
all Italian BB-ratedin high
20%-50% of Eurozone
yield bonds traded
gov’t
tighterbonds
than trading with bonds.
US Treasury yields below 0%, andwith
As someone (c) led to a shift
31 years at J.P.in Morgan,
risk-takingthis
to might
absurdbelevels. The
the single
second chart shows how by the middle of 2017, almost all Italian BB-rated high yield
biggest fixed income distortion I have ever seen. I still can’t believe it as I am writing this. As a reminder bonds traded
tighter
of whatthan US Treasury
happened bonds.
in the past whenAscentral
someone with
banks were 31 too
years at for
easy J.P.too
Morgan, thispage
long: see might 38be
on the
the single
surge
biggest fixed income distortion I have ever seen. I
in poorly underwritten credit derivatives from 2004 to 2007. still can’t believe it as I am writing this. As a reminder
of what happened in the past when central banks were too easy for too long: see page 38 on the surge
ECB
in sovereign
poorly and corporate
underwritten purchases vs
credit derivatives issuance
from 2004 to 2007. The strange pricing of Italian high yield bonds
EUR bn
Face value, EUR billions
ECB
€200 sovereign and corporate purchases vs issuance The
EUR bn Corporate bonds
€2,000
Sovereign bonds 40 strange pricing of Italian high yield bonds
Face value, EUR
Yield billions
< than US Treasuries
€200 €1,600 35
€150 €2,000 40 Yield > than US Treasuries
Corporate bonds Sovereign bonds
30 Yield < than US Treasuries
€1,200
€1,600 35
€150
€100 25 Yield > than US Treasuries
€800 30
€1,200 20
€100
€50 25
€400
€800 15
20
€50
€0 10
€0
€400 15
Estimated ECB purchases Issuance: ECB 5
€0 Eurozone term (CSPP) Eurozone purchases 10
€0 0
debt issuance ECB purchases
Estimated (PSPP)
Issuance: ECB 5 '05 '06 '07 '08 '09 '10 '11 '12 '13 '14 '15 '16 '17 '18
Source:Eurozone termEuropean
J.P. Morgan (CSPP)
Credit/Rates Strategy, JPMAM.purchases
Eurozone Data since
debt issuance
ECB program inception (CSPP 2016, PSPP 2015). 2018. (PSPP) 0
Source: BAML, JPMAM. Q3 2018.
'05 '06 '07 '08 '09 '10 '11 '12 '13 '14 '15 '16 '17 '18
Source: J.P. Morgan European Credit/Rates Strategy, JPMAM. Data since
ECB program
Small wonderinception
that(CSPP 2016,
after allPSPP
the 2015). 2018. repression by
financial Source: BAML,
central banks,JPMAM. Q3 2018.
investor allocations to cash fell to
their lowest levels on record by 2016. As policy rates rise in the US and investors take profits on
Small wonder
investments thatnever
they after meant
all the to
financial
hold forrepression
the long byhaul,
central banks,
that’s investortoallocations
beginning to cash
change. The $32 fell to
billion
their lowest levels on record by 2016. As policy rates rise in the US and investors
outflow from active US equity mutual funds in the week ending December 18, 2018 was the largest on take profits on
investments
record3. In the never meant
theyprocess, elevatedtoP/E
hold for thehave
multiples longbeen
haul,falling
that’saround
beginning
the to change.
world Theonly
despite $32modest
billion
outflow
declines from active US equity mutual funds in the week ending December 18, 2018 was
in earnings expectations. The last chart on European P/E multiples and earnings is characteristic the largest on
3
record . In the process, elevated P/E multiples
of what’s happening in the US, China and Japan as well. have been falling around the world despite only modest
declines in earnings expectations. The last chart on European P/E multiples and earnings is characteristic
of what’sallocations
Investor happeningtoincash
thefell
US,toChina
recordand
lowsJapan as well. Eurozone multiples collapse as earnings growth slows
by 2016
% (both axes) 12m forward P/E ratio 12m forward EPS, EUR
Investor
60% allocations to cash fell to record lows by 2016 16% Eurozone
15.0x multiples collapse as earnings growth slows 275
% (both axes) Households 12m forward P/E ratio 12m forward EPS, EUR
14.5x
60% 14%
16% 15.0x 275
50% 265
Households 14.0x
12% 14.5x
Pensions 14% 13.5x
50%
40% 265
255
14.0x P/E multiple
10%
12% 13.0x
40%
30% Pensions 13.5x 255
245
12.5x P/E multiple
8%
10% 13.0x
12.0x Earnings per
30%
20% Non-US 12.5x share 245
235
6%
8%
investors 11.5x
12.0x Earnings per
20%
10% Non-US 4%
6% 11.0x share 235
225
1980 1985 1990 investors
1995 2000 2005 2010 2015 11.5x
Dec-16 Jun-17 Dec-17 Jun-18 Dec-18
10%
Source: Bridgewater Associates. June 27, 2018. 4% 11.0x
Source: Datastream, Bloomberg. December 24, 2018. 225
1980 1985 1990 1995 2000 2005 2010 2015 Dec-16 Jun-17 Dec-17 Jun-18 Dec-18
Source: Bridgewater Associates. June 27, 2018. Source: Datastream, Bloomberg. December 24, 2018.
3
“How bad is the Q4 selloff”, UBS Equity Strategy, December 18, 2018.
3 6
6 “How bad is the Q4 selloff”, UBS Equity Strategy, December 18, 2018.
6
Guardrails against a larger collapse: lower systemic risks and lower equity supply
In Q4, developed
Guardrails against world equities
a larger fell 15%-20%
collapse: from their
lower systemic risks2018 Theresupply
peaks. equity
and lower are 3 factors which
argue against the larger equity collapses of the 1970’s and 2000’s, illustrated below.
In Q4, developed world equities fell 15%-20% from their 2018 peaks. There are 3 factors which
EXECUTIVE
SUMMARY
argue
Theagainst
decline the
in global
largercurrent
equityaccount
collapsesimbalances,
of the 1970’s whichand was2000’s,
a largeillustrated
contributorbelow.
to the 2008 crisis.
This reduces risks of violent cross-border capital outflows that destabilize markets
 The decline in global current account imbalances, which was a large contributor to the 2008 crisis.
 Bank capital,risks
This reduces liquidity and reliance
of violent on deposits
cross-border capital rather
outflows than
thatwholesale funding
destabilize marketshave all improved. In
addition, shadow banking is now back at 2000 levels, and the gross market value of OTC derivatives
 Bank capital,
declined fromliquidity andinreliance
$35 trillion 2008 toon$10deposits
trillion rather
in 2018. thanSeewholesale funding
pages 35-42 have details
for more all improved. In
addition, shadow banking is now back at 2000 levels, and the gross market value of OTC derivatives
 declined
Technicalfrom
factors
$35may eventually
trillion in 2008provide
to $10support
trillion into2018.
equitySeemarkets.
pages Low
35-42 IPO/secondary offerings and
for more details
stock buybacks resulted in almost zero global equity supply growth over the last 3 years. This trend is
 Technical factors may
heavily impacted by the eventually
US, where provide support
the S&P divisorto(aequity
proxymarkets.
for equityLow IPO/secondary
supply) offerings
is back at its and
2001 level,
stock buybacks resulted in almost zero global equity supply growth over the last
and poised to decline further after more stock buybacks in 2019. However, there might be too much 3 years. This trend is
heavily impacted by the US, where the S&P divisor (a proxy for equity supply)
optimism on this latter point, since peak buybacks are probably behind us, based on Flow of Fundsis back at its 2001 level,
and
datapoised to decline
and company further after more stock
reports/announcements 4 buybacks in 2019. However, there might be too much
optimism on this latter point, since peak buybacks are probably behind us, based on Flow of Funds
data and company reports/announcements4
A history of S&P 500 drawdowns since 1969 A decline in global imbalances
0% Absolute value of all country current account surpluses and deficits,
A history of S&P 500 drawdowns since 1969 % decline
A of world GDP
in global imbalances
-10% 6%
Absolute value of all country current account surpluses and deficits,
0%
% of Asia
worldmanufacturers,
GDP oil exporters and
-20% 6%
5% Northern Europe finance housing
-10%
booms in Anglo-Saxon world (US,
Asia manufacturers, oil exporters and
Australia, Ireland, UK), and in
-30%
-20% 5%
4% Northern Europe finance housing
Spain/Portugal
booms in Anglo-Saxon world (US,
Australia, Ireland, UK), and in
-40%
-30% 4%
3% Spain/Portugal
-50%
-40% 3%
2%
-60%
-50%
2%
1%
1985
2007
1969
1971
1973
1975
1977
1979
1981
1983
1987
1989
1991
1993
1995
1997
1999
2001
2003
2005
2009
2011
2013
2015
2017
1980 1984 1988 1992 1996 2000 2004 2008 2012 2016
-60%
Source: Bloomberg, JPMAM. December 24, 2018. 1%
Source: IMF, n=191 countries. 2018.
1985
2007
1969
1971
1973
1975
1977
1979
1981
1983
1987
1989
1991
1993
1995
1997
1999
2001
2003
2005
2009
2011
2013
2015
2017
1980 1984 1988 1992 1996 2000 2004 2008 2012 2016
Source: Bloomberg, JPMAM. December 24, 2018. Source: IMF, n=191 countries. 2018.
Decreased risk in the financial system Slow growth in global equity supply
Bank risk-weighted-capital ratio 9.5 1000
Decreased risk in the financial system2007 2017 Slow growth in global equity supply
S&P divisor
Bank risk-weighted-capital ratio
US 8.5% 13.9% 9.5 800
1000
Europe 2007
8.0% 2017
16.0% 9.0
S&P divisor
US 8.5% 13.9% 600
800
Bank
Europeliquid assets as % of short term liabilities
8.0% 16.0% 9.0
2007 2017 8.5 400
600
Bank liquid assets as % of short term liabilities
US 41% 48%
Europe 2007
35% 2017
40% 8.5 200
400
US 41% 48% 8.0
Bank
Europeloan-to-deposit ratio 35% 40% 0
200
8.0 Annual expansion of MSCI All
2007 2017 Country World Index, US$ bn
Bank loan-to-deposit ratio
US 97% 76% 7.5 -200
0
1997 2002 2007Annual expansion
2013 2018
of MSCI All
Europe 2007
139% 2017
105% Country World Index, US$ bn
US 97% 76% 7.5
Source: J.P. Morgan US Equity Strategy. October 18, 2018. -200
Source: Fed, FDIC, ECB, JPMAM. 2018.
1997 2002 2007 2013 2018
Europe 139% 105%
Source: Fed, FDIC, ECB, JPMAM. 2018. Source: J.P. Morgan US Equity Strategy. October 18, 2018.
4
Flows & Liquidity Report, “Confirmation that US repatriation is decelerating”, J.P. Morgan Global Market Strategy, Dec 7 2018.
7
4
Flows & Liquidity Report, “Confirmation that US repatriation is decelerating”, J.P. Morgan Global Market Strategy, Dec 7 2018.7
7
The Q4 2018 selloff. The table shows peak 2018 valuations and where they stood at year end, with
percentiles compared to history. All percentiles were below median as of December 26th. P/E ratios can
EXECUTIVE
be a moving target as earnings growth declines, but investors are being paid to take risk for the first time
SUMMARY
in many years, according to the data below.

US equities European equities EM equities High yield Investment grade
S&P 500 Stoxx 600 MSCI EM US HY US IG
Fwd P/E Fwd P/E Fwd P/E Spreads (bps) Spreads (bps)
Peak 2018 level 18.5 15.1 13.2 305 108
Percentile vs history 86% 91% 59% 89% 89%
Current level 14.3 12.0 10.3 534 182

Percentile vs history 42% 34% 18% 35% 35%
Start date 1/31/1985 1/31/2006 1/29/1988 1/30/1987 1/3/2000
Source: Bloomberg, J.P. Morgan Global Index Research, Datastream, JPMAM. December 26, 2018.
Since the 1920’s, there have been twenty episodes of P/E multiple contractions of 20% or more. In
fifteen of these twenty episodes, US equity market returns were positive over the next 12 months,
averaging 12%. A rebound could be sparked by short-covering after a December surge in short interest
on the S&P ETF, which took place at a time of very thin year-end markets. However, lower valuations for
stocks and corporate bonds would represent more of a clear-cut buying opportunity if this were a run-of-
the-mill mid-cycle correction without the overhang of central bank stimulus withdrawal, and without the
unorthodoxies of the Trump administration, which we review on the following page.
While cheaper valuations lower the bar for investors in 2019, the upside appears more limited
than in the past, unless there’s a deal with China. For 2019, we expect volatile, single digit
returns on diversified stock/bond mixes given all the risks and headwinds.
S&P 500 returns after P/E ratio declines of 20%+ Short interest in S&P similar to levels before 2016 correction
Subsequent 12-month return Short interest (LHS) S&P 500 Index level (RHS)
40% 6% 2200 6% 3000
Post-1950 Avg
30% 2150 2900

5% 5%
20% 2100
Average
2800
May-70
May-77
May-84
Sep-46
Aug-66
Feb-82
Mar-94
Feb-10
Jun-62
Apr-39
Oct-87
Oct-05
Oct-08
4% 4%
Jul-34
Jul-02
10% 2050
2700
3% 2000 3%
0% 2600
1950
Oct-31
Apr-37
Nov-29
Nov-00
May-73
-10% 2% 2%
2500
1900
-20% 1% 1% 2400
1850
-30% 0% 1800 0% 2300
-40% Nov-15 May-16 Nov-16 Jun-18 Aug-18 Nov-18
Source: Empirical Research Partners. December 2018. Source: J.P. Morgan Global Market Strategy, Bloomberg. Dec 26, 2018.
8
8
Here’s an exhibit I use to discuss the Trump administration and its impact on markets, by drawing
on prior Presidents and common policies. In addition to items mentioned below, there’s also the
EXECUTIVE
unprecedented level of turnover for investors to deal with, which has no historical parallel; senior level
SUMMARY
turnover in the Trump administration now exceeds the prior four Presidents combined.
For investors, most market-positive impacts of Trumpism occurred in 2017. Its market-negative policies
began in 2018, and will probably last into 2019. I sympathize with FedEx CEO Fred Smith, who said this
when cutting his profit forecast and international delivery capacity for 2019: “I’ll just conclude by saying
most of the issues that we are dealing with today are induced by bad political choices."
Elements of Trumpism for investors
Jackson Hoover JFK Nixon Reagan Bush

Anti-globalization Tariffs and trade Re-engineering the Bullying of Federal Deregulation and Large fiscal deficits
wars economy, and Reserve Chairman tax cuts outside of
triggering a bear recession
market
Loyalty based Deportation of Attacks on Political scandals Government Conservative court
political patronage undocumented individual and constitutional shutdowns appointments
workers companies risks
Anti-globalization. Trump’s anti-globalist shift vs prior post-war Presidents is similar to Jackson’s foreign policy
compared to his predecessors. Key premise: America wants to be left alone and has little interest in the Wilsonian
project of spreading democracy/liberty. But when attacked or at risk, wars must be fought with all available force.
Tariffs. If all tariffs ever mentioned by Trump were implemented, US tariff rates could rise from 1.5% to 10% and
be the largest rise in 50 years. This includes taxes on all Chinese imports and taxes on US auto imports from
Europe/Japan. See further discussion on pages 14 and 31.
Re-engineering of the economy and attacks on individual companies. In April 1962, JFK accused US Steel
and other steel companies of inappropriate price increases, citing “pursuit of power and profits exceeding their
public responsibility” and a “wholly unjustifiable and irresponsible defiance of the public interest”. Steel companies
were threatened with audits and rollback of depreciation allowances, and Attorney General Robert Kennedy sent
FBI agents to the homes of steel executives. After JFK’s attack on US Steel, a 20% bear market took place (the
worst decline in the 1942-1974 period) as investors lost confidence. A few months later, JFK responded to market
weakness with new depreciation allowances, an investment tax credit and a tax cut, but the damage was done.
There are parallels between JFK’s interventions on domestic prices and Trump’s intervention on export prices, and
as well as parallels to Trump’s public attacks on Amazon, Comcast, Boeing, Delta, ESPN, GM, Lockheed Martin,
Merck, Nordstrom, Toyota and the Washington Post. Both are concerning for long-term investors.
Bullying of Federal Reserve Chairman. Nixon threatened to double the number of Fed board members to dilute
the Fed Chairman’s powers, and floated negative stories about Chairman Arthur Burns in the press. Trump has
been blunter, reportedly asking aides whether he can fire the Central Bank President, as Turkish and Argentine
autocrats have done in the past. Administration factotums rejected the idea, but for investors used to an
independent Federal Reserve overseeing the world’s largest reserve currency, the damage was done. Turkish and
Argentine P/E multiples are in single digits, reflecting a lack of investor confidence in their policies and policymakers.
Notes continued on following page…
9
9
Deregulation. In 2017, the Federal Register of government regulations expanded by the lowest
number of new pages since 1992; new pages were 25% below the 2009-2016 average. “Regulation
EXECUTIVE
and Red Tape” was the largest problem cited by small business in the 2014 NFIB small business survey. It
SUMMARY
has declined and is now cited as the 3rd largest problem, behind labor quality and taxes.
Tax cuts. The 2017 Tax Cuts and Jobs Act was the 4th largest tax cut as a percentage of GDP since
1950, and only slightly smaller than the 2009 stimulus. US corporate marginal effective tax rates fell
from the highest in the OECD to below median. Corporate tax cut reform has been an objective of
both parties. In 2010, President Obama’s Bipartisan Fiscal Commission proposed a switch to a territorial
tax system as well: “the current system puts US corporations at a competitive disadvantage vs their
foreign competitors. A territorial tax system should be adopted to help put the US system in line with
other countries, leveling the playing field”. There was no consensus on personal tax cuts, however.
Furthermore, personal tax cuts were financed in part by a one-time tax on non-repatriated offshore
earnings. During the Presidential campaign, Trump pledged to use these taxes to finance infrastructure,
which would have had a much greater growth multiplier than tax cuts for higher income taxpayers.
Large fiscal deficits outside recession. The US has the largest fiscal deficit as a percentage of GDP at
a time of full employment in over 50 years. The 2018 deficit was 3.8%, and is projected to rise to 4.6%
in 2019 (CBO).
Loyalty-based political patronage. As a frequent flyer, my preferred example: Trump proposed that
his personal pilot run the Federal Aviation Administration.
Deportations of undocumented workers. US Immigration and Customs Enforcement arrests of non-
criminal undocumented immigrants rose by 171% in 2017 vs 2016. These deportations are occurring at
a time of full employment and large job shortages in construction (see page13). There are parallels with
Hoover’s deportations of undocumented immigrants via the Mexican Repatriations of the 1930’s, but
that’s where the parallels end: US unemployment ranged from 10% to 20% in the 1930’s when
Hoover’s programs were enacted. Given the impact of a restrictive immigration policy on wage inflation
at a time of full employment, it seems inconsistent to also attack the Federal Reserve for raising rates.
Political scandals and constitutional crises. US equity markets dropped by 15% after the October
1973 Saturday Night Massacre, when Nixon fired the Special Prosecutor and the Attorney General
resigned. This price action was sudden, and part of a 40% S&P 500 selloff from Sep ‘72 to Dec ’74 that
was mostly driven by stagflation. However, the 15% selloff in October/November 1973 was directly
related to the unfolding constitutional crisis. The best piece so far on parallels to the 1970’s: “The Eerie
Parallels Between Trump and the Watergate Road Map”, Atlantic Monthly, November 20, 2018.
Government shutdowns. Reagan was one of the first Presidents willing to shut down the government
in the pursuit of fiscal or policy goals. There were three brief shutdowns during his first administration.
Conservative court appointments. Eighty percent of Trump Federal Judiciary nominees have ties to
the conservative Federalist Society. Similarly, all federal judges appointed by George W Bush were either
members of the Federalist Society or were approved by the group.
For more on the President’s policies and implications for the 2020 election, please see our 2018 holiday
piece which examined the possibility of voters facing the most polarized choice in 100 years.
10
10
The fall selloff came as a surprise to many investors and strategists, since most expect another year of US
growth in 2019. However, as we wrote in October5, as business cycles age, GDP and profits often
The
keepfallgrowing
selloff came
even asafter
a surprise
assettoprices
many peak.
investors and strategists,
That’s since
the lesson of themost expect
5 cycles another
before 2000year of US
shown in
growth in 2019. However, as we wrote in October 5
, as business cycles age, GDP and
the table: when markets peaked, there was still a year to go of economic and earnings growth (the last profits often
EXECUTIVE
keep growing
were even after asset prices peak.will
SUMMARY
two cycles exceptions). It looks like 2018 That’s the lesson
be another entryofinthe
the5top
cycles
partbefore
of the2000
table.shown in
the table: when markets peaked, there was still a year to go of economic and earnings growth (the last
Asset
two prices
cycles tend
were to peak before
exceptions). growth/profits
It looks like 2018 will be another entry in the top part of the table.
Asset prices tend to peak before growth/profits
US equity Next 12 month Months until Next 12 month
market peak S&P 500 return economic data peak earnings growth
US equity
Jan-1966 Next 12-7%month Months10 until Next 12 4%month
market peak
Nov-1968 S&P 500
-13% return economic 9data peak earnings 2%growth
Jan-1966
Dec-1972 -7%
-19% 10
11 4%
27%
Nov-1968
Nov-1980 -13%
-13% 9
9 2%
4%
Dec-1972
Aug-1987 -19%
-18% 11
19 27%
41%
Nov-1980
Sep-2018 -13%
-15% 9
?? 4%
??
Aug-1987 -18% 19 41%
Sep-2018
Aug-2000 -15%
-25% ??
1 ??
-16%
Oct-2007 -25% 4 -23%
Aug-2000 -25% 1 -16%
Source: Bloomberg, JPMAM, Shiller. December 28, 2018. Economic cycle peak defined by
Oct-2007of unemployment
combination -25% and capacity utilization. 4 -23%
Source: Bloomberg, JPMAM, Shiller. December 28, 2018. Economic cycle peak defined by
combination of unemployment and capacity utilization.
It was a great run over the last decade. Even with the selloff, the 13% annualized price return on
the S&P from March 2009 to December 2018 has only been matched 3 times in the post-war era: briefly
It
in was
1959a and
great run and
1992, overduring
the last decade.
a few monthsEven withend
at the the of
selloff, the 13% While
the 1990’s. annualized price return
we expect modestlyon
the S&P from March 2009 to December 2018 has only been matched 3 times in the post-war
positive returns next year after the correction, it’s worth holding plenty of liquidity to take advantage of era: briefly
in 1959 and 1992,
opportunities that mayandarise,
during a few months
particularly at the
with cash end to
poised of yield
the 1990’s.
a positiveWhile we expect
real return, modestly
at least in the
positive returns next year after the correction, it’s worth holding plenty of liquidity to take
US. Emerging Markets have the least demanding valuations in the world and are worth a look for under- advantage of
opportunities that may arise, particularly with cash poised to yield a positive real return, at
risked investors, particularly if there is a cease-fire in the trade war. See pages 31-32 for more details. least in the
US. Emerging Markets have the least demanding valuations in the world and are worth a look for under-
Michael
risked Cembalest
investors, particularly if there is a cease-fire in the trade war. See pages 31-32 for more details.
Michael Cembalest
Contents
United States p. 12
Contents
Europe,States
United China and Japan p. 12
p. 19
Thoughts
Europe, on the
China andfinancial
Japan crisis, 10 years later p. 19
p. 35
Anyone trying to understand the crisis should start with banks, but not end there. We review the
Thoughts on the financial crisis, 10 years later
important and underappreciated crisis points: the hijacking of Fannie/Freddie balance sheets, the
p. 35
Anyone trying
impact of to understand
broker-dealer the crisisthe
deregulation, should start with
implosion banks,
of bond but notand
reinsurers endoutsized
there. contributions
We review the
of
important
individual firms to systemic risk at the time. We conclude with what has changed since. sheets, the
and underappreciated crisis points: the hijacking of Fannie/Freddie balance
impact of broker-dealer deregulation, the implosion of bond reinsurers and outsized contributions of
individual firms to systemic risk at the time. We conclude with what has changed since.
5
“How Business Cycles End”, JP Morgan Eye on the Market, October 25, 2018.
5 11
“How Business Cycles End”, JP Morgan Eye on the Market, October 25, 2018. 11
11
United States
There’s plenty of good news on the US economy:
 Business surveys still in expansion mode; latest PMI reading one of the strongest since 1978
 December same-store retail sales registered among the highest readings in 20 years
 Consumer/small business confidence surveys are at their highest levels in years
 Wages are rising across all levels of income, supported by the strongest employer hiring and wage
growth intentions since 2000
UNITED
S TAT E S
Even so, there’s a drag coming from rising interest rates and fading effects of tax cuts, which we believe
will reduce GDP growth from 3.40% in Q3 2018 to 2.25% by the end of 2019. Early estimates of Q4
2018 growth are already at 2.60%. There are already signs of weakness in housing (see page 14), and
lower readings on capital spending surveys and new orders, albeit from high levels.
Small business and consumer confidence surging Wages picking up
Index level, 3-month moving average (both axes) % y/y %, 4q mov avg
140 115 4.0%
Personal finances Private sector Share of
Hundreds
Hundreds
130 50%
3.5% wages companies
120 105 reporting
110 3.0% higher wages 40%
100 95 2.5%
30%
90
2.0%
80 85
Small business 20%
70 optimism 1.5%
60 75 1.0% 10%
'75 '80 '85 '90 '95 '00 '05 '10 '15 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018
Source: NFIB, University of Michigan. November 2018. Source: Bureau of Labor Statistics, NABE. Q3 2018.
US core capital goods US business surveys rolling over from high levels
Rolling 3-month % change Expected growth in next 12m PMI, 50+ = expansion
6% 15% 70
Orders New orders
Hundreds
4% 10%
60
2% 5%
0% 0% 50
-2% -5%
Shipments Capital spending 40
-4% -10%
-6%
-15% 30
2014 2015 2016 2017 2018 '00 '02 '04 '06 '08 '10 '12 '14 '16 '18
Source: Census Bureau, J.P. Morgan Asset Management. November 2018. Source: Duke CFO Survey, ISM. December 2018.
12
12
US households are in much better shape than they were a decade ago. Homeowners’ equity has now
surpassed 2007 peaks, household debt levels and debt service have declined, and surveys show low levels
of firings and plenty of voluntary job departures. Here’s another positive sign on the consumer: the BEA
made a massive upward revision to the US savings rate, which had been mentioned as an Achilles’ heel
of the recovery. However, keep an eye on construction job shortages (last chart); above-trend wage
inflation could increase pressure on the Fed to keep raising rates in 2019.
Homeowners' equity above pre-crisis levels Household debt

US$ trillions Percent of disposable income (both axes)
UNITED
S TAT E S
$16 140% 13.5%
Thousands
$15 130% 13.0%

$14
120% 12.5%
$13
$12 110% 12.0%
$11 100% 11.5%
$10 90% 11.0%
$9
80% Household 10.5%
$8 Debt
70% debt 10.0%
$7 service
$6 60% 9.5%
2000 2004 2008 2012 2016 1980 1984 1988 1992 1996 2000 2004 2008 2012 2016
Source: Federal Reserve. Q3 2018. Source: Federal Reserve. Q3 2018.
Signs of a healthy US labor market Sharp upward revision in US savings rate

% of labor force, 3-month average Personal savings rate, 3 month moving average
11%
2.5% 1.9%
Hundreds
Post-revision
Hundreds
Hundreds
Voluntary quit rate 1.8% 10%

2.3% 1.7% 9%
1.6% 8%
2.0% 7%
1.5%
1.4% 6%
1.8%
1.3% 5%
1.5% 1.2% 4%
Firing rate 1.1% 3% Pre-revision
1.3% 1.0% 2%
2001 2003 2005 2007 2009 2011 2013 2015 2017 '90 '92 '94 '96 '98 '00 '02 '04 '06 '08 '10 '12 '14 '16 '18
Source: Bureau of Labor Statistics. October 2018. Source: Bureau of Economic Analysis. July 2018.
Job openings rate: construction

4.5% Job openings in construction are at the highest
Hundreds
4.0% levels in 20 years, and that’s before the possible

3.5%
termination of the Temporary Protected Status program,
under which 300,000 people from Central America are
3.0% allowed to remain and work in the US. The larger
2.5% programs are scheduled to end in 2019/2020. Trump
2.0% has filed to terminate these programs, but has been
1.5%
blocked in Federal courts. These individuals primarily live
and work in Florida, Texas and California, three states
1.0% with massive rebuilding programs underway due to
0.5% hurricanes, floods and wildfires.
0.0%
2001 2003 2005 2007 2009 2011 2013 2015 2017
Source: Bureau of Labor Statistics. October 2018.
13
13
E Y E O N T H E M A R K E T  M I C H A E L C E M B A LE ST  stJ . P . M O R G A N 2019 Outlook
Headwinds: interest rates. As shown in the 1 chart, housing is already slowing after only a 0.5%
increase in mortgage rates and with Fed Funds stillstbarely above inflation. In addition to variables shown,
Headwinds:
homebuyer traffic interest rates. As
has declined as shown in the 1 housing
well. Another chart, housing
headwind: is already
for the slowing
first timeafter
in aonly a 0.5%
decade, the
increase in mortgage rates and with Fed Funds still barely above inflation.
average homeowner no longer has an “in the money” option to move, since prevailing mortgage In addition to variables shown,
rates
homebuyer
have now trafficmovedhasabove declined theas average
well. Another housingmortgage
outstanding headwind:rate for the
owed first by
timeUSin ahomeowners.
decade, the
average homeowner no longer has an “in the money” option to move, since
Housing/autos are turning from a positive contributor to growth to a small negative contributor. From prevailing mortgage rates
have now moved
an investor’s above
perspective, thisthe
shiftaverage
translated outstanding mortgage rate owed
into 20% underperformance by housing by US andhomeowners.
autos vs the
Housing/autos are turning from a positive contributor to growth to a
S&P 500 in 2018. We expect only a modest housing downturn given the continued excess of household small negative contributor. From
an investor’s perspective, this shift translated into 20% underperformance
formation over completions, and the increase in pent-up demand from young adults still living at home. by housing and autos vs the
S&P 500 in 2018. We expect only a modest housing downturn given the continued excess of household
Headwinds:
formation overtariffs. If the full
completions, andrange of proposals
the increase were demand
in pent-up implemented, US consumer
from young price
adults still inflation
living could
at home.
UNITED
S TAT E S
rise faster than markets expect. If a deal is reached (see page 31), the impact of existing tariffs would be
Headwinds:
small; see point tariffs. the full
#3 in Iftariff chartrange
below.of proposals
However,were implemented,
if additional SectionUS 301
consumer price on
tariff hikes inflation
Chinacould
take
rise
placefaster
and/orthan markets
if there areexpect.
SectionIf232a deal is reached
tariffs on US auto(see page
imports31),(points
the impact
#4 and of existing tariffs would
#5), investors would be be
small; see point #3 in tariff chart below. However, if additional
6 Section 301
looking at the largest globalization rollback in 50 years . Even tariffs imposed so far have some bite: tariff hikes on China take
place
while and/or
they look if there
small are Section
relative 232 tariffs
to GDP, consumer on US auto imports
spending and S&P (points #4 and
earnings, #5),it investors
I think makes more would be
sense
looking at the largest globalization rollback in 50 years 6
. Even
to consider their impact on specific sectors and companies, which is larger (4 chart). tariffs imposed
th so far have some bite:
while they look small relative to GDP, consumer spending and S&P earnings, I think it makes more sense
th
to consider
Housing their impact
measures on specific
declining as rates sectors
rise and companies, which isproducts
Consumer larger (4would chart).
be hit by next round of tariffs
% y/y change US imports from China by economic category, US$ billions
12%
Housing measures2017
declining
1H as
18 rates rise 18
Sep-Nov Consumer
$140 products would be hit by next round of tariffs
%9%
y/y change US Capital
$120imports from China by economic category, US$ billions
12% $140
6% 2017 1H 18 Sep-Nov 18 $100 Intermediate
9% Capital
$120
3% $80 Consumer
6% $100 Intermediate
0% $60
3% $80 Consumer
-3% $40
0% $60
-6% 0.0% -0.1% $20
-3% $40
-9% $0
-6% Housing Building Building
0.0%Housing Housing Existing New MBA
-0.1% $20 Round 1: $50bn Round 2: $200bn Round 3: $267bn
afford- permits permits starts starts home home purchase
-9% ability (total) (single (total) (single sales sales index $0
Housing Building Building
units) Housing Housing
units) Existing New MBA Source: "Trump
Roundand China formalize
1: $50bn tariffs
Round 2: on $260 billionRound
$200bn of imports and look
3: $267bn
Source:afford- permits MBA,
NAR, Census, permits starts
JPMAM. starts 2018.
November home home purchase ahead to next phase," Bown, Peterson Institute, September 2018.
ability (total) (single (total) (single sales sales index
units) units) Source: "Trump and China formalize tariffs on $260 billion of imports and look
A century
Source: NAR,of globalization:
Census, USNovember
MBA, JPMAM. import 2018.
tariffs, 1900-2018 ahead to next phase," Bown, Peterson Institute, September 2018.
US tariffs on China as a share of selected measures
US tariff rate on total imports
14%
20%
A century of globalization:5:US import tariffs,
25% @1900-2018
Section 232 autos/parts $290 bn. Possible
US tariffs ontariffs
Total China as aas a share
share of: of selected measures
US tariff rate on total imports 4: China Section 301, 25% @ $460 bn. Possible 12%
14%
20% 3: China Section 301, 10% @ $200 bn. Imposed
15% 5: Section 232 autos/parts 25% @ $290 bn. Possible
2: China Section 301, 25% @ $50 bn. Imposed 10% Relevant
Total tariffs
tariffs as aas a share
share of: of affected
4: China Section 301, 25% @ $460 bn. Possible 12% companies' earnings by industry:
1: Wash machines, solar, steel/alum. Imposed
3: China Section 301, 10% @ $200 bn. Imposed 8%
15% 2: China Section 301, 25% @ $50 bn. Imposed
5 10% Relevant tariffs as a share of affected
10% companies' earnings by industry:
1: Wash machines, solar, steel/alum. Imposed 6%
4 8%
5
10% 4%
5% 3
6%
4
2 2%
1 4%
5% 3
0% 0%
2 2% GDP Consumer S&P 500 Industrial Technology
1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010 1
Source: Esteban Ortiz-Ospina and Max Roser "International Trade", US spending earnings capital goods hardware
0% 0%
International
1910 1920 Trade Commission,
1930 1940 1950JPMAM. September
1960 1970 2018.2000 2010
1980 1990 Source: Empirical
GDP Research Partners.S&P
Consumer October
500 2018.Industrial Technology
spending earnings capital goods hardware
Source: Esteban Ortiz-Ospina and Max Roser "International Trade", US
International Trade Commission, JPMAM. September 2018. Source: Empirical Research Partners. October 2018.
6
Peter Navarro, head of the White House National Trade Council, wrote a book called “Death by China:
Confronting the Dragon – A global call to action”.
6
Peter Navarro, head of the White House National Trade Council, wrote a book called “Death by China:
14
Confronting
14 the Dragon – A global call to action”.
14
Longer-dated risks: corporate debt. While household debt is low relative to history, the opposite is
true for US companies, whose debt relative to equity and cash flow is close to the highest levels on
Longer-dated risks: corporate
record. Furthermore, the currentdebt.median While
debthousehold
to cash flowdebtfigure
is lowofrelative
~2.0x todoeshistory, the opposite
not reflect the wide is
true for US companies, whose debt relative to equity and cash flow is close to
distribution around this level. The second chart shows substantial portions of the small cap and large cap the highest levels on
record. Furthermore,
universe with much higher the current
leverage, median
and/ordebt to cash
negative cashflow
flow.figure of ~2.0x
According to JPdoes not reflect
Morgan Globalthe wide
Markets
distribution around this level. The second chart shows substantial portions of the
Strategy, 50% of US and European BBB-rated issuers have higher leverage than the BB average . Note: small cap and large
7 cap
universe with much higher leverage, and/or negative cash flow. According
EBITDA measures cash flow by adding back interest, taxes and non-cash charges to earnings. to JP Morgan Global Markets
Strategy, 50% of US and European BBB-rated issuers have higher leverage than the BB average7. Note:
While debt
EBITDA servicecash
measures is lowflowduebytoadding
the decline in rates and
back interest, taxes spreads, it’s already
and non-cash rising
charges toand will gradually take
earnings.
a bite out of highly leveraged sectors (staples, telecom, utilities, etc) as corporate debt reprices to higher
While
yields. debt
This service is low
is a longer due risk,
dated to the decline
given the in rates
time and take
it will spreads, it’s already
for this risingHigh
to happen. and will
yieldgradually take
default rates
UNITED
S TAT E S
aare
bite out of highly leveraged sectors (staples, telecom, utilities, etc) as corporate
very low despite the sharp rise in leverage. Easy money from central banks created ample demand debt reprices to higher
yields.
for highThis is abut
yield, longer
we do dated risk, given
not expect this the time gap
unusual it will
to take for this to happen. High yield default rates
last forever.
are very low despite the sharp rise in leverage. Easy money from central banks created ample demand
Corporate
for debtbut we do not expect this unusual gap to last
high yield, forever. of leverage at small and large cap companies
Distribution
Universe = largest 1,500 stocks % of equity index market cap
Corporate
0.55x debt 2.2x Distribution of leverage at
50% small and large cap companies
Universe = largest 1,500
Median netstocks
debt Median net debt Companies
% of equity index market cap
0.50x 2.0x Russell 2000 S&P 500
to equity to EBITDA with net cash
0.55x 2.2x 40%
50%
0.45x Median net debt Median net debt 1.8x Companies
0.50x 2.0x Russell 2000 S&P 500
to equity to EBITDA with net cash
0.40x 1.6x 30%
40%
0.45x 1.8x
0.35x 1.4x
0.40x 1.6x 20%
30%
0.30x 1.2x
0.35x 1.4x
0.25x 1.0x 10%
20%
0.30x 1.2x
0.20x 0.8x
0.25x 1.0x 0%
10%
0.15x 0.6x <0 0-3 3-6 6-12 12+ Negative
0.20x '74 '77 '80 '83 '86 '89 '92 '95 '98 '01 '04 '07 '10 '13 '16 0.8x EBITDA
0% Net Debt to EBITDA ratio
0.15x
Source: Morgan Stanley. Q3 2018. 0.6x <0Morgan0-3
Source: J.P. 3-6
Asset Management, 6-12 12+Q3 2018.
Bloomberg. Negative
'74 '77 '80 '83 '86 '89 '92 '95 '98 '01 '04 '07 '10 '13 '16 EBITDA
Net Debt to EBITDA ratio
S&P 500 debt service ratio High yield default rates low despite sharp rise in debt
Source: Morgan Stanley. Q3 2018. Source: J.P. Morgan Asset Management, Bloomberg. Q3 2018.
Interest expense / operating income, median company 47% 12%
S&P
30% 500 debt service ratio Debtrates
High yield default to GDP
low despite sharpHY default
rise in debt
46% (non-financial rate
Interest expense / operating income, median company 47% 10%
12%
30% 45% companies)
Debt to GDP HY default
25% 46% (non-financial rate
44% 8%
10%
45% companies)
43%
25% 6%
20% 44% 8%
42%
43%
41% 4%
6%
20% 42%
15% 40%
41% 2%
4%
39%
15% 40%
10% 38% 0%
2%
1990 1994 1998 2002 2006 2010 2014 2018 39%1987 1990 1993 1996 1999 2002 2005 2008 2011 2014 2017
10%
Source: JPMAM, Bloomberg. December 2018. 38% 0%
Source: Federal Reserve, Moody's, J.P. Morgan Credit Research. Nov 2018.
1990 1994 1998 2002 2006 2010 2014 2018 1987 1990 1993 1996 1999 2002 2005 2008 2011 2014 2017
Source: JPMAM, Bloomberg. December 2018. Source: Federal Reserve, Moody's, J.P. Morgan Credit Research. Nov 2018.
7
J.P. Morgan Global Markets Strategy Flows & Liquidity Report, “Gauging Downgrade Risk”, December 14, 2018.
7 15
J.P. Morgan Global Markets Strategy Flows & Liquidity Report, “Gauging Downgrade Risk”, December 14, 2018. 15
15
On valuations and earnings
On valuations
We and growth
expect earnings earningsto continue in 2019, but at a much lower rate than in 2018 when the global
economy was growing at a faster pace and when US earnings benefitted from tax cuts, and since higher
We expect earnings growth to continue in 2019, but at a much lower rate than in 2018 when the global
interest rates tend to negatively affect earnings for value stocks (financials, staples and healthcare).
economy was growing at a faster pace and when US earnings benefitted from tax cuts, and since higher
interest rates
Consensus tend
S&P 500toearnings
negatively affect earnings for valueRising
growth stocksrates
(financials, staples
lead weaker and
value healthcare).
sector earnings
% change over prior year EPS % of index % point change, advanced 18mo (inverted)
Consensus
25% S&P 500 earnings growth Rising
100% rates lead weaker value sector earnings -3%
% change over prior year EPS % 80%
of index % point change, advanced
Change in 10 yr 18mo (inverted)
100% UST -3%
-2%
25%
20% 60%
Change in 10 yr
80%
40% UST
UNITED
S TAT E S
20%
15% -2%
-1%
60%
2018 20%
2019 40%
15%
10% 0% -1%
0%
2018 20%
2019 -20%
10%
5% 0% 0%
1%
-40%
-20%
-60% S&P value stocks with
5% 1%
2%
0% -40% positive revisions
-80%
-60% S&P value stocks with
-100% 2%
3%
0%
-5% -80%2006 2007 2009 positive revisions
2011 2013 2015 2017 2019
Aug-17 Feb-18 Aug-18
Source: J.P. Morgan Equity Strategy. December 2018. -100% Cornerstone, Bloomberg. UST change measured over 2 years. 2018.
Source: 3%
-5%
2006 2007 2009 2011 2013 2015 2017 2019
Aug-17 Feb-18 Aug-18
ItSource:
can J.P.
be Morgan
hard Equity Strategy. December
to determine 2018.
exactly when Source:
high valuations Cornerstone,
become an Bloomberg.
issue forUST change measured
markets, whichover
can2 years.
rise 2018.
despite them. Even so, I felt last summer that high valuations would soon become a headwind given
It can be hard to determine exactly when high valuations become an issue for markets, which can rise
rising policy rates, tariff risks and plenty of investor complacency8. Some valuation measures fell sharply
despite them. Even so, I felt last summer that high valuations would soon become a headwind given
during the late 2018 correction. While many are still higher than average (see table)9, much lower
rising policy rates, tariff risks and plenty of investor complacency8. Some valuation measures fell sharply
historical valuations typically coincided with periods of very high inflation and/or recession. 9
during the late 2018 correction. While many are still higher than average (see table) , much lower
historical valuations typically coincided with periods of very high inflation
US valuation and/or recession.
measures
Historical Deviation from long-term average
S&P 500 valuation metric Current percentile US
4
valuation measures
Historical Deviation from long-term average
Home prices
US market cap / GDP 164% 88% 3
S&P 500 valuation metric Current percentile 4
S&P 500 forward
EV / Sales 2.0x 87% Home prices
US market cap / GDP 164% 88% 2
3 P/E ratio
Cyclically adjusted P/E 24.0x 81% S&P 500 forward
EV / Sales 2.0x 87% 1
Price / Book 2.9x 70% 2 P/E ratio
Cyclically adjusted P/E 24.0x 81%
EV / EBITDA 10.1x 69% 0
1
Price / Book 2.9x 70%
Forward P/E 14.3x 56% -1
0
EV / EBITDA 10.1x 69%
Free cash flow yield 5.1% 20% -2 Commercial real
Forward P/E 14.3x 56% -1
S&P earnings yield - 10Y UST 422 bps 18% estate prices
Free cash flow yield 5.1% 20% -3
-2 Commercial real
Median metric 70% '50 '55 '60 '65 '70 '75 '80 '85 '90 '95 '00 '05 '10 '15
S&P earnings yield - 10Y UST 422 bps 18% estate prices
Source: Goldman Sachs Investment Research. December 21, 2018. -3
Source: Fed, Shiller, Bloomberg, Datastream, JPMAM. December 24, 2018.
Median metric 70% '50 '55 '60 '65 '70 '75 '80 '85 '90 '95 '00 '05 '10 '15
Source: Goldman Sachs Investment Research. December 21, 2018. Source: Fed, Shiller, Bloomberg, Datastream, JPMAM. December 24, 2018.
8
“It’s Time for Investors to Play Defense”, an interview I did with Barron’s, July 17, 2018.
9
8 Percentiles vs history are sensitive to start dates and end dates. The table above starts in 1976, when P/E
“It’s Time for Investors to Play Defense”, an interview I did with Barron’s, July 17, 2018.
multiples were depressed given inflation at the time. Using 1976 as a start date and a Dec 21 st end date, the
9
Percentiles vs history
current P/E multiple rankedare
in sensitive to start dates
the 56th percentile. and8,end
On page we dates. The table
used a 1985 start above
date tostarts in 1976,
coincide with when P/E
inception
st
multiples were depressed given
of S&P operating earnings and a Dec inflation at
th the time. Using 1976 as a start date and a Dec 21
26 end date, in which case the current P/E multiple ranked in the 42 nd end date, the
th
current P/E multiple ranked in the 56 percentile.
percentile. Either way, the percentile of USthP/E ratios Ondeclined
page 8, sharply
we usedfrom
a 1985 start date
elevated levelstoearlier
coincide with inception
in 2018.
of S&P operating earnings and a Dec 26 end date, in which case the current P/E multiple ranked in the 42 nd
Note: the free
percentile. cash
Either flow
way, thepercentile inof
percentile the
UStable is lowdeclined
P/E ratios vs history in part
sharply dueelevated
from to the substantial post-2002
levels earlier in 2018. decline in
the capital spending intensity of most large cap companies. Since 2002, S&P 500 capital spending as % of cash
Note:from
flow the free cash flow
operations has percentile in the table
averaged 40-50%. is low2002,
Before vs history in part60-80%.
it averaged due to the substantial post-2002 decline in
the capital spending intensity of most large cap companies. Since 2002, S&P 500 capital spending as % of cash
flow 16
16 from operations has averaged 40-50%. Before 2002, it averaged 60-80%.
16
What looks oversold: technology, banks and mining; healthcare unclear given possible reform
FAANG premiums have collapsed, and the tech sector trades at one of the smallest premiums to the
market in history. Banks also trade at low multiples, similar to levels that preceded the financial crisis. As
we illustrated in the Executive Summary, we believe systemic risks in the financial sector are lower now.
Metals/Mining stocks are understandably depressed given the secular and cyclical slowdown in China,
but current levels are also pricing in high probabilities of a global recession in 2019 and a bad ending to
the US-China trade war.
FAANG premium to the market Tech P/E ratios relative to the market at cycle peaks
UNITED
S TAT E S
Average forward P/E relative to S&P 500 2.6x
3.4x
2.4x
3.2x
2.2x
3.0x
2.8x 2.0x
2.6x 1.8x
2.4x 1.6x
Mid-Dec 18
2.2x
1.4x
Nov-73
Aug-57
Dec-69
Dec-07
2.0x
Mar-01
Mar-00
Jan-80
Apr-60
Jul-53
Jul-81
Jul-90
FAANG: Facebook, Amazon, Apple, Netflix, Google 1.2x
1.8x
Jun-12 Jun-13 Jun-14 Jun-15 Jun-16 Jun-17 Jun-18 1.0x
Source: Bloomberg. December 24, 2018. Source: Empirical Research Partners. December 2018.
Bank P/E ratios relative to the market at cycle peaks Metals/Mining: price to sales relative to the market
1.2x 1.4x
1.1x
1.2x
1.0x
1.0x
0.9x
0.8x
0.8x
0.7x 0.6x
Mid-Dec 18
0.6x 0.4x
Dec-69
Nov-73
Dec-07
Mar-01
Jan-80
Apr-60
Jul-81
Jul-90
0.5x
0.2x
0.4x '52 '56 '60 '64 '68 '72 '76 '80 '84 '88 '92 '96 '00 '04 '08 '12 '16
Source: Empirical Research Partners. December 2018. Source: Empirical Research Partners, NBER. December 2018.
On drug pricing, here are some Democratic proposals to control them. It’s unclear what support they have in the
Senate or White House, but I believe something may pass in 2019, clouding the outlook for healthcare investors.
 Drug price controls on gouging, defined as  Increase Medicaid rebate as percentage of
increases over medical inflation and costs manufacturing price
 Allow “dual eligible” drugs to be purchased at  Reduce biologic patents to 7 years from 12
lower Medicaid pricing years
 Gov’t can negotiate drug pricing  Cap out of pocket costs at $250 per month
 Independent board to track/set drug pricing  Reduce Medicare Part B drug prices
 Limit tax deduction for advertising  Require FDA pre-approval for ads
 Require disclosure of development costs  Allow drug re-importation
Source: Cornerstone Macro Research. November 13, 2018.
17
17
On US credit market risks

Central banks purchased $14 trillion in securities since 2009, which drove down interest rates and led to
massive growth in both issuance of and demand for corporate debt. This coincided with the impact of
the Volcker rule in the US, which led to a decline in market making and proprietary trading. As a result,
as shown in the first chart, an explosion in fixed income supply took place alongside a collapse in
fixed income liquidity. This could lead to problems when/if investors exit, and would be all the more
ironic since this conundrum would be linked to central bank policy and also to a policy named for an ex-
central banker. In other words, this should have been anticipated by the architects of these policies.
UNITED
S TAT E S
More details. Since 2007, the share of BBB-rated issuance has grown as the expense of higher-rated
corporate bonds. As shown below, 2016 and 2017 were prime examples of this pattern. BBB yields
have now widened by the largest amount vs trend since the 1980’s, other than during the financial crisis.
Debt stock expanding while liquidity shrinks BBB rated bonds take over post-crisis
Change in market size and turnover, 2006-2017 % of US investment grade corporate bond index
250%
Market size (debt stock) 20%
200% December 2007 December 2018
Turnover (trading
150% volume/debt stock) 15%
100%
50% 10%
0%
-50% 5%
-100%
Mortgages Municipals High Yield Investment US 0%
grade Treasuries BBB3 BBB2 BBB1 A3 A2 A1 AA3 AA2 AA1 AAA
Source: SIFMA, Finra Factbook, Bloomberg, JPMAM. 2017. Source: ICE/BAML, JPMAM. December 2018.
Highest rated corporate bonds squeezed out by BBBs Rise in US corporate borrowing costs
Single A or better as a % of investment grade supply Ratio of US BBB yields to trailing 5-year average
1.75x
2017 2016 2008-2017 range
1.50x
1.25x
US
1.00x
0.75x
Europe
0.50x
1925 1935 1945 1955 1965 1975 1985 1995 2005 2015
20% 30% 40% 50% 60% 70% 80% 90% 100%
Source: Morgan Stanley November 23 Strategy Chart Wall, NBER. 2018. Grey
Source: J.P. Morgan Global Credit Research. 1H 2018. bars indicate recession.
18
18
Non-US markets overview
Non-US
A markets
year ago, globaloverview
growth was synchronized and rising; since then, US and non-US indicators have been
softening. The first 3 charts show changes in business surveys, earnings revisions and business
A year ago, global growth was synchronized and rising; since then, US and non-US indicators have been
confidence. Outside the US, conditions are weaker.
softening. The first 3 charts show changes in business surveys, earnings revisions and business
Some of theOutside
confidence. most disappointing economic
the US, conditions data has been coming from Europe. If there’s a negative
are weaker.
growth surprise, it will be difficult for the ECB to do much about it: its short term interest rates are
Some of the most disappointing economic data has been coming from Europe. If there’s a negative
already negative, the ECB already owns 20%-30% of many Eurozone government bonds (close to their
growth surprise, it will 10be difficult for the ECB to do much about it: its short term interest rates are
self-imposed 33% limit ), and German wages/home prices are starting to heat up. For that and other
already negative, the ECB already owns 20%-30% of many Eurozone government bonds (close to their
reasons, we prefer Emerging Markets to Europe as a deep-value investment for 2019 (see page 32).
self-imposed 33% limit10), and German wages/home prices are starting to heat up. For that and other
reasons, we prefer Emerging Markets to Europe as a deep-value investment for 2019 (see page 32).
US growth holding up better than Rest of World Earnings revisions
Manufacturing PMI survey (both axes) # of positive revisions less negative revisions as % of total companies
US
63 growth holding up better than Rest of World 55 Earnings
40% revisions
Manufacturing PMI survey (both axes) # of positive revisions less negative revisions as % of S&P
total companies
500
30%
60
63 55
54 40%
20% S&P 500
MARKETS
30%
NON–US
57
60 54 10% Europe
53 20%
54 US 0%
57 10% Europe
53
52 -10%
51
54 US 0%
-20%
Global 52
51 -10% China
48
51 -30% Offshore
-20%
Global 51 -40% China
45
48 50 -30% '10 Offshore
2013 2014 2015 2016 2017 2018 '11 '12 '13 '14 '15 '16 '17 '18
45 50 -40%
Source: Source:
'10IBES,'11
JPMAM.
'12December
'13 2018.
'14 Series
'15are 3m
'16moving
'17averages.
2013 ISM, J.P.
2014Morgan2015
Economic Research.
2016 November
2017 2018.
2018 '18
Global ex-US
Source: ISM, and ex-China
J.P. Morgan Economic business confidence
Research. November 2018. Source: IBES, JPMAM. December 2018. Series are 3m moving averages.
German home prices and wages starting to heat up
Deviation from long-term average y/y % change
Global
1.5 ex-US and ex-China business confidence German home prices and wages starting to heat up
7%
Deviation from long-term average y/y % change House prices
6%
1.5
1.0 7%
5% House prices
6%
4%
1.0
0.5 5%
3% Hourly wages
4%
0.5 2%
0.0 3% Hourly wages
1%
0.0
2% GDP deflator Core CPI
-0.5 0%
1%
-1% Core CPI
-0.5 0% Unit GDP
labordeflator
cost
-1.0 -2%
2013 2014 2015 2016 2017 2018 -1%2010 2011 2012 2013 2014 2015 2016 2017 2018
Unit labor cost
-1.0 -2%
Source: J.P. Morgan Economic Research. November 30, 2018. Source: Bundesbank, Statistisches Bundesamt, Haver Analytics. Q3 2018.
2013 2014 2015 2016 2017 2018 2010 2011 2012 2013 2014 2015 2016 2017 2018
Source: J.P. Morgan Economic Research. November 30, 2018. Source: Bundesbank, Statistisches Bundesamt, Haver Analytics. Q3 2018.
10
Compounding the problem: the private sector only owns 20%-25% of German and Dutch government
bonds, given large amounts owned by non-EU central banks as well as by the ECB itself.
10
Compounding the problem: the private sector only owns 20%-25% of German and Dutch government
bonds, given large amounts owned by non-EU central banks as well as by the ECB itself. 19
19
19
Europe
Eurozone
Europe balance of payments issues emerged in 2011. Since December of that year, European equities
rose by 62%, in part due to trillions of Euros of intervention from the ECB. In contrast, the S&P 500 rose
Eurozone
by 116% over balance
the of payments
same issues On
time frame. emerged in returns,
relative 2011. Since
I haveDecember
less to sayofthis
that year,
year European
since equities
I am becoming
rose
a broken record. 2018 was yet another year during which the US outperformed Europe and Japan. rose
by 62%, in part due to trillions of Euros of intervention from the ECB. In contrast, the S&P 500
by 116% over the same time frame. On relative returns, I have less to say this year since I am becoming
As shownrecord.
a broken in the first
2018chart, other
was yet than year
another during the unsustainable
during mid-2000’s growth
which the US outperformed Europeboom in Southern
and Japan.
Europe, an equity overweight to the US generated positive returns in almost every period since I joined
As shown
J.P. Morganin 31 theyears
first ago.
chart,While
other European
than during the unsustainable
equities mid-2000’s
trade at a discount to thegrowth boombeen
US11, that’s in Southern
true for
Europe, an equity overweight to the US generated positive returns
the last few years and Europe still underperformed. I don’t see anything on the horizon in almost every periodin 2019I that
since joinedis
J.P. Morgan 31 years ago. While European equities trade at a discount to the
going to change that streak, particularly with European earnings revisions weakening faster than in theUS 11
, that’s been true for
the last
US. few years2018
If anything, and Europe
may be still underperformed.
remembered as the yearI don’t
when seetheanything
ECB was onno thelonger
horizon in to
able 2019 thatthe
offset is
going to change that streak, particularly with European earnings revisions
economic shackles of the Euro on France and Italy, which are headed back to 1% growth. The end. weakening faster than in the
US. If anything, 2018 may be remembered as the year when the ECB was no longer able to offset the
economic shackles
US outperformed forofmost
the of
Euro
the on
lastFrance and Italy, whichEurope:
30 years are headed back tovs1%
P/E discount thegrowth.
US is parThe end.
for the course
3-year rolling out (under) performance vs MSCI All World Index Stoxx 600 P/E discount vs S&P 500 based on forward earnings
US outperformed for most of the last 30 years Europe:
0% P/E discount vs the US is par for the course
15%
3-year rolling out (under) performance
All equity vs MSCIrebalanced
portfolio, All World Index
quarterly, Stoxx 600 P/E discount vs S&P 500 based on forward earnings
no currency hedging. 15% OW US, -5%
0%
15%
10% 10% UW Europe, 5% UW Japan
All equity portfolio, rebalanced quarterly, -10%
no currency hedging. 15% OW US, -5%
10%
5% 10% UW Europe, 5% UW Japan
-15%
-10%
5%
0%
-20%
EUROPE
-15%
0%
-5% -25%
-20%
-5%
-10% -30%
-25%
1991 1994 1997 2000 2003 2006 2009 2012 2015 2018 '06 '07 '08 '09 '10 '11 '12 '13 '14 '15 '16 '17 '18
-10%
Source: Bloomberg, JPMAM. Q3 2018. -30%
Source: Datastream, IBES, JPMAM. December 24, 2018.
1991 1994 1997 2000 2003 2006 2009 2012 2015 2018 '06 '07 '08 '09 '10 '11 '12 '13 '14 '15 '16 '17 '18
Source: Bloomberg, JPMAM. Q3 2018. Source: Datastream, IBES, JPMAM. December 24, 2018.
11
On European equities:
11 OnThe Stoxx 600
European Index includes both Eurozone and non-Eurozone countries in Europe. Before 2006, International
equities:
Financial Reporting Standards required European companies to amortize goodwill, and the amounts involved
 The wereStoxx 600 Index
at times includes
substantial. Asboth Eurozone
a result, and non-Eurozone
pre-2006 P/E multiples countries
for Europein Europe.
are not Before 2006,to
comparable International
post-2006
Financial Reporting Standards required European companies
multiples, and can distort time series comparisons vs the US to amortize goodwill, and the amounts involved
were at times substantial. As a result, pre-2006 P/E multiples for Europe are not comparable to post-2006
 The S&P 500 has higher weights to tech than the Stoxx 600, and lower weights to Financials and Consumer
multiples, and can distort time series comparisons vs the US
Staples. Even when adjusting for these differences, the P/E discount based on “sector-neutral P/E ratios” looks
 similar
The S&Pto500the has
onehigher
shownweights
above. toSimilarly,
tech thanUS theoutperformance
Stoxx 600, and lower weightslooks
vs Europe to Financials
the same andsince
Consumer
2010
Staples. Even
whether wewhen adjustingcap-weighted
use market for these differences,
indices,the
orP/E discount
US/EU basedthat
indices on “sector-neutral
have the same P/Eexact
ratios”sector
looks
similar
weights.to In
theother
onewords,
shownUS above. Similarly, US
outperformance outperformance
is not vs Europe
just due to the Tech looks
sector, and alsothe same insince
occurred 2010
Financials,
whether
Consumer we use market
Discretionary and cap-weighted
Energy sectors indices, or US/EU indices that have the same exact sector
weights. In other words, US outperformance is not just due to the Tech sector, and also occurred in Financials,
20
20 Consumer Discretionary and Energy sectors
20
Ok that’s not really the end; here are a few more comments. A year ago, it looked like Europe was
at the cusp of a region-wide revival. Growth estimates surged above 3% in early 2018, but that turned
Ok
out that’s notpeak;
to be the reallygrowth
the end; here
rolled aresince
over a fewthen.more comments.
Based on earningsA year ago,
beats andit revisions,
looked likeQ3Europe
2018 was
was
at the cusp of a region-wide revival. Growth estimates surged above 3% in early
one of the weakest quarters for Europe since 2014. Credit creation across Europe is modestly positive 2018, but that turned
(in
out to betothe
contrast peak; growth
2013-2015), butrolled
2019 over
lookssince then. Based
like another year on earningsgrowth
of sub-2% beats and revisions,The
in Europe. Q3 ECB
2018might
was
one of the
consider weakest
more quarters
low-cost for Europe
financing aimedsince 2014. Credit
at encouraging creation
banks across
to lend Europe
to the privateis sector,
modestly positive (in
particularly in
contrast
12 to 2013-2015), but 2019 looks like another year of sub-2% growth
Italy . However, ECB bazookas haven’t done much for investors: Eurozone equities are almost rightin Europe. The ECB might
consider more
back12 where low-cost
they startedfinancing aimed at
in 2014, before 2.6encouraging
trillion Eurosbanks to lend to by
of intervention thethe
private
ECB sector, particularly in
(third chart).
Italy . However, ECB bazookas haven’t done much for investors: Eurozone equities are almost right
Whenwhere
back digging into
they European
started underperformance,
in 2014, before 2.6 trillion weEuros
find ofthat Europe’s return
intervention by theonECBequity is chart).
(third lower for most
industries than for US counterparts. Just as importantly, Europe’s tech sector market cap weight is less
When
than halfdigging
of USinto European
levels, and its underperformance,
tech companies are we bothfind
lessthat Europe’s
profitable return
and moreonexpensive
equity is (see
lower for most
table).
industries than for US counterparts. Just as importantly, Europe’s tech sector market cap weight is less
than half of US levels, and its tech companies are both less profitable and more expensive (see table).
Tracking Eurozone GDP growth Eurozone bank lending to non-financial corporations
q/q % change y/y % change, adjusted for loan sales and securitizations
Tracking
4% Eurozone GDP growth Eurozone
30% bank lending to non-financial corporations
q/q % change Actual growth y/y % change, adjusted for loan sales and securitizations
25%
3%
4% 30% Spain
20% Nowhere near pre-crisis levels,
Actual growth 25% but improving from abysmal
2%
3% 15% Spain
France 2013-2015 period
20% Nowhere near pre-crisis levels,
1%
2% 10% but improving from abysmal
15% FranceItaly 2013-2015 period
5%
0%
1% 10%
Business survey 0% Italy
-1% prediction of growth 5%
EUROPE
0% -5% Germany
Business survey 0%
-2% -10%
-1% prediction of growth
2010 2011 2012 2013 2014 2015 2016 2017 2018 -5% '05 Germany
'06 '07 '08 '09 '10 '11 '12 '13 '14 '15 '16 '17 '18
-2%
Source: Markit, Eurostat, J.P. Morgan Economic Research. November 2018. Source: European Central Bank, Haver Analytics. October 2018.
-10%
2010 2011 2012 2013 2014 2015 2016 2017 2018 '05 '06 '07 '08 '09 '10 '11 '12 '13 '14 '15 '16 '17 '18
Eurozone
Source: equities
Markit, Eurostat, and ECB asset
J.P. Morgan purchases
Economic Research. November 2018. Source: European Central Bank, Haver Analytics. October 2018.
Index level EUR trillion, cumulative
Tech sector: US vs Europe
Eurozone
140 equities and ECB asset purchases € 3.0
Index level MSCI Eurozone EUR trillion, cumulative Tech sector composition of:
130
Tech sector: US vs Europe
140 €€ 3.0
2.5 S&P MSCI MSCI MSCI
MSCI Eurozone
Tech sector composition of:
120 500 US Europe Eurozone
130 €€ 2.5
2.0
S&P MSCI MSCI MSCI
Index weight 20% 20% 5% 9%
110
120 €€ 2.0
1.5 Operating margin 500
24% US
22% Europe
12% Eurozone
15%
Index weightmargin
Net income 20%
16% 20%
15% 5%
9% 9%
11%
100
110 €€ 1.5
1.0
Operating margin
12mo forward P/E ratio 14.0 24% 22%
14.1 12%
16.1 15%
15.9
90
100 €€ 1.0
0.5 Net income
Return margin
on equity 16%
27% 15%
26% 9%
11% 11%
14%
ECB purchases
12mo forward P/E ratio 14.0 14.1 16.1 15.9
Source: Bloomberg, Dec 24, 2018. Note: Tech index w eights do
80
90 €€ 0.5
0.0
2014 2015 ECB purchases
2016 2017 2018 Return on equity 27% 26% 11% 14%
not include companies classified in Communications Services as
80 € 0.0 Source: Bloomberg,
of September 2018. Dec 24, 2018. Note: Tech index w eights do
Source: European Central Bank, Bloomberg, JPMAM. December 24, 2018.
2014 2015 2016 2017 2018 not include companies classified in Communications Services as
Source: European Central Bank, Bloomberg, JPMAM. December 24, 2018.
of September 2018.
12
Italian bank reliance on ECB funding ranges from 6% of assets (Unicredit) to 12% (Monte dei Paschi and
Banco BPM). The ECB could lend more low-cost funds to Italian banks, expecting them to buy government debt.
12
Italian
While the bank
spreadreliance
betweenon ECBbonds
Italian funding
andranges fromis 6%
ECB funds of assets
growing (Unicredit)
(attractive from atoyield
12% (Monte deiItalian
perspective), Paschibanks
and
Banco
alreadyBPM).
own 20% The ECBof allcould lend more
government low-cost
bonds, funds to
an amount Italian
equal to banks,
15% ofexpecting theminterplay
assets. The to buy government debt.
between deposit
While the spread
flight risk, between
rising bank Italian bonds
borrowing andand
spreads ECBbank
funds is growing
holdings (attractive from
of government debta is
yield perspective),
complicated, andItalian banks
potentially
already
unstable. ownThe20%good ofnews:
all government
even whenbonds, an amount
assuming equal
liquidation to 15%
values of 20ofand
assets. The on
40 cents interplay
the Eurobetween
for Italiandeposit
NPLs,
flight
the two risk, risingItalian
largest bank banks
borrowing spreads
(Unicredit and bank
& Intesa) would holdings of government
still reportedly have Tierdebt is complicated,
1 Capital ratios aboveand
10%. potentially
unstable. The good news: even when assuming liquidation values of 20 and 40 cents on the Euro for Italian NPLs,
21
the two largest Italian banks (Unicredit & Intesa) would still reportedly have Tier 1 Capital ratios above 10%. 21
21
History, the Euro and the future. I gave a presentation at our International Council meetings in Berlin
last October, and at dinner, I interviewed Henry Kissinger. This was the 6th time I’ve had the chance to
speak with Henry in front of our clients, and at age 95, he shows few signs of slowing down
(intellectually). Most of the conversation was about China and Russia, but at the end, we talked about
Europe and Germany, where Henry was born. I mentioned that German per capita GDP more than
tripled from 1946 to 1960 (the Wirtschaftswunder), one of the fastest recoveries on record for a major
economy, and which is an example of what international cooperation and diplomacy can accomplish.
Henry responded by remembering the vibrant energy in those post-war days, when leaders like Konrad
Adenauer were brimming with new ideas on how to rebuild a Europe that had been destroyed (see
boxes). Henry lamented the loss of vitality among Europe’s current leaders. We will not know for many
years, but I reminded Henry that the jury is out as to whether efforts required to maintain the
Euro are adding to European vitality, or subtracting from it. As shown in the second chart, the
economic efficiency gap between Italy and Germany is not that different from the gap between the US
and Mexico. These are not the raw materials for a typical monetary union.
Post-war recovery in per capita GDP, 1946-1960 Economic efficiency based on goods markets, labor
Ratio, 1960 level vs 1946 level markets, innovation, corruption, legal framework and
3.5 investor protections, Country score, 100=best
100
3.0 90
80
EUROPE
2.5 70
60
2.0
Philippines
50
Germany
Hungary
Greece
Taiwan
Austria
France
40
USSR
Japan
1.5
Italy
30
1.0 20
Germany Italy United States Mexico
Source: "Statistics on World Population, GDP and Per Capita GDP, 1-2008
AD", Angus Maddison, University of Groningen. Source: World Economic Forum. J.P. Morgan Asset Management. 2018.
Recollections of post-war Europe. “The ports in Europe and many in Asia had been destroyed or badly damaged; bridges had
been blown up; railway locomotives and rolling stock had vanished. Great cities such as Warsaw, Kiev, Tokyo and Berlin were piles
of rubble and ash. In Germany, it has been estimated, 70% of housing had gone and, in the Soviet Union, 1,700 towns and
70,000 villages. Factories and workshops were in ruins, fields, forests and vineyards ripped to pieces. Millions of acres in north
China were flooded after the Japanese destroyed the dykes. Many Europeans were surviving on less than 1,000 calories per day; in
the Netherlands they were eating tulip bulbs. Apart from the United States and allies such as Canada and Australia, who were
largely unscathed by the war's destruction, the European powers such as Britain and France had precious little to spare. Britain had
largely bankrupted itself fighting the war and France had been stripped bare by the Germans. They were struggling to look after
their own people and dealing with reincorporating their military into civilian society. The four horsemen of the apocalypse –
pestilence, war, famine and death – so familiar during the middle ages, appeared again in the modern world.”
Margaret MacMillan, professor of international history at the University of Oxford, September 2009
Vienna, 1945. “Vienna is a ghost town with all the famous landmarks gone. The Rathaus and Parliament were bombed by
retreating Germans, and the museums and stores are destroyed. Every house on Taborstrasse and Karmelitergasse was hit with
artillery shells, and the city is full of bombed-out German vehicles. The Reichsbruecke is the only bridge left standing. The people
of Vienna are skeletons, and are starving to death. The Russian Army has no provisions from home, so they live off the fat of the
land, and eat all the food and dairy products. They loot everything (jewelry, food, clothing) and then sell it on the black market.
The people think the Americans are coming, but they are wrong and will be disappointed since the Russians are staying.”
Excerpt from a letter my uncle wrote on August 4, 1945. He emigrated from Vienna to the US in 1938, and was then drafted into
the US army, fighting on the German front until the end of the war. In August 1945, he snuck into the Russian zone of Vienna to
retrieve the ashes of his father from a local cemetery, and wrote a letter home describing the experience.
22
22
Unlike the 1800’s, when the US monetary union was reinforced by shrinking regional economic
dispersions, some European dispersions rose with the inception of the Euro. This is the opposite of what
was supposed to happen. Another sign of reverse integration: German bank lending to the periphery
remains close to the lowest levels of the last decade.
Death in Venice German banks less willing to lend to periphery banks
Industrial Production Index, 12/31/1999 = 100 German outbound lending, US$ billion
$350
Economic cycles more
130 Germany
synchronous before the Euro $300
120 German bank lending to Spain
$250
110
$200
100 France
$150
90
80 $100 German bank lending to Italy

Euro exchange
Italy
rate fixed $50
70
1980 1985 1990 1995 2000 2005 2010 2015 2005 2007 2009 2011 2013 2015 2017
Source: Respective national statistical agencies. October 2018. Source: Bank for International Settlements. Q2 2018.
The Italian budget deal lowers probability of default, but recession risk goes up. Italy reached a
deal with Brussels, which eased investor concerns about near-term default risk. But since the deal was
EUROPE
based on a lower budget deficit that results from reduced infrastructure investment and corporate tax
hikes, Italy’s recession risk arguably goes up. Italy’s infrastructure quality ranks close to the bottom of
the OECD, above only Mexico and Poland; cutting it is the last thing Italy needs. A budget deal prevents
a near-term unraveling but does not argue for a lot of investor optimism.
Italy: the cost of protecting against default Foreign investors lose confidence in Italy, again
Italian 5 year CDS contract price (bps) Quarterly debt flows by non-Italian investors, annualized, EUR bn
650 300
ISDA 2014: Protects against events
550 of default and any redenomination 200
that reduces the value of the security
450 100
ISDA 2003: Protects against events
of default and redenomination into
350 non-G7 currencies 0
250 -100
150 -200
50 -300
2010 2011 2012 2013 2014 2015 2016 2017 2018 1996 1999 2002 2005 2008 2011 2014 2017
Source: Bloomberg. December 24, 2018. Source: Banca d'Italia. Q2 2018.
From a broader perspective, Merkel’s decision not to run for Chancellor again in 2021 and the strikes in
France (see next page) reduce the prospects of further fiscal integration or risk-pooling in the Eurozone,
which was the dream of the Euro’s creators, and in my view one of the required precedents to narrow
the valuation gap with the US.
23
23
Strikes in France might seem surprising since France did not suffer the huge unemployment spike seen
in Italy and Spain. Even so, the wealth gap between France and Germany is at its widest level in 50
years, and the collapse in French growth is something that hasn’t occurred since the 19th century, other
than during wartime. Macron’s shelved fuel tax hike was billed as climate-related, but with France
having among the lowest carbon footprints and highest gasoline prices in the developed world, that rung
hollow. The regressive fuel tax hike probably had more to do with France complying with Eurozone fiscal
targets, which is painful for the French, whose taxes are already the highest in Europe. Some attribute
strikes to greater activism of French workers (propensity to strike), but I think this goes deeper than that.
Franco-German wealth gap Remembrance of things past: low French growth

Germany real per capita GDP divided by France, ratio 6-year % change in real GDP; excluding world wars
1.40 40%
1. Franco Prussian War, tariffs
1.35 2. Phylloxera epidemic
3. Union Generale failure, Paris
1.30 30% Bourse crash
1.25 4. Radicals elected, factory strikes
5. Great Depression
1.20 20% 6. Euro crisis
1.15
1.10 10%
1.05
1.00
0%
0.95 2 3 4 6
0.90 1 5
1850 1865 1880 1895 1910 1925 1940 1955 1970 1985 2000 2015
-10%
1825 1845 1865 1885 1905 1925 1945 1965 1985 2005
EUROPE
Source: Angus Maddison, Conference Board, JPMAM. 2018. Source: Groningen University, Conference Board, JPMAM. 2018. Grey bars
indicate WW1 and WW2.
France CO2 emissions versus OECD France: taxed to the gauls

Tons of CO2 per $1,000 of GDP Total personal tax revenue to GDP
0.5
45%
AUS

FRA
40%
DNK
0.4
CZE
SWE
CAN
FIN
BEL

ITA
AUT
POL
35%
JOR

ARG
GRC
HUN
DEU
NLD
ISL
ISL
0.3
SVN
SVN
KOR

SVK
30%
NOR
MAR
LUX
FIN
MEX
POL
NLD
PRT
EST

ESP
CHL
CZE

TUR

ROU
GBR
USA

SVK
LUX
ISR

CAN
LVA
25%
LTU

ESP
LTU

GRC

JPN
PER
NZL
GBR

0.2

TUN
NOR

ISR
USA
CHE
COL

EGY

DEU
SWE
20%

HUN

NZL
TUR

KOR
BEL
AUT

PRT
LVA

ITA
IRL
BRA

DNK
0.1 15%

IRL
FRA

CHL
CRI

CHE
Country rank 10%
MEX
0.0 Country rank
0 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30 32 34 36 38 40 42 44 46 5%
0 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30 32 34
Source: EDGAR v4.3.2, European Commission, Netherlands Environmental
Assessment Agency. 2016. Includes OECD members and applicants. Source: OECD. 2017.
Gasoline prices per gallon Average days not worked due to strikes
160
NLD
DNK
ITA

ISR
$7 2000-2009 2010-2017
PRT
FIN
CHE

140

BEL

NOR
SVK
CZE

AUT

ISL
ESP
$6 120

GRC

POL

LUX
IRL
CHL

DEU

ROU

FRA

SWE

TUR
GBR
100
MAR

$5

NZL

EST
CRI
MEX

LVA

SVN

80
JOR
CAN

KOR

JPN

LTU

HUN
$4

60
BRA

USA
PER

ARG

AUS
$3 40

EGY
20
COL

$2
TUN
0
Country rank
Swi
Bel
Swe
Spa
Fin
Por
Aus
Pol
Ger
Mal
Fra
Avg
Ire
UK
Est
Lit
Nor
Den
Net
Hun
Lat
Slo
$1
0 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30 32 34 36 38 40 42 44 46
Source: Global Petrol Prices. December 10, 2018. Source: European Trade Services Institute. 2017.
24
24
A brief comment on Brexit
A
Mybrief comment
primary source onforBrexit
understanding Brexit is economist Malcolm Barr, who works for J.P. Morgan in
London and has spent more time on the issue than he could ever have imagined13. As of mid-
My primary source for understanding Brexit is economist Malcolm Barr, who works for J.P. Morgan in
December, a deal on the UK’s initial withdrawal has been reached with the EU. The deal seeks to create
London and has spent more time on the issue than he could ever have imagined13. As of mid-
the time and political space for the UK and EU to discuss what happens next while keeping much of
December, a deal on the UK’s initial withdrawal has been reached with the EU. The deal seeks to create
the status quo in place. Opposition to the deal in the House of Commons was sufficiently large for PM
the time and political space for the UK and EU to discuss what happens next while keeping much of
May to delay a vote on it at a late stage. Now that PM May has survived a confidence vote in her
the status quo in place. Opposition to the deal in the House of Commons was sufficiently large for PM
leadership among Conservative MPs, here’s what Malcolm believes may come next. Importantly, he
May to delay a vote on it at a late stage. Now that PM May has survived a confidence vote in her
does not assume a second referendum is the most likely outcome.
leadership among Conservative MPs, here’s what Malcolm believes may come next. Importantly, he
does
 The notagreement
assume awithsecondthe referendum is the
EU will still fail to most
pass inlikely outcome.
the House of Commons at the first attempt in
early January, since several Tory and Labour blocs believe that a better deal is possible; or because
 The agreement with the EU will still fail to pass in the House of Commons at the first attempt in
they prefer a shot at another referendum; or because they see Brexit as a means of bringing down
early January, since several Tory and Labour blocs believe that a better deal is possible; or because
the current government; or because of localized politics related to Northern Ireland and Scotland
they prefer a shot at another referendum; or because they see Brexit as a means of bringing down
 the
Another no-confidence
current government; vote in the ofCommons,
or because most likely
localized politics relatedprompted
to Northernby Ireland
Labour,and is likely at some
Scotland
point. PM May will likely survive that
 Another no-confidence vote in the Commons, most likely prompted by Labour, is likely at some
 point.
There is PMnoMay
better deal coming
will likely survive from
that the EU, and the path to another referendum is lengthy, divisive
and complex (requiring either an Article 50 extension or the UK to revoke its Article 50 notification)
 There is no better deal coming from the EU, and the path to another referendum is lengthy, divisive
 and
All ofcomplex
the above suggesteither
(requiring the current agreement
an Article will eventually
50 extension or the UK topass theitsHouse
revoke Articleof50Commons, once
notification)
various constituencies figure out that all other options are less palatable than what’s on the table
 All of the above suggest the current agreement will eventually pass the House of Commons, once
 various
After the deal passes,figure
PM May will all
likely step downare at less
some point inthan
2019, yielding power
table to a
EUROPE
constituencies out that other options palatable what’s on the
Conservative with stronger pro-Brexit attitudes as negotiations on the future begin. However, the
 After the deal passes, PM May will likely step down at some point in 2019, yielding power to a
withdrawal agreement that will already have been signed will influence those talks, and place
Conservative with stronger pro-Brexit attitudes as negotiations on the future begin. However, the
limits on the new PM’s approach. The “backstop” in the withdrawal agreement protects the peace in
withdrawal agreement that will already have been signed will influence those talks, and place
Ireland from a breakdown of those talks, and makes such a breakdown less likely
limits on the new PM’s approach. The “backstop” in the withdrawal agreement protects the peace in
 Ireland
Much has frombeen written about
a breakdown the talks,
of those agreement, but it’s
and makes such just a roadmapless
a breakdown forlikely
future discussions on all
issues on the table: the trading regime between UK and EU (including the Irish border), free
 Much has been written about the agreement, but it’s just a roadmap for future discussions on all
movement for EU citizens in the UK, jurisdiction of the European Court of Justice, the UK and the
issues on the table: the trading regime between UK and EU (including the Irish border), free
Common Agricultural Policy, etc. Few issues have been definitively resolved, so it’s still premature to
movement for EU citizens in the UK, jurisdiction of the European Court of Justice, the UK and the
judge Brexit’s ultimate impact on the UK. The “transition period” of status quo to allow discussion
Common Agricultural Policy, etc. Few issues have been definitively resolved, so it’s still premature to
most likely will be extended to 2022. There’s an outside chance of a Norway-type arrangement which
judge Brexit’s ultimate impact on the UK. The “transition period” of status quo to allow discussion
could last for years after 2022, and under which most things would remain as they are
most likely will be extended to 2022. There’s an outside chance of a Norway-type arrangement which
Thiscould
is an last for years after
abbreviated 2022,that
summary andcould
underhavewhich most
gone onthings wouldMany
for pages. remainof as
ourthey are have studied
clients
1,000 years of English history, its parliamentary democracy14 and its contribution to the Enlightenment.
This is an abbreviated summary that could have gone on for pages. Many of our clients have studied
I can’t tell yet if Brexit is going to represent a high or low water mark in that canon (Malcolm, on the
1,000 years of English history, its parliamentary democracy14 and its contribution to the Enlightenment.
other hand, has made up his mind already).
I can’t tell yet if Brexit is going to represent a high or low water mark in that canon (Malcolm, on the
other hand, has made up his mind already).
13
Clients with access to Morgan Markets can read any of Malcolm’s 87 Brexit pieces there.
14
13 The firstwith
Clients British parliament
access is often
to Morgan cited
Markets asread
can occurring
any ofinMalcolm’s
the year 1258 under
87 Brexit realm of Simon de Montfort,
the there.
pieces
who summoned together the knights, barons and burgesses of major towns. By the 14 th century, this had become
14
The first British parliament is often cited as occurring in the
the norm, and the gathering was referred to as the House of Commons. year 1258 under the realm of Simon de Montfort,
who summoned together the knights, barons and burgesses of major towns. By the 14 th century, this had become
the norm, and the gathering was referred to as the House of Commons. 25
25
25
While it’s tempting to dismiss all of this as politics without real consequences for investors,
we’re keeping an eye on risks of a “hard” Brexit, which would carry substantial risks for the UK
While it’s tempting to dismiss all of this as politics without real consequences for investors,
economy and investors in it. Here’s why: three sectors (production, distribution and financials) account
we’re keeping an eye on risks of a “hard” Brexit, which would carry substantial risks for the UK
for a large proportion of the UK economy’s tax payments, value added and employment. As per the
economy and investors in it. Here’s why: three sectors (production, distribution and financials) account
table, these sectors have large exposures to the EU, as measured by the extent to which they rely on
for a large proportion of the UK economy’s tax payments, value added and employment. As per the
foreign workers, imports from the EU and exports to the EU.
table, these sectors have large exposures to the EU, as measured by the extent to which they rely on
foreign workers,
Tracking UK exposureimports from Union
to the European the EU and exports to the EU.
Medical risks from a hard Brexit
Distribution/ Finance/ Medical experts believe May's plan to leave Euratom (EU
Tracking UK exposure to the European Union
Production transport insurance Medical risks from a hard Brexit
atomic energy agency) will disrupt inward flows of isotopes
Distribution/ Finance/ Medical
Contribution to UK economy used for experts believe May's plan to
cancer treatment/diagnosis, andleave Euratom (EU
put thousands of
Production transport insurance atomic
Corporate tax, % of total 14% 20% 18% patientsenergy
at riskagency) will disrupt
of delays. The UKinward
gov’t flows of isotopes
advised pharma
Contribution to UK economy used for cancer
companies treatment/diagnosis,
to stockpile and put just
certain medicines thousands of
in case.
Global Value Added, % of total 14% 18% 7%
Corporate tax, % of total 14% 20% 18% patients
However,atnuclear
risk ofmaterial
delays. used
The inUKcancer
gov’t treatment
advised pharma
rapidly
Employment, % of total 9% 26% 3% companies to stockpile
loses radioactivity certain be
and cannot medicines just in
stockpiled. case.
Euratom
Global Value Added, % of total 14% 18% 7%
UK Exposure to EU However,
oversees nuclear material
the smooth andused in cancer
safe treatment
movement rapidly
of nuclear
Employment, % of total 9% 26% 3% loses radioactivity
11% 14% 12% materials between and cannot
European be stockpiled.
states, and up to Euratom
80% of
Foreign workforce, % of total oversees
UK Exposure to EU radioactivetheisotopes
smoothusedandinsafe movementareof imported
UK hospitals nuclear
Imports to inputs ratio 51% 31% 26% materials between European
from the Netherlands, states,
France and and up to 80% of
Belgium.
Foreign workforce, % of total 11% 14% 12%
Exports as % of total demand 52% 21% 40% radioactive isotopes used in UK hospitals are imported
Imports to inputs ratio 51% 31% 26% Source: British Medical Association
from the Netherlands, France and Belgium.
EU share of total exports 51% 49% 37%
Exports as % of total demand 52% 21% 40% Source: British Medical Association
Source: Barclays Research. June 2018.
EU share of total exports 51% 49% 37%
Source: Barclays Research. June 2018.
So far, Brexit has exerted a modest drag on the UK15, whose growth has lagged the developed world by
EUROPE
1%. Much of the weakness results from slower business investment. The market appears to be pricing
So far, Brexit has exerted a modest drag on the UK15, whose growth has lagged the developed world by
in substantial no-deal Brexit risks. UK equities now trade at a large discount to Europe. If/when there’s
1%. Much of the weakness results from slower business investment. The market appears to be pricing
clarity that what lay ahead is a multi-year process of negotiation rather than a violent divorce, the UK
in substantial no-deal Brexit risks. UK equities now trade at a large discount to Europe. If/when there’s
could be one of the better relative equity performers of 2019.
clarity that what lay ahead is a multi-year process of negotiation rather than a violent divorce, the UK
could be one of
Real business theinvestment
fixed better relative equity performers of 2019.
UK: P/E discount vs Europe
% change versus level at Brexit MSCI UK P/E discount/premium based on fwd earnings
Real
15% business fixed investment UK:
25% P/E discount vs Europe
% change versus level at Brexit US MSCI UK P/E discount/premium based on fwd earnings
20%
15% 25% vs Eurozone
10% US
EU 15%
20%
10% 10% vs Eurozone
5% EU 15%
UK 5%
10%
5%
0% 0%
UK 5%
-5%
0% 0%
-5%
-10% vs Europe
-5%
-5% Brexit -15%
-10% -10% '06 vs Europe
'07 '08 '09 '10 '11 '12 '13 '14 '15 '16 '17 '18
2014 2015 2016 2017 2018
Brexit -15%
-10%
Source: J.P. Morgan Asset Management. Q3 2018. Source: Datastream, IBES, JPMAM. December 24, 2018.
'06 '07 '08 '09 '10 '11 '12 '13 '14 '15 '16 '17 '18
2014 2015 2016 2017 2018
Source: J.P. Morgan Asset Management. Q3 2018. Source: Datastream, IBES, JPMAM. December 24, 2018.
15
Brexit has contributed to misleading press reports, which might reflect the disposition of journalists to believe
whatever they hear about Brexit. A November 2018 report in the Financial Times referred to $1 trillion (!!!) in
15
UKBrexit hasoutflows
equity contributed misleading
sincetothe press
Brexit vote. reports,
After we sentwhich might
a note reflect
to the the disposition
FT pointing out theoferror,
journalists to believe
they revised the
whatever they down
outflow figure hear about
to $20Brexit. November 2018 report in the Financial Times referred to $1 trillion (!!!) in
billion.A Oops!
UK equity outflows since the Brexit vote. After we sent a note to the FT pointing out the error, they revised the
outflow figure down to $20 billion. Oops! 26
26
26
China and the Emerging Markets
China
China isand
now soEmerging
the large that Markets
we’re going to spend most of the Emerging Markets section discussing it. As
shown in the first chart, China’s weight in the EM equity index is now 30%, a figure we expect to rise as
China is now so large
more companies meet that
MSCIwe’re
Indexgoing to spend
eligibility tests.most
The of the Emerging
second Markets
chart is even moresection discussing
remarkable, it. As
and shows
shown in the first chart, China’s weight in the EM equity index is now 30%,
how other EM countries are becoming more and more tied to whatever happens in China.a figure we expect to rise as
more companies meet MSCI Index eligibility tests. The second chart is even more remarkable, and shows
how otherMarket
Emerging EM countries
equities:are becoming
China then andmore
now and more tied to whatever
EM countries happens
becoming moreintied
China.
to China
Weight in MSCI EM Index, % 10 year rolling correlation of GDP growth of 19 EM countries to China,
Emerging
35% Market equities: China then and now GDP-weighted
EM countries becoming more tied to China
Weight in MSCI EM Index, % 1070%
year rolling correlation of GDP growth of 19 EM countries to China,
30% China GDP-weighted
35% 60%
70%
25% China
30% 50%
60%
20% 40%
25%
50%
15% S. Korea 30%
20% LatAm 40%
10% Taiwan
15% India
S. Korea 20%
30%
LatAmAsia
Other
5% Taiwan 10%
10% India 20%
0% Other Asia 0%
5% 10%
1998 2003 2008 2013 2018 1989 1992 1995 1998 2001 2004 2007 2010 2013 2016
Source:
0% MSCI, Bloomberg. November 2018. Source:
0% International Monetary Fund, J.P. Morgan Asset Management. 2017.
1998 2003 2008 2013 2018 1989 1992 1995 1998 2001 2004 2007 2010 2013 2016
Source: MSCI, Bloomberg. November 2018. Source: International Monetary Fund, J.P. Morgan Asset Management. 2017.
Let’s start with our China monitor, which tracks 8 different variables. The 2017 recovery has begun to
roll over, given the transient nature of China stimulus measures16. Fiscal/monetary stimulus and the rise
Let’s start with
in corporate debtour China monitor,
is important which tracksChina:
in understanding 8 different
as pervariables. The 2017
the16IMF, China wouldrecovery
have grown has begun
by 5.5%to
roll over, given the transient nature of China stimulus measures . Fiscal/monetary
from 2012 to 2016 instead of by 7.25% if debt levels hadn’t increased. I’m not concerned about a stimulus and the rise
in corporate
balance debt is important
of payments in understanding
crisis, since China:
China’s external as per the
debt/GDP IMF, China
is among would in
the lowest have thegrown
world.by Lower
5.5%
trend growth is the bigger risk. In its analysis of China’s future, the Conference Board estimated in 2014a
from 2012 to 2016 instead of by 7.25% if debt levels hadn’t increased. I’m not concerned about
balance
that of payments
Chinese crisis, converge
growth would since China’s
to 4%external debt/GDPI is
by 2020-2025. among
think that the lowest
forecast in the
is still world. Lower
on track.
EMERGING
trend growth is the bigger risk. In its analysis of China’s future, the Conference Board estimated in 2014
MARKETS
that Chinese
China economygrowth would converge to 4% by 2020-2025.
monitor I think
Chinese thatgrowth
credit forecast is stillbut
slowing, on from
track.high debt level
% y/y change %
Legend: employment surveys, exports, business Chinese 220%
credit growth slowing, but from high debt level
China economy monitor 35%
conditions, GDP, corporate earnings, industrial % y/y change Total credit / GDP %
production, retail sales, non-state owned 30% 200%
220%
Legend: employment surveys, exports, business 35%
enterprise fixed asset investment
conditions, GDP, corporate earnings, industrial Total credit / GDP
production, retail sales, non-state owned 25% 180%
200%
30%
enterprise fixed asset investment
20% 160%
180%
25%
15%
20% 140%
160%
10%
15% 120%
140%
Credit growth
5%
10% 100%
120%
2011 2012 2013 2014 2015 2016 2017 2018 '03 '05 '07 '09 '11 '13Credit
'15growth
'17
Source: CFLP, Markit, CC, PBOC, CNBS, MSCI, JPMAM. Nov 2018. 5%
Source: PBOC, MOF, CCDC, JPM Economic Research. Oct 2018. 100%
2011 2012 2013 2014 2015 2016 2017 2018 '03 '05 '07 '09 '11 '13 '15 '17
Source: CFLP, Markit, CC, PBOC, CNBS, MSCI, JPMAM. Nov 2018. Source: PBOC, MOF, CCDC, JPM Economic Research. Oct 2018.
16
Chinese car sales are also slowing, and were down 15% y/y in November; the series is too volatile for the chart.
November
16
retail sales and industrial production grew at their slowest pace in a decade.
Chinese car sales are also slowing, and were down 15% y/y in November; the series is too volatile for the chart.
27
November retail sales and industrial production grew at their slowest pace in a decade. 27
27
Tariff risks and semiconductor warfare. China’s reliance on exports has been declining, and it
imports plenty of semiconductor equipment from Japan and other countries. However, this masks
Tariff risks
important and semiconductor
realities warfare.
about China’s reliance on theChina’s
US. reliance
The US on exports
export ban on has ZTE
been declining,shut
effectively andthe
it
imports plenty of semiconductor equipment from Japan and other countries. However,
company down, since most of ZTE’s critical networking chips and optical component chips are sourced this masks
important realities about
from US companies, and China’s
there arereliance on the US.
no substitutes TheofUS
outside theexport
US forban on ZTE effectively
Broadcom’s networkingshut the
chips,
company down, since most of ZTE’s critical networking chips and optical component chips
Inphi’s optical chips or Intel’s microprocessors. As for Huawei, its core semiconductor suppliers include are sourced
from Qualcomm,
Intel, US companies, and and thereand
Micron, aresoftware
no substitutes outside
companies of theand
Microsoft US Oracle.
for Broadcom’s networking chips,
Inphi’s optical chips or Intel’s microprocessors. As for Huawei, its core semiconductor suppliers include
17
Here’sQualcomm,
Intel, an assessmentand of the USand
Micron, multi-year
softwarelead in advanced
companies semiconductors
Microsoft and Oracle.:
US semi companies
Here’s an assessment of the Est. market share
US multi-year Product
lead in advanced semiconductors17:
Intel, AMD 99% Microprocessor chips for PCs/servers
US semiAMD
NVIDIA, companies Est. market share
95% Product processors for artificial intelligence, deep learning
Graphics
Intel, AMD
Broadcom 99%
95% Microprocessor
Networking chips
chips for PCs/servers
for cloud datacenters
NVIDIA, AMD
Qualcomm, Intel 95%
70% Graphics processors
Smartphone cellular for artificialchips
processing intelligence, deep learning
for 4G/5G
Broadcom
Texas Inst, Analog, Maxim 95%
90% Networking
Electric chips
vehicle for cloud
power datacenters
management chips
Qualcomm,
Intel, NVIDIAIntel 70%
90% Smartphone cellular
Next generation fullyprocessing
autonomous chips
carfor 4G/5G
processors
Texas Inst, Analog, Maxim 90% Electric vehicle power management chips
China has been the big equity
Intel, NVIDIA 90% market loser in the
Nexttrade war so
generation far;
fully its P/E multiples
autonomous are close to the
car processors
lowest levels in a decade. The tariff issue is starting to bite as some companies front-loaded investments
China
in 2018has been sets
(which the the
big stage
equityfor
market
weakerloser in the in
demand trade warand/or
2019), so far;began
its P/Etomultiples are close out
move production to the
of
lowest levels in a decade. The tariff issue is starting to bite as some companies front-loaded
China to other countries. Large Chinese and US exporters are both trading with P/E multiples of ~10x. investments
in 2018 (which sets the stage for weaker demand in 2019), and/or began to move production out of
China
China'stodecreasing
other countries.
relianceLarge Chinese and US exportersChina
on exports are both trading with
semiconductor P/E multiples of ~10x.
imports
Exports as a % of GDP US$ billions
China's
36% decreasing reliance on exports China
$2.5 semiconductor imports
Exports as a % of GDP US$ billions Chips
36% $2.5
$2.0
32% Equipment
Chips
32% $2.0
$1.5
28% Equipment
EMERGING
28% $1.5
MARKETS
24% $1.0
KoreaKorea
Singapore
Taiwan
24%
20% $1.0
$0.5
JapanJapan
SouthSouth
USA USA
Singapore
Taiwan
20%
16% $0.5
$0.0
2000 2003 2006 2009 2012 2015 2018
16%
Source: China National Bureau of Statistics, China Customs. Q3 2018. Source: International Trade Centre. 2017.
$0.0
2000 2003 2006 2009 2012 2015 2018
Source: China National Bureau of Statistics, China Customs. Q3 2018. Source: International Trade Centre. 2017.
China is the big equity market loser from the tariff war Chinese equity market valuations
Performance vs respective local market, Index, Jan 1, 2018 = 100 12-month forward P/E
China is the big equity market loser from the tariff war
110 Chinese
30x equity market valuations
Performance vs respective local market, Index, Jan 1, 2018 = 100
105 12-month forward P/E
110
100 30x
25x
105
95
100
90 25x
20x
95
85
90
80 Onshore
EUR stocks w/ US exposure 20x
15x
85
75 JPN stocks w/ US exposure
80
70 US stocks Onshore
EUR stocksw/w/Int'l
USexposure
exposure 15x
10x
75
65 US
JPNstocks
stocksw/w/EUR exposure
US exposure
70
60 US
US stocks
stocks w/
w/ China exposure
Int'l exposure Offshore
China
US stocks
stocks w/ w/
EUR USexposure
exposure 10x
5x
65
55
Jan-18 US stocks w/ China
Mar-18 May-18exposure
Jul-18 Sep-18 Nov-18 '05 '06 '07 '08 '09Offshore
'10 '11 '12 '13 '14 '15 '16 '17 '18
60
China stocks w/ US exposure 5x
Source: Bloomberg. December 24, 2018.
55
Source: Bloomberg, Goldman Sachs. December 24, 2018.
Jan-18 Mar-18 May-18 Jul-18 Sep-18 Nov-18 '05 '06 '07 '08 '09 '10 '11 '12 '13 '14 '15 '16 '17 '18
Source: Bloomberg, Goldman Sachs. December 24, 2018. Source: Bloomberg. December 24, 2018.
17
Harlan Sur, Head of J.P. Morgan's US Semiconductor and Semiconductor Capital Equipment team.
17 28
28Harlan Sur, Head of J.P. Morgan's US Semiconductor and Semiconductor Capital Equipment team.
28
The risk of a large decline in the Chinese RMB
We address
The risk of anextlargesteps in theintrade
decline war on page
the Chinese RMB 31. If it escalates, China could respond with an RMB
decline to restore competitiveness. To date, China has spent reserves to prevent the RMB from falling
We address(ironically,
too much next stepstheinopposite
the tradeintervention
war on page 31.what
from If it China
escalates, China
did for manycould respond
years). But with an were
if there RMB
decline to restore competitiveness. To date, China has spent reserves to prevent the
ever a time China could risk a large RMB decline, it might be now: capital outflows are stable in spite of RMB from falling
too
the much (ironically,
FX decline the due
(perhaps opposite interventionsurveillance);
to government from what Chinaits FX did for many
reserves have years). But if there
fallen slightly belowwerethe
ever a time China could risk a large RMB
18 decline, it might be now: capital outflows
IMF’s estimate of adequate reserves ; and China’s current account surplus has evaporated , highlighting are stable
19 in spite of
the FX decline
its need (perhaps
for a more due to currency.
competitive government surveillance);
With its interest its
rateFXdifferential
reserves have fallen
vs the slightlyabelow
US falling, declinethein
IMF’s estimate of adequate reserves 18
; and
the RMB would be the natural state of affairs anyway. China’s current account surplus has evaporated 19
, highlighting
its need for a more competitive currency. With its interest rate differential vs the US falling, a decline in
HowRMB
the large a decline?
would Something
be the natural statelike 10%-15%
of affairs could offset the competitiveness loss from US tariffs.
anyway.
Given the high economic correlation of other EM countries shown earlier, this kind of move could be very
How large a for
destabilizing decline? Something
countries like 10%-15%
whose corporate could offset
sector borrows the competitiveness
extensively in hard currency.loss from US tariffs.
Given the high economic correlation of other EM countries shown earlier, this kind of move could be very
destabilizing for countries whose corporate sector borrows
The RMB sold off as the trade war progressed
extensively
China in hard currency.
capital flows
USDCNY exchange rate, inverted Change in FX reserves less current account balance, US$ billions
The
6.2 RMB sold off as the trade war progressed China
$200 capital flows
USDCNY exchange rate, inverted Change inNet
FX capital
reserves less current account balance, US$ billions
inflows
6.3 $200
6.2 $100
6.4 Net capital inflows
6.3
6.5 $100
$0
6.4
6.6
6.5 $0
-$100
6.7
6.6 Trump
6.8 CNY announces -$100
-$200
6.7
weaker $50bn Trump
tariffs
6.9 Net capital outflows
6.8 CNY on China
announces -$200
7.0 weaker -$300
6.92016 2017 $50bn
2018 tariffs '98 Net
'00capital
'02 outflows
'04 '06 '08 '10 '12 '14 '16 '18
on China -$300
Source: Bloomberg. December 24, 2018.
7.0 Source: People's Bank of China, IMF, China SAFE. Q3 2018.
2016 2017 2018 '98 '00 '02 '04 '06 '08 '10 '12 '14 '16 '18
EMERGING
MARKETS
China Bloomberg.
Source: current account
Decemberbalance
24, 2018. Source: People's
Shrinking netBank of China,
interest IMF, China
carry SAFE.China
between Q3 2018.
and US
% of GDP Spread between 12 month SHIBOR and LIBOR, %
China
12% current account balance Shrinking
5% net interest carry between China and US
Surplus
% of GDP
10% Spread between 12 month SHIBOR and LIBOR, %
12% 5%
4%
Surplus
8%
10%
4%
3%
6%
8%
4% 3%
2%
6%
2%
4% 2%
1%
0%
2%
Deficit 1%
0%
-2%
0% 2015 2016 2017 2018
'98 '00 '02 '04 '06 '08 '10 '12 '14 '16 '18
Deficit 0%
-2%
Source: People's Bank of China, IMF, China SAFE. Q3 2018. Source: Bloomberg. December 24, 2018.
'98 '00 '02 '04 '06 '08 '10 '12 '14 '16 '18 2015 2016 2017 2018
Source: People's Bank of China, IMF, China SAFE. Q3 2018. Source: Bloomberg. December 24, 2018.
18
See “Foreign capital has been propping up China’s currency: here’s what happens when it leaves”, Ben Steil,
Council
18
on Foreign Relations, November 9, 2018.
19 See “Foreign capital has been propping up China’s currency: here’s what happens when it leaves”, Ben Steil,
China’s balanced trade account might seem like a surprise given its large goods surplus with the US. However,
Council on Foreign Relations, November 9, 2018.
China runs a large services deficit with the world, and large overall deficits with Taiwan, Korea, Australia and Brazil.
19
China’s balanced trade account might seem like a surprise given its large goods surplus with the US. However,
29
China runs a large services deficit with the world, and large overall deficits with Taiwan, Korea, Australia and Brazil. 29
29
There’s potential upside for Chinese and global markets if there’s a comprehensive trade deal.
Chinese profits were improving in early 2018, but once tariff issues kicked in, profits rolled over and led
There’s potential upside for Chinese and global markets if there’s a comprehensive trade deal.
to a decline in Chinese equities. This decline has been worsened by Chinese CEOs borrowing heavily
Chinese profits were improving in early 2018, but once tariff issues kicked in, profits rolled over and led
against their own stock, either to obtain liquidity for their companies, or to make personal investments.
to a decline in Chinese equities. This decline has been worsened by Chinese CEOs borrowing heavily
As the Chinese equity market declined, margin calls on Chinese CEOs exacerbated the selloff.
against their own stock, either to obtain liquidity for their companies, or to make personal investments.
As theonshore
China Chineseprofits
equitygrowth
market declined, margin calls on Chinese CEOs
Margin calls onexacerbated theexacerbate
Chinese CEOs selloff. market decline
EBIT growth, % y/y, 3q moving avg % y/y change # of firms
China
75%
onshore profits growth Margin
30% calls on Chinese CEOs exacerbate market decline
EBIT growth, % y/y, 3q moving avg % y/y change 400
Firms where CEO pledged 80%+ # of firms
20%
30% of their stock, and where stock
75% Private
50% Firmsprices
whereare
CEOdown 40%+80%+
pledged 400
10%
20% 300
of their stock, and where stock
Private prices are down 40%+
50% 0%
10% 300
25% 200
-10%
0% Shenzhen
25% Total Composite Index 200
-20%
-10%
0% Shenzhen 100
-30% Composite Index
0% State-owned Total -20%
100
-25% -40%
-30% 0
3Q08 3Q09 3Q10 3Q11 3Q12State-owned
3Q13 3Q14 3Q15 3Q16 3Q17 3Q18 Jan-17 Apr-17 Jul-17 Oct-17 Jan-18 Apr-18 Jul-18 Oct-18
-25%
Source: Bloomberg, J.P. Morgan China Economic Research. Q3 2018. -40%
Source: Bloomberg, Gavekal Dragonomics. November 5, 2018. 0
3Q08 3Q09 3Q10 3Q11 3Q12 3Q13 3Q14 3Q15 3Q16 3Q17 3Q18 Jan-17 Apr-17 Jul-17 Oct-17 Jan-18 Apr-18 Jul-18 Oct-18
Source: Bloomberg, J.P. Morgan China Economic Research. Q3 2018. Source: Bloomberg, Gavekal Dragonomics. November 5, 2018.
J.P. Morgan Economic Research outlined how tariffs and an FX decline could affect its 2019 China profits
growth outlook. The result: Chinese profits growth of 10% instead of 15%20.
J.P. Morgan Economic Research outlined how tariffs and an FX decline could affect its 2019 China profits
growth
Earningsoutlook.
revisionsThe result: Chinese profits growth of 10% instead
China 2019of 15%20.outlook
earnings
# of positive revisions less negative revisions as % of total companies % y/y change
Earnings
20% revisions China
20%
2019 earnings outlook
# of positive revisions less negative revisions as % of total companies % y/y change
China Offshore 18%
10%
20% 20%
16%
China Offshore 18%
14%
EMERGING
0%
10%
MARKETS
16%
12%
-10% 14%
10%
0%
12%
8%
-20%
-10% Asia ex- 10%
6%
Japan 8%
4%
-30%
-20% Asia ex- 6%
2%
Japan
-40% 4%
0%
-30%
'10 '11 '12 '13 '14 '15 '16 '17 '18 2% Consensus Tax cut CNY Trade GDP Adjusted
-40% 0% depreciation growth
Source:
'10IBES,'11
JPMAM.
'12December
'13 2018.
'14 Series
'15are 3m
'16moving
'17averages.
'18 Source:Consensus
J.P. Morgan Tax
Economic
cut Research.
CNY November
Trade 16, GDP
2018. Adjusted
depreciation growth
Source: IBES, JPMAM. December 2018. Series are 3m moving averages. Source: J.P. Morgan Economic Research. November 16, 2018.
20
China Earnings Outlook, J.P. Morgan Asia Pacific Equity Research, Haibin Zhu, November 16, 2018.
20 30
30China Earnings Outlook, J.P. Morgan Asia Pacific Equity Research, Haibin Zhu, November 16, 2018.
30
Where to from here on tariffs?

Takeaways from the USMCA trade agreement with Mexico and Canada:
 Tariffs are being used as a means of exacting concessions rather than as a desired final step
 USMCA is still a rules-based agreement, which maintains the core of the international trading system
 The US opted for a multi-lateral agreement instead of several bilateral agreements
 Net economic impacts of USMCA vs NAFTA are very modest
That said, there are issues to be negotiated with China that were not sticking points with Mexico and Canada.
The National Security Council and US trade reps may not have the final say, but they may be against a
comprehensive deal absent Chinese concessions on IP transfer for economic and military purposes. The US
and China have until February to build a framework to address trade-related matters, or Round 2 tariffs of
25% may come back into play. More US indictments of Chinese nationals for espionage in December
highlight the importance of this issue to the Trump administration.
What the US is asking for:
 Increased market access through reduced tariffs in “non-critical” sectors (services and agricultural goods)
and fewer restrictions and ownership requirements on inbound foreign direct investment
 Greater oversight and enforcement of cyber intrusions targeting US intellectual property and businesses
 Elimination of market-distorting industrial subsidies covered by the Made in China 2025 plan
China’s concessions so far:
 China has agreed to buy more US agricultural, industrial, and energy goods, and will temporarily reduce
its tariff on US autos from 40% to 15%
 Enforcement of IP theft in specific instances, with punishments including restricted access to government
financial support and bans on issuing corporate bonds
 Banned exports of the opioid drug fentanyl, and fewer restrictions on foreign investment in banking/autos
EMERGING
MARKETS
 Reconsideration of Qualcomm-NXP merger that China regulators rejected (this may be of little significance
since Qualcomm already paid a breakup fee and will likely not pursue the deal)
At the session we had with Henry Kissinger last October
in Berlin, he described the impasse as one in which both Expectations declining faster than current conditions,
countries have more to gain by making a deal. But Henry which could reverse with a comprehensive deal
56 68
also reminded us that our session took place on the 100th Current global
anniversary of the end of WWI, the ultimate example of output survey
54 66
unintended consequences taking a turn for the worse.
We might end up with a mixed result: a deal with China 52 64
under which Round 2 tariff increases to 25% do not take
place, but the beginning of a tariff conflict with Europe 50 62
and Japan regarding $300 bn of US auto/auto parts
imports. We should know more by March. 48 Future global 60
output survey
The chart shows how global business sentiment has fallen 46 58
faster than current activity. This gives us some sense 2012 2013 2014 2015 2016 2017 2018
of the potential upside if a deal is reached. If there’s Source: J.P. Morgan Economic Research. November 2018.
no deal and more tariffs are put in place, costs would be
shared by Chinese and European producers accepting lower margins and by US consumers who would see
higher prices, and tempered in China by tax cuts and lower rates. Even so, markets would probably assume
the worst, shoot first and ask questions later.
31
31
If you’re looking for a contrarian deep-value position for 2019, Emerging Markets seem more
interesting than Europe. European and EM earnings have had the same trajectory since 2014, but
Europe trades at a 15-20% P/E premium to EM. There are more deep value stocks in EM as denoted by
the third chart on valuation spreads between the cheapest stocks and the regional average. Lastly, the
EM share of global mutual fund and ETF holdings is close to the lowest level in a decade, suggesting that
EM is even more unloved than Europe. If the EM currency index stabilizes after its 40% decline since
2012, that would help; but again, on that front, all roads lead back to China.
Europe vs Emerging Markets: 12-month forward earnings Europe: P/E premium vs the Emerging Markets
Index, January 1, 2015 = 100 Stoxx 600 P/E discount/premium vs MSCI EM based on fwd earnings
115 40%
110
Stoxx 600 30%
105
100 20%
95
10%
90
85 MSCI Emerging 0%
Markets
80
-10%
75
70 -20%
Jan-15 Jul-15 Jan-16 Jul-16 Jan-17 Jul-17 Jan-18 Jul-18 '06 '07 '08 '09 '10 '11 '12 '13 '14 '15 '16 '17 '18
Source: Datastream, IBES, JPMAM. December 24, 2018. Source: Datastream, IBES, JPMAM. December 24, 2018.
Europe and Emerging Markets valuation spreads EM countries no longer worried about too much FX
Deviations of top quintile from long-term average appreciation, EM currency index, Dec 31, 2009 = 100
3 120
Wide
disparities
Emerging 110
EMERGING
2
MARKETS
Markets
100
1
90
0
80
-1
Narrow 70
Europe
disparities
-2 60
'00 '02 '04 '06 '08 '10 '12 '14 '16 '18 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018
Source: Empirical Research Partners. 2018. Source: Bloomberg. December 24, 2018.
32
32
Japan
Japanese corporate profits are booming, and have kept pace with the US. Capital spending on fixed
assets and corporate plans to invest in software have been rising steadily, and at a much faster pace than
before Abenomics began. One problem: profits aren’t helping workers/consumers. Japanese real
household incomes fell for many years despite rising corporate profits, and are still stagnant.
Both the US and Japan had a profits rebound... ...but household incomes only rose in the US
Earnings per share, trailing 12-months (both axes) Real HH earnings index (both axes), Japan is 3-mo. avg.
¥80 101
$155 126
¥70 100
$140 122 US
99
¥60
$125 118 98
S&P 500 ¥50
97
$110 114
¥40 96
$95 110 Japan 95
MSCI Japan ¥30
$80 106 94
¥20
93
$65 ¥10 102
92
$50 ¥0 98 91
2007 2009 2011 2013 2015 2017 2007 2009 2011 2013 2015 2017
Source: IBES, Datastream. November 2018. Source: BLS, BEA, Japanese Ministry of Health, Labour, & Welfare. Nov 2018.
Japan capital investments Japan software investments

y/y % change y/y % change
20% 12%
8%
10%
4%
0%
0%
-10%
-4%
-20%
-8%
Abenomics begins Abenomics begins
-30% -12%
JAPAN
'06 '07 '08 '09 '10 '11 '12 '13 '14 '15 '16 '17 '18 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12 '13 '14 '15 '16 '17 '18
Source: Japan Ministry of Finance. Q3 2018. Source: Bank of Japan. Q3 2018.
33
33
More evidence of dormant consumers: inflation is still below the Central Bank’s target, and the
deflationary mindset among Japanese consumers has been difficult to break. Spending intentions have
only improved to neutral from their depths 2 years ago. Furthermore, Japan remains exposed to a trade
war that results in a decline in the Chinese RMB (see page 29).
Japan CPI ex food, alcoholic beverages and energy Japanese consumers spending plans
y/y % change Net % of respondents planning to spend more on service
3% 10%
Japan VAT hike
Hundreds
2% April 2014 0%
-10%
1%
-20%
0%
Entertainment tickets
-30%
Housekeeping
-1% Eating out
-40%
Amusement parks
Self-enlightenment
-2% -50%
2005 2007 2009 2011 2013 2015 2017 1991 1995 1999 2003 2007 2011 2015
Source: Ministry of Internal Affairs and Communication. October 2018. Source: Cabinet Office of Japan. Q3 2018.
In 2018, international investors didn’t care much about the good earnings news and pulled
money out of Japan anyway, at a pace rivaling 2008 and 2016. Since Abenomics began, the P/E
ratio of Japanese stocks flirted with 15x on several occasions, only to fall back again. For international
investors looking for value, Japanese equities could be interesting, but probably only if a global recovery
takes root in 2019. And if that happens, emerging markets would probably benefit more than Japan.
Non-resident net purchases of Japanese equities Japan P/Es at low end of range
Rolling 6 months, Yen trillions Price to forward 12 months earnings
¥10 25x
¥8
¥6
¥4 20x
¥2
¥0
-¥2 15x
JAPAN
-¥4
-¥6 Abenomics
begins Abenomics begins
-¥8 10x
2005 2007 2009 2011 2013 2015 2017 2005 2007 2009 2011 2013 2015 2017
Source: Japan Ministry of Finance. November 2018. Source: Bloomberg. December 24, 2018.
34
34
10 years later: observations on the financial crisis
Anyone trying to understand the financial crisis should start with the banks, but not end there. The crisis
resulted from a complex set of interactions involving banks, broker-dealers, investors, insurance
companies, rating agencies, the Federal Reserve, politicians and policymakers. Remove any 2 or 3 of
these protagonists, and the crisis would have been much smaller and less damaging. I wrote this section
by drawing on pieces I wrote in the aftermath of the crisis. I find them useful when people oversimplify
what happened, a trend which continues ten years later.
To be clear, banks in the US and Europe made many terrible underwriting decisions. As shown on the
left, deposits in failed US banks in 2008/2009 exceeded the Great Depression when measured vs GDP.
And as shown on the right, hundreds of billions of dollars in emergency borrowing facilities had to be
made available by the Federal Reserve so that the crisis wouldn’t get even worse than it was. Plenty of
financial sector regulation followed, much of which was sorely needed to restore solvency and
confidence. But in terms of what led to all of this, well, that’s a more complicated story.
Deposits in failed and assisted US banks Emergency facilities created by the Federal Reserve during
% of GDP the Financial Crisis
10% Great Great Peak Outstanding
Savings & Loan Crisis
Depression Recession Balance ($ bn)
8% Term Auction Facility $493
Commercial Paper Funding Facility $348
6%
Term Securities Lending Facility $236
4% Asset-Backed Commercial Paper Money Market
$152
Mutual Fund Liquidity Facility
2% Primary Dealer Credit Facility $147
Term Repurchase Transactions $80
0%
AIG Revolving Credit Facility $72
1983
1990
1930
1931
1932
1933
1982
1984
1985
1986
1987
1988
1989
1991
1992
2007
2008
2009
Term Asset-Backed Securities Loan Facility $48

Source: FDIC, BEA, JPMAM. January 2016. Source: Levy Economics Institute, Bard College. 2011.
On the following pages, I review topics from the Eye on the Market archives that are worth remembering
as part of the bigger picture:
 The role of policymakers in the housing crisis: the hijacking of GSE balance sheets
 Broker-dealers and deregulation
 Underwriting decisions by rating agencies, bond reinsurers and institutional investors
 Individual bank and broker-dealer contributions to systemic risk
Y E A R S L AT E R
GFC: TEN
I conclude with 2 pages on the aftermath: substantial and welcome changes in capital requirements,
liquidity, leverage and shadow banking.
35
35
The role of policymakers in the housing crisis: the hijacking of GSE balance sheets
I wrote an in-depth piece about this entitled “Course of Empire”. The short version: for decades,
Fannie Mae and Freddie Mac (the GSEs) purchased loans originated by banks as long as they conformed
to accepted conservative loan to value and debt to income standards. That’s where things stood in
1990, with 10% or less of GSE loan purchases underwritten at “subprime” risk levels.
In 1993, a law was passed allowing Housing and Urban Development to set low and moderate lending
targets for GSEs. The target started at 30% and rose to 50% by 2001. The goal: raise home ownership
levels. In the wake of the bill, Fannie Mae issued a press release citing its commitment to transforming
housing finance, vowing to provide $1 trillion in lending and citing a goal of eliminating the “no” in the
mortgage application process. They succeeded, but at the cost of polluting their balance sheet with low
quality loans (red lines in chart). The GSE share of the mortgage market rose from 35% to 60%, and
mortgage origination volumes ballooned by a factor of 2.5x. Alan Greenspan and a few members of
Congress tried to curtail some of this, but for the most part, “experts” thought it was a great idea. Case
in point: in 2002, Nobel Laureate Joseph Stiglitz and future OMB Director Peter Orszag cited the
probability of a shock to GSE balance sheets as “substantially less than one in 500,000”, and estimated
the cost to the government of guaranteeing $1 trillion of mortgages at $2 million. That is not a misprint.
The important point: all of this preceded the rise in subprime and Alt A origination by the private sector.
There are remarkable quotes from HUD in 2000 on how a deliberate blurring of the lines by the GSEs
on the difference between conventional and subprime lending could redefine what conventional means;
and how they expected GSEs to lead the market with the private sector following. They were
right…banks and brokers eventually found a way to compete: by originating their own low quality loans,
and selling them to the public in securitized products. To be clear, private sector defaults and losses per
dollar of subprime were higher than on GSE loans; but there are many reasons to wonder how bad the
former would have ever been had the latter not preceded them.
Radical transformation of GSE balance sheets following 1993 HUD lending guideline change
preceded private sector subprime/Alt A expansion
Percent of annual underwriting (except Fannie/Freddie share based on total outstanding balances)
60%
FHA LTV >=97%
55%
50% Fannie/Freddie share of total
mortgage market
45% 1
2
40%
35% GSE Low & Moderate
3
Income lending target
30%
Y E A R S L AT E R
Freddie Mac/Fannie Mae

4
GFC: TEN
25% underwriting that exceeded

5 traditional standards*
20% 1. Non-traditional Freddie Mac
15% 2. Freddie cash out CLTV > 75%
3. Fannie/Freddie DTI > 38%
10% 4. Fannie purchase loan CLTV > 90%
Private sector subprime and 5. Fannie/Freddie DTI >= 42%
5%
Alt A % of total origination
0%
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
Source: American Enterprise Institute. J.P. Morgan Asset Management. November 2013. * The measures shown reflect underwriting at what was
known to be effectively subprime level lending at the time. DTI = Debt to Income. CLTV = Combined Loan to Value.
36
36
Broker-dealers and deregulation
Broker-dealers
For and deregulation
all the talk about changing bank regulations, changing broker-dealer regulations may have played an
even more prominent role in the scale of the crisis. As shown below, the 5 large US broker-dealers saw
For all the talk about changing bank regulations, changing broker-dealer regulations may have played an
enormous balance sheet growth after 2003 when the Uniform Net Capital Rule was changed. One
even more prominent role in the scale of the crisis. As shown below, the 5 large US broker-dealers saw
example: Lehman's $690 billion balance sheet in 2007 was larger than all assets (in real terms) of banks
enormous balance sheet growth after 2003 when the Uniform Net Capital Rule was changed. One
that failed during the Great Depression. To finance its balance sheet, Lehman held just $22 billion in
example: Lehman's $690 billion balance sheet in 2007 was larger than all assets (in real terms) of banks
equity, and its largest single source of financing was short-term repurchase agreements, some with
that failed during the Great Depression. To finance its balance sheet, Lehman held just $22 billion in
maturities as short as 24 hours. To understand how leveraged Lehman’s balance sheet had become, in
equity, and its largest single source of financing was short-term repurchase agreements, some with
early 2009 we replicated its 2004-2008 stock price closely by comparing it to a highly leveraged portfolio
maturities as short as 24 hours. To understand how leveraged Lehman’s balance sheet had become, in
of high yield bonds, high grade bonds and equities, a relationship that did not exist before the SEC
early 2009 we replicated its 2004-2008 stock price closely by comparing it to a highly leveraged portfolio
Uniform Net Capital Rule change.
of high yield bonds, high grade bonds and equities, a relationship that did not exist before the SEC
Uniform
Growth inNet Capital
assets andRule change.
major financial sector legislation Lehman's evolution into a leveraged, risky portfolio
Index, 12/31/1992 = 100 accelerated after SEC rule repeal, Index, 1994=100
Growth
1,000 in assets and major financial sector legislation Lehman's evolution into a leveraged, risky portfolio
2500
Index, $4.2 Trillion accelerated
End ofafter SEC rule
Netrepeal,
Capital Index,
Rule 1994=100
900 12/31/1992 = 100 Broker-dealers SEC Uniform
1,000 5 institutions
800 2500
SEC Uniform NetBroker-dealers $4.2 Trillion
2000 End of SEC Uniform Net Capital Rule
900
700 5 institutions
800 Capital Rule Change
600 2000
SEC Uniform Net 1500 Portfolio of stocks, high yield and
700
500 Capital Rule Change high grade bonds leveraged at 85%
600 Gramm-Leach-
400 $10 Trillion 1500
1000 Portfolio of stocks, high yield and
500
Bliley Act
300 Gramm-Leach- 513 institutions high grade bonds leveraged at 85%
400 $10 Trillion 1000
200 Bliley Act 500
300 Commercial banks 513 institutions
100
200 >$1billion in assets Lehman stock price
0 500
0
Commercial banks
100
Dec-92 Dec-95 Dec-98 Dec-01 Dec-04 Dec-07 '94 '97 '00
>$1billion in assets Lehman stock'03price '06
0 FDIC, Bloomberg. 2007.
Source: 0
Source: JPMAM. 2018.
Dec-92 Dec-95 Dec-98 Dec-01 Dec-04 Dec-07 '94 '97 '00 '03 '06
To reinforce
Source: the point,
FDIC, Bloomberg. 2007. here are some observations fromSource: Eric Rosengren
JPMAM. 2018. at the Federal Reserve Bank of
Boston on broker-dealer stability made in 2014 in a retrospective on the financial crisis21:
To reinforce the point, here are some observations from Eric Rosengren at the Federal Reserve Bank of
Boston
The onmost dramatic runsstability
broker-dealer of the financial
made incrisis
2014 affected broker-dealers
in a retrospective on the financial crisis21:
 Lehman’s collapse was
The most dramatic runsnot an isolated
of the financialfailure of a single
crisis affected broker-dealer. Bear Stearns failed earlier that
broker-dealers
year, Merrill experienced significant funding difficulties and was eventually acquired, and both
 Lehman’s collapse was not an isolated failure of a single broker-dealer. Bear Stearns failed earlier that
Goldman and Morgan Stanley had to become bank holding companies. Foreign broker-dealers
year, Merrill experienced significant funding difficulties and was eventually acquired, and both
operating in the US experienced substantial losses that required significant rebuilding of capital
Goldman and Morgan Stanley had to become bank holding companies. Foreign broker-dealers
 Broker-dealers
operating in thefund holdings in substantial
US experienced uninsured short-term credit markets,
losses that required which
significant makes of
rebuilding them inherently
capital
more subject to runs than institutions that finance holdings with longer-term or insured borrowing.
 Broker-dealers fund holdings in uninsured short-term credit markets, which makes them inherently
When investors lose confidence in broker-dealers, short-term funding “runs” from them, and broker-
more subject to runs than institutions that finance holdings with longer-term or insured borrowing.
dealers lose their ability to effectively serve as middlemen
When investors lose confidence in broker-dealers, short-term funding “runs” from them, and broker-
 While
dealerscapital ratios
lose their andtoliquidity
ability areserve
effectively higher and holdings of risky assets are lower, broker-dealer
as middlemen
Y E A R S L AT E R
reliance on wholesale funding remains elevated
GFC: TEN
 While capital ratios and liquidity are higher and holdings of risky assets are lower, broker-dealer
o See chart
reliance on pagefunding
on wholesale 42 showing
remainsrepo usage by broker-dealers, which has declined from 70% of
elevated
liabilities in 2008 to 50%
o See chart on page 42 showing repo usage by broker-dealers, which has declined from 70% of
liabilities in 2008 to 50%
21
“Broker-Dealer Finance and Financial Stability”, Eric Rosengren, President & Chief Executive Officer, Federal
Reserve Bank of Boston, August 2014.
21
“Broker-Dealer Finance and Financial Stability”, Eric Rosengren, President & Chief Executive Officer, Federal
Reserve Bank of Boston, August 2014. 37 37
37
Underwriting decisions by rating agencies, bond reinsurers and institutional investors

There was actually a point in 2007 when the level of subordination below AAA investors in securitized
commercial real estate loan transactions fell to 5%. In other words, a property writedown of just 5%
on the pool could expose AAA investors to losses. These subordination levels were approved by
rating agencies who ascribed ratings to them, and readily accepted by investors who bought them. The
CMBS example is one in a sea of structured credit, which culminated in a $5.5 trillion peak in late 2007.
Another contributing factor: the decision by monoline insurers to “diversify” by providing guarantees to
structured credit as well to municipal bonds. Municipals declined from 90% of insured annual risk to just
40% within a decade; this decline was remarkable, and added more fuel on the fire. From what I recall,
rating agencies voiced concerns about “undiversified” monoline insurers, which prompted many of them
to expand away from municipals by insuring untested and poorly underwritten structured credit.
This kind of euphoria could never have taken place without the involvement of banks and broker-dealers
originating these loans, but also required rating agencies approving of their design, bond
reinsurers willing to insure them and institutional investors willing to buy them. It’s also not a
coincidence that a surge in structured credit started in 2004, the last time the Federal Reserve cut rates to
1% and left them there, arguably, for too long.
Property decline cushion for AAA CMBS Investors US asset-backed securities

AAA CMBS subordination adjusted for rating agency LTVs Total amount outstanding, US$ billions
40% Non-agency residential mortgage backed securities
$6,000 Non-agency commercial mortgage backed securities
35%
Collateralized debt obligations
$5,000 Student loans
30%
Equipment
25% $4,000 Credit card
20% Automobile
$3,000 Other
15%
$2,000
10%
5% $1,000
0% $0
2001 2003 2005 2007 2010 2012 2014 2016 2018 '90 '92 '94 '96 '98 '00 '02 '04 '06 '08 '10 '12 '14 '16
Source: J.P. Morgan, Trepp, Rating agencies, Bloomberg. 2018. Source: SIFMA. 2017.
Monolines become multi-lines Structured credit market accelerated in 2004, in the

Municipals as a % of annual industry net par insured risk wake of a 1% Fed Funds rate
90% 9% 40%
8%
80% Universe: AMBAC, MBIA, American General, 7% Fed Funds rate 30%
CIFG, FGIC, FSA, SCA, ACA and Radian
Y E A R S L AT E R
70% 6%
GFC: TEN
5%
60% 20%
4%
50% 3%
2% 10%
40% Structured
1% credit to GDP
30% 0% 0%
1991 1993 1995 1997 1999 2001 2003 2005 '90 '92 '94 '96 '98 '00 '02 '04 '06 '08
Source: “Monolines and Mortgage Insurers: Implications from the
Subprime Crisis,” November 2007, UBS Securities. Source: SIFMA, Bloomberg, J.P. Morgan Asset Management. 2018.
38
38
Individual bank and broker-dealer contributions to systemic risk
Contribution to systemic
Individual bank risk varied bycontributions
and broker-dealer firm, and is worth remembering
to systemic risk as part of the historical record.
The chart below shows three things:
Contribution to systemic risk varied by firm, and is worth remembering as part of the historical record.
 The
The chartchange
belowin balance
shows sheet
three leverage heading into the crisis (x axis)
things:
 Writedowns
The change inasbalance
a percentage of book value
sheet leverage after
heading thethe
into crisis (y axis)
crisis (x axis)
 How much management
Writedowns paidofitself
as a percentage book and its employees
value heading
after the crisis into the whole mess (bubble size)
(y axis)
Firms at the
How much lower left with smaller
management bubbles
paid itself and itsreduced leverage
employees headingheading intowhole
into the the crisis,
messgenerated a lower
(bubble size)
rate of writedowns as the crisis unfolded, and shared more of their net income with shareholders rather
Firms at the
than with lower left with smaller bubbles reduced leverage heading into the crisis, generated a lower
management.
rate of writedowns as the crisis unfolded, and shared more of their net income with shareholders rather
Changing leverage, pre-crisis compensation and post-
than with management.
 There’s
Notes chart: debate on the losses Goldman could have experienced had it not been bailed out
on thelingering
of its AIG exposure at 100 cents on the dollar by the Federal Reserve. As noted in a 2015 review of
 the
There’s lingering
entire debate
episode, (a) AIG the losses Goldman
oncounterparties were notcould have experienced
required had it not
to take any haircut been exposures,
on their bailed out
of its AIG exposure at 100 cents on the dollar by the Federal Reserve. As noted in a 2015
(b) the NY Fed initially refused to disclose the counterparties’ identities, and (c) Goldman received reviewthe
of
the entire episode, (a) AIG counterparties were not required to take any
largest share of AIG bailout funds directly attributable to specific counterpartieshaircut
22 on their exposures,
(b) the NY Fed initially refused to disclose the counterparties’ identities, and (c) Goldman received the
Y E A R S L AT E R
 Losses
largest at Bear
share ofStearns
AIG bailout Lehman
and funds are understated
directly since
attributable to their counterparties
specific losses only reflect
22 what was realized
GFC: TEN
through 2008, when they were either acquired or liquidated
 Losses at Bear Stearns and Lehman are understated since their losses only reflect what was realized
 European
through 2008,bank losses
when theyoccurred in two
were either waves,orone
acquired from 2007 to 2010, and another from 2011 to
liquidated
2015; the chart only captures the first wave
 European bank losses occurred in two waves, one from 2007 to 2010, and another from 2011 to
2015; the chart only captures the first wave
22
See “Afterword to the AIG Bailout”, University of Arizona James Rogers School of Law, William Sjostrom, March
2015,
22
and “Securities Lending and the Untold Story in the Collapse of AIG”, Hester Peirce, George Mason
See “Afterword
University, to the AIG Bailout”, University of Arizona James Rogers School of Law, William Sjostrom, March
May 2014.
2015, and “Securities Lending and the Untold Story in the Collapse of AIG”, Hester Peirce, George Mason
University, May 2014. 39
39
39
Here’s another look at firm-specific contribution to systemic risk: collateral postings by firm to
the emergency Primary Dealer Credit Facility. This Federal Reserve lending facility extended $9
trillion in collateralized loans to banks and broker-dealers in 2008 and 2009. The amounts pledged and
their relative collateral risk varied substantially by firm. The PDCF was closed on February 1, 2010, and all
loans extended were repaid in full with interest. Even so, the chart is another way to understand each
firm’s respective contribution to systemic risk at the time.
We break down the Primary Dealer Credit Facility balances below since it was the largest of all the rescue
facilities at $9 trillion in cumulative balances, and also entailed the greatest degree of systemic risk given
collateral postings of equities, unrated securities and junk bonds. For a more complete picture of
government lending and guarantees provided to each firm across all facilities, see accompanying table.
Primary Dealer Credit Facility cumulative collateral postings by firm Total facility usage by firm
$, bn % of tot
Merrill Citigroup 2,830 14.0%
Citigroup Merrill Lynch 2,449 12.1%
Morgan Stanley Morgan Stanley 2,305 11.4%
Bear Stearns AIG 1,047 5.2%
Bank of America 1,129 5.6%
Bank of America
Goldman Sachs 1,033 5.1%
Goldman
Barclays 1,030 5.1%
Barclays BNP Paribas 1,002 5.0%
Lehman Bear Stearns 976 4.8%
Countrywide Credit Suisse 773 3.8%
BNP Paribas Deutsche Bank 711 3.5%
Royal Bk Scotland 628 3.1%
Mizuho
JP Morgan Chase 499 2.5%
UBS
UBS 426 2.1%
Cantor Fitz All others 3,323 16.5%
JP Morgan
Credit Suisse Facilities included:
Daiwa Agency Mortgage Backed Securities Program
Collateral type posted
AIG Revolving Credit and Borrowing Facilities
Dresdner Investment grade Non-investment grade Unrated/Loans Equities
Asset Backed Commercial Paper Facility
Deutsche
Bear Stearns Bridge Loan
$0.0 $0.5 $1.0 $1.5 $2.0 $2.5 Commercial Paper Funding Facility
Trillions of dollars Maiden Lane I, II and III
Source: Federal Reserve, JPMAM. 2018. Primary Dealer Credit Facility
Single Tranche Open Market Operation
Temporary Liquidity Guarantee Program
Term Asset Backed Securities Loan Facility
Y E A R S L AT E R
Term Auction Facility

GFC: TEN
Term Securities Lending Facility
Source: Bard College, FDIC, JPMAM. 2018.
40
40
Aftermath: substantial improvements in capital, liquidity and shadow banking

In the wake of the financial crisis, there have been substantial regulatory changes which reduce systemic
risk. We illustrate some of the more important ones below: the increase in risk-weighted capital ratios,
increased availability of liquid assets relative to short term liabilities, the decline in loan-to-deposit ratios,
and changes in the money market fund industry (which drove assets into government funds and away
from prime funds).
Rising capital ratios since crisis Improving liquidity ratios since crisis
Risk-weighted capital ratio Liquid assets as % of short term liabilities
18% 50%
2007 2017 2007 2017
16%
14% 45%
12%
10%
40%
8%
6%
4% 35%
2%
0% 30%
US Europe US Europe
Source: Federal Reserve Bank of New York, Bloomberg. 2017. Source: FDIC, Goldman Sachs, JP Morgan. 2017.
Bank loan-to-deposit ratios A shift to lower risk money market funds

150% US$ trillions, assets under management*
Hundreds
2.5
140% Lehman Crash Money Market Reform
Eurozone banks
130% 2.0
120% Government
1.5
110%
100% 1.0
90% Prime
0.5
US banks
80%
0.0
70%
'02 '04 '06 '08 '10 '12 '14 '16 '18
'95 '97 '99 '01 '03 '05 '07 '09 '11 '13 '15 '17
Source: Fed, ECB. 2017. Source: JPMAM. Feb 7, 2018. *Includes both institutional and retail funds.
Y E A R S L AT E R
GFC: TEN
41
41
The next two charts illustrate how US banks finance themselves: with more customer deposits, and less
reliance on interbank loans and repo. The overall repo market has declined from $4.2 trillion to $2.2
trillion since 2008. Most of this decline resulted from broker-dealers shrinking their balance sheets; repo
as a % of broker-dealer liabilities has declined as well but still represents ~50% of the total, down from
70% before the crisis. While 50% is still a high number, mitigating factors could include higher quality
assets being financed, and longer term repos used to finance less liquid assets.
Repo usage by financial intermediary
US commercial banks: deposits and interbank loans Repos as % of total respective liabilities
% of assets (both axes)
80%
6% 80% Broker-Dealer
Deposits 70%
5% 75% 60%
4% 50%
70%
40%
3% Foreign banks in US
65% 30%
2% Interbank
loans 20%
1% 60%
10%
0% US banks
0% 55%
'90 '95 '00 '05 '10 '15 '70 '75 '80 '85 '90 '95 '00 '05 '10 '15
Source: Federal Reserve. October 2018. Source: Fed Flow of Funds, Haver. Q3 2018.
Securities lending against cash collateral by institutional

Shadow banking’s share of liabilities has now investors, US$ trillions
$1.4
declined back to where it was in the year 2000. Retirement and pension plans
$1.2 Mutual funds
The decline in securities lending activity by
Insurance
institutional investors (see chart, right) partially $1.0
Other
explains why. What remains of institutional $0.8
securities lending is typically structured with $0.6
higher quality investments than in 2008. The end
$0.4
result is a gradually rising share of financial
intermediation by commercial banks, and less by $0.2
broker-dealers and other non-banks. $0.0
'07 '08 '09 '10 '11 '12 '13 '14 '15
Source: Foley-Fisher et al.“Securities Lending as Wholesale Funding:
Evidence from the U.S. Life Insurance Industry”. FEDS. 2016.
US: shadow banking and traditional banking

Commercial Bank share of intermediation
Liabilities as % of GDP
Percent
120%
100%
Y E A R S L AT E R
GFC: TEN
100% 90%
Commercial Banking
80% 80%
70%
60%
Shadow Banking 60%
40%
50%
20%
Bank Holding Co's 40%
0% and Broker Dealers 30%
'60 '65 '70 '75 '80 '85 '90 '95 '00 '05 '10 '15 '60 '65 '70 '75 '80 '85 '90 '95 '00 '05 '10 '15
Source: "Money, Banking, and Financial Markets", Cecchetti & Schoenholtz, Source: "Money, Banking, and Financial Markets", Cecchetti & Schoenholtz,
2017, JPMAM. 2017, JPMAM.
Stephen Cecchetti (Brandeis) and Kermit Schoenholtz (NYU) are the source for the bottom two charts, which
come from their excellent “Money, Banking and Financial Markets” website at www.moneyandbanking.com.
42
42
IMPORTANT INFORMATION
Purpose of This Material: This material is for information purposes only. The views, opinions, estimates and strategies expressed herein constitutes Michael
Cembalest’s judgment based on current market conditions and are subject to change without notice, and may differ from those expressed by other areas
of J.P. Morgan. This information in no way constitutes J.P. Morgan Research and should not be treated as such.
Non-Reliance: We believe the information contained in this material to be reliable and have sought to take reasonable care in its preparation; however, we
do not represent or warrant its accuracy, reliability or completeness, or accept any liability for any loss or damage (whether direct or indirect) arising out of
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Eye On The Market Outlook 2019

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Eye on the Market Outlook 2019

J.P. MORGAN PRIVATE BANK

Cover art by Gary Bullock.

J.P. Morgan Asset & Wealth Management

The Decline of Western Centralization, Part II January 1, 2019

8.5% Labor shortages -3 Wages

The real fed funds rate

What will the Decline of Western Centralization look like?

$15 $3.0 European Central Bank

5% Eurozone policy rate

Why does the Decline of Western Centralization matter so much?

Global business surveys Global earnings revisions

World still expanding, but fewer countries above trend

Survey > trend

in many years, according to the data below.

Current level 14.3 12.0 10.3 534 182

30% 2150 2900

Jackson Hoover JFK Nixon Reagan Bush

Notes continued on following page…

Homeowners' equity above pre-crisis levels Household debt

$15 130% 13.0%

Signs of a healthy US labor market Sharp upward revision in US savings rate

Voluntary quit rate 1.8% 10%

Job openings rate: construction

4.0% levels in 20 years, and that’s before the possible

On US credit market risks

80 $100 German bank lending to Italy

Franco-German wealth gap Remembrance of things past: low French growth

France CO2 emissions versus OECD France: taxed to the gauls

Country rank 10%

Where to from here on tariffs?

Japan capital investments Japan software investments

10 years later: observations on the financial crisis

Term Asset-Backed Securities Loan Facility $48

Freddie Mac/Fannie Mae

25% underwriting that exceeded

Underwriting decisions by rating agencies, bond reinsurers and institutional investors

Property decline cushion for AAA CMBS Investors US asset-backed securities

Monolines become multi-lines Structured credit market accelerated in 2004, in the

Term Auction Facility

Term Securities Lending Facility

Source: Bard College, FDIC, JPMAM. 2018.

Aftermath: substantial improvements in capital, liquidity and shadow banking

Bank loan-to-deposit ratios A shift to lower risk money market funds

Securities lending against cash collateral by institutional

US: shadow banking and traditional banking

© 2019 JPMorgan Chase & Co. All rights reserved. PB-18-TL-2398

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